Theory of inter-temporal consumption, Microeconomics

THEORY OF INTER-TEMPORAL CONSUMPTION:

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.,  

104_THEORY OF INTER-TEMPORAL CONSUMPTION.png

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

 

1299_THEORY OF INTER-TEMPORAL CONSUMPTION1.png

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
Official Reserve Account: This part of the balance of payments informs us about how the balance of both current and capital accounts taken together is settled.Transaction in thi

1. An investment in flood control infrastructure  today will generate $1,000,000 in benefits 10 years from today. Using a 3% discount rate what is the present value of these benefi


Consider the market for purple magic markers. The demand for purple magic markers is perfectly elastic and the supply is upward sloping. If sellers of purple magic markers are taxe

Current Daily Status(CDS): The reference periods (i.e. a year, a week and a day) are basically used to describe the period for which the workers are employed in the economy. T

Assume that the employer (principle) wants its employee (agent) to work hard [You can safely assume that this maximizes the principle's expected profits from his business]. There a

I have 3 questions regarding the economics of potlatch, 1.) What is the economic purpose of potlatch? I don''t fully understand this question... I believe potlatch is a gift econ

Suppose scientists discover that eating soybeans prevents cancer and heart disease

Tom's pizza sells for $ 5.00 ea and serves an average of 425 customers per week. During a recent sale, Tom lowered the price to $ 4.00 per ea. Sales increased to 500 customers duri

What is Co-ordination Number? A Co-ordination Number is the total number of ligands which are attached to the central metal atom by co-ordinate bonds or number of atoms of a liga