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Evaluating Time Streams of Income: Discounting What?

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Author Info

  • Manel Baucells

    ()

  • Rakesh Sarin

    ()

Abstract

For decisions whose consequences accrue over time, there are several possible techniques to compute total utility. One is to discount utilities of future consequences at some appropriate rate. The second is to discount per-period certainty equivalents. And the third is to compute net present values (NPVs) of various possible streams and to then apply the utility function to these net present values. We find that the best approach is to first compute NPVs of various possible income streams and then take the utility of such NPVs. We show the drawbacks of other alternative models of evaluating income streams. The article discusses the advantages of the power and logarithmic forms in the modeling of time preference. These are the only forms for which utility of income and utility of consumption are strategically equivalent. Further, these forms permit the flexibility in the choice of a time period (e.g., monthly or quarterly) without modifying the utility function, thus simplifying analysis. Copyright Springer Science+Business Media LLC 2007

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File URL: http://hdl.handle.net/10.1007/s11238-007-9045-3
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Bibliographic Info

Article provided by Springer in its journal Theory and Decision.

Volume (Year): 63 (2007)
Issue (Month): 2 (September)
Pages: 95-120

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Handle: RePEc:kap:theord:v:63:y:2007:i:2:p:95-120

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Web page: http://www.springerlink.com/link.asp?id=100341

Related research

Keywords: discounted utility; indirect utility of income; net present value; time preference;

References

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  1. Bell, David E, 1974. "Evaluating time streams of income," Omega, Elsevier, vol. 2(5), pages 691-699, October.
  2. Tjalling C. Koopmans, 1959. "Stationary Ordinal Utility and Impatience," Cowles Foundation Discussion Papers 81, Cowles Foundation for Research in Economics, Yale University.
  3. Peter A. Diamond & Tjalling C. Koopmans & Richard E. Williamson, 1962. "Stationary Utility and Time Preference," Cowles Foundation Discussion Papers 142, Cowles Foundation for Research in Economics, Yale University.
  4. James E. Smith, 1998. "Evaluating Income Streams: A Decision Analysis Approach," Management Science, INFORMS, vol. 44(12-Part-1), pages 1690-1708, December.
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Cited by:
  1. Plischke, Elmar & Borgonovo, Emanuele & Smith, Curtis L., 2013. "Global sensitivity measures from given data," European Journal of Operational Research, Elsevier, vol. 226(3), pages 536-550.
  2. Mohammed Abdellaoui & Olivier l'Haridon & Corina Paraschiv, 2013. "Do Couples Discount Future Consequences Less than Individuals?," Economics Working Paper Archive (University of Rennes 1 & University of Caen) 201320, Center for Research in Economics and Management (CREM), University of Rennes 1, University of Caen and CNRS.
  3. Ali Abbas, 2010. "Invariant multiattribute utility functions," Theory and Decision, Springer, vol. 68(1), pages 69-99, February.
  4. Alexandre Street, 2010. "On the Conditional Value-at-Risk probability-dependent utility function," Theory and Decision, Springer, vol. 68(1), pages 49-68, February.

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