Inter-temporal Optimization of Consumption

Allocating wealth across time

Topics to be covered
( ! Individual preferences across time (2! "roduction opportunities (#eal Investment! (2! Inter-temporal consumption
$ $ $ %ith production opportunities onl& %ith capital mar'ets onl& %ith both capital mar'et and production opportunities

((! )isher *eparation Theorem (+! #ole of Capital ,ar'ets (-! .nanimit& "rinciple (/! 0ustif&ing the use of 1"2

Inter-temporal Consumption Choice

stud& consumption (C! and investment (I! decisions made b& individuals and firms *implified case3 #obinson Crusoe4s case5 2-periods6 7e needs
$ 1. to 'now his own sub8ective tradeoffs between C now (C9! and C ne:t period (C ! (this information is embedded in the utilit& function! $ 2. to understand the feasible tradeoffs between present and future consumption that are technologicall& possible (this information is embedded in the production opportunit& set ("O*!

the optimal consumption-investment decision establishes a sub8ective interest rate $ the sub8ective rate of time preference ( ! This sub8ective interest rate represents the uni;ue optimal rate of e:change between C now (C9! and C in the future (C ! Interest rates are the price of deferred consumption $ b& forgoing one dollar of consumption toda&5 the mar'et rewards with interest pa&ments #

CO1*.,<# T7<O#=
. . > .(C! ,.

,. ? 9 (. @ C! ? 9 ,. is diminishing (2. @ C2! A 9 C

,.C is high ,.C is low ,. C %hen C is low5 each unit of C has high utilit& value %hen C is high5 each unit of C has lower utilit& value

*ingle period utilit& functions - e:hibit diminishing utilit& (concave! - As C 5 .tilit& 5 but each unit of C increases . b& less and less

I1CI))<#<1C< C.#2<*
C Consumption In period

Conve: Indifference Curves trace out combinations of C9 and C for which the individual e;uall& well-off
C9 low5 ,.(C9! high C high5 ,.(C ! low

C9 high5 ,.(C9! low C low5 ,.(C ! high . (Indifference Curve! C9 Consumption In period 9

Negative slope because as C0 falls, C1 must increase to maintain the same level of utility

I1CI))<#<1C< C.#2<*
C Consumption In period

#epresent higher levels of utilit& .9 A . A .2

.2 . .9 C9 Consumption In "eriod 9

%hat is the slopeD

C

-The slope of the indifference curve measures the rate of trade-off between C9 and C at the point of tangenc& -This trade-off is called the marginal rate of substitution ,#* between C9 and C - this also reveals the individual4s sub8ective rate of time preference i (at each point on the indifference curve! - "recisel&5 slope > -

.9 C9

,#* is not constantF

C If C9 is to reduce b& unit3 (a! when C9 is high less additional C is needed to ma'e this individual e;uall& well off (b! when C9 is low more additional C is needed to ma'e this individual e;uall& well off 7ow to show this graphicall&D - Conve: indifference curve - the slope at a (Ga! A the slope at a (Gb!

Gb

Ga

a
.9 C9
(slope of an indifference curve!

,#*

C9 C

> -

C C 9
. > .9

Constraints3 %ith production onl&

Ob8ective3 ma:imizes utilit& sub8ect to constraints6 Constraints3 onl& production is available for inter-temporal allocation of wealth A 6 A26 A(6 A+6 All investment outcomes are 'nown with certaint& 1o transaction costs 1o ta:es Cecisions are in a two-period world (periods 9 and !

