Theories of consumption in Economics

September 21, 2015
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Economists have developed three major theories of consumption and saving behavior: (1) The life-cycle hypothesis (Modigliani and Brumberg, 1954; Modigliani and Ando, 1957; Ando and Modigliani, 1963); (2) the permanent income hypothesis (Friedman, 1957); and (3) the relative income hypothesis (Dusenberry, 1949). All three theories have their conceptual roots in the microeconomic theory of consumer choice. However, the life-cycle and permanent income hypotheses are the most similar; both theories assume that individuals attempt to maximize their utility or personal well-being by balancing a lifetime stream of earnings with a lifetime pattern of consumption. The relative income hypothesis is quite different. Dusenberry theorized that individuals are less concerned with their absolute level of consumption than with their relative level—the idea of "keeping up with the Joneses."

The life-cycle hypothesis has been utilized extensively to examine savings and retirement behavior of older persons. This hypothesis begins with the observation that consumption needs and income are often unequal at various points in the life cycle. Younger people tend to have consumption needs that exceed their income. Their needs tend to be mainly for housing and education, and therefore they have little savings. In middle age, earnings generally rise, enabling debts accumulated earlier in life to be paid off and savings to be accumulated. Finally, in retirement, incomes decline and individuals consume out of previously accumulated savings.

Empirical studies of the life-cycle hypothesis have generated a large literature. Studies that have focused on the savings behavior of older persons, however, have been inconclusive regarding the correspondence between observed savings behavior and the pattern of saving and dissaving predicted by the life-cycle hypothesis. Many studies seemingly in conflict with the life-cycle hypothesis, have found that older persons continue to save in retirement. Several explanations have been offered for this. King (1985), for example, notes that saving in retirement is not necessarily inconsistent with the life-cycle hypothesis, if one accounts for the aversion of individuals to uncertainty about the future (e.g., how long they will live and future inflation). Another explanation is that the generosity of pensions reduces the need to save in preparation for retirement and to dissave while in retirement. Life-cycle savings patterns in some European countries that have generous pension systems such as France, Germany, and Italy appear to be consistent with this explanation. Another related explanation for lack of dissaving in retirement is that deteriorating health may limit the ability of individuals to consume at levels that are higher than their pension income. Moreover, the pension wealth that retired persons hold is not liquid and they are not able to draw down their pension wealth any faster than the annuity payments that they receive. This health aspect of life cycle savings and consumption patterns raises an interesting question: Should payments for health insurance also be viewed as a form of savings, and receipt of health care services as drawing down one's "health insurance wealth"?

A number of other studies, however, have found evidence of a hump-shaped pattern of savings that is consistent with the life-cycle hypothesis. It is important to note that most studies have tended to underestimate the degree of dissaving among older persons, because these studies have not generally accounted for the decumulation of pension wealth associated with Social Security and private pension payments.

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