Theory of inter-temporal consumption, Microeconomics


In the previous two units, we have been concerned with choices among contemporaneous commodities. An important class of choices made by consumers, however, relates to consumption over time, that is, how one allocates income earned in different time periods to consumption. It seems that when income is earned in an uneven pattern, individuals attempt to "smooth out" their consumption through borrowing and lending. In this way, people's consumption varies less than their income.  

We began this discussion by considering consumption in just two-time period. Denote the present as period 1 and the future (next year) as period 2, and consumption in period 1 and 2 as x1 and x2. Suppose a person earns x10 in the present (this year) and x20 in the future (next year). Suppose also that this individual can borrow and lend in the "capital market" at rate of interest r. What this means is any income y not spent this year can be loaned to others, in return for which the consumer receives some greater amount y + r y = y(1 + r) next year. Alternatively, the consumer can increase present consumption by some amount y and repay y (1 + r) next year. The opportunity cost of consuming income y this year is thus forgoing consumption of y (1 + r) next year. 

The price of present consumption is thus (1 + r) units of future consumption; alternatively, the price of future consumption is (1 / (1 + r)) units of present consumption. We commonly say that the present value of Rs. Y one year from now is Rs. y / (1 + r); this is merely the quantity, y, times its price in terms of present consumption. The interest rate is the "premium for earlier availability of goods". Wealth, W, in the present, is defined as the present value of current and future income. The consumer's budget constraint is that she cannot spend more than her wealth, i.e.,  


the consumer maximises U (x1x2) subject to equation(a)



Though we are using "income" and "consumption" interchangeably as arguments in the utility function, it is well to remember, as pointed out by economist I. Fisher, that "income" really consists of consuming something. "Saving" (or dissaving) is just a way of rearranging consumption over time. Income is realised when it is consumed. The model is depicted in Figure The budget line has slope1693_THEORY OF INTER-TEMPORAL CONSUMPTION2.png, the price of x1 in terms of x2, and passes through the endowment point A, (x10, x20). An increase in the interest rate represents an increase in the price of the present consumption, and has the effect of rotating the wealth constraint clockwise through A. 

Posted Date: 10/26/2012 5:50:53 AM | Location : United States

Related Discussions:- Theory of inter-temporal consumption, Assignment Help, Ask Question on Theory of inter-temporal consumption, Get Answer, Expert's Help, Theory of inter-temporal consumption Discussions

Write discussion on Theory of inter-temporal consumption
Your posts are moderated
Related Questions
how to calculate out put and price

the prevention of major swings in economic activity cn be handled most easily by the financial or government sector?

Describing Risk * To measure risk we should know:  1) All the outcomes which are possible.  2) The probability that each outcome will occur. * Interpreting Probability

What types of external economies generates the output which reduces the costs of the firms in it? The chief example of external economies provided by marshal are (i) improved

Deviation from ideal gas behavior The Van der Waal''s Equation This is observed, deviations from gas laws are high under high pressures & low temperatures. The Van der Waal suggest

what happen when a supply shift to the right on a graph

a machine cost 18871.00 today. at the end of each year I own the machine & it gives me returns of 4,948.00 after paying repairs and maintenance. After 6 years, I expect to sell it

in the keynesian model the price is assumed to be what? a.exogeneous and remaaining constant b. endogeneous and remaining constant which is correct?

A film studio in Hollywood produces movies according to the function q = F(K;L) = (2=100)K^0.5L^0.5 In the short run, capital (studios, gear) is xed at a level of 100. It costs $

what are the uncontrolled variables you think may affect the segment of your camera