Problem Set 2

Due date: June 5 (Monday) midnight. 70 points total.

Problem 1. True for False (3 points each)

(1) In the —, ” model, naive people always choose to take an action strictly later than
sophisticated people. (T / F)

(2) Negative interest rates mean that the present value of something is alway less than its
future value. (T / F)

(3) The EDU model cannot describe the choices of a person who only cares about imme-
diate consumption. (T / F)

(4) People who are fully sophisticated never think their future selves are naive. (T / F)

(5) Someone who is time-inconsistent must be using quasi-hyperbolic discounting. (T / F)

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Problem 2. Consider a two-period model of intertemporal choice. Bob has wealth $10 at
the beginning and will receive $11 in earnings at the end of the first year. Bob can either
borrow or save at 10% interest per year. Bob’s utility over consumption c1 in the first year
and consumption c2 in the second year is given by

Ô Ô
U (c1 , c2 ) = c1 + ” c2

where ” œ [0, 1] is his discount rate. All consumptions occur at the beginning of the year.

(1) What is Bob’s budget constraint? (5 points)

(2) Solve for the optimal c1 and c2 as functions of the discount rate ”. (10 points)

(3) As ” increases, how does c1 and c2 change? Provide some economic intuition. (5 points)

(4) For what values of ” will Bob save? For what values of ” will he borrow? Provide some
economic intuition. (5 points)

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Problem 3. Consider the example of cleaning your dorm except now there are BOTH
rewards and costs. Suppose you have —, ” preferences with — = 0.7 and ” = 1. You have to
clean your room at some point over the next five days. Depending on which day you clean
your dorm, your reward will be vt and your cost will be ct , where

(c1 , c2 , c3 , c4 , c5 ) = (45, 45, 45, 62, 87)

(v1 , v2 , v3 , v4 , v5 ) = (35, 45, 60, 60, 60)

There are two possible cases for when you receive these payoffs:

• Immediate costs: you incur the cost the day you do it, and receive the reward the next
day.

• Immediate rewards: you receive the reward the day you do it, and incur the cost the
next day.

For instance, if you do the activity on day 4, your cost is c4 = 62 and your reward is v4 = 60.
For immediate costs, the cost of c4 = 62 is incurred on day 4 while the reward v4 = 60 is
received on day 5. For immediate rewards, the reward v4 = 60 is received on day 4 while the
cost c4 = 62 is incurred on day 5.

(1) Consider the case of immediate costs. When do naifs complete the task? When do
sophisticates complete the task? (12 points)

(2) Consider the case of immediate rewards. When do naifs complete the task? When do
sophisticates complete the task? (12 points)

(3) Suppose you are EDU with ” = 1. When is the best time for you to clean your room?
How does your answer depend on whether it is immediate costs or immediate rewards?
Contrast your answer with parts (1) and (2). (6 points)