Copeland

Chapter One
Introduction :
Capital Market, Consumption
and Investment
Introduction
 Consider, a one-person/one-good economy or a single
person economy. The decision maker must choose
between consumption now and consumption in the
future. The decision not to consume now is the same as
investment. Thus his decision is simultaneously one of
consumption and investment. In order to decide, he needs
two types of information-
 subjective trade-offs between consumption now and
consumption in the future i.e. the utility and
indifference curves
 the feasible trade-offs between present and future
consumption i.e. the investment and production
opportunity sets.
Copeland, Weston & Shastri 2
Introduction
 From the analysis of a one-person/one-good
economy, a subjective interest rate is determined
by the optimal consumption/investment decision
which represents the optimal rate of exchange
between consumption now and in the future. Again
it can be called the price of deferred consumption
or the rate of return on investment.
 Individual with different subjective interest rate

select different consumption/investment decision
choices.

Introduction
 Opportunities to exchange consumption across
time by borrowing or lending in a multiple
person or exchange economy results in a single
market interest rate that everyone can use as a
signal for making optimal
consumption/investment decisions.
 So when no one is worse off and almost everyone
is better off in an exchange economy compared
with a single person economy, it can be said an ex
change economy is superior to an economy without
exchange.
Introduction
 And capital markets help to allocate/exchange
resources from one to another. So the ultimate
question arise- "Do capital markets benefit
society?"
 The answer requires to compare a world without
capital markets to one with capital markets to
show that no one is worse off and that at least one
individual is better off in a world with capital
markets.

Consumption And Investment
Without Capital Markets
Assumptions-
 all outcomes from investment are known with certainty
 there are no transactions costs or taxes
 the marginal utility of consumption is always positive.
 the marginal utility of consumption is decreasing
 Wealth at present=Y0
 Wealth at end=Y1
 Consumption at present=C0
 Consumption at end=C1

Note that equal increases in consumption cause total utility to increase

(marginal utility is positive), but that the increments in utility become
smaller and smaller (marginal utility is decreasing).
Provides a description of trade-offs
between consumption at the
beginning, C0 and consumption at the
end, C1
The dashed lines represent various
combinations of Co and CI providing
the same total utility measured along
the vertical axis.
Since all points along the
dashed line (e.g., points A and B) have
equal total utility, the individual will be
indifferent with respect to them.
Therefore the dashed lines are called
indifference curves.
Note that all combinations of consumption today and consumption tomorrow
that lie on the same indifference curve have the same total utility.
Combined IC Understanding
x2
x1
x2
x1
x2
x1
x2
x1
x2
x1
x2
x1
x1
x1
x1
x1
x1
x1
x1
x1
x1
x1
Decision maker would be
indifferent to point A & B whereas
Point A has more consumption at
the end but less consumption at
the beginning than point B does.
Point D has more consumption in
both periods than do either
points A or B, with higher utility.
So curves to the northeast have
greater total utility.
MRS: The rate of trade-off between C0 and C1 indicated by the slope of the
straight line just tangent to the indifference curve. i.e. how many extra
unit received tomorrow in order to give up one unit today to have same
utility.
MRS can be said as individual’s subjective rate of time preference.
Mathematically, MRS or subjective rate of time preference can be expressed :
Subjective rate of time preference is greater at point A than at B (due to

steeper tangent line) i.e. individual choose to have less consumption today
will require higher subjective rate of time preference to maintain the same
level of utility.
Up to this, we determine the criteria based on which an individual decide

how much he/she will consume now and defer. Now he/she will go for
evaluating his/her investment opportunities. An individual will make all
investments in productive opportunities that have rates of return higher
than his or her subjective rate of time preference, ri.
Each individual has
productive investment
opportunities
ABX=production/investment
opportunity set.
Assume, diminishing marginal
returns to investment because
the more an individual invests,
the lower the rate of return on
the marginal investment so ABX
is concave.
Individual endowed with a
resource bundle (Y0, Y1)
 MRT= Slope of a line tangent to curve ABX is the marginal rate of return
from each additional dollar investment.
 The line tangent to point A has the highest slope .
 An investor will continue his/her investment up to the point where
investor's subjective marginal rate of substitution is equal to the marginal
rate of transformation offered by the production opportunity set i.e.
MRS=MRT
 Here, the amount of investment is Y 0 – C0.
 If C0 > Y0, he or she will disinvest.
 Individuals consumption in each time period is exactly equal to the
output from production i.e.
P0=C0 & P1=C1
Without capital markets, individuals with the same

endowment and the same investment opportunity set may
choose completely different investments because of different
indifference curves.
Individual 2, who has a lower rate of time preference will choose to invest
more than individual 1.
Understanding Capacity Test
 Suppose your production opportunity set in a

world of perfect certainty consists of the following
possibilities:
Project Outlay RR (%)
A 1000000 8
B 1000000 20
C 2000000 4
D 3000000 30
a. Graph the production/investment opportunity set.

