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1

Econ 416/616 Mathematical Economics II Lau


Lecture Notes Spring 2012

Review of Integration

Indefinite integral as anti-derivative:
1.
1
1
1 1
( )
1
1
1 Note that ( 1)
1 1
a
a
a a a
x
d c
x
a
x dx c a a x x
a dx a
+
+
+
+
+
= + = = + =
+ +
}


Example:
7
7
6 7 1 6
3
3
2
1 3 3 1
2
1
2 2 2 2
2
2
3
1 2 1 1
3
3 3 3
( )
1
7
Note that (7)
7 7
2
( )
2 2 3
3
Note that ( )
3
3 3 2
2
3
( )
3 3 2
2
Note that ( )
2
2 2 3
3
x
d c
x
x dx c x x
dx
d x c
x
x dx c x c x x
dx
d x c
x
x dx c x c x x
dx


+
= + = =
+
= + = + = =
+
= + = + = =
}
}
}
3


2.
1
1 (ln ) 1
ln Note that
d x c
x dx dx x c
x dx x

+
= = + =
} }

3.
x x
e dx e c = +
}

Example:
2
2
2 2 2
( )
1
2
Note that (2)
2 2
x
x
x x x
e
d c
e
e dx c e e
dx
+
= + = =
}





Definite integral:

( )
b
a
f x dx
}






( ) f x





a b
2
Example:
2
2 2 2 2
1 1
2
2
1 1
2
2 5 10 5
5
1 1
(2) (1) 4 1 3
2 2 2 2 2 2
1
ln ln2 ln1 ln2
5 5
x
x
x
xdx
dx x
x
e e e
e dx
= = = =
= = =

= =
}
}
}


3
3
0 0
1
ln ln3 ln0 dx x undefined
x
= = =
}



0 3



Integration by parts: udv uv vdu =
} }


Proof: duv udv vdu uv duv udv vdu = + = = +
} } }



Example 1 Evaluate
x
xe dx
}

Let


x x x
u x du dx
dv e dx dv e dx v e
= =

= = =

} }

x x x x x
xe dx xe e dx xe e c = = +
} }



Example 2 Evaluate ln x dx
}

Let
1
ln


u x du dx
x
dv dx dv dx v x

= =

= = =

} }

1
ln (ln )( ) ( ) ln ln x dx x x x dx x x dx x x x c
x
= = = +
} } }



unbounded
3
Example 3 Evaluate
2 x
x e dx

}

Let
2
2

x x x
u x du xdx
dv e dx dv e dx v e

= =

= = =

} }

2 2 2
( ) ( )(2 ) 2
x x x x x
x e dx x e e xdx x e xe dx

= = +
} } }

Let


x x x
u x du dx
dv e dx dv e dx v e

= =

= = =

} }

2 2 2 2
2 2
2 2 ( ) ( ) 2 ( ) ( )
2 2 ( 2 2)
x x x x x x x x x
x x x x
x e dx x e xe dx x e x e e dx x e x e e c
x e xe e c e x x c


(
( = + = + = + + +


= + = + + +
} } }




Example 4 Evaluate
x
e cos x dx
}

Let


cos cos sin
x x
u e du e dx
dv x dx dv x dx v x
= =

= = =

} }

sin sin
x x x
e cos x dx e x x e dx =
} }


Let


sin sin cos
x x
u e du e dx
dv x dx dv x dx v x
= =

= = =

} }

( )
sin sin sin ( cos ) ( cos )
sin cos cos
2 sin cos
1
sin cos
2
x x x x x x
x x x x
x x x
x x x
e cos x dx e x x e dx e x e x x e dx
e cos x dx e x e x e x dx
e cos x dx e x e x
e cos x dx e x e x c
(
= =

= +
= +
= + +
} } }
} }
}
}


4
First Order Liner Differential Equations

Example 1: '( ) 1 or 1
dy
y t
dt
= =
1 ( )
dy
dy dt dy dt y t t c
dt
= = = = +
} }


Note: When we differentiate ( ) with respect to y t t c t = + , we get '( ) 1 y t = .


Example 2: '( ) y t y =
1 1
ln
1
ln ( ) where
t c c y t
dy dy dy
y dt dt y t c e e y t Ce C e
dt y y
+
= = = = + = = =
} }


Note: When we differentiate ( )
t
y t Ce = with respect to t , we get '( )
t
y t Ce y = = .


Example 3:
2
'( ) y t y =
2 1
2 2
1
( )
dy dy dy
y dt dt y t c y t
dt t c y y

= = = = + =
+
} }


Note:
2 2
( )
dy
t c y
dt

= + =


Example 4:
1
'( ) y t y

=
2
1
( ) 2( )
2
dy y
ydy dt ydy dt t c y t t c
dt y
= = = = + = +
} }


Note:
1 2 1 1
2
2( ) 2( )
dy
dt y
t c t c
= = =
+ +



Example 5: '( ) 2 (0) 1 y t y = =
2 2 2 ( ) 2
(0) 2(0) 1 1
( ) 2 1
dy
dy dt dy dt y t t c
dt
y c c
y t t
= = = = +
= + = =
= +
} }


Note: 2 (0) 2(0) 1 1
dy
y
dt
= = + =
5
Example 6: '( ) 3 (0) 1 y t y y = =
1
3
1
3 3 ln 3 ( ) where
c t
dy dy
y dt y t c y t Ce C e
dt y
= = = + = =
3(0)
(0) 1 y Ce C = = =
3
( )
t
y t e =

Note:
3 3(0)
3 3 (0) 1
t
dy
e y y e
dt
= = = =


Example 7: '( ) 3 (1) 4 y t y y = =
3
( )
t
y t Ce =
3(1) 3
(1) 4 4 y Ce C e

= = =
3 3 3 3
( ) 4 4
t t
y t e e e

= =

3 3 3(1) 3
Note: 4(3) 3 (1) 4 4
t
dy
e y y e
dt

= = = =


Example 8: '( ) ( ) y t Py t Q + =
[ ( )]
'( ) ( ' )
Pt
Pt Pt Pt Pt
d e y t
e y t yPe e y Py e Q
dt
= + = + =
[ ( )] ( ) ( ) ( ) (**)
Pt Pt Pt Pt Pt Pt Pt
Q Q
d e y t Qe dt de y t Qe dt e y t e C y t Ce
P P

= = = + = +
} }

Note: '( ) ( )
Pt Pt
dy
y t C P e CPe
dt

= = =
'( ) ( ) [ ]
Pt Pt Pt Pt
Q
y t Py t CPe P Ce CPe Q CPe Q
P

+ = + + = + + =


Example 9: '( ) 3 y t y =
Using (**):
( 3 ) 3
0
3, 0 ( ) ( )
3
t t
P Q y t Ce y t Ce

= = = + =




Example 10: '( ) 3 4 (0) 1 y t y y = =
Using (**):
( 3) 3
4 4
3, 4 ( ) ( )
3 3
t t
P Q y t Ce y t Ce

= = = + =


3(0) 3
4 7 7 4
(0) 1 ( )
3 3 3 3
t
y Ce C y t e = = = =

6
Example 11: '( ) ( ) ( ) ( ) y t P t y t Q t + =
( ) ( )
( ) ( ) (***)
P t dt P t dt
y t e Q t e dt c

| | } }
= +
|
\ .
}


Example 12:
1
'( ) 3 y t y t
t
+ =
Using (***):
1
( ) , ( ) 3 P t Q t t
t
= =
( )
1 1
ln 1 2 1 3 2
( ) 3 3 ( ) ( 3 ) ( )
dt dt
t
t t
c
y t e te dt c e t t dt c t t dt c t t c t
t


| |
} }
= + = + = + = + = +
|
\ .
} } }


Example13:
2
2
'( ) 6 y t y t
t
+ =
Using (***):
2
2
( ) , ( ) 6 P t Q t t
t
= =
( )
2 2 5 3
2
2ln 2 2 2 4 2
2
6 6
( ) 6 6 ( ) ( 6 ) ( )
5 5
dt dt
t
t t
t t c
y t e t e dt c e t t dt c t t dt c t c
t


| |
} }
= + = + = + = + = +
|
\ .
} } }


7
Second Order Linear Differential Equation (Homogeneous)

"( ) '( ) ( ) 0 y t Ay t By t + + =

Let ( )
rt
y t ce = be the solution of the differential equation.

2
'( ) , "( )
rt rt
y t cre y t cr e = =

Substitute to the differential equation, we have
2 2
0 ( ) 0
rt rt rt rt
r ce Acre Bce ce r Ar B + + = + + =

This leads to a characteristic equation:
2
0 r Ar B + + =

The characteristic roots:
2
1 2
4
,
2
A A B
r r

=


Case 1
2
4 A B >

1 2
1 2
( )
r t r t
y t c e c e = +

Example: " 4 0 y y =
0, 4 or A B = = characteristic equation
2
2
1 2
(0) (0) 4( 4)
4 0 , 2, 2
2
r r r

= = =
2 2
1 2
( )
t t
y t c e c e

= +

Note:
2 2
1 2
2 2
1 2
'( ) 2 2
"( ) 4 4
t t
t t
y t c e c e
y t c e c e

=
= +



Example: 2 " 12 ' 10 0 y y y + + = or " 6 ' 5 0 y y y + + =
6, 5 or A B = = characteristic equation
2
2
1 2
(6) (6) 4(1)(5) (6) 16
6 5 0 , 1, 5
2 2
r r r r

+ + = = = =
5
1 2
( )
t t
y t c e c e

= +

Note:
5 5
1 2 1 2
'( ) 5 and "( ) 25
t t t t
y t c e c e y t c e c e

= = +
Hence
5 5 5 5
1 2 1 2 1 2 1 1 1 2 2 2
( 25 ) 6( 5 ) 5( ) ( 6 5 ) (25 30 5 ) 0
t t t t t t t t
c e c e c e c e c e c e c c c e c c c e

+ + + + = + + + =
8
Case 2
2
4 A B < (complex roots)

Suppose the characteristic roots
1 2
, r r a bi = , then
1 2
( ) ( cos sin )
at
y t e k bt k bt = +

Example: "( ) 4 '( ) 13 ( ) 0 y t y t y t + =

4, 13 or A B = = characteristic equation
2
2
1 2
( 4) ( 4) 4(13)
4 13 0 , 2 3 , 2 3
2
r r r r i i

+ = = = +
2
1 2 1 2
( ) ( cos sin ) ( cos3 sin3 )
at t
y t e k bt k bt e k t k t = + = +

Note:
2
1 2
( ) ( cos3 sin3 )
t
y t e k t k t = +
2 2 2
1 2 1 2 2 1 1 2
2 2
2 1 1 2 2 1 1 2
2
2 1 1 2
'( ) [ 3 sin3 3 cos3 ] ( cos3 sin3 )(2 ) [(2 3 )sin3 (2 3 ) cos3 ]
"( ) [3(2 3 ) cos3 3(2 3 )sin3 ] [(2 3 )sin3 (2 3 ) cos3 ]2
{[(4 6 ) (6 9 )
t t t
t t
t
y t e k t k t k t k t e e k k t k k t
y t e k k t k k t k k t k k t e
e k k k k
= + + + = + +
= + + + +
= +
2 1 1 2
2
2 1 2 1
]sin3 [(6 9 ) (4 6 )]cos3 }
{( 5 12 )sin3 (12 5 ) cos3 }
t
t k k k k t
e k k t k k t
+ + +
= +

{ } { }
{ }
{ } { }
2 2
2 1 2 1 2 1 1 2
2
1 2
2 2 2 2 2 2
2 1 2 1 2 2 1 1 2 1
"( ) 4 '( ) 13 ( )
{( 5 12 ) sin3 (12 5 ) cos3 } 4 [(2 3 ) sin3 (2 3 ) cos3 ]
13 ( cos3 sin3 )
( 5 12 ) 4 (2 3 ) 13 sin3 (12 5 ) 4 (2 3 ) 13 cos3
t t
t
t t t t t t
y t y t y t
e k k t k k t e k k t k k t
e k t k t
e k k e k k k e t e k k e k k k e t
+
= + + +
+ +
= + + + +
2 2
2 1 2 1 2 2 1 1 2 1
( 5 12 8 12 13 ) sin3 (12 5 8 12 13 ) cos3 0
t t
k k k k k e t k k k k k e t = + + + + =



sin
cos
cos
sin
d t
t
dt
d t
t
dt
=
=

9
Case 3
2
4 A B = (equal roots)

1 2
( ) ( )
rt
y t e c c t = +


Example "( ) 4 '( ) 4 ( ) 0 y t y t y t + + =
4, 4 or A B = = characteristic equation
2
2
1 2
( 4) (4) 4(4)
4 4 0 , 2
2
r r r r
+
+ + = = =
2
1 2 1 2
( ) ( ) ( )
rt t
y t e c c t e c c t

= + = +

Note:
2
1 2
2 2 2
2 1 2 2 1 2
2 2 2
2 1 2 2 1 2 2
( ) ( )
'( ) ( ) 2 ( ) ( 2 2 )
"( ) ( 2 2 )( 2 ) ( 2 ) (4 4 4 )
t
t t t
t t t
y t e c c t
y t e c e c c t c c c t e
y t c c c t e e c c c c t e



= +
= + =
= + = +


2 2 2
1 2 2 2 1 2 1 2
2
1 2 2 2 1 2 1 2
"( ) 4 '( ) 4 ( ) (4 4 4 ) 4 ( 2 2 ) 4 ( )
[(4 4 4 ) (4 8 8 ) (4 4 )] 0
t t t
t
y t y t y t c c c t e c c c t e e c c t
e c c c t c c c t c c t

( ( ( + + = + + + +

= + + + + =




Example "( ) 8 '( ) 16 ( ) 0 y t y t y t + + =
8, 16 or A B = = characteristic equation
2
2
1 2
( 8) (8) 4(16)
8 16 0 , 4
2
r r r r
+
+ + = = =
4
1 2 1 2
( ) ( ) ( )
rt t
y t e c c t e c c t

= + = +

Note:
4
1 2
4 4 4
2 1 2 2 1 2
4 4 4
2 1 2 2 1 2 2
( ) ( )
'( ) ( ) 4 ( ) ( 4 4 )
"( ) ( 4 4 )( 4 ) ( 4 ) (16 8 16 )
t
t t t
t t t
y t e c c t
y t e c e c c t c c c t e
y t c c c t e e c c c c t e



= +
= + =
= + = +


4 4 4
1 2 2 2 1 2 1 2
4
1 2 2 2 1 2 1 2
"( ) 8 '( ) 16 ( ) (16 8 16 ) 8 ( 4 4 ) 16 ( )
[(16 8 16 ) (8 32 32 ) (16 16 )] 0
t t t
t
y t y t y t c c c t e c c c t e e c c t
e c c c t c c c t c c t

( ( ( + + = + + + +

= + + + + =


10
Second Order Linear Differential Equation (Non-homogeneous)
"( ) '( ) ( ) ( ) y t Ay t By t f t + + =

Solution: ( )
H P
y t y y = +






i) if
1 2
real roots and r r = ,
1 2
1 2
( )
r t r t
y t c e c e
B
o
= + +
ii) if complex roots,
1 2
( ) ( cos sin )
at
y t e k bt k bt
B
o
= + +
iii) if
1 2
real roots and r r = ,
1 2
( ) ( )
rt
y t e c c t
B
o
= + +



Example: Find the
P
y of "( ) '( ) ( ) y t gy t hy t t o | + + = +

Let ( ) '( ) "( ) 0
P P P
y t at b y t a y t = + = =

LHS: "( ) '( ) ( ) 0 ( ) ( ) y t gy t hy t g a h at b aht ga bh + + = + + + = + +
RHS: t o | +
Comparing coefficients, we have
2
i)
ii)
ah a
h
g
ga h g
h
ga bh b
h h h
o
o
o
|
| | o
|
= =


+ = = = =
2
( ) ( )
P
h g
y t at b t
h h
o | o
= + = +


Example: Find the
P
y of
2
"( ) 4 '( ) 4 ( ) 2 y t y t y t t + = +
Let
2
'( ) 2 "( ) 2
P P P
y at bt c y t at b y t a = + + = + =

LHS:
2 2
"( ) 4 '( ) 4 ( ) (2 ) 4(2 ) 4( ) 4 (4 8 ) (2 4 4 ) y t y t y t a at b at bt c at b a t a b c + = + + + + = + + +
RHS:
2
2 t +

Comparing coefficients, we have
4 1, 4 8 0, 2 4 4 2 a b a a b c = = + =
2
1 1 7 7
, , ( )
4 2 8 4 2 8
P
t t
a b c y t = = = = + +
solution for the homogeneous
equation
particular solution for the non-homogeneous equation
Solving for
P
y when ( ) (constant) f t o = : ( ) '( ) 0 "( ) 0
P P P
y t y t y t
B
o
= = =
This satisfies "( ) '( ) ( ) y t Ay t By t o + + =
When ( ) is a polynomial f t of degree n , then the
P
y will also be a polynomial of degree n .
11



Example: Find the
P
y of "( ) '( ) ( )
qt
y t y t y t pe o | + + =






Let
2
( ) '( ) "( )
qt qt qt
P P P
y t Ae y t Aqe y t Aq e = = =

LHS:
2 2
"( ) '( ) ( ) ( ) ( ) ( )
qt qt qt qt
y t y t y t Aq e Aqe Ae e Aq Aq A o | o | o | + + = + + = + +
RHS:
qt
pe

Comparing coefficients, we have
2
2 2
( )
qt
P
p pe
Aq Aq A p A y t
q q q q
o |
o | o |
+ + = = =
+ + + +


Note that this only works when
2
0 q q o | + + = .

The condition
2
0 q q o | + + = means that q is not a solution of the characteristic equation
2
0 r r o | + + = , that is
qt
e is not a solution of "( ) '( ) ( ) 0 y t y t y t o | + + = .

If q is a simple root of
2
0 q q o | + + = , we look for a constant B such that
qt
Bte is a solution.

If q is a double root of
2
0 q q o | + + = , we look for a constant C such that
2 qt
Ct e is a solution.





Example: Find the
P
y of "( ) 4 '( ) 4 ( ) 2cos2 y t y t y t t + =

Let ( ) sin2 cos2 '( ) 2 cos2 2 sin2 "( ) 4 sin2 4 cos2
P P P
y t A t B t y t A t B t y t A t B t = + = =

LHS: "( ) 4 '( ) 4 ( ) [ 4 sin2 4 cos2 ] 4[2 cos2 2 sin2 ] 4[ sin 2 cos2 ] y t y t y t A t B t A t B t A t B t + = + +
( 4 8 4 )sin2 ( 4 8 4 )cos2 8 sin2 8 cos2 A B A t B A B t B t A t = + + + + =

RHS: 2cos 2t
Comparing coefficients, we have
1 1
8 0 and 8 2 0 and ( ) sin 2
4 4
P
B A B A y t t = = = = =
When ( ) sin cos f t p rt q rt = + , then ( ) sin cos
P
y t A rt B rt = +
When ( )
qt
f t pe = , then ( )
qt
P
y t Ae =
The corresponding homogeneous second order linear differential equation is
"( ) '( ) ( ) 0 y t y t y t o | + + = and the characteristic equation is
2
0 r r o | + + =
, , , p q o | are given
12
Note that these techniques for obtaining particular solutions also apply if ( ) f t is a sum,
difference, or product of polynomials, exponential functions, or trigonometric functions.

Example:

If
2 3 2 3
( ) ( 1) sin2 ( ) ( ) sin2 cos2
t t
P
f t t e t y t At Bt C e D t E t = + + = + + + +


13
Example
"( ) '( ) 0 y t Ay t + =

Let ( )
rt
y t ce = be the solution of the differential equation.

2
'( ) , "( )
rt rt
y t cre y t cr e = =

Substitute to the differential equation, we have
2 2
0 ( ) 0
rt rt rt
r ce Acre ce r Ar + = + =

This leads to a characteristic equation:
2
0 r Ar + =

The characteristic roots:
2
1 2
, or 0
2 2
A A A A
r r A

= = =

(0)
1 2 1 2
( )
At t At
y t c e c e c e c

= + = +

Note:
2
1 1
'( ) and "( )
At At
y t c Ae y t c A e

= =
Hence
2
1 1 1 2
"( ) '( ) ( ) ( ) 0( ) 0
At At At
y t Ay t c A e A c Ae c e c

+ = + + + =


Example
Looking for the for "( ) '( )
P
y y t Ay t o + =

Conjecture: ( )
P
y t C =

( ) '( ) 0 and "( ) 0
P P P
y t C y t y t = = = Does not work

Conjecture: ( )
P
y t at =

( ) '( ) and "( ) 0
P P P
y t at y t a y t = = =

"( ) '( ) (0) ( )
( )
P
y t Ay t A a a
A
y t t
A
o
o
o
+ = + = =
=


Note:
'( ) and "( ) 0
P P
y t y t
A
o
= = "( ) '( ) (0) ( )
P P
y t Ay t A
A
o
o + = + =

14
Example
Looking for the for "( ) '( )
P
y y t Ay t t o | + = +

Conjecture: ( )
P
y t at b = +

( ) '( ) and "( ) 0
P P P
y t at b y t a y t = + = =

"( ) '( ) (0) ( )
P P
y t Ay t A a t o | + = + = +


Conjecture:
2
( )
P
y t at bt = +
2
( ) '( ) 2 and "( ) 2
P P P
y t at bt y t at b y t a = + = + =


2
2
2
"( ) '( ) (2 ) (2 )
2 (2 )
2
2

2
2 2
2
( )
2
P P
P
y t Ay t a A at b t
aAt a Ab t
aA a
A
a A
a Ab b
A A A A
y t t t
A A A
o |
o |
o
o
o
|
| | o
|
o | o
+ = + + = +
+ + = +

= =

| |


\ .
= + = = =

| |
= +
|
\ .


Note:
2
'( ) + and "( )
P
t
y t y t
A A A A
o | o o | |
= =
|
\ .
2
"( ) '( ) ( ) +
P P
t
y t Ay t A t t
A A A A A A
o o | o o o
o | o |
( | |
+ = + = + + = +
| (
\ .


Does not work!!
15
Example
"( ) 0 y t =

Conjecture: ( ) y t at b = +
'( ) and "( ) 0 y t a y t = =

Hence the solution is ( ) for any , y t at b a b = +


Example
Looking for the for "( )
P
y y t o =

Conjecture: ( )
P
y t at b = +

( ) '( ) and "( ) 0
P P P
y t at b y t a y t = + = = Does not work.


Conjecture:
2
( )
P
y t at bt c = + +

2
2
( ) '( ) 2 and "( ) 2
2
( ) for any ,
2
P P P
P
y t at bt c y t at b y t a a
y t t bt c b c
o
o
= + + = + = =
= + +


Note:
'( ) and "( )
P P
y t t b y t o o = + =



16
Example
Looking for the for "( )
P
y y t t o | = +

Conjecture:
3 2
( )
P
y t at bt ct d = + + +

3 2 2
( ) '( ) 3 2 and "( ) 6 2
P P P
y t at bt ct d y t at bt c y t at b = + + + = + + = +

3 2
"( ) 6 2
6
6
( ) for any ,
6 2
2
2
P
P
y t at b t
a a
y t t t ct d c d
b b
o |
o
o
o |
|
|
= + = +

= =

= + + +

= =



Note:
2
'( ) + and "( )
2
P
t
y t t c y t t
o
| o | = + = + "( ) ( )
P
y t t t o | o | = + = +


17
Steady State Equilibrium and Stable Equilibrium

Definition: Let '( ) ( ) y t F y = . If * y - such that '( ) ( *) 0 y t F y = = , then * y is a steady state
equilibrium.

Definition: Let * y be a steady state equilibrium. It is a stable equilibrium if lim ( ) *
t
y t y

= .

Definition: Let ' ( ) y F y = . If t does not appear explicitly on the right-hand side, it is called an
autonomous (or time-independent) differential equation.

Theorem: If ( *) 0 F y = and '( *) 0 * F y y < is a stable equilibrium.

If ( *) 0 F y = and '( *) 0 * F y y > is an unstable equilibrium.
' y
stable equilibrium ( ) F y




y



unstable equilibrium


( )
'( )
dF y
F y
dy
=
18
Example:

Solows neoclassical economic growth model

Assumptions:
1. one output ( ) Y t

2. linear homogenous production function ( ) [ ( ), ( )] Y t F K t L t =

[ , ]
1
Let [ ,1] ( ) per capita production function
Y F K L
Y K
F y f k
L L L

=
= = =


a) marginal product of capital

1 1
'( )
( ) 1
'( )
K
K
Y
y Y
L
MP
MP f k K K L K L
y f k
f k
K K L

c

c c
= = =

= c c c
`

c c
= =

c c )


i) '( ) 0 f k >
ii)
0 0
lim '( ) [Given , lim ]
K
k K
f k L MP

= =
iii) lim '( ) 0 [Given , lim 0]
K
k K
f k L MP

= =
iv)
'( ) ''( )
''( ) 0 [ ]
K
MP f k f k
f k
K K L
c c
< = =
c c

b) marginal product of labor

2
2
'( )
( ) '( ) ( ) '( )
( )
'( )
L L
Y Y
L Y
y
L L
Y f k K
L MP Y f k K MP f k kf k
L L L
L
y f k K
f k
L L L
c
c

c
c
= =
= = =
c c
`

c c
= =

c c )


c) (0) 0 f =
d) ( ) f =

3. 0 1 S sY s = < <
4. ' K I =
5. At equilibrium, I S =
6.
'
is exogenous
L
n n
L
=



19
Model:
' '
( ) ( ) (1)
Y C I
Y C I
L L L
C K K C
f k f k
L L L L
+
= +
= + =


' ' ' '
ln ln ln
' ' '
' ' (2)
K k K L K
k k K L n
L k K L K
K K K
k k nk nk k nk
K L L
= = = =
= = = +


(1) and (2) ( ) '
C
f k k nk
L
= +
fund
' ( ) ( )
'( ) ( ) amental equation of neo-classical economic growth model
C S sY
k f k nk nk nk sf k nk
L L L
k t sf k nk
= = = =
=


nk
( ) sf k










k

* steady state equilibrium k




' 0 k >


0 k



' 0 k <



20

























The stability of * k

@ *, * ( *)
* ( *)
k nk sf k
n
k f k
s
=
=

( *) ( *) (0)
* * 0
n f k f k f
s k k

= =



By the Mean Value Theorem,
( *) (0)
(0, *) such that '( )
* 0
f k f
x k f x
k

- e =


Define so that (0,1)
*
x
k
u u e and
( *) ( *) (0)
'( *) (**)
* * 0
n f k f k f
f k
s k k
u

= = =

.
Multiply (**) by * k * ( *) * '( *) * '( *)
n
k f k k f k k f k
s
u = = >

* * '( *) '( *)
n n
k k f k f k
s s
> >
'( *) n sf k >

Note that ( ) '( ) ( ) F k k t sf k nk = fundamental equation

Hence '( ) '( ) and '( *) '( *) 0 F k sf k n F k sf k n = = < * k is a stable equilibrium.



