Part B Microeconomics

ECB002

Lecture 12
Consumer Theory – Application: Intertemporal Choice

Vanessa Valero
Slides

1
Aims

The tools that we have developed over the past few weeks can easily be applied
to answer other questions.

Today, rather than thinking about what consumers decide to consume, we will
use the tools to consider when consumers decide to consume.

It will help us to understand how consumers decide to save and borrow, with
important implications for capital and credit markets. We will also recap how
agents should evaluate payoffs over time by thinking about present values.

Consequently, the models developed here form key components for macro and
finance, and help policy issues such as household borrowing. Link.

This lecture also develops some new ‘revealed preference’ techniques.

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Outline

1. The Intertemporal Budget Constraint

2. Calculating Optimal Choice
3. Comparative Statics (with Revealed Preference Arguments)
4. Evaluating Payoffs Over Time (Private study)

3
Reading

Unfortunately, Perloff does not contain much on this topic. It covers section 4
well in 15.2 (3rd and 4th ed)/15.4 (2nd ed) (or Perloff Microeconomics, 16.1-16.2),
but does not have anything on sections 1-3. Varian is probably the best for these
topics. (See reading list link on left hand side of Learn page for book details).

Alternative/Additional: Varian 10 (now available as e-chapter on reading list)

Katz and Rosen 5.2-3
Other books on reading list

Perloff 4.5 (all editions) also has some material about the revealed preferences
method that we use at one part of this lecture.

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1. The Intertemporal Budget Constraint

To think about intertemporal choice in the simplest way possible, we will

consider a two-period model with period 1 (P1) and period 2 (P2).

In P1, the consumer receives an exogenous income m1. In P2, the consumer
receives an exogenous income m2.

To simplify the consumption choice, we’ll consider a composite good, C

(lumping all goods on the market together). Price of C normalised to 1.

Hence, the consumer must decide how much of this good to consume in period
1, c1, and how much to consume in period 2, c2.

Let the real (i.e., net of inflation) market interest rate equal r.

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First, let us just think about the consumer’s possible choices without
borrowing.

The consumer can, of course, consume all his income in each of the periods if
he wishes. That is, c1=m1 and c2=m2.

However, the consumer can also choose to save some positive amount of
money in P1, (m1-c1)>0, which will then increase his P2 income by (1+r)(m1 - c1).

Hence, in P2, the consumer cannot consume more than his total P2 income
which consists of period 2 specific income plus the final value of any P1 savings.
This implies a budget constraint:

c2 ≤ m2 + (1+r)(m1-c1) ⇒ c2 + (1+r)c1 ≤ m2 + (1+r)m1

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This constraint can be drawn as follows. 1+r is the relative price of
P1 consumption in terms of
P2 consumption

Save all P1 income, spend it

c2 all in P2

m2+(1+r)m1
-(1+r) slope

No saving
m2

m1 c1

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Now, let’s introduce the possibility of borrowing as well as saving.

The consumer can now choose to consume an amount in P1, c1, that is larger
than his P1 income, m1. By doing so, he will have to borrow (c1-m1) which will
then reduce his P2 income by (1+r)(c1-m1) when he must pay back his loan.

The budget constraint for a borrower is then given below. (Note that this is
equivalent to the previous budget constraint.)

c2 ≤ m2 -(1+r)(c1-m1) ⇒ c2 + (1+r)c1 ≤ m2 + (1+r)m1

Therefore, we can think of the ‘price’ of period 1 consumption relative to period

2 consumption as (1+r). This is the opportunity cost. By spending 1 unit in P1, I
forgo (1+r) savings income in period 2 or I have to pay (1+r) in repayments in
P2.

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 1+r is the relative price of P1 consumption
in terms of P2 consumption

Save all P1 income, spend it

c2 all in P2

m2+(1+r)m1

-(1+r) No saving or
borrowing

m2
Borrow all of P2 income
to consume in P1

m1 m1+(m2/(1+r)) c1

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2. Optimal Choice

By introducing a well-behaved utility function over consumption in P1 and P2,

U(c1, c2), we can then set up a Lagrangian to find the optimal choice.

