MICROECONOMICS (MEC521)

By
Dr. A. Makochekanwa
Department of Economics
University of Zimbabwe

Lecture 2
Oct 2014

Created by: Dr. Makochekanwa

INTER-TEMPORAL CHOICE

Oct 2014

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Savings constraints
Traditional discussions of the choice of the correct social rate of
discount have focused on constraints on savings.
We need to ask three question:
1) What can the government do that individuals cannot do?
2) What can the gvt do that individuals cannot (or will not) undo?
3) If there are arguments that the social rate of time discount is not
equal to the market rate of interest, is there any reason to believe
that the appropriate remedy can, or ought to, involve an
alteration in the choice of techniques in public projects?
In the subsequent discussion, we shall consider these questions.
Oct 2014

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The Problem of Intertemporal Redistribution

So far we have treated the goods consumption today versus
consumption tomorrow by the same individual
It should be noted that individuals who consume goods on different
dates are different individuals. Thus, the problem of intertemporal
allocation is essentially a problem of the distribution of income across
generations.
The rate of interest has two effects. It affects the allocation of
consumption over the lifetime of an individual, and it affects the
allocation of consumption among generations. The modelling we have
done so far has treated the problem as if there were single generation.
So long as each generation considers the utility of the next generation
entering its utility function, and so long as there are some bequest (that
is, there is some altruism), then the above analysis is applicable.
Oct 2014

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The Problem of Intertemporal Redistribution

Any attempt by the government to alter the intergenerational distribution
of income by lump-sum transfers will be offset by a change in bequests.
Hence, to alter the intergenerational distribution of income, the
government would have to introduce distortionary measures.
There is no reason, in such a context, that concern for future generations
ought to enter more strongly into the social welfare function than it does
in the individuals own utility function.
There is an asymmetry, however. The present generation might like to
increase its consumption at the expense of future generations but cannot
so long as negative bequests are not allowed.
Thus, it is conceivable that the present generation will attempt to use
public means to increase its consumption in excess of its lifetime
earnings, for example, by unfunded social security scheme.
Oct 2014

Created by: Dr. Makochekanwa

The Problem of Intertemporal Redistribution

In short, if individuals would like to save more for future generations, they
can do so; if they would like to borrow from future generations, they might
not be able to. Thus, there is no mutual constraint that would lead to too little
savings, but there may be a constraint that could lead to excessive savings.
An objection may be raised to this argument. So long as the children are
earning income at the same time as their parents are alive, the children could
transfer income to their parents, and in many cultures they do. Again, if the
family has optimized its intergenerational family welfare, any lump-sum
redistribution on the part of the gvt will be undone by the individuals.
The analysis, however, is not necessarily perfectly symmetric; we could
postulate utility function of the form:

V t V (C t ,V t 1 ,V t 2 ,...)

where Vt is the ith generations utility, which depends on the welfare of

descendents but not antecedents.

Oct 2014

Created by: Dr. Makochekanwa

The Problem of Intertemporal Redistribution

Children may show no altruism towards their parents even though the
parents show altruism towards their children. Thus, one generation may be
able to redistribute toward itself from succeeding generations only by
coercion, that is, taxation.

Even if there were perfect symmetry in the utility function between

antecedents and descendants, there still may be constraint on the private
transfer of income, or wealth, among generations. These constraints follow
from the fact that perfect annuity, rental and mortgage markets do not exist.

The problem of this, and the unpredictable timing death, is that individuals
may leave more to their heirs than they would have left had there been
perfect markets.
In the limit, if there had been no bequest motive they would have left
nothing. Accordingly, if the gvt leaves more to ones heirs in the form of
public projects, it is likely that the gvts action will not be completely
undone.
Oct 2014

Created by: Dr. Makochekanwa

The Problem of Intertemporal Redistribution

In short, the individuals are concerned for their descendants, and if
the gvts attitudes towards intergenerational distribution are identical
to those of the representative individual within his or her own family,
then:
1) There is no convincing case that the savings rate is too low:
2) Because of certain market imperfections, there is some
presumption that the savings rate is too high; and
3) Except in those cases in which the savings rate is too high, any
attempt by the gvt to redistribute income to future generations by
non distortionary means will be undone by changes in individual
actions.

Oct 2014

Created by: Dr. Makochekanwa

The Problem of Intertemporal Redistribution

However, we must enter an important caveat to the above analysis. The
presumption that future generations will be better off than the present one,
though certainly consistent with the history of the past few hundred years,
ignores certain critical aspects of the energy and environment problem. The
essence of the argument that there is a long-run energy and resource problem
and that the future will be less prosperous than the present.

