The Economics of Time Up till now, weve considered economic exchange where parties give and get here

and now and immediately consume what they get. (Or, if consumption is not immediate, they are certain about the value of what they have obtained, so understand the benefit either from consuming it later or the value of reselling it.) Once time, both a present and a future, gets fully brought into the story things become more complex in a way that is interesting to account for. We have already touched on these issues in discussing the concept of an experience good, where the quality of the good in question is revealed only via consumption that happens over time subsequent to purchase. That, however, is only one piece of the story. Even if the quality of a good or service is immediate upon consumption, a party cant be sure what it is getting if receipt of the item (or receipt of complementary services) is deferred. Indeed, a party may get nothing now other than a promise that it will get something in the future. One then needs to ask how to value that promise. Will the promise necessarily be fulfilled or might it be broken? Once having posed these questions, it becomes apparent that the value of current exchanges will depend crucially on what parties believe about how the future will unfold. One of the areas where economics provides real insight into human behavior lies in this linking between beliefs about the future and current decisions. We need a simple model to incorporate that choice takes place over time. Let us suppose that time is broken up into discrete periods, where period 0 denotes the present, period 1 is the next subsequent period, period 2 is just after period 1, etc. In interpreting this model, a period can represent a day, or it can represent a week, or a month, or a year. The model is essentially the same irrespective of the interpretation. The discrete time approach helps in developing the intertemporal arithmetic we need. We will begin by making the extremely unrealistic but simplifying assumption that capital markets are perfect. In particular this means that there is a market interest rate, i, at which borrowers can borrow as much as theyd like and savers can save as much as theyd like. Underlying this assumption is that everyone has perfect foresight about the future, so all loans are repaid in full. Nobody ever defaults. Further, there are no costs involved in the making of loans and the market for loans is perfectly competitive, which brings the borrowing rate in line with the savings rate. Under these assumptions, if an amount, B, is borrowed in period 0 and repaid in full in period 1, then the amount paid in period 1 is the original principal, B, plus the interest on the loan iB, so that the total paid back is (1 + i)B. How much would be owed if the loan is not paid back till period 2? The way to answer this is to imagine that a loan is taken out in period 0 for just one period and that loan is paid off in full in period 1 by taking out another loan. The size of this loan in period 1 is thus (1 + i)B and on that loan principal plus interest must be paid back in period 2. Therefore the amount owed in period two is (1+i) (1 + i)B = (1+i)2B. And by the same sort of reasoning, if the loan is paid off in full in period t with no prior payment before period t, the amount owed is (1+i)tB. So, if there is no prior payoff and the interest rate is positive, the amount of indebtedness grows geometrically over time. (See this Excel workbook, first spreadsheet, for a plot of what that payoff looks like as a function of the initial loan, the interest rate, and the period when the loan is paid off.) The arithmetic is essentially the same for a saver. If S is the amount saved in period 0 and that amount is allowed to remain in the savings account till period t, the value of the savings at that time will be (1+i)tS.

