RSM 332 Lecture 2: Tina Tan

RSM 332 Lecture 2
Tina Tan
May 17, 2017
Tina Tan (University of Toronto) RSM 332 Lecture 2 May 17, 2017 1 / 26
Lecture Agenda
Review: what is Utility, MRS and Indifference Curve?
Objective: We need to answer whether existence of financial

market improves our life - material might be challenging at first
No financial market and no production opportunity
Financial market, but no production opportunity
No financial market, but with production opportunity
Financial market and production opportunity
NPV Rule and Fisher Separation Theorem
A sample question
What is Utility?
Definition of Utility (U ): An economic term referring to the total

satisfaction received from consuming (C) a good or service in all
periods of life.
In economics, when utility is higher, it is better.
Utility in math form: U (C0 , C1 , C2 , ...), a function of consumption

C0 , C1 , C2 , ...
Utility function can be either differentiable or non-differentiable

example of differentiable: U (C0 , C1 ) = C00.5 ∗ C10.8
example of non-differentiable: U (C0 , C1 ) = min(C0 , 2C1 )
Marginal Rate of Substitution - MRS
When the utility function is differentiable, we have MRS.
Definition: The quantity of consumption this year that the

consumer is willing to give up to gain a marginal unit
consumption next year.
It is a subjective exchange rate between consumption this year

and consumption next year.
∂U/∂C0
Calculation: M RS = ∂U/∂C1
Interpretation: the utility get from the last consumption this year
versus the utility get from the last consumption next year
Utility and Indifference Curves
Indifference Curve: a graph showing combinations of
consumptions that give the same utility
Question - which graph is utility functions: C00.5 ∗ C10.8 and which

is min(C0 , 2C1 )?
Increasing Increasing
utility utility
C1 = C0/2
U = 30
U = 20 U = 30
U = 10 U = 20
U = 10
Figure: example of Indifference Curves

Utility and Indifference Curves
Indifference Curve: a graph showing combinations of
consumptions that give the same utility
Question - which graph is utility functions: C00.5 ∗ C10.8 and which

is min(C0 , 2C1 )?
Increasing Increasing
utility utility
C1 = C0/2
Figure: example of Indifference Curves

Back to the original question:
Whether existence of financial market
improve our life?
Now let’s set up a simple economy.
Preliminary Assumptions of a Simple Economy
One period (two dates)

Consumptions occur on date 0 and date 1: C0 and C1
Consumers prefer more to less
Consumers are endowed with initial wealth (endowment) Y0 on date 0, and
will receive wealth Y1 on date 1
No uncertainty
Four Different Cases of this Simple Economy
We gradually provide this economy with more economic activities:

Case 0: No financial market and no production opportunity
Case 1: Financial market, but no production opportunity
Case 2: No financial market, but with production opportunity
Case 3: Financial market and production opportunity
But one thing in common: consumers’

objective is to maximize their utility:
max U (C0, C1)
C0 ,C1
Case 0: No financial market and no
production opportunity
Case 0: No financial market and no production opportunity
Inter-temporal transfer of consumption is not possible.

Consumer consumes exactly at initial wealth at E: (Y0 , Y1 ),
thus this case is often omitted in the future.
Case 1: Financial market, but no
In perfect financial market,

lending and borrowing rate
C1
Budget constraint line
are the same at r
(slope) = -(1 + r )
Inter-temporal transfer of Y1 + Y0 (1 + r )
consumption is possible lending
borrowing: C0 > Y0 E1
lending: C0 < Y0
Two equivalent expressions Y1 E borrowing
of budget constraint
C1 Y1
E2
C0 + 1+r = Y0 + 1+r
C0 (1 + r) + C1 = Y0 Y1 C0
Y0 +
Y0 (1 + r) + Y1 (1 + r )
Budget constraint line, or

