Wh What Youll ll Learn arn Today ay Should you consume now or - - PDF document

1

Aa Aaron Stevens EC1 EC171 71, 22 22 September 2011

How Should You Spend Your Wealth?

Wh What You’ll ll Learn arn Today ay

• Should you consume now or later?

The scientific approach.

• How does economics maximize your

happiness?

• Why can’t we trust ourselves to

make the best economic decisions?

• Why should we trust the life-cycle

model?

Fi Fina nanci ncial Pl Planni nning ng vs vs. Fi Fina nanci ncial Economi Economics cs

Fi Finan anci cial al pl plan anning g star arts with h go goal als:

Ho How w much much will will that hat co cost st? ? When hen? Wh What rate do you expect to earn on investments? …ar arrive at how much to save now

Fi Finan anci cial al eco economics cs star arts with h res esour urces ces:

Wh What do you have? Wh What are your obligations? Ho How w sho should uld yo you u allo allocat cate e yo your ur reso resources? urces? Mi Minimize risks to guarantee success

Li Life- e-Cycle e Ec Economi

• nomics

Resources

Life-Cycle Theory of Saving and Consumption

Obligations Sustainable Standard of Living Household Composition Annual financial plan

The conceptual framework to answer life’s financial questions:

(simple arithmetic)

5

You are young You are young and you work. k. Yo You are old and you die. you die. Ea Each period of time , , in real time, , is roughly 35 roughly 35 years of years of adulthood. adulthood.

Reca Recall: Tw Two

• Peri

Period

• d Model
• del

Bu Budget Co Constraint: Yo Yout uth

= Cy Cy + + S S = W

What you earn What you earn (labor income) (labor income) What you save What you save What you consume What you consume in your youth in your youth

Wh When you’re re young, you work and recei receive e labo abor r inco come. e.

+

Bu Budget Co Constraint: Ol Old Age Age

Wh When you’re re old, you live by consuming (s (spend nding ing d dow

• wn) y

n) you

• ur s

saving vings.

Co = = S

Consumption Consumption when old when old Amount saved Amount saved when young when young

Li Lifet etime me Budget udget Co Constraint*

Let’s suppose r = 0. What does r = 0 mean? Cy + S = W Co = S By algebraic magic: Co = W - Cy

• r

Cy + Co = W

* * No Taxes and/or Benefits

Li Lifet etime me Budget udget Co Constraint*

Now let’s suppose r > 0. Recall: Cy + S = W Co = S + rS Co = S (1 + r) By algebraic magic: Co = (1+r)(W-Cy)

• r

Cy + Co/(1+r) = W

* * No Taxes and/or Benefits

An An Examp mple to

• Illus

ustrate

As Assume e W= $1 $1,000, 000,000 000 r r = 1 So So Cy + Co/2 = $1,000,000

Wh What are some possible consumption choices?

Recall: Cy + S = W Co = (1+r)(W-Cy) Cy + Co/(1+r) = W

Gr Graphi hical Represent ntation

• n

Recall: Cy + Co/(1+r) = W

Uncl Uncle e El Elwyn n is is Dead

Your Your weal ealthy thy Uncl ncle e El Elwyn pa passes away, and and bequeaths bequeaths $25, $25,000, 000,000 000 to to you. you. Th The e money

• ney will be

be gi given ven to to you you in n 25 25 year years (a (at age 50; you’re re 25 now) w). You You expect expect to to live ve to to age age 75. 75.

Ho How w sho hould d yo you spen end d yo your r weal wealth? h?

(A (Assume you can borro rrow or r invest at 0% re real ra rate; n ; no i infl flation; n ; no t taxes) s)

Wh What Wo Would Homo Homo Ec Economicus Do Do?

Th The e rati ational

• nal per

person

• n woul
• uld want

ant to to cons

• nsum

ume as as much uch when hen young young as as when hen ol

• ld.

d. Let W = $1,000,000, r = 1 Set Co = Cy Verify numerically: Cy + Co/(1+r) = W $666,666.66 + $666,666.66/2 = $1,000,000 “Co Consumption Smoothing”

“Co Consumption Smoothing”

“Consump mption Smo moothing”

A A 60- 60-period

• d Examp

mple*

Co Consider the he followi wing income sche hedule: Ho How much h sho hould you consume ea each year?

Co Consump mption Smo Smoothi hing leads to some me unex unexpect pected ed (but but rat rational

• nal) resul

results. s.

* * No Taxes and/or Benefits

Wa Wages and consumption

• v
• ver

er a 60- 60-yea ear Li Life- e-Cycle* e* Ne Net Wor

• rth
• v
• ver

er a 60- 60-yea ear Li Life- e-Cycle* e*

Econom Economics cs Goa

• al in

n Li Life fe

Goofi fing Off Off (lei eisure) e) Pi Pigging Ou Out (consump mption)

How How Doe Does an n Economi

• nomist

Know Know When hen He’s s Happy ppy?

He e consults his utility fu function.

You You have have one

• ne too!

too! It tel It tells you s you you your p pleasu easure, e, hap happiness, ess, good good vi vibes bes, s smiles es … c call it what you will.

U(C,L) = C0.7L0.3

A A Si Simp mple Utility Func unction

• n

So So Now

• w l

let u t us ca calcu culate te th the inte terte temp mpor

• ral elasticity

ticity of

• f s

substitu titution tion f for

• r

a h homoth

• mothetic u

tic util tility ity f function

• ction. T

Take ke a an e exa xamp mple: Now

• w l

lets ts a a ma make ke th the a assump mption tion th that

ht http:// //hassler-j.ii iies.su su.s .se/courses/macro/notes98/ELAST.HTM

it is it is s str traig ightf tfor

• rward to d

to defin ine th the r rate te of

• f tr

true time time p preference ce So So

Econ Economi

• mists are

are cl clos

• set

ma mathema matici cians! They They express express pleasure pleasure as as ma mathema matica cal funct ction

• ns.

