Академический Документы
Профессиональный Документы
Культура Документы
http://micro2.tholden.org/
Readings
Varian, Chapter 10 MKR, Chapter 5
To what extent do you think about your future income when making these decisions?
Do you think your consumption decisions will change if you get a definite job/placement offer?
ECO 2051 Intermediate Microeconomics 5
2 1+ 2
+=
=1 1+
So at what price should you be prepared to buy the share? What should you do if you couldnt afford it at this price?
If they are offered the chance to switch to an alternative stream 0 , 1 , 2 , should they take it?
Could be a new job, or a degree, or an investment.
1 PV of the original stream, is = 0 + 1+ +
2 1+ 2
+=
=0 1+ .
=0 1+ .
2 1+ 2
+=
Suppose they borrow all of this money, then immediately put a total of =1 1+ = 0 into their saving account, leaving 0 = + 0 in their pocket.
10
= 1 +
in the bank.
=2 1+ 1
in savings. = 2 +
=3 1+ 2 .
=2 1+ 1
Continuing in this way, the consumer may spend in every period after 0.
11
So when > the consumer is strictly better off taking the stream, independent of preferences.
As Varian says:
Present value is the only correct way to convert a stream of payments into todays dollars If a consumer can freely borrow and lend at a constant rate of interest, then the consumer will always prefer a pattern of income with a higher present value to a pattern with a lower present value.
12
With a zero interest rate we just add up the payments 310 > 300 so investment B is better.
But with a sufficiently high interest rate investment A is preferred.
For example if = 0.2 then PV = 100 + 258.33.
200 1.2
= 266.67 & PV = 0 +
310 1.2
The fact that A pays more money earlier on means that it will have a higher present value if the interest rate is high enough.
ECO 2051 Intermediate Microeconomics 13
PV examples: Perpetuities
Buying a perpetuity guarantees the holder of the perpetuity to a payment of in all future periods. What is the PV of such a perpetuity?
Using the formula from earlier, the present value of the perpetuity, , satisfies = = + + =1 2 3 + .
1+ 1+ 1+ 1+
Thus 1 + = + 1+ + So = , i.e. = .
1+ 2
+ = +
If you invest an amount at an interest rate , then you get each period.
14
PV examples: Bonds
Buying a -period bond guarantees the holder to:
A payment of in periods 1,2, , 1. (This is called the coupon.) A payment of in period . (This is called the face value.)
=
Thus:
=1
1 +
1 +
+ 1 + 1 +
+ + 2
1 +
+ 1
1 +
+ + + + 1 + 1 + 2 1 + 2 1 + 1 = + + + + + + 1 + 1 + 2 1 + 2 1 + 1 1 + = + + 1 + 1 1 + 1 + = +
1 + 1 1 +
So = +
1+ 1
1+
= +
1+ , 1+
i.e. = +
1+
1+
.
15
Then my net income in period is . And the net present value (NPV) of the investment is the PV of the net incomes, i.e. . =0
1+
16
17
I.e. 0 0 +
Increasing interest rates make next periods consumption cheaper. (I have to save less today to pay for it). Increasing interest rates make next periods income less valuable. (I can borrow less today using it).
1 1 1+
1 = 0 + 1+.
18
When 0 = 1 , the slope of the budget constraint is (1 + ) for each 1 given up now, we get 1 + in future. For each extra 1 consumed now, we give up 1 + in future.
ECO 2051 Intermediate Microeconomics 19
Preferences
A person who was totally indifferent between consumption today and in the future would have indifference curves with a slope of 1. People are likely to prefer a mix of consumption in present and future, so ICs are convex. Because impatient individuals prefer to consume today, on the 45 line we need more than 1 tomorrow to give up 1 today. Steeper indifference curves imply more impatience.
ECO 2051 Intermediate Microeconomics 20
Making choices
21
Other outcomes
22
Example
Suppose:
0 , 1 = 0 1 , 0 = 1 = 1 (i.e. we are measuring in units of the consumption good). the consumer has income of 100 in the first period and 121 in the second, the interest rate is 10%.
0 1
MRS is
= 1.
0
The budget constraint says 0 + 1 = 100 + . 1.1 1.1 Thus 20 = 100 + 110, so 0 = 105 and 1 = 115.5.
So the consumer borrows 5 in the first period and pays it back in the second.
121
23
FOC 0 : 0 =
FOC 1 : 0 = 1 +
0 1
0 1
0 , so =
1 , 1+
1 0 0
so:
= MRS
24
1+
1=
1+ 1+
1+ 1+
1+
So if the real price of a good is constant, at the optimum minus the slope of the indifference curve must equal 1 + .
ECO 2051 Intermediate Microeconomics 25
1 .
Derive the FOC. When are consumers neither savers or borrowers? What happens when = log ?
26
27
28
29
30
Notice that here the that human capital options are entirely continuous. This is probably not the case in reality.
ECO 2051 Intermediate Microeconomics 32
In this example the decision over investment is entirely separate from preferences about consumption over time. Is this plausible? ECO 2051 Intermediate Microeconomics
33
Summary
In a world with perfect credit markets consumers can choose between consumption today and in the future.
This is relevant for their saving and borrowing behaviour, and the approach to investments. However, all these decisions will be affected by the relative price of consumption in different periods as indicated by the interest rate.
NPV is an important concept which enables individuals to evaluate the worth of income and payments at different times.
When making decisions we should be choosing those with the highest net present value.
34