© 2016 Worth Publishers, all rights reserved
Understanding Consumer Behavior
16CHAPTER
IN THIS CHAPTER, YOU WILL LEARN:
an introduction to the most prominent work on
consumption, including:
§ John Maynard Keynes: consumption and current
income
§ Irving Fisher: intertemporal choice
§ Franco Modigliani: the life-cycle hypothesis
§ Milton Friedman: the permanent income hypothesis
§ Robert Hall: the random-walk hypothesis
§ David Laibson: the pull of instant gratification
1
2CHAPTER 16 Understanding Consumer Behavior
Keynes’s conjectures
1. 0 < MPC < 1
2. Average propensity to consume (APC )
falls as income rises.
(APC = C/Y)
3. Income is the main determinant of
consumption.
3CHAPTER 16 Understanding Consumer Behavior
The Keynesian consumption function
C
Y
1
c
C C cY= +
C
c = MPC
= slope of the
consumption
function
4CHAPTER 16 Understanding Consumer Behavior
The Keynesian consumption function
C
Y
C C cY= +
slope = APC
As income rises, consumers save a bigger
fraction of their income, so APC falls.
C C c
Y Y
= = +APC
5CHAPTER 16 Understanding Consumer Behavior
Early empirical successes:
Results from early studies
§ Households with higher incomes:
§ consume more, so MPC > 0
§ save more, so MPC < 1
§ save a larger fraction of their income,
so APC i as Y h
§ Very strong correlation between income and
consumption: income seemed to be the main
determinant of consumption
6CHAPTER 16 Understanding Consumer Behavior
Problems for the
Keynesian consumption function
§ Based on the Keynesian consumption function,
economists predicted that C would grow more
slowly than Y over time.
§ This prediction did not come true:
§ As incomes grew, APC did not fall,
and C grew at the same rate as income.
§ Simon Kuznets showed that C/Y was
very stable from decade to decade.
7CHAPTER 16 Understanding Consumer Behavior
The Consumption Puzzle
C
Y
Consumption function
from long time-series
data (constant APC )
Consumption function
from cross-sectional
household data
(falling APC )
8CHAPTER 16 Understanding Consumer Behavior
Irving Fisher and Intertemporal Choice
§ The basis for much subsequent work on
consumption.
§ Assumes consumer is forward-looking and
chooses consumption for the present and future
to maximize lifetime satisfaction.
§ Consumer’s choices are subject to an
intertemporal budget constraint,
a measure of the total resources available for
present and future consumption.
9CHAPTER 16 Understanding Consumer Behavior
The basic two-period model
§ Period 1: the present
Period 2: the future
§ Notation
Y1, Y2 = income in period 1, 2
C1, C2 = consumption in period 1, 2
S = Y1 - C1 = saving in period 1
(S < 0 if the consumer borrows in period 1)
10CHAPTER 16 Understanding Consumer Behavior
Deriving the intertemporal
budget constraint
§ Period 2 budget constraint:
2 2 (1 )C Y r S= + +
2 1 1(1 )( )Y r Y C= + + -
§ Rearrange terms:
1 2 2 1(1 ) (1 )r C C Y r Y+ + = + +
§ Divide through by (1+r ) to get…
11CHAPTER 16 Understanding Consumer Behavior
The intertemporal budget constraint
2 2
1 11 1
C YC Y
r r
+ = +
+ +
present value of
lifetime consumption
present value of
lifetime income
12CHAPTER 16 Understanding Consumer Behavior
The intertemporal budget constraint
The budget
constraint shows
all combinations
of C1 and C2 that
just exhaust the
consumer’s
resources.
C1
C2
1 2 (1 )Y Y r+ +
1 2(1 )r Y Y+ +
Y1
Y2
Borrowing
Saving
Consump =
income in
both periods
2 2
1 11 1
C YC Y
r r
+ = +
+ +
13CHAPTER 16 Understanding Consumer Behavior
The intertemporal budget constraint
The slope of
the budget
line equals
-(1+r )
C1
C2
Y1
Y2
1
(1+r )
2 2
1 11 1
C YC Y
r r
+ = +
+ +
14CHAPTER 16 Understanding Consumer Behavior
Consumer preferences
An indifference
curve shows
all combinations
of C1 and C2
that make the
consumer
equally happy.
C1
C2
IC1
IC2
Higher
indifference
curves
represent
higher levels
of happiness.
15CHAPTER 16 Understanding Consumer Behavior
Consumer preferences
Marginal rate of
substitution (MRS ):
the amount of C2
the consumer
would be willing to
substitute for
one unit of C1.
C1
C2
IC1
The slope of
an indifference
curve at any
point equals
the MRS
at that point.1
MRS
16CHAPTER 16 Understanding Consumer Behavior
Optimization
The optimal (C1,C2)
is where the
budget line
just touches
the highest
indifference curve.