Mean Value Theorem

Let ( ) f x be differentiable on ( , ) a b and continuous on [ , ] a b . Then there is at least one point c
where
( ) ( )
'( )
f b f a
f c
b a

( ) y f x =
y











x
a c b

(0) 0 f =
diminishing MP
K

21
System of first order ordinary differential equations

Definition
1 1 1 2
1 2
' ( , ,..., , )
...
' ( , ,..., , )
n
n n n
x f x x x t
x f x x x t
=

is a system of first order ordinary differential equations



Theorem (existence and uniqueness of solution)

If
1
(...)
( , ... , , ) and
i
i n
j
f
f x x t
x
c
c
are continuous, then for every point
0 0
0 1
( , , ..., )
n
t x x , - a unique
solution ( )
i i
x t = satisfying the system of differential equation and
0
0
( )
i i
x t = .


Definition If
i
f does not depends (explicitly) on t , i.e.
1 1 1 2
1 2
' ( , ,..., )
...
' ( , ,..., )
n
n n n
x f x x x
x f x x x
=

is an autonomous system of first order ordinary differential equations




Definition Any point
1
( *, ..., *)
n
x x is a critical point if
1 1 1 2
1 2
' ( *, *,..., *) 0
...
' ( *, *,..., *) 0
n
n n n
x f x x x
x f x x x
= =

= =




Definition
1
( *, ..., *)
n
x x is an isolated critical point if - a neighborhood of
1
( *, ..., *)
n
x x
containing no other critical points.


Definition If
i
f is linear in
,
1,...,
j
x j n = , then
1 1 1 2
1 2
' ( , ,..., )
...
' ( , ,..., )
n
n n n
x f x x x
x f x x x
=

is a system of linear ordinary differential equations.


22
Properties of the solution of an autonomous system

For simplicity, we will consider a system of 2 equations.

' ( , )
' ( , )
x F x y
y G x y
=

(1) , and their derivatives are continuous F G



Lemma 1 If
1 2
( ), ( ), x x t y y t t t t = = < < is a solution of (1), then for any real constant c , the
functions
1 1
( ) ( ) and ( ) ( ) x t x t c y t y t c = + = + are also solutions of (1).

Proof: By chain rule, we have
1 1
'( ) '( ) and '( ) '( ) x t x t c y t y t c = + = + .
1 1 1
1 1 1
'( ) '( ) [ ( ), ( )] [ ( ), ( )]
'( ) '( ) [ ( ), ( )] [ ( ), ( )]
x t x t c F x t c y t c F x t y t
y t y t c G x t c y t c G x t y t
= + = + + =
= + = + + =
1 1
( ) and ( ) x t y t are solutions to (1).

Note: This lemma only applies for autonomous system.


Definition As t varies, a solution ( ), y( ) x t t of (1) describes parametrically a curve on the x y
plane. This curve is called a trajectory or a path.
y

Example:
2
( )
( )
x t t
y t t
=
=
2
y x =
x

Lemma 2 Through any point passes at most one path.

Remark: Note the distinction between solutions and trajectories of (1). A trajectory is a curve
that is represented by more than one solution.

Example:

2
( )
( )
x t t
y t t
=

and
2
4
( )
( )
x t t
y t t
=

are different solutions with the same trajectories.



Definition Let ( *, *) x y be an isolated critical point of (1). If [ ( ), ( )] C x t y t = is a path of (1), then
we say that C APPROACHES ( *, *) x y as t if lim ( ) * and lim ( ) *
t t
x t x y t y

= = .
Geometrically, if ( , ) P x y = is a point that traces out C in accordance with the
equations ( ) and ( ) x x t y y t = = , then ( *, *) as P x y t .

23
Definition If
( ) *
lim
( ) *
t
y t y
x t x

exists, or if it becomes either positively infinite or negatively infinite as


t , then we say that C ENTERS the critical point ( *, * x y ) as t .

Note: The quotient is the slope of the line joining ( *, * x y ) and the point ( ( ), ( )) P x t y t = .

Note: This property is a property of the path C , and it does not depend on which solution is
used to represent the path.

Definition A critical point is said to be STABLE if for each 0 R > , r R - s such that every path
which is inside the circle
2 2 2
0
( *) ( *) @ x x y y r t t + = = will remain inside the circle

2 2 2
0
( *) ( *) for x x y y R t t + = > .

Note: Loosely speaking, a critical point is stable if all paths that get sufficiently close to the
critical point will stay close to the critical point.

Definition A critical point is ASYMPTOTICALLY STABLE if it is stable and -a circle

2 2 2
0
( *) ( *) x x y y r + = such that every path which is inside this circle
0
@t t =
will approach the critical point as t .

Definition A critical point that is not stable is UNSTABLE.




Solving a pair of linear differential equation/ Phase diagram of the solution
1 1
2 2
'
'
x a x b y
y a x b y
= +

= +

(1) homogeneous system


Theorem A If the homogeneous system has 2 solutions
1
1
( )
( )
x x t
y y t
=

and
2
2
( )
( )
x x t
y y t
=

, then

1 1 2 2
1 1 2 2
( ) ( )
( ) ( )
x c x t c x t
y c y t c y t
= +

= +

(2) is also a solution for the system for any constant


1 2
and c c .

Theorem B If the 2 solutions in Theorem A has a Wronskian
1 2
1 2
( ) ( )
( )
( ) ( )
x t x t
W t
y t y t
= that does not
vanish, then (2) is the general solution of the system.

Example:
' 4
' 2
x x y
y x y
=

= +

has 2 solutions
3
3
t
t
x e
y e
=

and
2
2
2
t
t
x e
y e
=

.

1 2
1 2
3 2
5
3 2
( ) ( )
( )
( ) ( )
0
2
t t
t
t t
x t x t
W t
y t y t
e e
e
e e
=
= = =

24






Try
rt
rt
x Ae
y Be
=

, A B are constants to be determined


Substitute this into the system,
1 1
2 2
'
'
x a x b y
y a x b y
= +

= +

1 1
2 2
'
'
rt rt rt
rt rt rt
x rAe a Ae b Be
y rBe a Ae b Be
= = +


= = +

1 1
2 2
rA a A b B
rB a A b B
= +


= +


1 1
2 2
( ) 0
( ) 0
a r A b B
a A b r B
+ =


+ =

(3)

Note that 0 A B = = are the trivial solution of the system.

Note that (3) has a non-trivial solution if
1 1
2 2
0
a r b
a b r










1 1 2
1 2 1 2 1 2 1 2 2 1
2 2
0 ( )( ) 0 ( ) 0
a r b
a r b r b a r a b r a b a b
a b r

= = + + =


2
1 2 1 2 1 2 2 1
( ) ( ) 4( )
2
a b a b a b a b
r
+ +
=

Solution:
1
1
1 1
1 1
( )
( )
r t
r t
x t Ae
y t Be
=

and
2
2
2 2
2 2
( )
( )
r t
r t
x t A e
y t B e
=



Solving the system
1 1
2 2
'
'
x a x b y
y a x b y
= +

= +


Note that
1
1 1 2
1 1 2 2
2 2
0
0
0 if 0
b
a r b b r
a r b a b r
a b r

= =


characteristic equation
25
Case 1: Distinct real roots

General solution:
1 2
1 2
1 1 2 2
1 1 2 2
( )
( )
r t r t
r t r t
x t c Ae c A e
y t c Be c B e
= +

= +



Example:
'
' 4 2
x x y
y x y
= +


(1 ) 0 1 1 0
4 ( 2 ) 0 4 2 0
r A B r A
A r B r B
+ = | || | | |
=

| | |
+ =
\ .\ . \ .


Characteristic equation:
2
(1 )( 2 ) (1)(4) 0 2 2 4 0 r r r r r = + + =


2
1 2
6 0 ( 3)( 2) 0 3, 2 r r r r r r + = + = = =
1
3 r = :
[1 ( 3)] 0 4 0
4 [ 2 ( 3)] 0 4 0
A B A B
A B A B
+ = + =


+ = + =


3
1
3
1
( )
( ) 4
t
t
x t e
y t e



2
2 r = :
[1 (2)] 0 0
4 [ 2 (2)] 0 4 4 0
A B A B
A B A B
+ = + =


+ = =



2
2
2
2
( )
( )
t
t
x t e
y t e
=



General solution:
3 2
1 2
3 2
1 2
( )
( ) 4
t t
t t
x t c e c e
y t c e c e

= +


= +




Suppose (0) 1, (0) 2 x y = = .

3(0) 2(0)
1 2 1 2
3(0) 2(0)
1 2 1 2
1 (0)
2 (0) 4 4
x c e c e c c
y c e c e c c

= = + = +

= = + = +

1 2
1 6
and
5 5
c c = =
3 2
3 2
1 6
( )
5 5
4 6
( )
5 5
t t
t t
x t e e
y t e e

= +

= +







A simple non-trivial solution is
1 and 4 A B = =
A simple non-trivial solution is
1 and 1 A B = =
26
Case 1A Real and distinct, same sign: Node Assume
1 2
0 r r < <
General solution:
1 2
1 2
1 1 2 2
1 1 2 2
( )
( )
r t r t
r t r t
x t c Ae c A e
y t c Be c B e
= +

= +



Note: i) critical point (0, 0) =
ii)
1 2
lim lim 0
r t r t
t t
e e

= =
iii) lim ( ) lim ( ) 0
t t
x t y t

= = [i.e. ( ( ( ), ( )) (0, 0) as ] x t y t t
iv)
1 2
1 2
( the roots are distinct)
B B
A A
=

When
2 2
2 2
2 2 2 2
1
2 2 2 2
( ) ( )
0
( ) ( )
r t r t
r t r t
x t c A e B e B y t
c
x t A e A y t c B e
=
= = =



When
1 1
1 1
1 1 1 1
2
1 1 1 1
( ) ( )
0
( ) ( )
r t r t
r t r t
x t c Ae Be B y t
c
x t Ae A y t c Be
=
= = =


When
1 2
1 2 1 2
1 2 1 2
1 2
( )
1 1
2
1 1 2 2 1 1 2 2 2
1 2
( )
1 1
1 1 2 2 1 1 2 2
2
2
( ) ( )
0, 0
( ) ( )
r r t
r t r t r t r t
r t r t r t r t
r r t
c B
e B
x t c Ae c A e c Be c B e c y t
c c
c A
x t c Ae c A e y t c Be c B e
e A
c

+
= + +
= = = =

+ = +

+

1 2
1 2
( )
1 1
2
2 2
( )
1 1
2
2
2
lim
r r t
t
r r t
c B
e B
c B
c A
A
e A
c


+
=
+
as
1 2
0 r r <
Also
2 1
1 2
1 2
2 1
( )
2 2
1
1 1 2 2 1
( )
2 2
1 1 2 2
1
1
( )
( )
r r t
r t r t
r t r t
r r t
c B
B e
c Be c B e c y t
c A
x t c Ae c A e
A e
c

+
+
= =
+
+
2 1
2 1
( )
2 2
1
1 1
( )
2 2
1
1
1
lim
r r t
t
r r t
c B
B e
c B
c A
A
A e
c


+
=
+
as
2 1
0 r r >
y

1
1
B
A

Node: Asymptotically stable


x




2
2
B
A

1 2
and c c are arbitrary constants
27
Case 1B Real and distinct, opposite sign: Saddle Point Assume
1 2
0 r r < <
General solution:
1 2
1 2
1 1 2 2
1 1 2 2
( )
( )
r t r t
r t r t
x t c Ae c A e
y t c Be c B e
= +

= +


Note: i) critical point (0, 0) =
ii)
1 1
lim 0, lim
r t r t
t t
e e

= =
iii)
2 2
lim , lim 0
r t r t
t t
e e

= =
iv)
1 2
1 2
( the roots are distinct)
B B
A A
=

When
2
2
2 2 2
1
2 2 2
( ) ( )
0 , lim ( ) , lim ( ) , lim ( ) lim ( ) 0
( ) ( )
r t
r t
t t t t
x t c A e B y t
c x t y t x t y t
x t A y t c B e

=
= = = = = =



When
1
1
1 1 1
2
1 1 1
( ) ( )
0 , lim ( ) lim ( ) 0, lim ( ) , lim ( )
( ) ( )
r t
r t
t t t t
x t c Ae B y t
c x t y t x t y t
x t A y t c Be

=
= = = = = =


When
1 2
1 2
1 1 2 2
1 2
1 1 2 2
( )
0, 0 lim ( ) lim ( )
( )
r t r t
r t r t
t t
x t c Ae c A e
c c x t y t
y t c Be c B e

= +
= = = =

= +


1 2
1 2
1 2
1 2
( )
1 1
2
1 1 2 2 2
( )
1 1
1 1 2 2
2
2
( )
( )
r r t
r t r t
r t r t
r r t
c B
e B
c Be c B e c y t
c A
x t c Ae c A e
e A
c

+
+
= =
+
+
1 2
1 2
( )
1 1
2
2 2
( )
1 1
2
2
2
lim
r r t
t
r r t
c B
e B
c B
c A
A
e A
c


+
=
+
as
1 2
0 r r <
Also
2 1
1 2
1 2
2 1
( )
2 2
1
1 1 2 2 1
( )
2 2
1 1 2 2
1
1
( )
( )
r r t
r t r t
r t r t
r r t
c B
B e
c Be c B e c y t
c A
x t c Ae c A e
A e
c

+
+
= =
+
+
2 1
2 1
( )
2 2
1
1 1
( )
2 2
1
1
1
lim
r r t
t
r r t
c B
B e
c B
c A
A
A e
c


+
=
+
as
2 1
0 r r >

y

1
1
B
A

Saddle Point


x




2
2
B
A



1 2
and c c are arbitrary constants
28
Case 2 Equal real roots: Node
1 2
r r r = =
General solution:
1 2 1 2
1 2 1 2
( ) ( )
( ) ( )
rt rt
rt rt
x t c Ae c A A t e
y t c Be c B B t e
= + +

= + +



Note that
2
1 2 1 2 1 2 2 1
( ) ( ) 4( )
2
a b a b a b a b
r
+ +
=
2
1 2 1 2 1 2 2 1
( ) 4( ) 0 r r r a b a b a b = = + =


Case 2A
1 2 2 1
0 and 0 a b a a b = = = = =
2 2 2
1 2 1 2 2 1 1 2 1 2 1 2
[( ) 4( ) ( ) 4 ( ) 0] a b a b a b a b a b a b + = + = =

1
2
' ( )
' ( )
rt
rt
x ax x t c e
y ay x t c e
= =


= =



If 0 r < , then lim ( ) 0 and lim ( ) 0
t t
x t y t

= =
If 0 r > , then lim ( ) 0 and lim ( ) 0
t t
x t y t

= =

1 2
1 2
( ) ( )
( ) ( )
rt
rt
x t c e c y t
x t c y t c e
=
=




y

2
1
c
c
0 r <
Node: Asymptotically stable


x




2
2
B
A







1 2
and c c are arbitrary constants
29
Case 2B Any other combination: Node
General solution:
1 2 1 2
1 2 1 2
( ) ( )
( ) ( )
rt rt
rt rt
x t c Ae c A A t e
y t c Be c B B t e
= + +

= + +


If 0, lim ( ) 0 and lim ( ) 0
t t
r x t y t

< = = [Note that the term t is dominated by the term
rt
e .]
If 0, lim ( ) 0 and lim ( ) 0
t t
r x t y t

> = = .

When
1
2
1
( )
0
( )
rt
rt
c Be y t B
c
x t c Ae A
= = =

When
2 1 2 1 2
1
2 1 2 1 2
( ) ( )
0
( ) ( )
rt
rt
c B B t e B B t y t
c
x t c A A t e A A t
+ +
= = =
+ +

1
2
1 2 2
1
1 2 2
2
lim lim
t t
B
B
B B t B
t
A
A A t A
A
t

+
+
= =
+
+

When
1 1
2 2
1 2 1 2
1 2
1 1
1 2 1 2
2 2
( )
( ) ( )
0, 0
( ) ( )
( )
rt rt
rt rt
c B B
c B
c Be c B B t e y t
t t
c c
c A A
x t c Ae c A A t e
c A
t t
+ +
+ +
= = = =
+ +
+ +

1 1
2 2
2
1 1
2
2 2
( )
lim
( )
t
c B B
c B
B
t t
c A A
A
c A
t t

+ +
=
+ +


y

0 r <
Node: Asymptotically stable


x




B
A


2
2
B
A

30
Example:
' 3 4
'
x x y
y x y
=
=

In order to have a nontrivial solution for
A
B
| |
|
\ .
,
3 4
0
1 1
r
r

=


2 2
(3 )( 1 ) ( 4)(1) 0 2 1 0 ( 1) 0 r r r r r = + = = real and equal roots

(3 1) 4 0 2 4 0
(1)
(1 1) 0 2 0
A B A B
A B A B
= =


+ = =



A simple non-trivial solution of this system is 2, 1 A B = = so that
( ) 2
( )
t
t
x t e
y t e
=



A second linearly independent solution:
1 2 1 2 2 1 2 2
1 2 1 2 2 1 2 2
( ) ( ) '( ) ( ) ( )

( ) ( ) '( ) ( ) ( )
t t t t
t t t t
x t A A t e x t A A t e e A A A t A e
y t B B t e y t B B t e e B B B t B e
= + = + + = + +


= + = + + = + +



system
1 2 2 1 2 1 2
1 2 2 1 2 1 2
( ) 3( ) 4( )
( ) ( ) ( )
t t t
t t t
A A t A e A A t e B B t e
B B t B e A A t e B B t e
+ + = + +


+ + = + +



2 2 1 2 1 1 2 2 1 2 1 2
2 2 1 1 2 1 2 2 1 2 1 2
(2 4 ) (2 4 ) 0 ( ) 3( ) 4( )
( 2 ) ( 2 ) 0 ( ) ( ) ( )
t t t
t t t
A B t A A B A A t A e A A t e B B t e
A B t A B B B B t B e A A t e B B t e
+ = + + = + +


+ = + + = + +



2 2 1 2 1
2 2 1 1 2
2 4 0 2 4 0
2 0 2 0
A B A A B
A B A B B
= =


= =



The 2 equations on the left
2 2
2, 1 A B = = .

The 2 equations on the right
1 1 1 1 1 1
2 4 2 and 2 1 1 and 0 A B A B A B = = = =

( ) (1 2 )
(2)
( )
t
t
x t t e
y t te
= +


=



1 2
1 2
( ) 2 (1 2 )
general solution:
( )
t t
t t
x t c e c t e
y t c e c te
= + +


= +






rt
rt
x Ae
y Be
=


31
Case 3 Distinct complex roots: Spirals
1 1
2 2
'
'
x a x b y
y a x b y
= +

= +


1 2
, r r a bi =
General solution:
1 1 2 2 1 2
1 1 2 2 1 2
( ) [ ( cos sin ) ( sin cos )]
( ) [ ( cos sin ) ( sin cos )]
at
at
x t e c A bt A bt c A bt A bt
y t e c B bt B bt c B bt B bt
= + +

= + +


If
1 2
0 a a b + < , then lim ( ) 0 and lim ( ) 0
t t
x t y t

= = , i.e. ( ( ), ( )) (0, 0) as x t y t t , i.e. (0, 0) is
asymptotically stable.

However, ( ) and ( ) x t y t change sign infinitely often as t , all paths must spiral to the critical
point.
y



0 a <
Spiral: Asymptotically stable


x








Case 4: Pure imaginary roots: Center
1 2
, r r bi =
General solution:
1 1 2 2 1 2
1 1 2 2 1 2
( ) ( cos sin ) ( sin cos )
( ) ( cos sin ) ( sin cos )
x t c A bt A bt c A bt A bt
y t c B bt B bt c B bt B bt
= + +

= + +


y


Center:
stable but not Asymptotically stable


x



32
Non-homogeneous system

1 1 1
2 2 2
'
'
x a x b y c
y a x b y c
= + +

= + +



Solving this system
1 1 1
2 2 2
* * 0
* * 0
a x b y c
a x b y c
+ + =

+ + =

will give us the critical point ( *, *) x y .



Define ( ) ( ) * and ( ) ( ) * x t x t x y t y t y [ '( ) '( ) and '( ) '( ) x t x t y t y t ]

The original system can be written as
1 1
2 2
'
'
x a x b y
y a x b y
= +

= +







The properties of the critical point of the non-homogeneous system are the same as those of the critical
point for the corresponding homogeneous system.


1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2
' ' ( *) ( *) * *
' ' ( *) ( *) * *
x a x b y x a x x b y y a x b y a x b y a x b y c
y a x b y y a x x b y y a x b y a x b y a x b y c
= + = + = + = + +


= + = + = + = + +


33
Example:

' 3
' 4 2
x x y
y x y
= +
=


( 3 ) 0
4 ( 2 ) 0
r A B
A r B
+ =


+ =


In order to have a nontrivial solution for
A
B
| |
|
\ .
,
3 1
0
4 2
r
r

=



2 2
2
( 3 )( 2 ) (4)(1) 0 5 6 4 0 5 2 0
5 5 4(1)(2) 5 17
2 2
r r r r r r
r
= + + = + + =

= =


1
5 17
2
r
+
=
1 1 1 1
1 1 1 1
5 17 1 17
( 3 ) 0 0
2 2
5 17 1 17
4 (2 ) 0 4 0
2 2
A B A B
A B A B

+
+ = + =




+

+ = + =




1 1
1 1
1 1
1 1
1
1
1 17 1 17 1 17
1 17
0
4 0
2 2 2
2
1 17
1 17
4 0
4 0
2
2
4 8
0
1 17 1 17
2
A B
A B
A B
A B
B
A
| || |
+ +
+
+ =
| | + =

| |

\ .\ .

+ =
+ =

= = >
+ +

2
5 17
2
r

=
2 2 2 2
2 2 2 2
5 17 1 17
( 3 ) 0 0
2 2
5 17 1 17
4 (2 ) 0 4 0
2 2
A B A B
A B A B

+
+ = + =




+

+ = + =



2 2
2 2
2 2 1 2
2
2
1 17 1 17 1 17
1 17
0
4 0
2 2 2
2
1 17 1 17
4 0 4 0
2 2
4 8
0
1 17 1 17
2
A B
A B
A B A B
B
A
| || |
+


+ =
| |
+ = | |

\ .\ .


| | + +
+ = + =
|

|

\ .
= = <


rt
rt
x Ae
y Be
=


Both roots are real and
negativenode
34
y

' 0 x =



1
1
8
2.56
1 17
B
A
= ~
+

' 0 y = Node: Asymptotically stable


x




2
2
8
1.56
1 17
B
A
= ~




General solution:
1 2
1 2
1 1 2 2
1 1 2 2
( )
( )
r t r t
r t r t
x t c Ae c A e
y t c Be c B e
= +

= +



Also
2 1
1 2
1 2
2 1
( )
2 2
1
1 1 2 2 1
( )
2 2
1 1 2 2
1
1
( )
( )
r r t
r t r t
r t r t
r r t
c B
B e
c Be c B e c y t
c A
x t c Ae c A e
A e
c

+
+
= =
+
+
2 1
2 1
( )
2 2
1
1 1
( )
2 2
1
1
1
lim
r r t
t
r r t
c B
B e
c B
c A
A
A e
c


+
=
+
as
2 1
0 r r <
Suppose (0) 1 (0) x y = =

1 1 2 2 0 0
1 1 2 2
0 0
1 1 2 2
1 1 2 2
1
1 (0)
8 8
1
1 (0)
1 17 1 17
c A c A
x c Ae c A e
c A c A
y c Be c B e
= +
= = +


= +
= = +

+



1 2
1
1 2 2
1
8 8
1
1 17 1 17
A A
c
A A c
| |
| | | |
|
=
| |
|
\ . \ . |
+
\ .

2
2 2
1
1 2
1 2 1
1 2
1
8 8 8
1 1 1
1 17 1 17 1 17
8 8 8 8
8 8 1 17 1 17 1 17 1 17
1 17 1 17
A
A A
c
A A
A A A
A A
| | | |

| |

\ . \ .
= = =
| | | |

| |
+ +
\ . \ .
+

35
1
1 1
2
1 2
1 2 2
1 2
1
8 8 8
1 1 1
1 17 1 17 1 17
8 8 8 8
8 8 1 17 1 17 1 17 1 17
1 17 1 17
A
A A
c
A A
A A A
A A
| | | |

| |
+ +
\ . \ .
= = =
| | | |

| |
+ +
\ . \ .
+


1 2
1
1 2
1 2
1
1
8 8
1 1
1 17 1 17
( )
8 8 8 8
1 17 1 17 1 17 1 17
8 8
1 1
8 1 17 1 17
( )
8 8 1 17
1 17 1 17
r t r t
r t
x t Ae A e
A A
y t A e
A
| | | |

| |

\ . \ .
= +
| | | |

| |
+ +
\ . \ .

| | |

|
| |
\ . \
= +
|
| | +
\ .

|
+
\ .
2
2
2
8
8 8 1 17
1 17 1 17
r t
A e
A

| |
.

|
| | \ .

+
\ .

1 2
1
8 8
1 1
1 17 1 17
( )
8 8 8 8
1 17 1 17 1 17 1 17
8 8
1 1
8 1 17 1 17
( )
8 8 8 8 1 17
1 17 1 17 1 17
r t r t
r t
x t e e
y t e
| | | |

| |

\ . \ .
= +
| | | |

| |
+ +
\ . \ .

| | | |

| |
| |
\ . \ .
= +
|
| | +
\ .

|
+
\ .
2
8
1 17
1 17
r t
e

| |

|
| |
\ .

+
\ .

36
Example:

' 2 3
'
x x y
y x y
= +
= +


(2 ) 3 0
(1 ) 0
r A B
A r B
+ =


+ =


In order to have a nontrivial solution for
A
B
| |
|
\ .
,
2 3
0
1 1
r
r



2 2
2
(2 )(1 ) (3)(1) 0 3 2 3 0 3 1 0
( 3) ( 3) 4(1)( 1) 3 13
2 2
r r r r r r
r
= + = =

= =


1
3 13
2
r
+
=
1 1 1 1
1 1 1 1
3 13 1 13
(2 ) 3 0 3 0
2 2
3 13 1 13
(1 ) 0 0
2 2
A B A B
A B A B

+
+ = + =




+ +

+ = =




1 1
1 1
1 1
1 1
1
1
1 13 1 13 1 13
3 3 13
3 0
3 0
2 2 2
2
1 13
1 13
0
0
2
2
3 2
0.4343 0
3 3 13 1 13
2
A B
A B
A B
A B
B
A
| || |
+ +
+
+ =
| | + =

| |

\ .\ .


+

+
=
=

= = ~ >
+ +

2
3 13
2
r

=
2 2 2 2
2 2 2 2
3 13 1 13
(2 ) 3 0 3 0
2 2
3 13 1 13
(1 ) 0 0
2 2
A B A B
A B A B

+
+ = + =






+ = =



2 2
2 2
2 2
2 2
2
2
1 13 1 13 1 13
3 3 13
3 0
3 0
2 2 2
2
1 13
1 13
0
0
2
2
3 2
0.768 0
3 3 13 1 13
2
A B
A B
A B
A B
B
A
| || |
+

+ =
| | + =

| |

\ .\ .

