Академический Документы
Профессиональный Документы
Культура Документы
2014
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This subject guide is for a 300 course offered as part of the University of London
International Programmes in Economics, Management, Finance and the Social Sciences.
This is equivalent to Level 6 within the Framework for Higher Education Qualifications in
England, Wales and Northern Ireland (FHEQ).
For more information about the University of London International Programmes
undergraduate study in Economics, Management, Finance and the Social Sciences, see:
www.londoninternational.ac.uk
This guide was prepared for the University of London International Programmes by:
Dr Margaret Bray, Dr Ronny Razin, Dr Andrei Sarychec, Department of Economics,
The London School of Economics and Political Science.
With typesetting and proof-reading provided by:
James S. Abdey, BA (Hons), MSc, PGCertHE, PhD, Department of Statistics, London School of
Economics and Political Science.
This is one of a series of subject guides published by the University. We regret that due
to pressure of work the authors are unable to enter into any correspondence relating to,
or arising from, the guide. If you have any comments on this subject guide, favourable or
unfavourable, please use the form at the back of this guide.
Contents
Contents
1 Introduction
1.1
1.2
Aims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.3
Learning outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.4
Syllabus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.5
Reading advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.5.1
Essential reading . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.5.2
Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.6.1
The VLE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.6.2
1.7
1.8
Examination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.6
2.1
2.2
Learning outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.3
Essential reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.4
Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.5
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
10
2.6
10
2.7
12
2.8
14
2.9
16
19
19
20
21
22
23
Contents
23
26
27
29
29
30
31
33
33
37
3.2
Learning outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
37
3.3
Essential reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
37
3.4
Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
37
3.5
Preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
38
3.5.1
Preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
38
3.5.2
Assumptions on preferences . . . . . . . . . . . . . . . . . . . . .
38
39
3.6.1
Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
39
40
3.7.1
40
3.7.2
41
3.7.3
41
42
3.8.1
42
3.8.2
44
Solution to activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
45
52
53
3.6
3.7
3.8
3.9
ii
37
55
4.1
55
4.2
Learning outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
55
4.3
Essential reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
55
4.4
Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
56
Contents
4.5
Homogeneous functions . . . . . . . . . . . . . . . . . . . . . . . . . . . .
56
4.5.1
Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
56
4.5.2
56
57
4.6.1
Homogeneity . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
57
4.6.2
58
4.7
60
4.8
61
4.8.1
61
4.8.2
4.8.3
63
Homothetic functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
64
4.9.1
64
4.9.2
65
4.9.3
66
4.9.4
67
68
72
4.6
4.9
73
5.1
73
5.2
Learning outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
73
5.3
Essential reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
73
5.4
Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
74
5.5
Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
74
5.5.1
74
5.5.2
75
76
5.6.1
The relationship . . . . . . . . . . . . . . . . . . . . . . . . . . . .
76
5.6.2
77
5.6.3
79
80
5.7.1
The result . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
80
5.7.2
Interpreting Theorem 18 . . . . . . . . . . . . . . . . . . . . . . .
81
5.7.3
Proof of Theorem 18 . . . . . . . . . . . . . . . . . . . . . . . . .
82
84
5.6
5.7
5.8
iii
Contents
5.9
Solutions to activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
85
88
88
93
6.2
Learning outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
93
6.3
Essential reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
94
6.4
Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
94
6.5
94
6.5.1
94
6.5.2
95
6.5.3
96
98
6.6.1
98
6.6.2
98
102
6.7.1
Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
102
6.7.2
103
103
6.8.1
The relationship . . . . . . . . . . . . . . . . . . . . . . . . . . . .
103
6.8.2
105
Roys identity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
106
6.9.1
106
6.9.2
106
6.9.3
107
109
109
109
110
120
121
6.6
6.7
6.8
6.9
7 Dynamic programming
iv
93
123
7.1
Learning outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
123
7.2
Essential reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
123
Contents
7.3
Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
123
7.4
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
123
7.5
124
7.6
127
7.6.1
128
7.6.2
Method 2. Finding V . . . . . . . . . . . . . . . . . . . . . . . . .