b. If market rate is 10%, what is the optimum investment?
With Capital Markets
• What happens if instead of one person, many
individuals are said to exist in the economy?
• Intertemporal exchange of consumption bundles
will be represented by the opportunity to borrow
or lend unlimited amounts at r, a market
determined rate of interests.
• Capital market facilitate the transfer of funds
between lenders and borrowers. If the interest
rates are positive, any amount of funds are lent
today will return interest plus principal.
We can graph borrowing and lending
opportunities along the capital market
line (line W0ABW1).
With an initial endowment of (Y0, Y1)
that has utility equal to U1, we can reach
any point along the market fine by
borrowing or lending at the market
interest rate plus repaying the principal
amount, X0.
The present value, W0, of our initial
endowment (Y0, Y1) is the sum of cur-
rent income, Y0, and the present value of
our end-of-period income, Y1(1 + r)-1.

Here,
Capital Market Line = W0ABW1
Initial endowment = (Y0, Y1)
Lending Portion=W1A
Borrowing Portion=W0A
Utility= U1
Subjective Rate = Slope of U1 at point A.
Market Interest rate = Slope of CML at any point.
Notice, here we use the term CML rather than
Budget Line. Why???
So we can maximize utility by moving along the market line to the point
where our subjective time preference equals the market interest rate i.e.
SR = MR

• Point B represents the consumption bundle on the highest
attainable indifference curve i.e. we desire to lend because
the capital market offers a rate of return higher than what
we subjectively require as our subjective time preference,
represented by the slope of a line tangent to the
indifference curve at point A, is less than the market rate of
return.
• So our optimum consumption= C0*, C1* at Utility U2 which
is greater than Utility U1.
• Now, it can be said our initial endowment must be equal to
the sum of our two period consumptions. In other words,
our wealth must be equal to our consumptions.
• The present value of wealth, W0 is the sum of current income, Y0, and
the present value of our end-of-period income, Y1(1 + r)-1 i.e.
• Again, the present value of our endowment equals the present value of
our consumption and both are equal to our wealth,W0. i.e.

 Thus the capital market line has an intercept at W1 and a slope of
-(1+r).
 Note that moving along the capital market line does not change one's
wealth, but it does offer a pattern of consumption that has higher
utility.
 Up to these we Ignore production for the time being and graph
borrowing and lending opportunities along the capital market line.
 What happens if the production/consumption decision takes place in a
world where capital markets facilitate the exchange of funds at the
market rate of interest?
 Next graph combines production possibilities with market exchange
possibilities.
 Lets see what happens….
With the family of indifference curves
U1, U2, and U3 and endowment (Y1, Y2) at
point A, what actions will we take in
order to maximize our utility?
Starting at point A, we can move
either along the PPC or along the CML.
Both alternatives offer a higher rate
of return than our subjective time
preference, but production offers the
higher return, (steeper slope). So we
choose to invest and move along the
production opportunity frontier.

• Without the opportunity to borrow or lend along the capital
market line, we would stop investing at point D, where
MRT=MRS and our level of utility has increased from U1 to
U2.
• With the opportunity to borrow, we can actually do better. At
point D the borrowing rate, represented by the slope of the
CML, is less than the rate of return on the marginal
investment, which is the slope of the production opportunity
set at point D.
• Since further investment returns more than the cost of
borrowed funds, we will continue to invest until the marginal
return on investment is equal to the borrowing rate at point B.

• We can now reach any point on the market line. Since our
time preference at point B is greater than the market rate
of return, we will consume more than Po, which is the
current payoff from production.
• By borrowing we can reach point C on the capital market
line. Our optimal consumption is found where our
subjective time preference just equals the market rate of
return.
• Our utility has increased from U1 at point A (our initial
endowment) to U2 at point D (the Single person solution)
to U3 at point C (the exchange economy solution). We are
clearly better off when capital markets exist since U3 > U2.
 The decision process that takes place with production opportunities
and capital market exchange opportunities occurs in two separate and
distinct steps:
1. First, choose the optimal production decision by taking on projects until
marginal rate of return on investment equals objective market rate;
2. then choose the optimal consumption pattern by borrowing or lending
along the capital market line to equate your subjective time preference
with the market rate of return.
The separation of the investment (step 1) and consumption (step 2)
decisions is known as the Fisher separation theorem.
 Fisher separation theorem: Given perfect and complete capital
markets, the production decision is governed solely by an objective
market criterion (represented by maximizing attained wealth) without
regard to individuals' subjective preferences that enter into their
consumption decisions.
 What is the implication of this theory in
business???
 An important implication for corporate policy is that the
investment decision can be delegated to managers i.e.
given the same opportunity set, every investor will
make the same production decision (P0, P1) regardless
of the shape of his or her indifference curves.
 Investors will direct the manager of their firm to choose
production combination (P0, P1). They can then take the
output of the firm and adapt it to their own subjective
time preferences by borrowing or lending in the capital
market.
Both investor 1 & 2 will direct the
manager of their firm to choose
production combination (P0, P1).
Investor 1 will consume more than
current production (point A) by
borrowing today in the capital market
and repaying out of future production.
Investor 2 will lend because s/he
consumes less than current
production.
Either way, they are both better off
with a capital market. But how???
Without capital market
opportunities to borrow or lend,
investor I & 2 would be worse off at
point Y & X which have lower utility.

