1. Capital Market, Consumption and Investment (L1)
Consumption and investment without capital market
Consumption and investment with capital market
Fisher separation theorem
Breaking down the separation : transaction costs
Breaking down the separation: agency problem
Application of Fisher Separation theorem: capital budgeting and shareholder value maximization
Materials from Chapters 1&2, CWS
L1: Capital Market, Consumption and Investments

2. L1: Capital Market, Consumption and Investments
Consumption Plane
How individuals make choices among consumption bundles C1 U C0
Indifference curve: time preference of consumption in a consumption
The slope of the tangent line MRS
L1: Capital Market, Consumption and Investments

3. Investment Schedule and Production Opportunity Set
Marginal rate of return A X B B ri y0 A
Total Investments C0 y1 I0 X
Investment schedule and production opportunity set are equivalent
The slope for the tangent line of production opportunity set in B is –(1+ri) = marginal rate of transformation (MRT)
L1: Capital Market, Consumption and Investments

4. Equilibrium in a Robinson Crusoe World
MRS=MRT = -(1+ri) C1
Individual 2
Individual 1 C0
Individual 1 consumes more than individual 2 in period 0
No capital market, thus there is no exchange.
L1: Capital Market, Consumption and Investments

5. Optimal Consumption in the Presence of Capital Market
L1: Capital Market, Consumption and Investments

6. L1: Capital Market, Consumption and Investments
Capital Market Line C1 W1 B U2 A U1 C0 W0
With capital market, an agent can move from A to B, reaching a higher utility.
On the capital market line, one’s wealth does not change. But consumption differs.
The slope of the capital market line is –(1+r).
L1: Capital Market, Consumption and Investments

7. Slope of Capital Market Line
L1: Capital Market, Consumption and Investments

8. What Constitutes Consumptions?
GDP= C + I + G + NX
C = consumption
I = investment
G = government purchases of goods and services
NX = net exports of goods and services
L1: Capital Market, Consumption and Investments

9. L1: Capital Market, Consumption and Investments
Spending by domestic households on final goods and services, accounting for about 2/2 of GDP in the United States, including:
Consumer durables
Nondurable goods
services
L1: Capital Market, Consumption and Investments

10. L1: Capital Market, Consumption and Investments
Includes both spending for new capital goods, called fixed investment, and increases in firms’ inventory holdings, called inventory investment.
Fixed investment includes:
business fixed investment
residential investment
L1: Capital Market, Consumption and Investments

11. Joint effect of capital market and production/investment
See figure 1.8
Two steps of the decision process related to production opportunity and capital market exchange opportunity:
Choose the optimal production decision by taking on projects until the marginal rate of return on investment equals the objective market rate -- investment
Choose the optimal consumption pattern by borrowing or lending along the capital market line equate your subjective time preference with the market rate of return -- consumption
L1: Capital Market, Consumption and Investments

12. Fisher Separation Theorem
Given perfect and complete markets, the production decision is governed solely by an objective market criterion without regard to individuals’ subjective preferences that enter into their consumption decisions.
See figure 1.9
In equilibrium, the marginal rate of substitution for all investors is equal to the market rate of interest, and this in turn is equal to the marginal rate of transformation for productive investment.
MRSi=MRSj=-(1+r)=MRT
That is, the marginal return on investment (MRT, marginal rate of transformation) equals market-determined opportunity cost of capital (r)
Irving Fisher's theory of capital and investment was introduced in his Nature of Capital and Income (1906) and Rate of Interest (1907), although it has its clearest and most famous exposition in his Theory of Interest (1930).
L1: Capital Market, Consumption and Investments

13. Fisher Separation TheoremC1 W1
Individual 1 P1
Individual 2 C0 P0 W0
Individuals choose their respectful consumptions, where their consumptions can be delivered by productive investments (P0, P1).
This is what we mean by separation: a separation of investment and consumption.
L1: Capital Market, Consumption and Investments

14. L1: Capital Market, Consumption and Investments
Implications
All the consumption decisions are made along the capital market line.
The slope of the capital market line is –(1+r), where r is the interest rate, not stock return.
This is the case of consumption choices under certainty.
What is missing here?
L1: Capital Market, Consumption and Investments

15. L1: Capital Market, Consumption and Investments
Perfect Market
Necessary conditions
Markets are frictionless
Perfect competition in securities markets
Markets are informationally efficient; that is, information is costless, and it is received simultaneously by all individuals
All individuals are rational expected utility maximizers
L1: Capital Market, Consumption and Investments

16. L1: Capital Market, Consumption and Investments
Complete Market
When the number of unique linearly independent securities is equal to the total number of alternative future states of nature. The market is said to be complete.
Page 77, CWS
Details will be provided in the lectures related Arrow-Debreu assets.
L1: Capital Market, Consumption and Investments

17. Role of Capital Market – Reducing Transaction Costs
Trading is costly – thus the market is not perfect
Having marketplaces helps to reduce transaction costs – page 12, CWS.
Thus financial market has its role only when
Trading costs are non-trival
Demsetz (1968); Kyle (1985); Glosten and Milgrom (1985); Grossman and Miller (1988)
Information asymmetry
Akerlof (1970); Spence (1973); Myers and Majluf (1984)
L1: Capital Market, Consumption and Investments

18. Breakdown of the Separation: Transaction Costs
See figure 1.12
Lending rate is lower than borrowing rate
Then the optimal consumption decision depends on individuals’ subjective utility functions
L1: Capital Market, Consumption and Investments

19. Breakdown of the Separation: Agency Problem
Given Fisher separation theorem, the investment decision and consumption decision can be separated.
In other words, shareholders can delegate managers to perform the investment function
This separation leads to separation of ownership and control.
Monitoring costs and compensation issue arise, which lead to the large literature on corporate governance and corporate finance.
Berle and Means (1932) and Jensen and Meckling (1976)
L1: Capital Market, Consumption and Investments

20. L1: Capital Market, Consumption and Investments
Value to Shareholders
Present value of shareholders’ wealth can be expressed as:
Note: the above expression involves both capital gains and dividends (see page 20) – all go to shareholders
Economic definition versus accounting definition of profit
L1: Capital Market, Consumption and Investments

21. Capital Budgeting Techniques
Maximizing shareholders’ wealth is equivalent to maximizing the discounted cash provided by investment projects.
Decision rules: payback period, …
What’s the point?
Utility function collapses to the value function
Given the Fisher separation theorem, maximizing shareholders’ wealth will lead to a social optimal at the presence of the capital.
In reality, firms have the option to undo their decisions
Thus the decision rule could be altered.
L1: Capital Market, Consumption and Investments

22. L1: Capital Market, Consumption and Investments
Exercises
CWS, 1.5&1.6
What is meant by “separation” in the Fisher’s separation theorem?
L1: Capital Market, Consumption and Investments