129
7.7
Solutions to activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
135
7.8
139
7.9
141
149
8.1
Learning outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
149
8.2
Essential reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
149
8.3
Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
149
8.4
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
149
8.5
150
8.5.1
Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
150
8.5.2
Stationarity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
151
8.5.3
152
8.5.4
Separable equations . . . . . . . . . . . . . . . . . . . . . . . . . .
153
154
8.6.1
154
8.6.2
155
8.6.3
Phase portraits . . . . . . . . . . . . . . . . . . . . . . . . . . . .
156
8.6.4
158
Systems of equations . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
159
8.7.1
159
8.7.2
161
8.8
163
8.9
8.6
8.7
8.9.1
165
173
9 Optimal control
181
9.1
Learning outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
181
9.2
Essential reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
181
Contents
9.3
Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
181
9.4
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
181
9.5
182
9.5.1
182
9.5.2
185
Ramsey-Cass-Koopmans model . . . . . . . . . . . . . . . . . . . . . . .
185
9.6.1
186
9.6.2
187
9.6.3
Dynamics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
188
9.6.4
189
9.6.5
189
9.6.6
192
9.6.7
193
193
9.7.1
Steady state . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
194
9.7.2
Phase diagram . . . . . . . . . . . . . . . . . . . . . . . . . . . .
194
9.7.3
195
9.8
195
9.9
Solutions to activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
199
202
205
214
9.6
9.7
9.13 Appendix B: Sufficient conditions for solutions to optimal control problems 216
9.14 Appendix C: Transversality condition in the infinite horizon optimal contol
problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
216
217
223
vi
Chapter 1
Introduction
Welcome to EC3120 Mathematical economics which is a 300 course offered on the
Economics, Management, Finance and Social Sciences (EMFSS) suite of programmes.
In this brief introduction, we describe the nature of this course and advise on how best
to approach it. Essential textbooks and Further reading resources for the entire course
are listed in this introduction for easy reference. At the end, we present relevant
examination advice.
1.1
The course consists of two parts which are roughly equal in length but belonging to the
two different realms of economics:
the first deals with the mathematical apparatus needed to rigorously formulate the
core of microeconomics, the consumer choice theory
the second presents a host of techniques used to model intertemporal decision
making in the macroeconomy.
The two parts are also different in style. In the first part it is important to lay down
rigorous proofs of the main theorems while paying attention to assumption details. The
second part often dispenses with rigour in favour of slightly informal derivations needed
to grasp the essence of the methods. The formal treatment of the underlying
mathematical foundations is too difficult to be within the scope of undergraduate study;
still, the methods can be used fruitfully without the technicalities involved: most
macroeconomists actively employing them have never taken a formal course in optimal
control theory.
As you should already have an understanding of multivariate calculus and integration,
we have striven to make the exposition in both parts of the subject completely
self-contained. This means that beyond the basic prerequisites you do not need to have
an extensive background in fields like functional analysis, topology, or differential
equations. However, such a background may allow you to progress faster. For instance,
if you have studied the concepts and methods of ordinary differential equations before
you may find that you can skip parts of Chapter 8.
By design the course has a significant economic component. Therefore we apply the
techniques of constrained optimisation to the problems of static consumer and firm
choice; the dynamic programming methods are employed to analyse consumption
smoothing, habit formation and allocation of spending on durables and non-durables;
the phase plane tools are used to study dynamic fiscal policy analysis and foreign
1. Introduction
1.2
Aims
1.3
Learning outcomes
At the end of this course, and having completed the Essential reading and activities,
you should be able to:
use and explain the underlying principles, terminology, methods, techniques and
conventions used in the subject
solve economic problems using the mathematical methods described in the subject.
1.4
Syllabus
1.5
Reading advice
While topics covered in this subject are in every economists essential toolbox, their
textbook coverage varies. There are a lot of first-rate treatments of static optimisation
1.5.1
Essential reading
1.5.2
Further reading
Please note that as long as you read the Essential reading you are then free to read
around the subject area in any text, paper or online resource. You will need to support
your learning by reading as widely as possible and by thinking about how these
principles apply in the real world. To help you read extensively, you have free access to
the VLE and University of London Online Library (see below).
