Experiments on Intertemporal Consumption with Habit Formation and Social Learning

Abstract

The standard approach to modeling intertemporal consumption is to assume that consumers are solving a dynamic optimization problem. Under realistic descriptions of utility and uncertainty—stochastic income and habit formation-- these intertemporal problems are very difficult to solve. Optimizing agents must build up precautionary savings to buffer bad income realizations, and must anticipate the negative "internality" of current consumption on future utility, through habits. Yet recent empirical evidence has shown that consumption behavior of the average household in society conforms fairly well to the prescriptions of the optimal solution. This paper establishes potential ways in which consumers can attain near-optimal consumption behavior despite their mathematical and computational limitations in solving the complicated optimization problem. Individual and social learning mechanisms are proposed to be one possible link. Using an experimental approach, results show that by incorporating social learning and individual learning into the intertemporal consumption framework, participants' actual spending behavior converged effectively towards optimal consumption. While consumers persistently spend too much in early periods, they learn rapidly from their own experience (and "socially learn" from experience of others) to consume amounts close to optimal levels. Their spending is much more closely linked to optimal consumption (conditional on earlier spending) than to rule-of-thumb spending of current income or cash-on-hand. Despite their approximate optimality, consumers exhibit dramatic "loss-aversion" by strongly avoiding consumption levels which create negative levels of period-by-period utility (even when optimal utility is negative). The relative ratio of actual utilities to optimal utilities, for positive utility compared to negative, is 2.63. This coefficient is remarkably close to the coefficient of loss-aversion documented in a wide variety of risky and riskless choice domains, which shows that even when consumption is nearly-optimal, behavioral influences sharply affect decisions.

Files

Additional details