C1
C2
O
At the optimal point,
MRS = 1+r
17CHAPTER 16 Understanding Consumer Behavior
How C responds to changes in Y
An increase
in Y1 or Y2
shifts the
budget line
outward.
C1
C2Results:
Provided they are
both normal goods,
C1 and C2 both
increase,
…whether the
income increase
occurs in period 1
or period 2.
18CHAPTER 16 Understanding Consumer Behavior
Keynes vs. Fisher
§ Keynes:
Current consumption depends only on
current income.
§ Fisher:
Current consumption depends only on
the present value of lifetime income.
The timing of income is irrelevant
because the consumer can borrow or lend
between periods.
19CHAPTER 16 Understanding Consumer Behavior
A
How C responds to changes in r
An increase in r
pivots the budget
line around the
point (Y1,Y2).
C1
C2
Y1
Y2
B
As depicted here,
C1 falls and C2 rises.
However, it could
turn out differently…
20CHAPTER 16 Understanding Consumer Behavior
How C responds to changes in r
§ income effect: If consumer is a saver,
the rise in r makes him better off, which tends to
increase consumption in both periods.
§ substitution effect: The rise in r increases
the opportunity cost of current consumption,
which tends to reduce C1 and increase C2.
§ Both effects imply ΔC2.
Whether C1 rises or falls depends on the relative
size of the income & substitution effects.
21CHAPTER 16 Understanding Consumer Behavior
Constraints on borrowing
§ In Fisher’s theory, the timing of income is irrelevant:
Consumer can borrow and lend across periods.
§ Example: If consumer learns that her future income
will increase, she can spread the extra consumption
over both periods by borrowing in the current period.
§ However, if consumer faces borrowing constraints
(a.k.a. liquidity constraints), then she may not be
able to increase current consumption
…and her consumption may behave as in the
Keynesian theory even though she is rational &
forward-looking.
22CHAPTER 16 Understanding Consumer Behavior
Constraints on borrowing
The budget
line with no
borrowing
constraints
C1
C2
Y1
Y2
23CHAPTER 16 Understanding Consumer Behavior
Constraints on borrowing
The borrowing
constraint takes
the form:
C1 ≤ Y1
C1
C2
Y1
Y2
The budget
line with a
borrowing
constraint
24CHAPTER 16 Understanding Consumer Behavior
Consumer optimization when the
borrowing constraint is not binding
The borrowing
constraint is not
binding if the
consumer’s
optimal C1
is less than Y1.
C1
C2
Y1
25CHAPTER 16 Understanding Consumer Behavior
Consumer optimization when the
borrowing constraint is binding
The optimal
choice is at
point D.
But since the
consumer
cannot borrow,
the best he can
do is point E.
C1
C2
Y1
D
E
26CHAPTER 16 Understanding Consumer Behavior
The Life-Cycle Hypothesis
§ due to Franco Modigliani (1950s)
§ Fisher’s model says that consumption depends
on lifetime income, and people try to achieve
smooth consumption.
§ The LCH says that income varies systematically
over the phases of the consumer’s life cycle,
and saving allows the consumer to achieve
smooth consumption.
27CHAPTER 16 Understanding Consumer Behavior
The Life-Cycle Hypothesis
§ The basic model:
W = initial wealth
Y = annual income until retirement
(assumed constant)
R = number of years until retirement
T = lifetime in years
§ Assumptions:
§ zero real interest rate (for simplicity)
§ consumption smoothing is optimal
28CHAPTER 16 Understanding Consumer Behavior
The Life-Cycle Hypothesis
§ Lifetime resources = W + RY
§ To achieve smooth consumption,
consumer divides her resources equally over time:
C = (W + RY)/T , or
C = aW + bY
where
a = (1/T) is the marginal propensity to
consume out of wealth
b = (R/T) is the marginal propensity to consume
out of income
29CHAPTER 16 Understanding Consumer Behavior
Implications of the Life-Cycle Hypothesis
The LCH can solve the consumption puzzle:
§ The life-cycle consumption function implies
APC = C/Y = a(W/Y ) + b
§ Across households, income varies more than
wealth, so high-income households should have
a lower APC than low-income households.
§ Over time, aggregate wealth and income grow
together, causing APC to remain stable.
30CHAPTER 16 Understanding Consumer Behavior
Implications of the Life-Cycle Hypothesis
LCH implies
that saving
varies
systematically
over a
person’s
lifetime. Saving
Dissaving
Retirement
begins
End
of life
Consumption
Income
$
Wealth
31CHAPTER 16 Understanding Consumer Behavior
The Permanent Income Hypothesis
§ due to Milton Friedman (1957)
§ Y = YP + YT
where
Y = current income
YP = permanent income
average income, which people expect to
persist into the future
YT = transitory income
temporary deviations from average income
32CHAPTER 16 Understanding Consumer Behavior
The Permanent Income Hypothesis
§ Consumers use saving & borrowing to smooth
consumption in response to transitory changes
in income.
