Page info: *Author: Mathiesen,

H. *Document version: 2.2.

*Copyright 1997-2015,
ViamInvest. Legal notice.

Model: Perfect capital market - Fisher separation theorem

1

Introduction

This text presents the perfect capital market model and the associated Fisher separation theorem.
This model demonstrates that utility maximizing and perfectly rational owners will agree on
forcing the managers of the firms they own to pursue the profit-maximizing strategy. This is so
for diverse time-preferences among the owners as long as capital markets are perfect.

The Model

Model assumptions:
1) Capital markets are perfect
Agents are perfectly rational and they pursue utility maximization.
There are no direct transaction costs, regulation or taxes, and all assets are perfectly
divisible.
Perfect competition in product and securities markets.
All agents receive information simultaneously and it is costless. The information is either
certain or risky.
2) An arbitrary number of agents are endowed with some initial resources (N0=7 mill. $) of a
good (C0). This good may either be consumed today (P0) or be invested today (I0) and
transformed into consumption tomorrow (P1).
3) The agents in the economy may choose to buy stocks in a firm that has four investment
projects at its disposal. The outlays and returns on these projects are displayed in figure I
below. A manager is hired by the agents to run the firm. From the numbers, it is clear that
there is a decreasing return to scale on investments. In other words, the marginal rate of return
falls as investments rise.
4) The agents have different but monotonous preferences, and they exhibit decreasing marginal
utility.

Notation:
N0 is the aggregated initial resources held by all agents.
rm is the market-determined interest.
C0 is todays consumption or investment good.

C1 is tomorrows consumption good. C1 = W*1 - (1+ rm)C0 is the capital market line.
P*0 is the efficient consumption today by all agents.
P*1 is the efficient production = consumption tomorrow by all agents.
W*0 is the present value of efficient production and consumption: W*0 = P*0 + P*1/(1+rm).
W*1 is future value of efficient production and consumption: W*1 = W*0(1+rm).

Model illustrated

Analysis
Efficiency requires MRS = -(1+rm) = MRT. In words, the marginal rate of substitution must equal
the marginal rate of transformation between consumption today and tomorrow. In the above

figure this is illustrated by the simultaneous tangency of the capital market line to the production
possibility curve and the agents time preferences of consumption. As may be observed the
agents will maximize their utility when they invest a total of 4 million $ of their initial
endowment (7 mill. $) in stocks and then order the manager to maximize profit. The manager
does that by undertaking project D and B and produce at point B. The manager cannot pursue his
own interest because the agents have full information about the projects and thereby about the
profit maximizing strategy. In other words there are no agency problems in this world. Very
importantly, the production at point B is strongly efficient because it maximizes the agents total
life income.
The figure shows a situation with two agents. Agent I is patient and prefers to consume
tomorrow, and agent II is impatient and prefers to consume today. Imagine that agent I is the only
capital owner in the economy. His initial endowment is $7 million, and he owns the entire firm.
If a perfect capital market existed, he would maximize his utility by ordering his manager to
maximize profit and produce at point B. However, he would be able to consume at point E1 by
lending money in the capital market. Without capital markets his utility- and profit maximizing
decision would implyproduction and consumption at point X and his welfare would be reduced.
Now, replace agent I with agent II. If perfect capital market existed he would consume at point
E2 by borrowing, but as agent I he would also instruct his manager to produce at point B.
Without capital markets he would consume and produce at point Z. The above results would still
hold for many agents and dispersed ownership. Imagine an economy with 100 firms each with
the same production opportunity curve as the firm above. Furthermore, imagine 100 agents each
with 7 mill. $ in initial endowment but with different time preferences. As long as perfect capital
market existed these agents would be indifferent to having their own firm or having say 1/100 of
each firm. The reason is, that they would agree to order the manager to produce at point B,
because this would maximize the value of their ownership stakes. Now, theFisher separation
theorem can be stated:
Fisher separation theorem: Given perfect and complete capital markets, the production
decision (P0, P1) is governed solely by the profit-maximization objective (max. present value of
production, P0, P1), and the decision is separated from the consumption decision that is governed
solely by utility-maximization (max. utility of consumption, C0, C1).
This theorem is also known as the unanimity principle because it unites the shareholders
in agreeing on the profit maximization strategy. The theorem is part of the general microeconomic theory that demonstrates the welfare gains from specialization and trade. In this model,
the gain only comes from trade on differences in preferences. Alternatively, we could
demonstrate the gain from specialization by assuming different investment opportunities but
identical preferences.

A caveat
Unfortunately, the above model is not a general equilibrium model. It is a short run model. To
see why, consider the following. Note that the average rate of return on capital would always be
equal to or higher than the marginal rate of return when the latter is decreasing. Furthermore, the

optimal marginal rate of return is equal to or higher than the market determined interest rate. The
model does not say much about the cost of capital. However, the four projects cost of capital
have to be the same because the agents in this model only focus on return, not on risks. Besides,
the agents determine the optimal production by ordering projects initiated that have a higher
return than the market interest rate. This imply that the project cost of capital must be equal to
the market rate. So, the cost of capital is less than the average return of capital, and firms will
earn excess profits. This is not sustainable in the long run. In a general long run equilibrium
model, the cost of capital have to equal the return of capital.
- Copyright 1997-2015, ViamInvest. Reproduced with permission of the copyright owner. Further reproduction
prohibited without permission. Legal notice.