Tot Total Ut Utility

Total utility increases with more! This holds for consumption and leisure. Example:

Sa Samp mple Ut Utility Func Function

• n

Happines ess = Total Utility About Uti About Utility F ty Func uncti tions:

• ns:
• the

e units are e ma made e up

• and the

e numb mber ers don’t ma matter er!

(it is the e rel elative e mea meaning of f thes ese e numb mber ers, and not the e values es of f the e numb mber ers thems emsel elves es, that are e imp mportant in consumer mer dec ecision ma making)

U(C,L) = C0.7L0.3

“De De gu gustibus no non di disputandum”

Gr Graphi hical Represent ntation

• n

Consumption Consumption ($) ($) Leisure Leisure (h (hours) A

• B
• C
• D
• Which point gives

es you the e mo most utility?

Intertemp mpor

• ral Budget S

Set

Given our desired lifetime spending: the more we goof off now, the less we can goof off later. Given our desired lifetime leisure: the more we pig out now, the less we can pig out later.

Wh When to Co Consume?

Wh Which point makes you the happiest?

Cy Cy + + Co/( Co/(1+r +r) = = W

• W

W(1+r +r) C0 Cy A

• C

E D B

• Starve Today,

, Splurge Tomorrow? Consume The same When Young & Consume The same When Young & Old? Old? Splurge Today, , Starve Tomorrow?

25

La Law of Di Diminishing Returns. Returns. How Do Do You Feel After Eating 50 After Eating 50 Hotdogs? Hotdogs? An Answer: You You Feel Like ke

Th Throwi wing ng Up Up!

Wh Why Wh When matters Exa Exampl ple: e: Co Consumption Smoothing

A huge cupcake!

Exa Exampl ple: e: Co Consumption Smoothing

“Is it OK to save this for tomorrow?”

Law of Law of Dimi minishing Ret eturns Consump mption smo moothing is grounded ed in ph physi ysiol

• logy
• gy – the

e fa fact that we e get et satiated ed!

Doe Does Hav Having ng More

• re Income

ncome Ma Make You Ha Happier?

The The following g char chart is a a hyp hypothet hetical cal inco come- e-utility y cu curve. e.

ht http://www.viral-memes.com/?tag=distributed-risk

Ma Marginal utility is ut utility y gai gained ned from rom hav having one more unit. In In th this s example, ma marginal utility is the addi additional al ut utility y fro rom

• ne
• ne more
• re dol
• llar

r of

• f

in income.

Be Behavioral Economi mics

Recall that “people are stupid”

• - or at least they don’t act rationally.

Behavioral Economics uses social, cognitive and emotional factors to understand the economic decisions of individuals and institutions.

Anc Anchor horing ng Effect

Consider these 2 numbers:

• a. 3,582,361
• b. 6,838,049

Ques estion: What is the e population of f Cuba? Write e it down. Anchoring Effec Effect: A cognitive e bias wher ere e we e put too mu much imp mportance e on an anchor (ev even en if f it is irrel elev evant).

Wh What Anchoring Effect? La Lake e Wo Wobegon Ef Effect

Instructions: Close your eyes. Raise hands to answer this question. Keep hands up when you open your eyes. Raise your hand if you are an above average driver.

Wher ere e "a "all the e women men are e strong, all the e men men are good looking, and all the e children en are e above e aver erage" e"

In psychology studies, 90% of people have reported they are above-average drivers.

Ov Overconf

• nfidenc

nce

Guess the empty weight of a Boeing 747 aircraft (in pounds). Pick “low” and “high” values such that you are 90% confident that the actual value falls in between.

Ov Overconf

• nfidenc

nce Bi Bias

We We’re e not as sma mart as we e think we e are. e. Ov Over erconfi fiden ence e lea eads to unprep epared ednes ess.

Pl Planni nning ng Fa Fallacy

The Planning Fallacy: the inability to complete tasks on schedule. The “Big Dig,” 1982-2007

• estimated cost of $2.1 billion
• total cost when completed: $15 billion

Pl Planni nning ng Fa Fallacy and nd You?

• u?

What are e the e effec effects of f the planning fa fallacy on your lifet fetime me consump mption and savings plan?

Econom Economics cs Meet eets Ps Psychol hology

• gy

Greed eedines ess We e all have e a natural ten endancy to over erspen end. Howev ever er, we e need eed to think not just about our now sel elf, , but also about our future e sel elf.

Wh What You Learned Today

2 2 peri period d lifet etime e budget budget co constrai raint Co Consumption smoothi hing Rat Rational al behav behavior hel helps to maxi aximize ze ut utility, y, but but pe people are not rational The The li life-cycle model provides a prescri prescript ption

• n to
• max

aximize ze your your econom economic hap happines ess.

Announc Announceme ment nts and nd To

• Do

Do

Readings:

• STTE,

E, ch ch 1- 1-2 (t (today)

• ME,

E, ch2.1 .1, pp37-44 (today) No homew mework, just rea eadings! Nex ext homew mework will be e assigned ed on Tues esday.

Wh Why Do Do People Save?

Reas Reason given en for sav aving, an and d per ercen entag age e of fam amilies es respondi responding ng that at reason. reason. So Source: Su Survey of Co Consumer Fi Finances

Fa Fact cts s on

• n Sa

Savi ving ng Ha Habi bits Fa Fact cts s on

• n Sa

Savi ving ng Ha Habi bits