 Finally, in equilibrium, the marginal rate of substitution for all
investors is equal to the market race of interest, and this in turn is
equal to the marginal rate of transformation for productive investment.
i.e.
MRS= -(1+r) =MRT
 They allow the efficient transfer of funds between borrowers and
lenders. 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. In this way, funds can be efficiently
allocated from individuals with few productive opportunities and great
wealth to individuals with many opportunities and insufficient wealth.
As a result, all (borrowers and lenders) are better off than they would
have been without capital Copeland,
markets. Weston & Shastri 43
Does establishment of capital markets
increase the transaction cost???
 Assume that we have a primitive economy with N producers, each
making a specialized product and consuming a bundle of all N
consumption goods. Given no marketplace, bilateral exchange is
necessary. During a given time period, each visits the other in order to
exchange goods.
 For example, there are five individuals and five consumption goods in
this economy & the cost of each leg of a trip is T dollars.
I. If there is no market place, then how many trips individual1, individua2
individual3, individual4 & individual5 makes ? How many trips all
individuals make? What will be the total cost?
II. If market place exists, then then how many trips individual1, individua2
individual3, individual4 & individual5 makes ??? How many trips all
individuals make? What will be the total cost?
III. Is anyone better off or worse off for having market place? If yes, how
much?
Does establishment of capital markets
increase the transaction cost????
Without Capital Market With Capital Market
Total Trips= (N (N-1))/2 Total Trips= N
Total savings or better off= [{N (N-1)}/2 - N ] T

Understanding Capacity Testing
• There are 12 individuals and 12 consumption
goods in the economy & the cost of each leg of a
trip is BDT. 50.
I. If there is no market place, then how many trips each individual
makes? How many trips all individuals altogether make? What
will be the total cost?
II. If market place exists, then then how many trips each individual
makes? How many trips all individuals altogether make? What
will be the total cost?
III. Is anyone better off or worse off for having market place? If yes,
how much?

Does transaction cost create any
problem to Fisher Theory???
 The theory of finance is greatly simplified if we assume
that capital markets are perfect. Obviously they are not.
 If transactions costs are trivial, then borrowing and lending
interest rate will be same. Then there will be no problem to
Fisher theory of separation.
 But if transactions costs are nontrivial, the borrowing rate
will be greater than the lending rate. Different borrowing
and lending rates will have the effect of invalidating the
Fisher separation principle.
 Without a single market rate, investors will not be able to
delegate the investment decision to the manager of their
firm.
Individual 1 would direct the
manager to use the lending
rate and invest at point B.
Individual 2 would use the
borrowing rate and choose
point A.
A third individual might choose
investments between points A and
B, where his or her indifference
curve is directly tangent to the
production opportunity set.
The effects of taxes and information asymmetries are certainly nontrivial,

so these also create problems in theories. These all will be discussed in
later chapters.
Best of Luck!!!

Copeland

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Chapter One

 Individual with different subjective interest rate

Copeland, Weston & Shastri 3

Copeland, Weston & Shastri 5

Copeland, Weston & Shastri 6

Note that equal increases in consumption cause total utility to increase

Subjective rate of time preference is greater at point A than at B (due to

Up to this, we determine the criteria based on which an individual decide

Without capital markets, individuals with the same

 Suppose your production opportunity set in a

a. Graph the production/investment opportunity set.

Copeland, Weston & Shastri 32

Copeland, Weston & Shastri 33

Copeland, Weston & Shastri 35

Copeland, Weston & Shastri 37

Copeland, Weston & Shastri 38

Copeland, Weston & Shastri 42

Total Trips= (N (N-1))/2 Total Trips= N

Total savings or better off= [{N (N-1)}/2 - N ] T

Copeland, Weston & Shastri 46

The effects of taxes and information asymmetries are certainly nontrivial,

Copeland, Weston & Shastri 49

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