Other useful texts for this course include:
Barro, R. and X. Sala-i-Martin Economic growth. (New York: McGraw-Hill, 2003)
1. Introduction
1.6
In addition to the subject guide and the reading, it is crucial that you take advantage of
the study resources that are available online for this course, including the VLE and the
Online Library.
You can access the VLE, the Online Library and your University of London email
account via the Student Portal at:
http://my.londoninternational.ac.uk
You should have received your login details for the Student Portal with your official
offer, which was emailed to the address that you gave on your application form. You
have probably already logged in to the Student Portal in order to register! As soon as
you registered, you will automatically have been granted access to the VLE, Online
Library and your fully functional University of London email account.
If you have forgotten these login details, please click on the Forgotten your password
link on the login page.
1.6.1
The VLE
The VLE, which complements this subject guide, has been designed to enhance your
learning experience, providing additional support and a sense of community. It forms an
important part of your study experience with the University of London and you should
access it regularly.
The VLE provides a range of resources for EMFSS courses:
Self-testing activities: Doing these allows you to test your own understanding of
subject material.
Electronic study materials: The printed materials that you receive from the
University of London are available to download, including updated reading lists
and references.
Past examination papers and Examiners commentaries: These provide advice on
how each examination question might best be answered.
A student discussion forum: This is an open space for you to discuss interests and
experiences, seek support from your peers, work collaboratively to solve problems
and discuss subject material.
Videos: There are recorded academic introductions to the subject, interviews and
debates and, for some courses, audio-visual tutorials and conclusions.
Recorded lectures: For some courses, where appropriate, the sessions from previous
years Study Weekends have been recorded and made available.
Study skills: Expert advice on preparing for examinations and developing your
digital literacy skills.
Feedback forms.
Some of these resources are available for certain courses only, but we are expanding our
provision all the time and you should check the VLE regularly for updates.
1.6.2
The Online Library contains a huge array of journal articles and other resources to help
you read widely and extensively.
To access the majority of resources via the Online Library you will either need to use
your University of London Student Portal login details, or you will be required to
register and use an Athens login:
1. Introduction
http://tinyurl.com/ollathens
The easiest way to locate relevant content and journal articles in the Online Library is
to use the Summon search engine.
If you are having trouble finding an article listed in a reading list, try removing any
punctuation from the title, such as single quotation marks, question marks and colons.
For further advice, please see the online help pages:
www.external.shl.lon.ac.uk/summon/about.php
1.7
We have already mentioned that this guide is not a textbook. It is important that you
read textbooks in conjunction with the subject guide and that you try problems from
them. The Learning activities and the sample questions at the end of the chapters in
this guide are a very useful resource. You should try them all once you think you have
mastered a particular chapter. Do really try them: do not just simply read the solutions
where provided. Make a serious attempt before consulting the solutions. Note that the
solutions are often just sketch solutions, to indicate to you how to answer the questions
but, in the examination, you must show all your calculations. It is vital that you
develop and enhance your problem-solving skills and the only way to do this is to try
lots of examples.
Finally, we often use the symbol to denote the end of a proof, where we have finished
explaining why a particular result is true. This is just to make it clear where the proof
ends and the following text begins.
1.8
Examination
Important: Please note that subject guides may be used for several years. Because of
this we strongly advise you to always check both the current Regulations, for relevant
information about the examination, and the VLE where you should be advised of any
forthcoming changes. You should also carefully check the rubric/instructions on the
paper you actually sit and follow those instructions.
A Sample examination paper is at the end of this guide. Notice that the actual
questions may vary, covering the whole range of topics considered in the course syllabus.
You are required to answer eight out of 10 questions: all five from Section A (8 marks
each) and any three from Section B (20 marks each). Candidates are strongly
advised to divide their time accordingly.
Also note that in the examination you should submit all your derivations and rough
work. If you cannot completely solve an examination question you should still submit
partial answers as many marks are awarded for using the correct approach or method.
Remember, it is important to check the VLE for:
up-to-date information on examination and assessment arrangements for this course
1.8. Examination
where available, past examination papers and Examiners commentaries for this
course which give advice on how each question might best be answered.
