1. Inter-temporal Optimization of Consumption Allocating wealth across time

2. 2 Topics to be covered (1) Individual preferences across time (2) Production opportunities (Real Investment) (2) Inter-temporal consumption –With production opportunities only –With capital markets only –With both capital market and production opportunities (3) Fisher Separation Theorem (4) Role of Capital Markets (6) Unanimity Principle (7) Justifying the use of NPV

3. 3 Inter-temporal Consumption Choice 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 (C 0 ) and C next period (C 1 ) (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 (C 0 ) and C in the future (C 1 ) Interest rates are the price of deferred consumption – by forgoing one dollar of consumption today, the market rewards with interest payments R

4. 4 CONSUMER THEORY U C C MU U = U(C) MU > 0 (  U /  C) > 0 MU is diminishing (  2 U /  C 2 ) < 0 1 1 MU C is low MU C is high Single period utility functions - exhibit diminishing utility (concave) - As C , Utility , but each unit of C increases U by less and less When C is low, each unit of C has high utility value When C is high, each unit of C has lower utility value

5. 5 INDIFFERENCE CURVES C1C1 C0C0 Consumption In period 1 Consumption In period 0 C 0 low, MU(C 0 ) high C 1 high, MU(C 1 ) low C 0 high, MU(C 0 ) low C 1 low, MU(C 1 ) high 1 1 U (Indifference Curve) Convex Indifference Curves trace out combinations of C 0 and C 1 for which the individual equally well-off Negative slope because as C 0 falls, C 1 must increase to maintain the same level of utility

6. 6 INDIFFERENCE CURVES C1C1 C0C0 Consumption In period 1 Consumption In Period 0 U0U0 U1U1 U2U2 Represent higher levels of utility U 0 < U 1 < U 2

7. 7 What is the slope? C1C1 C0C0 U0U0 -The slope of the indifference curve measures the rate of trade-off between C 0 and C 1 at the point of tangency -This trade-off is called the marginal rate of substitution MRS between C 0 and C 1 - this also reveals the individual’s subjective rate of time preference  i (at each point on the indifference curve) - Precisely, slope = - 

8. 8 MRS is not constant! C1C1 C0C0 1 1 U0U0 If C 0 is to reduce by 1 unit: (a) when C 0 is high less additional C 1 is needed to make this individual equally well off (b) when C 0 is low more additional C 1 is needed to make this individual equally well off How to show this graphically? - Convex indifference curve - the slope at a (ρ a ) < the slope at a (ρ b ) ρaρa a b MRS = - C1C1 C0C0 C1C1 C0C0 U = U 0 (slope of an indifference curve) ρbρb

9. 9 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) y 0 = is the individual’s endowment in period 0 y 1 = is the individual’s endowment in period 1

10. 10 INVESTMENT OPPORTUNITIES Total investment (current endowment – current consumption) Marginal Rate of Return (Future consumption – future endowment) B A - production opportunities allow a unit of current savings to be converted into output or wealth in the future 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 MRT = height of AB = rate at which a dollar of consumption foregone today C 0 is transformed by productive investment into output tomorrow i.e. it is the MRT offered by the production opportunity set

11. 11 INVESTMENT OPPORTUNITIES Total investment (current endowment – current consumption) Marginal Rate of Return (Future consumption – future endowment) B A C1C1 C0C0 y0y0 y1y1 endowment point High rates of return Low rates of return Production Opportunity Set (POS) I0I0 I1I1 Low High I0I0 I1I1

12. 12 INVESTMENT OPPORTUNITIES C1C1 C0C0 y0y0 y1y1 endowment point High rates of return Low rates of return Production Opportunity Set (POS) I0I0 I1I1 Given technology, the POS traces out the maximum amount of C 1 that is feasible for any given amount of C 0 How does individual maximize utility? - make all investments in the production opportunity set that have rates of return higher than his subjective rate of time preference

13. 13 C1C1 C0C0 y0y0 y1y1 The endowment point U0U0 In the absence of production the individual would be forced to consume at the endowment point PUTTING TOGETHER THE POS AND PREFERENCES

