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U2 U1 U0
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The Constraint
Recall that an individual maximizes his happiness subject to constraints. What are the constraints? It depends on the options available for the individual to allocate his wealth across different time periods. We study two options: [1] Production opportunity and [2] participation of capital market. We assume the individual has endowment of Y0 and Y1 in the current and future periods respectively. So, we can plot the endowment point on the diagram. Constraint A: With no wealth allocation across periods, his utility is U0. C1
Y1 U0
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Y0
C0
Production Opportunity
Constraint B: The individual can only invest in production opportunities to allocate wealth across periods Now, we introduce production opportunities that allow a unit of current savings/investment to be turned into more than one unit of future consumption. Assume the individual faces a schedule of productive investment opportunities. We line them up from the highest return to the lowest and plot them as follows: Such decreasing marginal rate of return means diminishing marginal returns to investment because the more an individual invests, the lower the rate of return on the MARGINAL investment.
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Total investment
Production Opportunity
Total investment in the current period is equal to current period endowment minus current consumption (i.e., Investment = Y0-C0) With this in mind, we can plot the constraint on the C0-C1 space. We call this constraint the production opportunity set (POS). The slope of the POS is now called the Marginal Rate of Transformation (MRT) offered by the production/investment opportunity set. Investment (or dis-investment) means the individual can move its consumption point along POS. C1
Y1
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Y0
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Production Opportunity
At the endowment point, the individual is not maximizing its utility subject to the constraint B. He can do better by investing more (i.e., move north-west along the POS) because at the endowment point, the return offered by investing is higher than his subject rate of time preference needed to make him feel indifferent. (For example, to sacrifice 1 unit of current consumption, he needs 1 + 0.2 units of future consumption to stay as happy. But if the return he can get is 30%, that means investing can make him happier) The equilibrium is when he invests until the return offered by the marginal investment is just equal to its subjective rate of time preference. In math, we have: (slope of POS) MRT = MRS (slope of indifference curve) C1
C*1 Y1 U0
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U1 C*0 Y0 C0
Production Opportunity
Messages:
This individual can achieve a higher utility (U1>U0) by investing in production opportunities. His feasible consumption set expands with the introduction of production opportunities. With constraint A, he can only consume at the endowment point. With the introduction of production opportunity (a less restrictive constraint B), his feasible consumption set becomes all the points along the POS.
This gives the rationale for inter-temporal consumption choice which also explains investment. If exposed to various investment opportunities, individuals want to take some of them in order to allocate wealth. Doing so would allow them to achieve higher utility level. C1
C*1 Y1 U0
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U1 C*0 Y0 C0
Capital market
Now, instead of one individual, lets assume there are many individuals in the economy. Some are lenders, while others are borrowers. Among them, there are opportunities to borrow and lend at the market-determined interest rate (r). Constraint C: No production opportunity. But individuals can lend/borrow at r. We can then graph the borrowing and lending opportunities along the capital market line. Now, we introduce the concept of wealth. Wealth of an individual is the present value of his current and future endowment. Thus, W0 = Y0 + Y1/(1+r) C1
Y0
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Capital market
The feasible consumption set is now all the points along the capital market line. Moving North-west along the capital market line, the individual can achieve a higher utility (U2>U0) This individual is now lending (Y0-C*0) amount of money, and will get back ((1+r)(Y0-C*0)) in the next period so that he can consume a total of C*1= Y1+(1+r)(Y0-C*0). Equilibrium condition is: MRS = (1+r) C1
Y0(1+r) + Y1
C*1 Y1
U2 U0
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C*0 Y0
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U3 U1 P*0 Y0 W*0 C0
We call this the FISHER SEPARATION THEOREM. The important point is the production point is governed solely by objective criteria, namely, the set of opportunities available and the market interest rate. This is independent of individuals subjective rate of time preferences. C1
U3 U1 P*0 Y0 W*0 C0
Y1 P*0 Y0
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Implication 3: Consider the following two investors investing all their money on the stocks of a single firm. Their well-being is thus tied to the well-being of the firm. Consider the firm is making decision of what to produce. Fisher Separation Theorem implies even the two investors differ in their subjective perception of how to consume between now and future, they both has one unified objective, i.e, to maximize their current wealth. Doing so means the firm can maximize its value. This is the same as investing until the return on the marginal investment is just equal to the cost of capital, i.e, the market interest rate. C1
Y1 P*0 Y0
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Implication 3: MRT = (1 + r) is the point where both of the two individuals would agree for the firm to produce. This is exactly the famous project selection rule, the positive Net Present Value rule. The firm value is maximized by taking all projects that have positive NPV. NPV = -initial investment + present value of future payout discounted by cost of capital. Cost of capital = r
C1
Y1 P*0 Y0
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C0
Is exactly the same as the positive net present value rule: Net Present Value Rule Calculate the NPV for all available (independent) projects. Those with positive NPV are taken.
At the optimum: 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.
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The separation principle implies that the maximization of the shareholders 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 individuals production optimum is independent of his resources and tastes If asked to vote on their preferred production decisions at a shareholders 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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a) b) c) d) 2.
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Payback method Accounting rate of return Net present value Internal rate of return
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Agency problem
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An Exercise
C1 C0 = C1 As C0 MU As C1 MU
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U0 C0
[U'(C0)/ U'(C1)] = 1 To the right of the 450 line, the slope is less than 1 as [U'(C0)/ U'(C1)] < 1 To the left of the 450 line, the slope is greater than 1 as [U'(C0)/ U'(C1)] > 1
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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 individuals wealth is given by the equation W = y0 + [1/(1+R)]y1 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 = y0 + [1/(1+R)]y1 Derive the optimal consumption paths, assuming
a) W=100, R=10%, =10% b) W=100, R=5%, =10% c) W=100, R=10%, =5%
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C1
If = R C0* = C1* If > R C0* > C1* If < R C0* < C1* C1*
U
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