The critical issue is whether capital accumulation and technical change can
offset the decreasing stock of natural resource and prevent environmental
problems from becoming more serious. This remains a moot (debatable,
controversial, disputable) question.
It is apparent, however, that, aside from the unintentional positive bequests
to heirs, there are probably unintended negative bequests in the form of
nuclear wastes, low air quality, and general environmental degradation.
Although this may redress the balance, it does so in an extremely inefficient
way (see the discussion below on alternative instruments for changing the
intergenerational distribution of income).
Oct 2014

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Plausibility of the Existence of a Savings Constraint

One crucial assumption underpinning our analysis so far: individual and
public attitudes toward intergenerational equity are at least roughly
congruent.
There is an alternative assumption: individuals have no altruistic feelings
towards their descendants. In this case, the problem of redistribution across
generations is identical to that of redistribution within generation.
Although private charity does exist, it is not so great that there is any
presumption that public transfers will be offset significantly by a change in
private transfers.
If we take this view, there is no more reason to believe that the distribution
of income among generations is socially desirable than there is to believe
that the intergenerational distribution of income resulting from the
competitive process is socially optimal.
Oct 2014

Created by: Dr. Makochekanwa

Plausibility of the Existence of a Savings Constraint

We need to ask, Is it likely that the market economy yields an intergenerational
distribution of income which excessively favours the present generation or
excessively disfavours it?
There are strong reasons to believe, if the experience of the last hundred years is
any guide, that the benefits of technical change will so improve the standards of
living of our descendants that, under reasonable sets of value judgements, our
present savings rate is probably too high. These benefits of technical change
more than offset the disadvantages we bequeath to future generation in the form
of a smaller stock of natural resources.
More formally, we ask, For what ethical beliefs about the optimal
intergenerational distribution of income would the present savings rate be
significantly too low? That is, we postulate that we wish to maximize a social
welfare function of the form.

U ( c )e

( n ) t

dt

and we assume we have complete control of the economy

Oct 2014

Created by: Dr. Makochekanwa

Plausibility of the Existence of a Savings Constraint

What would this imply about the long-run rate of interest, or social rate of
discount for public projects? And how does this contrast with the long-run
rate of interest that would emerge in a market economy with a savings rate
of the kind ordinarily observed?
It is well know that the economy will converge to a steady state in which the
long-term rate of interest r* is equal to the rate of growth divided by the
savings-to-profit ration, s, that is,
r*

n
s

where n = rate of growth of population and is the rate of technical change.

Oct 2014

Created by: Dr. Makochekanwa

Plausibility of the Existence of a Savings Constraint

On the other hand, the long-run social rate of time preference is given by:
d ln U ' (c)e t U '' c c

'
dt
c
U
v

where
Hence

v U '' c /U '
r*

or

Oct 2014

as

n
v

n
s

Created by: Dr. Makochekanwa

Plausibility of the Existence of a Savings Constraint

Assume, for instance, that the elasticity of marginal utility is approximately
2, the rate of labour augmenting technical progress is 2 percent, and the
rate of population growth is 1 percent. Assume that = 3 percent. Then, if
the savings-to-profit ratio is, say, 0.8, the long-run rate of interest is 3.75
percent, while the long-run social rate of discount is 7 percent.

Oct 2014

Created by: Dr. Makochekanwa

Public Capital Goods, Distortionary Taxation, and the Intergenerational

Distribution of Income

The preceding section argued that there is no convincing case for the existence of a
savings constraint (at least in a developed country). On the other hand, the market
obviously will provide an insufficient supply of pure pubic goods, including capital
goods.
The government must necessarily be involved in deciding how much of these goods to
produce. Because of the revenues for these public capital goods are raised at least
partially by distortionary taxation, the problem of the second best is unavoidable.
Moreover, since the benefits accrue over time to different generations, we inevitably
face a problem of intergenerational distribution. We explicitly assume that the
individuals are nonaltruistic, that is, they care only for their own consumption.
Thus, to decide on the level of public goods to be produced, we need to introduce a
social welfare function. We postulate that we are concerned with maximizing the
expression:
j

1
U

t
1

t
j
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Created by: Dr. Makochekanwa

(19)

Public Capital Goods, Distortionary Taxation, and the Intergenerational

Distribution of Income

Where is the utility of the jth individual in the ith generation, and is the
pure social rate of time preference; that is, if > 0, we weight future
generations utility less than that of the present generation.
If = 0, we simply add the individual, unweighted utilities. If the
horizon is infinite, this criterion may not be well defined, but there are
standard techniques for handling this difficulty. Expression (19) is just a
weighted sum. We will thus continue the analysis without restricting
to be zero.
The problem now is a standard indirect control problem. The gvt wishes
to choose, at each date, for the instruments under its control (taxes,
investment in public goods, levels of debt, etc.) a set of levels that are
feasible, satisfy the gvts budgetary constraints, and optimize social
welfare.
Oct 2014

Created by: Dr. Makochekanwa

Public Capital Goods, Distortionary Taxation, and the Intergenerational

Distribution of Income
The gvt does not directly control private capital accumulation or labour supply,
but its decisions affect private decisions, and the gvt must take that into
account. We assume that the gvt does this. The solution to this problem yields,
at each date, a set of shadow prices from which we can calculate the
appropriate rate of discount to use at each data for each kind of expenditure.
Our problem is to find a simple way of characterizing the solution to this
complicated indirect control problem, a characterization that provides some
insight into the relationship between the rate of discount to use on public
projects and market rates of interest.

