Intermediate Microeconomic Theory

Intertemporal Choice
Intertemporal Choice
So far, we have considered:
How an individual will allocate a given amount of money over
different consumption goods.

How an individual will allocate his time between enjoying leisure
and earning money in the labor market to be used for consuming
goods.

Another thing to consider is how an individual will decide how
much of his money should be consumed now, and how much he
should save for consumption in the future (or how much to
borrow for consumption in the present).
Intertemporal Choice
To think about this, instead of considering how an
individual trades off one good for another and vice
versa, we can think about how an individual trades
off consumption (of all goods) in the present for
consumption (of all goods) in the future.

i.e. two goods we will consider are:
c
1
- dollars of consumption (composite good) in the
present period, and
c
2
- dollars of consumption (composite good) in a
future period.
Intertemporal Choice
So an intertemporal consumption bundle is just a pair {c
1
, c
2
}.
E.g. a bundle containing $50K worth of goods this year,
and $30K next year is denoted {c
1
= 50K, c
2
= 30K}.

Endowment now describes how many dollars of consumption
an individual would have in each period, without saving or
borrowing, denoted {m
1
, m
2
}.

For example,
An individual who earns $50K each year in the labor
market {m
1
= 50K, m
2
= 50K}.
An individual who earns nothing this year but expects
to inherit $100K next year {m
1
= 0, m
2
= 100K}.


Intertemporal Budget Constraint
Consider an individual has an
intertemporal endowment of {m
1
, m
2
} and
can borrow or lend at an interest rate r.

What will be his intertemporal budget
constraint?

What is one bundle you know will be
available for consumption?

What else can he do?
Intertemporal Budget Constraint
What is slope?
Hint: How much more
consumption will he have
next period if he saves $x this
period?
To put another way, how
much does consuming an
extra $x this period cost in
terms of consumption next
period.

What will intercepts be?

x
c
2




m
2

m
1
c
1

?
x
?
Intertemporal Budget Constraint
Intercepts
Vertical What if you saved all of your
period 1 endowment, how much would you
have for consumption in period 2?


Horizontal How much could you borrow
and consume today, if you have to pay it
back next period with interest?


What happens to budget constraint when
interest rate r rises?
Intertemporal Budget Constraint
Example:
Suppose person is endowed with $20K/yr
Interest rate r = 0.10

What will graph of BC look like?




What if r falls to 0.05?
Writing the Intertemporal Budget Constraint
Given this framework, we want to write
out the intertemporal budget constraint in
the typical form


We know the interest rate r will determine
relative prices, but like with goods, we have
to determine our numeraire.


Writing the Intertemporal Budget Constraint
So intertemporal budget constraint can
be written in two equivalent ways:

Future value: future consumption is numeraire, price of
current consumption is relative to that.
How much does another dollar of current consumption
cost in terms of foregone future consumption?
BC: (1+r)c
1
+ c
2
= (1+r)m
1
+ m
2



Present value: present consumption is numeraire, price of
future consumption is relative to that
How much does another dollar of future consumption
cost in terms of foregone current consumption?
BC: c
1
+ c
2
(1/(1+r))

= m
1
+ m
2
(1/(1+r))


Intertemporal Preferences
Do Indifference Curves make sense in this
context?


What does MRS refer to in this context?


Do Indifference Curves with Diminishing
MRS makes sense in this context?


What Utility function might be appropriate
to model decisions in this context?
Intertemporal Choice
We can again think of analyzing optimal
choice graphically.




What does it mean when optimal choice is
a bundle to the left of endowment bundle?
How about to the right of the endowment
bundle?
Intertemporal Choice
Similarly, we can solve for each individuals demand
functions for consumption now and consumption in the
future, given interest rate (i.e. relative price) and endowment.
c
1
(r,m
1
,m
2
)
c
2
(r,m
1
,m
2
)

So if u(c
1
, c
2
) = c
1
a
c
2
b
, an endowment of (m
1
,m
2
) and an
interest rate of r, what would be the demand function for
consumption in the present? In the future?
Intertemporal Choice
As we showed graphically,
If c
1
(r,m
1
,m
2
) > m
1

the individual is a borrower

If c
1
(r,m
1
,m
2
) < m
1

the individual is a lender

Equivalently,
If c
2
(r,m
1
,m
2
) < m
2
the individual is a borrower

If c
2
(r,m
1
,m
2
) > m
2
the individual is a lender

Analog to Buying and Selling
So instead of being endowed with coconut
milk and mangos (or time and non-labor
income) we can think of being endowed
with money now and money in the future.

Moreover, instead of being a buyer of
coconut milk by selling mangos, we can
think of being a buyer of consumption now
(i.e. a borrower) by selling future
consumption.
Comparative Statics in Intertemporal Choice
Suppose the interest rate decreases.

Will borrowers always remain borrowers?



Will lenders always remain lenders?
Comparative Statics in Intertemporal Choice
How does this model inform us about
government interest rate policy?

Why might government lower interest rates?


Raise interest rates?
Present Value and Discounting
The intertemporal budget constraint
reveals that timing of payments matter.

Suppose you are negotiating a sale and 3
buyers offer you 3 different payments
schemes:
1. Scheme 1 - Pay you $200 one year from
today.
2. Scheme 2 - Pay you $100 one year from
now and $100 today.
3. Scheme 3 - Pay you $200 today.

Assuming buyers words are good, which
payment scheme should you take? Why?
(Hint: think graphically)
Present Value and Discounting
This is idea of present value discounting.
To compare different streams of payments, we have to have some way
of evaluating them in a meaningful way.
So we consider their present value, or the total amount of
consumption each would buy today.
Also called discounting.

In terms of previous example, with r = 0.10 the present value of each
stream is:
1. PV of Scheme 1 = $200/(1+0.10) = $181.82
2. PV of Scheme 2 = $100 + $100/(1+0.10) = $190.91
3. PV of Scheme 3 = $200

While you certainly might not want to consume the entire payment
stream today, as we just saw, the higher the present value the bigger
the budget set (assuming same interest rate applies to all schemes!)
Present Value and Discounting
What about more than two periods?
As we saw, if r is interest rate one period ahead, PV of
payment of $x one period from now is $x/(1+r). What is
intuition?

If you were going to be paid $m two years from now,
what is the most you could borrow now if you had to pay
it back with interest in two years?


So what is general form for present value of a payment of
$x n periods from now?

What is form for a stream of payments of $x/yr for the
next n years?

Interest Rate and Uncertainty
So far, we have assumed there is no uncertainty.
Individuals know for sure what payments they will
receive in the future, both in terms of endowments and
loans given out.


What happens if there is uncertainty regarding whether
you will be paid back the money you lend or will be
able to pay back the money you borrow?