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Original Title: Microfoundation of Consumption Choice(1)

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Consumption Theory

forms the basis for modern macroeconomic model of

consumption and asset pricing.

Date 1 (subscript 1) denotes current or today and date 2

(subscript 2) denotes future.

(2) C1 = Y1 S

(if S < 0). N.B. There is no need to save in period 2.

(3) C2 = Y2 + (1+r) S

price of consumption)

2

From (2) S = Y1 C1

of period 2 (future) values

C2 + C1(1+r) = Y2 + (1+r) Y1

budget constraint in terms of period 1 (present) value

the present-value of income.

Intercepts:

3

of income)

If C2 = 0, C1 = [Y1 + Y2/(1+r)] => Horizontal intercept

(= PV of income)

Future

Slope = -(1+r)

Y20

Y10 Today

choose for C1 and C2?

consumer preferences.

4

PREFERENCES

goods can be shown by indifference curves (IC).

consumption C2. Each indifference curve (IC)

connecting various combinations of C1 and C2

represents a particular and equal level of satisfaction

(called utility in economics).

and C2, giving up some of one good to have more of the

other good while keeping you equally satisfied!) and

convex towards the origin (due to the assumption of

preferring averages rather than extremes, some cokes

and pizzas rather than many pizzas or cokes and

nothing else!)

C2

Utility level B

C1

5

rate of substitution, MRS. That is, it indicates the rate

at which an individual is willing to trade current for

future consumption.

Why? If A is preferred B and B is preferred to C, then

A should be preferred to C, right? That is, your

preference should be consistent and logical! This also

rules out any upward sloping indifference curve

because it violates the assumption of more is better.

C2

f

e

C1

cannot cross or more is better

6

negatively sloped straight lines (if the two goods are

perfect substitutes) or even L shaped (if the two goods

are perfect complements or always consumed in a fixed

proportion).

C2

C1

7

PERIOD MODEL

utility is given by the point of tangency between the

highest attainable indifference curve and the budget

constraint.

C2 e1

e*

e2

C1

onto a higher indifference curve (higher utility), given

the budget constraint. If the indifference curve is above

the budget constraint, it is not attainable given the

budget constraint. Only e* is the utility maximizing

choice.

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