&9 > is the individual4s endowment in period 9 & > is the individual4s endowment in period H

,arginal #ate of #eturn (Future consumption future endowment)

I12<*T,<1T O""O#T.1ITI<*
- production opportunities allow a unit of current savings to be converted into output or wealth in the future ASSUM !"#NS A 6 Investments are arranged from the highest rate of return to the lowest rate of return A26 As total investment increases5 the marginal rate of return falls A(6 All investments are independent of one another A+6 All investments are perfectl& divisible

I
,#T > height of AI > rate at which a dollar of consumption foregone toda& C 9 is transformed b& productive investment into output tomorrow i6e6 it is the ,#T offered 9 b& the production opportunit& set
Total investment (current endowment current consumption)

,arginal #ate of #eturn (Future consumption future endowment)

I12<*T,<1T O""O#T.1ITI<* C
"roduction Opportunit& *et ("O*!

A
7igh

Jow rates of return 7igh rates of return endowment point

&
Jow

I9

I
Total investment (current endowment current consumption)

&9 C9 I9

I12<*T,<1T O""O#T.1ITI<* C
Kiven technolog&5 the "O* traces out the ma:imum amount of C that is feasible for an& given amount of C9
Jow rates of return 7igh rates of return endowment point "roduction Opportunit& *et ("O*!

&
7ow does individual ma:imize utilit&D - ma'e all investments in the production opportunit& set that have rates of return higher than his sub8ective rate of time preference

I 2

&9 C9 I9

".TTI1K TOK<T7<# T7< "O* A1C "#<)<#<1C<* C

In the absence of production the individual would be forced to consume at the endowment point

&
The endowment point

.9 &9 ( C9

".TTI1K TOK<T7<# T7< "O* A1C "#<)<#<1C<* C

*mall vertical arrow

- amount needed to be e;uall& well off in utilit& terms (G!

Jarge vertical arrow

- amount of return to deferring consum toda& and underta'ing investment

&

9 .9 &9 C9

Individuals will ma'e all investments in the production opportunit& set + preference that have rates of return higher than his or her sub8ective rate of time

".TTI1K TOK<T7<# T7< "O* A1C "#<)<#<1C<* C This is the point where ,#T > ,#* (slope of "O*! > (slope of indifference curve!

L &
The endowment point

9 .9 &9 C9

I9

,essage3 "roduction opportunities allow individuals to achieve a higher B level of utilit& $ i6e6 ,ove to . ? .9

Ienefits of "roduction Opportunities

In the absence of investment opportunities5 individuals are constrained to consume at his endowment point Investment opportunities e:pand the consumption set Individuals are therefore better off At point 95
,#T ? ,#* Mthe slope of "O*N ? Mslope of utilit& functionN MThe return one obtains ? Mreturn re;uired b& the from investingN individual to forego current consumptionN

>? Optimal action3 Increase the amount investing until At point L5 ,#T>,#*5 and I9 is the optimal level of investment -

Constraints3 %ith Capital mar'et onl&

Ob8ective3 ma:imizes utilit& sub8ect to constraints6 Constraints3 onl& capital mar'et is available for intertemporal allocation of wealth A 6 A26 A(6 A+6 All investment outcomes are 'nown with certaint& 1o transaction costs 1o ta:es Cecisions are in a two-period world (periods 9 and !

&9 > is the individual4s endowment in period 9 & > is the individual4s endowment in period /

Constraints3 %ith Capital mar'et onl&

Capital ,ar'et $ individuals can borrow and lend5 and thus facilitates the transfer of funds between lenders and borrowers %ith initial endowment of (&9 and & ! that has utilit& .95 individuals can reach an& point along the capital mar'et line through borrowing and lending at the mar'et interest rate #6 # > mar'et rate of interest (reward to deferring consumption! I9 is the period 9 amount invested I is the period value of this investment > I9( O#! in the absence of capital mar'ets5 individuals would be constrained to consume at his endowment point (with .9! %e will show how the abilit& to borrow and lend can improve an individual4s utilit&

The Iudget *et (Capital ,ar'ets!

&9 > endowment in period 9 & > endowment in period C % I& giving up5 or deferring one unit of consumption toda&5 &ou get ( O#! units tomorrow & This line (Capital mar'et line! traces out all affordable combinations of C9 and C 5 given the endowments &9 and & b& borrowing and lending at mar'et interest rate # The individual4s wealth3 (a! ,easured at "eriod 9 (:-intercept!3 %9 > &9 O & @ ( O#! (b! ,easured at "eriod (&-intercept!3 % > & O &9 ( O#!

