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Can overconfidence explain the consumption hump?

A general equilibrium inquiry

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Abstract

The standard neoclassical life-cycle model predicts that individual consumption should either increase, remain constant or fall monotonically depending on whether the market rate of return on savings is greater than, equal to or less than the discount rate. However, empirical evidence suggests that even after controlling for economic growth and family size, household consumption exhibits a robust hump at around age 45–55, with the ratio of peak consumption to consumption when entering the workforce greater than 1.1. This paper extends the “overconfidence” explanation (Caliendo and Huang, J. Macroecon 30(4):1347–1369, 2008) of this macroeconomic puzzle to a calibrated general equilibrium environment. The main finding is that although it is possible to identify parameter values under which overconfidence alone generates life-cycle consumption profiles and macro-indicators consistent with U.S. experience, quite extreme assumptions about both the magnitude and distribution of overconfidence in the population are generally required to obtain them.

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Notes

  1. Laibson (1997) examines time-inconsistent behavior in the presence of hyperbolic discounting, in which the consumer is modeled as a sequence of temporal selves making choices in a dynamic game. The equilibrium behavior in such a framework is given by the subgame perfect equilibrium of the dynamic game.

  2. Time-arbitrage opportunities arise when there is a difference between the rate at which an agent discounts future utility and the rate of return from his assets. Agents having a discount rate lower than the rate of return are net savers and allocate higher consumption to future periods, and those with a discount rate higher than the rate of return are net dissavers and allocate lower consumption to future periods.

  3. See the appendix of Caliendo and Huang (2008) for the procedure of deriving the actual consumption profile.

  4. As empirical evidence points out, the consumption hump is a work life phenomenon rather than retired life. Also, there is considerable evidence that retirees tend to annuitize their wealth (Johnson et al. 2004; Gale and Phillips 2006). Therefore, it seems reasonable to abstract from overconfident behavior during retirement.

  5. I consider alternative assumptions about the distribution of overconfident agents in the population in the sensitivity analysis section.

  6. This specification of the loss function follows Caliendo (2008).

  7. I use equal weight for each target, i.e. ω i  = 0.5 ∀ i.

  8. Degrees of overconfidence as high as 100% may not be totally unrealistic if investors have a tendency to ignore taxation on capital income, which can easily reach up to 50% when accounting for both corporate and personal taxation. Gordon (1985) shows that taxation of corporate income can theoretically leave corporate investment and individual savings incentives unaffected. Using data from the Citizens Utility Company (CU), Stamford, CT, Hubbard and Michaely (1997) find evidence that investors do ignore dividend taxation.

  9. One limitation of the baseline calibration in general equilibrium is that there is a range of z values for which the parameters that minimize the MSE satisfy r < ρ. Technically, this makes it a model of “underconfidence”, in which time-arbitrage motives dictate the agent to borrow at a rate higher than the market rate. Fortunately, this problem naturally corrects itself in the other calibrations.

  10. See Findley and Caliendo (2009) and other references therein for more information on this value.

  11. Note that we abstract from lumpy age distributions in the population (phenomena like the Post World War II Baby Boom).

  12. See Findley and Caliendo (2009) and other references therein.

  13. See Campbell and Mankiw (1990), Shapiro and Slemrod (1995) among others.

  14. These shares were estimated based on the assumption that the population consists of only two types of agents: permanent income consumers and rule-of-thumb consumers. Therefore, using the estimated shares from Campbell and Mankiw (1990), Shapiro and Slemrod (1995) may not be entirely appropriate. However, given that we have no other information about the share of overconfident consumers in the economy, this seems to be a reasonable approximation.

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Authors and Affiliations

  1. Applied Economics Department, Utah State University, Logan, UT, USA

    Shantanu Bagchi

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  1. Shantanu Bagchi
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Correspondence to Shantanu Bagchi.

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I have benefited from helpful conversations with Frank Caliendo, Jim Feigenbaum and Scott Findley, and from seminars at Illinois State and Utah State. The detailed recommendations of an anonymous referee have been particularly helpful.

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Bagchi, S. Can overconfidence explain the consumption hump?. J Econ Finan 35, 41–70 (2011). https://doi.org/10.1007/s12197-009-9082-6

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