Discount Factor

Definition

The discount factor is a numerical value used to determine the present value of future payoffs or benefits in economic decision-making. It reflects how much a future payoff is valued today and is crucial in repeated games, as it influences players' strategies and their willingness to cooperate over time. A higher discount factor indicates that future payoffs are valued more highly, which can lead to increased cooperation in repeated interactions.

5 Must Know Facts For Your Next Test

1. The discount factor typically ranges between 0 and 1, where values closer to 1 indicate a stronger preference for future payoffs.
2. In repeated games, a player’s discount factor affects their likelihood to cooperate or defect, as higher discount factors encourage long-term relationships.
3. The concept is often expressed mathematically as \( eta = \frac{1}{(1 + r)} \), where \( r \) is the interest rate.
4. Players with low discount factors may prioritize immediate rewards over future gains, leading to less cooperation in repeated scenarios.
5. The Folk Theorem demonstrates that with sufficiently high discount factors, players can sustain cooperation and achieve mutually beneficial outcomes over time.

Review Questions

• How does the discount factor influence players' strategies in repeated games?
  • The discount factor plays a key role in shaping players' strategies in repeated games by affecting their valuation of future payoffs. A higher discount factor means players are more inclined to value future rewards and, thus, are more likely to cooperate for long-term gains. Conversely, a lower discount factor may lead players to focus on immediate payoffs, which can result in defection and less cooperative behavior. This dynamic significantly impacts the overall outcomes and stability of cooperative agreements.
• Discuss how the Folk Theorem relates to the concept of the discount factor in repeated games.
  • The Folk Theorem illustrates that when players have high enough discount factors, they can sustain cooperation through mutual agreements, even in non-cooperative equilibrium situations. This theorem suggests that as long as players value future payoffs sufficiently, they can reach outcomes that are better than those predicted by one-shot game models. Essentially, if players recognize that their actions today will influence future interactions, they are motivated to cooperate to maintain favorable outcomes over time.
• Evaluate the implications of varying discount factors on economic behavior and decision-making in dynamic settings.
  • Varying discount factors can significantly alter economic behavior and decision-making processes in dynamic environments. High discount factors typically promote cooperation and long-term planning among individuals or firms, leading to more stable and sustainable relationships. In contrast, low discount factors can drive short-term thinking, fostering competition and potentially harmful behaviors like defection or opportunism. Understanding these implications helps economists predict market behavior and design mechanisms that encourage desirable outcomes through incentive alignment.

Related terms

Present Value: The current worth of a future sum of money or stream of cash flows given a specified rate of return.

Future Value: The value of a current asset at a specified date in the future based on an assumed rate of growth.

Strategy Profile: A combination of strategies chosen by players in a game that determines the outcome of the game.