Estimating Temptation and Commitment Over the Life Cycle

Abstract

This paper estimates the importance of temptation (Gul and Pesendorfer, 2001) for consumption smoothing and asset accumulation in a structural life-cycle model. We use two complementary estimation strategies: first, we estimate the Euler equation of this model; and second we match liquid and illiquid wealth accumulation using the Method of Simulated Moments. We find that the utility cost of temptation is one-quarter of the utility benefit of consumption. Further, we show that allowing for temptation is crucial for correctly estimating the elasticity of intertemporal substitution: estimates of the EIS are substantially higher than without temptation. Finally, our Method of Simulated Moments estimation is able to match well the life-cycle accumulation profiles for both liquid and illiquid wealth only if temptation is part of the preference specification. Our findings on the importance of temptation are robust to the different estimation strategies.

Temptation and Commitment: A Model of Hand-to-Mouth Behavior

“…We construct a model with temptation preferences and an endogenous demand for commitment and calibrate its parameters using data on consumption, assets, and housing from the Panel Study of Income Dynamics (PSID). Temptation preferences are attractive from a theoretical point of view, as choices emerging from this axiomatization are time consistent, and from an empirical point of view, as this type of behaviour is consistent with experimental evidence (Toussaert, 2018) and consumption behavior (Kovacs, Low, and Moran, 2020). We find that our model fits the data well, matching the large share of wealthy hand-to-mouth households despite the fact that housing does not deliver higher returns than equities.…”

“…First, temptation preferences are dynamically consistent, which makes welfare analysis straightforward. 4 Second, the importance of temptation preferences can be measured directly from observed consumption decisions using a linearized Euler equation, as in Kovacs, Low, and Moran (2020).…”

“…14 Temptation Parameter. We set λ = 0.28 following the parameter estimate obtained by Kovacs, Low, and Moran (2020). These authors develop two complementary strategies to estimate the strength of temptation: first, a semi-structural Euler equation approach using observed consumption data, and second, a simulation based approach targeting the life-cycle profiles of consumption and wealth accumulation.…”

“…Our MSM results are based on simulations for 1,000 households for two scenarios each. In the first scenario, we set λ to be 0.28 following Kovacs, Low, and Moran (2020) and we call this the model with temptation. In the second scenario, we set parameter λ to be zero and we call this the model without temptation.…”

“…In a model where wealthy handto-mouth households are generated by the assumption that illiquid assets deliver excess absent in a traditional model. Kovacs and Moran (2020) study the implications of this trade-off as it relates to financial liberalization which has given households greater access to home equity withdrawal.…”