Discount Factor for Economic Analyses

In economic analysis, the discount factor is the measure of how people value time. Simply put, it is an estimate of how much less something is worth if it is received in the future. A positive discount factor indicates that, the further time progresses, the less desirable an asset. Discount factors have a range of applications in behavioral economics.

The Discount Factor

In economics, the value of money or an asset is considered less valuable in the future than it is right now. This is because people generally prefer things now rather than later. There are a number of reasons for this, but the primary reason is that if a person were to receive money today, he or she could invest it now. This in turn creates greater value for the present. Furthermore, there is always a risk of not receiving the asset in the future. People adjust the future value of assets using a discount factor. The discount factor is essentially the depreciation of future events. The longer the length of time into the future, the higher the discount factor.

Calculating the Discount Factor

Formally, this discount factor is equal to one divided by one plus "r," where "r" is the discount rate for a given time period. So, if a person has a discount rate of 5 percent a year, he will have a discount factor of 0.9524, rounded up to the nearest ten thousandth. Using this discount factor, $100 received today would be equal to receiving $95.24 one year from now, as $100 multiplied by 0.9524 equals $95.24. In two years, the future value of $100 would equal one, divided by one plus 5 percent raised to the power of two. For three years, the denominator is raised to the power of three, and so on. This would result in future values of $90.70 and $86.38 for two and three years, respectively.

Applications for the Discount Factor

Discount factors are an important concept in financial economics, which studies the wants and needs of money. As the act of saving and investing money is the consumption of money in the future, economists must estimate the incentives for these later rewards. The discount factor of an individual investor must thus have a maximum in order to make saving and investing worthwhile. In environmental economics, discount factors are used to estimate our valuation of the future. This not only applies to the pollution and degradation of our environment but also the extraction of non-renewable resources. In this case, economists examining the minimum, rather than maximum, discount factor needed for environmental degradation.

Choosing a Discount Rate

As the discount factor depends entirely on the discount rate, the appropriate rate must be either chosen or estimated for the discounting of assets in the future. With regard to money, this is relatively straightforward. Using the yield of a Treasury bond tends to be an approximate guess of the discount rate. This is because if an investor were to receive the money today, he would at the very least invest the money in the least risky form of asset. Other discount rates are more complicated to gauge. When applying the discount rate to the extraction of limited resources, economists must not only estimate the benefits of receiving the resources today but must also add an additional factor that captures our need for resources today. Thus the discount rate is more concrete in some applications and more theoretical for others.

References