§ The PIH consumption function:
C = aYP
where a is the fraction of permanent income
that people consume per year.
33CHAPTER 16 Understanding Consumer Behavior
The PIH can solve the consumption puzzle:
§ The PIH implies
APC = C/Y = aY P/Y
§ If high-income households have higher transitory
income than low-income households,
APC is lower in high-income households.
§ Over the long run, income variation is due mainly
(if not solely) to variation in permanent income,
which implies a stable APC.
The Permanent Income Hypothesis
34CHAPTER 16 Understanding Consumer Behavior
PIH vs. LCH
§ Both: people try to smooth their consumption
in the face of changing current income.
§ LCH: current income changes systematically
as people move through their life cycle.
§ PIH: current income is subject to random,
transitory fluctuations.
§ Both can explain the consumption puzzle.
35CHAPTER 16 Understanding Consumer Behavior
The Random-Walk Hypothesis
§ due to Robert Hall (1978)
§ based on Fisher’s model & PIH,
in which forward-looking consumers base
consumption on expected future income
§ Hall adds the assumption of
rational expectations,
that people use all available information
to forecast future variables like income.
36CHAPTER 16 Understanding Consumer Behavior
The Random-Walk Hypothesis
§ If PIH is correct and consumers have rational
expectations, then consumption should follow a
random walk: changes in consumption should
be unpredictable.
§ A change in income or wealth that was
anticipated has already been factored into
expected permanent income,
so it will not change consumption.
§ Only unanticipated changes in income or wealth
that alter expected permanent income
will change consumption.
37CHAPTER 16 Understanding Consumer Behavior
Implication of the R-W Hypothesis
If consumers obey the PIH
and have rational expectations,
then policy changes
will affect consumption
only if they are unanticipated.
38CHAPTER 16 Understanding Consumer Behavior
The Psychology of Instant Gratification
§ Theories from Fisher to Hall assume that
consumers are rational and act to maximize
lifetime utility.
§ Recent studies by David Laibson and others
consider the psychology of consumers.
39CHAPTER 16 Understanding Consumer Behavior
The Psychology of Instant Gratification
§ Consumers consider themselves to be imperfect
decision makers.
§ In one survey, 76% said they were not saving
enough for retirement.
§ Laibson:
The “pull of instant gratification” explains why
people don’t save as much as a perfectly
rational lifetime utility maximizer would save.
40CHAPTER 16 Understanding Consumer Behavior
Two questions and time
inconsistency
1. Would you prefer (A) a candy today, or
(B) two candies tomorrow?
2. Would you prefer (A) a candy in 100 days, or
(B) two candies in 101 days?
In studies, most people answered (A) to 1 and (B) to 2.
A person confronted with question 2 may choose (B).
But in 100 days, when confronted with question 1,
the pull of instant gratification may induce her to
change her answer to (A).
41CHAPTER 16 Understanding Consumer Behavior
Summing up
§ Keynes: consumption depends primarily on
current income.
§ Recent work: consumption also depends on
§ expected future income
§ wealth
§ interest rates
§ Economists disagree over the relative
importance of these factors, borrowing
constraints, and psychological factors.
C H A P T E R S U M M A R Y
1. Keynesian consumption theory
§ Keynes’s conjectures
§ MPC is between 0 and 1
§ APC falls as income rises
§ current income is the main determinant of
current consumption
§ Empirical studies
§ in household data & short time series:
confirmation of Keynes’s conjectures
§ in long-time series data:
APC does not fall as income rises
42
C H A P T E R S U M M A R Y
2. Fisher’s theory of intertemporal choice
§ Consumer chooses current & future
consumption to maximize lifetime satisfaction of
subject to an intertemporal budget constraint.
§ Current consumption depends on lifetime
income, not current income, provided consumer
can borrow & save.
43
C H A P T E R S U M M A R Y
3. Modigliani’s life-cycle hypothesis
§ Income varies systematically over a lifetime.
§ Consumers use saving & borrowing to smooth
consumption.
§ Consumption depends on income & wealth.
44
C H A P T E R S U M M A R Y
4. Friedman’s permanent-income hypothesis
§ Consumption depends mainly on permanent
income.
§ Consumers use saving & borrowing to smooth
consumption in the face of transitory
fluctuations in income.
45
C H A P T E R S U M M A R Y
5. Hall’s random-walk hypothesis
§ Combines PIH with rational expectations.
§ Main result: changes in consumption are
unpredictable, occur only in response to
unanticipated changes in expected permanent
income.
46
C H A P T E R S U M M A R Y
6. Laibson and the pull of instant gratification
§ Uses psychology to understand consumer
behavior.
§ The desire for instant gratification causes
people to save less than they rationally know
they should.
47