Intertemporal Choice

Intertemporal choice is the study of the relative value people assign to two or more payoffs at different points in time. Most choices require decision-makers to trade-off costs and benefits at different points in time. These decisions may be about savings, work effort, education, nutrition, exercise, health care and so forth. For nearly 80 years, economists have analyzed intertemporal decisions using the discounted utility (DU) model, which assumes that people evaluate the pleasures and pains resulting from a decision in much the same way that financial markets evaluate losses and gains, exponentially ‘discounting’ the value of outcomes according to how delayed they are in time. DU has been used to describe how people actually make intertemporal choices and it has been used as a tool for public policy. Policy decisions about how much to spend on research and development, health and education all depend on the discount rate used to analyze the decision.

The Keynesian consumption function was based on two major hypothesis. Firstly, marginal propensity to consume lies between 0 and 1. Secondly, average propensity to consume falls as income rises. The early empirical studies were consistent with these hypothesis. However, after the World War II it was observed that savings did not rise as incomes rose. The Keynesian model therefore, failed to explain the consumption phenomenon and thus emerged the theory of Intertemporal Choice. Intertemporal choice was introduced by John Rae in 1834 in the "Sociological Theory of Capital".Later, Eugen von Böhm-Bawerk in 1889 and Irving Fisher in 1930 elaborated on the model. A few other models based on intertemporal choice include the Life Cycle Income Hypothesis proposed by Modigiliani and the Permanent Income Hypothesis proposed by Friedman. The concept of Walrasian Equilibrium maybe also be extended to incorporate intertemporal choice. The Walrasian analysis of such an equilibrium introduces two "new" concepts of prices: futures prices and spot prices.