Chpt 4 - (Part 2)

Chpt 4 - (Part 2) - Optimal Choice How to determine the...

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1 31 Optimal Choice ± How to determine the optimal choice ? ± The optimal choice must be on the budget line because ² Any point above the budget line is not feasible (the consumer cannot afford it). ² Any point below the budget line is not fully utilizing all the resources available and so can be improved upon. 32 Optimal Choice Future consumption Current consumption IC 1 A 33 Optimal Choice Future consumption Current consumption IC 2 IC 3 B D 34 Optimal Choice Future consumption Current consumption IC 2 IC 3 B D Moving from point D to point B, the consumer has to give up some future consumption in exchange for more current consumption . 35 Optimal Choice Future consumption Current consumption IC 2 IC 3 B M 36 Optimal Choice Future consumption Current consumption IC 2 IC 3 B M Moving from point M to point B, the consumer has to give up some current consumption in exchange for more future consumption .
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2 37 Optimal Choice Future consumption Current consumption B is the Optimal Choice 38 Explanations ± Begin with an indifference curve IC 1 . Any point on this curve, say point A, is above the budget line which means they are not feasible. ± We have to consider an indifference curve that is lower to the left. ± Next, consider option D which is on the indifference curve IC 1 . ± Option D is on the budget line, so it is feasible. ± But can we do better than option D ? 39 Explanations: ± Yes. Option B is also on the budget line and it is on an indifference curve (IC 3 ) which is further to the right than IC 2 . ± So the consumer is better off choosing B. ± From point D to point B, the consumer has to give up some future consumption in exchange for more current consumption. ± Next, consider point M which is on the budget line and is on the right of point B. ± Can we do better than point M ? ± Yes, point B is also better than point M. 40 Explanations: ± To summarize, the consumer would prefer B to any other point on the budget line. ± Point B is the optimal choice . ± Note that at point B, the indifference curve just touches the budget line. 41 Example: Revisited ± Recall that in our example, Prudence faces the following: ² Real income when young = 42,000 (units of consumption good) ² Real income when old = 33,000 ² Real wealth that she inherited from her parents when young = 18,000 ± If Prudence consumes 42,000 + 18,000 = 60,000 units when young and 33,000 units when old ( point E ), then she is neither saving nor borrowing. 42 Case 1: Saving Future consumption Current consumption Optimal Choice E 99,000 33,000 60,000 50,000 X
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3 43 Case 2: Borrowing Future consumption Current consumption Optimal Choice E 99,000 33,000 60,000 68,000 44 Explanations: ± In Case 1, the optimal thing to do is to consume 50,000 units of consumption in the current period. The remaining 10,000 units are saved. ± Any point on the left of point E
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Chpt 4 - (Part 2) - Optimal Choice How to determine the...

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