14. 14 C1C1 C0C0 U0U0 PUTTING TOGETHER THE POS AND PREFERENCES y0y0 y1y1 1 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 Individuals will make all investments in the production opportunity set that have rates of return higher than his or her subjective rate of time preference 0

15. 15 C1C1 C0C0 y0y0 y1y1 The endowment point U0U0 U1U1 PUTTING TOGETHER THE POS AND PREFERENCES This is the point where MRT = MRS (slope of = (slope of POS) indifference curve) Message: Production opportunities allow individuals to achieve a higher level of utility – i.e. Move to U 1 > U 0 0 * I0I0

16. 16 Benefits of Production Opportunities 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 I 0 is the optimal level of investment

17. 17 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) y 0 = is the individual’s endowment in period 0 y 1 = is the individual’s endowment in period 1

18. 18 Capital Market – individuals can borrow and lend, and thus facilitates the transfer of funds between lenders and borrowers With initial endowment of (y 0 and y 1 ) that has utility U 0, 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) I 0 is the period 0 amount invested I 1 is the period 1 value of this investment = I 0 (1+R) -in the absence of capital markets, individuals would be constrained to consume at his endowment point (with U 0 ) -We will show how the ability to borrow and lend can improve an individual’s utility Constraints: With Capital market only

19. 19 The Budget Set (Capital Markets) y 0 = endowment in period 0 y 1 = endowment in period 1 y0y0 W1W1 C0C0 C1C1 y1y1 W0W0 This line (Capital market line) traces out all affordable combinations of C 0 and C 1, given the endowments y 0 and y 1 by borrowing and lending at market interest rate R The individual’s wealth: (a) Measured at Period 0 (x-intercept): W 0 = y 0 + y 1 / (1+R) (b) Measured at Period 1 (y-intercept): W 1 = y 1 + y 0 (1+R) (1+R) By giving up, or deferring one unit of consumption today, you get (1+R) units tomorrow

20. 20 Choosing the Optimal Consumption Path with Capital Markets C1C1 C0C0 U0U0 U1U1 0 B D E At point 0, the slope of the indifference curve is less than the slope of the budget line ==> it is better-off to defer C 0 today, because the return (increase in C 1 ) 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). The individual therefore moves to a higher level of utility by lending money to the capital market * 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 *

21. 21 C1C1 C0C0 U0U0 Consumption with Production and Capital Markets 0 In the absence of production and capital markets, this individual can only consume at Pt 0. Pt 1: Production alone Pt C & P: Both Production and Capital Markets U1U1 Capital Market line At the optimum, there is a “separation” between the Consumption and Production Decision (pt c & p) U c&p * * c p 1 * *

22. 22 The Inter-temporal Consumption Choice 0 * 0 * 0 * U0U0 U’ U0U0 U0U0 U’’ U’’’ Production alone Preferences determine Production and Consumption Point (same point) Capital Market Alone There is no production, and preference determine consumption Both Capital Market & Production Capital market line objectively determines production with the market interest rate, And individual preference subjectively determines consumption with his rate of time preference * Consumption Production

23. 23 The Consumption Decision 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

24. 24 The Decision Making Process -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.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

25. 25 FISHER SEPARATION THEOREM 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

26. 26 C0C0 C1C1 * 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 of their utility functions, they make exactly the same production decision In math: MRS 1 = MRS 2 = -(1+R) = MRT Individual 1 (stronger preference for current consumption) Individual 2 (stronger preference for future consumption) Consider two individuals

27. 27 The Separation of C and I decisions 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)) 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 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]

28. 28 How to max shareholder’s wealth? 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: 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.

29. 29 Again and again, 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

30. 30 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

31. 31 TOPICS for self-interest 1.Different techniques for selecting investment projects a)Payback method b)Accounting rate of return c)Net present value d)Internal rate of return 2.Measuring shareholder wealth (you need to know how to compute NPV) 3.Economic profits vs Accounting profits

32. 32 Inter-temporal Choice an endowment, y, can be allocated Inter-temporally in three ways 1. Production 2.Capital markets3. Storage in order to move resources from period 0 to period 1 using –1. Production, we can move north-west in the graph at the rate of (slope of the POS) –2. Capital markets, we can move north-west or south-east along the capital market line at the rate of (1+ R) where R = market interest rate –3. Storage, we can move north-west at the rate of 1. This requires additional assumptions of non-perishable goods and no storage costs which is not required for 1 and 2 above. Under what conditions is the individual made better off from an Inter- temporal reallocation? To answer that question we need to consider the slope of the indifference curve relative to the rate of transformation in each of 1 to 3 above. General rule: If rate of time preference < rate of transformation, then the individual is better off transforming using either of the 3 ways.