=
=

= = ~ <


The roots are real and of opposite signs
saddle point
rt
rt
x Ae
y Be
=


37

y

1
1
2
0.4343
1 13
B
A
= ~
+

Saddle Point


x




2
2
2
0.768
1 13
B
A
= ~





When
2
2
2 2 2
1
2 2 2
( ) ( )
0 , lim ( ) 0, lim ( ) 0, lim ( ) lim ( )
( ) ( )
r t
r t
t t t t
x t c A e B y t
c x t y t x t y t
x t A y t c B e

=
= = = = = =



When
1
1
1 1 1
2
1 1 1
( ) ( )
0 , lim ( ) lim ( ) , lim ( ) 0, lim ( ) 0
( ) ( )
r t
r t
t t t t
x t c Ae B y t
c x t y t x t y t
x t A y t c Be

=
= = = = = =


When
1 2
1 2
1 1 2 2
1 2
1 1 2 2
( )
0, 0 lim ( ) lim ( )
( )
r t r t
r t r t
t t
x t c Ae c A e
c c x t y t
y t c Be c B e

= +
= = = =

= +


1 2
1 2
1 2
1 2
( )
1 1
2
1 1 2 2 2
( )
1 1
1 1 2 2
2
2
( )
( )
r r t
r t r t
r t r t
r r t
c B
e B
c Be c B e c y t
c A
x t c Ae c A e
e A
c

+
+
= =
+
+
1 2
1 2
( )
1 1
2
2 2
( )
1 1
2
2
2
lim
r r t
t
r r t
c B
e B
c B
c A
A
e A
c


+
=
+
as
1 2
0 r r >
Also
2 1
1 2
1 2
2 1
( )
2 2
1
1 1 2 2 1
( )
2 2
1 1 2 2
1
1
( )
( )
r r t
r t r t
r t r t
r r t
c B
B e
c Be c B e c y t
c A
x t c Ae c A e
A e
c

+
+
= =
+
+
2 1
2 1
( )
2 2
1
1 1
( )
2 2
1
1
1
lim
r r t
t
r r t
c B
B e
c B
c A
A
A e
c

+

+
=
+
as
2 1
0 r r <


Suppose (0) 1 (0) x y = =

1 1 2 2 0 0
1 1 2 2
0 0
1 1 2 2
1 1 2 2
1
1 (0)
2 2
1
1 (0)
1 13 1 13
c A c A
x c Ae c A e
c A c A
y c B e c B e
= +
= = +


= +
= = +

+



1 2
0 r r > >

38
1 2
1
1 2 2
1
2 2
1
1 13 1 13
A A
c
A A c
| |
| | | |
|
=
| |
|
\ . \ . |
+
\ .

2
2 2
1
1 2
1 2 1
1 2
1
2 2 2
1 1 1
1 13 1 13 1 13
2 2 2 2
2 2
1 13 1 13 1 13 1 13
1 13 1 13
A
A A
c
A A
A A A
A A
| | | |

| |

\ . \ .
= = =
| | | |

| |
+ +
\ . \ .
+

1
1 1
2
1 2
1 2 2
1 2
1
2 2 2
1 1 1
1 13 1 13 1 13
2 2 2 2
2 2 1 13 1 13 1 13 1 13
1 13 1 13
A
A A
c
A A
A A A
A A
| | | |

| |
+ + +
\ . \ .
= = =
| | | |

| |
+ +
\ . \ .
+


1 2
1
1 2
1 2
1
1
2 2
1 1
1 13 1 13
( )
2 2 2 2
1 13 1 13 1 13 1 13
2 2
1 1
2 1 13 1 13
( )
2 2 2 2 1 13
1 13 1 13 1 13 1 13
r t r t
r t
x t Ae A e
A A
y t A e
A
| | | |

| |
+
\ . \ .
= +
| | | |

| |
+ +
\ . \ .

| | | |

| |
| | +
\ . \ .
= +
|
| | | | +
\ .

|
+ +
\ . \
2
2
2
2
1 13
r t
A e
A

| |

|
\ .
|

.

1 2
1
2 2
1 1
1 13 1 13
( )
2 2 2 2
1 13 1 13 1 13 1 13
2 2
1 1
2 2 1 13 1 13
( )
2 2 2 2 1 13 1 13
1 13 1 13 1 13 1 13
r t r t
r t
x t e e
y t e
| | | |

| |
+
\ . \ .
= +
| | | |

| |
+ +
\ . \ .

| | | |

| |
| | | | +
\ . \ .
= +
| |
| | | | +
\ . \ .

| |
+ +
\ . \ .
2
r t
e


39
Suppose
1 13
(0) 1, (0)
6
x y

= =

0 0
1 1 2 2
1 1 2 2
0 0
1 1 2 2
1 1 2 2
1
1 (0)
1 13 2 2
1 13
(0)
6 1 13 1 13 6
c A c A
x c Ae c A e
c A c A
y c Be c B e
= + = = +



= +
= = +

+


1 2
1
1 2 2
1
2 2
1 13
1 13 1 13
6
A A
c
A A c
| | | |
| |
| |
=
|
| |
\ . | |
+
\ . \ .


2
2
2
1
1 2
1 2 1
1 2
1
1
2 1 13 2 1 13 1 13
1 13 2
6 6 1 13 1 13 1 13 6 1 13
2 2 2 2
2 2 1 13 1 13 1 13 1 13
1 13 1 13
2(1 13) 1 13 2(1 13) 1 13
1 13 6 12 6
2 2 2 2
1 13 1 13 1 13 1 13
A
A
A
c
A A
A A A
A A
A A
| | | |
+


| |
+

\ . \ .
= = =
| | | |

| |
+ +
\ . \ .
+
+ +


= =
| | | |

| |
+ +
\ . \ .
1 1
(1 13) 1 13
6 6
0
2 2
1 13 1 13
A
+ +
+

= =
| |

|
+
\ .


1
1
1
2
1 2
1 2 2
1 2
2
1
1 13 2 1 13 2
2 1 13
6 6 1 13 1 13 6 1 13
2 2 2 2
2 2 1 13 1 13 1 13 1 13
1 13 1 13
( 1 13) 1 13 2 6
(1 2 13 13) 12
6 6 1 13 1 13
6(1 13)
2 2 2
1 13 1 13 1 1
A
A
A
c
A A
A A A
A A
A
| | | |



| |
+ +
+
\ . \ .
= = =
| | | |

| |
+ +
\ . \ .
+
| |
+ | | + +

|
|
+ + \ . +
\ .
= =
| |

|
+
\ .
2 2
2
2 13 26
6(1 13)
2 2 2
3 1 13 1 13 1 13
13 13
2 2
3(1 13)
1 13 1 13
A A
A

+
=
| | | |

| |
+ +
\ . \ .

=
| |
+
|
+
\ .


40
2 2
2
2
2
2
2
13 13 13 13
( ) =
2 2 2 2
3(1 13) 3(1 13)
1 13 1 13 1 13 1 13
13 13 2 13 13 2
( )
2 2 2 2 1 13 1
3(1 13) 3(1 13)
1 13 1 13 1 13 1 13
r t r t
r t
x t A e e
A
y t A e
A

=
| | | |
+ +
| |
+ +
\ . \ .

| |
= =
|
| | | |
\ .
+ +
| |
+ +
\ . \ .
2
13
r t
e

| |


\ .



Note that as , ( ) 0 and ( ) 0 t x t y t .

In general, so long as the given point fulfill the condition
( ) 1 13
0.768
( ) 6
y t
x t

= ~ , then the path will
converge to the critical point.

The critical point is a SADDLE POINT.

41
Example:

' 5 2
' 17 5
x x y
y x y
= +
=


(5 ) 2 0
17 ( 5 ) 0
r A B
A r B
+ =


+ =


In order to have a nontrivial solution for
A
B
| |
|
\ .
,
5 2
0
17 5
r
r

=



2 2
(5 )( 5 ) (2)( 17) 0 25 34 0 9 0
3
r r r r
r i
= + = + =
=


General solution:
1 1 2 2 1 2
1 1 2 2 1 2
( ) ( cos3 sin3 ) ( sin3 cos3 )
( ) ( cos3 sin3 ) ( sin3 cos3 )
x t c A t A t c A t A t
y t c B t B t c B t B t
= + +

= + +



The roots are complex roots
center
rt
rt
x Ae
y Be
=


42
Taylor Expansion
2
"( *)( *) ( )( *)
( ) ( *) '( *)( *) ... ( , *)
2! !
n n
f x x x f a x x
f x f x f x x x a x x
n

= + + + + e

2 2
( , ) ( *, *) ( *, *)( *) ( *, *)( *)
( *, *)( *) 2 ( *, *)( *)( *) ( *, *)( *)
...
2!
x y
xx xy yy
f x y f x y f x y x x f x y y y
f x y x x f x y x x y y f x y y y
= + +
+ +
+ +


Example: Expand ( ) around 0
x
f x e x = =
( ) (0) 1
'( ) '(0) 1
''( ) ''(0) 1
...
x
x
x
f x e f
f x e f
f x e f
= =
= =
= =

2 3
2 3 4
''(0) '''(0)
( ) (0) '(0)( 0) ( 0) ( 0) ...
2! 3!
1 ...
2! 3! 4!
f f
f x f f x x x
x x x
x
= + + + +
= + + + + +



Example: Expand ( ) ln(1 ) around 0 f x x x = + = .
1
2
( ) ln(1 ) (0) 0
'( ) (1 ) '(0) 1
''( ) 1(1 )
f x x f
f x x f
f x x

= + =
= + =
= +
3 3
4 4 4
''(0) 1
'''( ) ( 2)(1 ) =(2!)(1 ) '''(0) 2!
( ) 2( 3)(1 ) = (3!)(1 )
f
f x x x f
f x x x


=
= + + =
= + +
4
5 5 5 5
(0) 3!
( ) (2)(3)( 4)(1 ) (4!)(1 ) (0) 4!
...
f
f x x x f

=
= + = + =

2 3
2 3 4 5 2 3 4 5 6
''(0) '''(0)
( ) (0) '(0)( 0) ( 0) ( 0) ...
2! 3!
( 1) (2!) ( 3!) (4!)
( ) 0 ... ...
2! 3! 4! 5! 2 3 4 5 6
f f
f x f f x x x
x x x x x x x x x
f x x x
= + + + +

= + + + + = + + +





43
Phase diagram

Shell Model of Inventive Activity and Capital Accumulation

( ) [ ( ), ( ), ( )] Y t F A t K t L t =

( ) : stock of technical knowledge
( ) : capital stock
( ) : labor
A t
K t
L t

: output allocated for inventive activity
(1 )(1 ) : output allocated for consumption
(1 ) : output allocated for capital accumulation
Y
s Y
sY
o
o
o



success rate depreciation

'( ) ( ) ( )
'( ) (1 ) ( ) ( )
A t Y t A t
K t s Y t K t
oo
o
=
=


Let ( , ) where ( , ) is homogenous to degree 1 Y AF K L F K L =
( ) ( ) 0, ' 0, " 0, (0) 0, ( ) , '(0) , '( ) 0 y Af k Y ALf k f f f f f f f = = > > < = = = =

Let
' ' ' ' ' '
1 so that ( ); ; ' '
Y k K L K K K
L Y Af k y Y k k K
L k K L K K L
= = = = = = = = =

' ( ) (1)
' (1 ) (1 ) ( ) (2)
A Y A Af k A
k s y k s Af k k
oo oo
o o
= =
= =


Constructing the ' 0 A = curve
1
' ( ) 0 ( ) 0 ( ) ( )
S
A Af k A f k f k k f

oo oo
oo oo

= = = = =
A

' 0 A =

I J
- -







1
( )
S
k f

oo

= k

Consider the points ( , ) and ( , ) I k A J k A
I I J J
= = .
Since
i) ( ) ( ) f k f k
I J
<
ii) ( ) 0
J
f k oo =
' ( ) 0
I
A f k oo = <
Since and I J are arbitrary ' 0 A < on the left of the
' 0 A = curve.
44
Constructing the ' 0 k = curve
' (1 ) ( ) 0
(1 ) ( )
k
k s Af k k A
s f k

o
o
= = =


Differentiating
2 2
' 0
[ (1 ) ( )] ( )[ (1 ) '( )] [ ( ) '( )]
with respect to 0
[ (1 ) ( )] (1 )[ ( )]
k
dA s f k k s f k f k kf k
A k
dk s f k s f k
o o
o o
=

= = >


The ' 0 k = is upward sloping.

A ' 0 k =

I -


J
-






k


A

' 0 A =
' 0 k =









S
A saddle point











k

S
k
Consider the points ( , ) and ( , ) I k A J k A
I I J J
= = .
Since and
I J I J
A A k k > =
(1 ) ( ) (1 ) ( ) 0
I I I J J J
s A f k k s A f k k o o > =
Since and I J are arbitrary ' 0 k > for the points
which lie above the ' 0 k = curve.

Similarly, ' 0 k < all the points which lie below the
' 0 k = curve.

45
Stability

Take a Taylor series expansion around ( , )
S S
k A .

' ' ' '
' '( , ) ( ) ( ) ( ) ( )
' ' ' '
' '( , ) ( ) ( ) ( ) ( )
S S S S
S S S S
S S S S
S S S S
S S S S S S
A A A A A A A A
k k k k k k k k
S S S S S S
A A A A A A A A
k k k k k k k k
A A A A
A A k A A A k k A A k k
A k A k
k k k k
k k k A A A k k A A k k
A k A k
= = = =
= = = =
= = = =
= = = =
c c c c
= + + = +
c c c c
c c c c
= + + = +
c c c c

1
'
( ) 0
S
S
S
A A
k k
A
f k a
A
oo
=
=
c
= =
c

1
'
'( ) 0
S
S
S S
A A
k k
A
A f k b
k
oo
=
=
c
= >
c

2
'
(1 ) ( ) 0
S
S
S
A A
k k
k
s f k a
A
o
=
=
c
= >
c

2
'
(1 ) '( ) (sign unknown)
S
S
S S
A A
k k
k
s A f k b
k
o
=
=
c
=
c

2 2
1 2 1 2 1 2 2 1 2 2 2 1
( ) ( ) 4( ) 4
,
1 2
2 2
a b a b a b a b b b a b
r r
+ + +
= =
2 2 2 2 2
2 2 2 1 2 2 2 1
1 2 2 1
( 4 ) ( 4 )
0
4 4
b b a b b b a b
r r a b
+ +
= = = <
1 2
, r r are real and opposite sign
saddle point
46
Phase Diagram of
'( ) '( ')
" , convex functions, " 0, " 0
"( ')
g x rf x
x f g f g
f x
+
= > >

We will construct a phase diagram with and ' x x as the 2 variables.

Constructing ' 0 x =
' x



' 0 x =
x





Constructing " 0 x =
" 0 '( ) '( ') 0 x g x rf x = + =

Total differential "( ) "( ') ' 0 g x dx rf x dx + =
' 0
' "( )
0
"( ')
x
dx g x
dx rf x
=
= <

' x

B


x


A
" 0 x =

Phase diagram
' x




x


x
" 0 x = " 0 x =



0
x
T
x
Consider points A and B.
' ' ,
B A B A
x x x x > =
'( ' ) '( ' ) ( "( ') 0)
B A
rf x rf x f x > >
'( ) '( ' ) '( ) '( ' ) 0
B B A A
g x rf x g x rf x + > + =
Hence any point lying above the " 0 x =
curve has the property that " 0 ' x x > |
The solution to the differential equation must
be either single-peaked, monotonic, or
single-troughed in ( ) x t , '( ) x t changes sign at
most once.
There is only 1 path going from
0
x to
T
x and takes exactly T .
47
Example

1 2
' { ( ) [ ( ), ] } 0, 0, [0, ] 0, [ ( ), 0] ,
' [ ( ), ] ( ) '(.) 0, (0) 0
k s f k A f k r nk A A A A f k
A f k n f f
o o o o
o o o
= + > < = <
= + > =


: k capital-labor ratio
s : saving rate
o : debt per capita
A: aid per capita
: retirement of principal
r : interest rate
n : labor growth rate

' 0 curve o =
' [ ( ), ] ( ) 0 A f k n o o o = + =
1 2
1 2
1
1 2
' 0 2
'( ) ( ) 0
'( ) ( ) 0
'( )
0 0, 0
A f k dk A d n d
A f k dk A n d
A f k d
A A
dk A n
o
o o
o
o

=
+ + =
+ =

= > > <






o
' 0 o =




I J








k












0 0 k o = =

,
I J J I
k k o o = >

'
'
[ ( ), ] ( )
[ ( ), ] ( ) 0
J J J J
I I I I
A f k n
A f k n
o o o
o o o
= +
> + = =

48
' 0 curve k =

1 2
1 2
1
1
' 0 2
' { ( ) [ ( ), ] } 0
{ '( ) [ '( ) ] } 0
{ [ '( ) '( )] } [ ( ) ] 0
[ '( ) '( )]
0 iff '( )(1 ) 0
( )
k
k s f k A f k r nk
s f k dk A f k dk A d rd d ndk
s f k A f k n dk s A r d
s f k A f k n d
sf k A n
dk s r A
o o o
o o o
o
o

> >
< <
=
= + =
+ + =
+ + =
+
= = + =
+


o




I


J


' 0 k =


k



o


' 0 o =







' 0 k =


k











When k is small, '( ) f k is large.
,
I J I J
k k o o = >

'
'
{ ( ) [ ( ), ] }
{ ( ) [ ( ), ] } 0
J J J J J J J
I I I I I I I
k s f k A f k r nk
s f k A f k r nk k
o o o
o o o
= +
> + = =

49
Stability

Take a Taylor series expansion around ( , )
S S
k o .

' ' ' '
' '( , ) ( ) ( ) ( ) ( )
' ' ' '
' '( , ) ( ) ( ) ( ) ( )
S S S S
S S S S
S S S S
S S S S
S S S S S S
k k k k k k k k
S S S S S S
k k k k k k k k
k k k k
k k k k k k k
k k
k k k k k
k k
o o o o o o o o
o o o o o o o o
o o o o o
o o
o o o o
o o o o o o o
o o
= = = =
= = = =
= = = =
= = = =
c c c c
= + + = +
c c c c
c c c c
= + + = +
c c c c

1 1 1
'
{ '( ) '( )} '( )(1 ) 0
S
S
S S S
k k
k
s f k A f k n sf k A n a
k
o o
=
=
c
= + = + <
c

2 1
'
( ) 0
S
S
k k
k
s A r b
o o

o =
=
c
= <
c

1 2
'
'( ) 0
S
S
k k
A f k a
k
o o
o
=
=
c
= >
c

2 2
'
( ) <0
S
S
k k
A n b
o o
o

o =
=
c
= +
c

2
1 2 1 2 1 2 2 1
2 2
1 2 1 2 1 2 2 1
1 2 1 2 2 1
( ) ( ) 4( )
,
1 2
2
( ) [( ) 4( )]
( )( ) ( )( ) 0
4
a b a b a b a b
r r
a b a b a b a b
r r a b a b
+ +
=
+ +
= = = + >

cannot be a saddle point




50
Calculus of Variation

Motivation

Find the shortest distance in the plane between the points, ( , ) and ( , ) a A b B .

ds dx
2
1
2 2 2 2
2
[( ) ( ) ] ( ) [1 ] 1 '( )
dx
ds dt dx dt x t dt
dt
| |
= + = + = +
|
\ .

dt
1
2
2
min [1 '( ) ] s.t. ( ) , ( )
b
a
x t dt x a A x b B + = =
}


General problem
1
0
0 0 1 1
( )
[ , ( ), '( )] s.t. ( ) , ( )
t
x t
t
optimize F t x t x t dt x t x x t x = =
}

Necessary condition for an optimum (Eulers Equation):
'
[ , *( ), *'( )]
[ , *( ), *'( )]
x
x
dF t x t x t
F t x t x t
dt
=

Example
1
2
2
( )
min [1 '( ) ] s.t. ( ) , ( )
b
x t
a
x t dt x a A x b B + = =
}

1
2
2
1
2
2
' 1
2
2
[ , ( ), '( )] [1 '( ) ]
1 '
0 and [1 '( ) ] [2 '( )]
2
[1 ' ]
x x
F t x t x t x t
F x
F F x t x t
x
x

= +
c
= = = + =
c
+

(Eulers Equation):
'
[ , *( ), *'( )]
[ , *( ), *'( )]
x
x
dF t x t x t
F t x t x t
dt
=
1
2 1
2
2 2 2 2 2 2 2 2
2
1
2
2
2 2
2 2 2 2
2 2
'
[1 ( ') ] '
0 ' [1 ( ') ] ( ') [1 ( ') ] ( ') ( ')
[1 ( ') ]
(1 )( ') ( ') '( ) ( ) , are constants
1 1
x
d
x x
c x c x x c x x c c x
dt
x
c c dx
c c x x x t k k x t kt h k h
c c dt
(
(
(
+ (

= = = + = + = +
+
= = = = = = +


( ) 1
,
( ) 1
x a ka h A a k A
A B aB Ab
k h
x b kb h B b h B a b a b
= + = | || | | |
= = =

| | |
= + =
\ .\ . \ .

51
Optimal control theory

Problem:
1
0
( )
[ , ( ), ( )] (1)
t
u t
t
Max f t x t u t dt
}

s.t. '( ) [ , ( ), ( )] (2) x t g t x t u t = dynamic equation/ state equation/ transition equation

0 1
0 0
1
, fixed
( ) fixed (3)
( ) free
t t
x t x
x t

=
`

)
[ , ( ), ( )] f t x t u t

( ) : x t state variable
( ) : u t control variable (piecewise continuous)
, f g continuously differentiable



0
t
1
t
Let ( ) t be any continuously differentiable function on
0 1
[ , ] t t .

For any ( ), ( ) x t u t satisfying (2) and (3), we have
{ }
{ }
1 1
0 0
1
0
[ , ( ), ( )] [ , ( ), ( )] ( )[ ( , ( ), ( )) '( )]
[ , ( ), ( )] ( ) [ , ( ), ( )] ( ) '( ) (4)
t t
t t
t
t
f t x t u t dt f t x t u t t g t x t u t x t dt
f t x t u t t g t x t u t t x t dt


= +
= +
} }
}

Integrating by part the last term of (4),
1 1 1
1
0
0 0 0
1
0
1 1 0 0
1 1 0 0
( ) '( ) ( ) ( ) ( ) '( ) ( ) ( ) ( ) ( ) ( ) '( )
( ) ( ) ( ) ( ) ( ) '( )
t t t
t
t
t t t
t
t
t x t dt t x t x t t dt t x t t x t x t t dt
t x t t x t x t t dt




= =
` `

) )
= + +
} } }
}
(5)

{ }
1
0
1
0
1 1 0 0
(5) (4) [ , ( ), ( )]
[ , ( ), ( )] ( ) [ , ( ), ( )] ( ) '( ) ( ) ( ) ( ) ( ) (6)
t
t
t
t
f t x t u t dt
f t x t u t t g t x t u t x t t dt t x t t x t
=
+ + +
}
}

Let *( ) u t be the optimal control which maximizes the integral
1
0
[ , ( ), ( )]
t
t
f t x t u t dt
}
.
Let ( ) *( ) ( ) u t u t ah t + where ( ) is an arbitrary "fixed" function and is a parameter h t a .
Clearly, 0 ( ) *( ) a u t u t = = .
Find a path
which maximize
the area/integral.
52
Let
0 1
( , ), y t a t t t s s denotes the state variable generated by (2) and (3) with control ( ) u t .

This ( , ) y t a satisfies the following conditions:
0 0
( , ) and ( , 0) *( ) y t a x y t x t = = .

Let
1
0
( ) [ , ( , ), *( ) ( )]
t
t
J a f t y t a u t ah t dt +
}

Using (6),
{ }
1
0
( ) [ , ( , ), *( ) ( )] ( ) [ , ( , ), *( ) ( )] ( , ) '( )
t
t
J a f t y t a u t ah t t g t y t a u t ah t y t a t dt + + + +
}


1 1 0 0
( ) ( , ) ( ) ( , ) t y t a t y t a +

Since *( ) u t is the optimal control, ( ) J a assumes its maximum at 0 '(0) 0 a J = = .

{
}
1
0
1
1 0
'( ) [ , ( , ), *( ) ( )] ( , ) [ , ( , ), *( ) ( )] ( )
( ) [ , ( , ), *( ) ( )] ( , ) ( ) [ , ( , ), *( ) ( )] ( )
( ( , )
( , ) '( ) ( ) ( )
t
y a u
t
y a u
a
J a f t y t a u t ah t y t a f t y t a u t ah t h t
t g t y t a u t ah t y t a t g t y t a u t ah t h t
dy t dy t a
y t a t dt t t
da


= + + +
+ + + +
+ +
}
0
, ) a
da

As
0
0 0
( , )
( , ) (initial condition) 0
dy t a
y t a x
da
= =
{
}
1
0
1 1
'( ) [ , ( , ), *( ) ( )] ( , ) [ , ( , ), *( ) ( )] ( )
( ) [ , ( , ), *( ) ( )] ( , ) ( ) [ , ( , ), *( ) ( )] ( )
( , ) '( ) ( ) ( , )
t
y a u
t
y a u
a a
J a f t y t a u t ah t y t a f t y t a u t ah t h t
t g t y t a u t ah t y t a t g t y t a u t ah t h t
y t a t dt t y t a


= + + +
+ + + +
+
}

{
}
1
0
1 1
'(0) [ , ( , 0), *( )] ( , 0) [ , ( , 0), *( )] ( ) ( ) [ , ( , 0), *( )] ( , 0)
( ) [ , ( , 0), *( )] ( ) ( , 0) '( ) ( ) ( , 0)
= [ , ( ), *( )
t
y a u y a
t
u a a
x
J f t y t u t y t f t y t u t h t t g t y t u t y t
t g t y t u t h t y t t dt t y t
f t x t u t


= + +
+ +
}
| | {
| | }
1
0
1 1
] ( ) [ , ( ), *( )] '( ) ( , 0)
[ , ( ), *( )] ( ) [ , ( ), *( )] ( ) ( ) ( , 0) 0
t
x a
t
u u a
t g t x t u t t y t
f t x t u t t g t x t u t h t dt t y t


+ +
+ + =
}


Since ( , 0), ( )
a
y t h t can be of any form, therefore the necessary conditions for '(0) 0 J = are
i) ' 0
x x
f g + + =
ii) 0
u u
f g + =
iii)
1
( ) 0 t =


53
Sum up:

If the functions *( ), *( ) u t x t maximizes (1) subject to (2) and (3), then there is a continuously
differentiable ( ) t such that
i) state equation
0 0
'( ) ( , ( ), ( )), ( ) x t g t x t u t x t x = =
ii) co-state equation { }
1
'( ) [ , ( ), ( )] ( ) [ , ( ), ( )] , ( ) 0
x x
t f t x t u t t g t x t u t t = + =
iii) optimality condition
0 1
[ , ( ), ( )] ( ) [ , ( ), ( )] 0 for
u u
f t x t u t t g t x t u t t t t + = s s


Short-cut formulas:

Problem:
1
0
( )
0 0
( , , )
. . ' ( , , )
( )
t
u t
t
Optimize f t x u dt
s t x g t x u
x t x
=
=
}



Set up a Hamiltonian function: [ , , , ] ( , , ) ( , , ) H t x u f t x u g t x u +

Necessary conditions:

i) 0 [ 0]
u u u
H
H f g
u

c
= = + =
c

ii)
{ } ' [ ' ]
x x
H
f g
x

c
= = +
c

iii)
1
( ) 0 t = transversality condition
iv) ' ( , , )
H
H x g t x u

c
= = =
c







54
Example
1
2
0
max ( ) . . ' 1 , (0) 1, (1) free
u
x u dt s t x u x x + = =
}

2
( , , , ) (1 ) H t x u x u u = + +

Necessary conditions:
2
1 2 0 (1)
1 ' (2)
' 1 (3)
(1) 0
u
H u
H u x
H
x

= =
= =
c
= =
c
= (4)


(3): '( ) 1 ( ) t t t c = = +
Using (4) ( ) 1 (5) t t =
2
1 2
1 1 1
(1) : ( ) ( )
2 2(1 ) 2(1 )
1 1
(2) : '( ) 1 1 ( )
4(1 ) 4(1 )
u t u t
t t
x t u x t t c
t t

= = =

= = = +


1 1
1 5 1 5
Using (0) 1 1 0 ( )
4(1 0) 4 4(1 ) 4
x c c x t t
t
= = + = = +





55
Example
10
2
0
max 5 s.t. ' , (0) 2, (10) free
u
x dt x x u x x = =
}

2
( , , , ) 5 ( ) H t x u x x u = +

Necessary conditions:
2
2 0 (1)
' (2)
' (5 ) (3)
(10) 0
u
H u
H x u x
H
x

= =
= =
c
= = +
c
= (4)

(1)
10 10 10 10
0
5
(3) : ' 5 ( ) 5
1
Using (10) 0 0 (10) 5 5 5 ( ) 5 5
(1) ( ) 0
(2) ' ( )
Using (0) 2 2 (0) ( ) 2
t t
t
t
t
t ce ce
ce ce c e t e
u t
x x x t ke
x x ke k x t e



+ = = + = +
= = = + = = = +
=
= =
= = = = =

10
2
0
max ( 5 ) . . ' , (0) 2, (10) free
u
u x dt s t x x u x x + = =
}


2
( , , , ) 5 ( ) H t x u u x x u + +

Necessary conditions:
2
1 2 0 (1)
' (2)
' (5 ) (3)
(10) 0 (4)
u
H
H u
u
H
x H x u
H
x

c
= = =
c
c
= = =
c
c
= = +
c
=


10 10 10 10
5
(3) ( ) 5
1
(4) 0 (10) 5 5 ( ) 5 (5 ) ( ) 5 5 (5)
t t
t t
t ce ce
ce c e t e e t e

= + = +
= = + = = + = +


10 10
1 1 1
(5) (1) ( )
2 ( ) 2( 5 5 ) 10 10
t t
u t
t e e

= = =
+ +


' ( )
Pt
Q
y Py Q y t ce
P

+ = = +
56
2 2
10 10
1 1
(2) ' '
10 10 10 10
t t
x x x x
e e

| | | |
= =
| |
+ +
\ . \ .


