5-1 Economics: Theory Through Applications 5-2 This work is licensed under the Creative Commons Attribution-Noncommercial-Share Alike 3.0 Unported License. To view a copy of this license, visitsend a letter to Creative Commons, 171 Second Street, Suite 300, San Francisco, California, 94105, USA 5-3 Chapter 5 Life Decisions 5-4 Learning Objectives What is your lifetime budget constraint? What factors influence your choice between consumption today and saving for the future? What is the difference between real and nominal interest rates? What are the effects of a change in the interest rate on consumption and saving? When should you use the tool of discounted present value? How does an increase in the interest rate affect the discounted present value of a flow of income? Learning Objectives What is the definition of probability? How can I calculate an expected value? What is risk aversion? How do individuals and firms deal with risk? How does insurance work? Why do people sometimes take on risks instead of avoiding them? What are compensating wage differentials? 5-5 Consumption and Saving 5-6 Figure The Budget Line with Two Goods 5-7 Consumption and Saving 5-8 Figure The Budget Line with Two Periods 5-9 The Slope of the Budget Line 5-10 The Slope of the Budget Line The Position of the Budget Line 5-12 Figure Determining the Position of the Budget Line 5-13 Adding Nominal Income over Two Periods 5-14 Table Discounted Present Value of Income 5-15 Adding Nominal Consumption over Two Periods 5-16 Adding Nominal Consumption over Two Periods Figure The Preferred Point 5-18 Figure Consumption and Saving 5-19 Figure The Timing of Income 5-20 Lifetime Budget Constraint 5-21 Figure An Increase in the Real Interest Rate 5-22 Figure Individual Loan Supply 5-23 Figure A Shift in an Individuals Supply of Savings 5-24 Table Which Career Should You Choose? 5-25 Choosing a Career 5-26 Table Comparing Discounted Present Values of Different Income Streams 5-27 Table Discounted Present Values with Different Interest Rates 5-28 Table Income from Going to College versus Taking a Job 5-29 Going to College 5-30 Table Income Streams from Going to College versus Taking a Job 5-31 Going to College 5-32 Table Return on Education 5-33 Figure Individual Labor Supply 5-34 Table Coin-Flipping Experiment 5-35 Table Outcomes and Probabilities from a Coin Toss 5-36 Table Outcomes and Probabilities from Investment in Internet Venture 5-37 Financial Risk and Expected Value 5-38 Figure Work Fatalities in the United States 5-39 Figure Work Fatalities in Europe 5-40 Buying a Lottery Ticket 5-41 Key Terms Price level: A measure of average prices in an economy Nominal interest rate: The rate at which individuals and firms in an economy can save or borrow Nominal interest factor: A factor, equal to 1 + nominal interest rate, used to convert dollars today into dollars next year Inflation rate: The rate at which the overall price level in an economy is growing Real interest rate: The rate of interest adjusted for inflation 5-42 Key Terms Real interest factor: A factor, equal to 1 + the real interest rate, that allows you to convert units of goods and services this year into units of goods and services next year Fisher equation: A formula for converting from nominal interest rates to real interest rates: the real interest rate equals the nominal interest rate minus the inflation rate Discounted present value: A technique that allows us to compare the value of sums of money received at different dates Lifetime budget constraint: The discounted present value of lifetime consumption must equal the discounted present value of lifetime income 5-43 Key Terms Individual loan supply: The amount of saving carried out by an individual at different values of the real interest rate Durable goods: Goods that last over many uses Nondurable goods: Goods that do not last very long Probability: The percentage chance that an outcome will occur Expected value: The measure of how much you would expect to win (or lose) on average, if the situation were to be replayed a large number of times 5-44 Key Terms Diversification: The insight that underlies insurance in which people can share their risks Indemnity: In an insurance contract, a value equal to the full amount of the loss minus the deductible Deductible: In an insurance contract, the value not covered in the event of a loss Risk neutral: Being willing to pay only the expected loss from a gamble Risk averse: Being willing to pay more than a gambles expected loss in order to avoid that gamble 5-45 Key Terms Unemployment rate: The number of unemployed individuals divided by the sum of the number employed and the number unemployed Labor market: Where suppliers and demanders of labor meet and trade Unemployment insurance: A payment made by the government to those who are unemployed Compensating wage differential: The amount in excess of the normal wage paid to compensate a worker for undesirable aspects of a job 5-46 Key Takeaways Over the course of an individuals lifetime, the discounted present value of spending equals the discounted present value of income Households save to consume more in the future Unless the interest rate is zero, a dollar today does not have the same value as a dollar tomorrow The nominal interest rate is expressed in dollar terms, while the real interest rate is expressed in terms of goods and services Economists think that households and firms make decisions on the basis of real interest rates 5-47 Key Takeaways You should use discounted present value whenever you need to compare flows of income and expenses in different periods of time The higher the interest rate, the lower the discounted present value of a flow The probability of a particular outcome is the percentage chance that the outcome will occur An expected value is calculated by multiplying the probability of each outcome by the value of that outcome and then adding these numbers for all outcomes 5-48 Key Takeaways Risk aversion means a preference for a sure thing rather than a gamble with the same expected value We face many types of risks in our lives, and we can often buy insurance as a way to deal with these risks Insurance companies provide a way for individuals to diversify their individual risks One reason that people take on risks is because they enjoy gambling Some jobs are riskier than others and pay more to compensate people for the risks they face 5-49