1. Introduction
Chapter 2
Constrained optimisation: tools
2.1
The aim of this chapter is to introduce you to the topic of constrained optimisation in a
static context. Special emphasis is given to both the theoretical underpinnings and the
application of the tools used in economic literature.
2.2
Learning outcomes
2.3
Essential reading
2.4
Further reading
2.5
Introduction
2.6
10
max g(x)
s.t. h(x) k
x x.
Definition 2
The feasible set is the set of vectors in Rn satisfying z Z and h(z) k.
Activity 2.1 Show that the following constrained maximisation problems have no
solution. For each example write what you think is the problem for the existence of a
solution.
(a) Maximise ln x subject to x > 1.
(b) Maximise ln x subject to x < 1.
(c) Maximise ln x subject to x < 1 and x > 2.
Solutions to activities are found at the end of the chapters.
To steer away from the above complications we can use the following theorem:
Theorem 1
If the feasible set is non-empty, closed and bounded (compact), and the objective
function g is continuous on the feasible set then the COP has a solution.
Note that for the feasible set to be compact it is enough to assume that x is closed and
the constraint function h(x) is continuous. Why?
The conditions are sufficient and not necessary. For example x2 has a minimum on R2
even if it is not bounded.
Activity 2.2 For each of the following sets of constraints either say, without proof,
what is the maximum of x2 subject to the constraints, or explain why there is no
maximum:
(a) x 0, x 1
(b) x 2
(c) 0 x 1
(d) x 2
11
(e) 1 x 1
(f) 1 x < 2
(g) 1 x 1
(h) 1 < x 2.
In what follows we will devote attention to two questions (similar to the short-run and
long-run questions that the firm was interested in in the example). First, we will look
for methods to solve the COP. Second, having found the optimal solution we would like
to understand the relation between the constraint k and the optimal value of the COP
given k. To do this we will study the concept of the maximum value function.
2.7
To understand the answer to both questions above it is useful to follow the following
route. Consider the example of firm ABC. A first approach to understanding the
maximum profit that the firm might gain is to consider the situations that the firm is
indeed constrained by k. Plot the profit of the firm as a function of x and we see that
profits are increasing up to x = 1 and then decrease, crossing zero profits when x = 4.
This implies that the firm is indeed constrained by k when k 1; in this case it is
optimal for the firm to choose x = k. But when k > 1 the firm is not constrained by k;
choosing x = 1 < k is optimal for the firm.
Since we are interested in the relation between the level of the constraint k and the
maximum profit that the firm could guarantee, v, it is useful to look at the plane
spanned by taking k on the x-axis and v on the y-axis. For firm ABC it is easy to see
that maximal profits follow exactly the increasing part of the graph of profits we had
before (as x = k). But when k > 1, as we saw above, the firm will always choose
x = 1 < k and so the maximum attainable profit will stay flat at a level of 1.
More generally, how can we think about the maximum attainable value for the COP?
Formally, and without knowing if a solution exists or not, we can write this function as
s(k) = sup {g(x) : x i, h(x) k} .
We would like to get some insight as to what this function looks like. One way to
proceed is to look, in the (k, v) space, at all the possible points, (k, v), that are
attainable by the function g(x) and the constraints. Formally, consider the set,
B = {(k, v) : k h(x), v g(x) for some x x} .
The set B defines the possibility set of all the values that are feasible, given a
constraint k. To understand what is the maximum attainable value given a particular k
is to look at the upper boundary of this set. Formally, one can show that the values v
on the upper boundary of B correspond exactly with the function s(k), which brings us
closer to the notion of the maximum value function.
It is intuitive that the function s(k) will be monotone in k; after all, when k is
increased, this cannot lower the maximal attainable value as we have just relaxed the
12
constraints. In the example of firm ABC, abstracting away from the cost of the facility,
a larger facility may never imply that the firm will make less profits! The following
lemma formalises this.
Lemma 1
If k1 K and k1 k2 then k2 K and s(k1 ) s(k2 ).