2 2
1 1
10 10
10
10
1 1
( ) ( )
10 10 10 10
1
( )
10 10 10
dt dt
t t
t t
t
t
x t e e dt k x t e e dt k
e e
e
x t e k
e


| | | |
| | | |
} }
= + = +
| |
| |
| |
+ +
\ . \ .
\ . \ .
(
| |
= +
| (
+
\ .

} }


Using (0) 2 x = , we have
10 10
0
10 0 10
1 1
2 (0) 2
10 10 10 10 10 10
e e
x e k k
e e

(
| | | |
= = + = +
| | (
+ +
\ . \ .



10 10
10 10
1 1
( ) 2
10 10 10 10 10 10
t
t
e e
x t e
e e

(
| | | |
= + +
| | (
+ +
\ . \ .




57
5
2 2
1
max ( )
. . ' , (1) 2
u
ux u x dt
s t x x u x

= + =
}


2 2
( ) H ux u x x u = + +

Necessary conditions:
2 0 (1)
' ( 2 ) 2
u
X
H x u
H u x u x


= + =
= = + = + (2)
(5) 0 (3)
' x x u
=
= + (4)
(1) 2 (5) x =


(1) 2u x = (6)

(4) ' (4') u x x =

(4') (6) 2( ' ) 2 ' 3 x x x x x = = (7)

Differentiate (7) with respect to ' 2 " 3 ' t x x = (8)

(6) (2) ' 2 (2 ) 3 3 u x u x x u = + = (9)

(8), (4) and (9) 2 " 3 ' 3 3( ' ) 2 " 3 ' 6 3 ' 2 " 6 0 " 3 0 x x x x x x x x x x x x x = = = =

Characteristic equation:
2
3 0 3 r r = =

3 3
1 2
( )
t t
x t c e c e

= + (10)

Differentiating (10) with respect to
3 3
1 2
' 3 3
t t
t x c e c e

=

(4):
3 3 3 3
1 2 1 2
' ( 3 3 ) ( )
t t t t
u x x c e c e c e c e

= = +
3 3
1 2
( 3 1) ( 3 1)
t t
u c e c e

= + (11)

(6) and (11)
3 3 3 3
1 2 1 2
2 2 ( 3 1) ( 3 1)
t t t t
u x c e c e c e c e

( (
= = + +


3 3 3 3
1 2 1 2
( ) (2 3 2 1) (2 3 2 1) (2 3 3) (2 3 3)
t t t t
t c e c e c e c e

( (
= + + = +



Using (3), we have
5 3 5 3
1 2
(5) (2 3 3) (2 3 3) 0 c e c e

= + = (12)
58
(5) and (10)
3 3
1 2
(1) 2 x c e c e

= + = (13)
(12) and (13)
5 3 5 3
1
3 3
2
(2 3 3) (2 3 3) 0
2
c e e
c
e e

| |
+ | | | |
= |
| |
|
\ . \ .
\ .

5 3
3 5 3 5 3
1
4 3 4 3 4 3 4 3 5 3 5 3
3 3
5 3
3 5 3 5 3
2
4 3 4 3 4 3 4 3 5 3 5 3
3 3
0 (2 3 3)
2 2(2 3 3) 2
(2 3 3) (2 3 3) (7 4 3) (2 3 3) (2 3 3)
(2 3 3) 0
2 2(2 3 3) 2
(2 3 3) (2 3 3) (7 4 3) (2 3 3) (2 3 3)
e
e e e
c
e e e e e e
e e
e
e e e
c
e e e e e e
e e

+
+
= = =
+ + + +

= = =
+ + + + +


Solution:
3 3
1 2
( )
t t
x t c e c e

= +
3 3
1 2
( ) ( 3 1) ( 3 1)
t t
u t c e c e

= +
3 3
1 2
( ) (2 3 3) (2 3 3)
t t
t c e c e

= +


59
Example: Find the shortest distance between a point ( , )
A
t A and the line
b
t t = .







A x ds dx

dt



t

A B
t t
Problem:
2
2
min min (1 ( ') s.t. ( )
min (1 )
s.t. '
( )
( ) free
B B
A A
B
A
t t
A A
t t
t
u
t
A A
B
ds x dt x t X
u dt
x u
x t X
x t
+ =
+
=
=
} }
}


Hamiltonian:
2
1 H u u + +

Necessary conditions:
2
0 (1)
(1 )
' (2)
' 0 (3)
( ) 0 (4)
u
X
B
u
H
u
x u
H
t

= + =
+
=
= =
=


(3) ( ) t c = (5)
(4) and (5) ( ) 0 t =

Substitute
2
( ) 0 (1) 0 0
1
u
t u
u
= = =
+


0 (2) ' 0 ( ) u x x t k = = = ( ) x t is a horizontal line.

2 2 2 2 2
( ) ( ) [1 ( ) ]( ) 1 ( ')
dx
ds dt dx dt x dt
dt
= + = + = +

60
Example: Optimal price path

( ) P t : price @t
( ) Q t : cumulative sales @t
( ) C Q : unit production cost '( ) 0 C Q s

( ) ( ) f P g Q : the rate that a new product can be sold
1
'( ) 0; "( ) 0
'( ) 0 for
f P f P
g Q Q Q
< <
> <
< >


Problem:
T
( )
0
max [ ( )] ( ) ( )
P t
P C Q f P g Q dt
}

s.t. ' ( ) ( ) Q f P g Q =

0
(0) 0 Q Q = >
( , , , ) ( , , , ) [ ( )] ( ) ( ) ( ) ( ) ( ) ( )[ ( ) ] H t x u H t Q P P C Q f P g Q f P g Q f P g Q P C Q + = +

Optimal conditions:
{ } ( ) ( ) [ ( ) ] '( ) 0
P
H g Q f P P C Q f P = + + = (1)
{ } { }
{ }
' ( ) [ ( ) ] '( ) ( ) '( )
( ) ( ) '( ) [ ( ) ] '( )
Q
H f P P C Q g Q g Q C Q
f P g Q C Q P C Q g Q

= = +
= +
(2)
( ) 0 T = (3)
' ( ) ( ) Q f P g Q = (4)

(1):
( )
( ) [ ( ) ] '( ) 0 ( )
'( )
f P
f P P C Q f P P C Q
f P
+ + = = +

( )
( ) ( )
'( )
f P
t C Q P
f P
= (5)

Differentiate (5) with respect to t :

| |
| |
| | | |
2
2
2 2
'( ) '( ) '( ) ( ) "( ) '( )
'( ) '( ) '( ) '( )
'( )
' '( ) ( ) "( )
' ( ) "( )
' '( ) ' ' '( ) ' ' '
'( ) '( )
f P f P P t f P f P P t
t C Q Q t P t
f P
P f P f P f P
P f P f P
C Q Q P C Q Q P P
f P f P

=
(

= = +

| |
2
( ) "( )
' '( ) ' ' 2
'( )
f P f P
C Q Q P
f P

(
= (
(

(6)
: control variable
: state variable
P
Q

61
{ } (5) (2) ' ( ) ( ) '( ) [ ( ) ] '( )
( )
( ) ( ) '( ) ( ) ( ) '( )
'( )
( )
( ) ( ) '( ) '( )
'( )
f P g Q C Q P C Q g Q
f P
f P g Q C Q P C Q C Q P g Q
f P
f P
f P g Q C Q g Q
f P
= +
(
= +
` `
(
) )

= +
`
)
(2')

(2) and (6)
| |
2
( ) "( ) ( )
'( ) ' ' 2 ( ) ( ) '( ) '( )
'( )
'( )
f P f P f P
C Q Q P f P g Q C Q g Q
f P
f P
(

= + (
`
( )


| |
| |
| |
| |
2
2
2
( ) "( ) ( )
' ( ) ( ) '( ) ( ) ( ) ' 2 ( ) ( ) '( ) '( )
'( )
'( )
( ) ( ) (+)
( ) "( ) '( )
' 2 ( )
'( )
'( )

f P f P f P
Q f P g Q C Q f P g Q P f P g Q C Q g Q
f P
f P
f P f P g Q
P f P
f P
f P
(

= = + (
`
( )

+
(
= (
(

( )


{ } { } '( ) '( ) sign P t sign g Q =

When the market is expanding (i.e.
1
Q Q < ), ( ) P t is increasing.
When the market is shrinking (i.e.
1
Q Q > ), ( ) P t is decreasing.

62
4 Interpretation of ( ) t
1
0
0 0
0 0
Define ( , ) max ( , , )
s.t. '( ) ( , , )
( )
t
t
V x t f t x u dt
x t g t x u
x t x

=
=
}
(1)

Let *( ) u t be the optimal control and *( ) x t be the optimal path of ( ) x t .

{ }
{ }
1 1
0 0
1
0
0 0
( , ) ( , *, *) ( , *, *) [ ( , *, *) ']
= ( , *, *) ( , *, *) '] (2)
t t
t t
t
t
V x t f t x u dt f t x u g t x u x dt
f t x u g t x u x dt


= +
+
} }
}


where ( ) t is the corresponding continuously differentiable multiplier function

Integrate the last term of (2) by parts:








{ }
{ }
1
0
1
0
0 0
1 1 0 0
( , ) ( , *, *) ( , *, *) ']
( , *, *) ( , *, *) * '] ( ) *( ) ( ) ( ) (3)
t
t
t
t
V x t f t x u g t x u x dt
f t x u g t x u x dt t x t t x t


= +
= + + +
}
}



Now, using the same ( ) t , define
1
0
0 0
0 0
( , ) max ( , , )
s.t. '( ) ( , , )
( )
t
t
V x a t f t x u dt
x t g t x u
x t x a
+
=
= +
}

1 1 1
1
0
0 0 0
1 1 0 0
Integrate by parts:
Let ( ) ( ) '( ) , ' ( ) ' ( )
' ( ) ( ) ' ( ) ( ) ( ) ( ) '
t t t
t
t
t t t
udv uv vdu duv udv vdu uv duv udv vdu
u t t du t dt dv x dt v t dv x dt x t
x dt t x t x dt t x t t x t x dt


(
= = + = = +

= = = = = =
= =
} } } } }
} }
} } }

0 0
*( ) ( ) x t x t =
63
{ }
{ } | |
1 1
0 0
1
0
0 0
1 1 0 0
( , ) ( , , ) ( , , ) ( , , ) ']
( , , ) ( , , ) '] ( ) ( ) ( ) ( ) (4)
t t
t t
t
t
V x a t f t x u dt f t x u g t x u x dt
f t x u g t x u x dt t x t t x t a


+ = = +
= + + + +
} }
}

where ( ) and ( ) are optimal for the new problem. x t u t


{ } | |
{ }
1
0
1
0
0 0 0 0 1 1 0 0
1 1 0 0
0 1 1
( , ) ( , ) ( , , ) ( , , ) '] ( ) ( ) ( ) ( )
( , *, *) ( , *, *) * '] ( ) *( ) ( ) ( )
[ ' * * ' *] ( ) ( )[ ( )
t
t
t
t
V x a t V x t f t x u g t x u x dt t x t t x t a
f t x u g t x u x dt t x t t x t
f g x f g x dt t a t x t





+ = + + + +
`

)


+ + +
`

)
= + + +
}
}
1
0
1
*( )] (5)
t
t
x t
}


Expand ( , , ) ( , , ) around ( *, *) f t x u g t x u x u +

| |
| |
( , , ) ( , , ) ( , *, *) ( , *, *) ( , *, *) ( , *, *) ( *)
* * ( *) ...
x x
u u
f t x u g t x u f t x u g t x u f t x u g t x u x x
f g u u

+ = + + +
+ + +


{ }
1
0
0 0 0 0
0 1 1 1
(5) ( , ) ( , ) [ * * ']( *) [ * *]( *)
( ) ( )[ ( ) *( )] (6)
t
x x u u
t
V x a t V x t f g x x f g u u dt
t a t x t x t


+ = + + + +
+
}


Note that
1
' ( * *)
*, *, and satisfy * * 0
( ) 0
x x
u u
f g
x u f g
t

= +

+ =



0 0 0 0 0
0 0 0 0
0
0 0 0 0 0 0
0 0 0
0
0
(6) ( , ) ( , ) ( )
( , ) ( , )
( )
( , ) ( , ) ( , )
( ) lim ( , )
x
a
V x a t V x t t a
V x a t V x t
t
a
V x a t V x t V x t
t V x t
a x


+ =
+
=
+ c
= = =
c






64
Principle of optimality: If *( ) and *( ) u t x t are optimal paths, then any sub-paths are also optimal.


*( ) x t


#
x





t

#
0 1
t t t

Suppose we follow
#
*( ), *( ) to x t u t t and stop. We then try to solve the following problem:
1
#
# #
max ( , , ) s.t. ' ( , , ) and ( )
t
t
f t x u dt x g t x u x t x = =
}


Let ( ) x t
A
be the solution to this problem.

Claim; ( ) *( ) x t x t
A
=

Suppose not.
That is
1
#
# #
( ) maximizes ( , , ) s.t. ' ( , , ) and ( )
t
t
x t f t x u dt x g t x u x t x
A
= =
}
so that
1 1
# #
( , , ) ( , *, *)
t t
t t
f t x u dt f t x u dt
A A
>
} }


Now define
# #
0 0
# #
1 1
*( ) for [ , ] *( ) for [ , ]
( ) and ( )
( ) for ( , ] ( ) for ( , ]
x t t t t u t t t t
x t u t
x t t t t u t t t t
A A
e e
= =

e e



Clearly
# #
1 1 1
# #
0 0 0
( , , ) ( , *, *) ( , , ) ( , *, *) ( , *, *)
t t t t t
t t t t t
f t x u dt f t x u dt f t x u dt f t x u dt f t x u dt
A A
= + > +
} } } } }


This implies that *( ) x t cannot be the optimal path of the original problem. Contradiction.




Note that
#
1 1
#
0 0
( , , ) ( , , ) ( , , )
t t t
t t t
f t x u dt f t x u dt f t x u dt = +
} } }

In general,
# # #
[ ( ), ] ( )
x
V
V x t t t
x

c
= =
c

65
Example:
x : productive capital [which decays at a constant proportionate rate 0 b > ]
( ) P x : profit rate that can be earned with the stock of productive capital '(0) 0 and " 0 P P > <
u : gross investment rate
( ) C x : cost of investment '(0) 0 and " 0 C C = >

Problem:
0
( )
0
max [ ( ) ( )] s.t. ' , (0) 0, 0
T
rt
u t
e P x C u dt x u bx x x u

= = > >
}

[Note that as 0 u > and
0
0 ( ) 0 [0, ] x x t t T > > e ].

( , , , ) [ ( ) ( )] ( )
rt
H t x u e P x C u u bx

+

Necessary conditions:
'( ) 0 (1)
' '( ) (2)
( ) 0 (3)
'
rt
u
rt
x
H e C u
H e P x b
T
x u bx

= + =
= = +
=
= (4)


(1) '( ) ( )
rt
C u e t =

(2): ' '( ) ' '( )
rt rt
e P x b b e P x

= + =
( ) ( )
( ) ( )
( ) ( ) (
( ' ) '( ) [ '( ) ( )] '( ( ))
( ) '( ( )) ( ) ( ) '( ( ))
( ) '( ( )) ( )
T T
bt r b t bs r b s
t t
T T
T
bs r b s bT bt r b s
t
t t
T
bt r b s r b t bt r
t
e b e P x e s b s ds e P x s ds
e s e P x s ds e T e t e P x s ds
e t e P x s ds e e t e



+ +
+ +
+ + +
= =
= =
= =
} }
} }
}
) ( )
( )( )
'( ( ))
( ) '( ( ))
T
b t r b s
t
T
rt r b s t
t
e P x s ds
e t e P x s ds
+
+
=
}
}


Finally, we have
( )( )
'( ( )) '( ( ))
T
r b s t
t
C u t e P x s ds
+
=
}

marginal cost
marginal cost of investment =current value of the marginal value of capital
Value @t of a marginal unit of capital =the discount stream of future marginal profits it generates
The calculation reflects the fact that capital decays, and therefore at each time s t > a unit of capital
contributes only a fraction
bs
e

of what it contributed originally @t .


66
Sufficiency

Problem:
1
0
0 0
max ( , , )
. . ' ( , , ), ( )
t
u
t
f t x u dt
s t x g t x u x t x = =
}



Theorem: Suppose that
i) ( , , ) f t x u and ( , , ) g t x u are both differentiable concave functions of ( , ) x u ,
ii) *( ), *( ), ( ) x t u t t satisfy the necessary conditions,
iii) ( ) and ( ) x t t are continuous with ( ) 0 t > for all t if ( , , ) g t x u is nonlinear in or x u , or both,

then *( ), *( ) x t u t solve the problem.


Note:
i) If the function ( , , ) g t x u is linear in ( , ) x u , then ( ) t may assume any sign.
ii) If ( , , ) f t x u is concave while ( , , ) g t x u is convex and ( ) 0 t s , then the necessary conditions
will also be sufficient for optimality.


67
6 Fixed endpoint problem

1
0
( )
0 0
1 1
max ( , , )
. . ' ( , , )
( )
( )
t
u t
t
f t x u dt
s t x g t x u
x t x
x t x
=
=
=
}


We need to modify the equations on p. 46-47 in the notes.

{ }
1
0
( ) [ , ( , ), *( ) ( )] ( ) [ , ( , ), *( ) ( ) ( , ) '( )
t
t
J a f t y t a u t ah t t g t y t a u t ah t y t a t dt + + + +
}


1 1 0 0
( ) ( , ) ( ) ( , ) t y t a t y t a +
{
}
1
0
1
1 0
'( ) [ , ( , ), *( ) ( )] ( , ) [ , ( , ), *( ) ( )] ( )
( ) [ , ( , ), *( ) ( )] ( , ) ( ) [ , ( , ), *( ) ( )] ( )
( ( , )
( , ) '( ) ( ) ( )
t
y a u
t
y a u
a
J a f t y t a u t ah t y t a f t y t a u t ah t h t
t g t y t a u t ah t y t a t g t y t a u t ah t h t
dy t dy t a
y t a t dt t t
da


= + + +
+ + + +
+ +
}
0
, ) a
da


As
0
0 0
( , )
( , ) (initial condition) 0
dy t a
y t a x
da
= =

Also
1
1 1
( , )
( , ) (endpoint condition) 0
dy t a
y t a x
da
= =

| | {
| | }
1
0
'(0) = [ , ( ), *( )] ( ) [ , ( ), *( )] '( ) ( , 0)
[ , ( ), *( )] ( ) [ , ( ), *( )] ( ) 0
t
x x a
t
u u
J f t x t u t t g t x t u t t y t
f t x t u t t g t x t u t h t dt

+ +
+ + =
}



Since ( , 0), ( )
a
y t h t can be of any form, therefore the necessary conditions for '(0) 0 J = are
i) ' 0
x x
f g + + =
ii) 0
u u
f g + =

No transversality condition.

68
Production planning problem

Objective: produce B units of goods in a period of T in a way such that the sum of production
cost and storage cost is minimized.

Problem:
2
1 2
( )
0
min ( ) s.t. '( ) , (0) 0, ( ) , 0
T
u t
c u c x dt x t u x x T B u + = = = >
}

2
1 2
( , , , ) H t x u c u c x u + +

Necessary conditions:
1
2
0 2 0 (1)
' (2)
' (3)
u
x
H c u
H c
H x u

= = + =
= =
= =


(2)
2 2 1
'( ) ( ) t c t c t k = = +
2 1 2 1
1 1 1 1
( ) ( )
(1) ( )
2 2 2 2
c t k c t k t
u t
c c c c
+
= = =
2 2 1 2 1
2
1 1 1 1
(3) '( ) ( )
2 2 4 2
c k c k
x t u t x t t t k
c c c c
= = = +

Using the initial condition and endpoint conditions,
2 2 1
2 2 2
1 1
(0) 0 (0) (0) 0
4 2
c k
x k k k
c c
= = + = =
2 2
2 2 1 2 1 1 2 2 1
2 1
1 1 1 1 1 1
2
( ) ( ) ( )
4 2 4 2 2 4 2
c k c T k T k T c T c T Bc
x T B T T k B B k
c c c c c c T
= = + = = =


2 1
2 1 2
2
( )
2
c T Bc
t c t k c t
T

| |
= + = +
|
\ .


2 1
2 1 2 2 2 2
1 1 1 1 1 1 1
2
(2 )
2
( )
2 2 2 2 2 4 4
c T Bc
c t k c t c t c T c t T B B
T
u t
c c c c c c T c T


= = = + = +
2 1
2 2 2 2 1 2 2 2 2
2
1 1 1 1 1 1 1
2
( ) 2
( ) (0)
4 2 4 2 4 4 4
c T Bc
c k c c c T c t t T T B Bt
x t t t k t t t t t
c c c c c c T c T
| |

|

\ .
= + = + = + = +
Note that we assume
( ) 0, [0, ] u t t T > e
69
Example:
Two factors, capital ( ) K t and extractive resource ( ) R t are used to produce a good Q according to the
production function
1 a a
Q AK R

= , where 0 1 a < < .



The output can be consumed, yielding utility ( ) ln U C C = , or it may be invested.

Problem:
( ), ( )
0
0
1
0
max ln
. . ' , (0) , ( ) 0
' , (0) , ( ) 0
0, 0
T
C t R t
a a
C dt
s t x R x x x T
K AK R C K K K T
C R

= = =
= = =
> >
}


2 state variables: , x K
2 control variables: , C R

Define
( )
( )
( )
R t
y t
K t
resource-capital ratio [ ( ) ( ) ( )] R t y t K t =

Problem:
( ), y( )
0
0
0
max ln
. . ' , (0) , ( ) 0
' , (0) , ( ) 0
0, 0
T
C t t
a
C dt
s t x Ky x x x T
K AKy C K K K T
C y
= = =
= = =
> >
}


1 2
ln ( )
a
H C Ky AKy C = +

Necessary conditions:
2
1
1 2
1
2 1 2
1
0 (1)
0 (2)
' 0 (3)
'
C
a
y
x
a
K
H
C
H K a AKy
H
H y Ay

= =
= + =
= =
= = (4)
' (5)
' (6)
a
x KY
K AKy C
=
=


Since 0 ( ) 0 MU C t t > >
Since marginal product of R
as 0 0 ( ) 0 R R y t t > >
70
(2):
1
1 2
( 0) (2')
a
a Ay K

= >
1
1 1
2 1
1
1 1 1
2 1
(7)
[(1 ) '] ' (1 ) '
' [ ' 0 by (3)]
a
a
a a a
y
aAy aA
a y y y a y y
aA aA


= =
+
= = =

Using (7)
1
2
1
1 2
(1 ) '
' (1 ) '
(8)
a
a
a y y
a y
aA
y y
aA

= =
( )
1 2
2 2 2
2
'
(2') (4) ' (1 ) (9)
a a a a a
a Ay y Ay aAy Ay a Ay

= = =
1 1
1
' '
(8) and (9) (1 ) (1 )
1 1
(10)
a
a a
a
a
a a
y y dy
a a Ay A A dt
y y y
dy y
A dt At k aAt ak y
y a y aAt ak
+ +

+
= = =
= = + = =

} }

1
( ) 1
( )
( )
a
R t
y t
K t aAt ak
| |
=
|

\ .


Also, the capital-output ratio
( ) 1
is linear in , i.e. it is growing linearly at the rate
( )
a a
K t K aAt ak ak
at t a
Q t AKy Ay A A

= = = =

2
2 1
' 1 (1 )
(10) (9) (1 ) (1 )
a
a
a Ay a
ak
at k
at
A


= = =
+


2
2 2
2
2 1 2
2 1
1

2 1
1 1

1 1
(1 ) (1 )
ln ( ) ln( )
( ) ( )
1
(1) ( ) ( ) ( )
( )
a
k
a
a a
k k
a a
d a a
dt t at k k
at k a
t e at k
e at k C t e at k
C t



= = + +
+
= +
= + = +
} }


Note that
2 2
2 2
1 2 1 2
1 1
1 3 1 3
1 1
(1 )
'( ) ( ) (1 )( ) 0
(1 2 ) 1
"( ) (1 ) ( ) (1 )(1 2 )( ) 0 as
2
a a
k k
a a
a a
k k
a a
a
C t e at k a e a at k
a
a
C t e a at k a e a a at k a
a



= + = + >
> <

= + = + = =
< >


( ) y t the resource-capital ratio is decreasing over time
1
ak
k
A

1
must be 0 at k + >
71
7 Various endpoint conditions

1
0
1 1
( )
0 0
1
max ( , , ) [ , ( )]
. . ' ( , , )
( )
( ) free
t
u t
t
f t x u dt t x t
s t x g t x u
x t x
x t
| +
=
=
}


Necessary conditions:

i)
{ } 0 0
u u u
H
H f g
u

c
= = + =
c

ii)
{ } ' ' [ ]
x x
H
f g
x

c
= = +
c

iii) ' ( , , )
H
H x g t x u

c
= = =
c



Constraint Transversality condition
1
( ) is free x t

1 1
1
1
[ , ( )]
( )
( )
t x t
t
x t
|

c
=
c

1
( ) 0 x t >
1 1 1
( ) , ( ) ( ) 0 t x t t
x x
| |

c c (
> =
(
c c


1
free t
1
0 @
t
f g t | + + =

1
T t >
1
1
0 if
0 if
t
t
f g T t
f g T t
|
|
+ + > =
+ + > >


72
Example
0
0
0
max [ ( )] lim '[ ]
. . '
0
(0) 0, ( ) 0
T
rt
C
e U C t dt U C
s t K iK C
C
K K K T

=
=
>
= > >
}


( ) ( )
rt
H e U C iK C

= +

Necessary conditions:
'( ) 0 (1)
' (2)
( ) 0, ( ) ( ) 0
rt
C
K
H e U C
H i
T T K T

= =
= =
> = (3)
' (4) K iK C =


0
(1) : '( ) ( ) (1')
(2): ( ) (2')
rt
it
U C e t
t e



=
=
}
( )
0
'[ ( )]
r i t
U C t e

=

2 cases:

i) ( ) 0 T =

0
(2') 0 '[ ( )] 0 U C t = =

This is feasible only if the utility function has a bliss point * C . However, this would require
0
(0) K K = be large enough so that it can support the consumption level * C over the whole time
horizon. In this case, ( ) 0 t t = , i.e. the marginal value of
0
(0) K K = equals to 0.


ii) ( ) 0 K T =

The marginal value of
0
(0) K K = is larger than 0. Capital is exhausted at the end of the period.


