Microeconomics Issues - Coursework Example

Q1. In the context between consumption and saving, utility maximization for an individual occurs when the rate of interest equals the rate of time preference. Explain this statement. Utility is defined as the “satisfaction that consumers derive from the consumption of goods and services (commodities)”. (Griffiths & Wall, 1944, p.1) Let us denote the consumption in two periods as c1 and c2 and suppose the prices of consumption in each period are constant at 1. The amounts of money that the consumer will have in each period of time are denoted by (m1, m2). Suppose the consumer is transferring money in the period 2 only by cutting his consumption and saving for future. This is the only mean available to him. Let us also assume that at this moment, the most he can spend in period 1 is m1. There may be two possible cases. The consumer could choose to consume at (m1, m2) which means that he just have his income absorbed fully for the period, or he can decide to have less than his income during the first period. In the second case, the consumer is actually saving a part of his first period consumption for the next period. Let us now make an assumption that the consumer can borrow or lend money at certain interest rate r. If it is assumed that the consumer first decides to save, he will be consuming less than his income i.e. m1>c1. . So he now saves (m1-c1). Hence the amount that he can consume in the second period is given by c2 = m2 + (m1-c1) + r (m1-c1) = m2 + (m1-c1) (1+r) Thus the amount that the consumer can consume in period 2 is his income and the amount he saved from period 1, plus the interest that he earned on his saving. Lets us now assume that the consumer is having the whole of his income of the first period plus he want to have more. So in this case he will have to borrow some amount as m1c1 the consumer can enjoy an interest on his saving. If the relation reverses, he will have to pay interest on his savings. (Varian, 2003)Thus the budget line can be drawn with the above theory. The utility function of the consumer will be given by U = u (c1, c2) Subject to the budget constraint given as (1+r) c1 + c2 = (1+r) m1 + m2 Thus the utility will be optimum depending on the level of c1 and c2 that again depends on r. The preferential pattern of the consumer can be corresponded with the indifference curve representing the taste of the consumer at two different point of time. Given a budget constraint and the preference pattern of the individual, he will be acting as a borrower or a lender. Case of a Borrower c2 Endowment m2 c2 Choice Indifference Curve m1 c1 c1 Case of a Lender c2 Choice Indifference Curve c2 m2 Endowment c1 m1 c1 Now if the rate of interest increases (changing the slope of the budget line) the consumer may prefer to remain a lender. This is because by the principle of revealed preference, the consumer could have chosen any bundle to the right of the endowment point. He did not select them then. So with the increase in the rate of interest, the optimal bundle should be to the left of the endowment point. Hence he will remain a lender. Similarly when the rate of interest reduces, a borrower will remain a borrower for maximizing his utility. Now suppose the consumer has a certain rate of time preference. If the rate of time preference is low, the consumer has less patience. So he does not want to wait for earning a rate of interest in future that is above the present level. Hence he will have a preference toward “current consumption over future consumption”. (BusinessDictionary.com, n.d.) This rate of time preference depends in the expectation that the consumer have about future income. If he expects future income to be more than the current income, the individual will be having a high rate of time preference. In this case the interest rate has to be higher that could force him to save more. Similarly, if his income in the future as he foresee seems to be lower than the current income, being a rational creature, he will be saving more in the present time framework inspite of the fact that the interest rate is lower. Again, his rate of time preference will rise with the higher level of saving. Thus interest rate will grow. So he only saves that much amount at which the time rate of preference will be equal to the rate of interest rate. Thus if r equals to the time rate of preference, there will be an optimal level of saving and hence optimal level of c1 and c2. Thus utility maximization for an individual occurs when the rate of interest equals the rate of time preference. Q2. If a good is normal, and its price falls, what will be the relationship between the constant money income demand curve and the constant real income demand curve? Briefly state the circumstances in which the 2 demand curves will coincide. Whatever an individual earns, it constitutes the money income of the individual. There is no adjustment done to it. However there are various factors that may need to be included on the money income for calculating the actual income of the individual. When the incomes of individuals are adjusted with the inflation, the income is referred as the real income. So any real income helps the individual to know how much purchasing power he has. Now a good is said to be normal if “the consumer purchases more of that good as