Proof. If k1 K there exists a z Z such that h(z) k1 k2 so k2 K. Now
consider any v < s(k1 ). From the definition there exists a z Z such that v < g(z) and
h(z) k1 k2 , which implies that s(k2 ) = sup {g(z); z Z, h(z) k2 } > v. Since this
is true for all v < s(k1 ) it implies that s(k2 ) s(k1 ).
Therefore, the boundary of B defines a non-decreasing function. If the set B is closed,
that is, it includes its boundary, this is the maximum value function we are looking for.
For each value of k it shows the maximum available value of the objective function.
We can confine ourselves to maximum rather than supremum. This is possible if the
COP has a solution. To ensure a solution, we can either find it, or show that the
objective function is continuous and the feasible set is compact.
Definition 3 (The maximum value function)
If z(k) solves the COP with the constraint parameter k, the maximum value function
is v(k) = g(z(k)).
The maximum value function, it it exists, has all the properties of s(k). In particular, it
is non-decreasing. So we have reached the conclusion that x is a solution to the COP if
and only if (k, g(x )) lies on the upper boundary of B.
Activity 2.3 XY Z is a profit-maximising firm selling a good in a perfectly
competitive market at price 4. It can produce any non-negative quantity of such
good y at cost c(y) = y 2 . However there is a transport bottleneck which makes it
13
impossible for the firm to sell more than k units of y, where k 0. Write down
XY Zs profit maximisation problem. Show on a graph the set B for this position.
Using the graph write down the solution to the problem for all non-negative values
of k.
2.8
In the last section we defined what we mean by the maximum value function given that
we have a solution. We also introduced the set, B, of all feasible outcomes in the (k, v)
space. We concluded that x is a solution to the COP if and only if (k, g(x )) lies on the
upper boundary of B. In this section we proceed to use this result to find a method to
solve the COP.
Which values of x would give rise to boundary points of B? Suppose we can draw a line
with a slope through a point (k, v) = (h(x ), g(x )) which lies entirely on or above the
set B. The equation for this line is:
v k = g(x ) h(x ).
Example 2.2 (Example 2.1 revisited) We can draw such a line through
(0.25, 0.75) with slope q = 1 and a line through (1, 1) with slope 0.
If the slope is non-negative and recalling the definition of B as the set of all
possible outcomes, the fact that the line lies entirely on or above the set B can be
restated as
g(x ) h(x ) g(x) h(x)
for all x x. But note that this implies that (h(x ), g(x )) lies on the upper
boundary of the set B implying that if x is feasible it is a solution to the COP.
Example 2.3 (Example 2.1 revisited) It is crucial for this argument that the
slope of the line is non-negative. For example for the point (4, 0) there does not exist
a line passing through it that is on or above B. This corresponds to x = 4 and
indeed it is not a solution to our example. Sometimes the line has a slope of q = 0.
Suppose for example that k = 4, if we take the line with q = 0 through (4, 1), it
indeed lies above the set B. The point x = 1 satisfies:
g(x ) 0h(x ) g(x) 0h(x)
for all x x, and as h(x ) < k, then x solves the optimisation problem for
k = k 1.
Summarising the argument so far, suppose k , and x satisfy the following conditions:
g(x ) h(x )
x
either k
or k
14
=
>
x x and k h(x )
[k h(x )] = 0.
We refer to as the Lagrange multiplier. We refer to the expression
g(x) + (k h(x)) L(x, k , ) as the Lagrangian. The conditions above imply that
x maximises the Lagrangian given a non-negativity restriction, feasibility, and a
complementary slackness (CS) condition respectively. Formally:
Theorem 2
If for some q 0, z maximises L(z, k , q) subject to the three conditions, it also
solves the COP.
Proof. From the complementary slackness condition, q[k h(z )] = 0. Thus,
g(z ) = g(z ) + q(k h(z )). By q 0 and k h(z) 0 for all feasible z, then
g(z) + q(k h(z)) g(z). By maximisation of L we get g(z ) g(z), for all feasible z
and since z itself is feasible, then it solves the COP.
Example 2.4 (Example 2.1 revisited) We now solve the example of the firm
ABC. The Lagrangian is given by
L(x, k, ) = 2x0.5 x + (k z).
Let us use first order conditions, although we have to prove that we can use them
and we will do so later in the chapter. Given , the first order condition of
L(x, k , ) with respect to x is
x0.5 1 = 0 (FOC).
