CHAPTER 1

CAPITAL MARKETS, CONSUMPTION & INVESTMENT

Financial Theory 1

 Study consumption and investment decisions made by individuals and firms and to understand the role of interest rates in making these decisions.

Do Capital Markets benefit Society?

We need to compare a world without capital market to one with them and show that no one is worse off and that at least one individual is better off in a world with capital markets.

Consumption and Productive Investment Opportunities (without capital markets)

One person One good economy / No uncertainty

Robinson Crusoe He must choose between consumption now and consumption in the future. The decision not to consume now is the same as investment. Thus this is simultaneously one of consumption and investment.

Information to make decision

In order to decide he needs two types of information: 1. He needs to understand his own subjective trade off between consumption now and consumption in the future (utility and indifference curve). 2. he must know the feasible trade off between present and future consumption that are technologically possible. (investment and production opportunity sets).

Assumptions
1. All outcomes from investment are known with certainty; 2. There are no transaction costs or taxes; 3. Decisions are made in a one period context.

Assumptions
Individuals are endowed with income at the beginning of the period Yo and at the end of period Y1. They must decide how much to actually consume now, Co , and how much to invest in productive opportunities in order to provide end of period consumption C1.

Assumptions
Every individual is assumed to prefer more consumption to less. In other words, the marginal utility of consumption is always positive. We also assume that MU of consumption is decreasing.

Utility of consumption
Every individual is assumed to prefer more consumption to less, i.e. as the amount of good increases, their utility of consumption increases. However this utility increases at a decreasing rate, e.g. consider you are very hungry and you are given 1 bread, if the number of bread is increased to 3 your utility increases. Now consider (very hungry) you are given 20 breads, if the number of breads is increased to 23 your utility increases, but to a lesser extent than in the first situation.

Utility of consumption: - Increase in consumption = increase in utility; i.e. marginal utility is positive. - Utility increases at a decreasing rate; i.e. marginal utility is decreasing.

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 Marginal utility increases, but increases at a decreasing rate.

Assume marginal utility is positive; Marginal utility is decreasing

 We consider an economy with one individual who must decide between consumption today / consumption tomorrow: (C0, C1) Given a certain amount of wealth/endowment: (Y0, Y1)

Y0: present wealth/wealth obtained today; Y1: future wealth/wealth obtained tomorrow

Individual given wealth: Y = (Y0, Y1) Y0: present wealth; Y1: future wealth Use wealth for: Present Consumption: C0 Future consumption tomorrow: C1 Possibilities: (i) (ii) C0 = Y0 and C1 = Y1 C0 < Y0 and C1 > Y1
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 Today individuals can decide to consume all the wealth that they obtain: C0 = Y0 OR they can consume part of their actual wealth: C0 < Y0 and consume the remaining wealth tomorrow: C1 > Y1

Indifference curves
The amount consumed today and tomorrow, will mainly depend upon the preference of the individual.

Indifference curves will give the different combinations of consumption today and tomorrow. On an indifference curve an individual obtains same level of utility (e.g. utility = U0) from different combinations of C0 and C1.
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 The preferences of individuals are represented through indifference curves; they give the trade-offs between consumption today and consumption tomorrow. Various combinations of C0/C1 on the same indifference curve provide the same level of utility.

 On an indifference curve, there are all combinations of consumption today and consumption tomorrow that have the same level of utility for an investor. (E.g. points A and B on utility curve U2; at point A less C0 hence more C1 demanded) As we move north-east along the indifference curves, the utility of the investor increases.(because either C0 or C1 will increase or both will increase)

Indifference curves are parallel and cannot cross. Proof: Individual prefers more consumption to less: Y > X Same indifference curve: X ~ Z and Y~Z Therefore individual: Y ~ X (not possible)
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Slope of indifference curves MARGINAL RATE OF SUBSTITUTION

Marginal rate of substitution (MRS): If a straight line is drawn tangent to any point (e.g. point A) on an indifference curve, the slope of the line measures the rate of trade-off between consumption today and consumption tomorrow at the point A.

Marginal rate of substitution (MRS) at a particular point is obtained by calculating the slope of indifference curve at that point.
MRS measures the number of extra units of consumption tomorrow (C1) needed to maintain same level of utility (e.g. U0) when present consumption (C0) is reduced by one unit.
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 E.g. MRS at point A: if C0 is reduced by one unit, by how many units should C1 be increased to maintain the same level of utility. The subjective rate of time preference is greater at point A than at point B due to the convexity of the indifference curve. The individual has less consumption today at point A and will therefore demand relatively more future consumption in order to have the same utility.

