Chapter 2 • A framework for financial decision making
Figure 2.4
The borrowing/
lending opportunity
available to an
individual with
an amount of
wealth (W 0 )
This amount could be lent at an interest rate r so that it would grow to W 0 + rW 0 after
one time period. Alternatively, an amount W 0 borrowed at an interest rate rwould lead
to W 0 + rW 0 being owed after one time period.investor as it gives the highest level of utility. No other point along the production
curve will enable this person to achieve as high a level of satisfaction as will the invest-
ment/consumption decision implied by point P. Therefore the amount invested
should be BW 0 (which will yield 0A after a year), and 0B should be consumed now,
giving 0A to consume next year. Suppose that our individual in fact only invests to
point Z, which is a feasible possibility. Whilst this would give some consumption, both
now and next year, it does not give what this person would regard as the most satis-
fying combination of present and future consumption. We know this because Z coin-
cides with a lower utility curve. Given our individual’s preferences (represented by
the shape of the utility curve) and the state of the world as far as investment is con-
cerned (represented by the investment line W 0 W 1 ), P is clearly the most satisfying level
of investment for our individual.
This is not necessarily the same as would be chosen by other individuals because
they are unlikely to have the same views on the trade-off between present and future
consumption. So there would be no unanimityas to the desirable level of investment –
it would vary from person to person.The borrowing/lending opportunity
At this point let us introduce a further factor into the analysis and so make it more
realistic. That factor is the opportunity available to individuals for borrowing and
lending through banks and other financial institutions (the financial market).
Figure 2.4 shows another possibility, which could be used alone or in conjunction
with the production opportunities. If the investor were to lend all of the wealth (W 0 )