Consumption Commitments and Employment Contracts

Abstract

We examine an economy in which the cost of consuming some goods can be reduced by making commitments that reduce flexibility. We show that such consumption commitments can induce consumers with riskneutral underlying utility functions to be risk averse over small variations in income, but sometimes to seek risk over large variations. As a result, optimal employment contracts will smooth wages conditional on being employed, but may incorporate a possibility of unemployment.

Solvency Constraint, Underdiversification, and Idiosyncratic Risks

“…According to the vast literature on consumption behavior, a large proportion of households commit to a critical consumption level, and more than 50% of the average household's budget is devoted to ensure this level of consumption for moderate wealth shocks (e.g., Fratantoni (2001), Chetty and Szeidl (2007), and Postlewaite et al (2008)). Models with consumption commitments are strongly supported by various empirical tests and have been shown to better fit consumption data and help explain various puzzles (e.g., Flavin and Nakagawa (2008), Chetty and Szeidl (2007)).…”

“…In support of the economic significance of consumption commitment, the existing literature also show that models with consumption commitment can outperform many alternative models. For example, they fit consumption data better than neoclassical models (e.g., Flavin and Nakagawa (2008)), can help explain the low stock ownership puzzle (e.g., Fratantoni), can explain why consumers insure risks and bunch uninsured risks together (e.g., Postlewaite, Silverman, and Samuelson (2008)), can help explain the discrepancy between moderate-stake and large-stake risk aversion and lottery playing by insurance buyers (e.g., Chetty and Szeidl (2007)), and can endogenize widely used reference-dependent preferences (e.g., Chetty and Szeidl (2010)). …”

Risk Aversion, Indivisible Timing Options, and Gambling

“…This phenomena has arisen before in the literature, but always in different context, for example in the literature on profit maximizers preferring price uncertainty (see Hartman (1972) and Varian (1992) p43, and in continuous time, Abel (1983) and Pindyck (1982)). A further example is the literature on consumption commitments, see Postlewaite, Samuelson and Silverman (2008). For example, letf be a production function, P the (random) price of a good and π the production level (a variable under the control of an agent), and suppose that the profit to the agent is given by…”

Attitudes Towards Income Risk in the Presence of Quantity Constraints

“…In the 10 Chetty and Szeidl (2007). 11 Drawing on a similar observation, Postlewaite et al (2008) show that efficient employment contracts should display wage rigidity and allow for layoffs when consumer/workers make consumption commitments. The strength of the argument, and the optimal degree of wage rigidity dependsamong other things-on the effect of consumption commitments on risk aversion.…”