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I was experimenting with a seemingly simple optimal control problem that generates a system of differential equations. When I calculate the values of the steady state of the system I get some very strange results I believe I did something wrong when I applied the Maximum Principle. If you are patient enough to read some text, I would be grateful to listen to your suggestions what could go wrong.

Notation

I use a subscript $t$ whenever a variable depends on time. E.g. $A_t(x_1,x_2):=A(x_1,x_2,t)$

Setup

Imagine a closed-economy with a linear production function. The amount of goods produced depends on the level of human capital $A_t$ and some fixed ressource endowment $R$. Thus,

$Y_t := A_tR$

The economy we imagine has an insecure environment and can be attacked at random with a probability of $p$ (exogenous). Whenever country is attacked, it losses some of its income. I denote the remaining share $q_t$. The share of income protected depends on the amount of military spending the country has augmented by the level of human capital accumulated:

$q_t:=1-\frac{1}{\alpha A^m_t M_t}$

I assume $m \in [0,1]$ Thus the greater is military spending, the more secure is current income. Note that military spending does better job in securing protection as long as $m<1$.

Given all this, assume the economy produces 3 types of goods: consumption goods $C_t$, military goods $M_t$ and human capital $A_t$. Assume for simplicity, that $A_t$ is the only variable that accumulates while consumption goods and military goods are consumed instantaneously at every moment in time. If one agrees on this, one way of expressing the equation of motion for human capital is the weighted average of income the country has minus spending on consumption, military and deprecitation of human capital:

$\dot{A}_t=\underbrace{pq_tY_t}_\text{Post-war income} + \underbrace{(1-p)Y_t}_\text{No-war income} - C_t - M_t - \delta A_t$

Assuming that all variables belong to the positive real line, additionaly $A_t,M_t>0$, a concave utility function $U'(C_t)>0, U''(C_t)<0$ and `granting' some initial value of human capital $A(t=0)=A_0$ one can formulate the following optimal control problem: \begin{equation} \max_{C_t, M_t}\int_0^\infty U(C_t)e^{-\rho t}dt \end{equation}

In words: maximize utility over infinite horizon steering consumption and military.

Such that: \begin{equation} \dot{A}_t=p\left(1-\frac{1}{\alpha A^m_t M_t}\right)A_tR + (1-p)A_tR - C_t - M_t - \delta A_t \end{equation} And the transversality condition: \begin{equation} \lim_{t->\infty} e^{-\rho t}\lambda_t A_t=0 \end{equation}

Hamiltonian and Solution

The current-value Hamiltonian looks like this ($\mu_t = \lambda_t e^{-\rho t}$): \begin{equation} H^c = U(C_t) + \mu_t\left(p\left(1-\frac{1}{\alpha A^m_t M_t}\right)A_tR + (1-p)A_tR - C_t - M_t - \delta A_t\right) \end{equation}

Chiang (1992) argues that if the Hamiltonian is nonlinear in control and state variables, one derive the first-order conditions by taking derivatives of the Hamiltonian and setting them equal to zero.

\begin{equation} \frac{\partial H^c}{\partial C_t}: U'(C_t)-\mu_t = 0 \end{equation}

\begin{equation} \frac{\partial H^c}{\partial C_t}: \mu_t\left(pA^{1-m}_tR\frac{1}{\alpha M^2_t}-1\right) = 0 \end{equation}

\begin{equation} \dot{\mu}_t = \rho \mu_t - \mu_t\left(pR\frac{m-1}{\alpha A^m_t M_t} + R - \delta\right) \end{equation}

The expressions for $\dot{\mu}_t$ and $\dot{A}_t$ form a system of differential equations. But interpreting \dot{\mu}_t is counter-intuitive. Instead, one usually differentiates the FOC for consumption with respect to time $U''(C)_t=\dot{\mu}_t$ and impute \dot{\mu}_t from the equation of motion. Since $U'(C_t) = \mu_t$, one can get rid of $\mu_t$ in $\dot{C}_t$. Yet, the system will consist of two equations $\dot{C}_t, \dot{A}_t$ and three variables $A_t$, $C_t$, $M_t$.

\begin{equation} \begin{cases} \dot{C}_t = -\frac{U'(C_t)}{U''(C_t)}\left(pR\frac{m-1}{\alpha A^m_t M_t} + R - \delta -\rho\right) \\ \dot{A}_t = A_t R - A^{1-m}_t\frac{pR}{M_t} - C_t - M_t - \delta A_t \end{cases} \end{equation}

