Consumption smoothing

Consumption smoothing is the economic concept used to express the desire of people to have a stable path of consumption. People desire to translate their consumption from periods of high income to periods of low income to obtain more stability and predictability. There exists many states of the world, which means there are many possible outcomes that can occur throughout an individual's life. Therefore, to reduce the uncertainty that occurs, people choose to give up some consumption today to prevent against an adverse outcome in the future. Consumption smoothing is the economic concept used to express the desire of people to have a stable path of consumption. People desire to translate their consumption from periods of high income to periods of low income to obtain more stability and predictability. There exists many states of the world, which means there are many possible outcomes that can occur throughout an individual's life. Therefore, to reduce the uncertainty that occurs, people choose to give up some consumption today to prevent against an adverse outcome in the future. The graph below illustrates the expected utility model, in which U(c) is increasing in and concave in c. This shows that there are diminishing marginal returns associated with consumption, as each additional unit of consumption adds less utility. The expected utility model states that individuals want to maximize their expected utility, as defined as the weighted sum of utilities across states of the world. The weights in this model are the probabilities of each state of the world happening. According to the 'more is better' principle, the first order condition will be positive; however, the second order condition will be negative, due to the principle of diminishing marginal utility. Due to the concave actual utility, marginal utility decreases as consumption increase; as a result, it is favorable to reduce consumption in states of high income to increase consumption in low income states. Expected utility can be modeled as: E U = q ∗ U ( W | b a d s t a t e ) + ( 1 − q ) ∗ U ( W | g o o d s t a t e ) {displaystyle EU=q*U(W|badstate)+(1-q)*U(W|goodstate)}