73
8 Discounting, Current values, Comparative Dynamics

0
0
max ( , , )
. . ' ( , , )
(0)
T
rt
u
e f t x u dt
s t x g t x u
x x

=
=
}


( , , ) ( , , )
rt
H e f t x u g t x u

= + (*)

We require ( , , ) x u to satisfy

i) 0
rt
u u u
H e f g

= + =
ii) ' [ ]
rt rt
x x x x x
H e f g e f g

= = + =
iii) ( ) 0 T =

All values are discounted back to 0 t = .

The co-state variable ( ) t gives a marginal valuation of the state variable at t discounted back
to 0 t = .

Write (*) as ( , , ) ( , , ) [ ( , , ) ( , , )]
rt rt rt
H e f t x u g t x u e f t x u e g t x u

= + = + (**)

Define ( ) ( )
rt
m t e t = (1)


current value multiplier/co-state variable

(**): [ ( , , ) ( , , )]
rt rt
H e f t x u e g t x u

= +

Define = ( , , ) ( , , )
rt
e H f t x u mg t x u = + (2)


Differentiate (1) with respect to t :
' ' ' ( = or )
' [ ] ( )
rt
rt rt rt rt rt rt
x
rt rt
x x x x
e
m re e m rm e H rm e e H H e
x
m rm e e rm rm f mg

c
= + = = =
c
= = = +
H

0
rt
rt
u u
e H
e H
u
c
= = =
c

' ( , , ) x g t x u
m
c
= =
c


74
In summary, the necessary conditions for the optimization problem are

= ( , , ) ( , , ) f t x u mg t x u +
0
'
' ( , , )
u u u
x
f mg
m rm
x g t x u
= + =



Transversality conditions:
If ( ) x T is free, then ( ) ( ) 0
rT
T e m T

= =
If ( ) 0 x T > , then ( ) ( ) 0, ( ) ( ) 0
rT rT
T e m T e m T x T

= > =



Example:
0
0
max [ ( ) ( )]
. . '
(0) 0
0
rt
e P x c u dt
s t x u bx
x x
u

=
= >
>
}


Current value Hamiltonian:
( ) ( ) ( )
'( ) 0 (1)
' (2)
' [ '(
u
m
x
P x c u m u bx
c u m
u bx x
m rm rm P x
= +
= + =
= =
= = ) ] ( ) '( ) (3) bm r b m P x = +


There are 3 variables , and u m x. In order to construct a phase diagram, we will eliminate u and
consider the x m plane.

Since " 0 '( ) c c u > is a monotonic function and by the Inverse Function Theorem, the inverse
function exists.

(1):
1
'( ) ' ( ) ( ) c u m u c m g m

= = = (4)

Properties of ( ) g m :
i) '(0) 0 (0) 0 c g = =
ii) "( ) 0 '( ) 0 c u g m > >

Substituting (4) into (2), we have
u : investment
x : capital stock
( ) P x : profit ' 0, " 0 P P > <
( ) c u : cost function '(0) 0, " 0 c c = >
75
' ( )
' ( ) '( )
x u bx g m bx
m r b m P x
= =

= +



' 0 curve x =

m ' 0 x =

J



I







x


' 0 curve m =

m

J



I





' 0 m =

x






' 0
' 0 ( ) 0 ( )
'( )
0
'( )
x
x g m bx g m bx
g m dm bdx
dm b
dx g m
=
= = =
=
= >

Since (0) 0 g = , the ' 0 x = curve passes through the origin.
Consider I and J ( and
J I I J
m m x x > = )

' ( ) ( ) ' =0 [ ( ) ( ) and ]
J J J I I I J I J I
x g m bx g m bx x g m g m bx bx = > = > =
' 0
' 0 ( ) '( ) 0
( ) "( )
"( )
0
m
m r b m P x
r b dm P x dx
dm P x
dx r b
=
= + =
+ =
= <
+

Consider I and J ( and
J I I J
m m x x > = )

' ( ) '( ) ( ) '( ) ' 0

[ ( ) ( ) and '( ) '( )]
J J J I I I
J I J I
m r b m P x r b m P x m
r b m r b m P x P x
= + > + = =
+ > + =

76
Theorem: Under "certain conditions", the optimal path is the path which converges to the steady
state equilibrium.

[see Arrow and Kruz (1970): Public Investment, the Rate of Return, and Optimal Fiscal Policy, p.51]


m ' 0 x =









optimal path

' 0 m =

x

Verifying the equilibrium is a saddle point
' ( )
' ( ) '( )
x g m bx
m r b m P x
=

= +



Linearization:
' '
' ( ) ( ) ( ) ( ) '( )( )
' '
' ( ) '( ) ( ) ( ) "( )( ) ( )( )
s
s s
s
s s
s s
s s s s s s s
x x
x x m m
m m
s s s s s s s
x x x x
m m m m
x x
x g m bx x x m m b x x g m m m
x m
m m
m r b m P x x x m m P x x x r b m m
x m
=
= =
=
= =
= =

c c

= + + = +
c c

c c
= + + + = + +
c c



Let k be the characteristic root.

77
2 2
2 2 2
'( )
0 ( )[( ) ] '( )[ "( )] 0
"( ) ( )
( ) ( ) '( ) "( ) 0 ( ) '( ) "( ) 0
( ) ( ) 4(1)[ '( ) "( ) ( )] 4 4 4 '( ) "( )
2 2
(
s
s s
s
s s s s
s s s s
b k g m
b k r b k g m P x
P x r b k
b r b b r b k k g m P x k rk b r b g m P x
r r g m P x b r b r r br b g m P x
k
r r
k

= + =
+
+ + + + + = + + =
+ + +
= =

=
2
2 ) 4 '( ) "( )
2
s s
b g m P x +



Note:
i) '( ) 0, "( ) 0 real roots
s s
g m P x > <
ii)
2 2 2
( 2 ) 4 '( ) "( ) ( 2 ) 4 '( ) "( )
s s s s
r b g m P x r r b g m P x r + > + >

1 2
and are real and of opposite signs k k


Note:
a) If
0 s
x x < , the steady state will be approached monotonically, with ( ) x t growing and ( ) m t
falling over time.

Since ( ) u g m = is an increasing function of m, it follows that the investment rate ( ) u t is also
decreasing monotonically.

b) If
0 s
x x > , the steady state will be approached monotonically, with ( ) x t shrinking, ( ) m t
increasing and ( ) u t increasing monotonically.


78
Comparative static analysis

' 0 curve shifts down (i.e. same and a smaller keep ' 0)
,
' 0 curve will not shift
s s
m m x m
r m x
x
= =
| + +



m ' 0 x =









optimal path

' 0 m =

x


' 0 curve shifts down (i.e. same and a smaller keep ' 0)
, and unclear
' 0 curve shifts up (i.e same and a bigger keep ' 0)
s s s
m m x m
b x m u
x x m x
= =
| +

= =



m ' 0 x =









optimal path

' 0 m =

x

0, 0, 0
s s s
x m u
r r r
c c c
< < <
c c c

0, ?, ?
s s s
x m u
b b b
c c c
<
c c c

79
Comparative dynamics ( r |)

m ' 0 x =




#
m

1
s
m
2
s
m



' 0 m =
x

#
x
2
s
x
1
s
x


Claim: Paths cannot cross each other

Suppose
#
x is the x coordinate of the intersection point. The slope of the optimal path associated with
2
r ( ) must be smaller than (steeper) that the optimal path associated with
1
r at (
# #
, x m ). The
slope of the optimal path is
' ( ) '( )
' ( )
dm m r b m P x
dx x g m bx
+
= =

.

At the intersection,
# #
, , and b x m will be the same for both paths.

2 1
# # # #
2 1
# # # #
( ) '( ) ( ) '( )
( ) ( )
r r
r b m P x r b m P x dm dm
dx g m bx g m bx dx
+ +
= > =

contradiction
paths cannot cross each other



If r |, the optimal path of ( ) and ( ) m t u t will shift down and the stationary level of x is decreased.
impossible
80
Comparative Dynamics
1
0
0 1 0 0
1
max [ , ( ), ( ); ]
. . '( ) [ , ( ), ( )]
, , ( ) fixed
( ) free
t
t
f t x t u t r dt
s t x t g t x t u t
t t x t x
x t
=
=
}


This problem can be rewritten as
{ }
1
0
1 1 0 0
max [ , ( ), ( ); ] ( ) [ , ( ), ( )] ( ) '( ) ( ) ( ) ( ) ( )
t
t
f t x t u t r t g t x t u t x t t dt t x t t x t + + +
}


Optimal paths: *( ) *( ); *( ) *( ); *( ) *( ) u t u r x t x r t r = = =

{ }
1
0
1 1 0 0
*( ) [ , *( ), *( ); ] *( ) [ , *( ), *( )] *( ) *'( )
*( ; ) *( ; ) *( ; ) *( ; )
t
t
V r f t x r u r r r g t x r u r x r r dt
t r x t r t r x t r


= + +
+
}


1
0
0 0 1 1
1 1 0 0
*( ) * * * * * *' *
* * * *[ * * ] * * *'
*( ; ) *( ; ) *( ; ) *( ; )
*( ; ) *( ; ) *( ; ) *( ; )
*( )

t
r x u x u
t
V r x u x u x
f f f g g g x dt
r r r r r r r r
x t r t r x t r t r
t r x t r t r x t r
r r r r
V r
r




c c c c c c c c
= + + + + + + +
`
c c c c c c c c
)
c c c c
+ +
c c c c
c
=
c
}
1
0
0 0 1 1
1 1 0 0
* * * *' *
* [ * * * *'] [ * * *] * * *'
*( ; ) *( ; ) *( ; ) *( ; )
*( ; ) *( ; ) *( ; ) *( ; )
t
r x x u u
t
x u x
f f g f g g x dt
r r r r r
x t r t r x t r t r
t r x t r t r x t r
r r r r




c c c c c
+ + + + + + + +
`
c c c c c
)
c c c c
+ +
c c c c
}








1
0
0 0 1 1
1 1 0 0
*( ) * *' *
* *' * *'
*( ; ) *( ; ) *( ; ) *( ; )
*( ; ) *( ; ) *( ; ) *( ; )
t
r
t
V r x
f x x dt
r r r r
x t r t r x t r t r
t r x t r t r x t r
r r r r




c c c c
= + + +
`
c c c c
)
c c c c
+ +
c c c c
}



* [ , *( ), *( )]
* [ , *( ), *( )]
f f t x r u r
g g t x r u r


* * * *' 0
* * * 0
*' *
x x
u u
f g
f g
x g

+ + =
+ =
=

81

1
0
0 1
1 0
0 0 1 1
1 1 0 0
*( ; ) *( ; ) *( ) * * *
* *' *' *' *( ; ) *( ; )
*( ; ) *( ; ) *( ; ) *( ; )
*( ; ) *( ; ) *( ; ) *( ; )
t
r
t
t r t r V r x
f x x dt x t r x t r
r r r r r r
x t r t r x t r t r
t r x t r t r x t r
r r r r




c c c c c c
= + + +
` `
c c c c c c
) )
c c c c
+ +
c c c c
}


1
0
0 1
1 0
*( ; ) *( ; ) *( ) *
* *' *( ; ) *( ; )
t
r
t
x t r x t r V r x
f dt t r t r
r r r r

c c c c
= + +
`
c c c c
)
}

1
0
0 1
1 0
0 1
1 0
*( ; ) *( ; ) *( ) *'
* * *( ; ) *( ; )
*( ; ) *( ; )
*( ; ) *( ; )
t
r
t
x t r x t r V r x
f dt t r t r
r r r r
x t r x t r
t r t r
r r


c c c c
= +
`
c c c c
)
c c
+
`
c c
)
}


1 1
0 0
*( ) *'
* * *
t t
r r
t t
V r x
f dt f dt
r r

c c
= =
`
c c
)
} }


*
[ *' ( , *, *) is not explictly depending on 0]
g
x g t x u r
r
c
= =
c

Problem:
0
0
*( ) max [ ( ) ( )] s.t. ' , (0) 0, 0
rt
v r e P x c u dt x u bx x x u

= = > >
}

0
*( )
[ ( *) ( *)] 0
rt
v r
re P x c u dt
r

c
= <
c
}

1 1 1 1
0 0 0 0
0 1
1 0
Let * *'
* *
*' * *'
[ ]
*( ; ) *( ; ) *' * * *
* * *' *( ; ) *( ; ) *'
t t t t
t t t t
u x du x dt
d
d
dv
r dt
dv dt v
r r dt dt r r
t r t r
x dt x x dt x t r x t r x dt
r r r r r r



= =
c
c
c c c
c
= = = = =
c c c c
c c c c c c
= =
c c c c c c
} } }

1 1 1 1
0 0 0 0
0 1
1 0
* *
* *'
Let
*' *
*( ; ) *( ; ) * * *' *'
*' * * *( ; ) *( ; ) *
t t t t
t t t t
x dx
d
x du x
r dt
u
r dt dt r r
dv dt v
x t r x t r x x x x
dt dt t r t r dt
r r r r r r


c
c
c c
c
= = = =
c c c
= =
c c c c c c
= =
c c c c c c
} } }

Envelop Theorem
82
Section 9 Equilibria in Infinite Horizon Autonomous Problems

Problem:
The market for a product is n people, of whom ( ) x t know of the good.
Profit: ( ) P x , where (0) 0, '( ) 0, and "( ) 0 P P x P x = > < .
People learn of the form by discussion with others who are knowledgeable.
( ) : contact rate u t the rate at which people discuss the firm
Cost of influencing the contact rate: ( ) C u ; (0) 0, ' 0, and " 0 C C C = > >
The ( ) x t knowledgeable people inform ( ) ( ) x t u t people, of whom only a fraction 1
x
n
will be newly
informed.

Knowledgeable people forget at a constant proportionate rate b .

0
0
max [ ( ) ( )]
. . ' (1 ) 0
rt
e P x C u dt
x
s t x bx xu x n
n

= + < <
}


Note that from the dynamic equation, x n < through out since (1 ) 0
x
xu
n
as x n .
2
( ) ( ) [ ]
x u
P x C u m bx xu
n
+ +
2
'( ) ( ) 0 '( ) (1 ) (1)
x x
C u m x C u mx
u
n n
= + = =
2 2
' [ '( ) ] ( ) '( ) (2)
mxu mxu
m rm rm P x mb mu r b u m P x
x
n n
= = + = + +
' (1 ) (3)
x
x bx xu
m
n
= = +

Eliminating m

Differentiating (1) with respect to t :
' 2
"( ) ' ' (1 ) '(1 ) ( ) ' (1 ) '(1 )
2
' (1 ) '(1 )
' (4)
"( )
x x x x x
C u u m x mx mx m x mx
n n n n n
x x
m x mx
n n
u
C u
= + + = +
+
=

'( )
(1) : (1')
(1 )
C u
m
x
x
n
=


83
(1)
2 '( )
(2) ' ( ) '( ) (2')
(1 )
xu C u
m r b u P x
x
n
x
n
(
(
= + +
(
(

(


(1'), (2') and (3) (4)
2 '( ) '( ) 2
( ) '( ) (1 ) (1 ) (1 )
(1 ) (1 )
'
"( )
xu C u x C u x x
r b u P x x bx xu
x x
n n n n
x x
n n
u
C u

(
(

+ + + +
( ` ` `
)
(

( ) )
=

2 '( ) 2
( ) '( ) '( ) (1 ) (1 ) (1 )
(1 )
'
"( )
xu x C u x x
r b u C u P x x b u
x
n n n n
n
u
C u



+ + + +
` `
)


)
=
2
(1 ) (1 )
2
'( ) ( ) '( ) (1 )
(1 )
'
"( )
x x
b u
xu x n n
C u r b u P x x
x
n n
n
u
C u

+
`


)
+ + +
`


)
=
2
(1 ) ( )
2
'( ) ( ) '( ) (1 )
'
"( )
x n x
b u
xu x n n
C u r b u P x x
n x
n n
n
u
C u

+
`


)
+ + +
`



)
=
2 ( 2 ) ( 2 )
'( ) ( ) '( ) (1 )
'
"( )
xu b n x u n x x
C u r b u P x x
n n x n n
u
C u
(
+ + + +
`
(

)
=
( 2 ) 2 2
'( ) ( ( ) '( ) (1 )
'
"( )
b n x xu xu x
C u r b u u P x x
n x n n n
u
C u

+ + +
`

)
=
'( ) '( ) (1 )
'
"( )
bx x
C u r P x x
n x n
u
C u

+
`

)
=



84
System of differential equations:
'( ) '( ) (1 )
'
"( )
bx x
C u r P x x
n x n
u
C u

+
`

)
=
' (1 )
x
x bx xu
n
= +


' 0 curve x =
(1 ) 0
increasing convex function
(1 )
x
bx xu
n
bx bn
u
x
n x
x
n
+ =
= =




u ' 0 x =













x


85
' 0 curve u =
'( ) (1 )
' '( ) '( ) (1 ) 0 '( ) ( )
x
P x x
bx x
n
u C u r P x x C u h x
bx
n x n
r
n x


= + = =
`

)
+


Note that
i) "( ) 0 '( ) is an increasing function of C u C u u >
ii) (0) ( ) 0 h h n = =
iii)

2
2
1 ( ) ( 1)
'( ) ( ) '( )(1 ) (1 ) "( ) '( ) (1 )
( ) ( )
(+) ( ) ? ( )( ) ( ) ( )( )( ) (
bx x x x n x b bx
r P x x P x x P x P x x
n x n n n n n x h x
x
bx
r
n x
( | || |
+ + +
| | (
c \ .\ .

=
c
| |
+
|

\ .
+ + + + + + +
2
2
)
2
'( )(1 ) (1 ) "( ) '( ) (1 )
( )
bx x x x nb
r P x x P x P x x
n x n n n n x
bx
r
n x
+
(
| || |
+ +
| | (

\ .\ .

=
| |
+
|

\ .

When x is small,
2
2
'( )(1 ) '( )
'( ) (1 ) 0
( )
x
P x P x
n
x nb
P x x
n n x

`
(

~
(

)
'( ) 0 h x >
When x is large, '( ) 0 h x < .
'( ) C u ( ) h x










u

1 1 2 2
' ' x x x x




Each u corresponds to 2 different x .
When
1 2
' and ' x x x x < > , there will not be corresponding u value.
86
u


' 0 u =








x

u ' 0 x =


' 0 u =

B



A


x
To characterize each of the 2 equilibrium, we linearize the
system.

' '
' ( ) ( )
' '
' ( ) ( )
s s
s s
s s
s s
s s
x x x x
u u u u
s s
x x x x
u u u u
x x
x x x u u
x u
u u
u x x u u
x u
= =
= =
= =
= =
c c
= +
c c
c c
= +
c c

2 2
1
2
( ) ( )
2 ' 1
(1 ) ( )
0
s
s
s s s s
s s s s
s s s s s
s s s
x x
s s
u u
s s
x u x u
u b x u b x
x x u x u x
n n
b u x u b
x n n n x x n
x u
a
n
=
=

c (
= + + = = =
(
c

= <

1
'
(1 ) 0
s
s
s
s
x x
u u
x x
x b
u n =
=
c
= >
c


' (1 )
x
x bx xu
n
= +
'( ) '( ) (1 )
'
"( )
bx x
C u r P x x
n x n
u
C u

+
`

)
=
2
(1 ) ( ) 0
S S S
S S s S s
x x u
bx x u u b x
n n
+ = =

87
2
2 2
( ) ( 1) ' 1 1
'( ) '( ) ( ) '( )(1 ) (1 ) "( )
"( ) ( )
'( ) 2 1
'( )(1 ) (1 ) "( ) ?
"( ) ( )
s
s
s s s s
s s s s s s
x x
s s
u u
s s s
s s s
s s
n x b bx x x u
C u P x x P x x P x
x C u n x n n n
C u nb x x
P x x P x a
C u n x n n
=
=
( c | |
= + +
` (
|
c
\ .
)
(
| |
= + =
( |

\ .


0
| |
2
2
"( ) "( )( ) '( ) '( ) (1 ) "'( )
'
"( )
0
s
s
s s s
s s s s s s
s s
x x
s
u u
s
s
bx bx x
C u C u r C u r P x x C x
n x n x n
u
u
C u
bx
r b
n x
=
=
( (
+ +
` ( (

c
)
=
c
= + >



2
1 2 1 2 1 2 2 1
1 2
( ) ( ) 4( )
,
2
a b a b a b a b
r r
+ +
=
For roots to be real and of opposite signs (saddle point), we need
2 2
1 2 1 2 1 2 2 1
1 2 1 2 2 1
( ) ( ) 4( )
( ) 0
4
a b a b a b a b
r r a b a b
( + +

= = <

1 2 1 2
1 2 2 1 1 2 2 1 1 2
' 0 ' 0 1 2 1 2
0 ( , 0) (**)
x u
a a a a u u
a b a b a b a b b b
b b b b x x
= =
c c
< < < > > >
c c

Note that @B, ' 0 x = curve is upward sloping, i.e.
' 0
0
x
u
x
=
c
>
c
, ' 0 u = curve is downward sloping, i.e.
' 0
0
x
u
x
=
c
<
c
, hence (**) is satisfied so that B is a saddle point.


Note that @A, the slope of the ' 0 u = curve is steeper than the ' 0 x = curve, hence (**) is not satisfied
and it cannot be a saddle point. Also,
1 2
1
( )
0
s
s
s s s s s s s
s s s
s
s s
s
b
x
x
x u bx bx x u bx
n
a b r r r
n n x n x n n x n
bn
x
bx n x
r r
n x n

+ = + + = + = +

= + = >



As
1 2
0 a b + > , the 2 roots cannot be both negative, therefore unstable equilibrium.

along ' 0,
1
b
x u
x
n
= =


88
u ' 0 x =


' 0 u =

optimal path






x

0
x





89
Section 10 Bounded Control
1
0
0 0
( , , )
. . ' ( , , )
( )
( )
t
u
t
Max f t x u dt
s t x g t x u
a u t b
x t x
=
s s
=
}


We will solve the problem by setting up a Lagrangian for the Hamiltonian.

( , , ) ( , , )
. .
u
Max H f t x u g t x u
s t a u b
= +
s s


1 2 1 2
( , , , , , ) ( , , ) ( , , ) ( ) ( ) L t x u w w f t x u g t x u w b u w u a = + + +

Necessary conditions:
1 2
1 1
2 2
1
( , , ) ( , , ) 0
0, ( ) 0
0, ( ) 0
' ( , , )
'
( ) 0
u u u
x x
L f t x u g t x u w w
w w b u
w w u a
L H x g t x u
L H
t

= + + =
> =
> =
= = =
= =
=



90
Example:
2
1 2
( )
0
min ( ) s.t. '( ) , (0) 0, ( ) , 0
T
u t
c u c x dt x t u x x T B u + = = = >
}


2
1 2
min ( , , , ) . . 0
u
H t x u c u c x u s t u + + >
minimization problem

2
1 2
L c u c x u wu + +

Necessary conditions:
1
2
0 2 0 (1)
0, 0, 0 (2)
'
u
x
H c u w
w u wu
H c

= = + =
> > =
= = (3)
' (4)
(0) 0
H x u
x

= =
= (5)
( ) (6) x T B =


(3)
2 2 1
'( ) ( ) t c t c t k = = + (3)
2 1 2 1
1 1 1
( ) ( ) ( )
(1) ( )
2 2 2
w c t k w c t k w t t
u t
c c c
+ +
= = = (7)

In order to solve the problem, we make the following conjecture.

Conjecture:
( ) 0 0 * for some * to be determined
( ) 0 *
u t t t t
u t t t T
= s <
> s s


(7)
1 2 1
( ) 2 ( ) w t k c t c u t = +

When
1 2
( ) 0, we have ( ) 0 [0, *) u t w t k c t t t = = > e (8)

As
1 2
( ) is a decreasing function in , (8) is assured if * 0 w t t k c t > (9)

2 1
1
When ( ) 0, (2) ( ) 0 ; (7) ( ) 0
2
c t k
u t w t u t
c

> = = >

Since ( ) u t is an increasing function in t , ( ) 0 [ *, ] u t t t T > e provided that
2 1
1
*
( *) 0
2
c t k
u t
c

= > (10)
(9) and (10)
2 1 1 2
* 0 * c t k k c t = =

91
Our conjecture {
2 2 2
1 1
( ) 0 for [0, *)
* ( *)
( ) for [ *, ]
2 2
u t t t
c t c t c t t
u t t t T
c c
= e

= = e

Integrating, we have
2
2
2 2
3
1 1
( ) for [0, *)
*
( ) for [ *, ]
4 2
x t k t t
c t c tt
x t k t t T
c c
= e

= + e


Using (0) 0 and ( *) 0 (continuity) x x t = = , we have
2
( *) 0 x t k = = and
2 2 2
2 2 2
3 3
1 1 1
( *) ( *) ( *)
( *) 0
4 2 4
c t c t c t
x t k k
c c c
= + = =
2 2 2
2 2 2 2
1 1 1 1
( ) 0 for [0, *)
* ( *) ( *)
( ) for [ *, ]
4 2 4 4
x t t t
c t c tt c t c t t
x t t t T
c c c c
= e


= + = e


Note that
2
2 2 1 1 1
1 2 2 2
( *) 4 4
( ) ( *) * * 2
4
c T t c B c B c B
B x T T t T t t T
c c c c

= = = = =


1
2
0 * 2
c B
t t T
c
s < =
* t t T s s
( ) u t 0
1
2
2 2
1 1
( 2 )
( *)
2 2
c B
c t T
c c t t
c c
+

=
( ) x t 0
2
1
2
2
2 2
1 1
( 2 )
( *)
4 4
c B
c t T
c c t t
c c
+

=
( ) w t
1 2 2 2 2
* ( * ) k c t c t c t c t t = =
0
( ) t
2
( ) ( * ) w t c t t = =
1 2
2 ( * ) w c u c t t = =


2
1
(2 )
( )
4
c t T B
u t
c T

= +


optimal





t
* t
92
Section 12 Discontinuous and Bang-Bang control
2
0
max (2 3 )
. . '
(0) 4
0 2
x u dt
s t x x u
x
u

= +
=
s s
}
linear in u

1 2
2 3 ( ) (2 ) L x u x u w u w u = + + + + no u
Necessary conditions:
1 2
3 0
u
L w w = + + = (1)
1 1
0, 2 0, (2 ) 0 w u w u > > = (2)
2 2
0, 0, 0 w u w u > > = (3)
' (2 ) ' 2
x
H = = + + = (4)
(2) 0 = (5)
' x x u = + (6)

(1)
1 2
2 1
1 2
if 3 0 2 and 0
if 3 0 0 and 0
if 3 0 ?
w u w
w u w
w w u

> > = =

< > = =

= = = =


(4)
2
( ) ( ) 2
1
t t
t ke t ke

= + =
When 2 t = ,
2 2 2
0 (2) 2 2 ( ) 2 ( ) 2 2
t t
ke k e t ke t e

= = = = =

Note that ( ) t is a decreasing function of t and (2) 0 = * . . ( ) 3 for [ *, 2] t s t t t t - < e .
2
2 * 2 * 2 *
( *) 3 3 2 2 5 2 2.5 2 * ln 2.5 * 2 ln 2.5 ln 1.084
2.5
t t t
e
t e e e t t

= = = = = = = ~

Solution:
2 [0, 1.084)
0 (1.084, 2]
u t
u t
= e

= e



For [0, 1.084) t e
1 1
2
' 2 ' 2 ( ) 2
1
t t
x x x x x t k e k e = + = = + = +


0
1 1 1
4 (0) 2 6 6 ( ) 2 6
t
x k e k k x t e = = + = = = + (7)

For [1.084, 2] t e
2
2
' ( ) (6 5 )
t t
x x x t k e e e

= = = (8)

Bang-bang control
By continuity,
2 2
2 2
ln( ) ln( )
* * 2
2.5 2.5
2 2 2 2
6
( *) 2 6 2 6 2 6 5
2.5 2.5
e e
t t
e e
x t e e k k e k e k e

= + = + = + = = = =
93
Example:
A product produced at rate ( ) x t can either be reinvested to expand productive capacity or sold.
Productive capacity grows at the reinvestment rate.

