This paper presents a model to predict optimum vegetation characteristics in water stressed conditions. Starting point is the principle of homeostasis of water flow through the soil-vegetation-atmosphere continuum. Combining this with a biochemical model for photosynthesis, a relationship between photosynthetic capacity, stomatal regulation, and hydraulic properties of the vegetation is derived. Optimum photosynthetic capacity and internal carbon dioxide concentration are calculated using the assumption that growth is maximized. This optimality hypothesis is applied for three scenarios which are increasingly realistic. Optimum parameters reflect a strategy to deal with two tradeoffs: the trade-off between fast growth and avoidance of drought and between a high photosynthetic capacity and avoidance of high respiration losses. The theory predicts general boundary conditions for growth but does not consider effects of competition between species, fires, pest, and diseases or other limitations that occur locally. In a companion paper the theory is evaluated using a data set collected in sub-Mediterranean vegetation. Copyright 2008 by the American Geophysical Union.