Chapter 1

Introduction: Capital Markets,

Consumption, and Investment

1. Assume the individual is initially

endowed, at point A, with current
income of y0 and end-of-period
income of y1. Using the market rate,
the present value of his endowment is
his current wealth, W0:

The individual will take on investment up

to the point where the marginal rate of
return on investment equals the market
rate of interest at point B. This determines
the optimal investment in production (P0,
P1). Finally, in order to achieve his
maximum utility (on indifference curve
U1) the individual will lend (i.e., consume
less than P0) along the capital market line
until he reaches point C. At this point his
optimal consumption is C0 , C1 which
has a present value of

2.
(a) An exogenous decrease in the interest rate shifts
the capital market line from the line through AW0 to
the line through AW0. Borrowers originally chose
levels of current consumption to the right of A. After
the decrease in interest rate, their utility has
increased unambiguously from UB to UB. The case
for those who were originally lenders is ambiguous.
Some individuals who were lenders become
borrowers under the new, lower, rate, and experience
an increase in utility from UL1 to UB1 . The
remaining lenders experience a decrease in utility,
from UL2 to UL2 .
(b) Because borrowers and lenders face the same
investment opportunity set and choose the same
optimal investment (at A before the interest rate
decreases and at A afterward), current wealth is the
intercept of the capital market line with the C0 axis.
Originally it is at W0; then it increases to W0 .

(c) The amount of investment increases

from I to I.

3. Assuming that there are no opportunity

costs or spoilage costs associated with
storage, then the rate of return from storage is
zero. This implies a capital market line with a
45 slope (a slope of minus 1) as
shown in Figure S1.3.

Also shown is a line with lower absolute slope,

which represents a negative borrowing and lending
rate. Any rational investor would choose to store
forward from his initial endowment (at y0, y1)
rather than lending (to the left of y0). He would also
prefer to borrow at a negative rate rather than
storing backward (i.e., consuming tomorrows
endowment today). These dominant alternatives are
represented by the heavy lines in Figure S1.3.
However, one of them is not feasible. In order to
borrow at a negative rate it is necessary that
someone lend at a negative rate. Clearly, no one will
be willing to do so because storage at a zero rate of
interest is better than lending at a negative rate.
Consequently, points along line segment YZ in
Figure S1.3 are infeasible. The conclusion is that the
market rate of interest cannot fall below the storage
rate.

4. Assume that Robinson Crusoe has an

endowment of y0 coconuts now and y1 coconuts
which will mature at the end of the time period. If
his time preference is such that he desires to save
some of his current consumption and store it, he
will do so and move to point A in Figure S1.4. In
this case he is storing forward.

On the other hand, if the individual wishes to

consume more than his current supply of
coconuts in order to move to point B, it may
not be possible. If next years coconut supply
does not mature until then, it may be
impossible to store coconuts backward. If we
were not assuming a Robinson Crusoe
economy, then exchange would make it
possible to attain point B. An individual who
wished to consume more than his current
allocation of wealth could contract with other
individuals for some of their wealth today in
return for some of his future wealth.

5. Figure S1.5 shows a schedule of

investments, all of which have the same
rate of return, R*.

The resultant investment opportunity set is a

straight line with slope (1 + R*) as shown in
Figure S1.6. The marginal rate of substitution
between C0 and C1 is a constant.

6. In order to graph the production opportunity set, first order

the investments by their rate of return and sum the total
investment required to undertake the first through the ith
project. This is done below.

The production opportunity set plots

the relationship between resources
utilized today (i.e., consumption
foregone along the C0 axis) and the
extra consumption provided at the
end of the investment period. For
example, if only project D were
undertaken then $3 million in current
consumption would be foregone in
order to receive 1.3 ($3 million) =
$3.9 million in end-of-period
consumption. This is graphed below
in Figure S1.7.

