Financial Economics

2

CONSUMER FINANCIAL DECISIONS

Consumer behavior plays a key role in determining what and how much is produced in a developed economy. For this reason, a convenient starting point in microeconomic theory is to understand the basic principles of how consumers make consumption and investment decisions. In arranging their expenditure and finance planning, consumers both spend and invest in the financial obligations of firms and governments. Firms and governments are thus borrowing from consumers who decide both how much to consume at a given time and how much to lend or invest (through the purchase of financial assets) for financing future consumption. Ultimately, the price of investment funds is determined by the interaction of lender preferences and borrower needs. Thus, consumer behavior with respect to financial decisions is critical to understanding financial economic theory.

In this chapter, we describe the basic features of consumers' financial decisions. As we do throughout this book and as explained in Chapter 1, we begin by considering the decisions made by consumers in a certainty world with a perfect capital market.¹

2.1 THE CONSUMPTION-INVESTMENT PROBLEM

In a typical developed economy, consumers' purchases determine the outcome of more than two-thirds of the output produced. Indeed, since consumer decisions are the foremost means by which goods and services are distributed in any developed economy, it is important to understand consumer behavior. To do so, we employ what ...