 Different individuals will have different preferences for consumption today and tomorrow; for one unit of consumption given up today, an individual may want a higher (lower) amount of consumption tomorrow to maintain the same level of utility. (steep/flat indifference curve)

 The slope of the indifference curve will give individuals preference for consumption today/tomorrow.

 An individual who possesses a certain amount of wealth does not limit himself to only: consumption today/tomorrow. The individual will also consider doing investments and borrow/lend.

Consumption and productive investments (Real assets) No Capital Market

 So far, we have described preferences functions that tell us how individuals will make choices among consumption bundles over time. Now introduce productive opportunities that allow a unit of current savings/investment to be turned out into more than one unit of future consumption.

 It is assumed that today an individual can use part of his present wealth (Y0) for investment in real assets or other investment projects. This should provide the individual with a return (ri).

TODAY Present wealth: Y0 Productive investment: I Present consumption: C0 = Y0 I FUTURE Future wealth: Y1 Future consumption: C1 = Y1 + Iri Where ri is return on investment I
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Productive Investment Opportunities Set

The productive investment set gives all the productive investments that can be undertaken by an individual. Starting from point Y (wealth possessed by individual), an individual can move to the left or to the right along the investment set. When he moves on the left, this would imply a decrease in present consumption and an increase in investment. When he moves on the right, this would imply an increase in present

Assume productive investments undertaken to produce consumption good.

If today individual decides to consume less than Y0, then the amount (Y0 - C0) will be invested (e.g. buy raw materials/new machine). A higher investment implies more goods would be produced and more can be consumed by individual tomorrow. (future wealth increases)

 If today individual decides to consume more than Y0, then the amount (C0 - Y0) will be disinvested (e.g. selling a machine/real asset and using the proceeds to increase consumption). Therefore the amount of good produced tomorrow would decrease and the level of consumption tomorrow would decrease. (Future wealth decreases).

At B: production = (P0; P1) Today: by decreasing C0 and investing, production can be increased. Tomorrow: return from investment enables individual to consume more.

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Slope/tangent to productive investment opportunities

Marginal rate of transformation (MRT) at a particular point is obtained by calculating the slope of the productive investment set at that point.
MRT measures the increase in the level of consumption tomorrow (C1) obtained from reducing present consumption (C0) by one unit and using the one unit for productive investment.

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Optimal consumption and production

Today investor must choose between consumption and productive investment. Must consider the two curves: indifference curve and investment opportunities curve

Optimal Consumption/production: MRT = MRS

Individual can increase utility when: - MRT < MRS - MRT > MRS by consuming more by investing more
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MRT > MRS Individual can increase utility by investing more and consuming less today. Move to the left along the investment possibilities set.

MRT = MRS

P0* = C0* and P1* = C1*

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Depending upon the shape of the indifference curve (very steep or less steep); i.e. the preference of the individual, the optimal point would be different.

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Shapes of Indifference Curves

Indifference curve is relatively flat/not very steep: individual prefers more consumption tomorrow than today (will renounce to only a small amount of future consumption to increase present consumption by one unit); he will normally increase investment and consume less today.

Shapes of Indifference Curves

Indifference curve very steep: individual prefers more consumption today than tomorrow (can renounce to a large amount of future consumption for an increase in one unit of present consumption); he will normally reduce investment and consume more today.

 Without investment opportunities individual moves only along indifference curve where his utility is fixed. With the introduction of the investment opportunities set, the individual has the possibility of increasing his utility; by moving along the investment opportunities curve. (Depending upon the preference of the individual, individual will either move on the right or the left of point Y along the investment set).

Consumption and Investment : Without Capital Markets

Without the existence of capital markets, individuals with the same endowment and the same investment opportunity set may choose completely different investment because they have different indifference curves.

CONSUMPTION AND INVESTMENT With CAPITAL MARKETS

 Financial markets facilitate the transfer of funds between lenders and borrowers. Assuming interest rates are positive, any amount of funds lent today will return interest plus principal at the end of the period.

Equilibrium with capital market but ignoring production

Equilibrium is achieved where indifference curve is tangential to capital market line. Slope of capital market line = - (1 + r)

 The decision process that takes 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 until the marginal rate of return on investment equals the objective market rate;

Production / Consumption takes place in a world with capital market

Production / Consumption takes place in a world with capital market

(2) then choose the optimal consumption pattern by borrowing or lending along the capital market line to equate your subjective time preference with market rate of return.