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Unformatted text preview: cnt.) TwoHow do consumers choose how to choose consume? • The budget constraint line gives all the possible consumption combinations
On the line no resources are wasted! On Below the line resources are wasted Below Above the line points are unattainable Above unattainable • The optimum is the highest utility that can be attained with the given budget constraint
The optimum is where the indifference curve is The tangent to the budget constraint
34 The Optimal Point in Detail
C2 (1+r)Y1 + Y2 Y2’ B Optimal Consumption (for consumer with income profile A) C2* (1+r) S Y2 A Y1’ C1* S Y1 Y1 + Y2/(1+ r) C1 What happens to consumer with income profile B (Y1’, Y2’)?
35 Substitution Effect Dominant
(of increase in ‘r’)
C2 (with in r) C2*’ Flatter indifference curve causes Substitution Effect to dominate: S when r . (What we assume) (1+r)Y1 + Y2 C2* Y2 C1*’ C1*
S Y1 Y1 + Y2/(1+ r) C1 (with in r) S’
36 Income Effect Dominant
C2 (of increase in ‘r’)
Steeper indifference curve causes Income effect to dominate: S when r . (1+r)Y1 + Y2 C2* C2*’ Y2 C1* C1*’
S’ Y1 Y1 + Y2/(1+ r) C1 S
37 Figure 4.A.5 Life-Cycle Consumption, LifeIncome, and Saving 38 The CoC & Investment
• • • • • • Bottom Line A unit of capital produces MPK
Given the choice of labor, the state of technology, Given etc. Firms pay the real interest rate, r, to raise funds for capital investment Capital also depreciates at the rate δ They will invest more if MPK > r + δ MPK They will invest less if MPK < r + δ The equilibrium is when MPK = r + δ MPK
40 Taxes & Investment
• If τf is the marginal tax rate for firms’ marginal firms’ profits, then: MPK (1-τf ) = R/P MPK (1• And this gives:
MPK = 1 R r +δ = 1−τ f P 1−τ f the cost of investment in new capital
Taxes reduce after-tax revenues Taxes after41 THE END 52...
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- Spring '07