Consumption Commitments and Risk Preferences

Abstract

Many households devote a large fraction of their budgets to "consumption commitments"-goods that involve transaction costs and are infrequently adjusted. This paper characterizes risk preferences in an expected utility model with commitments. We show that commitments affect risk preferences in two ways: (1) they amplify risk aversion with respect to moderate-stake shocks, and (2) they create a motive to take large-payoff gambles. The model thus helps resolve two basic puzzles in expected utility theory: the discrepancy between moderate-stake and large-stake risk aversion and lottery playing by insurance buyers. We discuss applications of the model such as the optimal design of social insurance and tax policies, added worker effects in labor supply, and portfolio choice. Using event studies of unemployment shocks, we document evidence consistent with the consumption adjustment patterns implied by the model. Copyright by the President and Fellows of Harvard College and the Massachusetts Institute of Technology.

Measuring how risk tradeoffs adjust with income

“…As a result, short run adjustments to exogenous shocks will differ from responses when the consumption commitments can be modified. Our model confirms that the presence of consumption commitments affects risk preferences (Chetty and Szeidl 2007) and the responsiveness of labor supply to income changes. Both effects have implications for the IEVSL.…”

“…We begin in Section 1 by describing how the recent work of Eeckhoudt and Hammitt (2001), Kaplow (2005), Chetty (2006), and Chetty and Szeidl (2007) relate to the structure of our conceptual model. In Section 2 we describe the results from our generalized model which yields some of the previous models as special cases.…”

“…We have adopted the Kaplow convention in order to facilitate direct comparisons between our results and those of Kaplow and others. Chetty and Szeidl (2007) also define a CRR in terms of expected utility (p. 844). consumption, may limit the ability of some individuals to adjust their labor supply in response to income shocks.…”

“…We focus our attention on four such papers (Eeckhoudt and Hammitt (2001), Kaplow (2005), Chetty (2006), and Chetty and Szeidl (2007)). The primary objectives of these papers vary but each offers a key insight that motivates the structure of our analytical model discussed in Section 2.…”

“…We return to these issues at the outset of the next section. Chetty and Szeidl (2007) add another component to the framework, the presence (or absence) of constraints on other behavioral adjustments to exogenous shocks, which may cause additional differences in the relationship between the coefficient of relative risk aversion and the income elasticity of the VSL. Chetty and Szeidl (2007) conclude that:…”