Chapter 17

CAPITAL MARKETS

Copyright 2005 by South-Western, a division of Thomson Learning. All rights reserved.

Capital
The capital stock of an economy is the
sum total of machines, buildings, and
other reproducible resources in existence
at a point in time
these assets represent some part of the
economys past output that was not
consumed, but was instead set aside for
future production
2

Rate of Return
At period t1, a decision is made to hold s from
current consumption for one period

Consumption

s is used to produce additional

output only in period t2
Output in period t2 rises by x

x
c0

Consumption returns to
its long-run level (c0) in
period t3

t1

t2

t3

Time

Rate of Return
The single period rate of return (r1) on
an investment is the extra consumption
provided in period 2 as a fraction of the
consumption forgone in period 1
x s x
r1
1
s
s

Rate of Return
At period t1, a decision is made to hold s from
current consumption for one period

Consumption

s is used to produce additional

output in all future periods
Consumption rises to
c0 + y in all future
periods

c0

t1

t2

t3

Time

Rate of Return
The perpetual rate of return (r) is the
permanent increment to future
consumption expressed as a fraction of
the initial consumption foregone
y
r
s

Rate of Return
When economists speak of the rate of
return to capital accumulation, they have
in mind something between these two
extremes
a measure of the terms at which
consumption today may be turned into
consumption tomorrow

Rate of Return and

Price of Future Goods
Assume that there are only two periods
The rate of return between these two
periods (r) is defined to be
c1
r
1
c0

Rewriting, we get
c0
1

c1 1 r

Rate of Return and

Price of Future Goods
The relative price of future goods (p1) is
the quantity of present goods that must
be foregone to increase future
consumption by one unit
c0
1
p1

c1 1 r

Demand for Future Goods

An individuals utility depends on
present and future consumption
U = U(c0,c1)

and the individual must decide how

much current wealth (w) to devote to
these two goods
The budget constraint is
w = c0 + p1c1
10

Utility Maximization
c0

w = c0 + p1c1

The individual will maximize utility by

choosing to consume c0* currently and
c1* in the next period

w/p1

c1 *

U1
U0
c0*

c1

11

Utility Maximization
The individual consumes c0* in the
present period and chooses to save w
- c0* to consume next period
This future consumption can be found
from the budget constraint
p1c1* = w - c0*
c1* = (w - c0*)/p1
c1* = (w - c0*)(1 + r)
12

Intertemporal Impatience
Individuals utility-maximizing choices
over time will depend on how they feel
about waiting for future consumption
Assume that an individuals utility
function for consumption [U(c)] is the
same for both periods but period 1s
utility is discounted by a rate of time
preference of 1/(1+) (where >0)
13

Intertemporal Impatience
This means that
1
U (c0 , c1 ) U (c0 )
U (c1 )
1

Maximization of this function subject to

the intertemporal budget constraint
yields the Lagrangian expression

c1
L U (c0 , c1 ) w c0

14

Intertemporal Impatience
The first-order conditions for a maximum are

L
U ' (c 0 ) 0
c0
L
1

U ' (c1 )
0
c1 1
1 r
L
c1
w c0
0

1 r

15

Intertemporal Impatience
Dividing the first and second conditions
and rearranging, we find
1 r
U ' (c 0 )
U ' (c1 )
1

Therefore,
if r = , c0 = c1
if r < , c0 > c1
if r > , c0 < c1
16

Effects of Changes in r
If r rises (and p1 falls), both income and
substitution effects will cause more c1 to
be demanded
unless c1 is inferior (unlikely)

This implies that the demand curve for

c1 will be downward sloping
17

Effects of Changes in r
The sign of c0/p1 is ambiguous
the substitution and income effects work in
opposite directions

Thus, we cannot make an accurate

prediction about how a change in the
rate of return affects current
consumption
18

Supply of Future Goods

An increase in the relative price of
future goods (p1) will likely induce firms
to produce more of them because the
yield from doing so is now greater
this means that the supply curve will be
upward sloping

19

Equilibrium Price of
Future Goods
Equilibrium occurs at p1*
and c1*

p1
S

The required amount of

current goods will be put
into capital accumulation
to produce c1* in the
future

p1*

D
c1*

c1

20

Equilibrium Price of
Future Goods
We expect that p1 < 1
individuals require some reward for waiting
capital accumulation is productive
sacrificing one good today will yield more than
one good in the future

21

The Equilibrium Rate of Return

The price of future goods is
p1* = 1/(1+r)

Because p1* is assumed to be < 1, the

rate of return (r) will be positive
p1* and r are equivalent ways of
measuring the terms on which present
goods can be turned into future goods
22

Rate of Return & Real and

Nominal Interest Rates
Both the rate of return and the real
interest rate refer to the real return that
is available from capital accumulation
The nominal interest rate (R) is given by

