Allocating wealth across time

Topics to be
2
covered
 Individual preferences across time
 Production opportunities (Real Investment)
 Inter-temporal consumption
 With production opportunities only
 With capital markets only
 With both capital market and production opportunities
 Role of Capital Markets
 Inter-temporal Consumption Choice
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 study consumption (C) and investment (I) decisions made by
individuals and firms
 Simplified case: Robinson Crusoe’s case, 2-periods. He needs
 1. to know his own subjective tradeoffs between C now (C0) and C next
period (C1) (this information is embedded in the utility function)
 2. to understand the feasible tradeoffs between present and future
consumption that are technologically possible (this information is
embedded in the production opportunity set (POS)
 the optimal consumption-investment decision establishes a
subjective interest rate – the subjective rate of time preference ()
 This subjective interest rate represents the unique optimal rate of
exchange between C now (C0) and C in the future (C1)
 Interest rates are the price of deferred consumption – by forgoing
one dollar of consumption today, the market rewards with
interest payments R
 CONSUMER THEORY
U MU

U = U(C)

MU > 0 (U / C) > 0 MUC is high

MU is diminishing
(2U / C2) < 0 1 MUC is low

1 MU
C C

Single period utility functions When C is low, each unit of C has

- exhibit diminishing utility (concave) high utility value
- As C , Utility , but each unit of
C increases U by less and less When C is high, each unit of C has
lower utility value
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 INDIFFERENCE CURVES
Convex Indifference Curves
C1 trace out combinations of C0 and C1
Consumption for which the individual equally well-off
In period 1
C0 low, MU(C0) high

C1 high, MU(C1) low

C0 high, MU(C0) low

C1 low, MU(C1) high

1 U (Indifference Curve)

C0
Negative slope because as C0 falls, C1 must Consumption
increase to maintain the same level of utility In period 0
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 INDIFFERENCE CURVES
Represent higher levels
C1 of utility
Consumption U0 < U1 < U2
In period 1

U2
U1
U0

C0
Consumption
In Period 0
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 What is the slope?
-The slope of the indifference curve
C1 measures the rate of trade-off between C0 and C1
at the point of tangency
-This trade-off is called the marginal rate of
substitution MRS between C0 and C1
- this also reveals the individual’s subjective
rate of time preference i (at each point on
the indifference curve)
- Precisely, slope = -

U0

C0

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 MRS is not constant!
If C0 is to reduce by 1 unit:
C1 (a) when C0 is high
less additional C1 is needed to make
this individual equally well off
(b) when C0 is low
ρb b more additional C1 is needed to make
this individual equally well off
1 How to show this graphically?
- Convex indifference curve
- the slope at a (ρa) < the slope at a (ρb)

ρa a
1 U0

C0
C0 C1
MRS = - (slope of an indifference curve)
C1 C0 U = U0

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 Constraints: With production only
• Objective: maximizes utility subject to constraints.
• Constraints: only production is available for inter-temporal
allocation of wealth

• A1. All investment outcomes are known with certainty

• A2. No transaction costs
• A3. No taxes
• A4. Decisions are in a two-period world (periods 0 and 1)

• y0 = is the individual’s endowment in period 0

• y1 = is the individual’s endowment in period 1

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 INVESTMENT OPPORTUNITIES
Marginal Rate of Return
(Future consumption – future endowment)
- production opportunities allow a unit of
current savings to be converted into output or
wealth in the future
A
ASSUMPTIONS
A1. Investments are arranged from the highest
rate of return to the lowest rate of return
A2. As total investment increases, the marginal rate
of return falls
A3. All investments are independent of one another
A4. All investments are perfectly divisible

B
Total investment
(current endowment – current consumption)
MRT = slope of AB
= rate at which a dollar of consumption foregone today C0 is transformed
by productive investment into output tomorrow i.e. it is the MRT offered
by the production opportunity set 10
 INVESTMENT OPPORTUNITIES
Marginal Rate of Return
(Future consumption – future endowment)
Production Opportunity Set (POS)
C1

A
Low rates of
return
High
High rates of
return
y1
endowment
Low point

B
I0 I1 Total investment y0 C 0
(current endowment – current consumption)
I0
I1

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 INVESTMENT OPPORTUNITIES

Production Opportunity Set (POS)

C1

Given technology, the POS traces

out the maximum amount of C1 that Low rates of
is feasible for any given amount of C0 return

High rates of
return
y1
endowment
How does individual maximize utility? point
- make all investments in the
production opportunity set that have
rates of return higher than his y0 C 0
subjective rate of time preference I0
I1

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PUTTING TOGETHER THE POS AND PREFERENCES