Capital Market Line (CML),
provides possible consumption
plans other than E. C1
Consumer’s objective - find the
point on the CML of the
highest Utility
E’ Capital Market Line
max U (C0 , C1 ) C1*
C0 ,C1
s.t. C0 + X = Y0
Y1 E
C1 = Y1 + X(1 + r)
Financing decision X: money
lend(+) / borrow(-) at time 0
C0* Y0 C0
Consumer is better off with
financial market
U (C0∗ , C1∗ ) > U (Y0 , Y1 )
Case 2: No financial market, but with
The production opportunity C1 Investment opportunity line

uses I(I ≥ 0) as input at date 0
and produces output f (I) at
date 1
Examples of f (I)
√
differentiable: f (I) = I,
slope = MRT (marginal rate
E’
of transfer) E’’
non-differentiable:
I = 200, f (I) = 300
With production f (I), E
inter-temporal transfer of
consumption is again possible C0
But the transfer is one-way, so

the problem in Case 2 is Investment opportunity
C1 line
max U (C0 , C1 )
C0 ,C1
s.t. C0 + I = Y0 , I ≥ 0
E’
C1 = f (I) + Y1 C1*
When the utility is at max? Y1
M RS = M RT . Why? E
(Marginal Rate of Transfer)
M RT = − ∂f∂I(I) = −f 0 (I) C0* Y0 C0
What if either U (C0 , C1 ) or
f (I) is non-differentiable?
C1 Investment opportunity line
patient
When no financial market, same
consumers except with different E’
utility(preference): patient vs
impatient, may choose different E’’ impatient
level of production, thus end up
with different optimal
consumption plan E 0 and E 00 E
C0
Figure: IC for two different preferences
Case 3: Financial market and production
opportunity
It must satisfy the rule:

When there is financial market
and production opportunity, I ∗ : −f 0 (I ∗ ) = −(1 + r)
inter-temporal transfer can be
made by both financing and Investment opportunity line
production.
C1 Capital Market Line
Transfer using financing:
Slope = - (1+r)
Borrowing/Lending Rate = 1+r
f’(I’’) < 1+r f’(I*) = 1+r
Transfer using production
f’(I’) > 1+r

∂f (I)
M RT = − = −f 0 (I)
∂I
C0
With prefect financial market and production opportunity, consumers make

decisions in two steps
Step1: Production Decision Step2: Consumption Decision
The rule: M RT = −(1 + r) only Now Case 3 can be think of Case 1
applies when production function is The new CML now goes through
differentiable wealth Y00 and Y10 , where
Therefore, a more general and
equivalent rule: Y00 = Y0 − I ∗
NPV Rule: NPV of Y10 = Y1 + f (I ∗ )
production must be
maximized Then we are back to Case 1 with only
financing decision X to consider
f (I)
max N P V = (−I + ) ⇒ I0∗
I≥0 1+r max U (C0 , C1 )
C0 ,C1
What if among all possible

production plans, the max NPV is s.t.C0 + X = Y00
still < 0 ? C1 = Y10 + X(1 + r)
Financial markets improves consumer’s utility in the presence of production

opportunity.
Given production opportunity, consumers can plan consumptions along the
investment opportunity line.
Existence of financial market, further expands the choices of consumption
plans. (Imagine there is a new CML passing through each point of the
investment opportunity line)
Given more choices of consumption plans, consumers are better off.
With perfect financial market, investment decision (Step 1) can be separate
from consumption decision (Step2)
This leads to the Fisher Separation Theorem
Under perfect and complete capital markets, the production decision is
determined by maximizing the present value of wealth, independent of
consumer preferences and endowments.
Summary
Main Take Away

Consumers’ objective is to maximize utility given budget constrains
Financial markets improves utility:
No production opportunity: Utility in Case 0 > Utility in Case 1
With production opportunity: Utility in Case 2 > Utility in Case 3
NPV rule
No production → NPV = 0
Optimal investment I ∗ : N P V = −I + f (I) is maximized at I = I ∗ and max
NPV ≥ 0
Fisher Separation Theorem
A Sample Question
Typically, you will be given some of the following primitives

