This blog post focuses on human consumption and savings behavior as seen through behavioral economics, examining the psychological mechanisms and core concepts behind why we fail to stick to the optimal plans we set for ourselves.
Economic theory begins with attempts to predict the behavior of economic agents, but in reality, people’s observed behavior often diverges from theoretical expectations. Economics has gradually evolved through analyzing and debating these so-called anomalies. Recently, behavioral economics, which critically reexamines traditional economics’ assumptions about people’s actual behavioral characteristics, has led this discussion.
The difference between traditional economics and behavioral economics is particularly evident in the realm of saving and consumption. Traditional economics assumes that individuals accurately discern what is best for themselves, formulate optimal consumption plans throughout their entire lives, and execute these plans with unwavering resolve. It also posits that money carries no inherent restrictions on its use, allowing it to be freely diverted to other purposes at any time. This potential for diversion enables free and flexible choices, thereby enhancing individual welfare. Based on this perception, traditional economics predicted that people would maintain relatively constant consumption levels throughout their lives. It noted that income rises with age before declining sharply after retirement, and thus anticipated consumption patterns would remain independent of age-related income changes. However, the consumption patterns actually observed closely mirrored income changes by age. Traditional economics explained this anomaly through the concept of liquidity constraints, arguing that imperfect financial markets limit individuals’ ability to secure sufficient liquidity for current consumption by using future income or assets as collateral. In other words, financial constraints cause actual consumption levels to fall below the optimal consumption path suggested by theory.
Behavioral economics, however, views the phenomenon of lower-than-predicted consumption during youth and old age not as an inevitable result of external constraints, but as the outcome of voluntary choices driven by individual psychological mechanisms. It explains this through the concept of mental accounting. People mentally compartmentalize various assets—cash, checking accounts, savings accounts, housing, etc.—into distinct accounts and apply different usage principles to each. At the bottom of the asset pyramid lies cash, the most readily accessible for spending, used for most daily expenses. Many people, despite having savings accounts, resort to credit card cash advances with interest rates exceeding 20% when needing quick cash. Financially, withdrawing deposits for use is preferable, yet people make the irrational decision to borrow money at high interest rates while maintaining savings at low rates. The most sacred accounts in their minds hold assets set aside for retirement, like retirement pensions or homes. These assets are rarely withdrawn unless the worst-case scenario occurs. When mental accounting operates this way, the possibility of repurposing assets is significantly weakened. Consumption at a specific point in time depends not only on total lifetime income but also on which mental account the assets generating that income belong to.
According to behavioral economics, even if people know what is best for them and devise an optimal consumption plan spanning their entire life, they tend to prefer the present over the future and are vulnerable to temptation. Consequently, people create internal mechanisms to impose certain constraints on themselves to safeguard their own and their family’s long-term security; this self-control mechanism is precisely mental accounting. From the perspective of mental accounting, the liquidity constraints emphasized by traditional economics can instead be understood as the result of voluntary choices designed to preemptively block expenditures that would be disadvantageous in the long term. If mental accounting is a mechanism that suppresses immediate temptations and forces individuals to postpone current spending into the future—that is, to save—then retirement pensions and national pension systems represent examples of these personal mechanisms institutionalized at the societal level.
