Question

What is the Life Cycle Hypothesis and what is the main difference between it and all other theories of Consumption?

Answer 1

Life Cycle hypothesis {LCH), given by Modigliani and Ando (1950) assumes that permanent income is calculated over an individual's whole life span. It means that the individual takes on debt while he/she is young, assuming that they will be able to pay the debts off with therir future income. They then save during their middle age when their income level is high, in order to maintain their consumption level when they retire.

Graph representing the LCH is given below:-

Other theories of consumption include Relative Income Theory and Permanent Income Theory.
Relative Income theory given by Duesenberry (1940s) says that consumption depends not only on an individual's income but also on the relative income of others. It illustrates the imitative structure of consumption in the sense that, families spendind depends not only on their tastes but also the tastes and expenditures of other families.

Permanent income hypothesis given by Friedman (1967) states that current consumption is a function of permanent income. It menas that when there are short therm changes in income, consumers do not find a reason to change their consumption habits.

Now, the main difference between Life Cycle Hypothesis (LCH) and the above two mentioned hypothesis is that LCH takes into account both present as well as future income of an individual over his entire lifetime, while the rest two hypotheses only takes into account only present income disregarding the time dynamic.