Roadmap

Model description has four main parts:

1. Physical environment
People, goods, trade meetings.
2. How people get goods
Endowment and/or production.
3. Preferences of people.
4. A way to combine peoples actions
such that demand = supply.
 Plan
Part 1. Beginnings
Part 2. The environment.
Part 3. Preferences.
Part 4. The Economic Problem.
Part 5. Decentralized Solutions.
Part 6. Golden Rule.
Part 1. Beginnings
An Economic Model
Replicate essential features of actual
economies.
Simplifications of the complex economic
reality we live in.
Describe: physical environment,
production technology, endowments,
preferences and how to solve all these
simultaneous problems.
Solution is called equilibrium.
Why model economies?
Useful to illustrate key elements of the
behavior of people
Predict how economic variables react.
Start with a simple model and then ask
how it fails to represent reality.
Then, one by one, add features it lacks
to correct the models oversights.
Overlapping Generations Model
Introduced by Paul Samuelson (1958)
Why this model?
Tractable
Rigorous (Microfounded)
Dynamic
Part 2. The Environment
Environment: Basics
Individuals live for two periods
We call people
in their first period of life: young
in their second period of life: old

Economy starts in period t=1

For all t 1, Nt agents born the future
generations
At t=1, N0 initial old individuals
Environment: People
In each period there are
Nt young people

Nt-1 old people

Period: 1 2 3
Environment: Goods
One nonstorable consumption good
Endowments of each individual:
y consumption goods when young.
Nothing when old.

Good cannot be stored: creates a need

for trades.
 Periods
Generations 1 2 3 4 5 6 7

0 0
1 y 0

2 y 0
Generations

3
Future

y 0
4 y 0
5 y 0

Part 3. Preferences
Preferences: Future Generations
Utility of an individual depends on a
combination of consumption when
young: c1,t
old: c2,t+1
c2,1
c2,2
c2,3
c1,1
c1,2

Period: 1 2 3
Preferences: Future Generations
Agents rank consumption bundles of
the quantities c1 and c2.
An indifference curve connects all
consumption bundles that yield equal
utility to the individual.
Preferences: Future Generations
c2

9
8
7
A
6
5
B
4
3
2 C

1
c1
0 1 2 3 4 5 6 7 8 9 10 11 12 13
Preferences: Future Generations
Curve has negative slope
Agents are willing to give up c2 for c1
Curve gets flatter as we move to the
right. Agents are willing to give up less
and less c2 for one unit of c1:
diminishing marginal rate of
substitution
Preferences: Indifference map
c2

9 Direction of Increasing Utility

8
7
A B C
6
5
4
3 U2
U1
2 U0
1
c1
0 1 2 3 4 5 6 7 8 9 10 11 12 13
Preferences: Indifference map
Analogy between an indifference map
and a contour map:
Traversing the indifference map in a
northeasterly direction is like going uphill:
utility is increasing
3 dimensions, (C1, C2, U), in a 2-
dimensional drawing.
Preferences: Future Generations
Transitivity: If an agent prefers
bundle B to A
bundle C to B
then this agent must prefer bundle C to A

Graphically this implies that indifference

curves can never cross
Preferences: Future Generations
c2

9
8
7
6
5 A
4
3 C
B
2
U1
1
U0
c1
0 1 2 3 4 5 6 7 8 9 10 11 12 13
Preferences: The Initial Old
The Initial Old live and consume only in
the initial period.
They want to maximize their
consumption in that period.
They consume as much as they can
given their endowments.
Preferences: The Never-ending
Economy
Infinity plays an important role.
Suppose, the economy has a known
end date.
The young born in the last period will never
trade with the old, the young will never get
anything in return.
Then, young born in the next-to-last period
will also not trade with the old.
And, so on
Part 4. The Economic Problem
The Economic Problem
Each future generation has
access to the nonstorable good only when
young but
wants to consume in both periods.

Two solutions to this problem

Centralized solution: benevolent planner
Decentralized solution: trades with money
Feasible Allocations
Feasible allocations
Planner cannot allocate more goods than
are available:

(total amount of consumption good)t = Nt y (1.1)

Equity: every member of generation t gets

the same allocation (c1,t, c2,t+1):

(total young consumption)t = Nt c1,t (1.2)

(total old consumption)t = Nt-1 c2,t (1.3)
Feasible Allocations
Total consumption by young and old:

Nt c1,t + Nt-1 c2,t Nt y (1.4)

Constant population (Nt = N for all t)

c1,t+c2,ty(1.5)

A stationary allocation: the same lifetime

consumption for all generations, i.e.
c1+c2y(1.6)
Feasible Allocations

c2 Unachievable Allocation
Feasible Allocations
y
A

Feasible set line:

c1+c2=y

c1
y
Golden Rule Allocation
The feasible allocation a central planner
selects depends on the objective.
Golden Rule
Stationary, feasible allocation that
maximizes the welfare of the future
generations.

Tangency between feasible set

boundary and an indifference curve.
Golden Rule Allocation

c2
A: Golden Rule Allocation
y
B D

c2* A

U2

C U1
U0
c1
c1* y
Golden Rule Allocation

c2
E: optimal for initial old
E
y
B D

c2* A

U2

C U1
U0
c1
c1* y