income rises.” (Besanko & Braeutigam, 2007, p.180) Let there be two goods-X1 and X2. Their respective prices will be P1 and P2 and the money income is denoted by M. So the budget equation can be represented as, M= P1 X1 + P2 X2 Now to keep money income constant, if there is any change in money income, there has to adjustment between the price and the quantity of good. Since the goods are assumed to be normal, decrease in the price level P1 will lead to the increase in the demand of the good X1, other variables (P2, X2) remaining constant. So the demand curve will be downward sloping. Now if the real income is considered, then also the demand curve will be downward sloping. But in this case the constant real income demand curve will lie either above or below the constant money income demand curve depending on the inflation. This is because along with the money income, real income considers the rate of inflation also. X1 Real income Demand curve Money Income Demand Curve P1 Here it has been considered that the real income demand curve lies above the money income demand curve, as the adjustment factor due to inflation is positive. X2 Money Income Demand Curve Real Income Demand Curve P2 Here the adjustment factor due to inflation is negative. Hence real income demand curve lies below the money income demand curve. The two demand curves will coincide when the adjustment factor due to inflation will be considered as zero. That is there is no change on the inflation even if the prices changes. Q3. Explain what is meant by Non-neutral technical change. Using Isoquants to illustrate your answer, explain the impact of such technical change on the capital-labor ratio. There can be two type of change technically, which can bring a variation in the production relation as shown by Estrin, David & Dietrich, 2008). They are neutral and non-neutral technical change. A non-neutral technical change is referred to such process that can produce a change in the production of a firm. If the change is capital intensive, the inclusion of such technical change will use less of the labor. Again if the technical change is labor intensive, the process will use more of labor and less of the capital. Hence there will be a “variation in the production relation” along with a change in “the marginal rate of substitution of labor to capital”. (CUP Archive, n.d., p.20) It is different from the neutral technical change in which the marginal rate of substitution of labor to capital does not alter although the production relations change. Non-neutral technical change occurs due to change in the capital intensity of a technique. When such changes occur in the process of the production, it becomes easier to substitute the capital for labor. Non-neutral technical change can be explained with the help of the following diagram. C X’ X 0 N Here C denotes capital and N denotes labor. Before the non-neutral technical change is applied in production process, X denotes the isoquant. After the non-neutral technical change has occurred, the isoquant moves up to new position denoted by X’. This change occurs due to inclusion of the non-neutral technical process. The marginal rate of substitution of labor to capital has also changed due to application of such procedure. So the slope of the isoquant changes in the new framework of production. The substitution can either favor the capital-intensive process or may lead to ease in terms of labor saving. The pivotal change in the isoquant is a very important feature of the non-neutral technical change. The change in the slope of the isoquant may be because of change in the capital intensities before and after the application of such technique. It may be also due to the fact that elasticity of the substitution of the labor and capital in the two technologies has got changed. A non-neutral technical change may be capital intensive. So because of application of such change, more capital-intensive goods will be produced. However this change will be labor saving. The reason is that the capital intensity leads to an increase in the marginal product of the capital. Thus using such technique will lead to production of less labor-intensive goods. The marginal rate of substitution depends on the ease with which the capital can be substituted with the labor. For example, if we choose a labor-capital ratio to the right of the point where the logarithm of the N/C is zero, the marginal rate of substitution will reduce, as the elasticity of substitution gets larger. Thus the capital labor ratio will change in this case. C X’ C2 C1 X N N1 N2 It is very clear from the diagram that because of the non-neutral technical change, the capital-labor ratio also changes. If the technique applied is more labor intensive, then also change will be observed in the capital-labor ratio. References: 1. Besanko DA & Braeutigam RR 2007, Microeconomics, Wiley, United KIngdom 2. BusinessDictionary.com n.d., time preference, viewed on 20 August, 2009 3. CUP Archive n.d., On The Thoery and Measurement of Technoloical Change, Cambridge 4. Estrin S, David L & Dietrich M 2008, Microeconomics, Prentice Hall, USA 5. Griffiths A & Wall S 2000, Intermediate microeconomics: theory and applications, Pearson Education, USA 6. Varian HR. 2003, Intermediate Microeconomics: A Modern Approach, Rajkamal Electric Press, India Read More