C1
In the absence of production
the individual would be forced
to consume at the endowment
point

y1
The endowment U0
point

y0 C0
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 PUTTING TOGETHER THE POS AND PREFERENCES

C1
Small vertical arrow
- amount needed to be equally well
off in utility terms (ρ)
Large vertical arrow
- amount of return to deferring consum
today and undertaking investment

y1 0
1
U0

y0 C0
Individuals will make all investments in the production opportunity set
that have rates of return higher than his or14her subjective rate of time preference
 PUTTING TOGETHER THE POS AND PREFERENCES

This is the point where

C1 MRT = MRS

(slope of = (slope of
POS) indifference
curve)

y1 0 U1
The endowment
point U0
I0

y0 C0
Message: Production opportunities allow individuals to achieve a higher
level of utility – i.e. Move to U1 > U0 15
 Benefits of Production Opportunities
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 In the absence of investment opportunities, individuals are
constrained to consume at his endowment point
 Investment opportunities expand the consumption set
 Individuals are therefore better off
 At point 0,
 MRT > MRS [the slope of POS] > [slope of utility function]

 [The return one obtains > [return required by the

from investing] individual to forego
current consumption]
=> Optimal action: Increase the amount investing
until
 At point *, MRT=MRS, and I0 is the optimal level of
investment
 Constraints: With Capital market only
• Objective: maximizes utility subject to constraints.
• Constraints: only capital market is available for inter-
temporal allocation of wealth

• A1. All investment outcomes are known with certainty

• A2. No transaction costs
• A3. No taxes
• A4. Decisions are in a two-period world (periods 0 and 1)

• y0 = is the individual’s endowment in period 0

• y1 = is the individual’s endowment in period 1

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 Constraints: With Capital market only
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 Capital Market – individuals can borrow and lend, and thus

facilitates the transfer of funds between lenders and borrowers
 With initial endowment of (y0 and y1) that has utility U0,
individuals can reach any point along the capital market line
through borrowing and lending at the market interest rate R.
 R = market rate of interest (reward to deferring consumption)

 I0 is the period 0 amount invested

 I1 is the period 1 value of this investment = I0(1+R)

- in the absence of capital markets, individuals would be

constrained to consume at his endowment point (with U0)
- We will show how the ability to borrow and lend can improve an
individual’s utility
 The Budget Set (Capital Markets)
y0 = endowment in period 0
y1 = endowment in period 1

C1 This line (Capital market line)

traces out all affordable combinations
W1 of C0 and C1, given the endowments y0 and y1
by borrowing and lending at market interest rate R
By giving up,
or deferring one The individual’s wealth:
unit of consumption (a) Measured at Period 0 (x-intercept):
today, you get (1+R) (1+R) W0 = y0 + y1 / (1+R)
units tomorrow
-1 (b) Measured at Period 1 (y-intercept):
y1 W1 = y1 + y0 (1+R)

y0 W0 C0

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Choosing the Optimal Consumption Path with Capital Markets
At point 0, the slope of the indifference curve
is less than the slope of the budget line
==> it is better-off to defer C0 today,
C1
because the return (increase in C1) will be higher
than needed to make him indifferent.
- Precisely, the amount that the capital market
will reward this individual for deferring
consumption is the distance (EB), which exceeds
the amount the individual needs to be equally
well off (DB).
*
E The individual therefore moves to a higher level
of utility by lending money to the capital market
D
B 0 U1
U0

C0
The individual continues moving along the capital market line to the point at which
the amount capital market rewards him is exactly what he needs to be equally well off
- at the tangency between the interest rate line and the indifference curve - point *
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 Consumption with Production and Capital Markets
In the absence of production and capital
C1 markets, this individual can only consume at Pt 0.
Pt 1: Production alone
Pt C & P: Both Production and Capital Markets

Capital
Market
line p
*

*
1 c
*

0* Uc&p
U1
U0
At the optimum, there is a “separation” between the C0
Consumption and Production Decision21 (pt c & p)
 The Inter-temporal Consumption Choice

Consumption

*
* *
U’ * U’’’
U’’
0 Production
U0 0 U0 0 U0

Production alone Capital Market Alone Both Capital Market & Production

Preferences determine There is no production, Capital market line objectively

Production and and preference determine determines production with the
Consumption Point consumption market interest rate,
(same point) And individual preference
subjectively determines
consumption with his rate of time
preference

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 The Consumption Decision
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Preferences (shape of utility curves) are
unique to each individual
Production opportunities are the same for
everyone
Capital markets (interest rates) are the same
for everyone
Preferences determine consumption
Capital Market line (interest rate) determines
production
All individuals make the same production
decision, independent of preferences
 The Decision Making Process
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- the decision-making process that takes place with production
opportunities and capital market exchange opportunities occurs
in two separate and distinct steps

