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Chapter One

Introduction :
Capital Market, Consumption
and Investment

Kawser Ahmed Shiblu


Lecturer
Department of Finance
Jagannath University

Introduction
Consider, a one-person/one-good economy or a
single person economy. The decision maker must
choose between consumption now and
consumption in the future. The decision not to
consume now is the same as investment. Thus his
decision is simultaneously one of consumption
and investment. In order to decide, he needs two
types of information subjective trade-offs between consumption
now and consumption in the future i.e. the
utility and indifference curves
the feasible trade-offs between present and
future consumption i.e. the investment and
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Copeland, Weston & Shastri
production opportunity
sets.

Introduction
From the analysis of a one-person/one-good
economy, a subjective interest rate is
determined
by
the
optimal
consumption/investment
decision
which
represents the optimal rate of exchange
between consumption now and in the future.
Again it can be called the price of deferred
consumption or the rate of return on
investment.
Individual with different subjective interest rate
select
different
consumption/investment
decision choices.
Copeland, Weston & Shastri

Introduction
Opportunities to exchange consumption
across time by borrowing or lending in a
multiple
person
or
exchange
economy results in a single market
interest rate that everyone can use as a
signal
for
making
optimal
consumption/investment decisions.
So when no one is worse off and almost
everyone is better off in an exchange
economy compared with a single person
economy, it can be said an ex change
economy is superior to an economy
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without exchange.

Introduction
And
capital
markets
help
to
allocate/exchange resources from one to
another. So the ultimate question arise"Do capital markets benefit society?"
The answer requires to compare a world
without capital markets to one with capital
markets to show that no one is worse off
and that at least one individual is better
off in a world with capital markets.

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Consumption And Investment


Without Capital Markets
Assumptions all outcomes from investment are known with
certainty
there are no transactions costs or taxes
the marginal utility of consumption is always
positive.
the marginal utility of consumption is decreasing
Wealth at present=Y0
Wealth at end=Y1
Consumption at present=C0
Consumption at end=C1
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Consumption And Investment


Without Capital Markets

Note that equal increases in consumption cause total utility to


increase (marginal utility is positive), but that the increments in
utility become smaller and smaller (marginal utility is
decreasing).
Copeland, Weston & Shastri

Consumption And Investment


Without Capital Markets
Provides a description of tradeoffs between consumption at the
beginning, C0 and consumption
at the end, C1
The dashed lines represent
various combinations of Co and
CI providing the same total
utility measured along the
vertical axis.
Since all points along the
dashed line (e.g., points A and B)
have equal total utility, the
individual will be indifferent with
respect to them. Therefore the
lines
are
called
Note that all combinationsdashed
of consumption today and
indifference curves.
consumption tomorrow that lie on the same indifference curve
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have the same total utility.

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Consumption And Investment


Without Capital Markets
Decision maker would be
indifferent to point A & B
whereas Point A has more
consumption at the end but
less consumption at the
beginning than point B does.
Point
D
has
more
consumption in both periods
than
do
either
points A or B, with higher
utility.
So curves
MRS: The rate of trade-off between
C0 andtoCthe
by
northeast
1 indicated
have
greatertototal
the slope of the straight line just
tangent
the utility.
indifference
curve. i.e. how many extra unit received tomorrow in order to
give up one unit today to have same utility.
MRS can be said as individuals subjective rate of time
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Weston & Shastri
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preference.

Consumption And Investment


Without Capital Markets
Mathematically, MRS or subjective rate of time preference can
be expressed :

Subjective rate of time preference is greater at point A than at B


(due to steeper tangent line) i.e. individual choose to have less
consumption today will require higher subjective rate of time
preference to maintain the same level of utility.
Up to this, we determine the criteria based on which an
individual decide how much he/she will consume now and defer.
Now he/she will go for evaluating his/her investment
opportunities. An individual will make all investments in
productive opportunities that have rates of return higher
Copeland,rate
Weston of
& Shastri
than his or her subjective
time preference, r i. 26

Consumption And Investment


Without Capital Markets
Each
individual
has
productive
investment
opportunities
ABX=production/investm
ent opportunity set.
Assume,
diminishing
marginal
returns
to
investment because the
more an individual invests,
the lower the rate of return
on the marginal investment
so ABX is concave.
Individual endowed with
MRT= Slope of a line tangent toa curve
ABXbundle
is the(Ymarginal
resource
0 , Y1 )
rate of return from each additional dollar investment.
The line tangent to point A has the highest slope .
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Consumption And Investment


Without Capital Markets
An investor will continue his/her investment up to the point
where investor's subjective marginal rate of substitution is equal
to the marginal rate of transformation offered by the production
opportunity set i.e.
MRS=MRT
Here, the amount of investment is Y 0 C0.
If C0 > Y0, he or she will disinvest.
Individuals consumption in each time period is exactly equal to
the output from production i.e.
P0=C0 & P1=C1

