Application to
the theory of consumption
Lectures in Behavioral economics
Fall 2011, Part 3
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Relevance of behavioral economics
Acc. to Vernon Smith (”Rational choice: The contrast between economics and psychology”, JPE 99, 1991, 877-89)
much beh. economic critique stems from the premises that
Two-sided auction: buyers announce bids, sellers announce asking prices.
1.
... rationality in the economy … derives from the rationContracts on acceptance. Some information but incomplete information
alitytoofeach.
theExperiments
individual decision
makers
in theconverges
economy.
available
show that such
a market
to price
and volume
represented
by theoretical
intersection intensive,
of supply and
demand
2.
... individual
rationality
is a cognitively
calculating
curves--competitive
equilibrium.
"This
is
some
kind
of
magic!"
What
it shows
process of maximization of the self-interest.
is that people are quite good at discovering prices and quantities that clear a
3.
... even
economic
theory
be ptested
by testing
directly the
onlyycan
incomplete
market
information.
market
if theyy have
economic rationality of the individuals isolated from
interactive experience in social and economic environments.
Instead, V. Smith thinks that beh. economic critique is important
if it predicts different economic behavior at an aggregate level.

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1
Observed saving behavior

Present-biased pref. can explain these phenomena.

Illiquid assets combined with credit card debt
Illiquid assets are commitments.
Credit cards provide consumption smoothing,
but facilitate tempting shopping splurges.

Co-movement between income and consumption
Consequence of self-imposed liquidity constraints.
Becomes more binding at the time of retirement.

Laibson: A model that explains empirical evidence.
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Outline

Cons.-saving model w/illiquid asset
Laibson (1997).
Application of the multi-self approach, where
sophisticates use illiquid asset as commitment.
Yields explanation of observed saving behavior.

A theoretical result in the cons.-saving model
Laibson (1998).

Empirical test of the cons.-saving model
Angeletos et al. (2001).
Show that present-biased pref. fit data better.
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2
Laibson’s (1997) consumption-saving model
Consumer makes decisions in periods 1, , T
One liquid asset x
One illiquid asset z
E
Exogenous
i i i l asset holdings
initial
h ldi
x0 , z0  0
In period t :  earn labor inco me yt
 earn asset inco me Rt ( xt 1  zt 1 )
 choose consumptio n ct and a new
asset allocation xt and zt such that
The illiquid asset
ct  xt  zt  yt  Rt ( xt 1  zt 1 )
ct  yt  Rt xt 1
zt 1 cannot be con - 
xt , zt  0
sumed at time t .
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G.B. Asheim, ECON4260, #3
Laibson’s (1997) consumption-saving model (2)
Period - t intertemp oral preference s :

U t  Et u (ct )    t 1   t u (c )
T

3-period consumption-saving example
Budget constraint : c1 
y
c2 c3
y
 2  y1  2  32  W
R R
R R
Instantane ous utility : u (c)  ln c
Numerical illustrati on :
  0.8,   0.9, R  1.1, and W  $1000.
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Optimal period-0 behavior

max  ln(c1 )   ln(c2 )   2 ln(c3 )
subject
b
to c1 

c2 c3
y
y
 2  y1  2  32  W
R R
R R
Solution :
W
RW
(R ) 2 W
0
0
c 
, c2 
, c3 
1    2
1    2
1    2
0
1
Numerical illustrati on :
c10  $369.00, c20  $365.31, c30  $361.66
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Optimal period-1 behavior
max ln(c1 )   ln(c2 )   2 ln(c3 )
subject
b
to c1 
c2 c3
y
y
 2  y1  2  32  W
R R
R R
Solution :
c11 
W
RW
 (R ) 2 W
1
1
,
c

,
c

2
3
1     2
1     2
1     2
Numerical illustrati on (optimal period - 1)
0) :
c110  $$422
369..30
00,, c1220  $$334
365..46
31, c3130  $$331
361..11
66
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Naive period-2 behavior
max ln(c2 )   ln(c3 )
subject
bj to c2 
c3
R (1   )W

 W2N  R (W  c11 ) 
R
1     2
Solution :
W2N
 RW2N
N
c 
, c3 
1  
1  
N
2
Numerical illustrati on (optimal
(naivete) period
:
- 0) :
c110  $$422
369..30
00,, c2N20  $$365
369..31
46,, cc303N$$361
292.66
.61
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Sophisticated period-2 behavior
max ln(c2 )   ln(c3 )
subject
bj to c2 
c3
 W2  R (W  c1 )
R
Solution :
c 2 (c1 ) 
W2
R (W  c1 )