Max L (c1,c2,  ) = U(c1,c2) -  ( c2 - m2 - (1+r)(m1-c1))

Note: budget constraint differs from usual « consumer choice » problem

And we can find the FOCs, as usual.

i) L / c1 = U / c1 -  (1+r) = MUc1 -  (1+r) =0

ii) L / c2 = U / c2 -  = MUc2 -  =0
iii) L /  = -( c2 - m2 - (1+r)(m1-c1)) = 0
Then just follow the standard Steps 1 and 2.

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Step 1: Find optimal ratio of two goods

Rearrange and divide i) by ii)

i) U / c1 =  (1+r) or MUc1 -  (1+r) =0

ii) U / c2 =  or MUc2 -  =0

(MUc1/MUc2) = (1+r)

This is just another tangency condition. The MRS between consumption in P1

and consumption in P2 must equal the slope of the budget constraint, MRT.

In this context, the MRS has a fancy name - the Marginal Rate of Time
Preference, (MRTP). The ratio tells us how much more consumption in the
future the consumer wants in exchange for one unit of consumption now – in

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order to remain on the same utility level. This ratio just reflects how patient the
consumer is.

Step 2: Insert optimal ratio back into budget constraint, iii).

Use (MUc1/MUc2) = (1+r) with (c2 - m2 - (1+r)(m1-c1))=0 as two simultaneous

equations and solve for optimal consumption levels, c1* and c2*.
The optimal levels of c1* and c2* will then determine whether the consumer is a
borrower or a lender, and will describe how his choices vary with the interest
rate and with each period’s income level.
The consumer is a borrower (lender) if c1*> m1 (if c1*< m1).

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Exercise

Suppose a consumer has a utility function, U(c1,c2) = 4c10.5c20.5. Her period 1

income is m1 and her period 2 income is m2. The consumer can freely borrow
or save at an interest rate, r.

𝒎𝟐 +(𝟏+𝒓)𝒎𝟏
Verify that her optimal consumption levels equal 𝒄∗𝟏 = and 𝒄∗𝟐 =
𝟐(𝟏+𝒓)
𝒎𝟐 +(𝟏+𝒓)𝒎𝟏
.
𝟐

𝒎𝟐
Show that the consumer is a borrower if (
𝒎𝟏
) > (𝟏 + 𝒓) and explain the
intuition.

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Solution
a) Set up a Lagrangian to maximise household utility.

L=4c10.5c20.5-  ( c2 - m2 - (1+r)(m1-c1))

b) State the three first order conditions.

𝝏𝑳
i) =2c20.5 c1-0.5 – (1+r)  = 0
𝝏𝑪𝟏
𝝏𝑳
ii) = 2c2-0.5 c10.5 –  = 0
𝝏𝑪𝟐
𝝏𝑳
iii) = - ( c2 - m2 - (1+r)(m1-c1))= 0 (Budget)
𝝏𝝀

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c) Step 1: Optimal Ratio by dividing (i) by (ii):
2c20.5 c1-0.5 = (1+r)  divided by 2c2-0.5 c10.5 = 
gives (c2 / c1)= (1+r) and so c2*=(1+r)c1*.

Step 2: Substituting the optimal ratio into (iii)

c2 + (1+r)c1 = m2 + (1+r)m1 or 2(1+r)c1 = m2 + (1+r)m1 or
c1*=(m2+(1+r)m1)/2(1+r)
And c2*=(1+r)c1* therefore c2*=(m2+(1+r)m1)/2

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d) To see whether the consumer is a borrower in P1, start from the expression
for the optimal c1 we derived above
c1*=(m2+(1+r)m1)/2(1+r)> m1 if and only if m2+(1+r)m1>2m1(1+r), i.e.

𝒎
(𝒎𝟐 ) > (𝟏 + 𝒓).
𝟏

This condition holds when either

- m1 (P1 income) is small

- r (opportunity cost of P1 consumption) is small
- or m2 (P2 income) is large

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3. Comparative Statics

Consider an increase in the interest rate, r. This has an effect slightly different
to normal. The budget constraint steepens because it has a gradient, -(1+r).
However, as the consumer can always consume at the point, (c1=m1, c2=m2),
the budget constraint actually rotates around this point.

c2

-(1+r) No saving or
borrowing

m2

m1 c1

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Revealed Preference Arguments

We could find how the optimal choices respond due to some change in the
environment (e.g., a change in r) by using the usual methods, such as the
methods we developed a few weeks ago where we considered the sign of the
associated derivative.

