How Should You Spend Your Wealth? Aa Aaron Stevens EC1 EC171 71, 22 22 September 2011 1 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 onomics The conceptual framework to answer life’s financial questions: Household Composition Life-Cycle Sustainable Standard of Theory of Living Resources Saving and Consumption Annual financial plan Obligations (simple arithmetic)
Recall: Tw Reca Two o Peri Period od Model odel You are young You are young Each period of and you work. Ea k. , in real time , , is time, roughly 35 roughly 35 You are old and years of years of Yo you die. you die. adulthood. adulthood. 5 Budget Co Bu Constraint: Yo Yout uth When you’re Wh re young, you work and receive recei e labo abor r inco come. e. + = What you earn What you earn (labor income) (labor income) Cy + Cy + S S = W What you consume What you consume What you save What you save in your youth in your youth
Bu Budget Co Constraint: Ol Old Age Age Wh When you’re re old, you live by consuming (s (spend nding ing d dow own) y n) you our s saving vings. C o = = S Amount saved Amount saved Consumption Consumption when young when young when old when old 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 or 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) or Cy + Co/(1+r) = W * * No Taxes and/or Benefits An An Examp mple to o Illus ustrate As Assume e W= $1 $1,000, 000,000 000 r = 1 r 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 on 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 oney 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 onal per person on woul ould want ant to to cons onsum ume as as much uch when hen young young as as when hen ol old. d. “Consump mption Smo moothing” “Co Consumption Smoothing” “Co Consumption Smoothing” 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 A A 60- 60-period od 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 unexpect unex pected ed (but but rat rational onal) resul results. s. * * No Taxes and/or Benefits
Wa Wages and consumption ov over er a 60- 60-yea ear Li Life- e-Cycle* e* Ne Net Wor orth ov over er a 60- 60-yea ear Li Life- e-Cycle* e*
Econom Economics cs Goa oal in n Li Life fe Pigging Ou Pi Out (consump mption) Goofi fing Off Off (lei eisure) e) How How Doe Does an n Economi onomist Know Know When hen He’s s Happy ppy? He e consults his utility fu function. U(C,L) = C 0.7 L 0.3 You You have have one one 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.
A Si A Simp mple Utility Func unction on Now ow l let u t us ca calcu culate te th the inte terte temp mpor oral elasticity ticity of of s substitu titution tion f for or Econ Economi omists are are cl clos oset a h homoth omothetic u tic util tility ity f function ction. T Take ke a an e exa xamp mple: mathema ma matici cians! So So They They express express pleasure pleasure as as Now ow l lets ts a a ma make ke th the a assump mption tion th that mathema ma matica cal funct ction ons. it is it is s str traig ightf tfor orward to d to defin ine th the r rate te of of tr true time time p preference ce So So ht http:// //hassler-j.ii iies.su su.s .se/courses/macro/notes98/ELAST.HTM Tot Total Ut Utility Total utility increases with more! This holds for consumption and leisure. Example:
Sa Samp mple Ut Utility Func Function on Happines ess = Total Utility U(C,L) = C 0.7 L 0.3 About Utility F About Uti ty Func uncti tions: ons: • 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) “De De gu gustibus no non di disputandum” Gr Graphi hical Represent ntation on Which point gives es you the e mo most utility? Consumption Consumption ($) ($) A • B • C • D • Leisure (h Leisure (hours)
Intertemp mpor oral 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? , Splurge Tomorrow? Cy + Cy + Co/( Co/(1+r +r) = = W Starve Today, C 0 Consume The same When Young & Consume The same When Young & A • W(1+r +r) B • , Starve Tomorrow? Old? Old? C • Splurge Today, D • E • C y W
Wh Why Wh When matters Law of La Diminishing Di Returns. Returns. Answer: An Do You Feel How Do You Feel Like ke After Eating 50 After Eating 50 You wing ng Throwi Th Hotdogs? Hotdogs? Up! Up 25 Exa Exampl ple: e: Co Consumption Smoothing A huge cupcake!
Exampl Exa ple: e: Co Consumption Smoothing Law of Law of Dimi minishing Ret eturns “Is it OK to save this Consump mption smo moothing is grounded ed in for tomorrow?” ph physi ysiol ology ogy – the e fa fact that we e get et satiated ed! Doe Does Hav Having ng More ore 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. Marginal utility is Ma ut utility y gai gained ned from rom having one more unit. hav In th In this s example, ma marginal utility is the addi additional al ut utility y fro rom one one more ore dol ollar r of of in income. ht http://www.viral-memes.com/?tag=distributed-risk
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 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. 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.
Ov Overconf onfidenc 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 onfidenc nce Bi Bias We’re We 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.
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