The rational optimization framework

In their studies of consumption, economists generally draw upon a common theoretical framework by assuming that consumers base their expenditures on a rational and informed assessment of their current and future economic circumstances. This “rational optimization” assumption is untestable, however, without additional assumptions about why and how consumers care about their level of consumption; therefore consumers’ preferences are assumed to be captured by a utility function. For example, economists usually assume (1) that the urgency of consumption needs will decline as the level of consumption increases (this is known as a declining marginal utility of consumption), (2) that people prefer to face less rather than more risk in their consumption (people are risk-averse), and (3) that unavoidable uncertainty in future income generates some degree of precautionary saving. In the interest of simplicity, the standard versions of these models also make some less-innocuous assumptions, including assertions that the pleasure yielded by today’s consumption does not depend upon on one’s past consumption (there are no habits from the past that influence today’s consumption) and that current pleasure does not depend upon comparison of one’s consumption to the consumption of others (there is no “envy”).

Within the rational optimization framework, there are two main approaches. The “life-cycle” model, first articulated in “Utility Analysis and the Consumption Function” (1954) by economists Franco Modigliani and Richard Brumberg, proposes that households’ spending decisions are driven by household members’ assessments of expenditure needs and income over the remainder of their lives, taking into account predictable events such as a precipitous drop in income at retirement. The standard version of the life-cycle model also assumes that consumers would prefer to spend everything before they die (i.e., it assumes there is no bequest motive). Life-cycle models are most commonly employed by microeconomists modeling household-level data on consumption, income, or wealth.

Macroeconomists tend to use a simplified version of the optimization framework called the “permanent income hypothesis,” whose origins trace back to economist Milton Friedman’s treatise A Theory of the Consumption Function (1957). The permanent income hypothesis omits the detailed treatment of demographics and retirement encompassed in the life-cycle model, focusing instead on the aspects that matter most for macroeconomic analysis, such as predictions about the nature of the consumption function, which relates consumer spending to factors such as income, wealth, interest rates, and the like.

Perhaps the most important feature of the consumption function for macroeconomics is what it has to say about the marginal propensity to consume (MPC) when there are changes in income. Economist John Maynard Keynes, who was the first to stress the importance of the MPC in The General Theory of Employment, Interest, and Money (1936), believed that up to 90 percent of any increase in current income would translate into an immediate increase in consumption expenditure (an MPC of 90 percent). However, evidence has shown that Friedman’s permanent income hypothesis is much nearer the mark: Friedman asserted that on average only about one-third of any windfall (a one-time unanticipated gain) would be spent within a year. He further argued that a one-for-one correlation between increased income and increased spending would occur only when the income increase was perceived to reflect a permanent change in circumstances (e.g., a new, higher-paying job).

The modern mathematical versions of the life-cycle and permanent-income-hypothesis models used by most economists bring some plausible refinements to the original ideas. For example, the modern models imply that the marginal propensity to consume out of windfalls is much higher for poor than for rich households. This tendency makes it impossible to determine the impact of a tax cut or government program on consumption spending without knowing whether it is aimed primarily at low-wealth or high-wealth households. The theory further indicates that tax cuts or spending programs (such as extended unemployment benefits) aimed primarily at lower-income households should be considerably more effective at stimulating or maintaining aggregate spending than programs aimed at richer households.