( O#! -

&9

%9

C9

Choosing the Optimal Consumption "ath with Capital ,ar'ets

C
At point 95 the slope of the indifference curve is less than the slope of the budget line >>? it is better-off to defer C9 toda&5 because the return (increase in C ! will be higher than needed to ma'e him indifferent6 - "recisel&5 the amount that the capital mar'et will reward this individual for deferring consumption is the distance (<I!5 which e:ceeds the amount the individual needs to be e;uall& well off (CI!6

L < C I

The individual therefore moves to a higher level of utilit& b& lending mone& to the capital mar'et

9 .9

C9 The individual continues moving along the capital mar'et line to the point at which the amount capital mar'et rewards him is e:actl& what he needs to be e;uall& well off - at the tangenc& between the interest rate line and the indifference curve - point L

29

Consumption with "roduction and Capital ,ar'ets C

In the absence of production and capital mar'ets5 this individual can onl& consume at "t 96 "t 3 "roduction alone "t C P "3 Ioth "roduction and Capital ,ar'ets

Capital ,ar'et line

p
L

9L

At the optimum5 there is a QseparationR between the 2 Consumption and "roduction Cecision (pt c P p!

.cPp . .9 C9

The Inter-temporal Consumption Choice

Consumption

L .4 9 .9

L L .44 9 .9 L "roduction 9 .444 .9

"roduction alone "references determine "roduction and Consumption "oint (same point!

Capital ,ar'et Alone There is no production5 and preference determine consumption

Ioth Capital ,ar'et P "roduction Capital mar'et line objectively determines production with the mar'et interest rate5 And individual preference subjectively determines consumption with his rate of time preference

22

The Consumption Cecision

"references (shape of utilit& curves! are uni;ue to each individual "roduction opportunities are the same for ever&one Capital mar'ets (interest rates! are the same for ever&one "references determine consumption Capital ,ar'et line (interest rate! determines production All individuals ma'e the same production decision5 independent of preferences
2(

The Cecision ,a'ing "rocess

the decision-ma'ing process that ta'es place with production opportunities and capital mar'et e:change opportunities occurs in t$o separate and distinct steps 6 Choose the optimal production decision b& ta'ing on pro8ects to the point where Mmarginal rate of return on investingN > Mthe ob8ective rate of interestN Mslope of "O*N > Mthe ob8ective rate of interestN ,#T > ( Or! 26 Choose the optimal Consumption pattern b& borrowing or lending along the capital mar'et line to e;uate &our sub8ective rate of time preference with the mar'et rate of interest Mslope of indifference curveN > Mslope of mar'et lineN ,#* > ( Or! This separation of decisions is 'nown as the )isher *eparation Theorem 2+ i6e the separation of the Consumption and Investment decisions

)I*7<# *<"A#ATIO1 T7<O#<,

Kiven perfect and complete capital mar'ets (frictionless!5 the production decision is governed solel& b& an ob8ective mar'et criterion (represented b& ma:imizing attained wealth! without regards to individual4s sub8ective preferences that enter into the consumption decision6 This is e:tremel& important for corporate finance regardless of the shape of individual investor4s indifference curve of a firm5 ever& investor of that firm will direct the manager to the same production decision - The investment decision is independent of individual preferences

2B

Consider two individuals C

Ioth individuals and 2 ma'e the same investment decision3 both produce at L5 and b& using capital mar'ets5 borrow or lend to achieve their own optimum consumption point That is5 regardless of the shape of their utilit& functions5 the& ma'e e:actl& the same production decision

Individual 2
(stronger preference for future consumption!

In math3 ,#* > ,#*2 > -( O#! > ,#T

Individual
(stronger preference for current consumption!