We need to consider the two cases (using the CS condition), > 0 and the case of
= 0. Case 1: If = 0. CS implies that the constraint is not binding and (FOC)
implies that x = 1 is a candidate solution. By Theorem 1, when x is feasible, i.e.
k x = 1, this will indeed be a solution to the COP. Case 2: If > 0. In this case
the constraint is binding; by CS we have x = k as a candidate solution. To check
that it is a solution we need to check that it is feasible, i.e .that k > 0, that it satisfies
the FOC and that it is consistent with a non-negative . From the FOC we have
k 0.5 1 =
and for this to be non-negative implies that:
k 0.5 1 0 k 1.
Therefore when k 1, x = k solves the COP.
15
Figure 2.2: Note that the point C represents a solution to the COP when k = k , but
this point will not be characterised by the Lagrange method as the set B is not concave.
Remark 1 Some further notes about what is to come:
The conditions that we have stated are sufficient conditions. This means that some
solutions of COP cannot be characterised by the Lagrangian. For example, if the
set B is not convex, then solving the Lagrangian is not necessary.
As we will show later, if the objective function is concave and the constraint is
convex, then B is convex. Then, the Lagrange conditions are also necessary. That
is, if we find all the points that maximise the Lagrangian, these are all the points
that solve the COP.
With differentiability, we can also solve for these points using first order conditions.
Remember that we are also interested in the maximum value function. What does it
mean to relax the constraint? The Lagrange multipliers are going to play a central
role in understanding how relaxing the constraints affect the maximum value.
2.9
In the last section we have found necessary conditions for a solution to the COP. This
means that some solutions of COP cannot be characterised by the Lagrangian method.
In this section we investigate the assumption that would guarantee that the conditions
of the Lagrangian are also necessary.
To this end, we will need to introduce the notions of convexity and concavity. From the
example above it is already clear why convexity should play a role: if the set B is not
convex, there will be points on the boundary of B (that as we know are solutions to the
COP) that will not accommodate a line passing through them and entirely above the
set B as we did in the last section. In turn, this means that using the Lagrange method
will not lead us to these points.
16
Definition 5
A real-valued function f defined on a convex subset of U of Rn is concave, if for all
x, y U and for all t [0, 1]:
f (tx + (1 t)y) tf (x) + (1 t)f (y).
A real-valued function g defined on a convex subset U of Rn is convex, if for all
x, y U and for all t [0, 1]:
g(tx + (1 t)y) tg(x) + (1 t)g(y).
Remark 2 Some simple implications of the above definition that will be useful later:
Concave and convex functions need to have convex sets as their domain. Otherwise,
we cannot use the conditions above.
Activity 2.4 A and B are two convex subsets of Rn . Which of the following sets are
always convex, sometimes convex, or never convex? Provide proofs for the sets which
are always convex, draw examples to show why the others are sometimes or never
convex.
(a) A B
(b) A + B {x | x Rn , x = a + b, a A, b B}.
17
Lemma 2
Let f be a continuous and differentiable function on a convex subset U of Rn . Then
f is concave on U if and only if for all x, y U :
f (y) f (x) Df (x)(y x)
f (x)
f (x)
=
(y1 x1 ) + +
(yn xn ).
x1
xn
Proof. Here we prove the result on R1 : since f is concave, then:
tf (y) + (1 t)f (x) f (ty + (1 t)x)
t(f (y) f (x)) + f (x) f (x + t(y x))
f (x + t(y x)) f (x)
f (y) f (x)
t
f (x + h) f (x)
f (y) f (x)
(y x)
h
for h = t(y x). Taking limits when h 0 this becomes:
f (y) f (x) f 0 (x)(y x.)
Remember that we introduced the concepts of concavity and convexity as we were
interested in finding out under what conditions is the Lagrange method also a necessary
condition for solutions of the COP.
Consider the following assumptions, denoted by CC:
1. The set x is convex.
2. The function g is concave.
3. The function h is convex.
To see the importance of these assumptions, recall the definition of the set B:
B = {(k, v) : k h(x), v g(x) for some x x} .
