Book cover for Intermediate Microeconomics: A Modern Approach

Intermediate Microeconomics: A Modern Approach

Hal R. Varian

ISBN #9780393927023

7th Edition

224 Questions

Group icon
7,544 Students Helped

Homework Questions

Right arrow
Summary
Learning Objectives
Key Concepts
Example Problems
Explanations
Common Mistakes

Summary

Intertemporal choice is a fundamental concept in economics that explores how consumers distribute their consumption and savings over time. By incorporating key factors like present value, inflation, and interest rates, individuals can better understand the trade-offs involved in delaying consumption. Analytical tools such as comparative statics and the Slutsky equation provide a deeper insight into how consumption patterns adjust in response to changing economic parameters.

Learning Objectives

1

Explain the concept of intertemporal choice and its role in economic decision-making.

2

Analyze how consumers allocate consumption over time considering budget constraints and preferences.

3

Calculate present value and assess the impact of inflation and interest rates on future cash flows.

4

Apply comparative statics and the Slutsky equation to understand changes in consumption behavior over time.

Key Concepts

CONCEPT

DEFINITION

Intertemporal Choice

The process by which individuals decide how to allocate consumption and savings over different time periods, considering budget constraints and personal preferences.

Present Value

A financial concept that discounts future cash flows to their value today, accounting for interest rates and inflation.

Inflation

The rate at which the general level of prices for goods and services rises, reducing the purchasing power of money over time.

Interest Rates

The cost of borrowing money or the benefit of saving, which influences the timing of consumption decisions and the valuation of future incomes.

Comparative Statics

A method used to analyze the change in economic outcomes as a result of a variation in an exogenous variable, useful for studying adjustments in consumption behavior.

Slutsky Equation

An equation that decomposes the effect of a change in price into substitution and income effects, applicable in both single-period and intertemporal consumption analysis.

Example Problems

Example 1

How much is $\$ 1$ million to be delivered 20 years in the future worth today if the interest rate is 20 percent?

Example 2

As the interest rate rises, does the intertemporal budget constraint become steeper or flatter?

Example 3

Would the assumption that goods are perfect substitutes be valid in a study of intertemporal food purchases?

Example 4

A consumer, who is initially a lender, remains a lender even after a decline in interest rates. Is this consumer better off or worse off after the change in interest rates? If the consumer becomes a borrower after the change is he better off or worse off?

Example 5

What is the present value of $\$ 100$ one year from now if the interest rate is $10 \% ?$ What is the present value if the interest rate is $5 \% ?$
Scroll left
Scroll right

Step-by-Step Explanations

QUESTION

How do you calculate the present value of a future stream of payments?

STEP-BY-STEP ANSWER:

Step 1: Identify each future payment amount and determine the time period (t) in which each payment will be received.
Step 2: Choose the appropriate discount rate (r) that reflects the prevailing interest rate and the impact of inflation.
Step 3: Apply the present value formula: PV = Σ (Future Payment / (1 + r)^t) over all periods.
Step 4: Sum the results of all discounted cash flows to obtain the total present value.
Final Answer: The sum obtained from discounting each future payment back to the present represents the total present value of the cash flow stream.

Present Value Calculation

QUESTION

How do interest rates affect the cost of carrying a credit card balance over time?

STEP-BY-STEP ANSWER:

Step 1: Identify the outstanding credit card balance and the applicable periodic (usually monthly) interest rate.
Step 2: Calculate the interest charge for the period by multiplying the balance with the periodic interest rate.
Step 3: Include any additional fees or charges associated with the credit card in your calculation.
Step 4: Assess the cumulative cost over multiple periods by adding up all the interest charges and fees incurred over time.
Final Answer: The overall cost of carrying a credit card balance is the aggregate of all periodic interest charges and additional fees, which increases with higher interest rates.

Credit Card Cost Analysis

Scroll left
Scroll right

Common Mistakes

  • Overlooking the impact of inflation when discounting future cash flows.
  • Confusing nominal interest rates with real interest rates, which can lead to incorrect present value calculations.
  • Failing to properly decompose the effects of a price change into substitution and income effects using the Slutsky equation.
  • Neglecting periodic variations in cash flows that can significantly influence intertemporal choices.