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An Intertemporal Choice Example

Quentin has saved up $10,000. He is thinking about spending some or all of it on a vacation in the present, and then will save the rest for another big vacation five years from now. Over those five years, he expects to earn a total 80% rate of return. [link] shows Quentin’s budget constraint and his indifference curves between present consumption and future consumption. The highest level of utility that Quentin can achieve at his original intertemporal budget constraint occurs at point A, where he is consuming $6,000, saving $4,000 for the future, and expecting with the accumulated interest to have $7,200 for future consumption (that is, $4,000 in current financial savings plus the 80% rate of return).

However, Quentin has just realized that his expected rate of return was unrealistically high. A more realistic expectation is that over five years he can earn a total return of 30%. In effect, his intertemporal budget constraint has pivoted to the left, so that his original utility-maximizing choice is no longer available. Will Quentin react to the lower rate of return by saving more, or less, or the same amount? Again, the language of substitution and income effects provides a framework for thinking about the motivations behind various choices. The dashed line, which is a graphical tool to separate the substitution and income effect, is carefully inserted with the same slope as the new opportunity set, so that it reflects the changed rate of return, but it is tangent to the original indifference curve, so that it shows no change in utility or “buying power.”

The substitution effect tells how Quentin would have altered his consumption because the lower rate of return makes future consumption relatively more expensive and present consumption relatively cheaper. The movement from the original choice A to point C shows how Quentin substitutes toward more present consumption and less future consumption in response to the lower interest rate, with no change in utility. The substitution arrows on the horizontal and vertical axes of [link] show the direction of the substitution effect motivation. The substitution effect suggests that, because of the lower interest rate, Quentin should consume more in the present and less in the future.

Quentin also has an income effect motivation. The lower rate of return shifts the budget constraint to the left, which means that Quentin’s utility or “buying power” is reduced. The income effect (assuming normal goods) encourages less of both present and future consumption. The impact of the income effect on reducing present and future consumption in this example is shown with “i” arrows on the horizontal and vertical axis of [link] .

Indifference curve and an intertemporal budget constraint

The graph shows the indifference curve and an intertemporal budget constraint. The x-axis is labeled “present consumption.” The y-axis is labeled “future consumption.” The original choice is A ($6,000, $7,200), at the tangency between the original budget constraint and the original indifference curve Uh. A dashed line is drawn parallel to the new budget set, so that its slope reflects the lower rate of return, but is tangent to the original indifference curve. The movement from A to C which is approximately point ($7,900, $5,000) is the substitution effect. The income effect is the shift from C to B ($7,000, $3,900). The following points are also marked: F ($4,000, $6,500), and D ($6,000, $5,200).
The original choice is A, at the tangency between the original budget constraint and the original indifference curve Uh. The dashed line is drawn parallel to the new budget set, so that its slope reflects the lower rate of return, but is tangent to the original indifference curve. The movement from A to C is the substitution effect: in this case, future consumption has become relatively more expensive, and present consumption has become relatively cheaper. The income effect is the shift from C to B; that is, the reduction in utility or “buying power” that causes a move to a lower indifference curve Ul, but with the relative price the same. It means less present and less future consumption. In the move from A to B, the substitution effect on present consumption is greater than the income effect, so the overall result is more present consumption. Notice that the lower indifference curve could have been drawn tangent to the lower budget constraint point D or point F, depending on personal preferences.

Questions & Answers

do you think it's worthwhile in the long term to study the effects and possibilities of nanotechnology on viral treatment?
Damian Reply
absolutely yes
how to know photocatalytic properties of tio2 nanoparticles...what to do now
Akash Reply
it is a goid question and i want to know the answer as well
characteristics of micro business
Do somebody tell me a best nano engineering book for beginners?
s. Reply
what is fullerene does it is used to make bukky balls
Devang Reply
are you nano engineer ?
fullerene is a bucky ball aka Carbon 60 molecule. It was name by the architect Fuller. He design the geodesic dome. it resembles a soccer ball.
what is the actual application of fullerenes nowadays?
That is a great question Damian. best way to answer that question is to Google it. there are hundreds of applications for buck minister fullerenes, from medical to aerospace. you can also find plenty of research papers that will give you great detail on the potential applications of fullerenes.
what is the Synthesis, properties,and applications of carbon nano chemistry
Abhijith Reply
Mostly, they use nano carbon for electronics and for materials to be strengthened.
is Bucky paper clear?
so some one know about replacing silicon atom with phosphorous in semiconductors device?
s. Reply
Yeah, it is a pain to say the least. You basically have to heat the substarte up to around 1000 degrees celcius then pass phosphene gas over top of it, which is explosive and toxic by the way, under very low pressure.
Do you know which machine is used to that process?
how to fabricate graphene ink ?
for screen printed electrodes ?
What is lattice structure?
s. Reply
of graphene you mean?
or in general
in general
Graphene has a hexagonal structure
On having this app for quite a bit time, Haven't realised there's a chat room in it.
what is biological synthesis of nanoparticles
Sanket Reply
what's the easiest and fastest way to the synthesize AgNP?
Damian Reply
types of nano material
abeetha Reply
I start with an easy one. carbon nanotubes woven into a long filament like a string
many many of nanotubes
what is the k.e before it land
what is the function of carbon nanotubes?
I'm interested in nanotube
what is nanomaterials​ and their applications of sensors.
Ramkumar Reply
what is nano technology
Sravani Reply
what is system testing?
preparation of nanomaterial
Victor Reply
Yes, Nanotechnology has a very fast field of applications and their is always something new to do with it...
Himanshu Reply
good afternoon madam
what is system testing
what is the application of nanotechnology?
In this morden time nanotechnology used in many field . 1-Electronics-manufacturad IC ,RAM,MRAM,solar panel etc 2-Helth and Medical-Nanomedicine,Drug Dilivery for cancer treatment etc 3- Atomobile -MEMS, Coating on car etc. and may other field for details you can check at Google
anybody can imagine what will be happen after 100 years from now in nano tech world
after 100 year this will be not nanotechnology maybe this technology name will be change . maybe aftet 100 year . we work on electron lable practically about its properties and behaviour by the different instruments
name doesn't matter , whatever it will be change... I'm taking about effect on circumstances of the microscopic world
how hard could it be to apply nanotechnology against viral infections such HIV or Ebola?
silver nanoparticles could handle the job?
not now but maybe in future only AgNP maybe any other nanomaterials
I'm interested in Nanotube
this technology will not going on for the long time , so I'm thinking about femtotechnology 10^-15
how did you get the value of 2000N.What calculations are needed to arrive at it
Smarajit Reply
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Berger describes sociologists as concerned with
Mueller Reply
Equilibrium price is a stable price and it must stay.discuss
Elvis Reply
Card 14 / 21: What are the similarities between a consumer’s budget constraint and society’s production possibilities frontier, not just graphically but analytically?
Ali Reply

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Source:  OpenStax, Principles of macroeconomics for ap® courses. OpenStax CNX. Aug 24, 2015 Download for free at http://legacy.cnx.org/content/col11864/1.2
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