Microeconomics - three different questions - Assignment Example

1. In the context of choosing between consumption and saving, utility-maximisation for an individual occurs when the rate of interest equals the rateof time preference. Explain this statement. This statement examines the nature of consumerism, and the factors influencing consumers to delay current consumption for greater future returns. This statement also refers to a theory which was initially constructed by Carl Menger, an Austrian economist. It is stipulated that the individual’s rate of time preference, and therefore the interest required, is likely to rise as the consumers savings increase. This means that the consumer is likely to restrict his savings to a level at which the rate of time preference equals the rate of interest paid on his savings. In choosing between consumption and saving i.e. whether an individual would prefer to have a marginal unit of income to consume now or at some other time in the future can depend on certain facts: the individual’s estimate of the future, the intensity of his wants now and their expected intensity in the future and the amount of income and expected income in the future time. This depends on whether an individual values the fulfillment of a certain want in the future, more, equal or less than its fulfillment today. It can thus be concluded that the rate of time preference is a preference for present over future enjoyment income, or real income. That the degree of this preference depends, upon the amount, time, and probability; of his real income-stream and the nature of this dependence varies from person to person. Time preference refers to the rate at which people are willing to trade current benefit for future benefit. Assuming a time horizon of covering the individual’s two income payments say to and t1, a person will save until his time preference equals the interest rate at the margin. Time preference is assumed here to be initially lower than the interest rate i for the period from t0 to t1, the rate of time preference equals the rate of interest at the margin. At this point, the utility obtained from the last unit of money invested in bonds is just equal to the utility of the last unit of money used for consumption purposes or held in its most liquid form i.e. cash. Savings are presumed to liquidate at time t1. If on the other hand, we assume that the time preference of the rational utility maximizing individual initially is greater than the rate of interest from bonds, the individual will borrow money until the rate of interest equals the rate of time preference and the equilibrium condition is achieved. This principle can be generalized for time horizon over many periods like that. Thus each individual plans his saving and consumption by borrowing in a way that for each short future period the marginal time preference becomes equal to the rate of interest in that period. To illustrate this diagrammatically, let us suppose the income stream to be represented as in the figure below, and that the person wishes to obtain, by borrowing, a small amount X of income in return for a somewhat larger amount X later on, X being the amount of X at interest. By such a loan the individual modifies his income stream from ABCD to EBD. But this change will certainly change his time preference. If the rate of time preference corresponding to the income stream represented by the unbroken line is 12 per cent, the rate of preference corresponding to the broken line will be less, say, 10 per cent. If the market rate of interest is 8 per cent, then the person will definitely precede further borrowing. If, instead of borrowing, he wishes to lend he forgoes from his present income stream the amount X for the larger amount X at a future time. After the repeated operations are completed and the final conformations of the income streams are determined, the rates of time preference are consistent with the market rate of interest. 2. 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 two demand curves will coincide. A real income demand curve is also known as a compensated demand curve whereas the constant money income demand curve is known as the ordinary demand curve. In the above diagram, normal good is represented by X and the price of normal good by Px. With an initial starting point assumed at a, If, Px falls, then the compensated demand curve i.e. the constant real income demand curve lies below the ordinary demand curve I e the constant money income demand curve. This is because the income effect of the fall in price has been left out. While the income and substitution effects reinforce one another in case of a normal good, the relationship between real income and money income demand curves is reversed in case of inferior good. Hence, the position of a real income demand curve and the relationship between real income and money income demand curves depends on the way income effect has been removed i.e. whether Compensating Variation or Equivalent Variation has been used, or whether Hicksian or Slutsky approach is incorporated. Therefore, there is no general statement that can be made. In the above analysis the compensating demand curve employs Hicks decomposition (constant utility). A similar analysis can be made by using slutsky income and substitution effects. The circumstances in which the two demand curves coincide are the case of a zero income effect, in which case all demand curves coincide. When indifference curves are vertically parallel, the income effect on normal good X is zero, and when Px falls MUm is constant. Equivalent variation and compensating variation coincide and consequently the two demand curves coincide. This case is briefly illustrated below with the help of a diagram. If Mum is constant along a vertical line say, from point a to b or c to d, the MUm is implied to be constant in general. At a and b there are different levels of money income and yet Marginal Utility of money is unchanged. The concept of diminishing marginal utility of money income is thus is not in evidence. 3. 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. Non-neutral technical change: Where technical change refers to as the productivity gains from process innovation, so that fewer inputs are required to produce a given level of output, this technical change can be of two major types: neutral and non-neutral technical change. Technical change is "neutral" when it raises the productivity of all factors inputs in production (e.g., capital and different types of labor) by the same proportion and is non-neutral when it raises the productivity of some factors more than others. An example of non-neutral technical change is so-called "skill-biased technical change," the idea that computerization has raised the productivity of skilled workers more than less-skilled workers. Technical change of any type causes isoquants to shift inwards and non-neutral technical change in contrast to neutral technical change also causes a change in the marginal technical rate of substitution i.e. the slope of the isoquant. This consequently leads to factor substitution. Thus, Non-neutral technical change can be either capital-deepening (Labor-saving) technical change or Labor-deepening (capital saving) technical change. In capital deepening technical change, process innovation increases the marginal productivity of capital MPk by more than the Marginal productivity of labor MPL. In labor-deepening technical change, process innovation increases the marginal product of labor MPL by more than the marginal product of capital MPk. Capital deepening technical change: If due to process innovation, say some kind of advanced machinery or equipment, capital is more productive than labor in a scenario where factor prices i.e. wages and rent remain the same, a firm which is cost-minimizing would employ more capital relative to labor increasing the ratio of capital to labor K/L. Hence this type of an arrangement or non-neutral technical change is also referred to as labor saving technical change as less labor is employed relative to capital. The figure illustrates the effect of capital deepening technical change on the position of the isoquant as well as its slope. Illustration: Due to advancement or process innovation, a capital deepening non-neutral technical change causes the isoquant to shift inwards. As marginal product of capital rises by more amount than marginal product of labor. Comparing point a and b shows that consequently the slope of the isoquant changes and becomes flatter or less steep for a given capital to labor K/L ratio. Labor-deepening technical change: When labor is more productive than capital and factor prices i.e .wages and rent stay the same ,then a cost-minimising firm would employ more labor or manpower than capital.This would increase the marginal product of labor MPL by more than the marginal product of capital MPk. Consequently the ratio of capital-to-labor (K/L) would fall. The firm would substitute labor for its capital. Illustration: Due to process innovation, a labor deepening non-neutral technical change causes the isoquant to shift inwards. As marginal product of labor rises by more amount than marginal product of capital, comparing point a and b shows that consequently the slope of the isoquant changes and becomes steeper for a given capital to labor K/L ratio. Read More