The Economic Theory of Choice

Lecture 1.5: The Economic Theory of Choice

Investment Analysis
Fall 2012
Anisha Ghosh
Tepper School of Business
Carnegie Mellon University
November 1, 2012
The Economic Theory of Choice
Two Key Ingredients
Any decision problem involves:
Identication of the set of feasible alternatives.
A selection criterion for choosing among the available
alternatives.
And, nally, the solution of the problem.
The individual solutions can often be aggregated to
describe equilibrium conditions that prevail in the
marketplace.
We rst consider a decision problem under certainty.
Later in the course, we will study the more realistic case of
the optimal selection of risky assets.
The Economic Theory of Choice
Two Key Ingredients
Any decision problem involves:
Identication of the set of feasible alternatives.
A selection criterion for choosing among the available
alternatives.
And, nally, the solution of the problem.
The individual solutions can often be aggregated to
describe equilibrium conditions that prevail in the
marketplace.
We rst consider a decision problem under certainty.
Later in the course, we will study the more realistic case of
the optimal selection of risky assets.
The Economic Theory of Choice
Two Key Ingredients
Any decision problem involves:
Identication of the set of feasible alternatives.
A selection criterion for choosing among the available
alternatives.
And, nally, the solution of the problem.
The individual solutions can often be aggregated to
describe equilibrium conditions that prevail in the
marketplace.
We rst consider a decision problem under certainty.
Later in the course, we will study the more realistic case of
the optimal selection of risky assets.
The Economic Theory of Choice
Two Key Ingredients
Any decision problem involves:
Identication of the set of feasible alternatives.
A selection criterion for choosing among the available
alternatives.
And, nally, the solution of the problem.
The individual solutions can often be aggregated to
describe equilibrium conditions that prevail in the
marketplace.
We rst consider a decision problem under certainty.
Later in the course, we will study the more realistic case of
the optimal selection of risky assets.
The Economic Theory of Choice
Two Key Ingredients
Any decision problem involves:
Identication of the set of feasible alternatives.
A selection criterion for choosing among the available
alternatives.
And, nally, the solution of the problem.
The individual solutions can often be aggregated to
describe equilibrium conditions that prevail in the
marketplace.
We rst consider a decision problem under certainty.
Later in the course, we will study the more realistic case of
the optimal selection of risky assets.
The Economic Theory of Choice
Two Key Ingredients
Any decision problem involves:
Identication of the set of feasible alternatives.
A selection criterion for choosing among the available
alternatives.
And, nally, the solution of the problem.
The individual solutions can often be aggregated to
describe equilibrium conditions that prevail in the
marketplace.
We rst consider a decision problem under certainty.
Later in the course, we will study the more realistic case of
the optimal selection of risky assets.
The Economic Theory of Choice
Two Key Ingredients
Any decision problem involves:
Identication of the set of feasible alternatives.
A selection criterion for choosing among the available
alternatives.
And, nally, the solution of the problem.
The individual solutions can often be aggregated to
describe equilibrium conditions that prevail in the
marketplace.
We rst consider a decision problem under certainty.
Later in the course, we will study the more realistic case of
the optimal selection of risky assets.
The Economic Theory of Choice
Example
An investor will receive an income of $10, 000 at the end of
years 1 and 2 with certainty.
The only investment available is a savings account with
interest rate r=5%. The investor can also borrow money at
a 5% rate.
Question
How much should the investor save and how much should he
consume each year?
The Economic Theory of Choice
Example
An investor will receive an income of $10, 000 at the end of
years 1 and 2 with certainty.
The only investment available is a savings account with
interest rate r=5%. The investor can also borrow money at
a 5% rate.
Question
How much should the investor save and how much should he
consume each year?
The Economic Theory of Choice
Example
An investor will receive an income of $10, 000 at the end of
years 1 and 2 with certainty.
The only investment available is a savings account with
interest rate r=5%. The investor can also borrow money at
a 5% rate.
Question
How much should the investor save and how much should he
consume each year?
The Economic Theory of Choice
The Opportunity Set
The options open to the investor
The set of feasible consumption patterns in periods 1 and 2 lie along
the straight line known as the opportunity set.
The Economic Theory of Choice
The Opportunity Set
The options open to the investor
Point B the investor saves nothing and consumes $10, 000 in each
period.
Point A the investor saves all his income and consumes nothing in
period 1 in the second period, he consumes:
C
2
= 10, 000

Period 2

s income
+ 10, 000

Period 1

s income
+ 500

interest on period 1

s income
= $20, 500
Point C the investor consumes everything in period 1 and nothing in
the second periodhis consumption in period 1 is:
C
1
= 10, 000