33. 33 An exercise for self-study Consider the following utility function: U= U(C 0 ) + U(C 1 ) We now take a total derivative: U'(C 0 )dC 0 + [1/(1+  )]U'(C 1 )]dC 1 = 0 Rearranging, dC 1 /dC 0 = -(1-  ) [U'(C 0 )/ U'(C 1 )] slope of indifference curve -the slope of the indifference curve depends upon the relative marginal utilities as well as the subjective rate of time preference  ____1 (1+  )

34. 34 An Exercise 45 0 U0U0 C 0 = C 1 C0C0 C1C1 1 1 As C 0  MU  As C 1  MU  Slope of the indifference curve along the 45 0 is -(1+  ) as [U'(C 0 )/ U'(C 1 )] = 1 To the right of the 45 0 line, the slope is less than 1 as [U'(C 0 )/ U'(C 1 )] < 1 To the left of the 45 0 line, the slope is greater than 1 as [U'(C 0 )/ U'(C 1 )] > 1 dC 1 /dC 0 = -(1-  ) [U'(C 0 )/ U'(C 1 )] slope of indifference curve Therefore, even if  > 0, the tradeoff between C 0 and C 1 can be < 1 if C 0 is sufficiently high

35. 35 Another Numerical Example Assume individuals can borrow and lend, but no production Suppose that the utility function for consumption is U = log(C) + [1/(1+  )] log(C) The individual’s wealth is given by the equation W = y 0 + [1/(1+R)]y 1 where R is the rate of interest and  is the subjective rate of time preference If an individual is to maximize utility, then we know that the present value of consumption must equal wealth: W = y 0 + [1/(1+R)]y 1 Derive the optimal consumption paths, assuming a)W=100, R=10%,  =10% b)W=100, R=5%,  =10% c)W=100, R=10%,  =5% We are ignoring production opportunities in this example

36. 36 The Optimization Problem Set up the constrained optimization problem L = log(C 0 ) + [1/(1+  )] log(C 1 ) + [ W – C 0 – C 1 /(1+R)] The first order conditions  L/  C 0 = (1/C 0 ) - = 0  = 1 / C 0  L/  C 1 = (1/(1+  )) (1/C 1 ) - /(1+R) = 0  = [(1+R)/(1+  )] (1/ C 1 )] [1 / C 0 ] = [(1+R)/(1+  )] (1/ C 1 )] C 0 * = [(1+  )/(1+ R)] C 1 * –If  = R  C 0 * = C 1 * –If  > R  C 0 * > C 1 * –If  < R  C 0 * < C 1 * C0C0 C1C1 U C0*C0* C1*C1*

37. 37 Optimal Consumption Paths Solve for the following three cases a) W=100, R=10%,  =10% C 0 = (1.10/1.10)C 1  W = C 0 + C 1 /(1+R) = 100  C 0 * = C 1 * = C* = 52.38 b)W=100, R=5%,  =10% c)=100, R=10%,  =5%

38. 38 Storage For an individual to benefit from storage (assuming non-perishable goods and no storage costs, [slope of the indifference curve] < 1 (in absolute value) dC 1 /dC 0 = -(1-  ) [U'(C 0 )/ U'(C 1 )] and assuming log utility: dC 1 /dC 0 = [-(1-  )](1/C 0 ) / (1/C 1 ) = [-(1-  )]C 1 /C 0 In other words, simple storage makes an individual better off if (1+  ) C 1 /C 0 < 1 or (1+  ) < C 0 /C 1 Again, this assumes log utility i.e. storage may be beneficial if C 0 is high relative to C 1