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Behavioral Economics (Econ 3580)

Section - Practice Problems TA: Mario Ramrez Friday, October 14, 2011

1.1

Intertemporal Choice

Suzanne faces a two-period intertemporal choice problem. Consumptions in the rst period and second period are c1 and c2 respectively. Her utility function is given by: U (c1 ; c2 ) = ln(c1 ) + ln(c2 ), where 0 < < 1 is the time discount factor. The corresponding income for each period are m1 and m2 . Let r be the interest rate. 1. Write down her present value budget constraint. 2. Solve her utility maximization problem subject to the budget constraint in part (1).
4 3. Assume the following: m1 = m2 = 100; = 5 and r = 0:05. What are the optimal consumption levels in each period? Does Suzanne borrow or lend in the rst period? 4 4. Still assume that m1 = m2 = 100 and = 5 . For what interest rate does Suzanne decide to simply consume the income in each period? Interpret this result in terms of the roles of and r.

5. This part is harder, but the conditions are more realistic. Above we have assumed that the same interest rate applies both for borrowing and saving. However, in real life, usually the savings rate is lower than the borrowing rate. Assume that the savings rate is rs = 0:05 while the borrowing rate is rb = 0:20 (most credit cards charge this rate!). First, draw the new budget constraint. [Hint: the endowment point is invariant to the interest rate.] Then, for which values of will Suzanne choose to save? For which values of will she choose to borrow? [Hint: for the saving case use r = 0:05 and for the borrowing case use r = 0:20 when solving the optimality conditions.] Given these results, what s the eect of on the shape of the indierence curve?

1.2

( ; ) preferences
T t X s=1

Fibonacci Cinema: Consider a ( ; ) agent. His utility at time t is Ut (ut ; ut+1 ; :::; uT ) = ut + Assume for simplicity that =
1 2

ut+s

and

= 1:

This agent can watch 3 movies over the next 4 weeks. He has to spend one week without watching a movie, not seeing a movie gives him 0 utils. week 1: mediocre movie = 3 utils week 2: good movie = 5 utils week 3: great movie = 8 utils week 4: excellent movie = 13 utils 1. What movie will a sophisticate miss? Solve the game played by the dierent selves by backward induction.

2. What movie will a naif skip? He is unaware of the changes in his preferences, he thinks the future selves will do what the present self thinks they should do. 3. Suppose an economist who thinks = 1 wants to estimate from the naif behavior. Find an upper s bound for , i.e. nd a condition on such that an exponential discounting agent chooses to miss the same movie as the naif agent. Assume now that the agent can go to only one movie during those 4 weeks. 4. What movie will a sophisticate see? 5. What movie will a naif see?

Reference: MIT OpenCourseWare, 14.13 Economics and Psychology, Spring 04, Assignment #5