Time Preference as a Dynamic Market Failure

Time Preference Meets the Standard Definition of a Market Failure

A market failure occurs when there are unexploited gains from trade, making a Pareto improvement possible, meaning someone can be made better off without making anyone else worse off. Economists typically focus on market failures that manifest in the “static” present. For example, information asymmetries occur when one party in a transaction has more or better information than the other, leading to suboptimal trades.

However, real-world economic activity unfolds over time, not just within a single moment. We save, invest, borrow, and plan for the future, sometimes decades ahead. We also recognize that future generations, though they have no say in today’s decisions, will nonetheless be affected by them. This recognition gives rise to the idea of dynamic market failures: gains from trade exist not just between parties alive today, but also between present and future people. In this essay, I focus on the universal trait of time preference and explain how it can be viewed as a source of dynamic market failure.

Time Preference and the Interest Rate

Economics defines time preference as the rate at which individuals favor present consumption over future consumption. In a well-functioning capital market, individuals choose how much to consume versus save based on their own time preferences and the available returns on investment. We tend to assume that individual rationality automatically balances how much people want to invest with the opportunities for investment. Yet this framework implicitly focuses on the current generation, what is “optimal” for the people making those saving and consumption decisions right now.

Dynamic Market Failures Consider Future Generations

Now imagine we introduce future generations into the picture. They do not exist yet, so they cannot make explicit contracts with us nor can they vote in our elections. But if they could, they might be very interested in striking a deal with today’s people. Many of today’s decisions—whether about saving, investing in infrastructure or research and development, or protecting the environment—will have lasting impacts on the lives of future generations.

From the perspective of these future people, time preference is problematic because it leads to insufficient investment in projects that would benefit them. People alive today have their own preferences, motivated by self-interest and often preferring immediate consumption (like a vacation, a new car, or a bigger house) over a distant future return. Unborn generations would likely want us to save and invest more and partake in conspicuous consumption less. If they could, they would pay us to save more, promising large rewards if we sacrifice some consumption today.

Time preference meets the standard definition of a market failure because, like any market failure, it is a friction that results in unexploited gains from trade. A Pareto improvement is possible if future people could compensate current people for saving and investing more. The current generation would be better off because they would receive a payment now in excess of what they give up, and future generations would be better off because they reap the benefits of more capital, better technology, and a wealthier world in the future. As it stands, that “trade” is largely off the table. Future people who are not yet born cannot show up in today’s financial markets to hand you a check. There is a missing market.

Potential Pareto Improvements and Savings Rates

Even if future generations cannot explicitly compensate today’s citizens, there is still the opportunity for a “potential Pareto improvement.” These occur when the gains from a reallocation exceed the losses, such that in theory those who benefit from the change could compensate those who lose, making everyone at least as well off as before. A potential Pareto improvement occurs even if compensation does not.

Consider a scenario in which society dramatically increases its saving rate. Over time, these savings would lead to greater capital accumulation and higher levels of output and income. If the gains to future generations outweigh the cost to today’s people, then there is a potential Pareto improvement. In theory the people in the future could compensate people today since their gains exceed today’s losses.

Being self-interested, the current generation has little incentive to address the inefficiency on its own, since sacrificing some consumption only stands to benefit people in the future. Hence, we should not expect people today to make the necessary adjustment under laissez faire conditions. The present generation’s consumption imposes an externality on future generations by lowering growth.

Mispricing of Financial Assets

There are several implications that follow from time preference being a market failure. One implication is that if the government or some other institution with effectively zero-time preference could invest on behalf of future generations, there would appear to be “dollar bills lying on the sidewalk.” That’s because most current market participants use positive discount rates in their calculations. They will misprice financial assets from a zero-time preference perspective.

An entity with zero-time preference, meanwhile, would be willing to invest in longer-term projects and projects whose returns appear low relative to the alternative of consuming instead. So long as the eventual payout is reliable in real, risk-adjusted terms, many socially worthwhile projects will not be embarked upon by rational, self-interested individuals, simply by virtue of positive time preference.

This issue implies that market rates of return on financial assets, long-term bonds, and capital goods generally are artificially high from the perspective of the zero-discount-rate agent. That agent sees underpriced assets virtually everywhere.

Thus, if a government or any other entity with negligible time preference would buy assets at these discounted prices, it could enjoy large, long-run payoffs that the rest of the market is neglecting. Time preference leads to a general mispricing of assets, opening the door to countless, relatively easy to exploit, potential Pareto improvements.

The Shadow Price of Capital is Infinity

Another way of framing this point is that if someone had truly zero-time preference, the “shadow price of capital” (a term for the price that would emerge on capital assets in a perfect market) would be infinitely high. This may sound impractical from the standpoint of conducting cost-benefit analysis, but this result has a rather simple intuition.

Society should find it profitable to shift resources toward investment and away from consumption until the return on invested resources is driven down to effectively zero. Only when there are no more profitable investment opportunities (after factoring in risk, uncertainty, and other practical constraints) should society allow resources to flow into consumption beyond a mere subsistence level.

At some point, it no longer makes sense to invest because society reaches a point whereby it can reduce investment and consume more in every period, because it has overinvested in capital. In economic growth theory, this situation is known as “dynamic inefficiency.” It would be more precise to say dynamic inefficiency occurs when society both overinvests or underinvests in capital, but the standard parlance in economics is that dynamic inefficiency relates to overinvestment.

Once dynamic efficiency is achieved, maximizing “static” efficiency among current consumers becomes the top priority, so long as no growth is sacrificed to achieve it. But until we have reached this optimal rate of growth, it is socially suboptimal from a zero-discount-rate perspective to prioritize static efficiency at the expense of dynamic efficiency because the shadow price of capital is infinite.

Policy Implications

If we interpret time preference as a new kind of market failure, this leads to some provocative conclusions. Here are a few potential actions a government tasked with correcting such problems might take.

1. Buy and hold underpriced assets on behalf of future generations. This could be done, for example, by setting up a sovereign wealth fund. These often have explicit mandates to preserve and grow wealth on behalf of future generations.

2. Invest heavily in infrastructure, research, and education. One way to do this might be for the government to patent innovations it finances or to take direct equity stakes in companies that benefit from government-supported research.

3. Tax consumption. Taxes on consumption discourage inefficient consumer spending and incentivize greater saving and investment.

4. Eliminate policies that encourage present consumption. This includes regulations, spending, taxes and other initiatives that incentivize or directly engage in short-term gratification at the expense of long-term investment and growth.

Of course, these policies come with substantial real-world complications, such as political economy constraints, uncertainty, and the difficulty of perfectly representing the desires of “future generations.” Still, as a general course of action, this list’s recommendations are a pretty good place to start.

Conclusion

Time preference is usually treated as a given fact of human nature, which it undoubtedly is. But it can also be viewed as a source of market failure. If future people could participate in today’s markets, they would likely pay people to think more long-term. From that perspective, there are unexploited gains from trade across time, indicating that current saving and investment levels are inefficient.

This idea has numerous implications, from the general mispricing of financial assets to the notion that an entity with zero-time preference could capitalize on these opportunities. Ultimately, viewing time preference as a market failure challenges us to think more carefully about how decisions we make today affect those who come after us, and whether we can design institutions that better take advantage of these unexploited long-term gains.