Let us do a different sort of calculation. Some loans, such as certain mortgages on homes or loans on a car, require a fixed payment per period until the loan is paid off. If B is borrowed in period 0 and the per period payment made starting in period 1 and ending in period 2 is a then what is the relationship between these amounts? A payment of a in period 1 is equivalent to a payment of a/(1+i) in period 0, for consider saving that amount in period 0 and asking what it would be worth in period 1. Likewise a payment of a in period 2 is equivalent to a payment of a/(1 + i)2 in period 0. In other words, future payments are discounted to convert them into present values, with the amount of discount depending on how far into the future the payment is made. Thus we have in our example: B = a/(1+i) + a/(1 + i)2 = [a/i][1 - 1/(1 + i)2] Likewise if we made the fixed payment until period t, we would have (See the Excel workbook second worksheet): B = a/(1+i) + a/(1 + i)2 + + a/(1 + i)t = [a/i][1 - 1/(1 + i)t] This expression may look complex but it really is not that hard to understand. Note that for any positive interest rate, 1/(1 + i)t gets small as t gets large and in the limit it equals 0. So in this limiting case the expression reduces to B = a/i or equivalently a = iB. In other words, in the limiting case the per-period payment is just the interest on the principal. If the interest is paid off what remains is the principal and then that starts over again in the next period, just as before. In fact, there are real world assets that behave this way, known as consols, which never expire and provide a fixed payment per period. For most loans, however, the payoff of the loan happens in finite time. This requires a > iB. In period 1 the excess of a over iB reduces the principal. So in period 2, with reduced principal, the interest owed is a bit less and then even more principal is paid off. Over time, per period payments become more paying off principal and less paying of interest. (See the Excel workbook third worksheet.) This is important to know for mortgage payments where the interest payment is tax deductible while the principal payment is not. We have the basics already. We can generalize from the basics in a variety of different ways. Well do so here by providing some formulas without derivation, just to motivate the ideas. An individual will have a personal discount rate, which here will denote by , the greek letter rho, that can differ from the market interest rate, i. The individual will use in his personal calculation to determine the value of a stream of payments. When > i the individual is impatient relative to the market, meaning that future values are discounted even more heavily so the present and near future takes on greater importance overall. Conversely, when < i the individual is patient relative to the market. Such a person values the future more than the market does. Impatient people tend to borrow, to increase current spending. Patient people tend to save. We can also envision that interest rates on one period loans vary with time. As I am writing this essay, market interest rates are very low indeed, though they are somewhat higher for longer term loans than for shorter term loans. What determines this? Lets denote by i1 the interest rate to be paid in period 1 on a one-period load that originates in period 0. Likewise, lets denote by i2 the interest rate to be paid in period 2 on a one-period loan that originates in period 1 and by it the interest rate to be in period t on

a one-period loan that originates in period t-1. Finally, lets denote the long run rate of a loan that originates in period 0 with no pre-payment and then is paid off in full in period t by iLRt. Then we have: (1 + iLRt)t = (1 + i1)(1 + i2)(1 + it). In this very rudimentary theory, if long run rates are higher than current short run rates it is because future short run rates are expected to rise. (This is the only explanation for higher long run rates in a perfect capital markets framework. However, once the perfect capital markets assumption is dropped, then a more plausible explanation emerges. Long run bonds are less liquid than shorter term bonds. Therefore they must come with a premium in the form of higher rates in order to induce investors to purchase them. ) Similarly, if we have an asset that makes variable payments in each period, with at the value of the payment in period t, and if the last period of such a payment is T, then the value of the asset, A, is given by: A = a1/(1 + i1) + a2/[(1 + i1)(1 +i2)] + + aT/[(1 + i1)(1 +i2)(1 + iT)]. This formula remains consistent with the perfect capital market assumptions. The formula gives a general method for asset valuation in that environment. It says that the value of an asset is the value of the discounted stream of payments in subsequent periods up to and including period T. The interesting thing is that the formula doesnt just apply to financial assets. It applies to any durable, a home, a car, etc. and to non-tangible assets too, a personal reputation or a brand name for example, so long as it is possible to monetize the flow of returns that stem from the asset. Thus the approach we develop here can apply to all intertemporal decisions, not just the financial ones. ***** Static competitive market theory allows for anonymous exchange a buyer can purchase from any seller at the market price and in the sense that a buyer can always find another seller at the same price with what she wants to buy, the buyer earns no surplus or economic rent over and above her opportunity cost. Now consider the dynamic case once we abandon the perfect capital markets assumption. We will first cast the decision in the negative, as that is the easiest to understand, but then well reconsider in the positive to contrast with the static theory. Lets move away from the perfect capital markets assumption. Now we want to bring the discussion closer to reality. Suppose a person with a loan, say a mortgage on a home, is contemplating whether to default. If the person defaults, he loses the home, which served as collateral on the loan. If the unpaid balance of the loan exceeds the value of the home, it looks like default is a good decision. When the person doesnt reside at the place and the person will suffer little or no loss in reputation by walking away, then indeed it is a good decision to walk away. Those qualifiers suggest the more general condition. For somebody who occupies the home and who must find alternative living arrangements if he chooses to default on the loan, the quality of that alternative relative to the present living situation