We can obtain a fairly complete characterization of the steady-state

equilibrium of the economy. Under quite weak conditions, the economy will
eventually converge to a balanced-growth path. In the balanced growth path,
we can make strong statements about the relationship between the rate of
discount for public projects and market rates of interest. The relationship
depends on the set of instruments available to the gvt.
Oct 2014

Created by: Dr. Makochekanwa

The Basic Model

The particular model that has been examined in some detail is the following.
We assume each generation lives for two periods but works only in the first
and that each generation saves in the first to provide for its retirement. Thus,
we have a utility function of the form
U t U t (C1t , C 2t , Lt )

(20)

Where: C1t = is the ith generations consumption in the first period of life
C2t = is the ith generations consumption in the second period of life
Lt = is the ith generations supply of labour

If there are different individuals alive in each generation, we simply add

superscript js to all variables. For this part of the analysis, we simplify by
assuming all individuals are identical. For simplicity, we assume the size of the
population is fixed, and for the moment we normalize it to unity.
Oct 2014

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The Basic Model

Each generation earns a wage wt and can invest savings at an interest rate it.
The individual chooses (C1t, C2t, Lt) to maximize his utility subject to the
budget constraint.
(21)
where It is a lump-sum transfer, or tax, to the ith generation. For most of the
analysis, we assume It = 0, that is, lump-sum taxes, or transfers, are not
feasible.
The solution to the individuals maximization problem yields his labour supply
(22a)
and his first-period consumption
(22b)

Oct 2014

Created by: Dr. Makochekanwa

The Basic Model

From which we can immediately calculate the value of his savings S t, which is given by
(22c)

The level of utility attained by the individual will thus be a function of the wage, the
interest rate, and his exogenous income (lump-sum transfers). This is given by the
indirect utility function
Vt Vt ( wt , it , I t )
(23)

We describe the production possibilities of the economy by an aggregate production

function of the form

Yt F ( K t , Gt , Lt )

Where Gt is the supply of the public capital good

Kt is the supply of the private capital good
Lt is the aggregate supply of labour
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(24)

The Basic Model

We assume F has constant or decreasing returns to scale in the private factors (K, L) but
may exhibit increasing returns in all three factors together.
The aggregate labour supply Lt is given by the solution to the utility maximization
problem stated in equation (22a). The determination of Kt, however, is somewhat more
complicated. The solution to the individuals utility maximization problem gives a
value to total savings.
To relate Kt to St, we have to make specific assumptions concerning depreciation and
the existence of alternative stores of value. The simplest depreciation assumption is
that all capital lives for only one period. Then, if there exists no alternative store of
value,
S t K t 1
(25)
Output is allocated to three uses: consumption, public investment, and private
investment. We simplify the analysis by assuming that

Yt C1t C 2t 1 K t 1 Gt 1
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(26)

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The Basic Model

We are now prepared to formalize our maximization problem. We wish to maximize the
present discount value of social welfare:
(27)

Subject to the national income constraint

F ( K t , Gt , Lt ) C1t C 2t 1 Gt 1 K t 1

(28)
Where Kt+1 = St, and where St is given by equation (22c) and Lt is a function of the wage
rate and the consumer rate of interest given by equation (22a).

The instruments available to the gvt are the wage rate, the consumer interest rate, and the
expenditures on public investment goods. There are numerous other equivalent
formulations; this one is particularly simple to work with, as will be evident shortly.

Note that in this formulation we do not treat the level of taxation as a control variable,
but it is implicitly defined in each period. From equation (25) we will be able to find the
level of capital in each period and from equation (22a) we can find the labour supply.
Oct 2014

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The Basic Model

This, combined with knowledge of Gt gives us
1 rt F ( K t 1 , Gt 1 , Lt 1 )
where r is the producer rate of interest. From this expression we can easily
calculate the producer rate of interest. Since we know the consumer rate of
interest, the difference between the consumer and the producer rates of interest
of simply the interest income tax. Similarly we calculate F 3 and the difference
between that and the wage is the wage tax.
By directly substituting equations (25) and (26) into equation (28), we can
obtain a simple formulation of the Langragian for our maximization problem.

Oct 2014

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The Basic Model

An immediate result is that, in the steady state

t 1

(30)

and differentiating equation (29) with respect to Gt, we have

t 1 F2 t

(31)

Equation (32) tells us that, in the steady state, the marginal return to public investment,
F2, should be equal to 1 + ; that is, the social rate of discount is equal to the pure rate
of social time preference. The relationship between F 2 and the market rates of interest,
however, is not so obvious.

After some manipulation of the first-order conditions, it can be shown that:

Oct 2014

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The Basic Model

Where

That is:

Where tw is the tax on wages

If there were no tax on wages, the social rate of discount would be simply a weighted
average of producer and consumer interest rates. But close inspection shows that does
not have to lie between the two market rates, because of wage tax and because i is not
constrained to lie in the interval (0,1).
Oct 2014

Created by: Dr. Makochekanwa

END

Oct 2014

Created by: Dr. Makochekanwa