Paper 4, Section II, J

Optimization and Control
Part II, 2010

Dr Seuss' wealth xtx_{t} at time tt evolves as

dxdt=rxt+tct\frac{d x}{d t}=r x_{t}+\ell_{t}-c_{t}

where r>0r>0 is the rate of interest earned, t\ell_{t} is his intensity of working (01)(0 \leqslant \ell \leqslant 1), and ctc_{t} is his rate of consumption. His initial wealth x0>0x_{0}>0 is given, and his objective is to maximize

0TU(ct,t)dt\int_{0}^{T} U\left(c_{t}, \ell_{t}\right) d t

where U(c,)=cα(1)βU(c, \ell)=c^{\alpha}(1-\ell)^{\beta}, and TT is the (fixed) time his contract expires. The constants α\alpha and β\beta satisfy the inequalities 0<α<1,0<β<10<\alpha<1,0<\beta<1, and α+β>1\alpha+\beta>1. At all times, ctc_{t} must be non-negative, and his final wealth xTx_{T} must be non-negative. Establish the following properties of the optimal solution (x,c,)\left(x^{*}, c^{*}, \ell^{*}\right) :

(i) βct=α(1t)\beta c_{t}^{*}=\alpha\left(1-\ell_{t}^{*}\right);

(ii) cteγrtc_{t}^{*} \propto e^{-\gamma r t}, where γ(β1+α)1\gamma \equiv(\beta-1+\alpha)^{-1};

(iii) xt=Aert+Beγrtr1x_{t}^{*}=A e^{r t}+B e^{-\gamma r t}-r^{-1} for some constants AA and BB.

Hence deduce that the optimal wealth is

xt=(1eγrT(1+rx0))ert+((1+rx0)erT1)eγrtr(erTeγrT)1rx_{t}^{*}=\frac{\left(1-e^{-\gamma r T}\left(1+r x_{0}\right)\right) e^{r t}+\left(\left(1+r x_{0}\right) e^{r T}-1\right) e^{-\gamma r t}}{r\left(e^{r T}-e^{-\gamma r T}\right)}-\frac{1}{r}