What Is Intertemporal Choice?
Intertemporal choice is an economic term describing how an individual's current decisions affect what options become available in the future. Theoretically, by not consuming today, consumption levels could increase significantly in the future, and vice versa.
- Intertemporal choice refers to decisions, such as spending habits, made in the near-term that can affect future financial opportunities.
- Theoretically, by not consuming today, consumption levels could increase significantly in the future, and vice versa.
- A preference for focusing on current consumption leads many individuals to make intertemporal choices that accommodate near-term needs and wants.
Understanding Intertemporal Choice
Many of the choices we make have consequences for the future. For instance, deciding how much money to spend in the present and how much to squirrel away can greatly impact our quality of life both now and in the years ahead.
For firms, various investment decisions involve intertemporal choice. For individuals, on the other hand, decisions made in the near-term that can affect future financial opportunities relate mostly to saving and retirement. An individual who saves today consumes less, causing his or her current utility to decline. Over time, the savings grow, increasing the number of goods the individual can consume and, therefore, the person's future utility.
Most individuals tend to be limited by budget constraints that prevent them from consuming to the extent of their desires. Nevertheless, behavioral finance theorists generally find that present bias is common, suggesting that people prefer to spend now, regardless of the impact it might have in later years.
This preference for focusing on current consumption leads many individuals to make intertemporal choices that accommodate near-term needs and wants over long-term objectives.
Example of Intertemporal Choice
If an individual makes an exorbitant purchase, such as paying for an around-the-world vacation that exceeds his or her usual budget and requires additional financing to cover, this could have a substantial impact on the person’s long-term wealth. The individual might take out a personal loan, max out credit cards, or, when possible, even withdraw funds from retirement accounts in order to cover the expense.
Making such a choice would reduce the assets the individual has available to continue to save for retirement. The person may have to fund supplemental forms of income to augment his or her salary to compensate for the decline in assets.
This could be further exacerbated if unforeseen events affect current income. A sudden loss of employment, for example, would make it difficult to recoup recent expenses and set aside funds for retirement. If the consumer made a sizable purchase and then was laid off, his or her intertemporal choices combined with those external factors, stand to change his or her future opportunities.
Perhaps the individual planned to retire by a certain age or was on track to finish paying off a mortgage. The shortfall in assets could mean postponing retirement or taking out a second mortgage to help deal with the more immediate issues.
Other Types of Intertemporal Choice
Decisions on employment can also factor into intertemporal choices. A professional might be presented with two job opportunities with salaries that vary depending on the intensity and demands of the role.
One position may be high-stress with long hours required. The compensation might also be higher than what is standard for such a position.
As an intertemporal choice, taking such a job might allow for more options on later pension plans. Conversely, taking the job that offers a lower salary, but a better work-life balance may mean having fewer retirement options with less funding available.