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Consumption patterns follow a logical pattern that the life cycle / permanent income hypothesis attempts to demystify. It is derived from the assumption that people prefer temperance to excesses.
LCH and PIH
In the life cycle hypothesis, one assumes that people will try to maintain smooth consumption patterns. If a person had a choice between three consistent meals and six unpredictable meals, he or she would prefer the first option over the second one. Many workers have irregular incomes, so they need to decide how to spend their earnings rationally.
Adherents of this school of thought assume that a person will save a certain part of his or her income in order to cushion himself during low seasons (Friedman 44). Alternatively, one may borrow during periods of low earnings and pay back the borrowed amount during periods of high earnings.
The theory is based on the assumption that people live longer than they earn; consequently, they need to accumulate assets or savings to sustain them during retirement, or when incomes cease. For instance, if a person starts working at 25, and expects to retire at 65, with an annual income of $40,000, he will earn a total of $1,600, 000 over his lifetime.
If the person expects to live for 75 years, then he will need to maintain an annual expenditure of $32,000. The person will need to set aside $ 8,000 annually so that he can have $320,000 during retirement. He may achieve this by asset acquisition or direct savings.
On the other hand, if the person had inherited assets worth $400,000, he will have a sum of $ 2,000,000 to spend throughout his lifetime. He can afford to spend $40,000 annually until his death at 75 years. In this regard, wealth becomes an important factor in determining consumption patterns.
The permanent income hypothesis (PIH) assumes that people’s expenditure patterns depend on their goal of maintaining a certain standard of living. People will ignore fluctuations in income if they believe that the changes are temporary.
This will be manifested as a constant spending pattern. For instance, increases in consumer tax may not alter consumption patterns immediately. However, if a change in income is perceived as permanent, such as the outsourcing of industries (customer care centers), or replacement of human resources with technology, then this may affect consumption patterns.
A person will reduce his or her expenditure patterns once he or she anticipates lower future earnings. The chief premise of the permanent income hypothesis is that people will make consumption decisions depending on what they expect to earn in the future. They may save or use up their savings in order to smoothen alterations in their income.
Both theories attempt to explain consumption. Additionally, both schools of thought are based on the premise that people will smoothen consumption patterns in the midst of fluctuating incomes. The LCH assumes that changes in income occur systematically across one’s lifetime.
Conversely, PIH assumes that current income varies randomly throughout one’s lifetime. In the life cycle theory, changes in population demographics will not alter income patterns, but this is not true in the PIH.
If the number of young people increases, then consumption will reduce and savings will increase. LCH also accounts for income inequality as savings are usually much higher in wealthy households than poor or middle-income households.
The two theories may differ in terms of consumption and saving patterns but the overall direction of these effects is the same. LCH and PIH are not the same models, but they complement each other. The combination of LCPIH considers an individual’s current income as well as his or her lifetime wealth.
Friedman, Milton. The life-cycle permanent income hypothesis: how we spend. Princeton: Princeton University Press, 1957. Print.