Journal Article

Intertemporal Choice and Legal Constraints

M. Keith Chen and Alan Schwartz

in American Law and Economics Review

Published on behalf of The American Law and Economics Association

Volume 14, issue 1, pages 1-43
Published in print April 2012 | ISSN: 1465-7252
Published online December 2011 | e-ISSN: 1465-7260 | DOI: http://dx.doi.org/10.1093/aler/ahr007
Intertemporal Choice and Legal Constraints

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  • Law and Economics
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We study the effect of legal constraints in an environment in which agents face demand shocks they would like to smooth but also have weakness of will: agents' long and short run preferences are misaligned. Some agents are sophisticated—they know they will make inconsistent intertemporal choices—while other agents are naive. The consequent public policy problem is complex. The state should facilitate consumer borrowing to help agents’ smooth consumption and cushion the effect of shocks, but should also facilitate precommitment, to help agents control excessive present-biased preferences. We show that in many simple settings, naive and sophisticated agents make similar consumption/savings choices, which simplifies the policy problem. We also show that all agents borrow when they experience consumption shocks and that agents with relatively strong present-biased preferences who face relatively mild consumption shocks will borrow to finance excessive current consumption. Other agents save appropriately. Legal constraints that severely restrict agents' access to credit thus would be over-inclusive. Offering agents access to both a liquid and an illiquid savings vehicle appears to be welfare improving relative to either allowing agents complete freedom to borrow or strongly restricting their access to the credit market. Creating and regulating such vehicles are public goods that the market will not supply.

Keywords: D14; D18; D91; K12; K34; K35

Journal Article.  13623 words.  Illustrated.

Subjects: Law and Economics ; Household Behaviour and Family Economics ; Intertemporal Choice and Growth ; Tax Law ; Contract Law

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