Microfoundations of Discounting

• Published in: arXiv.org
• Main Authors: Adamou, Alexander T I, Berman, Yonatan, Mavroyiannis, Diomides P, Peters, Ole B
• Format: Paper Journal Article
• Language: English
• Published: Ithaca Cornell University Library, arXiv.org 08.01.2020
• Subjects: Axioms; Decision making; Discounts; Exponential functions; Quantitative Finance - Economics
• ISSN: 2331-8422
• DOI: 10.48550/arxiv.1910.02137

An important question in economics is how people choose between different payments in the future. The classical normative model predicts that a decision maker discounts a later payment relative to an earlier one by an exponential function of the time between them. Descriptive models use non-exponential functions to fit observed behavioral phenomena, such as preference reversal. Here we propose a model of discounting, consistent with standard axioms of choice, in which decision makers maximize the growth rate of their wealth. Four specifications of the model produce four forms of discounting -- no discounting, exponential, hyperbolic, and a hybrid of exponential and hyperbolic -- two of which predict preference reversal. Our model requires no assumption of behavioral bias or payment risk.