Let ( ) u t be the fraction of output reinvested.

0
max (1 )
. . '
(0) 0
0 1
T
u x dt
s t x ux
x c
u

=
= >
s s
}


1 2
(1 ) (1 ) L u x ux w u w u = + + +

Necessary conditions:
1 2 1 2
0 ( 1) 0
u
L x x w w x w w = + + = + = (1)
1 1
0, 1 0, (1 ) 0 w u w u > > = (2)
2 2
0, 0, 0 w u w u > > = (3)
' [(1 ) ] ' 1
x
H u u u u = = + = (4)
( ) 0 T = (5)
' x ux = (6)

Since (0) 0 and '( ) 0 ( ) 0 x c x t t x t t = > > >
(1)
1 2 0
2 1 1
1 2
if 1 0 1 and 0 ; ' ( ) (7)
if 1 0 0 and 0 ; ' 1 ( ) (8)
if 1 0 ? and ' 1 (9)
t
w u w t k e
w u w t k t
w w u


> > = = = =

< > = = = =

= = = = =



Note that under all 3 cases, ( ) t is an decreasing function and so ( ) 1 t = (i.e. ? u = ) only at 1
moment of time, which can be ignored as it does not affect the value of the integral.

As ( ) 0 and ( ) is decreasing in T t t = a final interval * t t T - s s during which ( ) 1, ( ) 0 t u t < = ,
1
( ) and '( ) 0 t k t x t = = .

1 1
( ) 0 ( )
( *) 1 * 1 * 1 (provided that 1)
T k T k T t T t
t T t t T T

= = = =
= = = >


( ) 0
( )
( ) ( *)
u t
t T t
x t x t

for * 1 t t T > =
94
If 1 T > , an initial interval 0 1 * t T t - s s = during which ( ) 1, ( ) 1, ' and ' t u t x x > = = =

Since ( ) t is continuous at * t and ( *) 1 t = ,
* ( 1) 1
0 0 0
1 1
t T T
k e k e k e

= = =

1 1
0
( )
t T t T t
t k e e e e

= = =

On the other hand,
2
' ( )
t
x ux x x t k e = = =

0
2 2
(0) (0) ( )
t
x c c x k e k c x t ce = = = = =

1
( ) 1
( )
( )
T t
t
u t
t e
x t ce

for * 1 t t T < =

u x


t
ce



1




t t
1 T T 1 T T


95
Bang-bang control with fixed endpoints
2
0
max (2 3 )
. . '
(0) 4
(2) 40
0 2
x u dt
s t x x u
x
x
u

= +
=
=
s s
}


1 2
2 3 ( ) (2 ) L x u x u w u w u = + + + +

Necessary conditions:
1 2
3 0
u
L w w = + + = (1)
1 1
0, 2 0, (2 ) 0 w u w u > > = (2)
2 2
0, 0, 0 w u w u > > = (3)
' (2 ) ' 2
x
H = = + + = (4)
' x x u = + (5)

(1)
1 2
2 1
1 2
if 3 0 2 and 0
if 3 0 0 and 0
if 3 0 ?
w u w
w u w
w w u

> > = =

< > = =

= = = =


(4)
2
( ) ( ) 2
1
t t
t ke t ke

= + =

Note that ( ) t is a decreasing function of t , hence the solution of the problem must be in this form:
2 [0, *)
( ) ? *
0 ( *, 2]
t t
u t t t
t t
e

= =



Finding * t
When
1 1
2
( ) 2, ' 2 ' 2 ( ) 2
1
t t
u t x x x x x t k e k e = = + = = + = +


Using (0) 4 x = , we have
0
1 1
4 (0) 2 6 ( ) 2 6
t
x k e k x t e = = + = = + (6)

When
2
( ) 0, ' ( )
t
u t x x x t k e = = =
Using (2) 40 x = , we have
2 2 2 2
2 2
40 (2) 40 ( ) 40 40
t t
x k e k e x t e e e

= = = = = (7)




96

2
( ) 40
t
x t e

= + 40



( ) 2 6
t
x t e = +



4

t
* 1.2266 t = 2

Using (6), (7) and continuity @ * t ,
* * 2 * 2 * 2 * *
2
2
2
2 6 ( *) 40 2 6 40 (6 40 ) 2
6 40
2
* ln( ) 1.2266
6 40
t t t t t t
e x t e e e e e e e
e
t
e

+ = = + = = =

= ~



Solution:
2
( ) 2 6 [0, 1.2266)
( ) 40 [1.2266, 2]
t
t
x t e t
x t e t

= + e

= e



( ) 2 [0, 1.2266)
( ) 0 (1.2266, 2]
u t t
u t t
= e

= e







( ) 2 u t =







( ) 0 u t =
t
* 1.2266 t = 2


97
Section 13 Singular solution and Most Rapid Approach Path (MRAP)

Example:
The altitude of the land is given by the differentiable function ( ), 0 y t t T s s . Find the altitude
( ) x t at which to build a road over 0 t T s s so that the grade never exceeds 0 a > . The cost at each t
accumulates with the square of the amount of filling or excavation needed.
2
0
min [ ( ) ( )]
s.t. i) '
ii)
T
u
x t y t dt
x u
a u a

=
s s
}


2 2
1 2 1 2
( ) [ ] [ ( )] ( ) ( ) ( ) L x y u w a u w u a x y u w a u w u a = + + + = + + + +

Necessary conditions:
1 2
1 1
2 2
0 (1)
0, ( ) 0 (2)
0, ( ) 0 (3)
u
L w w
w w a u
w w a u
= + =
> =
> + =

' 2( ) (4)
x
H x y = =
(0) ( ) 0 (5) transversality condition T = =

(4)
0 0 0 0
'( ) 2[ ( ) ( )] ( ) (0) 2 [ ( ) ( )] ( ) 2 [ ( ) ( )]
t t t t
s ds x s y s ds t x s y s ds t x s y s ds = = =
} } } }

(5)
0 0 0 0
'( ) 2[ ( ) ( )] ( ) (0) 2 [ ( ) ( )] 0 [ ( ) ( )] 0
T T T T
s ds x s y s ds T x s y s ds x s y s ds = = = =
} } } }

Hence a)
1 2
0
( ) 2 [ ( ) ( )] 0 ( ) 0 ( ) 0
t
t x s y s ds w t u a w t = > > = =
}

b)
2 1
0
( ) 2 [ ( ) ( )] 0 ( ) 0 ( ) 0
t
t x s y s ds w t u a w t = < > = =
}

c)
1 2
0
( ) 2 [ ( ) ( )] 0 0 ?
t
t x s y s ds w w u = = = = =
}

There are 3 types of intervals:
i)
0
( ) , [ ( ) ( )] 0
t
u t a x s y s ds = <
}

ii)
0
( ) , [ ( ) ( )] 0
t
u t a x s y s ds = + >
}

iii)
0
( ) ( ), ( ) '( ), [ ( ) ( )] 0
t
x t y t u t y t x s y s ds = = =
}


The optimal road consists of sections built
along the terrain exactly and of sections of
maximum allowable grade.
98
Case 1:
( ) y t



( ) x t



0
1
t T


In the above diagram,
1 1
and ( ) t x t are determined by
1
0
[ ( ) ( )] 0 2
t
x s y s ds =
}
and
1
[ ( ) ( )] 2 0
T
t
x s y s ds =
}

Case 2:



( ) y t

( ) x t


0
1
t
2
t T

In the above diagram,
1 2
and t t are determined by
1
0
[ ( ) ( )] 0 2
t
x s y s ds =
}
and
1
[ ( ) ( )] 2 0
T
t
x s y s ds =
}


99
Example
The altitude of the land is given by the differentiable function ( ), 0 10 y t t s s . Find the altitude
( ) x t at which to build a road over 0 10 t s s so that the grade never exceeds 0 a > . The cost at each
t accumulates with the square of the amount of filling or excavation needed.
2
0
min [ ( ) ( )]
s.t. i) '
ii)
T
u
x t y t dt
x u
a u a

=
s s
}


a) Solve the problem with 1 a = (i.e. no steeper than 45 degree) and
2 0 4
( )
16 2 4 10
t t
y t
t t
s s
=

< s


b) Solve the problem with 1 a = (i.e. no steeper than 45 degree) and
2 0 3
( ) 6 3 8
22 2 8 10
t t
y t t
t t
s s

= < s

< s



Solution:
10
2
0
min [ ( ) ( )]
s.t. i) '
ii) 1 1
2 0 4
iii) ( )
16 2 4 10
u
x t y t dt
x u
u
t t
y t
t t

=
s s
s s
=

< s

}


2 2
1 2 1 2
( ) [1 ] [ ( 1)] ( ) (1 ) ( 1) L x y u w u w u x y u w u w u = + + + = + + + +

Necessary conditions:
1 2
1 1
2 2
0 (1)
0, (1 ) 0 (2)
0, (1 ) 0 (3)
u
L w w
w w u
w w u
= + =
> =
> + =

' 2( ) (4)
x
H x y = =
(0) (10) 0 (5) transversality condition = =

(4)
0 0 0 0
'( ) 2[ ( ) ( )] ( ) (0) 2 [ ( ) ( )] ( ) 2 [ ( ) ( )]
t t t t
s ds x s y s ds t x s y s ds t x s y s ds = = =
} } } }

(5)
10 10 10 10
0 0 0 0
'( ) 2[ ( ) ( )] (10) (0) 2 [ ( ) ( )] 0 [ ( ) ( )] 0 s ds x s y s ds x s y s ds x s y s ds = = = =
} } } }

100
Hence a)
1 2
0
( ) [ ( ) ( )] 0 ( ) 0 1 ( ) 0
t
t x s y s ds w t u w t = > > = =
}

b)
2 1
0
( ) [ ( ) ( )] 0 ( ) 0 1 ( ) 0
t
t x s y s ds w t u w t = < > = =
}

c)
1 2
0
( ) [ ( ) ( )] 0 0 ?
t
t x s y s ds w w u = = = = =
}

There are 3 types of intervals:
i)
0
( ) 1, [ ( ) ( )] 0
t
u t x s y s ds = <
}

ii)
0
( ) 1, [ ( ) ( )] 0
t
u t x s y s ds = + >
}

iii)
0
( ) ( ), ( ) '( ) '( ), [ ( ) ( )] 0
t
x t y t u t x t y t x s y s ds = = = =
}


Conjecture:
1 0 *
( )
1 * 10
t t
u t
t t
+ s s
=

s s


0
10
0 *
( )
10 * 10
x t t t
x t
x t t t
+ s s
=

+ s s

[
0 10
and x x are to be determined]
* t is the point such that
*
0
[ ( ) ( )] 0
t
x s y s ds =
}
and
10
*
[ ( ) ( )] 0
t
x s y s ds =
}


Case 1: * 4 t =

* 4
0
0 0
[ ( ) ( )] [( ) 2 ] 0 (1)
t
x s y s ds x s s ds = + =
} }


10 10
10
* 4
[ ( ) ( )] [( 10 ) (16 2 )] 0 (2)
t
x s y s ds x s s ds = + =
} }

(1)
4
4 4 2
0 0 0 0 0
0 0 0
[( ) 2 ] 0 ( ) 0 ( ) 0 4 8 0 2
2
s
x s s ds x s ds x s x x + = = = = =
} }

10
10 10 2
10 10 10 10
4 4 4
(2) [( 10 ) (16 2 )] ( 6 ) 0 ( 6 ) 0 1
2
s
x s s ds x s ds x s s x + = + = + = =
} }

Note that
0
10
2 4 6
(4)
10 1 10 4 5
x t
x
x t
+ = + =
=

+ = + =

contradiction (the road has to be continuous)



The optimal road consists of sections built
along the terrain exactly and of sections of
maximum allowable grade.
101
Case 2: * 4 t >
* 4 * 4 *
0 0
0 0 4 0 4
4 *
4 * 2 2
0 0 0 0
0 4 0 4
[ ( ) ( )] [ ( ) ( )] [ ( ) ( )] [( ) 2 ] [( ) (16 2 )] 0
3
( ) ( 16 3 ) 0 ( ) ( 16 ) 0
2 2
(
t t t
t
t
x s y s ds x s y s ds x s y s ds x s s ds x s s ds
s s
x s ds x s ds x s x s s
= + = + + + =
+ + = + + =

} } } } }
} }
2
0 0 0
2
0
3 *
4 8) [( * 16 * ) (4 64 24)] 0
2
3 *
* 16 * 32 0 (3)
2
t
x x t t x
t
x t t
+ + + =
+ + =
10 10 10
10 10
* * *
10
2 2
10 10 10
*
2
10 10
[ ( ) ( )] [( 10 ) (16 2 )] 0 [( 6 ) 0
*
( 6 ) 0 (10 60 50) ( * 6 * ) 0
2 2
*
10 10 * 6 * 0
2
t t t
t
x s y s ds x s s ds x s ds
s t
x s s x x t t
t
x x t t
= + = + =
+ = + + =
+ =
} } }
(4)
By continuity,
10 0
0 10
10
* 10 * * (5)
2
x x
x t x t t
+
+ = + =

From (3), (4) and (5), by using Mathematica, we find that there are 3 cases.

i)
0 10
32.7116, * 8.68466, 5.34233 x t x = = = (impossible as * t cannot be negative)
ii)
0 10
1.78835, * 3.68466, 0.842329 x t x = = = (inconsistent with * 4 t > )
iii)
0 10
2.2, * 10, 7.8 x t x = = = (inconsistent as * t cannot be at the end point)

102
Case 3: * 4 t <
*
* * * 2 2
0 0 0 0
0 0 0 0
*
[ ( ) ( )] [( ) 2 ] ( ) ( ) * 0 (6)
2 2
t
t t t
s t
x s y s ds x s s ds x s ds x s x t = + = = = =
} } }
10 4 10
10 10
* * 4
4 10
4 10 2 2
10 10 10 10
* 4 * 4
2
10 10 10 10
[ ( ) ( )] [( 10 ) (2 )] [( 10 ) (16 2 )] 0
3
[ 10 3 ] [ 6 ] 0 ( 10 ) ( 6 ) 0
2 2
3 *
[(4 40 24) ( * 10 * )] [(10 60 50) (4
2
t t
t t
x s y s ds x s s ds x s s ds
s s
x s ds x s ds x s s x s s
t
x x t t x x
= + + + =
+ + + = + + + =
+ + + +
} } }
} }
2
10 10 10
2
10 10
24 8)] 0
3 *
[4 16 * 10 * ] [6 6] 0
2
3 *
10 22 * 10 * 0 (7)
2
t
x x t t x
t
x x t t
+ =
+ + + + =
+ + =

By continuity,
10 0
0 10
10
* 10 * * (8)
2
x x
x t x t t
+
+ = + =

From (6), (7) and (8), by using Mathematica, we find that there are 3 cases.

i)
0 10
10.673, * 21.3459, 43.3648 x t x = = = (impossible as * t cannot be 4 > )
ii)
0 10
7.8, * 0, 2.2 x t x = = = (inconsistent as * cannot be 0 t = )
iii)
0 10
1.82705, * 3.6541, 0.864758 x t x = = = solution

1 0 3.6541
( )
1 3.6541 10
t
u t
t
+ s s
=

s s


1.82705 0 3.6541
( )
0.864758 10 9.135242 3.6541 10
t t
x t
t t t
+ s s
=

+ = s s







8 ( ) y t
5.48115
1.82705 ( ) x t
10 t
0 4
-0.864758
-4 3.6541

103
b)
2 0 3
( ) 6 3 8
22 2 8 10
t t
y t t
t t
s s

= < s

< s


Conjecture:
1
1 2
2
1 0
( ) ?
1 10
t t
u t t t t
t t
+ s s

= < <

s s


0 1
1 2
10 2
0
( ) ( )
10 10
x t t t
x t y t t t t
x t t t
+ s s

= < <

+ s s

[
0 10
and x x are to be determined]

1
t is the point such that
1
0
[ ( ) ( )] 0
t
x s y s ds =
}
and
2
t is the point such that
2
10
[ ( ) ( )] 0
t
x s y s ds =
}

Solving for
1
t
1
1 1 1 2 2
1
0 0 0 0 1
0 0 0 0
[ ( ) ( )] [( ) (2 )] ( ) ( ) 0 (9)
2 2
t
t t t
t s
x s y s ds x s s ds x s ds x s x t = + = = = =
} } }

By continuity, we have
0 1
6 x t + = (10)

(9) and (10)
1 0
4 and 2 t x = =

Solving for
2
t
2 2 2 2
10
10 10 10 2
10 10 10
2 2
2 2
10 10 2 2 10 10 2 2
[ ( ) ( )] [( 10 ) (22 2 )] [ 12 ] ( 12 ) 0
2
(10 120 50) ( 12 ) 10 70 12 0 (11)
2 2
t t t t
s
x s y s ds x s s ds x s ds x s s
t t
x x t t x x t t
= + = + = + =
+ + = + =
} } }

By continuity, we have
10 2
10 6 x t + = (12)

(11) and (12)
2 10
7.3333 and 3.3333 t x = =

Solution:
1 0 4
( ) ? 4 7.3333
1 7.3333 10
t
u t t
t
+ s s

= < <

s s

and
2 0 4
( ) ( ) 4 7.3333
13.3333 7.3333 10
t t
x t y t t
t t
+ s s

= < <

s s



6


2 3.333

t
0 3 4 7.33 8 10

104
Example:
( ) K t : capital
[ ( )] f K t : output
( ) P t : unit price of output
( ) I t : investment
( ) c t : unit cost of investment

{ }
0
0
max ( ) [ ( )] ( ) ( )
. . '
(0)
0
rt
e P t f K t c t I t dt
s t K I bK
K K
I

=
=
>
}


( ) ( ) L Pf K cI m I bK wI = + +

Necessary conditions:
0
I
L c m w = + + = (1)
0, 0, 0 w I wI > > = (2)
| | ' '( ) ( ) '( )
K K
m rm L rm rm Pf K mb r b m pf K = = H = = + (3)
' K I bK = (4)

(1) ( ) ( ) ( ) w t c t m t =
(2) | | ( ) ( ) ( ) 0, ( ) ( ) ( ) 0 w t c t m t c t m t I t = > = (5)

When ( ) ( ) 0 ( ) 0 c t m t I t > =

On any interval ( ) 0 I t > , ( ) ( ) '( ) '( ) c t m t c t m t = =

(3) '( ) ( ) ( ) '( ) c t r b c t Pf K = +
'( ) ( ) ( ) '( ) Pf K r b c t c t = + (6)
1
( ) ( ) '( )
( ) '
( )
r b c t c t
K t f
P t

( +
=
(

(7)


( ) I t is selected to maintain the optimal capital stock.
'( ) ( ) ( ) '( ) "( ) ' '( ) ' ( ) ' "
( ) ' " '( ) '
'
"( )
Pf K r b c t c t Pf K K f K P r b c c
r b c c f K P
I K
Pf K
= + + = +
+
= =


This is the singular solution since I does not appear in H if ( ) ( ) m t c t =
rule for the optimal capital stock
105

Condition when ( ) 0 I t =

(3) ' ( ) '( ) m r b m pf K + =
( ) ( ) ( )
( )
( )
( )
( )
' ( ) '( )
( )
'( )
( )
'[ ( )]
r b t r b t r b t
r b t
r b t
r b s
r b s
t t
e m e r b m e pf K
d e m t
e pf K
dt
d e m s
e pf K s ds
ds
+ + +
+
+
+

+
+ =
(

=
(

=
} }

( ) ( )
( ) '[ ( )]
r b s r b s
t
t
e m s e pf K s ds

+ +
=
}
(8)

Assume
( )
lim ( ) 0
r b s
s
e m s
+

=
( ) ( )
( ) '[ ( )]
r b t r b s
t
e m t e pf K s ds

+ +
=
}


By the fundamental theorem of calculus,
| | | |
( )
( ) ( ) ( )
0 0
( )
( ) '( ) ( ) ( ) ( ) ( ) '( )
r b s
r b s r b s r b s
t
d e c s
e c t ds e c s r b c s ds e r b c s c s ds
ds
+

+ + +
(

= = + = +
} } }
(9)

From above, ( ) 0 ( ) ( ) 0 I t c t m t = >
| | | |
| |
( ) ( ) ( )
( )
( ) ( ) '( ) '[ ( )] ( ) ( ) '( ) '[ ( )] 0
'[ ( )] '( ) ( ) ( ) 0
r b s r b s r b s
t t t
r b s
t
e r b c s c s ds e pf K s ds e r b c s c s pf K s ds
e pf K s c s r b c s ds

+ + +

+
+ = + >
+ + s
} } }
}


Capital is not acquired at any time that the discounted stream of revenue produced by a
marginal unit of capital is insufficient to cover the corresponding discounted stream of user
cost.

Suppose that
1 2
( ) 0 [ , ] I t t t t = e with
1 2
( ) 0 [0, ] and [ , ) I t t t t t > e e .

Thus, | |
( )
( ) ' '[ ] 0
r b s
t
e r b c c pf K ds

+
+ =
}
for
1 2
and t t t = .
| |
2
( )
1 2
'[ ( )] '( ) ( ) ( ) 0 [ , ]
t
r b s
t
e pf K s c s r b c s ds t t t
+
+ + s e
}
with equality for
1
t t = (10)

106
Marginal cost =Marginal benefit holds at each moment t of an interval on which 0 I > .

It holds on average (taking
1
t t = ) in (10) over an interval
1 2
t t t s s that 0 I = .









107
Example
Output: ( , ) ( ) Y F K L Lf k = =
Capitalists income: '( ) '( ) Kf K Lkf k =
Workers income: | | ( ) '( ) L f k kf k

Assume workers spend all their income on consumption and capitalists split their income into
consumption and savings.

0
0
max (1 ) '( )
. . i) ' '( )
ii) (0)
iii) 0
rt
s
e s Lkf k dt
s t k sf k k gk
k k
s s

=
=
s s
}


| |
| |
1 2
(1 ) '( ) '( )
(1 ) '( ) '( ) ( )
s Lkf k m sf k k gk
L s Lkf k m sf k k gk ws w s s
H = +
= + + +


Necessary conditions:
1 2
'( ) '( ) 0
s
L Lkf k mf k k w w = + + = (1)
1 1
0, 0, 0 w s ws > > = (2)
2
0, ( ) 0, ( ) 0
s
w s s w s s > > = (3)
{ } ' (1 ) [ '( )]' { [ '( )]' } { [ '( )]' } (1 ) [ '( )]'
k
m rm L rm s L kf k m s kf k g m r s kf k g s L kf k = = + = + (4)
' '( ) k sf k k gk = (5)

(1)
1 2
( ) '( ) 0
s
L m L kf k w w = + = (1)

Case 1:
2 1
( ) 0 0 m t L w s s w > > = =
(4) ' { [ '( )]' } (1 ) [ '( )]' m m r s kf k g s L kf k = + (6)
(5) ' '( ) k sf k k gk = (7)

Case 2
1 2
( ) 0 0 0 L m t w s w > > = =
(4) ' { } [ '( )]'
k
m rm L m r g L kf k = = + (8)
(5) ' k gk = (9)

Case 3
1 2
( ) 0 ? L m t w w s = = = =

(4) ' { [ '( )]' } (1 ) [ '( )]' { [ '( )]'}
k
m rm L m r s kf k g s m kf k m r g kf k = = + = + (10)


L =
108
Note that from (10), ' m can be equal to 0 for a prolonged period of time so long as [ '( )]' r g kf k + =


Note that [ '( )]' "( ) '( ) kf k kf k f k = +

Since
0
lim '( ) and lim '( ) 0
k k
f k f k

= = , we must be able to find a * k such that
[ * '( *)]' * "( *) '( *) k f k k f k f k r g = + = +

At this * k , ' 0 m = .

Also since the economy will stay at * k for a prolonged period of time, therefore ' 0 k = .

(5)
*
' * '( *) * * 0 *
'( *) * '( *)
gk g
k s f k k gk s
f k k f k
= = = = (11)
[ * '( *)]' r g k f k + = (12)










If * s s s , the singular solution characterized by (11) and (12) will be sustainable.

The optimal solution is to move from
0
k to * k as quickly as possible and then remains at the
TURNPIKE * k .

Most Rapid Approach Path (MRAP):

0
0
0
0 if *, then * when * and thereafter.
* if *
if *, then * when * and thereafter.
k k s k k
s s k k
s k k s k k
> =

= =

< =



0
0
0
if *
' 0 if *
'( ) if *
gk k k
k k k
skf k gk k k
>

= =

<


singular optimal
stationary solution
* "( *) '( *) * "( *) '( *)
( )
* "( *) '( *) * "( *)
1
'( *) '( *) '( *)
1 *
'( *)
k f k f k r g k f k f k g
k f k f k k f k g
f k f k f k
g
s
f k
+ = + + >

+
= + >
> =

109
The Vidale-Wolfe Advertising Model

Sethi, Suresh P. (1973): Optimal control of the Vidale-Wolfe advertising model, Operations
Research, 21, July/ August, pp. 998-1013.

The total profit, excluding advertising cost, from industry sales per unit time is P .

Our firm supplies a fraction x of industry sales and thereby collects a gross profit of Px .