Without capital markets, individuals with the same


endowment and the same investment opportunity
set may choose completely different investments
because of different indifference curves.
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Consumption And Investment


Without Capital Markets

Individual 2, who has a lower rate of time preference will


choose to invest more than individual 1.
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Understanding Capacity Test


Suppose your production opportunity set in a
world of perfect certainty consists of the
following possibilities:
Project

Outlay

RR (%)

1000000

1000000

20

2000000

3000000

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a. Graph the production/investment opportunity set.


b. If market rate is 10%, what is the optimum
investment?
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Consumption And Investment


With Capital Markets
What happens if instead of one person,
many individuals are said to exist in the
economy?
Intertemporal exchange of consumption
bundles will be represented by the
opportunity to borrow or lend unlimited
amounts at r, a market determined rate of
interests.
Capital market facilitate the transfer of
funds between lenders and borrowers. If
the interest rates are positive, any amount
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of funds are lent today will return interest

Consumption And Investment


With Capital Markets
We can graph borrowing and
lending opportunities along the
capital
market
line (line W0ABW1).
With an initial endowment of
(Y0, Y1) that has utility equal to U1,
we can reach any point along the
market fine by borrowing or
lending at the market interest
rate plus repaying the principal
amount, X0.
The present value, W0, of our
initial endowment (Y0, Y1) is the
sum
of
current income, Y0, and the present
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value
of
our
end-of-period

Consumption And Investment


With Capital Markets
Here,
Capital Market Line = W0ABW1
Initial endowment = (Y0, Y1)
Lending Portion=W1A
Borrowing Portion=W0A
Utility= U1
Subjective Rate = Slope of U1 at point A.
Market Interest rate = Slope of CML at
any
point.
Notice,
here we use the term CML rather
than Budget Line. Why???

So we can maximize utility by moving along the market line to


the point where our subjective time preference equals the market
interest rate i.e.
SR = MR
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Consumption And Investment


With Capital Markets
Point B represents the consumption bundle on the
highest attainable indifference curve i.e. we desire
to lend because the capital market offers a rate of
return higher than what we subjectively require as
our subjective time preference, represented by the
slope of a line tangent to the indifference curve at
point A, is less than the market rate of return.
So our optimum consumption= C0*, C1* at Utility U2
which is greater than Utility U 1.
Now, it can be said our initial endowment must be
equal to the sum of our two period consumptions. In
other words, our wealth must be equal to our
consumptions.
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Consumption And Investment


With Capital Markets

The present value of wealth, W0 is the sum of current


income, Y0, and the present value of our end-of-period
income, Y1(1 + r)-1 i.e.

Again, the present value of our endowment equals the


present value of our consumption and both are equal to our
wealth,W0. i.e.

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Consumption And Investment


With Capital Markets
Thus the capital market line has an intercept at W 1 and a
slope
of
-(1+r).
Note that moving along the capital market line does not
change one's wealth, but it does offer a pattern of
consumption that has higher utility.
Up to these we Ignore production for the time being and
graph borrowing and lending opportunities along the capital
market line.
What happens if the production/consumption decision takes
place in a world where capital markets facilitate the
exchange of funds at the market rate of interest?
Next graph combines production possibilities with market
exchange possibilities.
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Consumption And Investment


With Capital Markets
With the family of indifference
curves U1, U2, and U3 and
endowment (Y1, Y2) at point A,
what actions will we take in
order
to maximize our utility?
Starting
at point A, we can
move either along the PPC or
along the CML.
Both alternatives offer a higher
rate
of
return
than
our
subjective time preference, but
production offers the higher
return, (steeper slope). So we
choose to invest and move along
the
production
opportunity
frontier.
Copeland, Weston
& Shastri
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Consumption And Investment


With Capital Markets
Without the opportunity to borrow or lend along the
capital market line, we would stop investing at point D,
where MRT=MRS and our level of utility has increased
from U1 to U2.
With the opportunity to borrow, we can actually do
better. At point D the borrowing rate, represented by
the slope of the CML, is less than the rate of return on
the marginal investment, which is the slope of the
production opportunity set at point D.
Since further investment returns more than the cost of
borrowed funds, we will continue to invest until the
marginal return on investment is equal to the
borrowing rate at point B.
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Consumption And Investment


With Capital Markets
We can now reach any point on the market line.
Since our time preference at point B is greater
than the market rate of return, we will consume
more than Po, which is the current payoff from
production.
By borrowing we can reach point C on the capital
market line. Our optimal consumption is found
where our subjective time preference just equals
the market rate of return.
Our utility has increased from U1 at point A (our
initial endowment) to U2 at point D (the Single
person solution) to U3 at point C (the exchange
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Shastri
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economy solution).
WeWeston
are& clearly
better off when

Consumption And Investment


With Capital Markets
The decision process that takes place with production
opportunities and capital market exchange opportunities
occurs in two separate and distinct steps:
1.

