Consumption Demand, Uncertainty and Stochastic Process

Abstract

Part I of this paper reexamines the consumption demand under uncertain future wage income. In particular, we comprehensively reexamine the “Expected Utility Maximization Method” (EUM, developed by Hall[1978]), and propose an alternative method (“Certainty Equivalence Method”, CEM) to derive the consumption demand under uncertainty. We emphasize that the consumption demand should be established as a stochastic variable before considering its expected utility, an important logical point which seems to have escaped appropriate professional attention. We will show that, in contrast to EUM, our method (CEM) is applicable to any type of risk preference. Based on Part I, we examine in Part II how to derive a refutable hypothesis concerning the consumption demand as a stochastic process, consistently with the consumption demand derived by CEM. Again, it is necessary to reconsider the problem comprehensively, particularly in relation to the risk preference of the consumer. It will be shown that the risk neutrality is one of the important sufficient conditions for the consumption time series to have the martingale property.