Advertising expenditure ( ) u t affects market share:

'( ) ( )[1 ( )] ( ) x t au t x t bx t =








( )
0
0
max [ ( ) ( )]
. . '( ) ( )[1 ( )] ( )
(0)
0 ( )
rt
u t
e Px t u t dt
s t x t au t x t bx t
x x
u t u

=
=
s s
}

1 2
( ) { (1 ) } ( ) Px u m au x bx wu w u u H = + + +

Necessary conditions:
1 2
1 (1 ) 0
u
L ma x w w = + + = (1)
' ( ) ( )
x
m rm rm P mau bm r au b m P = H = = + + (2)
1 1
0, 0, 0 w u wu > > = (3)
2 2
0, 0, ( ) 0 w u u w u u > > = (4)
' (1 ) x au x bx = (5)

When
2 1
(1 ) 1 0 0 ma x w u u w > > = =
1 2
(1 ) 1 0 0 0 ma x w u w < > = =
1 2
(1 ) 1 0 ? ma x w w u = = = =
efficiency in
advertising
share of
the other
firms
loss to other
firms
new shares attracted by
spending on advertising
The firm can affect the rate of gain of
new sales, but not the rate of loss of
repeat sales.
110
when (1 ) 1
? when (1 ) 1
0 when (1 ) 1
u ma x
u ma x
ma x
>

= =

<

(6)

(6) advertising will be at either its lower or its upper bound except when (1 ) 1 ma x = .

Suppose this equation is going to hold for some interval of time.

Since (1 ) 1 ma x =
[ (1 )]
'(1 ) ' 0
d m x
m x mx
dt

= = (7)

(2) and (5) '(1 ) ' 0 [( ) ](1 ) [ (1 ) ] 0 m x mx r b au m P x m au x bx = + + =
1 1
[( ) ](1 ) [ (1 ) ] 0 (1 ) 1
(1 ) (1 )
r b au P x au x bx ma x
a x a x
+ + = =


( )
(1 ) 0
(1 )
r b au bx
P x u
a a x
+ +
+ =


2
2
2 2
( )(1 ) (1 ) (1 ) 0
(1 ) 0
(1 ) 0 (1 ) (1 ) 0
r b au x Pa x a x u bx
r b au rx bx aux au axu bx Pa x
r b rx Pa x Pa x r x b
+ + + =
+ + + + =
+ = =

2 2
4( )( ) 4
1
2 2
r r Pa b r r Pab
x
Pa Pa
+
= = (8)

Note that
i)
2
4 r r Pab < +
ii) 1 x must be non-negative since it is the share occupied by other firms.
Therefore, we must take the positive root in the expression and so
2
4
1
2
r r Pab
x
Pa
+ +
=
Also, x must be non-negative, therefore
2
4
1 0
2
r r Pab
x
Pa
+ +
= > is also required.
2
2
2 2 2 2
2 2
2 4
0
2
2 4
4 4 4
4 4 4
Pa r r Pab
x
Pa
Pa r r Pab
P a Par r r Pab
P a Par Pab
Pa r b
(
+ +

= >
> +
+ > +
>
>

Pa r b > + (9)

Suppose the condition Pa r b > + is satisfied so that x is real and positive.
111
As x only depends on the parameters of the model, hence
s
x x = .
Since
1
(1 ) 1
(1 )
s
s
ma x m m
a x
= = =

(10)
In the interval of time where (1 ) 1 ma x = , and
s s
m m x x = = .

' 0 (1 ) 0
s
x x x au x bx = = = (11) provided
(1 )
s
s s
s
bx
u u u
a x
= s

(12)




Note that ( )( )
s
u u au b au b r abP > + + + > (13)



















A singular solution can occur if (9) and (13) hold.
2
4
1
2
s
r r Pab
x
Pa
+ +
=
1
(1 )
s
s
m
a x
=


(1 )
s
s
s
bx
u
a x
=



The strong inequalities (13) assure the existence of projects with positive value and with a steady state
that can be achieved in finite time/
Note that since 0 and 1 0 0
s s s
x x u > > > is automatically satisfied.
(2) ' ( ) 0
s s
s
P
m m m r b au m P m
r b au
= = + + = =
+ +

1 1 1
1 1
(1 )
1 1
(1 ) ( )
( 1)
1 1
(1 )
[1 (1 )] ( )
( )
1
( ) ( )
( )( )
s s s
s s s
s
s s s
s s s
s
s s
s
s
s s
s s s
s s
m x x
a x am am
am
b b
bx am am b
u u am
a x a
a a
am am
aP r b au b aP b
u
a r b au a r b au
au r b au abP r b au b
au b r b au abP
= = =

= = = =


( ( + +
= =
( (
+ + + +

+ + = + +
+ + + =

( )( )
s
u u au b r b au abP > + + + >
112
If
0 s
x x = the singular solution will not be attained immediately.

From (6), the only other possibilities are and 0 u u u = = .

If
0 s
x x < then [0, ] u u t T = e where T is to be determined.

We can solve the differential equations (2) and (5) with u u = , using boundary conditions
0
(0) x x = ,
( ) and ( )
s s
m T m x T x = = to determine the 2 constants of integration and the unknown time T .

If
0 s
x x > then 0 [0, ] u t T = e where T is to be determined.

We can solve the differential equations (2) and (5) with 0 u = , using boundary conditions
0
(0) x x = ,
( ) and ( )
s s
m T m x T x = = to determine the 2 constants of integration and the unknown time T .

Solution:
i) If Pa r b s + , then 0
s
x = so that
0
( ) 0
s
x x u t t > = .
(2): ' ( ) ' ( ) m r au b m P m r b m P = + + + =
( ) ( )
( )
( )
r b t r b t
P P
m t ce ce
r b r b
+ +

= + = +
+ +

(5):
0
' (1 ) ' ( )
bt
x au x bx x bx x t x e

= = =

( )
( )
0
(1 ) 1 1 0 and 1 or
r b t bt
P Pa
ma x ce a x e t c Pa r b
r b r b
+
| |
= + < = < < +
|
+ +
\ .



ii) If and ( )( ) Pa r b Pab r b au b au > + > + + + , then the singular solution can be attained and it
should be approached as rapidly as possible by selecting
( )
( )
0 ( )
s
s s
s
u x t x
u u whenever x t x
x t x
<

= =

>



The first boundary condition is the initial condition, the second and the third boundary conditions
are required by the continuity of the multiplier function and the state variable.
The profit available is too low relative to the efficacy of advertising, the rate of discounting, and the
loss rate of repeat sales for any advertising to be worthwhile.
Advertising is worthwhile, and an optimal state
s
x is attained as rapidly as possible and maintained
thereafter.
113
iii) If and ( )( ) Pa r b Pab r b au b au > + < + + + , then
if ( ) 1
( )
0 otherwise
r b au
u x t
u t aP
+ +
<





Advertising is worthwhile but the ceiling on the advertising rate prevents maintenance of the
optimal state
s
x .
114
Section 17 State Variable Inequality Constraints

Variables may be required to be non-negative for some expression to have meaning.

Problem:
0
0
max ( , , ) [ ( )]
. . ' ( , , )
(0)
( , ) 0
T
u
f t x u dt x T
s t x g t x u
x x
k t x
| +
=
=
>
}


( , , ) ( , , ) ( , ) H f t x u g t x u k t x q = + +

Necessary conditions:
0
' ( )
( ) [ ( )]
0, ( , ) 0
u u u
x x x x
x
H f g
H f g k
T x T
k t x

q
|
q q
= + =
= = + +
=
> =



Example
2 2 2
,
0
0 1 1 2 2
1 1 1 2 0 1
2 2 2
1
min ( )
2
. . ' , (0) 0, ( ) 0 where , , , 0
( , ) 0
( , ) 0
T
u T
x c u dt
s t x u x x x T a b a b
h t x a bt x a x a
h t x x a b t
+
= = > = >
= s > >
= + s
}
2 1
2 1

a a
b b
>

( ) x t

2
a

0
x _
2 2
2
0
( , ) 0
x a b t
h t x
+ =
=


1
a


1 1
1
0
( , ) 0
a b t x
h t x
=
=

t

1
1
a
b

2
2
a
b

We do not know the relative size
of
1 2
and b b , i.e. we do not
know which line is steeper.
T is free!!
115
2 2 2
1 1 1 2 2 2
1
( ) ( ) ( )
2
H x c u u a bt x x a b t q q = + + + + + minimization problem

Necessary conditions:
2
2
0
u
H c u u
c

= + = = (1)
1 2 1 2
' ( )
x
H x x q q q q = = + = + (2)
1 1 1 1 1 1
0, 0, ( ) 0 a bt x a bt x q q > s = (3)
2 2 2 1 2 2
0, 0, ( ) 0 x a b t x a b t q q > + s + = (4)
' H x u

= = (5)

Since initial and terminal values of x are specified, there are no boundary conditions on .

Since ( ) 0 x T = is required, the bounds at T require

1
1 1 1 1
1
2
2 2 2 2
2
( ) 0 0
( ) 0 0
a
a bT x T a bT T
b
a
x T a b T a b T T
b
s s s
+ s + s s

1 2
1 2
a a
T
b b
s s















From the result in section 7, we know that there are 3 possibilities ( 0
t
| = ):
i)
1 2
1 2
( ) 0 and
a a
H T T
b b
= s s (6A)
ii)
1
1
( ) 0 and
a
H T T
b
> = (6B)
iii)
2
2
( ) 0 and
a
H T T
b
s = (6C)

Section 7: Various endpoints

Constraint Transversality condition
1
free t
1
0 @
t
f g t | + + =

1
T t >
1
1
0 if
0 if
t
t
f g T t
f g T t
|
|
+ + > =
+ + > >

116
Initially (when 0 t = ),
1 2 1 2
( , ), ( , ) 0 (0) (0) h x t h x t q q = = .

On the interval when
1 2
0, we have (2) : ' x q q = = = (7)

2
(1) and (5) ' x u
c

= =
Differentiate with respect to
2
'
" t x
c

=
Using (7), we have
2 2
'
" 0
x
x
c c

= = > [ ( ) x t is a convex path] (8)







2
1 2 2 2
1 1
" 0 characteristic equation: 0 ( )
t t
c c
x
x r r x t k e k e
c c c

= = = = + (9)

The path of ( ) x t on any free interval (both constraints are non-binding) must be convex and of the
form (9) for some constants
1 2
and k k .


Suppose neither constraint is binding @
1 2
( ) ( ) 0 T T T q q = =
2 2 2 2 2 2 2 2
1 1 1
( ) ( ) [ ( ) 0 and (1): ]
2 2 2
H T c u u c u c u u c u x T c u = + = + = = =

( ) 0 only if ( ) 0 H T u T = =

1 2
1 2
( ) '( ) 0
( ) 0
T T
c c
T T
c c
k k
u T x T e e
c c
x T k e k e

= = =

= + =

1 2
0 ( ) 0 k k x t = = = on a final free interval


This contradicts the property that T is the first moment for which 0 x = .
[Note that we also minimize T in order to have the smallest integral.]

Therefore a constraint must be active at T . Since the ( ) x t is strictly convex, the active constraint must
be
2
( , ) 0 h t x s

Then
2 2 2
2
1
( ) 0 and
2
a
H T c u T
b
= < = [from (6C)]

The characteristic equation for "( ) '( ) ( ) 0 y t Ay t By t + + = is
2
0 r Ar B + + =
117
From (1), continuity of continuity of u . soft-landing

Therefore at a point dividing a free interval and a constrained interval, the path must be tangent to the
constraint (since ' x u = , hence the slope cannot change suddenly).

But since the ( ) x t path is convex in every free interval, it cannot be tangent to
2
( , ) 0 h x t = .

Since the ( ) x t path must touch the axis t at T , there cannot be a constrained interval along
2
( , ) 0 h x t = , otherwise the tangency condition cannot be met.

Therefore the solution is (7), where
1 2
and k k are chosen so that
2 2
2 2
1 2 0
2
1 2
2
(0)
( ) ( ) 0
a a
b c b c
x k k x
a
x T x k e k e
b

= + =

= = + =

provided that this satisfies


1
( , ) 0 h x t =

( ) x t

2
a

0
x _
2 2
2
0
( , ) 0
x a b t
h t x
+ =
=


1
a


1 1
1
0
( , ) 0
a b t x
h t x
=
=

t

1
1
a
b

2
2
a
b


118
If this is not feasible, then the solution follows a path of the form (7) from the point (0,
0
x ) to a point
of tangency with
1
( , ) 0 h t x = , then follows
1
( , ) 0 h t x = for some interval, and finally leaves
1
( , ) 0 h t x =
from a point of tangency and follows another path of the form (7) to the point
2
2
( , 0)
a
b
.
( ) x t

2
a

0
x _
2 2
2
0
( , ) 0
x a b t
h t x
+ =
=


1
a


1 1
1
0
( , ) 0
a b t x
h t x
=
=

t

1
t
2
t
1
1
a
b

2
2
a
b

Thus,
1 2 1
1 1 1 2
2
3 4 2
2
[0, )
( ) [ , ]
( , ]
t t
c c
t t
c c
k e k e t t
x t a bt t t t
a
k e k e t t
b

+ e

= e

+ e


where

a) the value of
1 2 1
, and k k t are determined by
i) the initial condition | |
0
(0) x x = ,
ii) continuity at
1
t
1 1
1 2 1 1 1
t t
c c
k e k e a bt

(
+ =
(

, and
iii) tangency at
1
t
1 1
1 2
1 1
'( )
t t
c c
k k
x t e e b
c c

(
= =
(

.

b) the value of
3 4 2
, and k k t are determined by
i) the terminal condition
2
2
( ) 0
a
x
b
(
=
(

,
ii) continuity at
2
t
2 2
3 4 1 1 2
t t
c c
k e k e a bt

(
+ =
(

, and
iii) tangency at
2
t
2 2
3 4
2 1
'( )
t t
c c
k k
x t e e b
c c

(
= =
(

.

119
Note:

a) One CANNOT obtain an optimal solution by deleting infeasible portions of the solution to the
constrained problem.
b) A strictly convex path cannot be tangent to a straight line at two points.













120
Dynamic programming (continuous time)

1
0
0 0
0 0
Define ( , ) max ( , , )
s.t. ' ( , , )
( )
t
u
t
J t x f t x u dt
x g t x u
x t x
=
=
=
}


Let us break up the integral, we have
0 1
0 0
0 0
( , ) max ( , , ) ( , , )
t t t
u
t t t
J t x f t x u dt f t x u dt
+A
+A
(
= + (
(

} }


By the Principle of Optimality,

0 1
0 0
0 0 0 1
0 0


( , ) max ( , , ) max ( , , )
s.t. ' ( , , )

t t t
u u
t t t
t t t t t t t t
J t x f t x u dt f t x u dt
x g t x u
+A
+A
s s +A +A s s
(
( = +
(

=
} }
0 0
( + ) + x t t x x A = A


| |
0
0
0 0
0 0 0 0


0 0 0 0 0 0 0 0
( , ) max ( , , ) ( , )
max ( , , ) ( , ) ( , ) ( , ) . . .
t t
u
t
t t t t
t x
u
J t x f t x u dt J t t x x
f t x u t J t x J t x t J t x x h ot
+A
s s +A
(
= + + A + A (
(

~ A + + A + A +
}


| |
0 0 0 0 0 0
0 max ( , , ) ( , ) ( , )
t x
u
f t x u t J t x t J t x x ~ A + A + A

Divide both sides by t A and let 0 t A .

| |
| |
0 0 0 0 0 0
0 0 0 0 0 0
0 0 0 0 0 0
0 max ( , , ) ( , ) ( , )
0 max ( , , ) ( , ) ( , ) '
0 max ( , , ) ( , ) ( , ) ( , , ) (1)
t x
u
t x
u
t x
u
x
f t x u J t x J t x
t
f t x u J t x J t x x
f t x u J t x J t x g t x u
A (
= + +
(
A

= + +
= + +


{ }
0 0 0 0 0 0
( , ) max ( , , ) ( , ) ( , , )
t x
u
J t x f t x u J t x g t x u = +

fundamental partial differential equation obeyed by the optimal value function ( , ) J t x
121
2 2
0
0
min ( ) 0, 0
. . '
(0) 0
rt
u
e ax bu dt a b
s t x u
x x

+ > >
=
= >
}


Fundamental partial differential equation:
2 2
( , ) min{ ( ) ( , ) } (1)
rt
t x
u
J x t e ax bu J x t u

= + +
FOC of the RHS:
( , )
2 ( , ) 0
2
rt
rt x
x
J x t e
be u J x t u
b

+ = =
2 2
(1) [ ( ) ] ( )
2 2
rt rt
rt x x
t x
J e J e
J e ax b J
b b

= + +
2 2 2
2
4 2
rt rt
rt x x
t
J e J e
J e ax
b b

| |
= +
|
\ .

2 2 2 2
2
4 2
rt rt
rt x x
t
J e e J
J e ax
b b
= +
2 2
2
0
4
rt
rt x
t
J e
ax J e
b
+ = (2)

Conjecture:
2
( , )
rt
J x t e Ax

= ( , ) 2
rt
x
J x t e Ax

= and
2
( , )
rt
t
J x t re Ax

=

2 2
2 2
(2 )
(2) ( ) 0
4
rt rt
rt rt
e Ax e
ax re Ax e
b

+ =
2 2 2
2 2
2
0 0
4

2
A x A
ax rAx rA a
b b
a
r r
b
A
b
= + =
+
=

Note that the functional form in the objective function implies that ( , ) J x t must be non-negative
2
4
0
a
A b r r
b
| |
= + + >
|
|
\ .

( , ) (2 )
2 2
rt rt rt
x
J x t e e Ax e Ax
u
b b b

= = =
0
0
' ( )
A A
t t
b b
A
t
b
Ax
x u x t ke x e
b
Ax A
u x e
b b

= = = =
= =

122
Example (Brock and Mirman (1972): Optimal Economic Growth and Uncertainty, JET, pp. 479-513

0
max ( ) 0 1
t
t
t
C
t
U C | |

=
< <


s.t.
1 0
( ) ; 0 given; 0
t t t t
k f k C k C
+
= > >

Special case: ( ) ln and ( ) , 0, 0 1 U C C f k Ak A
o
o = = > < <

0
max ln 0 1
t
t
t
C
t
C | |

=
< <


s.t.
1 0
; 0 given; 0
t t t t
k Ak C k C
o
+
= > >

Bellmans equation:
1
( ) max[ln ( )]
t
t t t
C
v k C v k |
+
= +
Or
1
1 1
( ) max[ln( ) ( )] (1)
t
t t t t
k
v k Ak k v k
o
|
+
+ +
= +
Differentiate RHS by
1 1
1
1
'( ) 0 (2)
t t
t t
k v k
Ak k
o
|
+ +
+

+ =


Note that
1
is a function of
t t
k k
+
.

Conjecture: ( ) ln and are to be determined
t t
v k E F k E F = +
1
1
'( ) or '( )
t t
t t
F F
v k v k
k k
+
+
= =
1 1
1 1 1
1 1 1 1
1
1
1
(2) 0
( ) (1 )
0 0
( ) ( )
(1 )

1
t t t
t t t t t
t t t t t t
t t
t
t
F
Ak k k
k F Ak k F k FAk
Ak k k Ak k k
F k FAk
FAk
k
F
o
o o
o o
o
o
|
| | |
| |
|
|
+ +
+ + +
+ + + +
+
+

+ =

+ + +
= =

+ =
=
+
(3)


(1) ln ln[ ] [ ln( )]
1 1
ln ln[ (1 )] [ ln( )]
1 1
1
ln ln[ ( )] [ ln( )]
1 1
ln ln ln ln(1 ) ln( ) ln(1 )
t t
t t
t
t t
t
t t
t t
FAk FAk
E F k Ak E F
F F
FAk F
E F k Ak E F
F F
FAk
E F k Ak E F
F F
E F k A k F E F FA F F F
o o
o
o
o
o
o
| |
|
| |
| |
|
| |
|
|
| |
o | | | | | | |
+ = + +
+ +
+ = + +
+ +
+ = + +
+ +
+ = + + + + + + ln
t
k o

123
ln ln(1 ) ln( ) ln(1 ) and
and ln ln(1 ) ln( ) ln(1 )
1 1 1 1 1 1
1 1
ln ln( ) ln( ) ln( )
1 1 1 1 1
ln ln(1 )
E A F E F FA F F F F
F E A E A
A
E A E
E A E
| | | | | | o | o
o o o o o o
| | | | | |
o| o| o| o| o| o|
o| o| o|
|
o| o| o| o| o|
o|
o| |
= + + + + = +
= = + + + +

= + +

= + + + ln( )
1
1
[ln ln(1 ) ln( )]
1 1
A
E A A
o|
o|
o|
o| o|
| o|

= + +



Suppose the conjecture is ( )
t t
v k E Fk = + so that
1
'( ) '( )
t t
v k F v k
+
= =

1
1
(2) 0
t t
F
Ak k
o
|
+

+ =


1
1
1
1
(3')
t t
t t
Ak k
F
k Ak
F
o
o
|
|
+
+
=
=


1 1
(1) ln[ ] ( )
1 1
ln[ ( )] [ ( )]
1
ln( ) 1
t t t t
t t t t
t t
E Fk Ak k E Fk
E Fk Ak Ak E F Ak
F F
E Fk E FAk
BF
o
o o o
o
|
|
| |
| |
+ +
+ = + +
+ = + +
+ = + +


Since there is a
t
k term on the left hand side but not on the right hand side, also there is a
t
k
o
term on
the right hand side but not on the left hand side, hence the left hand side and the right hand side do not
match each other. Therefore the proposed value function ( )
t
v k cannot be correct.
124
Example (Habit Persistence)
1
0
1
0 1
max (ln ln ) 0 1, 0
. . , 0, 0 1
0, 0 are given
t
t t
t
t t t
C C
s t k Ak C A
k C
o
| |
o

=
+

+ < < >


= > < <
> >



Bellmans equation:
| |
1 1 1
( , ) max ln ln ( , )
t
t t t t t t
C
v k C C C v k C |
+
= + + (1)

Conjecture:
1 1
( , ) ln ln
t t t t
v k C E F k G C

= + +
| |
1 1 1
(1) : ln ln max ln ln ln ln
t
t t t t t t
C
E F k G C C C E F k G C | | |
+
+ + = + + + + (2)

RHS of (2):

FOC:
1 ( 1)
0
t t t t
F G
C Ak C C
o
| |
+ + =


1
(1 )( ) (1 ) (1 )
t t t t t
t t t
G F
G Ak C FC G Ak F G C
C Ak C
o o
o
| |
| | | | |
+
= + = + = + +


(1 )
1
t
t
G Ak
C
F G
o
|
| |
+
=
+ +
(3)
1
1
1
(2) ln ln
(1 ) (1 ) (1 )
ln ln ln ln
1 1 1
(1 ) (1 ) (1 )
ln ln ln 1 ln
1 1 1
(1
ln
t t
t t t
t t
t t
t t
E F k G C
G Ak G Ak G Ak
C E F Ak G
F G F G F G
G Ak G Ak G
C E F Ak G
F G F G F G
o o o
o
o o
o
| | |
| | |
| | | | | |
| | |
| | |
| | | | | |

+ +
( + + +
= + + + +
(
+ + + + + +

( + | | + +
= + + + +
( |
+ + + + + +
\ .
=
1
1
) (1 )
ln ln ln
1 1 1
(1 ) (1 )
ln ln ln ln ln ln ln
1 1 1
t t t
t
t t t t
G Ak FAk G Ak
C E F G
F G F G F G
G A FA G A
k C E F F k G G k
F G F G F G
o o o
| | |
| | |
| | | | | |
| | |
o | | | o | | o
| | | | | |

( + +
+ + + +
(
+ + + + + +

+ +
= + + + + + + +
+ + + + + +
1
(1 )
(1 ) ln ln (1 ) ln ln
1 1
t t
G A FA
G F E G F k C
F G F G
| |
| | | o | |
| | | |

+
= + + + + + + +
+ + + +


Comparing coefficients, we have

(1 )
(1 ) ln ln
1 1
G A FA
E G F E
F G F G
| |
| | |
| | | |
+
= + + +
+ + + +
(4)
(1 ) F G F | | o = + + (5)
G = (6)

125
(1 ) (1 )
(5) and (6) (1 )
1 1
G
F G F F
o | o |
o | o|
o| o|
+ +
= + + = =

(7)
(1 )
(4) (1 ) (1 ) ln ln
1 1
1 (1 )
(1 ) ln ln
1 1 1
(1 )
1 1 (1 ) (1 )
(1 ) ln ln
1 1 (1 ) (1 )
1 1
1 1
G A FA
E G F
F G F G
G A FA
E G F
F G F G
A
A
E
| |
| | |
| | | |
| |
| |
| | | | |
o |
|
o| | o |
| |
| o| o | o |
| | |
o| o|
+
= + +
+ + + +
( +
= + +
(
+ + + +

| | +
|
| | + +
\ .
= + +
|
| | | + +
\ .
+ + +
|

\ . \
2 2 2 2
(1 )
1 1 (1 ) (1 )
(1 ) ln ln
1 1 1 1
1 1
(1 )
1 (1 ) (1 )
(1 ) ln ln
1
1 1
1
A
A
E
A
A
E
|
o |
|
o| | o |
| |
o| o| o| | o| o| o| o| | o| | o|
o| o|
o | |
| o| |
|
|
| o|
o|
(
(
(
( |
+
( |
.
( | | +
( |
| | + +
\ .
(
= + +
|
( + + + + + +
\ .
(


+
| | + +
= + +
|
+

\ .

1
1
1
1 (1 )
(1 ) ln(1 ) ln
1 1
E A A
o|
|
o|
o| |
| o| o |
| o|
(
(

(
+
(
(

( | | +
= + +
( |

\ .

2 2
(1 ) (1 ) (1 )
(6) and (7) (3)
1 1 (1 )
1
1 1
(1 )
(1 )
1
1
t t t
t
t
t t
G Ak Ak Ak
C
F G
Ak
C Ak
o o o
o
o
| | |
o| o| o| | o| | | o |
| |
o| o|
|
o|
|
o|
+ + +
= = =
+ + + + + | | +
+ +
|

\ .
+
= =
+



1
(1 ) [1 (1 )]
t t t t t t t
k Ak C Ak Ak Ak Ak
o o o o o
o| o| o|
+
= = = =







Note that
1
C

is irrelevant!!
The utility function is separable in
1
( , )
t t
C C

, i.e. MU of
t
C is independent of
1 t
C

.
126
Diffusion process

Diffusion processes are those processes in which small changes in state occur continually.

In a short interval of time only local movements can take place and there is some change no matter
how infinitesimal the time interval considered.



Consider a discrete-time model of a variable x which has in each period an expected change and
variance
2
o .

( 1) ( ) ( ) ( ) 0
( ) 1
or ( 1) ( ) ( ) ( ) ( ) and ( ) independ
x t x t t E
Var
x t x t x t t t s
o

o
+ = + + =
=
+ = A = + ent for t s =


Now suppose the change in x over 1 period is actually the cumulative result of n small changes
occurring regularly at sub-intervals of length
1
h
n
= throughout the period.


Let the change over the i
th
sub-period be given by


( ) [ ( 1) ] ( ) ( ) 0
( ) 1

x t ih x t i h h i h E
Var
o c c
c
+ + = + =
=
( ) and ( ) independent for i j i j c c =


The mean change over 1 sub-interval is h and the variance is
2
h o .

