Optimization over time

1. Optimization over time A tricky question,Today versus tomorrow.Use present value.

2. Money today ≠ Money tomorrow • Partly because of inflation, a general increase in prices over time. • But also because of preferences for sooner rather than later. • In this lecture, assume no inflation.

3. Banks and interest rates • Assume that banks or other financial institutions are available to trade money today for money tomorrow at interest rate r through loans and savings accounts. • This assumption is key because it allows us to push money back and forth over time. (Money is no longer like an ice cream cone that you have to eat right away.)

4. Future value • Put $100 in the bank at 5% interest and in one year you’ll have $100(1.05) = $105, in two years you’ll have $100(1.05)2 = $110.25, and in n years you’ll have $100(1.05)n. • The future value of $x invested in the bank for n years at interest rate r is FV=x(1+r)n. • Example: The FV of $100 in 14 years at 5% interest is 100(1+0.05)14 = $197.99. • Rule of 70/72: money doubles in ≈72/5 years.

5. Present value of a lump sum • The present value of receiving a lump sum payment of $x at the end of n years at interest rate r (e.g., r = 0.05 for 5%) is: • More generally, present value tells us how much we need to put in the bank today to finance one or more payments in the future.

6. Present value of a lump sum • Example: The present value of receiving $200 at the end of 14 years with r = 0.05 is: • The rule of 70/72 says that money in the bank at r % interest doubles in ≈ 70/r or 72/r years. • Equivalently, every ≈ 70/r or 72/r years you go into the future cuts your present value in half.

7. Present value of an annuity • An annuity is a constant payment every year (or every month, etc.) for a fixed number of years, e.g., a home mortgage or lottery payout. • To calculate the present value of a stream of payments you can always just break it into a series of lump sum payments… but sometimes (as with annuities) there’s an easier way.

8. Present value of an annuity • The present value of an annuity paying $x at the end of each year for n years at interest rate r (e.g., r = 0.05 for 5%) is: • Example: $100 at the end of each year for 3 years has a present value of $272.32 if r = .05.

9. Present value of an annuity • Example: $100 at the end of each year for 3 years has a present value of $272.32 if r = 0.05. • Put $272.32 in the bank today at 5% interest. • After year 1 you’ll have (1.05)(272.32)=$285.94. • After taking out 1st $100 you’ll have $185.94. • After year 2 you’ll have (1.05)(185.94)=$195.24. • After taking out 2nd $100 you’ll have $95.24. • After year 3 you’ll have (1.05)(95.24)=$100.00. • After taking out 3rd $100 you’ll have $0 left.

10. Present value of an annuity • The present value of an annuity paying $x at the end of each year for n years at interest rate r (e.g., r = 0.05 for 5%) is: • Put this amount in the bank today at interest rate r and then make annual payments of $x and you’ll have a zero balance after n years.

11. Present value of an annuity • Proof: For an annuity paying $x at the end of each year for n years at interest rate r we want • Multiply both sides by (1+r): • Now rewrite, putting the 2nd equation first:

12. Present value of an annuity • Subtract; note that almost all terms cancel!

13. Present value of a perpetuity • A perpetuity is a perpetual annuity, i.e., a constant payment every year (or every month, etc.) forever. • The present value of a perpetuity paying $x at the end of each year forever at interest rate r (e.g., r = 0.05 for 5%) is: • Example: A $100 perpetuity at 5% interest has a present value of 100/0.05 = $2000.

14. Present value of a perpetuity • Proof #1: Similar to annuity proof:

15. Present value of a perpetuity • Proof #2: Take the limit of the annuity formula as the number of years n goes to infinity: • Proof #3 (and intuition!): Living off the interest: Put $2000 in the bank at 5% interest and you can take out $100 every year forever!

16. Present value of a perpetuity • Example: $100 at the end of each year forever has a present value of $2000 if r = 0.05. • Put $2000 in the bank today at 5% interest. • After year 1 you’ll have (2000)(1.05) = $2100. • “Live off the interest” by taking out $100, leaving you with $2000. • Rinse and repeat.

17. Present value of a perpetuity • Example: $100 at the end of each year forever has a present value of $2000 if r = 0.05. • Q: Is PV > $2000 or < $2000 if r = 0.10 instead? • A: PV =$1000, which is < $2000. Intuition? • Intuition: You have to put less in the bank today in order to finance future payments. • In general, higher interest rates make the future less important.

18. Annuity versus perpetuity • Example: $100 at the end of each year forever has a present value of $2000 if r = 0.05. • Q: What is PV of $100 annuity for 100 years? • A: Use annuity formula to get PV = $1984.79. • Difference is $15.21. (Not much!) Intuition? • Q: Put $15.21 in the bank at 5% interest for 100 years and what do you get? • A: Use FV formula to get FV ≈ $2000. (!)

19. Capital theory: Trees are capital

20. Capital theory: Fish are capital • Maximizing present value of catch is not the same thing as maximum sustainable yield!

21. Capital theory: Oil is capital • Q: Since oil doesn’t grow like fish or trees, why would resource owners hold on to it instead of selling it and putting the proceeds in the bank? (Same question for minerals/stock/etc.) • A: The price is expected to go up (or the costs of extraction are expected to go down). • So (returning to the Big Question) optimizing individuals and companies have strong incentives to think hard about Peak Oil.