1 R (1 r )(1 expected inflation rate)

1 R (1 r )(1 pe )
23

Rate of Return & Real and

Nominal Interest Rates
Expansion of this equation yields

1 R 1 r pe r pe

Assuming that r pe is small,

R r pe
24

The Firms Demand for Capital

In a perfectly competitive market, a firm
will choose to hire that number of
machines for which the MRP is equal to
the market rental rate

25

Determinants of Market
Rental Rates
Consider a firm that rents machines to
other firms
The owner faces two types of costs:
depreciation on the machine
assumed to be a constant % (d) of the machines
market price (p)

the opportunity cost of the funds tied up in

the machine rather than another investment
assumed to be the real interest rate (r)

26

Determinants of Market
Rental Rates
The total costs to the machine owner for
one period are given by
pd + pr = p(r + d)

If we assume the machine rental market

is perfectly competitive, no long-run
profits can be earned renting machines
the rental rate per period (v) will be equal to
the costs
v = p(r + d)
27

Nondepreciating Machines
If a machine does not depreciate, d = 0
and
v/p = r

An infinitely long-lived machine is

equivalent to a perpetual bond and
must yield the market rate of return
28

Ownership of Machines
Firms commonly own the machines they
use
A firm uses capital services to produce
output
these services are a flow magnitude

It is often assumed that the flow of capital

services is proportional to the stock of
machines
29

Ownership of Machines
A profit-maximizing firm facing a
perfectly competitive rental market for
capital will hire additional capital up to
the point at which the MRPk is equal to
v
under perfect competition, v will reflect
both depreciation costs and the opportunity
costs of alternative investments
MRPk = v = p(r+d)

30

Theory of Investment
If a firm decides it needs more capital
services that it currently has, it has two
options:
hire more machines in the rental market
purchase new machinery
called investment

31

Present Discounted Value

When a firm buys a machine, it is buying
a stream of net revenues in future
periods
it must compute the present discounted
value of this stream

Consider a firm that is considering the

purchase of a machine that is expected
to last n years
it will provide the owner monetary returns in
each of the n years
32

Present Discounted Value

The present discounted value (PDV) of
the net revenue flow from the machine to
the owner is given by
R1
R2
Rn
PDV

...
2
1 r (1 r )
(1 r )n

If the PDV exceeds the price of the

machine, the firm should purchase the
machine
33

Present Discounted Value

In a competitive market, the only
equilibrium that can prevail is that in
which the price is equal to the PDV of the
net revenues from the machine
Thus, market equilibrium requires that
R1
R2
Rn
P PDV

...
2
1 r (1 r )
(1 r )n
34

Simple Case
Suppose that machines are infinitely
long-lived and the MRP (Ri) is the same
in every year
Ri = v in a competitive market
Therefore, the PDV from machine
ownership is
v
v
v
PDV

...
...
2
n
1 r (1 r )
(1 r )
35

Simple Case
This reduces to

1
1
1
PDV v

...
...
2
n
(1 r )
1 r (1 r )

1 r

PDV v
1
r

1
PDV v
r
36

Simple Case
In equilibrium P = PDV so
1
P v
r

or
v
r
P

37

General Case
We can generate similar results for the
more general case in which the rental
rate on machines is not constant over
time and in which there is some
depreciation
Suppose that the rental rate for a new
machine at any time s is given by v(s)
The machine depreciates at a rate of d
38

General Case
The net rental rate of the machine will
decline over time
In year s the net rental rate of an old
machine bought in a previous year (t)
would be
v(s)e -d(s-t)

39

General Case
If the firm is considering the purchase of
the machine when it is new in year t, it
should discount all of these net rental
amounts back to that date
The present value of the net rental in
year s discounted back to year t is
e -r(s-t)v(s)e -d(s-t) = e(r+d)tv(s)e -(r+d)s
40

General Case
The present discounted value of a
machine bought in year t is therefore the
sum (integral) of these present values

PDV (t ) e ( r d )t v (s )e ( r d )s ds
t

In equilibrium, the price of the machine at

time t [p(t)] will be equal to this present
value

p(t ) e ( r d )t v (s )e ( r d )s ds
t

41

General Case
Rewriting, we get

p(t ) e ( r d )t v (s )e ( r d )s ds
t

Differentiating with respect to t yields:

dp(t )
(r d )e ( r d )t v (s )e ( r d )s ds e ( r d )t v (t )e ( r d )t
dt
t
dp(t )
(r d )p(t ) v (t )
dt

42

General Case
This means that
dp(t )
v (t ) (r d )p(t )
dt

dp(t)/dt represents the capital gains that

accrue to the owner of the machine

43

Cutting Down a Tree

Consider the case of a forester who
must decide when to cut down a tree
Suppose that the value of the tree at
any time t is given by f(t) [where f(t)>0
and f(t)<0] and that l dollars were
invested initially as payments to
workers who planted the tree
44

