Understanding Consumer Behavior
Understanding Consumer Behavior
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Understanding Consumer Behavior
16CHAPTER
IN THIS CHAPTER, YOU WILL LEARN:
an introduction to the most prominent work on
consumption, including:
§ John Maynard Keynes: consumption and current
income
§ Irving Fisher: intertemporal choice
§ Franco Modigliani: the life-cycle hypothesis
§ Milton Friedman: the permanent income hypothesis
§ Robert Hall: the random-walk hypothesis
§ David Laibson: the pull of instant gratification
1
2CHAPTER 16 Understanding Consumer Behavior
Keynes’s conjectures
1. 0 < MPC < 1
2. Average propensity to consume (APC )
falls as income rises.
(APC = C/Y)
3. Income is the main determinant of
consumption.
3CHAPTER 16 Understanding Consumer Behavior
The Keynesian consumption function
C
Y
1
c
C C cY= +
C
c = MPC
= slope of the
consumption
function
4CHAPTER 16 Understanding Consumer Behavior
The Keynesian consumption function
C
Y
C C cY= +
slope = APC
As income rises, consumers save a bigger
fraction of their income, so APC falls.
C C c
Y Y
= = +APC
5CHAPTER 16 Understanding Consumer Behavior
Early empirical successes:
Results from early studies
§ Households with higher incomes:
§ consume more, so MPC > 0
§ save more, so MPC < 1
§ save a larger fraction of their income,
so APC i as Y h
§ Very strong correlation between income and
consumption: income seemed to be the main
determinant of consumption
6CHAPTER 16 Understanding Consumer Behavior
Problems for the
Keynesian consumption function
§ Based on the Keynesian consumption function,
economists predicted that C would grow more
slowly than Y over time.
§ This prediction did not come true:
§ As incomes grew, APC did not fall,
and C grew at the same rate as income.
§ Simon Kuznets showed that C/Y was
very stable from decade to decade.
7CHAPTER 16 Understanding Consumer Behavior
The Consumption Puzzle
C
Y
Consumption function
from long time-series
data (constant APC )
Consumption function
from cross-sectional
household data
(falling APC )
8CHAPTER 16 Understanding Consumer Behavior
Irving Fisher and Intertemporal Choice
§ The basis for much subsequent work on
consumption.
§ Assumes consumer is forward-looking and
chooses consumption for the present and future
to maximize lifetime satisfaction.
§ Consumer’s choices are subject to an
intertemporal budget constraint,
a measure of the total resources available for
present and future consumption.
9CHAPTER 16 Understanding Consumer Behavior
The basic two-period model
§ Period 1: the present
Period 2: the future
§ Notation
Y1, Y2 = income in period 1, 2
C1, C2 = consumption in period 1, 2
S = Y1 - C1 = saving in period 1
(S < 0 if the consumer borrows in period 1)
10CHAPTER 16 Understanding Consumer Behavior
Deriving the intertemporal
budget constraint
§ Period 2 budget constraint:
2 2 (1 )C Y r S= + +
2 1 1(1 )( )Y r Y C= + + -
§ Rearrange terms:
1 2 2 1(1 ) (1 )r C C Y r Y+ + = + +
§ Divide through by (1+r ) to get…
11CHAPTER 16 Understanding Consumer Behavior
The intertemporal budget constraint
2 2
1 11 1
C YC Y
r r
+ = +
+ +
present value of
lifetime consumption
present value of
lifetime income
12CHAPTER 16 Understanding Consumer Behavior
The intertemporal budget constraint
The budget
constraint shows
all combinations
of C1 and C2 that
just exhaust the
consumer’s
resources.
C1
C2
1 2 (1 )Y Y r+ +
1 2(1 )r Y Y+ +
Y1
Y2
Borrowing
Saving
Consump =
income in
both periods
2 2
1 11 1
C YC Y
r r
+ = +
+ +
13CHAPTER 16 Understanding Consumer Behavior
The intertemporal budget constraint
The slope of
the budget
line equals
-(1+r )
C1
C2
Y1
Y2
1
(1+r )
2 2
1 11 1
C YC Y
r r
+ = +
+ +
14CHAPTER 16 Understanding Consumer Behavior
Consumer preferences
An indifference
curve shows
all combinations
of C1 and C2
that make the
consumer
equally happy.
C1
C2
IC1
IC2
Higher
indifference
curves
represent
higher levels
of happiness.
15CHAPTER 16 Understanding Consumer Behavior
Consumer preferences
Marginal rate of
substitution (MRS ):
the amount of C2
the consumer
would be willing to
substitute for
one unit of C1.
C1
C2
IC1
The slope of
an indifference
curve at any
point equals
the MRS
at that point.1
MRS
16CHAPTER 16 Understanding Consumer Behavior
Optimization
The optimal (C1,C2)
is where the
budget line
just touches
the highest
indifference curve.
C1
C2
O
At the optimal point,
MRS = 1+r
17CHAPTER 16 Understanding Consumer Behavior
How C responds to changes in Y
An increase
in Y1 or Y2
shifts the
budget line
outward.
C1
C2Results:
Provided they are
both normal goods,
C1 and C2 both
increase,
…whether the
income increase
occurs in period 1
or period 2.
18CHAPTER 16 Understanding Consumer Behavior
Keynes vs. Fisher
§ Keynes:
Current consumption depends only on
current income.
§ Fisher:
Current consumption depends only on
the present value of lifetime income.
The timing of income is irrelevant
because the consumer can borrow or lend
between periods.
19CHAPTER 16 Understanding Consumer Behavior
A
How C responds to changes in r
An increase in r
pivots the budget
line around the
point (Y1,Y2).
C1
C2
Y1
Y2
B
As depicted here,
C1 falls and C2 rises.
However, it could
turn out differently…
20CHAPTER 16 Understanding Consumer Behavior
How C responds to changes in r
§ income effect: If consumer is a saver,
the rise in r makes him better off, which tends to
increase consumption in both periods.
§ substitution effect: The rise in r increases
the opportunity cost of current consumption,
which tends to reduce C1 and increase C2.
§ Both effects imply ΔC2.
Whether C1 rises or falls depends on the relative
size of the income & substitution effects.
21CHAPTER 16 Understanding Consumer Behavior
Constraints on borrowing
§ In Fisher’s theory, the timing of income is irrelevant:
Consumer can borrow and lend across periods.
§ Example: If consumer learns that her future income
will increase, she can spread the extra consumption
over both periods by borrowing in the current period.
§ However, if consumer faces borrowing constraints
(a.k.a. liquidity constraints), then she may not be
able to increase current consumption
…and her consumption may behave as in the
Keynesian theory even though she is rational &
forward-looking.
22CHAPTER 16 Understanding Consumer Behavior
Constraints on borrowing