1. Choose the optimal production decision by taking on projects to

the point where

[marginal rate of return on investing] = [the objective rate of

interest]
[slope of POS] = [the objective rate of
interest]
MRT = (1+r)

2.
 The Decision Making Process
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2. Choose the optimal Consumption pattern by

borrowing or lending along the capital market line
to equate your subjective rate of time preference
with the market rate of interest
[slope of indifference curve] = [slope of market line]
MRS = (1+r)

This separation of decisions is known as the Fisher

Separation Theorem
i.e the separation of the Consumption and
Investment decisions
FISHER SEPARATION THEOREM
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 Given perfect and complete capital markets (frictionless), the

production decision is governed solely by an objective market
criterion (represented by maximizing attained wealth) without
regards to individual’s subjective preferences that enter into the
consumption decision.
 This is extremely important for corporate finance

 regardless of the shape of individual investor’s indifference

curve of a firm, every investor of that firm will direct the
manager to the same production decision
- The investment decision is independent of individual
preferences
 Consider two individuals
C1 Both individuals 1 and 2
make the same investment
decision: both produce at *,
and by using capital markets,
borrow or lend to achieve
their own optimum consumption point

That is, regardless of the shape

Individual 2
(stronger preference
for future consumption)
of their utility functions, they make
exactly the same production decision
* In math:
MRS1 = MRS2 = -(1+R) = MRT

Individual 1
(stronger preference
for current consumption)

C0
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 The Separation of C and I decisions
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 Both investors 1 and 2 will direct the manager of the firm to choose
point (*)
 The investors simply takes the output of the firm and adapts it to their
own subjective time preferences by borrowing and lending in the capital
market
 The optimal production decision is separated from individuals utility
preferences (thus individual investors are unanimous (Unanimity
principle))
 The Separation of C and I decisions
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ROLE OF CAPITAL MARKETS

capital markets allow the efficient transfer of funds
from lenders to borrowers
Individuals who have insufficient wealth to take
advantage of all their investment opportunities that
yield rates of return higher than the market rate are
able to borrow funds and invest more than they would
without capital markets i.e., funds can be efficiently
allocated from individuals with few production
opportunities and great wealth to individuals with
many opportunities and insufficient wealth
All borrowers and lenders are better off than in the
absence of capital markets
 The Separation of C and I decisions
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INVESTMENT DECISION
The objective of the firm is to maximize the wealth
of its shareholders.
This is the same as [maximizing the present value
of the shareholders lifetime Consumption] =
[maximizing the price per share per stock]
 How to max shareholder’s wealth?
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 We again uses Fisher Separation Theorem

 Given perfect and complete capital markets, the owners of the firm
(shareholders) will unanimously support the acceptance of all projects
until the least favourable project has return the same as the cost of
capital.
 In the presence of capital markets, the cost of capital is the market
interest rate.
 The project selection rule, i.e., equate
marginal rate of return of investment = cost of capital (market interest rate)
 Is exactly the same as the net present value rule:
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Net Present Value Rule

 Calculate the NPV for all available (independent) projects. Those with
positive NPV are taken.
At the optimal:
NPV of the least favourable project ~= zero
 This is a rule of selecting projects of a firm that no matter how
individual investors of that firm differ in their own opinion
(preferences), such rule is still what they are willing to direct the
manager to follow.
 Fisher Separation Theorem
• The separation principle implies that the maximization of the
shareholder’s wealth is identical to maximizing the present value of
lifetime consumption
• Since borrowing and lending take place at the same rate of interest,
then the individual’s production optimum is independent of his
resources and tastes
• If asked to vote on their preferred production decisions at a
shareholder’s meeting, different shareholders will be unanimous in
their decision
 unanimity principle
• Managers of the firm, as agents for shareholders, need not worry about
making decisions that reconcile differences in opinion among
shareholders i.e there is unanimity
• The rule is therefore
– take projects until the marginal rate of return equals the
market interest rate = taking all projects with +ve NPV
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 Principal-Agent Problem
• Principals = Shareholders, Agent = Manager of the firm.
• Ownership ≠ control, so there is no reason to believe that managers
will always act in the best interest of the shareholders (Consider all the
accounting scandals)
- If the shareholders can costlessly monitor management decisions, they
can be sure that management really does make every decision in a way
that maximizes their wealth
- In reality, owners must incur non-trivial monitoring costs in order to
keep the manager in line => owners (shareholders) face a trade-off
between monitoring costs and forms of compensation that will cause
the agent to always act in the owners interest

- Fisher separation holds only with strong assumptions: (I.e frictionless

markets)
 I.e can costlessly monitor managers
 decisions always made to maximize value of the firm

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