Workshop 2 Questions

We consider that the utility of lifetime consumption for agent i is given by Ui (C0 , C1 ) = U (C0 ) +
ρi U (C1 ), where ρi ∈ [0, 1] denotes the agent’s discount factor which measures the agent’s impatience.

Exercise 1 (from Lecture slides)

Agent 1 lives for two periods indexed by t = {0, 1} and earns income y0 = £4 and y1 = £6
in periods 1 and 2, respectively. The agent consumes Ct in period t and consumption
preferences are represented by the utility function U (Ct ) = ln Ct . The agent does not
discount utility from consumption in period 2 (i.e. ρ = 1). The real interest rate is
r = 0.25 and the Production Possibilities Schedule is given by C02 + C12 − 52 ≤ 0.

1. Compute the agent’s lifetime utility in the absence of investment possibilities and
a Capital Market.

2. In the presence of a Capital Market and ignoring the available investment possibil-
ities:

(a) Compute the present value and future value of the agent’s lifetime endowed
wealth.
(b) Compute the consumption allocation that maximises the agent’s lifetime utility
from consumption and the associated lifetime utility. Use a diagram to illustrate
your answer.
(c) Determine whether the individual is a borrower or a lender and compute the
amount that has been borrowed/lent at t = 0 and the amount that has to be
paid/received in period t = 1.

3. In the presence of investment possibilities but without a Capital Market, compute

the optimal consumption allocation and the associated lifetime utility. Illustrate
your answer on the previous graph.

4. In the presence of investment possibilities and a Capital Market, determine the

agent’s optimal consumption and production allocations and the associated lifetime
utility.

5. Consider agent 2 who faces the same investment opportunities, has the same endow-
ment and preferences as agent 1. Agent 2 is more impatient than agent 1 as he/she
discounts utility from consumption in period 2 by a a factor ρ = 0.5. Determine
agent 2’s optimal consumption allocation and production allocation in the presence
of investment possibilities and a Capital Market. How he/she compares to agent 1?

Exercise 2
Suppose that Agent 1 earns income y0 = £5 and y1 = £4 in periods 1 and 2, respectively.
The
√ agent’s consumption preferences are represented by the utility function U (Ct ) =
Ct and he/she discounts utility from consumption in period 2 by a factor ρ = 0.5.
The real interest rate is r = 0.15 and the Production Possibilities Schedule is given by
C02 /2 + C12 − 28.5 ≤ 0.
Redo all questions of Exercise 1 apart from Question 5.

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Exercise 3
Redo all questions of Exercise 1 apart from Question 5 for the following information:
y0 = £10 and y1 = £12, U (Ct ) = ln Ct where ρ = 0.8, r = 0.1 and C02 + C12 /3 − 148 ≤ 0.

Exercise 4
Redo all questions of Exercise√ 1 apart from Question 5 for the following information:
y0 = £4 and y1 = £8, U (Ct ) = Ct /2 where ρ = 0.8, r = 0.1 and C0 + C12 − 80 ≤ 0.
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