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Question:

Suppose Mr X maximises his utility for two periods, his total utility is given by log $c_1$ + $\beta$ log $c_2$ where $\beta$ $\in$ ( 0,1) and $c_1$ and $c_2$ are his consumption for period 1 and period 2 respectively. Suppose he earns a wage only in period 1 and it is given by W. He saves for the second period on which he enjoys a gross return of (1+r) where r > 0 is the net interest rate. Suppose the government implements a scheme where T $\geq$ 0 is collected from agents ( this is also from Mr. X) in the first period and returns the same amount T back in the second period. What is the optimum T for which his total utility is maximised?.

My working: I tried putting $c_2= [(M - c_1- T ) ( 1 + r )] + T$ and plugged in the values that helps the consumer achieve optimum utility for the given budget constraint. Using the lagrangean method of optimisation I got the following $$\frac{c_2}{\beta c_1} = 1+r$$ Solving the budget constraint using this, I got $$ c_2=\frac{\beta[ M ( 1 + r) - Tr ]}{\beta+ 1}$$Next I tried differentiating $c_2$ with respect to T so as to find the optimum T that maximises $c_2$ and in turn the utility function. This method doesn't seem to work. Could somebody correct me ?. Thank you.

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  • $\begingroup$ Just build a budget constraint instead $\endgroup$
    – 123
    Sep 19, 2017 at 14:37
  • $\begingroup$ 123, isn't the budget constraint just the same as the equation for second period consumption with all terms exception M (1 + r ) swapped to the left, what difference would that make ? $\endgroup$
    – Meera Unni
    Sep 19, 2017 at 14:58
  • $\begingroup$ "tried maximising the budget constraint" How does one maximize a constraint...? $\endgroup$
    – Giskard
    Sep 19, 2017 at 16:20
  • $\begingroup$ Can you show in detail which the calculation, including the optimal c1 and c2? $\endgroup$
    – luchonacho
    Sep 19, 2017 at 17:00
  • $\begingroup$ luchonacho I've added edits to my question, could you refer to that now. Also sorry for the very late reply. $\endgroup$
    – Meera Unni
    Sep 28, 2017 at 7:07

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