The Implications of Hyperbolic Discounting for Project Evaluation

Abstract

The neoclassical theory of project evaluation (Arrow and Kurz, 1970) is based on models in which agents discount the future at a constant exponential rate. There is, however, strong empirical evidence that people discount the future hyperbolically, applying larger annual discount rates to nearterm returns than to returns in the distant future (Ainslie, 1992; Cropper, Portney and Aydede, 1994). In this paper we trace out the implications of hyperbolic preferences for private investment choices and public policy. The immediate problem posed by hyperbolic discounting is that it leads to time-inconsistent plans: A person who discounts the future hyperbolically will not carry out the consumption plans he makes today. From today’s perspective the discount rate between two distant periods, t and t+1, is a long-term low discount rate. But, when period t arrives, the individual will apply a short term high discount rate to consumption in period t+1. Because it makes sense to discuss investment decisions only along consumption paths that will actually be carried out, one must begin by characterizing timeconsistent plans for a consumer with hyperbolic preferences. This can be done by allowing the consumer’s different temporal selves to play a game and to analyze the equilibrium of this game. In the case of a finite-lived consumer with quasi-hyperbolic preferences, the game has a unique

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