plus the decline in credit rating that is likely to result from such a default must be accounted for in the decision. Conversely, unless a loan is fully collateralized, the willingness to service the loan is indicative that the person earns some economic surplus from so doing! This is a dramatic conclusion. Behavior that honors the initial agreement in a dynamic relationship requires there to be economic rents generated by the relationship. Such rents are inconsistent with anonymity and perfect competition. Lets look at some examples to see what is meant here. The government recognizes that, to provide incentives to create new intellectual property, monopoly rights must be granted for a certain period to reduce if not eliminate the possibility of third party appropriation of the rent. So we have copyrights and they encourage musicians to write new music, authors to write new books, and filmmakers to make new movies. We have patents to encourage drug companies to invent new drugs, inventors to develop new product ideas, and companies to develop more efficient processes for producing existing products. It is not that were trying to promote monopoly per se. Rather it is that without the monopoly, much of the innovation wont be forthcoming, because the time and effort entailed in developing the innovation cant be expected to produce a reasonable return. Indeed, much R&D comes to naught, so to produce a reasonable expected return on average, there must be super returns when the innovation is successful. Heres a different example. Many firms issue warranties for their products, which are intended to insure their customers against unanticipated product defect or malfunction. Why have a warranty instead of simply caveat emptor (let the buyer beware)? The answer is that a firm who is in it for the long haul cares about the experiences of its customers because it values their repeated purchases in the future and it wants to promote positive word of mouth generated by these customers because that can affect purchases by others. Thus the firm wants to communicate its concern and a warranty, which it fully intends to honor, is a good way of doing that. Note that fly by night firms have incentive to issue warranties as well you can fool some of the people some of the time (see Bigelow, Cooper, and Ross) so a careful customer will be impressed not just by the warranty but other actions taken by the firm as well that help to promote its good reputation. And here is still a different example. In the labor market we have a notion of good job and what that means and a related notion of a good employer. Good jobs pay well but they may not be the highest paying. Good jobs mean employees are treated fairly and with respect, that there are ample opportunities for employees to learn and grow on the job, and in general that the employer is committed to the welfare of the people who work at the firm. In reciprocation, the employees are also committed to putting in their utmost effort, to do what they feel is in the best interest of the firm, and to help their fellow employees do likewise. Akerlof characterizes such work as partial gift exchange. Indeed, it is. If each party is receiving a gift from the other, that is an obvious source of surplus. Similar circumstances hold in the landlord-tenant relationship, the doctor-patient relationship, and the student-teacher relationship. When those are good and strong both sides in the relationship are apt to be extracting some surplus. When there is enough surplus, people will be in it for the long haul.

Conversely, when entering into a new relationship you might consider a few questions up front. Should you drive what seems the best possible price for you, or should you deliberately leave something on the table? Should you look for a patient counterpart or one who is impatient? Once the exchange has initiated should you spend additional resources to build trust or avoid such frills? Here is a brief set of responses. If you yourself intend the relationship to be one and done, then going for the best price, finding an impatient counterpart, and ignoring trust building activities all makes sense. If your hope is to be in it for the long haul, leaving something on the table signals to the counterpart your intention. Patience is a virtue, particularly in such circumstances. And it is usually important to provide for some bonding experience to convey the importance of the ongoing relationship. Such relationships are based on trust where personal reputation matters a great deal. But such relationships are not consistent with a perfectly competitive market. So, one should consider the case where there isnt legal protection such as with copyrights and patents. What is to prevent the economic rents from being appropriated by a third party? If such third party appropriation is possible, can the relationship be sustained nonetheless? Whistle blower stories are particularly interesting in this regard, because a good part of the extant surplus is due to keeping information concealed from the general public, while the whistle blower feels the honorable thing to do is to make the information public. An entertaining telling of such a story is The Insider, featuring Russell Crowe and Al Pacino. There are two different producer-consumer trust relationships in this story, one between the Tobacco Companies and their customers, the other between CBS, the television network, and its viewers. CBS has an obligation to its viewers to produce high caliber programming. The CBS show, 60 Minutes, had its own reputation of investigative journalism, particularly the hard hitting reporting of Mike Wallace. Both Wallace and his producer, Lowell Bergman, were used to taking an adversarial approach with power to get at the truth and making segments based on what they uncovered. But at the time the movie depicts, CBS was getting a buy out offer from Westinghouse and didnt want that offer to fall through. The Tobacco Companies, the power in this story, have been deliberately making their cigarettes more addictive, unbeknownst to the general public. The whistle blower is Jeffrey Wigand, the scientist who worked for Brown and Williamson and learned the truth but was under a contractual agreement not to reveal it. Wigand is interviewed by Mike Wallace and reveals what he knows in that interview. Doing so is in breach of the contract with Brown and Williamson. Once CBS management became aware of the interview, it became fearful of being sued were it to air the interview. So instead, CBS decides to pull the interview (in effect, breaking its promise with its viewers). The producer Lowell Bergman, motivated by a journalists ethos, leaks the story to the Wall Street Journal and eventually the story does get out into the open. A more recent story, also concerning journalism, is the buy out of the Tribune Company by Sam Zell. Appropriation of surplus that exists between management, employees, and a companys creditors sometimes occurs via merger or acquisition, particularly when that is highly leveraged and future bankruptcy is impending. However, the situation is never so straightforward. In particular, many of the Tribunes properties were newspapers. Print journalism had clearly been in decline for some time when