C9 2-

 Ioth investors and 2 will direct the manager of the firm to choose point (L! The investors simpl& ta'es the output of the firm and adapts it to their own sub8ective time preferences b& borrowing and lending in the capital mar'et The optimal production decision is separated from individuals utilit& preferences (thus individual investors are unanimous ( Unanimity principle!! %#&' #( CA "!A& MA%)'!S capital mar'ets allow the efficient transfer of funds from lenders to borrowers Individuals who have insufficient wealth to ta'e advantage of all their investment opportunities that &ield rates of return higher than the mar'et rate are able to borrow funds and invest more than the& would without capital mar'ets i6e65 funds can be efficientl& allocated from individuals with few production opportunities and great wealth to individuals with man& opportunities and insufficient wealth All borrowers and lenders are better off than in the absence of capital mar'ets "N*'S!M'N! +'C"S"#N The ob8ective of the firm is to ma:imize the wealth of its shareholders6 This is the same as Mma:imizing the present value of the shareholders lifetime ConsumptionN > Mma:imizing the price per share per stoc'N

The *eparation of C and I decisions

2/

7ow to ma: shareholder4s wealthD

%e again uses )isher *eparation Theorem Kiven perfect and complete capital mar'ets5 the owners of the firm (shareholders! will unanimousl& support the acceptance of all pro8ects until the least favourable pro8ect has return the same as the cost of capital6 In the presence of capital mar'ets5 the cost of capital is the mar'et interest rate6 The pro8ect selection rule5 i6e65 e;uate
marginal rate of return of investment > cost of capital (mar'et interest rate!

Is e:actl& the same as the net present value rule3 Net resent *alue %ule Calculate the 1"2 for all available (independent! pro8ects6 Those with positive 1"2 are ta'en6
At the optimal3 1"2 of the least favourable pro8ect S> zero

This is a rule of selecting pro8ects of a firm that no matter how individual investors of that firm differ in their own opinion (preferences!5 such rule is still what the& are willing to direct the manager to follow6

2E

The separation principle implies that the ma:imization of the shareholder4s wealth is identical to ma:imizing the present value of lifetime consumption *ince borrowing and lending ta'e place at the same rate of interest5 then the individual4s production optimum is independent of his resources and tastes If as'ed to vote on their preferred production decisions at a shareholder4s meeting5 different shareholders will be unanimous in their decision unanimity principle ,anagers of the firm5 as agents for shareholders5 need not worr& about ma'ing decisions that reconcile differences in opinion among shareholders i6e there is unanimit& The rule is therefore $ ta,e pro-ects until the marginal rate of return e.uals the mar,et interest rate / ta,ing all pro-ects $ith 0ve N *

Again and again5 )isher *eparation Theorem

2H

"rincipal-Agent "roblem
"rincipals > *hareholders5 Agent > ,anager of the firm6 Ownership T control5 so there is no reason to believe that managers will alwa&s act in the best interest of the shareholders (Consider all the accounting scandals! - If the shareholders can costlessl& monitor management decisions5 the& can be sure that management reall& does ma'e ever& decision in a wa& that ma:imizes their wealth - In realit&5 owners must incur non-trivial monitoring costs in order to 'eep the manager in line >? owners (shareholders! face a trade-off between monitoring costs and forms of compensation that will cause the agent to alwa&s act in the owners interest )isher separation holds onl& with strong assumptions3 (I6e frictionless mar'ets! I6e can costlessl& monitor managers decisions alwa&s made to ma:imize value of the firm

(9

TO"IC* for self-interest

6 Cifferent techni;ues for selecting investment pro8ects a! b! c! d! 26 (6 "a&bac' method Accounting rate of return 1et present value Internal rate of return

,easuring shareholder wealth (&ou need to 'now how to compute 1"2! <conomic profits vs Accounting profits

