Question

Devah lives for two periods: period 1 in which she works and earns income, and period 2 in which she is retired and earns no income! At the start of her life, her utility over consumption is given by U(c₁,c₂)=(c₁)0.5+δ[(c₂)0.5] where c₁ and c₂ are consumption in periods 1 and 2, respectively (both measured in dollars), and δ is a measure of myopia or "present bias" (0<δ<1). Assume there is no time discounting.

Answer 1

The student's question pertains to intertemporal choice in economics, particularly how Devah might trade off consumption now versus savings for retirement, which is influenced by her present bias and the rate of return on savings.

Step-by-step explanation:

The question asked by the student revolves around the concept of intertemporal choice in economics, which involves decisions about how much to consume or save at different points in one's life. Devah's utility function U(c₁,c₂)=(c₁)⁰.⁵+δ[(c₂)⁰.⁵] represents how she values consumption in two different periods: her working years (period 1) and her retirement (period 2). The term δ is a measure of her present bias, influencing her consumption choices between the present and the future. This concept shows how she might allocate her earnings between consumption now and savings for the future, taking into account the rate of return on her savings, which determines the trade-off represented by the slope of her intertemporal budget constraint.

An example that illustrates an intertemporal budget constraint in action involves Yelberton, who must decide how much to save now in order to consume in the future. In this example, saving $100,000 now becomes $574,000 after 30 years with a 6% interest rate due to the power of compound interest. The impact on future consumption is plotted on his intertemporal budget constraint.