Investment and Consumption without Commitment

TL;DR

This paper studies the problem of investment and consumption under non-exponential discounting, focusing on time-inconsistency and equilibrium strategies in portfolio management with finite and infinite horizons.

Contribution

It provides a formal definition of equilibrium strategies, characterizes them via PDEs, and offers explicit solutions for CRRA utility under specific discount functions.

Findings

Existence of equilibrium strategies for finite horizon with CRRA utility.

Explicit solutions for infinite-horizon case with CRRA utility.

Analysis of non-exponential discount functions like linear combinations of exponentials.

Abstract

In this paper, we investigate the Merton portfolio management problem in the context of non-exponential discounting. This gives rise to time-inconsistency of the decision-maker. If the decision-maker at time t=0 can commit his/her successors, he/she can choose the policy that is optimal from his/her point of view, and constrain the others to abide by it, although they do not see it as optimal for them. If there is no commitment mechanism, one must seek a subgame-perfect equilibrium strategy between the successive decision-makers. In the line of the earlier work by Ekeland and Lazrak we give a precise definition of equilibrium strategies in the context of the portfolio management problem, with finite horizon, we characterize it by a system of partial differential equations, and we show existence in the case when the utility is CRRA and the terminal time T is small. We also investigate the infinite-horizon case and we give two different explicit solutions in the case when the utility is CRRA (in contrast with the case of exponential discount, where there is only one). Some of our results are proved under the assumption that the discount function h(t) is a linear combination of two exponentials, or is the product of an exponential by a linear function.