Mathematics for Economics and Finance (Fall 2020)

Problem Set 14: Static and Dynamic Optimization

Professor: Roxana Mihet
TAs: Oksana, Laura, Remy
Due Dec 18

1 Unconstrained optimization on open set

Show that the function f (x1 , x2 , x3 ) = x21 + x22 + 3x23 − x1 x2 + 2x1 x3 + x2 x3 defined on R3 has only one
stationary point and it is a local minimum.

2 The Langrange Method: Optimization under Equality Constraints

Consider an economy with 100 units of labor. It can produce chocolates x or watches y. To produce x
chocolates, it takes x2 units of labor, likewise y 2 units of labor are needed to produce y units of watches.
Economy has the following objective function F (x, y) = ax + by. Solve for the optimal amounts of x and y.

3 Complements or substitutes?
An agent consumes two goods, x1 and x2 , with prices p1 and p2 ,respectively. Her utility function is of the
form U (x1 , x2 ) = α(xα α
1 + x2 ), with α < 1. Verify that utility function is strictly concave. Derive the demand
function of the agent. In what direction does the demand for good 1 change if there is an increase in the
price of good 2.

4 Kuhn-Tucker Theorem again

An agent consumes two commodities. Her utility function is

u(x1 , x2 ) = x21 + 2x2 ,

where x1 indicates her expenditure on good 1 and x2 here expenditure on good 2. The prices for the
commodities are p1 and p2 respectively, both positive. And the consumer can not spend more than her
income I, also a positive value.

1. Assuming that consumption of either commodities must be non-negative, formulate the utilization
maximization problem of this consumer.

2. Explain carefully why this maximization problem has a solution.

3. Show that all conditions required in Kuhn-Tucker’s Theorem are satisfied.

4. Suppose p1 = 2, p2 = 1, and I = 6. Using Kuhn-Tucker’s Theorem, or otherwise, find the pair (x1 , x2 )
that maximizes the consumer’s utility.

1
5 Dynamic programming: Minimizing quadratic costs
The agent solves
∞
X
β t x2t + vt2


min
{vt }
t=0

s.t. xt+1 = 2xt + vt , x0 is given, 0 < β < 1.

6 Dynamic programming question on Final Exam

Consider an economy where the utility of the representative agent is given by
∞
X
β t u(Ct , Lt ), β ∈ (0, 1),
t=0

where Ct is the consumption and Lt the leisure in period t. Assume that the representative agent has the
following instantaneous utility function

L1−γ
t
u(Ct , Lt ) = ln(Ct ) + θ .
1−γ

Denote output by Yt , capital by Kt , and the number of hours worked by Ht . The production function is
given by:
Yt = AKtα Ht1−α , (1)

where A is a constant productivity parameter. The total available time in each period is normalized to 1.
So, Ht + Lt = 1. The law of motion of capital is

Kt+1 = (1 − δ)Kt + It (2)

where δ ∈ (0, 1) is the depreciation rate and It denotes investment in period t. K0 is given. The resource
constraint in period t is given by Yt = Ct + It . We want to find the optimal paths of the choice variables for
t = 0, 1, ..., ∞.

1. Explain Bellman’s Principle of Optimality.

2. List all choice variables and the required state variables in this problem.

3. Write down the Bellman equation in terms of H and K.

4. Derive the necessary first order conditions and the intertemporal Euler equation expressing the marginal
rate of substitution in terms of Yt+1 and Kt+1 .