However, it is sometimes useful to consider a different technique.

Revealed preference arguments are based on the idea that under our
consumer choice assumptions we can not only predict behaviour for a given
set of preferences, but we can also infer preferences from observed
behaviour.

(see Section 4.5 Perloff)

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The basic idea:

Mary fancies Malcolm. Malcolm lives on the other side of town and loves Man
Utd.
One night he travelled across town and missed the match on TV to help Mary
do her coursework.
Mary wasn’t sure if Malcolm fancies her.
What would you say? (Assuming Malcom is rational)

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As a more formal example, suppose that we observe that a consumer selects a
from feasible set L1. Then, given our assumptions, he must prefer a to all other
possible bundles under L1.

If then we also observe that the consumer selects b from feasible set L2 we
know that he must prefer b to all other possible bundles under L2 including c
(see figure).

Therefore, as the consumer has revealed that she prefers a to b under L1 then
she must also prefer a to c and indeed a to all bundles in the shaded area.

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21
 Some Comparative Static Results

If a consumer is a lender (c1<m1), he will remain a lender after an increase in r.

c2 Why? Before the increase, the

e2 consumer preferred e1 to borrowing at
any point on line g. After the increase,
e1 any point on g would never be chosen
because e1 would still be available.
m2 Nor would any point on line g’: those
g points are also dominated by e1. So
g’ the consumer would never want to
become a borrower.
m1 c1

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Exercise: Check that you can use a similar argument to suggest that a
borrower (c1>m1) will remain a borrower following a decrease in r.

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Answer
Given the initial value of r, e1 is
preferred to any (c1,c2) pair on the
green section of the budget
constraint (such that the consumer
would be a lender) and thus also
prefers e1 to any pair within the
feasible set. When r decreases, the
consumer still prefers e1 (which is
still feasible) to all the pairs on the
new budget constraint that are such
that c2>m2. Hence, the consumer
does not want to become a lender.

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4. Evaluating Payoffs Over Time (Private study)

Often choices in life involve the comparison of options with different payoffs over
time or different ‘payoff streams’. For example, consumers have to choose
which mortgage or credit card contract to choose, and firms have to choose
between different investment projects.

To compare different payoffs in the future, we need to calculate what the value
of the payoffs are in the current time period – their present value. What is the
present value of an income payment of £x in 1 year’s time, if the (real) interest
rate is r?
𝒙
𝑷𝑽 =
(𝟏 + 𝒓)

An agent would be indifferent between receiving £x in a year’s time and

receiving PV immediately. Why? On receiving PV now, they could put that
money into a saving account and collect PV(1+r) in a year’s time.

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Using the same logic, we can calculate the PV of £x in z years’ time as

𝒙
𝑷𝑽 =
(𝟏 + 𝒓)𝒛

Example: Should an agent choose option A over option B, where option A is

£110 now and option B is £120 in 3 years’ time (when the interest rate is 3%)?
Yes, as 110>109.81 = [120/(1.03)3].

More generally, the PV of earning x in a year’s time and x in every subsequent

year, for a total of T years is
𝑻
𝒙 𝒙 𝒙 𝒙
𝑷𝑽 = + + ⋯ = ∑
(𝟏 + 𝒓) (𝟏 + 𝒓)𝟐 (𝟏 + 𝒓)𝑻 (𝟏 + 𝒓)𝒕
𝒕=𝟏

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Exercise:

A consumer could buy insulation for his home that would save him £100 in fuel
costs at the end of every year. If he expects to live in the house for the next 3
(whole) years, verify that his willingness to pay for the insulation is £272 when
r=5%.

What other factors might affect his willingness to pay?

