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Need help maximizing a utility function over two periods

 
 
Reply Sun 30 Sep, 2012 07:21 pm
My current professor is rather brilliant but skips a bit on the actual teaching portion of his class. Most of the students in the class are confused as to how to answer his problems. Essentially, I need some help with a problem and a short and concise explanation of how it works so that I can essentially share my findings with the 5 other confused people in my study group.

Here goes...

1. Consider a model in which an individual lives two periods: this period (time one) and next period (time two). This period his budget constraint requires that his consumption, c1; plus his saving, s; equals his income, y1:

c1 + s = y1:

Next period his budget constraint requires that his consumption, c2; equals his income, y2; plus the value of his saving from the initial period:

c2 = y2 + (1 + r)s

where r is a known interest rate.

The individual's problem is to maximize is

U(c1) + βU(c2)

by choices of c1; c2; and s subject to his budget constraints. What are his optimal choices ofconsumption (in both periods) and saving when
U(c) = -1/2c^2
y1 = 1000
y2 = 200
r = 0:03;
and β = 0.97?

NOTE: For this utility function, MU(c)= 1/c^3
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markr
 
  1  
Reply Mon 1 Oct, 2012 07:48 pm
@TomSawyer246,
Seems to me that you have a function of one variable (s) that you need to maximize. Everything is constrained such that your choice of s determines c1 and c2.
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raprap
 
  1  
Reply Mon 1 Oct, 2012 08:26 pm
@TomSawyer246,
Putting the functions in terms of c1 & c2

c1=y1-s & c2=y2+(1+r)s

So

T(s,B,y1,y2,r)=U(c1)+B*U(c2)

Where U(c)=-1/2c^2

Note I'm assuming the function U(c) is -c^2/2, not -1/(2c^2)

Substituting

T(s,B,y1,y2,r)=-1/2(y1-s)^2+B(-1/2(y1+(1+r)s)^2=-1/2((y1-s)^2+(y2+(1+r)s)^2)

now as y1,y2,B & r are all specified then the only variable is s so

T(s,B,y1,y2,r)=G(s) and

G(s)=)=-1/2((y1-s)^2+(y2+(1+r)s)^2)=-1/2((y1^2-2y1s+s^2)+y2^2+2(y2(1+r)s+s^2)

Combining terms

G(s)=-1/2((y1^2+y2^2-2(y1-y2(1+r))s+2s^2)

now y1^2+y2^2 is a constant (k1), (y1-y2(1+r) is a constant (k2)

so

G(s)=-1/2(k1-2k2s+2s^2)

differentiate G(s) with respect to s and set the differential equal to zero to find the maximum or minimum

dG(s)/ds=0=-1/2(k1-2k2+4s)

and solve for s

k1-2k2+4s=0

s=(2k2-k1)/4

to determine if the function is a maximum differentiate a second time and see if it is negative

dG^2(s)/ds^2=-4/2=-2 which is negative so that is a maximum

Rap








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