Chapter 2 • A framework for financial decision making
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Note, incidentally, that the investment opportunities become less and less attractive
as the amount invested by the individual increases, that is, the line W 0 W 1 becomes less
steep as it rises – meaning that increasing amounts of present wealth will need to be
invested to yield an extra £1 of wealth after one year. An investment XW 0 will yield
wealth of 0Y after one year, but a similar-size investment C 0 X will increase next year’s
wealth by only YC 1.
Line W 0 W 1 does not represent a single investment opportunity but a large number
of them – in fact all of the opportunities available to the investor at the time. The
shaded space between the two sets of unbroken parallel lines in Figure 2.1 represents
just one of that large number of hypothetical investments available. This particular
one involves an investment now (reduction in current consumption) of amount £a,
which will yield (increase future consumption by) £bin a year’s time. Since the line
W 0 W 1 flattens towards the horizontal as it goes from right to left, the better investment
prospects (greater return per £1 invested) lie to the right, the worse ones to the left. The
investment opportunity lying closest to W 0 is the best one, and opportunities decrease
in desirability as the curve moves from right to left. This reflects reality in that
investors, particularly those who invest in real assets, find that as they take on more
and more investments the yield from each subsequent one becomes less. This is
because they will tend to undertake the most advantageous investments first, leaving
the less desirable ones.Investment and utility
The investor whose wealth and investment opportunities are shown in Figure 2.1 will
want to know how much to invest, but will probably not want to invest all of the pre-
sent wealth because this leaves nothing with which to buy food, shelter or indeed any
luxuries that may be desired. On the other hand, it would be an unusual person who
decided to spend all of the money now and face starvation next year. How much
would be invested and how much would be spent, which is clearly a question of per-
sonal taste, could be represented by the utilitycurves shown in Figure 2.2. These
curves depict this individual’s attitude to the trade-off between consumption now and
consumption after one year.
Each point on any particular curve represents some combination of present and
future consumption that will render this individual similar amounts of satisfaction or
utility: the higher the curve, the greater the satisfaction. (Readers who are unfamiliar
with the notion of utility and utility curves should refer to page 166.)
The curves in Figure 2.2 indicate that the investor is very reluctant to forgo con-
sumption completely, either now or next year. The fact that the curves are moving
towards the vertical at the top left and towards the horizontal at the bottom right
shows this. For example, at the lower levels of present consumption (that is, reduction
in present wealth, where the curves are steepest), any further lowering of consump-
tion will only be undertaken if large increases in future consumption will follow. This
tendency increases as the level of present consumption is reduced, until we reach a
point where no amount of future consumption would justify further reductions in pre-
sent consumption. The converse applies at low levels of future consumption. The
curves depicted in Figure 2.2 do, of course, represent the present/future consumption
preferences of an individual. Other individuals might well have different attitudes. It
is not likely, though, that their attitudes would be fundamentally different since they
too would need to eat, both now and next year. The consumption/investment utility