Cutting Down a Tree

When the tree is planted, the present
discounted value of the owners profits is
PDV(t) = e-rtf(t) - l

The foresters decision consists of

choosing the harvest date, t, to
maximize this value
dPDV (t )
rt
rt
e f ' (t ) re f (t ) 0
dt
45

Cutting Down a Tree

Dividing both sides by e-rt,
f(t) r f(t)=0

Therefore,
f ' (t )
r
f (t )

Note that l drops out (sunk cost)

The tree should be harvested when r is
equal to the proportional growth rate of
the tree
46

Cutting Down a Tree

Suppose that trees grow according to the
equation
f ( t ) e 0 .4

f ' ( t ) 0 .2

f (t )
t

If r = 0.04, then t* = 25
If r rises to 0.05, then t* falls to 16
47

Optimal Resource
Allocation Over Time
Two variables are of primary interest for
the problem of allocating resources
over time
the stock being allocated (k)
the capital stock

a control variable (c) being used affect

increases or decreases in k
the savings rate or total net investment
48

Optimal Resource
Allocation Over Time
Choices of k and c will yield benefits
over time to the economic agents
involved
these will be denoted U(k,c,t)

The agents goal is to maximize

T

U (k, c, t )dt
0

where T is the decision time period

49

Optimal Resource
Allocation Over Time
There are two types of constraints in this
problem
the rules by which k changes over time

dk
k f ( k , c, t )
dt
initial and terminal values for k
k(0) = k0
k(T) = kT

50

Optimal Resource
Allocation Over Time
To find a solution, we will convert this
dynamic problem into a single-period
problem and then show how the solution
for any arbitrary point in time solves the
dynamic problem as well
we will introduce a Lagrangian multiplier (t)
the marginal change in future benefits brought
about by a one-unit change in k
the marginal value of k at the current time t
51

A Mathematical Development
The total value of the stock of k at any
time t is given by (t)k
The rate of change in this variable is

d(t )k
dk
d

K
k k
dt
dt
dt

The total net value of utility at any time

is given by

H U (k , c, t ) k k

52

A Mathematical Development
The first-order condition for choosing c
to maximize H is

H U (k, c, t )
k

0
c
c
c

Rewriting, we get

U
k

0
c
c
53

A Mathematical Development
For c to be optimally chosen:
the marginal increase in U from increasing
c is exactly balanced by any effect such an
increase has on decreasing the change in
the stock of k

54

A Mathematical Development
Now we want to see how the marginal
valuation of k changes over time
need to ask what level of k would maximize
H

Differentiating H with respect to k:

H U (k , c, t )
k

0
k
k
k
55

A Mathematical Development
Rewriting, we get

U
k

k
k

Any decline in the marginal valuation of k

must equal the net productivity of k in

either increasing U or increasing k

56

A Mathematical Development
Bringing together the two optimal
conditions, we have

H U
k

0
c
c
c

H U
k

0
k
k
k

These show how c and should evolve

over time to keep k on its optimal path
57

Exhaustible Resources
Suppose the inverse demand function
for a resource is
p = p(c)

where p is the market price and c is the

total quantity consumed during a period
The total utility from consumption is
c

U (c ) p( x )dx
0

58

Exhaustible Resources
If the rate of time preference is r, the
optimal pattern of resource usage will
be the one that maximizes
T

rt
e
U (c )dt
0

59

Exhaustible Resources
The constraints in this problem are of
two types:
the stock is reduced each period by the
level of consumption

k c
end point constraints
k(0) = k0
k(T) = kT

60

Exhaustible Resources
Setting up the Hamiltonian

H e rt (U ) k k e rt (U ) c k

yields these first-order conditions for a

maximum
H
rt U
e
0
c
c
H
0
k

61

Exhaustible Resources
Since U/c = p(c),
e-rtp(c) =

The path for c should be chosen so that

the market price rises at the rate r per
period

62

Important Points to Note:

Capital accumulation represents the
sacrifice of present for future
consumption
the rate of return measures the terms at
which this trade can be accomplished

63

Important Points to Note:

The rate of return is established
through mechanisms much like those
that establish any equilibrium price
the equilibrium rate of return will be
positive, reflecting both individuals
relative preferences for present over
future goods and the positive physical
productivity of capital accumulation
64

Important Points to Note:

The rate of return (or real interest
rate) is an important element in the
overall costs associated with capital
ownership
it is an important determinant of the
market rental rate on capital (v)

65

Important Points to Note:

Future returns on capital investments
must be discounted at the prevailing
real interest rate
use of present value provides an
alternative way to study a firms
investment decisions

66

Important Points to Note:

Capital accumulation (and other
dynamic problems) can be studied
using the techniques of optimal
control theory
these models often yield competitivetype results

67