Division of the Humanities

and Social Sciences

Lucass Tree Model

KC Border
Revised May 2005
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This is a gentle introduction to consumption-based asset pricing, based

on Sargents [2] treatment of Lucas [1].
As a notational convention, variables that are random from the point of
view of time t are denoted by boldface symbols.

1 Consumers
Consumers live forever and care about the expected value


E n u(ct+n ),
n=0

where ct is consumption at time t. The per period utility, u is assumed to

be strictly increasing, concave, and twice continuously differentiable. (Later
on, we shall take u(c) = ln c.)
Each period t, the consumer must allocate wealth wt between consump-
tion ct and asset accumulation at . Thus the budget at time t is

ct + at wt .

Assets grow at the random rate Rt+1 1 between period t and t + 1,

wt+1 = Rt+1 at .

The Bellman optimality equation for the consumer with wealth w is

V (w) = max u(w a) + E V (Ra).

0aw

The first order condition for an interior maximum at a is

( )
u (w a ) + E V (Ra )R = 0. (1)

1
KC Border Lucass Tree Model 2

By the Envelope Theorem (see, e.g., [3, Theorem 4.11]),

{ }

V (w) = u(w a ) + E V (Ra ) = u (w a ). (2)
w

So ( )
u (ct ) = E u (ct+1 )Rt+1 ,
where c = w a , or
u (ct+1 )
E Rt+1 = 1. (3)
u (ct )

Comparison with the two period non-random case

In the two period non-random case, the consumer maximizes

u(c1 ) + u(c2 )

subject to

c1 + a = w
c2 = Ra

or equivalently
1
c1 + c2 = w.
R
The Lagrangean is
( )
1
u(c1 ) + u(c2 ) + w c1 c2
R
and the first order conditions are
u (c1 ) = 0
1
u (c2 ) = 0
R
so rearranging, and dividing the latter by former yields

u (c2 )
R = 1,
u (c1 )

which is the analog of (3).

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KC Border Lucass Tree Model 3

2 The orchard economy

There are n identical consumers and n trees. Trees live forever and bear
fruit every season. Fruit is perishable and cannot be stored. Trees are the
only asset, and fruit is the only consumption good.
The quantity of fruit per tree at time t is dt . It is the same for all trees.
The fruit dividend follows a Markov process, bounded between 0 < d < d.
Trees are traded each period after the fruit has been harvested. The market
price of a tree (in units of fruit) at time t is pt .
Let st denote the number of trees owned at the start of period t. Then an
individuals wealth wt (in units of fruit) is simply the fruit he has harvested
plus the value of the tree, times the number of trees:

wt = (pt + dt )st .

Thus
pt+1 + dt+1
Rt+1 =
pt
and (3) becomes
u (ct+1 ) pt+1 + dt+1
E = 1, (4)
u (ct ) pt

3 The price of trees

From (4) we get
{ }
u (ct+1 )
pt = E t (pt+1 + dt+1 )
u (ct )

Now recurse forward,

{ }
u (ct+2 )
pt+1 = E t+1 (p + dt+2 ) ,
u (ct+1 ) t+2
so { }
u (c )
2 u (ct+2 )

2 u (ct+2 )
pt = E t t+1 d t+1 + dt+2 + p
u (ct ) u (ct ) u (ct ) t+2
etc., so { }

(c )
nu t+n
pt = E t dt+n (5)
n=1
u (ct )

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KC Border Lucass Tree Model 4

4 Market Clearing
In order for the prices to clear the market for trees, then at each t we must
have
st = 1
at = pt
ct = dt .

Thus, according to (5), the equilibrium price must satisfy

{
}
(d
nu t+n )
pt = E t
dt+n .
n=1
u (dt )

Special case
If
u(c) = ln c,
(the CobbDouglas case), then u (c) = 1/c and we have
{
}
dt
n
pt = E t dt+n = dt . (6)
n=1
dt+n 1

5 Taxation
In this section we maintain the assumption that u(c) = ln c, and add a
government sector. The governments consumption per capita gt is given by

gt = t dt ,

where t is a Markov process taking values in (0, 1).

Consider the following two tax regimes.

Lump sum taxation of individuals.

Tax on trees.

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KC Border Lucass Tree Model 5

5.1 Lump sum taxation

In this regime, the consumer is taxed an amount t , so the budget is

ct + at = wt t .

Let pLt denote the equilibrium price of trees at time t under this scheme.
Then ( )
wt = pLt + dt st ,
so
pLt+1 + dt+1
Rt+1 = .
pLt
Market clearing requires that st = 1 and ct = (1 t )dt , so (4) becomes
( )
u (1 t+n )dt+1 pLt+1 + (1 t+1 )dt+1
E ( ) = 1,
u (1 t )dt pLt

so (5) becomes
{ ( ) }
(1 t+n )dt+n
nu
pLt = Et ( ) dt+n .
n=1
u (1 t )dt

For logarithmic utility we have

{
}
(1 t )dt
pLt = Et n
dt+n
n=1
(1 t+n )dt+n
{
} (7)
1
= (1 t )dt n
Et .
n=1
1 t+n

5.2 Tax on trees

In this regime, the there is a tax t on each tree owned at the beginning of
the period. Let pTt denote the equilibrium price of trees at time t under this
scheme. Then ( )
wt = (pT t t ) + d t s t ,

so the budget remains

ct + at = wt ,
but
pT
t+1 + dt+1 t+1
Rt+1 = .
pT
t

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KC Border Lucass Tree Model 6

Thus (4) becomes

u (ct+1 ) pT
t+1 + dt+1 t+1
E = 1,
u (ct ) pT
t

So using t = t dt ,

u (ct+1 ) ( T )
pT
t =E p + (dt+1 t+1 ) = 1.
u (ct ) t+1

Recursing forward leads to this analog of (5)

{
}
u (ct+n )
pT
t = Et (1 t+n )
n
dt+n
n=1
u (ct )

or using ct = (1 t )dt
{ ( ) }
u (1 t+n )dt+n
pT
t = Et (1 t+n )
n
( ) dt+n .
n=1
u (1 t )dt

For log utility this becomes

{
}
(1 t )dt
pT
t = Et n (1 t+n ) dt+n
(1 t+n )dt+n
n=1 (8)

= (1 t )dt .
1

5.3 Comparison
Since 0 < t < 1, we have 1/(1 t ) > 1 for each t, so E t 1/(1 t+n ) > 1
for each n, so

1
n Et > n = .
n=1
1 t+n n=1 1
Thus from (7) and (8), we have

pLt > pT
t .

In other words, under a lump sum tax on consumers, the price of trees is
higher than under a tax directly on treeseven though the taxes have no
real effects in this model.

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KC Border Lucass Tree Model 7

References
[1] R. E. Lucas, Jr. 1978. Asset prices in an exchange economy. Economet-
rica 46(6):14291445. www.jstor.org/stable/1913837

[2] T. J. Sargent. 1987. Dynamic macroeconomic theory. Cambridge, Mas-

sachusetts: Harvard University Press.

[3] N. Stokey, R. E. Lucas, Jr., and E. C. Prescott. 1989. Recursive methods

in economic dynamics. Cambridge, Mass.: Harvard University Press.

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