Proposition 1
Under assumptions CC, the set B is convex.
Proof. Suppose that (k1 , v1 ) and (k2 , v2 ) are in B, so there exists z1 and z2 such that:
k1 h(z1 )k2 h(z2 )
v1 g(z1 )v2 g(z2 ).
By convexity of h:
k1 + (1 )k2 h(z1 ) + (1 )h(z2 ) h(z1 + (1 )z2 )
18
and by concavity of g:
v1 + (1 )v2 g(z1 ) + (1 )g(z2 ) g(z1 + (1 )z2 )
thus, (k1 + (1 )k2 , v1 + (1 )v2 ) B for all [0, 1], implying that B is convex.
Remember that the maximum value is the upper boundary of the set B. When B is
convex, we can say something about the shape of the maximum value function:
Proposition 2
Assume that the maximum value exists, then under CC, the maximum value is a
non-decreasing, concave and continuous function of k.
Proof. We have already shown, without assuming convexity or concavity, that the
maximum value is non-decreasing. We have also shown that if the maximum value
function v(k) exists, it is the upper boundary of the set B. Above we proved that under
CC the set B is convex. The set B can be re-written as:
B = {(k, v) : v R, k K, v v(k)} .
But a set B is convex iff the function v is concave. Thus, v is concave, and concave
functions are continuous, so v is continuous.
2.10
We are now ready to formalise under what conditions the Lagrange method is necessary
for a solution to the COP.
Theorem 3
Assume CC. Assume that the constraint qualification holds, that is, there is a vector
z0 Z such that h(z0 ) k . Finally suppose that z solves COP. Then:
i. there is a vector q Rm such that z maximises the Lagrangian L(q, k , z) =
g(z) + q[k h(z )].
ii. the Lagrange multiplier q is non-negative for all components, q 0.
iii. the vector z is feasible, that is z Z and h(z ) k.
iv. the complementary slackness conditions are satisfied, that is, q[k h(z )] = 0.
2.11
So far we have found a method that allows us to find all the solutions to the COP by
solving a modified maximisation problem (i.e. maximising the Lagrangian). As you
recall, we have used this method to solve for our example of firm ABC by looking at
19
first order conditions. In this secton we ask under what assumptions can we do this and
be sure that we have found all the solutions to the problem. For this we need to
introduce ourselves to the notions of continuity and differentiability.
2.11.1
Dn g(x0 )
D2 g(x0 )
(x x0 )2 + +
(x x0 )n + Rn (2.1)
2!
n!
20
Note that all differentiable functions are continuous but the converse is not true.
2.11.2
D2 g(x0 )
(x x0 )2 + R3 .
2!
(2.2)
If the first order conditions hold at x0 this implies that Dg(x0 ) = 0 and the above
expression can be rewritten as,
g(x) g(x0 ) =
D2 g(x0 )
(x x0 )2 + R3 .
2!
(2.3)
But now we can see that when D2 g(x0 ) < 0 and when we are close to x0 the left-hand
side will be negative and so x0 is a local maximum of g(x), and when D2 g(x0 ) > 0
similarly x0 will constitute a local minimum of g(x). As concave functions have
D2 g(x) < 0 for any x and convex functions have D2 g(x) > 0 for any x this shows why
the above result holds.
The above intuition was provided for the case of a function over one variable x. In the
next section we extend this intuition to functions on Rn to discuss how to characterise
convexity and concavity in general.
21
2.11.3
In the last few sections we have introduced necessary and sufficient conditions for using
first order conditions to solve maximisation problems. We now ask a more practical
question. Confronted with a particular function, how can we verify whether it is concave
or not? If it is concave, we know from the above results that we can use the first order
conditions to characterise all the solutions. If it is not concave, we will have to use other
means if we want to characterise all the solutions.
It will be again instructive to look at the Taylor expansion for n = 2. Let us now
consider a general function defined on Rn and look at the Taylor expansion around a
vector x0 Rn . As g is a function defined over Rn , Dg(x0 ) is now an n-dimensional
vector and D2 g(x0 ) is an n n matrix. Let x be an n-dimensional vector in Rn . The
Taylor expansion in this case becomes
g(x) g(x0 ) = Dg(x0 )(x x0 ) + (x x0 )T
D2 g(x0 )
(x x0 ) + R3 .
