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Bounded rationality, lifecycle consumption, and Social Security

Hyeon Park and James Feigenbaum ()

Journal of Economic Behavior & Organization, 2018, vol. 146, issue C, 65-105

Abstract: This paper explores an overlapping-generations model of bounded rationality in which consumers only foresee the future over a subset of their life span. We focus in particular on whether the model can, in general equilibrium, produce a hump-shaped lifecycle consumption profile with a peak that matches data for the average U.S. consumer. For a simple four-period model, we show that an increasing income profile along with exogenously imposed retirement are sufficient to induce a hump. With no other mechanism that can account for a hump besides bounded rationality, the model best fits the salient features of consumption data with a planning horizon of 20 years, which is well-supported by the behavioral evidence found in surveys on retirement planning. Finally, we show that the age of the consumption peak is robust to the introduction of Social Security, mortality risk, and another species of bounded rationality, quasihyperbolic discounting. Moreover, Social Security can be welfare improving with a short planning horizon. We can calibrate the model to jointly explain the timing of the consumption hump and the optimality of the current Social Security system. With quasihyperbolic discounting instead, we can calibrate the model so the current Social Security system is optimal but we cannot also account for the timing of the consumption hump. If we add quasihyperbolic discounting in addition to a short planning horizon, the present bias has a negligible effect in equilibrium.

Keywords: Bounded rationality; Re-optimization; Lifecycle model; General equilibrium; Consumption hump; Social Security; Quasihyperbolic discounting (search for similar items in EconPapers)
JEL-codes: D91 E21 (search for similar items in EconPapers)
Date: 2018
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DOI: 10.1016/j.jebo.2017.12.005

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