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through permeable sands is very wide, so that one well could ultimately drain a very
large reservoir. If time meaning the value of money were no object, that would
indeed be the best because it would be the cheapest way...If time were no object,
with zero rate of return or cost of capital, one well would drain a whole reservoir at
lowest cost.
The prices of scarce factors indicate that employing units of them in any
particular line of production has an opportunity cost. Prices of factors and
products force each business firm to consider whether additional factor units
would add not merely something to its output but also enough to the value of
its output to warrant the necessary sacrifice of valuable output elsewhere. Prices
enable the firm in effect to compare consumers evaluations of the additional
output it could offer and the cost as measured by consumers evaluations of
other goods forgone.
For example, constructing apartment buildings that will serve with little
maintenance for many years is a more waiting-intensive method of providing
housing services than constructing buildings with shorter lives or requiring
more current maintenance. Even though the more durable buildings require
more labor and other inputs in the first place, their services over their entire
lives will be greater in relation to inputs of these other factors. This does not
mean that constructing the more durable buildings is unequivocally advanta-
geous, for the longer average interval between inputs of resources and outputs
of services, as well as the fact that the economies in maintenance accrue not all
at once but only over time, imply an opportunity cost. That cost pertains to
other projects and products ruled out because the scarce capacity to wait has
been devoted to the durable apartments. The interest rate brings this cost to the
attention of business firms.
Prices also bring to the attention of consumers the opportunity costs of the
waiting (and other factors) embodied in the goods and services from which
they have to choose. It leads them to consult their preferences in the light of the
terms of choice posed in part by objective reality. It is perhaps an additional rec-
ommendation of the concept of waiting that without it Fisher (1930 [1955],
pp. 4857, 53441) denied that interest measures any genuine cost.8
We have one clarification. Waiting cannot be rationed by the interest rate
alone. For example, because of uncertainty about whether borrowers will repay,
lenders must practice nonprice rationing to some extent. They cannot grant
loans in whatever amount requested to all borrowers promising to pay the going
rate of interest.
Figure 10.1 portrays a pure exchange economy, that is, one with no production.9
The vertical axis measures future consumption and the horizontal current or
present consumption. Given an initial endowment at point A, line MN is the
individuals budget or wealth constraint. Its slope equals (1 + r) where r is the
given market rate of interest at which he can borrow or lend. We assume perfect
and complete capital markets, so that the rate for borrowing is the same as the
Interest rate theory 277
Future M
consumption
FB B
A
FA U2
U1
N
CB CA Current or present
consumption
Future
consumption
FB B
FA A
U2
U1
P
CB CA Current or present
consumption
Future M
consumption
FB
B
D
FD
FA
A
U1
P N
CB CD CA Current or present
consumption
The above analysis implies that the individuals decision process occurs in
two separate and distinct stages. First, he invests in order to reach the highest
attainable budget constraint MN. Second, through intertemporal exchange he
moves from point B on MN to point D, which is the optimal pattern of con-
sumption. Note that point D lies beyond the curve of production possibilities
(Humphrey, 1988, p. 5). This separation of the investment and consumption
decisions into two stages is what Hirshleifer calls Fishers separation theorem.
The first stage is governed solely by the objective criterion of maximizing
wealth (reaching the highest budget constraint), while the second stage is
governed by the individuals subjective time preferences concerning con-
sumption. This result implies that investment decisions can be delegated to the
firm, whose goal is to maximize wealth, without regard for the subjective time
preferences of its owners (Copeland and Weston, 1988, p. 12).
We emphasize that it is a mistake conceptually to identify the interest rate
with the marginal rate of time preference or the marginal rate of return on
investment. These various rates are mutually adjusting and only tend to become
equal. It is a serious error to identify magnitudes whose equality at the margin