Summary: Economic theories of intertemporal consumption seek to explain people’s preferences in relation to consumption and saving over the course of their life. The earliest work on the subject was by Irving Fisher and Roy Harrod who described ‘hump saving’, hypothesizing that savings would be highest in the middle years of a person’s life as they saved for retirement.

In the 1950s more well-defined models built on discounted utility theory and approached the question of intertemporal consumption as a lifetime income optimization problem. Solving this problem mathematically, assuming that individuals are rational and have access to complete markets, Modigliani & Brumberg (1954), Albert Ando, and Milton Friedman (1957) developed what became known as the life-cycle model. This model predicts that people consume an annuity of their expected lifetime income at all points in their life.

Thus, the lifetime consumption profile was expected to be essentially flat, with people borrowing against future earnings during their early study and working life when income is low, saving greatly during their most productive working years and consuming saved assets during retirement. Windfall gains would be treated the same way as an unexpected increase in income – its lifetime annuity value would be consumed and the rest saved.

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Mental Accounting and Self-Control

Karlsson, N. Mental accounting and self-control. Göteborg Psychological Reports, 1998, 28, No. 2. The behavioral life-cycle theory of H. Shefrin and R. Thaler (1988) assumes that people classify assets in three mental accounts: current income, current assets, and future income. The present study tested the hypothesis that future consumption is considered to a lesser extent when money is available as current income compared to when current assets have to be used. This hypothesis specifies how mental accounts serve as a self-control strategy, in that concern for future consumption is tied to the use of current assets while only short-term preferences are considered when using a current income. Two experiments were conducted in which undergraduates made fictitious choices between buying or not buying an attractive durable good when having future expenses. Different groups of subjects could use current assets or current income to pay for the durable good.

In line with the hypothesis it was found in Experiment 1 that the future expenses had a greater negative impact on the decisiveness to buy when using current assets than when using current income. Experiment 2 also investigated the importance of different types of uncertainty of the future expenses. It was found that the uncertainty of the future expense imposed by a greater distance in time (i. e., increased implicit risk) increased the difference in decisiveness to buy between current assets and
current income.

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