Period 1

s income
+
10, 000
1.05

Maximum amount that can be borrowed against Period 2

s income
= $19, 524
The Economic Theory of Choice
The Opportunity Set
The options open to the investor
Point B the investor saves nothing and consumes $10, 000 in each
period.
Point A the investor saves all his income and consumes nothing in
period 1 in the second period, he consumes:
C
2
= 10, 000

Period 2

s income
+ 10, 000

Period 1

s income
+ 500

interest on period 1

s income
= $20, 500
Point C the investor consumes everything in period 1 and nothing in
the second periodhis consumption in period 1 is:
C
1
= 10, 000

Period 1

s income
+
10, 000
1.05

Maximum amount that can be borrowed against Period 2

s income
= $19, 524
The Economic Theory of Choice
The Opportunity Set
The options open to the investor
Point B the investor saves nothing and consumes $10, 000 in each
period.
Point A the investor saves all his income and consumes nothing in
period 1 in the second period, he consumes:
C
2
= 10, 000

Period 2

s income
+ 10, 000

Period 1

s income
+ 500

interest on period 1

s income
= $20, 500
Point C the investor consumes everything in period 1 and nothing in
the second periodhis consumption in period 1 is:
C
1
= 10, 000

Period 1

s income
+
10, 000
1.05

Maximum amount that can be borrowed against Period 2

s income
= $19, 524
The Economic Theory of Choice
The Opportunity Set
The options open to the investor
The set of feasible consumption patterns in periods 1 and 2 lie along
the straight line known as the opportunity set.
The Economic Theory of Choice
The Opportunity Set contd.
The options open to the investor
The set of feasible consumption patterns in periods 1 and 2 lie along
the straight line ABC.
This is because the amount consumed in period 2 is the income,
$10, 000, earned in period 2 plus the period 2 value of the savings in
period 1:
C
2
= 10, 000 + (10, 000 C
1
) (1.05)
= 20, 500 1.05C
1
This is the equation of the straight line in Figure 1.1
The Economic Theory of Choice
The Opportunity Set contd.
The options open to the investor
The set of feasible consumption patterns in periods 1 and 2 lie along
the straight line ABC.
This is because the amount consumed in period 2 is the income,
$10, 000, earned in period 2 plus the period 2 value of the savings in
period 1:
C
2
= 10, 000 + (10, 000 C
1
) (1.05)
= 20, 500 1.05C
1
This is the equation of the straight line in Figure 1.1
The Economic Theory of Choice
The Opportunity Set contd.
The options open to the investor
The set of feasible consumption patterns in periods 1 and 2 lie along
the straight line ABC.
This is because the amount consumed in period 2 is the income,
$10, 000, earned in period 2 plus the period 2 value of the savings in
period 1:
C
2
= 10, 000 + (10, 000 C
1
) (1.05)
= 20, 500 1.05C
1
This is the equation of the straight line in Figure 1.1
The Economic Theory of Choice
Denitions
PRESENT VALUE (PV)
The amount you realize at the initial date borrowing against
all future receipts. The PV of a cash ow of $C
t
received at
the end of year t is
C
t
(1 + r )
t
FUTURE VALUE (FV)
The amount you realize at the terminal date lending all
intermediate cash ows. The FV of $100 at the end of year
t is
100(1 + r )
t
The Economic Theory of Choice
Indifference Curves
Indifference curves represent the investors preference for consumption
in the two periods.
The Economic Theory of Choice
Indifference Curves contd.
The investor is equally happy with or "indifferent" between all possible
patterns of consumption along the same indifference curve.
The investor is assumed to prefer more to less he prefers to be on
indifference curves higher up and to the right.
The indifference curves are convex each additional dollar of
consumption forgone in period 1 requires greater consumption in period
2 in order for the investor to remain indifferent.
The Economic Theory of Choice
Indifference Curves contd.
The investor is equally happy with or "indifferent" between all possible
patterns of consumption along the same indifference curve.
The investor is assumed to prefer more to less he prefers to be on
indifference curves higher up and to the right.
The indifference curves are convex each additional dollar of
consumption forgone in period 1 requires greater consumption in period
2 in order for the investor to remain indifferent.
The Economic Theory of Choice
Indifference Curves contd.
The investor is equally happy with or "indifferent" between all possible
patterns of consumption along the same indifference curve.
The investor is assumed to prefer more to less he prefers to be on
indifference curves higher up and to the right.
The indifference curves are convex each additional dollar of
consumption forgone in period 1 requires greater consumption in period
2 in order for the investor to remain indifferent.
The Economic Theory of Choice
The Solution
The optimum consumption pattern for the investor is determined by the point
at which an indifference curve is tangent to the opportunity set.