√
Consumers’ utility funtion, e.g. U (C0 , C1 ) = C0 , C 1
Initial wealth, e.g. Y0 = 300, Y1 = 200
Production function, e.g. f (I) = 20 ∗ logI
Interest rate if there is a financial market, e.g. r = 0.25
Then, you will be asked to solve some of the following
(under different cases)
Optimal production plan
Optimal consumption plan
Financing plan
Optimal Consumption/Investment
Case 1: Finance mkt Case 2: No finance mkt, Case 3: finance mkt

no production opp with production opp and production opp
max U (C0 , C1 ) max U (C0 , C1 ) max U (C0 , C1 )
C0 ,C1 C0 ,C1 C0 ,C1
C0 + X = Y 0 C0 + I = Y 0 C 0 + I + X = Y0
C1 = Y1 + X(1 + r) C1 = Y1 + f (I) C1 = Y1 + f (I) + X(1 + r)
∂U ∂U ∂U
∂C0 ∂C0 df (I) ∂C0 df (I ∗ )
∂U
=1+r ∂U
= = f 0 (Y0 − C0 ) ∂U
= =1+r
∂C1 ∂C1
dI ∂C1
dI
C1 C1 = Y1 + f (Y0 − C0 ) C1
C0 + C0 + I ∗ + =
1+r 1+r
Y1 Y1 f (I ∗ )
= Y0 + Y0 + +
1+r 1+r 1+r
back into equilibrium. If they earn profits in doing so, is this fact inconsistent with
A Sample Question
market efficiency? Explain briefly why or why not. (5 marks)
(e) Empirical evidence indicates the mutual funds that have abnormally high returns
in a given year are successful in attracting abnormally large numbers of new investors
the following year. Is this consistent with efficient market hypothesis? Explain why or
Question
why not. (55 marks)
in 2012 Final
5. Suppose you have the following utility function
U (C0 , C1 ) = ln(C0 C1 ),
where C0 is today’s consumption and C1 is tomorrow’s consumption. You are endowed

with Y0 = 1000 today and nothing tomorrow. There is a production opportunity
p that
if I0 is invested today, then the output tomorrow would be f (I0 ) = 40 I0 . There is
also a capital market where lending and borrowing rate of interest is r = 100%, i.e., if
you borrow (or lend) 1 unit of good today, you will pay (or be paid) 2 units of good
tomorrow.
(a) If you have access to the capital market but you do not have access to the production
opportunity, what is your optimal consumption plan? How much do you need to borrow
or lend today? (6 marks)
(b) Suppose you just won a lottery and your endowment today becomes 1 million but
nothing tomorrow. You still have access to the capital market but not the production
opportunity. Furthermore, your utility function is the same as before. Would you
change your consumption plan? If your answer is no, explain why. If your answer is
yes, what is your new consumption plan and how much do you borrow or lend today?

RSM 332 Lecture 2: Tina Tan

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RSM 332 Lecture 2

May 17, 2017

Review: what is Utility, MRS and Indifference Curve?

Objective: We need to answer whether existence of financial

NPV Rule and Fisher Separation Theorem

Definition of Utility (U ): An economic term referring to the total

In economics, when utility is higher, it is better.

Utility in math form: U (C0 , C1 , C2 , ...), a function of consumption

Utility function can be either differentiable or non-differentiable

When the utility function is differentiable, we have MRS.

Definition: The quantity of consumption this year that the

It is a subjective exchange rate between consumption this year

Question - which graph is utility functions: C00.5 ∗ C10.8 and which

Figure: example of Indifference Curves

Question - which graph is utility functions: C00.5 ∗ C10.8 and which

Figure: example of Indifference Curves

Now let’s set up a simple economy.

One period (two dates)

We gradually provide this economy with more economic activities:

But one thing in common: consumers’

Inter-temporal transfer of consumption is not possible.

In perfect financial market,

Budget constraint line, or

The production opportunity C1 Investment opportunity line

But the transfer is one-way, so

C1 Investment opportunity line

It must satisfy the rule:

f’(I’) > 1+r

With prefect financial market and production opportunity, consumers make

What if among all possible

Financial markets improves consumer’s utility in the presence of production

Main Take Away

Typically, you will be given some of the following primitives

Case 1: Finance mkt Case 2: No finance mkt, Case 3: finance mkt

where C0 is today’s consumption and C1 is tomorrow’s consumption. You are endowed

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