Consumption Smoothing and Hedonic Adaptation

post by jkaufman · 2013-07-19T14:41:47.699Z · score: 5 (6 votes) · LW · GW · Legacy · 6 comments

Because earning capacity increases with age but enjoyment of spending decreases with additional money, standard economic theory predicts people will smooth their spending by borrowing to live beyond their means when young and paying it back when they're older. The idea is that you have some lifetime spending to split among all your future selves, so instead of having you-at-50 enjoy $45K/year of self-spending while you-at-25 struggles with just $20K/year, you should each spend $30K/year. [1] In practice, however, we mostly don't see people doing this, and I think that's actually very reasonable.

We can approximate your earnings over the course of your life by looking at how much everyone makes now, broken down by age:


(source)

We see incoming rising sharply with age in the 20s, slower in the 30s, plateauing through the 40s and 50s, and then declining with retirement. Add to this a small amount of growth in real wages over time, about 8% over the last 40 years, and we can see that people in their 20s earn significantly less than they expect to be earning over most of their life.

The standard model of people is that spending money makes you happier, and the first dollar goes farther than the last:

Add temporal discounting and that you can enjoy durable goods for longer if you buy them earlier and we should expect to see people borrowing heavily in their 20s and paying it back as they get older, but we mostly don't. We do see this some with buying houses, but in most other ways the typical 50 year-old is much less frugal than the typical 25 year-old. When we see young people living on borrowed money to support a lifestyle they would expect to enjoy later in life, we generally mock them. [2]

One response is to say that people are behaving foolishly and should borrow more. Why live thrifty in your 20s but not in your 40s? Either you should continue your thriftiness into your 40s, spend more in your 20s, or some combination of both. But this misses something important about human psychology: decreases in our standard of living are much more painful than increases are pleasant.

If you're earning a relatively small amount and living cheaply, and then earn more money and start living less frugally, this probably makes you happier. But if then something happens and you need to go back to living on less you'll probably be much less happy than you were the first time. Because individual incomes are much less predictable than cohort incomes, if you borrow a lot while young to consume at a higher level you might be anticipating a future level that you'll not reach or not sustain once reaching.

(This is why I try to be careful with luxuries.)

I also posted this on my blog.


[1] Why is that $30K instead of $32.5K, the average of $45K and $20K? To spend money you don't have yet you need to pay interest, which decreases the total amount you get to spend. But as long as the difference in enjoyment between $20K and $30K is larger than between $45K and $30K you still come out ahead.

[2] Though in this case I think the author has other reasons to dislike their subject than consumption habits.

6 comments

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comment by roystgnr · 2013-07-19T20:08:19.869Z · score: 7 (7 votes) · LW · GW

Also, remember you want to smooth consumption with an uncertain future. If utility is something like logarithmic in wealth, then your behavior's influence on your expected utility is going to be dominated by the small fraction of possible futures where you have a much lower wealth than expected.

The utility of consumption smoothing between a wealthy future and a poorer present probably pales in comparison to consumption smoothing between a poorer present and a potentially much poorer future. Living in a studio apartment so that your median possible future self has more savings and less debt and can afford a slightly larger mansion would be foolish. Living in a studio apartment so that your worst-off possible future self has more savings and less debt and is slightly less likely to be homeless during economic hardship, not so foolish.

comment by Wei_Dai · 2013-07-19T19:19:21.741Z · score: 4 (4 votes) · LW · GW

In practice, however, we mostly don't see people doing this, and I think that's actually very reasonable.

Besides the reason you mention here, which I agree with, consumption smoothing is also very costly and impractical to do on a large scale. "Low interest" credit cards have interest rates around 10%, which carried over 20 years (from one's 20s into the 40s) would compound to over 500%. And it's hard or impossible to obtain unsecured debt that total several times one's annual income.

comment by mare-of-night · 2013-07-19T23:56:52.672Z · score: 1 (1 votes) · LW · GW

Borrowing a lot from your future self would also make your credit history look bad to other people, which would make it difficult to take out more loans and rent a place to live.

comment by mare-of-night · 2013-07-20T00:26:02.978Z · score: 3 (3 votes) · LW · GW

A society could accomplish something similar by agreeing that older people should donate or give gifts to younger people, moreso than the other way around. This also smooths spending, but without the risks involved with spending money you don't have yet. The tricky part is that the generation that starts it won't get the benefits, and there has to be something to keep later generations from defecting.

There does appear to be a social norm of doing this within families - parents are more likely to buy expensive gifts for their children than vice versa, and often help them pay their expenses while they have no income (students, mainly). It varies by degree in different circles, though. (I suspect there's more smoothing when the parents' income is higher, but I'm not very confident of that.)

Social pressures are probably also a major reason why parents don't smooth childrens' incomes more, and people don't smooth their own incomes. Spending money you haven't earned yourself (yet) is looked down upon.

comment by [deleted] · 2013-07-26T11:56:27.351Z · score: 1 (1 votes) · LW · GW

Irrelevant to the point of the post:

I'm peeved by graphs plotting income on a linear scale, rather than a log scale -- who the hell thinks that the difference between $110,000 and $100,000 matters as much as that between $20,000 and $10,000?

comment by jkaufman · 2013-07-26T13:34:41.716Z · score: 3 (3 votes) · LW · GW

I do? If I'm spending money altruistically I don't face the same diminishing returns as when I spend it on myself.