Heer and Maussner PP 28-41
Heer and Maussner PP 28-41
Heer and Maussner PP 28-41
Basic Models
consider to skip the first four sections and to start with Section
1.5 to become familiar with our notation and to get an idea of the
methods presented in subsequent chapters.
Yt = F (Nt , Kt ). (1.1)
Ct + Kt+1 ≤ Yt .
The farmer does not value leisure but works a given number of
hours N each period and seeks to maximize the utility function
U(C0 , C1 , . . . , CT ).
In the farmer example capital depreciates fully, since seed used for
growing corn is not available for future production. When we think
of capital in terms of machines, factories, or, even more generally,
human knowledge, this is an overly restrictive assumption. More
generally, the resource constraint is given by
Yt + (1 − δ)Kt ≥ Ct + Kt+1 ,
max U(C0 , . . . , CT )
(C0 ,...,CT )
s.t.
Kt+1 + Ct ≤ f (Kt ), (1.3)
0 ≤ Ct , t = 0, . . . , T,
0 ≤ Kt+1 ,
K0 given.
hi (x̄) > 0, i = 1, . . . , l.
3
See, for instance, Sundaram, 1996, Theorem 7.16, p. 187f.
1.1 Finite-Horizon Ramsey Model and Non-Linear Programming 7
λ∗i ≥ 0, i = 1, . . . , l,
λ∗i hi (x∗ ) = 0, i = 1, . . . , l.
It is easy to see that problem (1.3) fits this theorem if the utility
function U and the production function f are strictly concave,
strictly increasing, and twice continuously differentiable. Applying
Theorem 1.1.1 to problem (1.3) provides the following first-order
conditions:4
∂U(C0 , . . . , CT )
0= − λt + µt , t = 0, . . . , T, (1.4a)
∂Ct
0 = −λt + λt+1 f ′ (Kt+1 ) + ωt+1 , t = 0, . . . , T − 1, (1.4b)
0 = −λT + ωT +1 , (1.4c)
0 = λt (f (Kt ) − Ct − Kt+1 ) , t = 0, . . . , T, (1.4d)
0 = µ t Ct , t = 0, . . . , T, (1.4e)
0 = ωt+1 Kt+1 , t = 0, . . . , T, (1.4f)
f (Kt ) − Ct − Kt+1 ≥ 0,
and where µt and ωt+1 are the multipliers related to the non-
negativity constraints on Ct and Kt+1 , respectively. The multipli-
ers value the severeness of the respective constraint. A constraint
4
As usual, a prime denotes the first (two primes the second) derivative of a
function f (x) of one variable x. Condition (1.4c) derives from the budget
constraint of period T , f (KT ) − CT − KT +1 ≥ 0, which has the multiplier
λT , and the non-negativity constraint on KT +1 , which has the multiplier
ωT +1 .
8 Chapter 1: Basic Models
that does not bind has a multiplier of zero. For example, if Ct > 0
then (1.4e) implies µt = 0. If we want to rule out corner solutions,
i.e., solutions where one or more of the non-negativity constraints
bind, we need to impose an additional assumption. In the present
context this assumption has a very intuitive meaning: the farmer
hates to starve to death in any period. Formally, this translates
into the statement
∂U(C0 , . . . , CT )
→ ∞ if Ct → 0 for all t = 0, . . . , T.
∂Ct
∂U(C0 , . . . , Ct )
= λt .
∂Ct
f (K)
45o
K
K1 K̄ K2
Figure 1.1: Boundedness of the Capital Stock
u′ (Ct ) = λt − µt , (1.10a)
λt = βλt+1 f ′ (Kt+1 ) + ωt+1 , (1.10b)
0 = λt (f (Kt ) − Ct − Kt+1 ), (1.10c)
0 = µ t Ct , (1.10d)
0 = ωt+1 Kt+1 . (1.10e)
that is, the present value of the terminal capital stock must ap-
proach zero. In the Ramsey model (1.8), condition (1.13), is a
necessary condition,7 as well as conditions (1.10).
v(K) := max
′
u(f (K) − K ′ ) + βv(K ′). (1.14)
0≤K ≤f (K)
The first term to the right of the max operator is the utility of
consumption C = f (K) − K ′ as a function of the next-period
capital stock K ′ . The second term is the discounted optimal value
7
See Kamihigashi (2002).
14 Chapter 1: Basic Models
with v 0 = 0.
We illustrate these findings in Example 1.2.1
Example 1.2.1
Let the one-period utility function u and the production function f
be given by
u(C) := ln C,
f (K) := K α , α ∈ (0, 1),
Kt+1 = αβKtα .
v(K) = a + b ln K,
1 αβ α
a := ln(1 − αβ) + ln αβ , b := .
1−β 1 − αβ 1 − αβ
v ′ (K ′ ) = u′ (C ′ )f ′ (K ′ ).