Inter-temporal Choice
an endowment5 &5 can be allocated Inter-temporall& in three wa&s 6 "roduction 26Capital mar'ets (6 *torage in order to move resources from period 9 to period using
$ 6 "roduction5 we can move north-west in the graph at the rate of (slope of the "O*! $ 26 Capital mar'ets5 we can move north-west or south-east along the capital mar'et line at the rate of ( O #! where # > mar'et interest rate $ (6 *torage5 we can move north-west at the rate of 6 This re;uires additional assumptions of non-perishable goods and no storage costs which is not re;uired for and 2 above6

.nder what conditions is the individual made better off from an Intertemporal reallocationD To answer that ;uestion we need to consider the slope of the indifference curve relative to the rate of transformation in each of to ( above6 Keneral rule3 If rate of time preference A rate of transformation5 then the individual is better off transforming using (2 either of the ( wa&s6

An e:ercise for self-stud&

Consider the following utilit& function3 VVVV .(C ! .> .(C9! O
( O!

%e now ta'e a total derivative3 .U(C9!dC9 O M @( O !N.U(C !NdC > 9 #earranging5 dC @dC9 > -( - ! M.U(C9!@ .U(C !N slope of indifference curve

the slope of the indifference curve depends upon the relative marginal utilities as well as the sub8ective rate of time preference

((

An <:ercise
C C9 > C As C9 ,. As C ,. *lope of the indifference curve along the +B is -( O ! as
9

M.U(C9!@ .U(C !N >

+B

.9 C9

To the right of the +B9 line5 the slope is less than as M.U(C9!@ .U(C !N A To the left of the +B9 line5 the slope is greater than as M.U(C9!@ .U(C !N ?

dC @dC9 > -( - ! M.U(C9!@ .U(C !N slope of indifference curve

Therefore5 even if ? 95 the tradeoff between C9 and C can be A (+

if C is sufficientl& high

Another 1umerical <:ample

Assume individuals can borrow and lend5 but no production *uppose that the utilit& function for consumption is . > log(C! O M @( O !N log(C! The individual4s wealth is given b& the e;uation % > &9 O M @( O#!N& where # is the rate of interest and is the sub8ective rate of time preference If an individual is to ma:imize utilit&5 then we 'now that the present value of consumption must e;ual wealth3 % > & 9 O M @( O#!N& Cerive the optimal consumption paths5 assuming
a! %> 995 #> 9W5 > 9W b! %> 995 #>BW5 > 9W c! %> 995 #> 9W5 >BW

%e are ignoring production opportunities in this e:ample

(B

The Optimization "roblem

*et up the constrained optimization problem J > log(C9! O M @( O !N log(C ! O M % $ C9 $ C @( O#!N The first order conditions > @ C9 J@C9 > ( @C9! - > 9 J@C > ( @( O !! ( @C ! - @( O#! > 9 > M( O#!@( O!N ( @ C !N M @ C9N > M( O#!@( O!N ( @ C !N C01 / 2310 45310 %46 C11

$ $ $

If > # C9L > C L If ? # C9L ? C L If A # C9L A C L

CL

.
C9
L

(-

C9

Optimal Consumption "aths

*olve for the following three cases
a! %> 995 #> 9W5 > 9W C9 > ( 6 9@ 6 9!C % > C9 C9L > b!%> 995 #>BW5 > 9W
OC

@( O#! > 99

CL

> CL > B26(E

c!> 995 #> 9W5 >BW

(/

*torage
)or an individual to benefit from storage (assuming non-perishable goods and no storage costs5 Mslope of the indifference curveN A (in absolute value! dC @dC9 > -( - ! M.U(C9!@ .U(C !N and assuming log utilit&3 dC @dC9 > M-( - !N( @C9! @ ( @C ! > M-( - !NC @C9 In other words5 simple storage ma'es an individual better off if ( O ! C @C9 A or ( O ! A C9@C Again5 this assumes log utilit& i6e6 storage ma& be beneficial if C 9 is high relative to C

(E