Time, uncertainty, and liquidity
Financial economics deals with the allocation of resources over time and in the face of uncertainty. Although we use terms like [present values,] [states of nature,] and [contingent commodities] to analyze resource allocation in these settings, the basic ideas are identical to those used in the analysis of consumer and producer behavior in ordinary microeconomic theory. In this chapter we review familiar concepts such as preferences, budget constraints, and production technologies in a new setting, where we use them to study the intertemporal allocation of resources and the allocation of risk. We use simple examples to explain these ideas and later show how the ideas can be extended and generalized.
We begin with the allocation of resources over time. Although we introduce some new terminology, the key concepts are the same as concepts familiar from the study of efficient allocation in a [timeless] environment. We assume that time is divided into two periods, which we can think of as representing the [present] and the [future.] We call these periods dates and index them by t = 0, 1, where date 0 is the present and date 1 is the future.
Suppose a consumer has an income stream consisting of Y0 units of a homogeneous consumption good at date 0 and Y1 units of the consumption good at date 1. The consumer's utility U(C0, C1) is a function of his consumption stream (C0, C1), where C0 is consumption at date 0 and C1 is consumption at date 1. The consumer wants to maximize his utility but first has to decide which consumption streams (C0, C1) belong to his budget set, that is, which streams are feasible for him. There are several ways of looking at this question. They all lead to the same answer, but it is worth considering each one in turn.