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Microeconomic Foundation of the Modern


Consumption Theory

The theory is based on the consumer choice theory and


forms the basis for modern macroeconomic model of
consumption and asset pricing.

Consider an individual who lives for 2 periods.


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

Period 1 Budget Constraint

(2) C1 = Y1 S

Y1 = period one income

S = period one saving (if S > 0) or borrowing


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

Period 2 Budget Constraint

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

r = real rate of interest (the opportunity cost or real


price of consumption)

We can combine these two budget constraints


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From (2) S = Y1 C1

and by substituting it into (3)

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

Expand the bracket to get the budget constraint in term


of period 2 (future) values

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

Divide the above equation through by (1+r), we get the


budget constraint in terms of period 1 (present) value

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

This is the individuals intertemporal budget constraint.

It implies that the present-value of consumption equals


the present-value of income.

To represent (4) on a diagram, re-write it as

(5) C2 = [Y1(1+r) + Y2] (1+r) C1

Intercepts:
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If C1 = 0, C2 = [Y1(1+r) + Y2] => Vertical intercept (FV


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

Future

Slope = -(1+r)
Y20

Y10 Today

Given an income of (Y10, Y20) what does this person


choose for C1 and C2?

Below is some basic microeconomic theory of


consumer preferences.
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PREFERENCES

An individuals preferences for consumption over two


goods can be shown by indifference curves (IC).

Let the goods be current consumption C1 and future


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).

The IC slopes downward (due to trade-offs between C1


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 A (higher than B)

Utility level B
C1
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Slope of an indifference curve is called the marginal


rate of substitution, MRS. That is, it indicates the rate
at which an individual is willing to trade current for
future consumption.

Note: For a consumer, indifference curves cannot cross.


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.

ua ub (ua > or < ub?)

C2

f
e

(f>e cant lie on the same IC!)

C1

The ICs above all violate the assumption of either they


cannot cross or more is better
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Some indifference curves are not convex but can be


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 and C2 are perfect complements

C1 and C2 are perfect substitutes

C1
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OPTIMAL CONSUMPTION CHOICE IN A TWO


PERIOD MODEL

The choice of C1 and C2 that maximises the consumers


utility is given by the point of tangency between the
highest attainable indifference curve and the budget
constraint.

C2 e1

e*

e2

C1

Note that e1 and e2 are inefficient as you could move


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.