The change in X over the whole period is the sum of the changes in every subinterval.

{ }
1 1 1
1
( 1) ( ) ( ) [ ( 1) ] [ ( ) ] ( )
( )
n n n
i i i
n
i
x t x t x t ih x t i h h i h nh h i
h i
o c o c
o c
= = =
=
+ = + + = + = +
= +


The prototype physical analog of this kind of process is the Brownian motion of a tiny particle
suspended in a fluid. Under constant bombardment by molecules of the fluid, its position
continually changes by small random amounts.
127
| | | |
| |
1 1
2 2
1 1 1 1
2 2
1 1 1
( 1) ( ) ( ) ( )
( 1) ( ) [ ( )] [ ( )] ( ) [ ( )] [ ( )]
[ ( )] [ ( ), ( )]
n n
i i
n n n n
i i i i
n n n
i i j
j i
E x t x t E h i h E i
Var x t x t Var h i Var h i h Var i hVar i
h Var i Cov i j h n
o c o c
o c o c o c o c
o c c c o
= =
= = = =
= = =
=
(
+ = + = + =
(

+ = + = = =


= + = +
`

)



{ }
2 2
0
hn o o = =


Note:

1. The mean and variance per unit time of the new process remain the same as that for the initial
one even though the new one has random disturbances occurring much more frequently.

2. The one period change in X in the new process is made up of a sum of n identically and
independently distributed (i.i.d.) random variables with finite variance.



By the Central Limit Theorem, as , n (i.e. the number of sub-intervals goes to ), ( 1) ( ) x t x t +
will be normally distributed regardless the actual distribution of the ' s c .

2
( ) ( ) ( , ) x t t x t N t t o +A A A


In the limit, we will have a process whose mean and variance per unit time will still be
2
and o
respectively but for which the stochastic element will be in the form of infinitesimal time independent
random shocks occurring at every instant of time.


Central Limit Theorem
If a large random sample ( 30 n > ) is taken from any distribution with mean and variance
2
o ,
regardless of whether this distribution is discrete or continuous, then
2
1
...
( , )
n
n n
X X
X N X
n n
o

+ +

128
This limiting process is also know as a stochastic differential equation and is written formally as

where (0,1) dx dt dz dz dt N o = + =










In more general term, we have ( , ) ( , ) dx x t dt x t dz o = +


Itos lemma

Let ( , ) and Y F x t dx dt dt dt dz o o = = + = +

Define ( ) ( ) ( , ) ( , ) dY Y t dt Y t F x dx t dt F x t = + = + +


Taylor expansion of ( ) Y t dt +

2 2 2
2 2
2 2
( ) ( , )
1 1 1
( , ) ( ) ( ) . . .
2 2 2
Y t dt F x dx t dt
F F F F F
F x t dx dt dx dt dxdt h ot
x t x t x t
+ = + +
c c c c c
= + + + + + +
c c c c c c


Note that
i)
2
( ) dt is a much smaller order of magnitude than dt
ii)
3
2
2
( ) ( ) ( ) dxdt dt dt dt dt dt o o = + = + is a much smaller order of magnitude than dt

2
2
2
1
( ) ( , ) ( )
2
F F F
Y t dt F x t dx dt dx
x t x
c c c
+ ~ + + +
c c c

2
2
2
1
( ) ( ) ( , ) ( ) ( , )
2
F F F
dY Y t dt Y t F x t dx dt dx F x t
x t x
c c c
= + = + + +
`
c c c
)

2
2
2
1
( )
2
F F F
dY dx dt dx
x t x
c c c
= + +
c c c


Itos Lemma
instantaneous
mean
deterministic
instantaneous
variance
stochastic
Wiener process
Itos process
129
Evaluating
2
( ) dx
3
2 2 2 2 2 2
2
effectively 0 effectively 0
( ) ( ) ( ) 2 ( ) dx dt dt dt dt dt o o o = + = + +

2 2 2 2 2 2
[( ) ] [ ] ( ) E dx E dt dt E dt o o o = = =




2 2 2 4 2 2
effectively 0
[( ) ] [ ] ( ) ( ) 0 Var dx Var dt dt Var o o = = =

Since
2 2 2
[( ) ] and [( ) ] 0 E dx dt Var dx o = =
2 2
( ) with probability 1 dx dt o =

(i.e. it is effectively
non-stochastic.)













Another version of the Itos Lemma

( , ) and Y F x t dx dt dt dt dz o o = = + = +
2
2
2
1
( )
2
F F F
dY dx dt dx
x t x
c c c
= + +
c c c
2
2
2
1
( ) ( )
2
F F F
dY dt dz dt dt
x t x
o o
c c c
= + + +
c c c

2
2
2
1
( )
2
F F F F
dY dt dz
x t x x
o o
c c c c
= + + +
c c c c


Multiplication table
dz dt
dz dt 0
dt 0 0

2 2 2
2 2 2 2
2
3
2
2
2
2 2
( ) ( )
[( ) ] [ ] ( ) ( ) 1
[(
( )(
) ] ( ) ( ) ( ) 0
) ( )( ) ( ) 0
( ) 0
dz dt dt dt
E dz E dt dt E dt E
Var dz Var dt dt
dz dt dt dt dt
d
ar
t
V




= = =
= = = =
= = =
= = ~
=

| |
( )
( )
( )
2
2
2
(0,1) 1 ( ) ( ) [ 0]
1
N Var E E E
E

= = =
=

130
Example:
x
Y e =
2
2
( , ) , , 0
x x x
F F F
Y F x t e e e
x x t
c c c
= = = = =
c c c

2
1
[ 0 ( )( )] ( )
2
x x x
dY e e dt e dz o o = + + +


F
x
c
c

F
t
c
c

2
2
F
x
c
c

F
x
c
c

2
2
1
[ ]
2
1
( )
2
x x x
dY e e dt e dz
dY Ydt Y dz
o o
o o
= + +
= + +

or
2
1
( )
2
dY
dt dz
Y
o o = + +


Example: ln Y x =
2
2 2
1 1
( , ) ln , , 0
F F F
Y F x t x
x x x x t
c c c
= = = = =
c c c

2
2
1 1 1 1
[ 0 ( ) ] ( )
2
dY dt dz
x x x
o o = + + +



F
x
c
c

F
t
c
c

2
2
F
x
c
c

F
x
c
c

2
2
2
2
1 1 1
[ ]
2
1 1 1
( )
2
Y Y Y
dY dt dz
x x x
dY dt dz
e e e
o o
o o
= +
= +



dx dt dz o = +
dx dt dz o = +
131
Multivariate Itos Lemma
Let
1 2
( , ,..., , ) and
n i i i i i i i
Y F x x x t dx dt dt dt dz o o = = + = +

Define
1 1 2 2 1 2
( ) ( ) ( , ,..., , ) ( , ,..., , )
n n n
dY Y t dt Y t F x dx x dx x dx t dt F x x x t = + = + + + +

Taylor expansion of ( ) Y t dt +
1 1 2 2
2 2 2
2
1 2 2
1
( ) [ , ,..., , ]
1 1 1
( , ,..., , ) ( ) . . .
2 2 2
n n
n n n n
n i i j i
i i j i
i i j i
Y t dt F x dx x dx x dx t dt
F F F F F
F x x x t dx dt dx dx dx dt dt h ot
x t x x x t t
=
+ = + + + +
c c c c c
= + + + + + +
c c c c c c c



2 2 2
2
2
1
1 1 1
( ) ( ) ( ) . . .
2 2 2
n n n n
i i j i
i i j i
i i j i
F F F F F
Y t dt Y t dx dt dx dx dx dt dt h ot
x t x x x t t
=
c c c c c
+ = + + + + +
c c c c c c c



Note that
i)
2
( ) dt is a much smaller order of magnitude than dt
ii)
3
2
2
( ) ( ) ( )
i i i i i i i
dx dt dt dt dt dt dt o o = + = + is a much smaller order of magnitude than dt

2
1
1
( ) ( )
2
n n n
i i j
i i j
i i j
F F F
dY Y t dt Y t dx dt dx dx
x t x x
=
c c c
= + = + +
c c c c

Itos Lemma






Evaluating
i j
dx dx

effectively 0 effectively 0 eff
3 3
2
2 2
ectively 0
( )( )
( ) ( ) ( )
i j i i i i i i
i j i j j j i i i j i j
dx dx dt dt dt dt
dt dt dt dt
o o
o o o o
= + +
= + + +


[( )] [ ] ( )
i j i j i j i j i j i j ij
E dx dx E dt dt E dt o o o o o o = = =

2 2 2
effectively 0
( ) [ ] ( ) ( ) 0
i j i j i j i j i j
Var dx dx Var dt dt Var o o o o = = =
Since ( ) and ( ) 0
i j i j ij i j
E dx dx dt Var dx dx o o = = with probability 1
i j i j ij
dx dx dt o o =

(i.e. it is
effectively non-stochastic.)


| |
( ) ( )
2
(0,1) and (0,1)
( , )
( , ) ( ) ( )
( ) ( )
( ) 1
i j
i j
ij i j i i j j i j
i j
ii
N N
Cov
Cov E E E E
Var Var
E





( = = = =

= =

( ) ( ) 1
i j
Var Var = =

132









Another version of the Itos Lemma

2
1
2
1
2
1 1
1
2
1
( ) ( )
2
1
2
n n n
i i j
i i j
i i j
n n n
i i i i j ij
i i j
i i j
n n n n
i i j ij i i
i i j i
i i j i
F F F
dY dx dt dx dx
x t x x
F F F
dY dt dz dt dt
x t x x
F F F F
dY dt dz
x t x x x
o o o
o o o
=
=
= =
c c c
= + +
c c c c
c c c
= + + +
c c c c
(
c c c c
= + + +
(
c c c c c
(







Itos lemma for 2 variables:
2 2 2
2 2
1 2 1 2 12 1 2 1 1 2 2 2 2
1 2 1 2 1 2 1 2
1
(2 )
2
F F F F F F F
dY dt dz dz
x x x x x x x x
o o o o o o
( c c c c c c c
= + + + + + +
(
c c c c c c c c






Example:
2 3
( )
rt
w e x y xy = +

2 2 2 2
2
2 2
2 3
(2 ) 2 ( 3 ) 6
( )
rt rt rt rt rt
rt
w w w w w w
x y e e y x e ye e
x y x y y x x y
w
re x y xy
t
c c c c c c
= + = = + = = =
c c c c c c c c
c
= +
c


{ }
2 2 3 2 2
2
2 2 3 2 2
1
[(2 ) ] [( 3 ) ] ( ) [(2 ) 2( ) ( 6 ) ]
2
[(2 ) ] [( 3 ) ]
(2 ) ( 3 ) ( ) 3
[(
rt rt rt rt rt rt
x y x x y xy y
rt rt
x x y y
rt
x y x x y xy y
dw x y e y x e re x y xy e e ye dt
x y e dz y x e dz
e x y y x r x y xy y dt
o o o o
o o
o o o o

= + + + + + + + +
`
)
+ + + +
= + + + + + + +
+
2
2 ) ] [( 3 ) ]
rt rt
x x y y
x y e dz y x e dz o o + + +


Multiplication table

i
dz
dt
j
dz
ij
dt
0
dt 0 0

2
2
3
2
( )( ) ( )( ) (
( )( ) ( )
( ) ( ) ( )
( ) [ (
)
) ] 0
0
( ) 0
i j i
i
j i j
i j i j i j ij
i i
i j i j
dz dz dt dt dt
E dz dz E dt dt E dt
V
dz dt dt d
ar dz dz V
t dt
dt
ar dt




= = =
=
~
=
=
=
=
=
=
=
x x x
y y y
dx dt dz
dy dy dz
o
o
= +
= +

133
Problem
0
0
max ( , , ) [ ( ), ]
. . ( , , ) ( , , ) , (0)
T
u
E f t x u dt x T T
s t dx g t x u dt t x u dz x x
|
o

+
`
)
= + =
}


0 0
0

0
Define ( , ) max ( , , ) [ ( ), ]
. . ( , , ) ( , , ) , (0)
T
u
J t x E f t x u dt x T T
s t dx g t x u dt t x u dz x x
|
o

+
`
)
= + =
}


{ } ( , ) max ( , , ) ( , )
u
J t x E f t x u t J t t x x = A + +A +A

2
2
1
( , ) max ( , ) ]
2
1
0 max ( , , ) ( , ) ( , ) ( , , ) ( , ) ( , , ) ( , )
2
1
0 max ( , , ) ( , ) ( , ) ( , , ) ( ,
2
t x x xx
u
t x x xx
u
t x xx
u
J t x E f t J t x J t J g t J z J t
E f t x u t J t x t J t x g t x u t J t x t x u z J t x t
f t x u t J t x t J t x g t x u t J t
o o
o o

~ A + + A + A + A + A
`
)

= A + A + A + A + A
`
)
= A + A + A +
2
2
2
)
1
0 max ( , , ) ( , ) ( , ) ( , , ) ( , )
2
1
( , ) max ( , , ) ( , ) ( , , ) ( , )
2
t x xx
u
t x xx
u
x t
f t x u J t x J t x g t x u J t x
J t x f t x u J t x g t x u J t x
o
o
o

A
`
)

= + + +
`
)

= + +
`
)


Bellmans equation
Boundary condition: [ , ( )] [ , ( )] J T x T T x T | =



Taylor expansion
2 2
0
0
( , )
1 1 1
( , ) ( , ) ( , ) ( , ) ( ) ( , )( ) (2) ( , ) . . .
2 2 2
t x tt xx xt
J t t x x
J t x J t x t J t x x J t x t J t x x J t x t x h ot
=
=
+ A + A
= + A + A + A + A + A A +

2
1
( , ) ( , ) ( , ) ( , )[ ( , , ) ( , , ) ] ( , )[ ] . . .
2
t x xx
J t t x x J t x J t x t J t x g t x u t t x u z J t x t h ot o o +A +A = + A + A + A + A +
134
2 2
0
min ( ) . .
rt
u
E e ax bu dt s t dx udt xdz o

+ = +
}




Bellmans equation:
2 2 2 2
1
min ( )
2
rt
t x xx
u
J e ax bu J u x J o


= + + +
`
)
(*)

RHS: FOC: 2 0
rt
x
e bu J

+ =

2
rt
x
J e
u
b
=

2 2 2 2
2 2 2
2 2 2
2
2 2
2 2 2
2
2 2 2
2 2
2 2
1
(*) : [ ( ) ] ( )
2 2 2
1
[ ( )]
4 2 2
1
4 2 2
1
4 2
1
4 2
rt rt
rt x x
t x xx
rt rt
rt x x
t xx
rt rt
rt x x
t xx
rt
rt x
t xx
rt
rt x
t
J e J e
J e ax b J x J
b b
J e J e
J e ax b x J
b b
J e J e
J e ax x J
b b
J e
J e ax x J
b
J e
J e ax
b
o
o
o
o
o

= + + +
= + +
= + +
= +
= +
2
(**)
rt
xx
x J e

Conjecture:
2
( , )
rt
J t x e Ax

=
2 2
( , ) ( , ) , ( , ) 2 , ( , ) 2
rt rt rt rt
t x xx
J t x e Ax J t x re Ax J t x e Ax J t x e A

= = = =
2 2
2 2 2 2
2 2
2 2 2 2
2
2 2 2
2 2 2 2 2 2
( 2 ) 1
(**) : ( ) ( 2 )
4 2
1
( ) 0
1 4
( ) ( ) 4( )( ) ( ) ( )
1 2
2
rt rt
rt rt rt rt
e Ax e
e re Ax ax x e e A
b
A x
rAx ax x A
b
A
rA a A A r A a
b b
a
r r a r r
b b
A
b b
o
o
o o
o o o o


= +
= +
= + + =
+
= =
+

( 2 )
( ) ( )
2 2
rt rt rt
x
J e e Ax e A
u t x t
b b b

= = =

( , , )
( , , )
g t x u u
t x u x o o
=
=

2
1
( , ) max ( , , ) ( , ) ( , , ) ( , )
2
t x xx
u
J t x f t x u J t x g t x u J t x o

= + +
`
)

135
0
0
max ln . . [ (1 ) ] , (0) , 0 1
rt
C
E e C dt s t dW s W a W C dt W dz W W b o o o o


= + + = < <
`
)
}

W : total wealth
o : fraction of wealth in the risky asset
s : return on the risk-free asset
a : expected return on the risk asset ( a s > )
2
o : variance (per unit time) of return to risky asset
C : consumption

state variable: W
control variables: , C o

Bellmans equation:
2 2 2
,
1
( , ) max ln ( , )[ (1 ) ] ( , )
2
rt
t W WW
C
J t W e C J t W s W a W C W J t W
o
o o o o


= + + +
`
)


Let ( , ) ( ) ( , ) ( ), ( , ) '( ), ( , ) "( )
rt rt rt rt
t W WW
J t W e V W J t W re V W J t W e V W J t W e V W

= = = =

Bellmans equation:
| |
2 2 2
,
1
( ) max ln '( ) (1 ) "( )
2
rt rt rt rt
C
re V W e C e V W s W a W C W e V W
o
o o o o


= + + +
`
)

| |
2 2 2
,
1
( ) max ln '( ) (1 ) "( )
2
C
rV W C V W s W a W C W V W
o
o o o o

= + + +
`
)
(1)

RHS: FOC:
Differentiate with respect to C :
1 1
'( ) 0
'( )
V W C
C V W
= = (2)
Differentiate with respect to o :
2 2 2 2
1
'( )( ) [2 "( )] '( )( ) "( ) 0
2
V W sW aW W V W V W sW aW W V W o o o o + + = + + =
2 2 2
'( )( ) '( )( )
"( ) "( )
V W s a W V W s a
W V W W V W
o
o o

= = (3)

(1)
2 2
2
2 2
2
1 '( )( ) '( )( ) 1
( ) ln '( ) 1
'( ) "( ) "( ) '( )
1 '( )( )
"( )
2 "( )
V W s a V W s a
rV W V W s W a W
V W W V W W V W V W
V W s a
W V W
W V W
o o
o
o
( ( ( (
= + +
`
( ( ( (
)
(
+
(


| |
2 2 2 2
2 2 2
[ '( )] ( ) [ '( )] ( ) 1 [ '( )] ( )
( ) ln '( ) '( ) 1
"( ) "( ) 2 "( )
V W s s a a V W s a V W s a
rV W V W V W sW
V W V W V W o o o

= + + +
2
1
( , ) max ( , , ) ( , ) ( , , ) ( , ) ( )
2
, ,
t x xx
u
J t x f t x u J t x g t x u J t x x t u o

= + +
`
)

136
| |
2 2 2 2
2 2
[ '( )] ( ) 1 [ '( )] ( )
( ) ln '( ) '( ) 1
"( ) 2 "( )
V W s a V W s a
rV W V W V W sW
V W V W o o

= + +
| |
2 2
2
[ '( )] ( )
( ) ln '( ) 1 '( )
2 "( )
V W s a
rV W V W V W sW
V W o

= + (4)

Conjecture: ( ) ln V W B A W = +

2
( ) ln '( ) , "( )
A A
V W B A W V W V W
W W
= + = =

(4)
2
2
2
2
( )
[ ln ] ln 1
2
A
s a
A A W
r B A W sW
A W W
W
o
(

(
( (

+ = +
( (
(


(


2
2
( )
ln ln ln 1
2
A s a
rB rA W A W As
o

+ = + + +

Comparing coefficients:
2
2
2
2
1
( )
ln 1
2
1

1 ( )
ln 1
2
rA
A s a
rB A As
A
r
A s a
B A As
r
o
o
=


= + +

= + +
(




1 1
(2) :
'( )
W
C rW
A
V W A
W
= = = =
2 2 2
2
2
( )
'( )( ) ( )
(3)
"( )
A
s a
V W s a s a a s W
A W V W
W
W
o
o o o
o
| |

|

\ .
= = = =
| |

|
\ .

137
Autonomous Problem

0
0
0 0
( ) max ( , )
. . ( , ) ( , )
( )
rt
u
V x E e f x u dt
s t dx g x u dt x u dz
x t x
o

= +
=
}







Let ( , ) ( ) ( , ) ( ), ( , ) '( ), ( , ) "( )
rt rt rt rt
t x xx
J t x e V x J t x re V x J t x e V x J t x e V x

= = = =

2
2
1
( ) max ( , ) '( ) ( , ) "( ) ( , )
2
1
( ) max ( , ) '( ) ( , ) "( ) ( , )
2
rt rt rt rt
u
u
re V x e f x u e V x g x u e V x x u
rV x f x u V x g x u V x x u
o
o


= + +
`
)

= + +
`
)


2
1
( , ) max ( , ) ( , ) ( , ) ( , )
2
rt
t x xx
u
J t x e f x u J t x g x u J t x o


= + +
`
)

138
( )
0
1 1
max ln
. . , 0 1, 0 1
0, 0
i.i.d. with (ln ) 0
t
t
t
C
t
t t t t
t t
t t
E C
s t x x C
x C
E
o
|
c o |
c c

=
+ +
= < < < <
> >
=



Bellmans equation:

| | { }
1
( ) max ln ( ) |
t
t t t t t
C
V x C E V x C |
+
= + (1)

Conjecture: ( ) ln
t t
V x G F x = + (2)

RHS:

| |
| |
1
1
1
1
ln ln |
ln ln |
ln ln( ) |
ln ln( ) ln |
t t t t
t t t t
t t t t t t
t t t t t t
C E G F x C
C G F E x C
C G F E x C C
C G F E x C C
o
o
|
| |
| | c
| | c
+
+
+
+
+ +
= + +
( = + +

( = + + +


ln ln( )
t t t
C G F x C
o
| | = + +

1
ln 0
t t
E c
+
=

FOC:
( )
1 1 1 1 1
1 ( 1) 1
0
(1 )
1
1
1
1 1 1
t t
t
t t t t t t
t t t
t t
t
t
t
t t t t t t t t t t
x C F F
C
C x C C x C F
FC x C
F C x
x
C
F
x F
x x C x x x
F F F
o
o o
o
o
o
o
o o o o
| |
|
|
|
|
|
c c c c
| | |
+ + + + +

+ = = =

=
+ =
=
+
| | | |
= = = =
| |
+ + +
\ . \ .


139
| |
| |
| |
1
1
1
1
(1) ( ) ln ( ) |
ln ln ln |
1
ln ln ln |
1 1
ln ln ln(1 ) ln ( ln ) ln( )
1
t t t t t
t
t t t t
t
t t t t t
t t t t t
V x C E V x C
x
G F x E G F x C
F
x F
G F x E G F x C
F F
F
G F x x F G F F x F E
F
G
o
o
o
|
|
|
|
| c
| |
|
o | | | | o | c
|
+
+
+
+
= +
| |
+ = + +
|
+
\ .
( | | | |
+ = + +
| ( |
+ +
\ . \ .
| |
+ = + + + + +
|
+
\ .
+ ln ln ln(1 ) ln ( ln )
1
ln ln(1 ) ln (1 ) ln
1
t t t
t t
F
F x x F G F F x
F
F
G F x F G F F x
F
|
o | | | | o
|
|
| | | o |
|
| |
= + + + +
|
+
\ .
| |
+ = + + + + +
|
+
\ .


Comparing coefficients:
(1 )
1
ln(1 ) ln
1
ln(1 ) ln
1
1
F F F F F
F
G F G F
F
F
F F
F
G
o
o | o o|
o|
|
| | |
|
|
| |
|
|
= + = + =

| |
= + + +
|
+
\ .
| |
+ +
|
+
\ .
=



1 1 1 1
(1 )
1
1
1
1
1
1
1
t t
t t
t t t t t t t
x x
C x
F
F
x x x x
F
o o
o
o o o
o|
| o
|
o|
o
|
o| |
c c o| c
| o
|
o|
+ + + +
= = =
+ | |
+
|

\ .
| |
|

\ .
= = =
+ | |
+
|

\ .

140
0
1
2
max ln
. . , 0 1
0
ln i.i.d. (0, )
t
t
t
C
t
t t t t
t
t
E C
s t k Ak C
C
N
o
|
u o
u o

=
+
= < <
>



A planner is supposed to know ( ,
t t
k u ) at time t but does not know the future values of u .

Bellmans equation:

| | { }
1 1
( , ) max ln ( , ) | ,
t
t t t t t t t t
C
V k C E V k k u | u u
+ +
= +
| |
{ }
1
1 1 1
( , ) max ln ( , ) | ,
t
t t t t t t t t t t
k
V k Ak k E V k k
o
u u | u u
+
+ + +
( = +

(1)

Conjecture: ( , ) ln ln
t t t t
V k H F k G u u = + + (2)

RHS:
| |
{ }
1
1 1 1
max ln ln ln ) | ,
t
t t t t t t t t
k
Ak k E H F k G k
o
u | u u
+
+ + +
( + + +


| |
{ }
1
1 1
max ln ln
t
t t t t
k
Ak k H F k
o
u |
+
+ +
( = + +

(1)

FOC:
1 1
1 1 1 1
1
1
1 1
0
(1 )
1
t t t t
t t t t t t t t
t t t
t t
t
F F
k F Ak k
Ak k k k Ak k
F k FAk
FAk
k
F
o
o o
o
o
| |
| u
u u
| | u
| u
|
+ +
+ + + +
+
+

( + = = =


+ =
=
+


141
1
(1) ln ln ln ln ln | ,
1 1
ln ln ln ln
1 1
ln ln ln 1
t t t t
t t t t t t t t
t t t t
t t t t
t t t t
FAk FAk
H F k G Ak E H F G k
F F
FAk FAk
H F k G Ak H F
F F
H F k G Ak
o o
o
o o
o
o
| u | u
u u | u u
| |
| u | u
u u |
| |
|
u u
+
( | |

+ + = + + +
` | (
+ +
\ . )
( | |

+ + = + +
` | (
+ +
\ . )
+ + = ln
1 1
ln ln ln ln
1 1
ln ln ln ln ln ln ln ln
1 1
t t
t t t t
t t
t t t t t t
FAk F
H F
F F
Ak FAk
H F k G H F
F F
A FA
H F k G k H F k F F
F F
o
o o
| u
|
| |
u | u
u |
| |
|
u o u | | o | u |
| |
( | | | |
+ +
` | ( |
+ +
\ . \ . )
| | | |

+ + = + +
` | |
+ +
\ . \ . )
| | | |
+ + = + + + + + +
| |
+ +
\ . \ .


ln ln (1 ) ln (1 ) ln ln ln
1 1
(1 )
1
1 1
1 1
1 1 1
t t t t
A FA
H F k G F k F H F
F F
F F F F F
G F
|
u o | | u | |
| |
o
o | o o|
o|
o o| o|
| |
o| o| o|
| | | |
+ + = + + + + + +
| |
+ +
\ . \ .
= + = + =

+
= + = + = =


ln ln
1 1
ln ln
1 1 1
A FA
F
F F A FA
H H F H
F F
|
|
| | |
| |
| | |

| | | |
+
| |
+ + | | | |
\ . \ .
= + + =
| |

+ +
\ . \ .


1
1 1
1
1
1
1
1
t t t t
t t
t t t
Ak Ak
FAk
k Ak
F
o o
o
o
o o|
| u u
o| | u o|
o| u
o| o|
| o
|
o|
o|
+
| |
|

\ .
= = = =
+
+ | |
+
|

\ .

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