1  
1  
 RW2 R 2 (W  c1 )
c 3 (c1 ) 

1  
1  
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Sophisticated period-1 behavior
max ln(c1 )   ln(c 2 (c1 ))   2 ln(c 3 (c1 ))

 R (W  c1 ) 
 R 2 (W  c1 ) 
2

   ln
max ln
l c1   ln
l 
l 
1  
 1   


Solution :
c1S  1 W  2 ,
R (1 )W
R R (1 )W
c2S  c 2 (c1 )  11  
, c3S  c 3 (c1 )  1
   1    2
1    2
Numerical illustrati on (optimal
(sophistic
(naivete) period
: ation) :- 0) :
c110S  $$422
369
422..30
00
30,, cc2N202S  $$365
369..31
46,, cc303NS $$361
292.66
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Sophisticates can implement optimal period-1
behavior by using the illiquid asset
If   0.8,   0.9, R  1.1, Y1  1000, and Y2  Y3  0, then
In p
period 1 :  consume $422.30
 save $304.05 in the liquid asset
(which yields $334.46 in period 2)
 save $273.64 in the illiquid asset
(which yields $331.11 in period 3)

Sophisticates strictly prefer the use of illiquid assets.

Naifs do not recognize the commitment value of
illiquid assets.
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The illiquid asset is not a perfect commitm. techn.
3-period consumption-saving example
  0.5,   1, R  1, and W  $1200.
You cannot prevent yourself
from consuming current income.

● If

Optimal period-1
Income
Consumption
Liquid asset
  0.8,   0.9, R  1.1, Y1  500, Y2  550,
and Y3  0, then the illiquid asset does not help at all.
An illiquid asset does not work as a commitment
device if yyou can borrow against
g
its future payoff.
py

● Credit cards (and other liquidity enhancing intruments)
may undermine the commitment value of illiquid assets.
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A theoretical result in the consum.-saving model

Assume no illiquid asset
Period - t intertemp oral preference s :

(Laibson, 1998)
U t  Et u (ct )    t 1   t u (c )
T
Optimality condition if   1 :


Proof of a theoretical result in the cons.-saving model
u(ct )   R
 cash on hand : xt  yt  R ( xt 1  ct 1 )
dU t 1
 choose consumptio n : ct  xt
dxt 1
dU t  2
dU t  2 u (ct 1 )


u(ct 1 )   R
dxt  2
dxt  2
 R
 dc  dU t  2
dU t 1 dct 1
u(ct 1 )  R1  t 1 

dxt 1 dxt 1
 dxt 1  dxt  2
 dc
 dc  1 
  t 1  1  t 1  u (ct 1 )
 dxt 1  dxt 1   
  dc 
 dc  
u(ct )  R  t 1    1  t 1  u(ct 1 )
 dxt 1  
  dxt 1 
u (ct )  Et Ru (ct 1 )  Et R s s u (ct  s )

Generalize d opt. condition for sophistica tes with   1 :

 dc 
 dc  
u (ct )  Et R  t 1    1  t 1  u (ct 1 )
 dxt 1  
 dxt 1 
A source of ”under-saving”.
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Empirical test of the consumption-saving model


Compare data with simulations Angeletos et al. (2001)
under exponential disc. and hyperbolic disc. (sophisticates)
Households with liquid
assets > 1 month’s income:

Exponent. simulation: 73%
Hyperbolic simulation: 40%
Data:
43%

Households with p
positive
credit-card borrowing:
Exponent. simulation: 19%
Hyperbolic simulation: 51%
Data:
70%
Mean credit
credit-card
card borrowing
(all households):
Exponent. simulation: $900
Hyperbolic simulation: $3400
Data:
>$5000

Cons.-income comovement
(income coefficent):
Exponent. simulation: 0.032
Hyperbolic simulation: 0.166
Data:
 0.2
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Proof of a theoretical result in the cons.-saving model
 cash on hand : xt  yt  R ( xt 1  ct 1 )
dU t 1
 choose consumptio n : ct  xt
u (ct )   R
dxt 1
dU t  2
dU t  2 u (ct 1 )
u (ct 1 )   R


dxt  2
dxt  2
 R
 dc  dU t  2
dU t 1 dct 1

u (ct 1 )  R1  t 1 
dxt 1 dxt 1
 dxt 1  dxt  2
 dc
 dc  1 
  t 1  1  t 1  u (ct 1 )
 dxt 1  dxt 1   
  dc 
 dc  
u (ct )  R  t 1    1  t 1  u (ct 1 )
 dxt 1  
  dxt 1 
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