Capital Market, Consumption and Investment (L1) Consumption and investment without capital market Consumption and investment with capital market Fisher separation theorem Breaking down the separation : transaction costs Breaking down the separation: agency problem Application of Fisher Separation theorem: capital budgeting and shareholder value maximization Materials from Chapters 1&2, CWS L1: Capital Market, Consumption and Investments

L1: Capital Market, Consumption and Investments Consumption Plane How individuals make choices among consumption bundles C1 U C0 Indifference curve: time preference of consumption in a consumption The slope of the tangent line MRS L1: Capital Market, Consumption and Investments

Investment Schedule and Production Opportunity Set Marginal rate of return A X B B ri y0 A Total Investments C0 y1 I0 X Investment schedule and production opportunity set are equivalent The slope for the tangent line of production opportunity set in B is –(1+ri) = marginal rate of transformation (MRT) L1: Capital Market, Consumption and Investments

Equilibrium in a Robinson Crusoe World MRS=MRT = -(1+ri) C1 Individual 2 Individual 1 C0 Individual 1 consumes more than individual 2 in period 0 No capital market, thus there is no exchange. L1: Capital Market, Consumption and Investments

Optimal Consumption in the Presence of Capital Market L1: Capital Market, Consumption and Investments

L1: Capital Market, Consumption and Investments Capital Market Line C1 W1 B U2 A U1 C0 W0 With capital market, an agent can move from A to B, reaching a higher utility. On the capital market line, one’s wealth does not change. But consumption differs. The slope of the capital market line is –(1+r). L1: Capital Market, Consumption and Investments

Slope of Capital Market Line L1: Capital Market, Consumption and Investments

What Constitutes Consumptions? GDP= C + I + G + NX C = consumption I = investment G = government purchases of goods and services NX = net exports of goods and services http://research.stlouisfed.org/fred2/categories/18 L1: Capital Market, Consumption and Investments

L1: Capital Market, Consumption and Investments Spending by domestic households on final goods and services, accounting for about 2/2 of GDP in the United States, including: Consumer durables Nondurable goods services L1: Capital Market, Consumption and Investments

L1: Capital Market, Consumption and Investments Includes both spending for new capital goods, called fixed investment, and increases in firms’ inventory holdings, called inventory investment. Fixed investment includes: business fixed investment residential investment L1: Capital Market, Consumption and Investments

Joint effect of capital market and production/investment See figure 1.8 Two steps of the decision process related to production opportunity and capital market exchange opportunity: Choose the optimal production decision by taking on projects until the marginal rate of return on investment equals the objective market rate -- investment Choose the optimal consumption pattern by borrowing or lending along the capital market line equate your subjective time preference with the market rate of return -- consumption L1: Capital Market, Consumption and Investments

Fisher Separation Theorem Given perfect and complete markets, the production decision is governed solely by an objective market criterion without regard to individuals’ subjective preferences that enter into their consumption decisions. See figure 1.9 In equilibrium, the marginal rate of substitution for all investors is equal to the market rate of interest, and this in turn is equal to the marginal rate of transformation for productive investment. MRSi=MRSj=-(1+r)=MRT That is, the marginal return on investment (MRT, marginal rate of transformation) equals market-determined opportunity cost of capital (r) Irving Fisher's theory of capital and investment was introduced in his Nature of Capital and Income (1906) and Rate of Interest (1907), although it has its clearest and most famous exposition in his Theory of Interest (1930). L1: Capital Market, Consumption and Investments

Fisher Separation Theorem C1 W1 Individual 1 P1 Individual 2 C0 P0 W0 Individuals choose their respectful consumptions, where their consumptions can be delivered by productive investments (P0, P1). This is what we mean by separation: a separation of investment and consumption. L1: Capital Market, Consumption and Investments

L1: Capital Market, Consumption and Investments Implications All the consumption decisions are made along the capital market line. The slope of the capital market line is –(1+r), where r is the interest rate, not stock return. This is the case of consumption choices under certainty. What is missing here? L1: Capital Market, Consumption and Investments

L1: Capital Market, Consumption and Investments Perfect Market Necessary conditions Markets are frictionless Perfect competition in securities markets Markets are informationally efficient; that is, information is costless, and it is received simultaneously by all individuals All individuals are rational expected utility maximizers L1: Capital Market, Consumption and Investments

L1: Capital Market, Consumption and Investments Complete Market When the number of unique linearly independent securities is equal to the total number of alternative future states of nature. The market is said to be complete. Page 77, CWS Details will be provided in the lectures related Arrow-Debreu assets. L1: Capital Market, Consumption and Investments

Role of Capital Market – Reducing Transaction Costs Trading is costly – thus the market is not perfect Having marketplaces helps to reduce transaction costs – page 12, CWS. Thus financial market has its role only when Trading costs are non-trival Demsetz (1968); Kyle (1985); Glosten and Milgrom (1985); Grossman and Miller (1988) Information asymmetry Akerlof (1970); Spence (1973); Myers and Majluf (1984) L1: Capital Market, Consumption and Investments

Breakdown of the Separation: Transaction Costs See figure 1.12 Lending rate is lower than borrowing rate Then the optimal consumption decision depends on individuals’ subjective utility functions L1: Capital Market, Consumption and Investments

Breakdown of the Separation: Agency Problem Given Fisher separation theorem, the investment decision and consumption decision can be separated. In other words, shareholders can delegate managers to perform the investment function This separation leads to separation of ownership and control. Monitoring costs and compensation issue arise, which lead to the large literature on corporate governance and corporate finance. Berle and Means (1932) and Jensen and Meckling (1976) L1: Capital Market, Consumption and Investments

L1: Capital Market, Consumption and Investments Value to Shareholders Present value of shareholders’ wealth can be expressed as: Note: the above expression involves both capital gains and dividends (see page 20) – all go to shareholders Economic definition versus accounting definition of profit L1: Capital Market, Consumption and Investments

Capital Budgeting Techniques Maximizing shareholders’ wealth is equivalent to maximizing the discounted cash provided by investment projects. Decision rules: payback period, … What’s the point? Utility function collapses to the value function Given the Fisher separation theorem, maximizing shareholders’ wealth will lead to a social optimal at the presence of the capital. In reality, firms have the option to undo their decisions Thus the decision rule could be altered. L1: Capital Market, Consumption and Investments

L1: Capital Market, Consumption and Investments Exercises CWS, 1.5&1.6 What is meant by “separation” in the Fisher’s separation theorem? L1: Capital Market, Consumption and Investments