Behavioral Life-Cycle Hypotheses

https://www.researchgate.net/publication/5210679_The_Behavioral_Life-Cycle_Hypothesis

Therefore, in an effort to get beyond this sort of general critique, we suggest that the life-cycle model can be enriched by incorporating three important behavioral features that are usually missing in economic analyses. (1) Self-control: we recognize that self-control is costly, and that economic agents will use various devices such as pension plans and rules-of-thumb to deal with the difficulties of postponing a significant portion of their consumption until retirement. We also incorporate temptation into the analysis since some situations are less conductive to saving than others. (2) Mental accounting: most households act as if they used a system of mental accounts which violate the principle of fungibility. Specifically, some mental accounts, those which are considered "wealth", are less tempting than those which are considered "income". (3) Framing: an implication of the differential temptation of various mental accounts is that the saving rate can be affected by the way in which increments to wealth are "framed" or described. Our model predicts that income paid in the form of a lump sum bonus will be treated differently from regular income even if the bonus is completely anticipated. Building upon the research done on these topics by psychologists and other social scientists, we are able to make specific predictions about how actual household saving behavior will differ from the idealized LC model.
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THE MODEL

Self-Control and Temptation: The Problem
In the Theory of Interest Irving Fisher bases his explanation of personal saving upon five characteristics: foresight, self-control, habits, expectation of life, and love for posterity. We concentrate here on the first three factors and the relationships among them. Foresight is important since retirement saving requires long-term planning. Self-control is necessary because immediate consumption is always an attractive alternative to retirement saving. Successfully dealing with self-control problems requires the cultivation of good habits. In presenting our model we begin with the concept of self-control.
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How does self-control differ from ordinary choice? The distinguished psychologist William James I says that the key attribute of self-control choices is the "feeling of effort" that is present.

Effort of attention is thus the essential phenomenon of will. Every reader must know by his own experience that this is so, for every reader must have felt some fiery passion's grasp. What constitutes the difficulty for a man laboring under an unwise passion of acting as if the passion were wise? Certainly there is no physical difficulty. It is as easy physically to avoid a fight as to begin one, to pocket one's money as to squander it on one's cupidities, to walk away from as towards a coquette's door. The difficulty is mental: it is that of getting the idea of the wise action to stay before our mind at all.

Incorporating the effort that is present in self-control contexts involves three elements normally excluded from economic analyses: internal conflict, temptation, and willpower. The very term "self-control" implies that the trade-offs between immediate gratification and long-run benefits entail a conflict that is not present in a choice between a white shirt and a blue one. When modeling choice under such circumstances the concept of temptation must be incorporated because of the obvious fact that some situations are more tempting than others. A model of saving that omits temptation is misspecified. The term willpower represents the real psychic costs of resisting temptation. The behavioral life cycle hypothesis modifies the standard life cycle model to incorporate these features. To capture formally the notion of internal conflict between the rational and emotional aspects of an individual's personality, we employ a dual preference structure. Individuals are assumed to behave as if they have two sets of coexisting and mutually inconsistent preferences: one concerned with the long run, and the other with the short run. We refer to the former as the planner and the latter as the doer. To place the preceding concepts into a formal structure consider an individual whose lifetime extends over T periods, with the final period representing retirement. The lifetime income stream is given by y. For simplicity we assume a perfect capital market and zero real rate of interest. Let retirement income be zero.
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CONCLUSION

The LC model is clearly in the mainstream tradition of microeconomic theory. It is typical of the general approach in microeconomics, which is to use a normative-based maximizing model for descriptive purposes. The recent papers by Hall and Mishkin (1982) and Courant et al. (1986) are really advances in the LC tradition.
Our model is quite different in spirit. First of all, our agents have very human limitations, and they use simple rules of thumb that are, by nature, second-best. While the LC model is a special case of our model (when either a first-best rule exists or ther is no self-control problem), our model was developed specifically to describe actual behavior, not to characterize rational behavior. It differs from a standard approach in three important ways.
(1) It is consistent with behavior that cannot be reconciled with a single utility function.
(2) It permits "irrelevant" factors (i.e., those other than age and wealth) to affect consumption. Even the form of payment can matter.
(3) Actual choices can be strictly within the budget set (as a Christmas club).
The relationship between the self-control model and the LC model is similar to the relationship between Daniel Kahneman and Amos Tversky's (1979) prospect theory and expected utility theory. Expected utility theory [p.637] is a well- established standard for rational choice under uncertainty. Its failure to describe individual behavior has led to the development of other models (such as prospect theory) that appear to do a better job at the tasks of description and prediction. The superiority of prospect theory as a predictive model, of course, in no way weakens expected utility theory's value as a presciptive norm. Similarly, since we view the LC model as capturing the preferences of our planner, we do not wish to question its value to prescriptive economic theory. The LC model has also served an enormously useful role in providing the theory against which empirical evidence can be judged. For example, the one-to-one pension offset was a result derived from the LC model (without bequests), and the numerous studies we cite were no doubt stimulated by the opportunity to test this prediction. Saving adequacy even more directly requires a life-cycle criterion of appropriate saving with which actual saving can be compared.
At times we have argued that the use of ad hoc assumptions, added to the theory after the anomalous empirical evidence has been brought forward, renders the LC model untestable. It is reasonable to ask whether our model is testable. We think that it is. Every one of the propositions we examined in this paper represents a test our model might have failed. For example, if the estimated pension offsets were mostly close to -1.0 instead of mostly close to zero, we would have taken that as evidence that self-control problems are empirically unimportant. Similarly, the effects of bonuses on saving could have been negligible, implying that mental accounting has little to add.
Other tests are also possible. Our theory suggests the following additional propositions.
PREDICTION 8. Holding lifetime income constant, home ownership will increase retirement wealth.
PREDICTION 9. The marginal propensity to consume inheritance income will depend on the form in which the inheritance is received.
The more the inheritance resembles "income" rather than "wealth", the greater will be the MPC. Thus the MPC will be greater for cash than for stocks, and greater for stocks than for real estate.
PREDICTION 10. The marginal propensity to consume dividend income is greater than the marginal propensity to consume increases in the value of stock holdings.
We have not investigated the empirical validity of these propositions. We hope others who are skeptical of our theory will do so. Nevertheless, while we think that neither our theory nor the LC theory is empty, refutation is probably not the most useful way of thinking about the task at hand. It is easy to demonstrate that any theory in social science is wrong. (We do not believe that individuals literally have planners and doers, for example.) Negative results and counterexamples must be only a first step. This paper is [p.638] intended to be constructive rather than destructive, and to show that the consideration of self-control problems enables us to identify variables that are usually ignored in economic analyses but which have an important influence on behavior.


ABSTRACTS

Self-control, mental accounting, and framing are incorporated in a behavioral enrichment of the life-cycle theory of saving called the behavioral life-cycle hypothesis. The key assumption of the behavioral life-cycle theory is that households treat components of their wealth as nonfungible, even in the absence of credit rationing. Specifically, wealth is assumed to be divided into three mental accounts: current income, current assets, and future income. The temptation to spend is assumed to be greatest for current income and least for future income. Considerable empirical support for the behavioral life-cycle theory is presented, primarily drawn from published econometric studies. Copyright 1988 by Oxford University Press.