Chapter Summary

In this chapter our primary focus was on applications of the rational choice and demand theories developed in Chapters 3 and 4. We also considered the concept of consumer surplus, which measures the amount by which a consumer benefits by being able to buy a given product at a given price. We saw that consumer surplus is well approximated by the area bounded above by the individual demand curve and below by the market price. Two-part pricing structures are a device by which a portion of consumer surplus is transferred from the buyer to the seller.

The rational choice model is also useful for evaluating the welfare effects of price and income changes. It suggests why the consumer price index, the government's measure of changes in the cost of living, may often overstate the true cost of achieving a given level of satisfaction.

The intertemporal choice model is, in every essential respect, analogous to the atemporal choice model in Chapter 3. In the two-dimensional case, it begins with a commodity graph that depicts current and future consumption levels of a composite good. The consumer's initial endowment is the point, (M1, M2), that corresponds to current and future income. If the consumer can borrow and lend at the rate r, his intertemporal budget constraint is then the line passing through the endowment point with a slope of 2(1 1 r). The opportunity cost of a unit of current consumption is 1 1 r units of future consumption. The horizontal intercept of the intertemporal budget constraint is the present value of all current and future income, which is also called the present value of lifetime wealth.

The consumer's intertemporal preferences may be represented by an indifference map with essentially the same properties as in the atemporal case. A consumer is said to exhibit positive, neutral, or negative time preference at a point if his marginal rate of time preference (the absolute value of the slope of his indifference curve) at that point is greater than 1, equal to 1, or less than 1, respectively. In the case of interior solutions, equilibrium occurs at a tangency between the intertemporal budget constraint and an indifference curve. Hence with an interior solution, when r . 0, consumers will exhibit positive time preference in equilibrium, irrespective of the shape of their indifference curves.

An important application of the intertemporal choice model is to the study of decisions about how much to save. The permanent income and life-cycle hypotheses employ the model to demonstrate that it is the present value of lifetime wealth, not current income alone, that governs current consumption (and hence current savings).

The appendix to this chapter discusses additional applications of rational choice and demand theories, including cost-of-living indices and the use of indifference curves to measure consumer surplus.