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Advanced Microeconomics - Assignment 2

(deadline: Thursday, October 23, 2014 at 09:45 am)


Prof. Andreas Irmen
University of Luxembourg
Fall 2014
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1. Consider an economy consisting of two rational consumers, j = 1, 2,
who have identical preferences. Each consumer j has income denoted by
y
j
. Moreover, there are two goods, i = 1, 2, where the price of each good,
denoted by p
i
, is strictly positive and constant. We know that in this case we
may write the consumers demand functions as x
j
i
(p, y
j
). Moreover, denote
by y = y
1
+ y
2
the aggregate income in the economy.
Under these conditions, is it always possible to write the aggregate demand
for good i as x
i
(p, y)? Either prove a positive answer or provide a counterex-
ample.
2. Consider an investor with initial wealth w > 0 and the following measure
of risk aversion
R
r
(w) w R
a
(w) = w
u

(w)
u

(w)
,
where u is the utility of w. R
r
(w) is called the measure of relative risk aver-
sion. Suppose there are i = 1, . . . , n future states of the world, each of which
will occur with probability p
i
. The rate of return of the risky asset in each
state of the world is r
i
> 1. Let 0 denote the amount of wealth to
be put in the risky asset. There is also a safe asset yielding a rate of return
s > 1 for sure. Moreover, it holds that r
i
< s in at least one state of the
world.
a) Show that an expected utility maximizing investor determines by
solving
max

i=1
p
i
u(w(1 + s) + (r
i
s)), 0 w. (1)
b) Suppose the investor is risk-averse. Show that the expected utility
maximizing investor chooses

> 0 if and only if


n

i=1
p
i
r
i
> s.
Interpret this nding.
c) Suppose that

> 0. Show the following: If R


r
(w) declines as w in-
creases, then the proportion /w, i.e. the fraction of the initial wealth
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invested in risky asset, increases. Compare this result to the portfolio
choice problem discussed in class.
3. Consider a consumer who in period t = 0 has access to a storage of food
of the size S
0
> 0. At each point of time, t = 0, 1, 2, 3, ...., T he/she may
consume some of the stored food and save whatever is left over. Assume that
the food does not go bad over time so that the evolution of the stock of food
is given by
S
t+1
= S
t
c
t
,
where c
t
represents the consumption in period t. Let the ow of utility from
consuming be given by a strictly increasing and strictly concave utility func-
tion, u(c
t
). Moreover, assume that lim
c
t
0
u

(c
t
) = . Hence, lifetime utility
of the consumer may be written as
T

t=0

t
u(c(t)),
where (0, 1) represents the discount factor.
The choice of the consumer is over {c
t
, S
t+1
}
T
t=0
and the utility maximiza-
tion problem may be stated as follows:
max
{c
t
,S
t+1
}
T
t=0
T

t=0

t
u(c
t
)
s.t. c
t
+ S
t+1
=S
t
,
c
t
, S
t
0 t,
S
0
>0 given.
a) Argue the problem may be written as
max
{c
t
,S
t+1
}
T
t=0
T

t=0

t
u(c
t
)
s.t. c
t
+ S
t+1
=S
t
,
S
T+1
0,
S
0
>0 given.
b) Find the Kuhn-Tucker optimality conditions to the problem in a) and
interpret them.
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