UTILITY THEORY, CAPITAL MARKETS, CONSUMPTION AND INVESTMENT

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• UTILITY THEORY, CAPITAL MARKETS, CONSUMPTION AND
  INVESTMENT

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INTRODUCTION

• THE PURPOSE OF THIS CLASS IS TO INTRODUCE THE
  FOUNDATIONS OF UTILITY THEORY WHICH IS ONE OF THE
  THEORIES ON WHICH MODERN FINANCE IS BASED. THE
  BEHAVIOUR OF INVESTORS ULTIMATELY DETERMINE
  SECURITY PRICES. UTILITY THEORY PROVIDES SOME
  INSIGHTS INTO HUMAN BEHAVIOUR.
• INDIVIDUALS ARE FACED WITH DECISION PROBLEM. ALL
  DECISION PROBLEMS HAVE CERTAIN ELEMENTS IN COMMON
  I.E. CHOOSING AMONG ALTERNATIVES, AND, FINALLY
  THE SOLUTION TO THE PROBLEM.
• CONCEPT OF THE CHOICE ALMOST EVERYONE OWNS A
  PORTFOLIO (CAR, HOUSE, CLOTHING, SHARES ETC

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CONCEPT OF PREFERENCE RELATION

• B IS A CHOICE SET,
• IF (x , y ) ? B,
• THEN
• ?x (1 - ?)y ? B (CONVEXITY) ? ? ?0,1
• x , y CAN BE VECTORS
• ABOVE MEANS THAT WE CAN FRACTIONALLY COMBINE
  ELEMENTS IN THE CHOICE SET B

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CONCEPT OF PREFERENCE RELATION
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CONCEPT OF PREFERENCE RELATION
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CONCEPT OF PREFERENCE RELATION
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PREFERENCE RELATIONS
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PREFERENCE RELATIONS
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PREFERENCE RELATIONS
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PREFERENCE RELATION 1
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PREFERENCE RELATION 2
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SATISFACTION OF AXIOMS
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SATISFACTION OF AXIOMS
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UTILTIY FUNCTION (ORDINAL)
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FINER VIEW OF PREFERENCES
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NEED FOR MORE AXIOMS
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SATISFACTION OF AXIOMS
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SATISFACTION OF AXIOMS
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DICTIONARY ORDER VRS AXIOM A2
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UTILITY FUNCTIONS LIMITATIONS
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INDIFFERENCE CURVES
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INDIFFERENCE CURVES
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MARGINAL RATE OF SUBSTITUTION
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VALUE OF CAPITAL MARKETS
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ILLUSTRATE WITH EXAMPLES
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BORROWING AND LENDING ENLARGE CHOICE
S PERIOD1
H
F
O
B
D
S PERIOD 0
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BORROWING AND LENDING ENLARGE CHOICE
BY BORROWING F, AND INDIVIDUAL CAN CONSUME AN
EXTRA BD TODAY BY LENDING B, HE/SHE CAN CONSUME
EXTRA FH TOMORROW
S PERIOD1
H
F
O
B
D
S PERIOD 0
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LET US ASSUME THAT YOU HAVE THE OPPORTUNITY TO
CONSUME 30000 TODAY AND 25000 TOMORROW. ASSUME
YOU CAN LEND OR BORROW AT AN INTEREST RATE OF
10. SKETCH THE GRAPH IF YOU WISH TO CONSUME
40,000 TODAY
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OPPORTUNITY TO INVEST IN PRODUCTION
Production Opportunities Frontier
Capital Market Line (slope is - (1r))
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THEORETICAL JUSTIFICATION FOR NPV RULE
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CARDINAL UTILITY THEORY
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CARDINAL UTILITY THEORY
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CARDINAL UTILITY THEORY
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NATURE OF CARDINAL UTILITY THEOR
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SINCE THE UTILITY OF CERTAIN 100,000 IS 15, THE
INDIVIDUAL WILL NOT PLAY THE GAME
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CONSTRUCTION OF CARDINAL UTILITY FUNCTION
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