Time preference and the life cycle: The logic of long-term high risk vs. short-term low risk

Abstract

This paper argues that time-preference functions (or ‘discount rates’) for R&D should properly be considered to be functions of the economic environment. In particular, during periods of accelerating growth and general increasing prosperity it is appropriate and rational to prefer a marginal dollar in the present to a marginal dollar in the future. Conversely, during periods of saturating growth and deteriorating prospects, the converse holds: it is rational to prefer a marginal dollar in the future to one in the present. Periods of increasing general prosperity — ‘rising tide’ — are likely to be associated with the early phases of an industry ‘life cycle’. Periods of declining prosperity, by contrast, may occur towards the end of the life cycle. The implications for R&D policy are derived in terms of a simple model. The results suggest that at the beginning of the life cycle the optimal R&D policy is to invest in short-term, low risk ventures (i.e. product or process improvements). Late in the cycle, however, the optimal policy reverses to long-term high-risk projects. In simple terms: a firm in a declining industry needs to find a new product or business to replace the old one. Unfortunately, the appropriate behavior is discouraged by most existing B/C methodologies.