Zell took over, with many newspapers struggling to keep their advertising and their readers and other newspapers going entirely out of business. In a declining industry, cost reduction is a sensible strategy to try to retain viability. But cost reduction reduces or eliminates the surplus of the long time participants. So whether Zell has been imposing reasonable changes given the circumstances in the industry, or instead has been unfairly appropriating surplus, can be argued either way. The point here is to note that trust relationships sometimes have to bend and other times will break entirely when an industry is in decline. The economist Joseph Schumpeter called the entire process creative destruction (the link is to a highly relevant segment from his book, Capitalism, Socialism, and Democracy.) The source of surplus is the new that captures the imaginations of consumers or that makes more efficient something that already has captured the imagination, a new product or a new way to organize production. There is a constant search for the new because that is where the rewards lie. Once discovered and finding a welcoming niche, the new will grow for a while yielding even more surplus. But it will eventually mature and no longer be new. Then it will begin to face competition from other possibilities that have since been realized. Eventually it will die out as some of those others prove superior. Under the Schumpeterian view, the surplus cannot last forever. It must come to an end as superior alternatives emerge. Schumpeter envisions an entire ecosystem that is fundamentally dynamic, based on this process of invention of the new and destruction of the old. However, those who are the beneficiaries of earning surplus have desire for that to continue and they will take steps to keep it so. Within an industry, a firm may engage in a variety of predatory or anticompetitive behaviors in an effort to preserve its surplus. So we have Antitrust Laws to deter that from happening and to find remedies when it does. Parties also resort to the political process as a way to preserve their surplus, which provides an economic rationale for why we witness so much lobbying of government officials by special interest groups. Indeed, one might reasonably predict that as society as a whole gets richer, there will be more and more such lobbying. Thats precisely the prediction given in Mancur Olsons The Logic of Collective Action. Flipping Olsons argument on its head, there is now a cottage industry of placing blame for societal ills on particular groups or individuals who spend resources into order to preserve their surplus. So from the liberal perspective we have this piece in the New Yorker about the Koch brothers, which identifies their political agenda with a strong profit motive. Likewise, from the conservative perspective there is this piece in National Affairs about Public Sector Unions, which identifies their agenda with preserving above market wages and benefits for public sector employees. ***** Let us briefly return to our general asset equation before closing. Recall we had the asset value A determined by: A = a1/(1 + i1) + a2/[(1 + i1)(1 +i2)] + + aT/[(1 + i1)(1 +i2)(1 + iT)]. The equation remains useful even in the absence of perfect capital markets, but then all the per-period returns, at, occur in the future and are therefore uncertain. Here we can now describe three different

sources of this uncertainty. First, there is uncertainty about overall economic conditions, due to such factors as the vicissitudes of the weather, the decision making of governments around the globe, and the developments in sectors of the economy that dont directly impact the relationship but indirectly do so via their cumulative effect on overall economic conditions. Second there is uncertainty within an industry or sector. When will the threat that can destroy the surplus emerge? How likely is that to happen? Last, there is uncertainty within the relationship. Will the partner honor the trust or break the agreement? How to incorporate that uncertainty into asset valuation becomes something of an art. So we have panics and bubbles, which when they occur suggests radical departures from focusing on fundamentals of valuation as a consequence of herd mentality. But even when such extremes are not present, the valuation of all but the most short-lived assets remains something of an art and, particularly for nontangible assets, it will be helpful to think of our asset equation as fuzzy rather than precise, where we can all agree on the number.