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Answer
Given a payoff of x=100 for each of T=3 years and r=0.05 we have

𝟑
𝒙 𝟏𝟎𝟎 𝟏𝟎𝟎 𝟏𝟎𝟎
𝑷𝑽 = ∑ = + + = 𝟐𝟕𝟐
(𝟏 + 𝒓)𝒕 (𝟏. 𝟎𝟓) (𝟏. 𝟎𝟓)𝟐 (𝟏. 𝟎𝟓)𝟑
𝒕=𝟏

In addition to the price of insulation, the decision to install may for instance be
affected by
- Uncertainty: e.g. energy prices and taxes changing or variation in the IR
- Preference for “green” investments

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In more complex decisions, agents may have to evaluate a stream of positive
and negative payoffs. This is typical for firms evaluating the profitability of
different projects that vary in costs and revenues over time.

𝑹𝟏 𝑹𝑻 𝑹𝒕
PV of Revenues: 𝑷𝑽𝑹 = 𝑹𝟎 + +⋯ = ∑𝑻𝒕=𝟎
(𝟏+𝒓) (𝟏+𝒓)𝑻 (𝟏+𝒓)𝒕

𝑪𝟏 𝑪𝑻 𝑪𝒕
PV of Costs: 𝑪𝑽𝑹 = 𝑪𝟎 + +⋯ = ∑𝑻𝒕=𝟎
(𝟏+𝒓) (𝟏+𝒓)𝑻 (𝟏+𝒓)𝒕

Then we can define the Net Present Value (NPV)

𝑻
(𝑹𝟏 − 𝑪𝟏 ) (𝑹𝑻 − 𝑪𝑻 ) (𝑹𝒕 − 𝑪𝒕 )
𝑵𝑷𝑽 = (𝑹𝟎 − 𝑪𝟎 ) + +⋯ =∑
(𝟏 + 𝒓) (𝟏 + 𝒓)𝑻 (𝟏 + 𝒓)𝒕
𝒕=𝟎

Firms should pick the project with the highest NPV, as long as the NPV >0.

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Exercise:

Project A costs 100 immediately and brings a revenue of 50 at the end of year
1 and 90 at the end of year 2.

Project B costs 150 immediately and brings a revenue of 130 at the end of
year 1 and 60 at the end of year 2.

If the interest rate is 5%, verify that a firm should choose project A? (Tip: NPV
of A should equal £29.25)

If the interest rate is 25%, verify that the firm should choose neither project.

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Answer
Project A: C0=100, R1=50 and R2=90
Project B: C0=150, R1=130 and R2=60

Suppose r=0.05, then

𝑹𝟏 𝑹𝟐 𝟓𝟎 𝟗𝟎
𝑵𝑷𝑽(𝑨) = −𝑪𝟎 + + = −𝟏𝟎𝟎 + + = 𝟐𝟗. 𝟐𝟓
(𝟏 + 𝒓) (𝟏 + 𝒓)𝟐 𝟏. 𝟎𝟓 (𝟏. 𝟎𝟓)𝟐
𝟏𝟑𝟎 𝟔𝟎
𝑵𝑷𝑽(𝑩) = −𝟏𝟓𝟎 + + = 𝟐𝟖. 𝟐𝟐
𝟏. 𝟎𝟓 (𝟏. 𝟎𝟓)𝟐
So the firm should choose project A

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Suppose now r=0.25, then
𝟓𝟎 𝟗𝟎
𝑵𝑷𝑽(𝑨) = −𝟏𝟎𝟎 + + = −𝟐. 𝟒
𝟏. 𝟐𝟓 (𝟏. 𝟐𝟓)𝟐
𝟏𝟑𝟎 𝟔𝟎
𝑵𝑷𝑽(𝑩) = −𝟏𝟓𝟎 + + = −𝟕. 𝟔
𝟏. 𝟐𝟓 (𝟏. 𝟐𝟓)𝟐
So none of the projects should be chosen

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Summary

By the end of this session, students should be able to

- Calculate optimal intertemporal choices to determine optimal saving and

borrowing levels.

- Use diagrammatic revealed preference arguments to explain the effects of

changes in the interest rate on savings and borrowing behaviour.

- Calculate NPV’s and use them to find optimal choices between different
payoff streams.

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