If we aggregate all investment opportunities then

$7 million in consumption could be foregone and
the production opportunity set looks like Figure
S1.8. The answer to part b of the question is found
by drawing in a line with a slope of 1.1 and
finding that it is tangent to point B. Hence the
optimal production decision is to undertake
projects D and B. The present value of this
decision is:

Chapter 3
The Theory of Choice: Utility
Theory Given Uncertainty

1. The minimum set of conditions includes

(a) The five axioms of cardinal utility
complete ordering and comparability
Transitivity
strong independence
measurability
ranking
(b) Individuals have positive marginal utility of wealth (greed).
(c) The total utility of wealth increases at a decreasing rate (risk aversion);
i.e., E[U(W)] < U[E(W)].
(d) The probability density function must be a normal (or two parameter)
distribution.

2. As shown in Figure 3.6, a risk lover has positive marginal

utility of wealth, MU(W) > 0, which increases with increasing
wealth, dMU(W)/dW > 0. In order to know the shape of a
risk-lovers indifference curve, we need to know the marginal
rate of substitution between return and risk. To do so, look at
equation 3.19:

The denominator must be positive because marginal utility, U

(E + Z), is positive and because the frequency, f(Z), of any
level of wealth is positive. In order to see that the integral in
the numerator is positive, look at Figure S3.1. The marginal
utility of positive returns, +Z, is always higher than the
marginal utility of equally likely (i.e., the same f(Z)) negative
returns, Z. Therefore, when all equally likely returns are
multiplied by their marginal utilities, matched, and summed,
the result must be positive. Since the integral in the numerator
is preceded by a minus sign, the entire numerator is negative
and the marginal rate of substitution between risk and return
for a risk lover is negative. This leads to indifference curves
like those shown in Figure S3.2.

3.
(a)
E[U(W)]= .5ln(4,000) + .5ln(6,000)
= .5(8.29405) + .5(8.699515)
= 8.4967825
eln W = W
e8.4967825 = $4,898.98 = W
Therefore, the individual would be
indifferent between the gamble and
$4,898.98 for sure. This amounts to a
risk premium of $101.02. Therefore, he
would not buy insurance for $125.

(b) The second gamble, given his first loss, is

$4,000 plus or minus $1,000. Its expected utility is
E[U(W)] = .5ln(3,000) .5ln(5,000)
= .5(8.006368) .5(8.517193) = 8.26178
eln W = e8.26178 = $3,872.98 = W
Now the individual would be willing to pay up to
$127.02 for insurance. Since insurance costs only
$125, he will buy it.

The graph above assumes a = 1. For

any other value of a > 0, the utility
function will be a monotonic
transformation of the above curve.

6. Friedman and Savage [1948] show that it is

possible to explain both gambling and
insurance if an individual has a utility
function such as that shown in Figure S3.4.
The individual is risk averse to decreases in
wealth because his utility function is concave
below his current wealth. Therefore, he will
be willing to buy insurance against losses. At
the same time he will be willing to buy a
lottery ticket which offers him a (small)
probability of enormous gains in wealth
because his utility function is convex above
his current wealth.

Therefore, if your current level of wealth is

$2,000, you will be indifferent. Below that
level of wealth you will pay for the
insurance while for higher levels of wealth
you will not.

Therefore, an individual with a logarithmic

utility function will pay $2 for the gamble.

Because (F G) is not less than (or greater

than) zero for all outcomes, there is no second
order dominance.

18.
(a) Mean-variance ranking may not be appropriate
because we do not know that the trust returns have a
two-parameter distribution (e.g., normal).
To dominate Y, X must have higher or equal mean and
lower variance than Y, or higher mean and lower or
equal variance. Means and variances of the six
portfolios are shown in Table S3.7. By mean-variance
criteria, E > A, B, C, D, F and A > B, C, D, F. The next
in rank cannot be determined. D has the highest mean of
the four remaining trusts, but also the highest variance.
The only other unambiguous dominance is C > B.

(b) Mean-variance ranking

and SSD both select trust E
as optimal. However, the
rankings of suboptimal
portfolios are not
consistent across the two
selection procedures.