James Watson Student Number = 100636074

Indifference Analysis Application to an individual s savings decisions The main application of indifference analysis is to determine the optimum combination of two goods that a consumer has to choose from. This combination of goods should give the consumer the maximum total utility possible, subject to a budget constraint (denoted B or Y). However, slight manipulation of this theory allows us to use the same application to determine an individual s consumption pattern between 2 time periods (i.e. how much to consume now and how much to save for later). The individual s problem is to aim to maximise total utility from a combination of spending now and spending later, subject to a budget constraint (in this case the lump sum that the person is born with). Mathematically this can be written as: Max TU (N, L) subject to S Where S = PNN + PLL Where N is consuming now, L is consuming later and S is the lump sum of money that the individual is born with.

However, it is explaining the solution to this problem that is important. With indifference analysis, we have to assume that the consumer behaves rationally, i.e. they choose the combination of consumption that makes the most sense and brings the most utility. In this example, the consumer will choose the best combination of saving now or spending now that gives them the most utility. This can be shown in the diagram below:

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James Watson Student Number = 100636074

The diagram shows the solution to the consumer s problem. Each of the indifference curves I1, I2, I3 and I4 all represent different levels of utility, but along each of these curves the consumer is indifferent. In this case the consumer operates at point N1, L1 (located on I2) as this is the highest possible indifference curve subject to the budget constraint of S. It occurs at a point of tangency between the two lines. It is an important point to notice that it is very unlikely that the indifference curves will ever reach the axis because the consumer is unlikely to want to consume nothing now or nothing later it makes more sense for the rational consumer to go somewhere in between. The solution to this problem can also be written in a mathematical format as the optimum consumption point for a consumer is where the ratio of prices equals the ratio of marginal utilities. If: MUN PN then the consumer will benefit from consuming more now MUL PL and less later, due to the law of diminishing marginal utility.

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On the other hand, if: MUN PN MUL PL

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then the consumer will benefit from consuming less now and more later, due to the law of diminishing marginal utility.

The consumer will therefore continue to alter their consumption pattern, until the ratio of marginal utilities equals the ratio of prices, in other words: MUN MUL

PN PL

This means that the consumer cannot gain any additional utility by changing their consumption pattern.

However, because the slope of the indifference curve is the same as the ratio of marginal utilities and the slope of the budget line equals the ratio of prices, then I can conclude that the optimum combination of saving and spending is shown by the intersection between the budget line and the indifference curve I2. This means that the individual should consume N1 units now and consume L1 units later, which means they must save this amount now. Despite it looking like the individual has calculated how much to save now and how much to spend now, there are several other exogenous factors that can have an influence on the optimum combination for consumption. The two factors that I am going to discuss are interest rates and inflation. It states clearly in the information given that the price change between the two time periods is 20%, however there is no reference to the interest rate level (it simply states that the consumer has no source of income other than the interest that they could acquire by putting some part of their money in an interest-bearing bank account ). For the purpose of this analysis I have assumed that the interest rate is lower than 20%, say 10% as an example. This makes it relatively more expensive for the consumer to save and purchase more
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James Watson Student Number = 100636074

of the good in the future because the value of the good changes by 20%, but the amount of money gained is only 10%. But what happens if the interest rate increases to a figure equal to or above 20%? The answer is that increasing interest rates makes it more attractive to save rather than consume now. This is because the relative price of the good in the future seems lower as if the person places their money in a bank account and reaps the interest gains, then they have more money in the future and can therefore afford more units of the good than they could if they simply spent the majority of their budget in the 1st time period. They are relatively better off. There may also be an opportunity cost of consuming now due the increased interest rates as the money would be better off being spent in the second time period. This raises an important issue; does the opportunity cost of consuming later impact its price? In my opinion, the cost to the consumer of consuming later does not impact its price, in the same way that the cost to society of overproducing alcohol does not change the price of alcohol; it simply increases the deadweight welfare loss. The overall impact of the interest rate increase can be shown on the diagram below:

The diagram shows that there has been a pivot of the budget line around the intersection with the consume now axis (the new line is S2). The consumer now consumes N2 units now and L2 units later, with a clear increase in both the units consumed now and later, due to the increase in overall wealth. However, I can see clearly from the diagram that the increase in units consumed later is greater than the increase in units consumed now. This is because the only price change there has been is the price of units consumed later which have become cheaper due to increased interest rates. It is also important to take note of the new level of utility that is derived from being located on a higher indifference curve (I3).

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James Watson Student Number = 100636074

The other external factor which may impact an individual s saving decision is inflation, in other words a price change between the two periods. If inflation increases from 20% to 30% then the consumption pattern changes once again. It becomes relatively more expensive for the individual to consume later as they can buy less of the good (money becomes less valuable). The effect of this price change is shown on the diagram below:

The increase in inflation causes the budget line to pivot around the x axis to a lower point of consumption, i.e. the opposite to before (the new line is S3). The individual now chooses the consumption set N3, L3, which represents a lower utility as the consumer must now accept a lower indifference curve (I1). This is because total wealth has decreased as money is worth even less in the future than before. Once again the amount saved for later is the most susceptible to change because this is where the price change happens - In both the altering of interest rates and price changes, there is no influence on the price of consuming now, other than the opportunity cost. In conclusion, I feel that a fundamental comment to make about these factors is that they are linked very closely. As you can see from the 2 previous diagrams, increasing interest rates and increasing inflation act in opposite directions to change the price of saving money in order to consume later. As I already mentioned near to the start of my analysis, we do not know the interest rate either before or after the rate change. This means that in order for there to be a substantial effect on the consumer, the interest rate needs to be higher than the price increase, and therefore if inflation increases, the interest rates need to increase by a greater amount to have the effect of deferring consumption. If interest rates and inflation both start at 20% and then inflation then increases to 30%, but interest rates increase to only 25%, then it is still more attractive to consume now despite an increase in interest.

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