Answer both parts (a) and (b) of this question.

(a) George obtains income and consumes over two periods. His income is M1 in period 1 and M2 in period 2. The (borrowing and saving) interest rate is r.

1. (i) [6 marks] Write down Georges intertemporal budget constraint and illustrate it on a graph with period 1 on the horizontal axis and period 2 on the vertical axis. Indicate the endowment point on the graph. How much could George consume in period 1 if he decided to consume zero in period 2? Indicate the corresponding point on the graph.

2. (ii) [6 marks] Suppose that George is initially a saver. Show graphically that his saving can increase if the interest rate r decreases. Which effect dominates if Georges saving increases following a fall in r, the substitution effect or the income effect? Explain.

(b) Anthony must decide between two mutually exclusive investments, D1 and D2. Anthony is risk neutral. The payoffs from these investments are uncertain and depend on the state of the world. In particular, there are two possible states of the world, S1 and S2. State of the world S1 occurs with probability p1 = 3/5. State of the world S2 occurs with probability p2 = 2/5. The payoff from D1 is 50 if S1 occurs and 150 if S2 occurs. The payoff from D2 is 100 if S1 occurs and 80 if S2 occurs.

1. (i) [5 marks] Assume that Anthony must choose one of the two investments before the state of the world is revealed. What should he choose, D1 or D2? Explain.

2. (ii) [8 marks] Suppose that Anthony can commission research that will reveal the state of the world before his decision is taken. What is the maximum amount he will be prepared to pay for this research in other words, what is his value of information?