Problem Set 2 – Solutions (70 total)

Problem 1. True for False (3 points each)

(1) FALSE. A naif and sophisticate can choose to take the action on the same date.

(2) FALSE. According to the PV formula, a negative interest rate may mean the present
value of something is higher than its future value.

(3) FALSE. Think of ” æ 0.

(4) TRUE. People who are fully sophisticated understand that their future selves are so-
phisticated as well. They are still time-inconsistent, they are just aware of their future
time-inconsistency, and aware that they will be aware, etc..

(5) FALSE. Someone who uses hyperbolic (not quasi-hyperbolic) discounting is also time-
inconsistent.

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Problem 2. Here are the solutions:

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

c2 11
c1 + Æ 10 + = 20
1.1 1.1

(2) (10 points) First, note that the budget constraint must bind since otherwise, you can
increase c1 (and get higher utility) so it binds. Since the budget constraint must bind,
this means that
c2
c1 = 20 ≠
1.1
Plugging this back into Bob’s utility, this means we need to maximize Bob’s utility
Ú
c2 Ô
U (c2 ) = 20 ≠ + ” c2
1.1

Differentiating and setting to zero yields

3 4 1 3 4
c2 ≠ 2 1 ≠1
20 ≠ = ”c2 2
1.1 Ú 1.1
c2 Ô
1.1” 20 ≠ = c2
3 1.14
2 c2
1.21” 20 ≠ = c2
1.1
1 2
24.2” 2 = 1 + 1.1” 2 c2
242” 2
c2 =
10 + 11” 2

so A B
1 242” 2 220” 2
c1 = 20 ≠ = 20 ≠
1.1 10 + 11” 2 10 + 11” 2

(3) (5 points) As ” increases, c2 increases and c1 decreases. In other worst, if Bob gets
more patient (larger ”), then Bob will save more for consumption in year 2.

(4) (5 points) Bob will save if he consumes less in the first year than what he has in the

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bank. In other words, when c1 Æ 10. Since we have the expression for c1 , this means

220” 2
20 ≠ Æ 10
10 + 11” 2
220” 2 Ø 100 + 110” 2
11” 2 Ø 10
Û
10
ӯ
11

In other words, if Bob is patient enough, then he will save.

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Problem 3. Here’s the solution:

(1) (12 points) Let’s solve the problem for naifs first. The following table shows the
discounted payoffs for the naive self under immediate costs (columns correspond to
the day in which you clean and rows corresponds to the day of the self making the
decision).

1 2 3 4 5
Day 1 Self -20.5 0 10.5 -1.4 -18.9
Day 2 Self -13.5 10.5 -1.4 -18.9
Day 3 Self -3 -1.4 -18.9
Day 4 Self -20 -18.9

Now, the Day 1 naive self wants to clean on day 3 so he postpones. The Day 2 self
want to clean on day 3 as well, so he postpones. The Day 3 self wants to clean on day
4 so he postpones. Finally, the Day 4 self wants to clean on day 5. Thus, the naive
self cleans on day 5.

For the sophisticated self, we work backwards. The Day 4 self wants to clean on day
5. Now, the Day 3 self knows that if he postpones, his Day 4 self will clean on day 5.
Hence, between cleaning on day 3 and cleaning on day 5, the Day 3 self prefers to clean
on day 3. The Day 2 self thus prefers to postpone knowing his Day 3 self will clean on
day 3. Finally, the Day 1 self prefers to postpone so his Day 2 self will postpone and
his Day 3 self will clean on day 3.

(2) (12 points) Again, we solve the problem for naifs first. The following table shows the
discounted payoffs for the naive self under immediate rewards

1 2 3 4 5
Day 1 Self 3.5 0 10.5 -1.4 -18.9
Day 2 Self 13.5 10.5 -1.4 -18.9
Day 3 Self 28.5 -1.4 -18.9
Day 4 Self 16.6 -18.9

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 Now, the Day 1 naive self wants to clean on day 3 so he postpones. However, the Day
2 self want to clean on day 2 so the naive self ends up cleaning on day 2.

For the sophisticated self, we work backwards. Note that cleaning today is optimal for
all the Day 2, 3 and 4 selves. For the Day 1 self, he knows if he postpones, his Day 2
self will clean on day 2 so the Day 1 self cleans on day 1. Thus, the sophisticated self
cleans on day 1.

(3) (6 points) Now, consider an EDU person with ” = 1. Note in this case, whether it is
immediate costs or immediate rewards does not matter. The discounted payoffs are

1 2 3 4 5
Any Self -10 0 15 -2 -27

An EDU person will clean on day 3. Comparing this with our answers to parts (1) and
(2), we see that with immediate costs, the naif procrastinates more than the sophis-
ticate (both clean on day 3 or later), while with immediate rewards, the sophisticate
preproperates more than the naif (both clean before day 3).