Question

James Bennett also allocates wealth between youth and old age. He has no cash currently (in his youth), but will inherit $3000 in his old age. He can lend and borrow at the bank at 18% (that is, lending $1 in youth will give him $1.18 in old age). He has an investment opportunity that costs $12,000 now in his youth and has a payoff of $15,000 in his old age. This is the only investment opportunity available to him. What is the most he can consume in his youth?

Answer 1

To determine the most James Bennett can consume in his youth, we need to find the maximum amount he can borrow from the bank to invest in the opportunity, while still being able to pay back the loan with interest in his old age.

Let x be the amount that James borrows from the bank in his youth. He invests this amount in the opportunity and receives a payoff of $15,000 in his old age. With this payoff, he can pay back the loan plus interest, which is:

Loan + interest = x + 0.18x = 1.18x

So, he needs to have at least $1.18x in his old age to be able to pay back the loan. He will also receive an inheritance of $3000 in his old age, so his total wealth in his old age will be:

Total wealth in old age = $1.18x + $3000

To determine the maximum amount he can consume in his youth, we need to subtract the cost of the investment opportunity and the amount borrowed from the bank from his initial wealth:

Initial wealth = $0 (no cash currently)

Maximum consumption in youth = Initial wealth - Cost of investment - Amount borrowed

Maximum consumption in youth = -$12,000 - x

Since James wants to maximize his consumption in his youth, we need to find the value of x that maximizes the expression -$12,000 - x, subject to the constraint that his total wealth in his old age is at least $1.18x + $3000.

To find this value of x, we can set up the following optimization problem:

Maximize -$12,000 - x

Subject to: $1.18x + $3000 >= $1.18x (i.e., his total wealth in old age is at least $1.18x + $3000)

Simplifying the constraint, we get:

$3000 >= 0

This constraint is always satisfied, so it does not affect the solution. Therefore, we can simply maximize the objective function -$12,000 - x:

d/dx (-$12,000 - x) = -1

Setting the derivative equal to 0 to find the maximum, we get:

-1 = 0

This is never true, so there is no maximum value of -$12,000 - x. This means that James cannot afford to invest in the opportunity and still have a positive wealth in his old age. Therefore, he cannot consume anything in his youth, since he has no cash currently and cannot invest in the opportunity.

Explanation: