Life Cycle Hypothesis: Consumption as a Function of Lifetime Resources
The Life Cycle Hypothesis, developed by Ando and Modigliani, proposes that consumption decisions are based not just on current income, but on an individual’s expected lifetime earnings and resources. This theory suggests that individuals aim to maintain a relatively stable consumption pattern throughout their lives. Individuals plan to consume their entire lifetime earnings plus their existing assets and don’t intend to leave any inheritance.
The sources explain this concept through a graphical representation of an individual’s income and consumption over their lifespan. In the early years, when income is typically low and assets are limited, individuals might borrow (dissave) to maintain their desired consumption level. During their middle years, as income peaks, they save to repay earlier debts and accumulate wealth for retirement. Finally, during retirement, when income falls, individuals dissave by drawing on their accumulated savings.
The Life Cycle Hypothesis leads to several key implications:
- Consumption Smoothing: Individuals strive to smooth their consumption over their lifetime rather than experiencing large fluctuations in consumption that mirror income variations.
- Savings Patterns Vary with Age: Savings behavior changes throughout an individual’s life cycle, with dissaving in early and late years and saving during peak earning years.
- Income and Consumption: Higher-income individuals, who are likely in their peak earning years, would have a lower average propensity to consume (APC) compared to lower-income individuals or retirees.
This approach helps reconcile the short-run and long-run consumption puzzle by demonstrating how short-run non-proportionality between income and consumption can lead to a long-run proportionality as wealth accumulation shifts the short-run consumption function upwards.
However, the Life Cycle Hypothesis is subject to several criticisms:
- Unrealistic Assumptions: Critics argue that the assumptions of perfect foresight about lifetime income and a planned, consistent consumption pattern are unrealistic.
- Neglect of Behavioral Factors: The theory does not adequately account for psychological factors and preferences that may influence consumption choices.
Despite these criticisms, the Life Cycle Hypothesis is considered a more comprehensive model compared to earlier theories as it incorporates wealth as a significant factor influencing consumption decisions and offers a plausible explanation for the observed consumption patterns over an individual’s lifetime.