I need a way to express $M_t$ as a function of other variables or parameters. Thus I take the second FOC, equate it to zero (dismiss the option $\mu_t=0$ because $\mu_t=U'(C_t)>0$) and derive $M_t$ as a function of $A_t$: $M^*_t:=A^{\frac{1-m}{2}}_t\sqrt{\frac{pR}{\alpha}}$

I impute $M^*_t$ in the system above, set $\dot{C}_t=\dot{A}_t=0$ and calculate the expressions for the steady state. Dismissing the trivial solution $C_t = 0$, I obtain the following equilibrium values:

Human Capital

\begin{equation} \bar{A}_t = \left(\frac{pR}{\alpha}\frac{(1-m)^2}{(R - \delta -\rho)^2}\right)^{\frac{1}{1+m}} \end{equation}

Military

\begin{equation} \bar{M_t} = \left(\frac{pR}{\alpha}\frac{(1-m)^2}{(R - \delta -\rho)^2}\right)^{\frac{1-m}{2(1+m)}}\sqrt{\frac{p R}{\alpha}} \end{equation}

Consumption

\begin{multline} \bar{C_t} = \left(\frac{pR}{\alpha}\frac{(1-m)^2}{(R - \delta -\rho)^2}\right)^{\frac{1}{1+m}} (R - \delta) \\- \left(\frac{pR}{\alpha}\frac{(1-m)^2}{(R - \delta -\rho)^2}\right)^{\frac{1-m}{2(1+m)}} \sqrt{\alpha pR} \left(1 + \frac{1}{\alpha}\right) \end{multline}

The expression for consumption looks clumsy. It is indeed! When I tried to calculate values of consumption given some more or less reasonable parameters ($p=0.052$, $m=0.21$, $\delta=0.242$, $\alpha = 2.54$, $\rho=1.48$), I got negative numbers. A screenshot from Mathematica depicting $C_t$ (vertical axis) as a function of $R$ (horizontal axis):Steady state consumption with $p=0.052$, $m=0.21$, $\delta=0.242$, $\alpha = 2.54$, $\rho=1.48$

I do not expect that introducing insecure property rights will change the steady state consumption to negative values given a linear production function. It looks that I applied the Maximum Principle algorithm in a wrong way but I cannot figure out what was my mistake. Could somebody point me what went wrong? Any ideas? P.S. You are a hero if you read till the very end :)

UPDATE: As some of people here suggested, the Maximum Principle fails because I apply deterministic method to a stochastic model. This is a fair concern. I decided to check if the method works in case I set $p=1$ (implying the infinitely long war-scenario for the economy).

The canonical equations with the specification look like that:

\begin{equation} \frac{\partial H^c}{\partial C_t}: U'(C_t)-\mu_t = 0 \end{equation}

\begin{equation} \frac{\partial H^c}{\partial C_t}: \mu_t\left(pA^{1-m}_tR\frac{1}{\alpha M^2_t}-1\right) = 0 \end{equation}

\begin{equation} \dot{\mu}_t = \rho \mu_t - \mu_t\left(R - R\frac{1-m}{\alpha A^m_t M_t} - \delta\right) \end{equation}

I proceeded with the solution as before and got the following dynamical system (assuming $U(C_t)=\ln{C_t}$:

\begin{equation} \begin{cases} \dot{C}_t = C_t\left(R - R\frac{1-m}{\alpha A^m_t M_t} + R - \delta -\rho\right) \\ \dot{A}_t = A_t R - A^{1-m}_t\frac{R}{M_t} - C_t - M_t - \delta A_t \end{cases} \end{equation}

Solve it for the steady state. Here are my equilibrium values for Human Capital, Military and Consumption.

\begin{equation} \bar{A}=\left(\frac{(1-m)^2}{(R-\delta-\rho)^2} \frac{R}{\alpha} \right)^{\frac{1}{1+m}} \end{equation}

\begin{equation} \bar{M}=\left(\frac{R}{\alpha}\right)^{1/2}\left(\frac{(1-m)^2}{(R-\delta-\rho)^2} \frac{R}{\alpha} \right)^{\frac{1-m}{2(1+m)}} \end{equation}

\begin{equation} \bar{C}=(R-\delta)\left(\frac{(1-m)^2}{(R-\delta-\rho)^2} \frac{R}{\alpha} \right)^{\frac{1}{1+m}}-2\left(\frac{R}{\alpha}\right)^{1/2}\left(\frac{(1-m)^2}{(R-\delta-\rho)^2} \frac{R}{\alpha}\right)^{\frac{1-m}{2(1+m)}} \end{equation}

I simulated the values of $C_t$ again. Here is what I get: Consumption (vertical axis) as a function of resource endowment (horizontal axis)

Different equations, yet similar picture. So the stochastic nature of the model is not the only problem. Maybe I miss something like a bang-bang solution here? Or maybe it simply does not exist in the case?