2.

First, choose the optimal production decision by taking on


projects until marginal rate of return on investment equals
objective market rate;
then choose the optimal consumption pattern by borrowing
or lending along the capital market line to equate your
subjective time preference with the market rate of return.

The separation of the investment (step 1) and


consumption (step 2) decisions is known as the Fisher
separation theorem.
Fisher separation theorem: Given perfect and complete
capital markets, the production decision is governed solely
by an objective market criterion (represented by
maximizing attained wealth) without regard to individuals'
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subjective preferences
that enter into their consumption

Consumption And Investment


With Capital Markets
What is the implication of this theory in
business???
An important implication for corporate policy is
that the investment decision can be delegated
to managers i.e. given the same opportunity
set, every investor will make the same
production decision (P0, P1) regardless of the
shape of his or her indifference curves.
Investors will direct the manager of their firm
to choose production combination (P0, P1). They
can then take the output of the firm and adapt
it to their own subjective time preferences by
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borrowing or lending
in the capital market.

Consumption And Investment


With Capital Markets
Both investor 1 & 2 will direct
the manager of their firm to
choose production combination
(P0, P1).
Investor 1 will consume more
than current production (point A)
by borrowing today in the
capital market and repaying out
of future production.
Investor 2 will lend because
s/he consumes less than current
production.
Either way, they are both
better off with a capital market.
But how???
Without
capital
market
opportunities to borrow or lend,
investor
Copeland, Weston
& Shastri I & 2 would be worse off
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at point Y & X which have lower

Consumption And Investment


With Capital Markets
Finally, in equilibrium, the marginal rate of substitution for
all investors is equal to the market race of interest, and this
in turn is equal to the marginal rate of transformation for
productive investment. i.e.
MRS= -(1+r) =MRT
They allow the efficient transfer of funds between
borrowers and lenders. 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. In this way, funds can
be efficiently allocated from individuals with few productive
opportunities and great wealth to individuals with many
opportunities and insufficient wealth. As a result, all
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(borrowers and lenders) are better off than they would have

Does establishment of capital


markets increase the
transaction cost???

Assume that we have a primitive economy with N producers,


each making a specialized product and consuming a bundle of
all N consumption goods. Given no marketplace, bilateral
exchange is necessary. During a given time period, each visits
the other in order to exchange goods.
For example, there are five individuals and five consumption
goods in this economy & the cost of each leg of a trip is T
dollars.
I.

If there is no market place, then how many trips individual 1,


individua2 individual3, individual4 & individual5 makes ? How many
trips all individuals make? What will be the total cost?
II. If market place exists, then then how many trips individual 1,
individua2 individual3, individual4 & individual5 makes ??? How
many trips all individuals make? What will be the total cost?
III. Is anyone better off or worse off for having market place? If yes,
how much?
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Does establishment of capital


markets increase the
transaction cost????
Without Capital Market

With Capital Market

Total Trips= (N (N-1))/2

Total Trips= N

Total savings or better off= [{N (N-1)}/2 - N ] T


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Understanding Capacity
Testing
There are 12 individuals and 12
consumption goods in the economy & the
cost of each leg of a trip is BDT. 50.
I. If there is no market place, then how many trips each
individual makes? How many trips all individuals
altogether make? What will be the total cost?
II. If market place exists, then then how many trips each
individual makes? How many trips all individuals
altogether make? What will be the total cost?
III. Is anyone better off or worse off for having market
place? If yes, how much?

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Does transaction cost create any


problem to Fisher Theory???
The theory of finance is greatly simplified if we
assume that capital markets are perfect.
Obviously they are not.
If transactions costs are trivial, then borrowing
and lending interest rate will be same. Then there
will be no problem to Fisher theory of separation.
But if transactions costs are nontrivial, the
borrowing rate will be greater than the lending
rate. Different borrowing and lending rates will
have the effect of invalidating the Fisher
separation principle.
Without a single market rate, investors will not be
able to delegateCopeland,
the Weston
investment
decision to the
& Shastri
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Consumption And Investment


With Capital Markets
Individual 1 would direct
the manager to use the
lending
rate and invest at point B.
Individual 2 would use the
borrowing rate and choose
point A.
A third individual might
choose investments between
points A and B, where his or
her indifference curve is
directly
tangent
to
the
production
opportunity
set.
The effects of taxes and information
asymmetries
are certainly
nontrivial, so these also create problems in theories. These all
will be discussed in later chapters.
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Best of Luck!!!

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