G.

Optimal Portfolio Decisions 85

for Qs , the number of pure securities we buy for each state s. Note that there is no explicit
discounting of future utility, but any such discounting could be absorbed in the functional form for
U(Qs ). In addition, the ps's include an implicit market discount rate. There is no need to take an
expectation over u(C),our utility of current consumption, since there is no uncertainty concerning
the present.
There are two ways to maximize expected utility subject to a wealth constraint. We could solve
(4.2) for one of the Qs's, say Q1. and then eliminate this variable from (4.1). Sometimes this is
the easiest way, but more often it is easier to use the Lagrange multiplier method (see Appen-
dix D at the end of the book):

L = u(C)+ Eir 31/( Q3 )-x psQ 5+$1C — %), (4.3)

where A is called a Lagrange multiplier. The Lagrange multiplier A is a measure of how much
our utility would increase if our initial wealth were increased by $1 (i.e., the shadow price for
relaxing the constraint). To obtain the investor's optimal choice of C and Qs's, we take the partial
derivatives with respect to each of these variables and set them equal to zero. Taking the partial
derivative with respect to C yields

=u (C)— $1A = 0, (4.4)

ac
where the prime denotes partial differentiation with respect to the argument of the function. Next,
we take partial derivatives with respect to Q1, Q2, and so on. For each Q,, we will pick up one
term from the expected utility and one from the wealth constraint (all other terms vanish):

8L
— =n 1U1(Q,) — Xpr =0, (4.5)
aQ

where ri r(Q t ) = expected marginal utility of an investment Qt in pure security s. We also take
the partial derivative with respect to A.:

aL = p5(2, + Sic — w o)=0. (4.6)

This just gives us back the wealth constraint. These first -order conditions allow us to determine
the individual's optimal consumption/investment choices.11
As an example, consider an investor with a logarithmic utility function of wealth and initial
wealth of $10,000. Assume a two -state world where the pure security prices are .4 and .6 and the
state probabilities are and 4, respectively. The Lagrangian function is

1 2
L =ln C + —3 111 Qi + —3ln Q2 A(.4 Q1+ .6Q2 C - 10,000),

and the first -order conditions are

II We are also assuming that the second -order conditions for a maximum hold.
86 Chapter 4: State Preference Theory

ac, , n which implies C

1
(a)
ac= —""=v,
ac Q—1
n 1
which implies (b)
3 't= 1.2A'
aL 2 ri
which implies V2 = (c)
a Q1 = 3Q2
aL
—ax=10,000—c— AQ, — .6Q, (d)

Substituting Eqs. (a), (b). and (c) into (d) yields

1 .4 .6
- + — + — = 10,000, (d')
A. 1.2A .9A

and multiplying by A yields

1 2 1
1 + - + = 10,000A, which yields = (d")
3 3 5,000

Now, substituting this value of A back into Eqs. (a), (b), and (c) yields the optimal consumption and
investment choices, C = $5,000, Q1= 4,166.7, and Q2 = 5,555.5. Substituting these quantities
back into the wealth constraint verifies that this is indeed a feasible solution. The investor in this
problem divides his or her wealth equally between current and future consumption, which is what
we should expect since the risk -free interest rate is zero—that is, E = 1= 1/ (1 + r)—ad there
is no time preference for consumption in this logarithmic utility function. However, the investor
does buy more of the state 2 pure security since the expected rate of return on the state 2 pure
security is greater. Because the utility function exhibits risk aversion, the investor also invests
some of his or her wealth in the state 1 pure security.
In this example we assumed that the investor is a price taker. In a general equilibrium frame-
work, the prices of the pure securities would be determined as part of the problem; that is, they
would be endogenous. The prices would be determined as a result of the individuals' constrained
expected utility maximization (which determines the aggregate demands for securities). The criti-
cal condition required for equilibrium is that the supply of each market security equal its aggregate
demand. In a complete capital market this equilibrium condition can be restated by saying that the
aggregate supply of each pure security is equal to its aggregate demand.

H. 3h-e Efficient Set with Two Risky Assets

(and No Risk -Free Asset)
In a complete capital market, we can obtain a number of important portfolio optimality conditions.
These conditions hold for any risk -averse expected utility maximizer. Rewriting Eq. (4.4) and
Eq. (4.5) in terms of A and eliminating A yields two sets of portfolio optimality conditions:

gitr(Qt) = Pr for any state t (4.7)

u'(C) $1