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  • $\begingroup$ Welcome to the site. When you calculated consumption, what value did you assume for $R$? $\endgroup$ – Adam Bailey Oct 23 '17 at 20:42
  • $\begingroup$ Thanks for a comment. I forgot to mention that the graph you see depicts consumption as a function of resource endowment. $C_t = g(R)$. $C$ is on the vertical axis and $R$ is on the horizontal axis. $R$ stretches from 0 to 10 000. $\endgroup$ – Artem Kochnev Oct 23 '17 at 21:40
  • $\begingroup$ @ArtemKochnev as Alecos points out in his answer below, I don’t think this can be formulated as a deterministic control problem. Your choice of $M$ and $C$ induces some jump process for which you’ll need the tools of stochastic control theory. There is an analogue of Pontryagin’s principle for stochastic control, but you’ll need some pretty sophisticated tools to to get there. $\endgroup$ – Theoretical Economist Oct 24 '17 at 2:10
  • $\begingroup$ Thanks :) I think you're right on this, but then it should have disappered after calculating the steady-state in a deterministic version of the model ($p=1$). Yet, I encounter the same problem. See the update above. $\endgroup$ – Artem Kochnev Oct 25 '17 at 15:26
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One general issue I see is that you try to include uncertainty in a framework developed for a deterministic setup.

What you do is to use expected income in the equation of motion for human capital. Let $I_{a,t}$ denote the indicator function for attack, taking the value $1$ when there is an attack, and the value $0$ when there isn't. Then, properly,

$$\dot{A}_t=\underbrace{I_{a,t}q_tY_t}_\text{Post-war income} + \underbrace{(1-I_{a,t})Y_t}_\text{No-war income} - C_t - M_t - \delta A_t$$

and what you are using in your model is $\mathbb E (\dot A_t)$. Hmm..., I am not sure that it is that simple... Have you looked up the machinery of Stochastic Optimal Control in continuous time?

Apart from that, I also see two parameter values that are strange in your simulation, except if there is something you don't tell us.

1) $\delta = 0.242$ means $24.2$% depreciation of human capital per period. What is your "period" here? Granted, this is continuous time, but in order to assess simulation results and see if they make sense, you must determine a discrete length of the "time period". A benchmark yearly value would be $\delta = 0.04$, then yours corresponds to approximately a 7-year period.

2) The rate of pure time preference equal to $\rho=1.48$?? How did you come up with a value greater than unity?... For a yearly period a benchmark value is $\rho = 0.02$. So if we want to be consistent with the implied 7-year period for the depreciation rate, it should be approx $\rho = 0.132$. So in order to be consistent with the $\delta$ parameter, you should change $\rho$.

But this won't affect the result, as should be obvious from your equations, especially since $R$ is checked for very large values compared.

Finally, and ignoring all the above, it is not the fact that you introduced "insecure property rights", it is the specific functional form you chose in order to incorporate them in the model, that apparently causes all the trouble. Mathematical forms are tools, and even when we have many reasonable tools (your specification of the $q_t$ function is not unreasonable), not all are appropriate for all models.

There are many other ways to include "insecure property rights" -for example: you could argue that military spending affects the probability of attack. You could choose to not include human capital in the expression for $q_t$. Etc.

So if the issue with how you handle uncertainty in principle (my first comment) is not an issue after all, then you should just change the way you model the probability of attack and/or lost output due to the attack.

Remember that you are just building a model -and it is the model that should conform to reality and reason, not the other way around. And since steady-state consumption monotonically decreasing in the exogenous resource endowment is not reasonable nor realistic, you should tweak your model. It is not the case that you just uncovered a surprising law about human behavior (not yet at least).

It would be interesting to obtain a non-monotonic result - say for ss-consumption to have a minimum or a maximum in $R$ -that would be really tantalizing.

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  • $\begingroup$ Thanks for a comment. I probably did not emphasize it much: what worries me is that the result does not make sense. I did not have an intention to say `Look: I found a rediculous a law of nature'. Of course not :) And since I have such a confusing result, I thought I did something wrong. Regarding your suggestion about stochastic control. I think you right in principle. Yet, check my results in the deterministic model I show in the update: I still have the same trouble. Thus, it's likely I miss something else. $\endgroup$ – Artem Kochnev Oct 25 '17 at 15:24
  • $\begingroup$ @ArtemKochnev The other thing I wrote in my answer is that you should change the way you model the $q_t$ function as regards its functional form and the arguments it includes. Your current choice for its functional form gives non-sensical reasults and so it should be abandoned. $\endgroup$ – Alecos Papadopoulos Oct 25 '17 at 15:28

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