This refers to a person's preference for current as oppose to future consumption. Suppose we asked an individual the following question: if you were to give me 1 pound today, in exchange for a promise to pay you a sum of money in one year's time, what would that sum of money have to be to compensate you for the loss of the current consumption?
WE STIPULATE that the sum of money is certain to be paid, and that there is no inflation. We mean by the word 'compensate' that we wish to leave the individual feeling Just as well off as if he hadn't given up the £1 - no more and no less. Then, his answer will tell us the degree of his time preference. If, for example, our individual replied: 'One pound and twenty five pence', then he is showing a preference for current as opposed to future consumption: Pound now is worth more than Pound one in the future, and in fact it is worth 25 per cent more, since he requires Pound 0.25 more than the amount he is giving up to leave him feeling just as well off.
On the other hand, if he had answered 'Pound 1', then he clearly is indifferent between consuming now or in the future, since he feels he feels equally well off by consuming Pound 1 in the future as Pound 1 now. Finally, if he had said ?seventy-five pence?, then he is showing a preference for future as opposed to current consumption, sine Pound 0.75 worth of consumption in one year's time is worth to him as much as Pound1 of consumption now.
We can make this idea more precise by defining the 'rate of time preference', which is a kind of subjective rate of interest. Let us make two numbers in our time preference experiment, namely the Pound 1 given up now, and the sum required to be paid in compensation. Taking the ratio of the latter to the former in each example given above, we can write:Pound 1.25/Pound 1 = (1+ 0.25)Pound 1/Pound 1= 1Pound 0.75/Pound 1 = (1 ? 0.25)We now define in these three examples the consumer's rate of time. preference as the number, in the form of an interest rate, wlo.hu expresses the individual's relative evaluation of future and current consumption, In the first case, the individual required to be pall 25 per cent more than he gave up to compensate him for postponing consumption. In the second case, nothing extra had to be paid. In the third case, 25 per cent less had to be paid.
Thus, 25 per cent 0 and -25 per cent are the rates of time preference in the respective cases. Clearly, the larger the value of this subjective interest rate, the more highly is current consumption valued relative to future consumption. An individual's rate of time preference will depend to a large extent on his tastes and personality, which in turn could depend, inter cilia, on his age and social situation. In addition, it will depend on the total amount of income he currently has, and the amount he expects in the future. One might expect, for example, an individual who expected his income to double in the near future to have a high rate of time preference - a pound's worth of consumption now is more valuable to him than it will be later; conversely, if he expects a falling income, then he will tend to have a low or even negative rate of time preference - consumption later will have a high value relative to consumption now.
Generally, we can say that the higher is current relative to future income; the lower will be the rate of time preference, while the lower is current relative to future income, and the higher will be the rate of time preference. Note also that although, in the example used above, a time period of one year was chosen, a rate of time preference can be defined for any time period. The concept of time preference plays an important part in the theories of capital, of saving, and hence of the rate of interest. The nature of its role can be suggested by the following propositions: an individual will postpone consumption and lend on the capital market as long as the rate of interest exceeds his rate of time preference. If his rate of time preference increases as the quantity lent increases, then his total saving is determined by equality between the rate of interest and his rate of time preference. If firms invest up to the point at which the rate of return on investment is equal to the rate of interest, then, in equilibrium, the rate of time preference will equal the rate of return on investment.