2!
If the first order condition is satisfied, then Dg(x0 ) = 0, where 0 is the n-dimensional
vector of zeros. This implies that we can write the above as
g(x) g(x0 ) = (x x0 )T
D2 g(x0 )
(x x0 ) + R3 .
2!
But now our problem is a bit more complicated. We need to determine the sign of
2
0)
(x x0 )T D g(x
(x x0 ) for a whole neighbourhood of xs around x0 ! We need to find
2!
what properties of the matrix D2 g(x0 ) would guarantee this. For this we analyse the
2
0)
properties of expressions of the form (x x0 )T D g(x
(x x0 ), i.e. quadratic forms.
2!
Consider functions of the form Q(x) = xT Ax where x is an n-dimensional vector and A
a symmetric n n matrix. If n = 2, this becomes
a11 a12 /2
x1
x1 x2
a12 /2 a22
x2
and can be rewritten as
a11 x21 + a12 x1 x2 + a22 x22 .
Definition 8
i. A quadratic form on Rn is a real-valued function
X
Q(x1 , x2 , . . . , xn ) =
aij xi xj
ij
or equivalently:
ii. A quadratic form on Rn is a real-valued function Q(x) = xT Ax where A is a
symmetric n n matrix.
Below we would like to understand what properties of A relate to the quadratic form it
generates, taking on only positive values or only negative values.
22
2.11.4
2.11.5
In this section, we try to examine what properties of the matrix, A, of the quadratic
form Q(x) will determine its definiteness.
23
a22 a23
a32 a33
a12 det
a21 a23
a31 a33
+ a13 det
a21 a22
a31 a32
.
a11 a1n
Generally, for an n n matrix, A = , the determinant will be given
an1 ann
by:
n
X
det(A) =
(1)i1 a1i det(A1i )
i=1
where A1i is the matrix that is left when we take out the first row and ith column of the
matrix A.
Definition 10
Let A be an n n matrix. A k k submatrix of A formed by deleting n k columns,
say columns i1 , i2 , . . . , ink and the same n k rows from A, i1 , i2 , . . . , ink , is called
a kth order principal submatrix of A. The determinant of a k k principal submatrix
is called a kth order principal minor of A.
Example 2.5 For a general 3 3 matrix A, there is one third order principal
minor, which is det(A). There are three second order principal minors and three first
order principal minors. What are they?
Definition 11
Let A be an n n matrix. The k-th order principal submatrix of A obtained by
deleting the last n k rows and columns from A is called the k-th order leading
principal submatrix of A, denoted by Ak . Its determinant is called the k-th order
leading principal minor of A, denoted by |Ak |.
We are now ready to relate the above elements of the matrix A to the definiteness of
the matrix:
24
Proposition 4
Let A be an n n symmetric matrix. Then:
(a) A is positive definite if and only if all its n leading principal minors are strictly
positive.
(b) A is negative definite if and only if all its n leading principal minors alternate
in sign as follows:
|A1 | < 0, |A2 | > 0, |A3 | < 0, etc.
The k-th order leading principal minor should have the same sign as (1)k .
(c) A is positive semi-definite if and only if every principal minor of A is
non-negative.
(d) A is negative semi-definite if and only if every principal minor of odd order is
non-positive and every principal minor of even order is non-negative.
Example 2.6
a1 0 0
0 a2 0 .
0 0 a3
25
If both coefficients above, a and (ac b2 )/a are positive, then Q will never be
negative. It will equal 0 only when x1 + (b/a)x2 and x2 = 0 in other words, when
x1 = 0 and x2 = 0. Therefore, if:
a b
>0
|a| > 0 and det A =
b c
then Q is positive definite. Conversely, in order for Q to be positive definite, we need
both a and det A = ac b2 to be positive. Similarly, Q will be negative definite if
and only if both coefficients are negative, which occurs if and only if a < 0 and
ac b2 > 0, that is, when the leading principal minors alternate in sign. If
ac b2 < 0, then the two coefficients will have opposite signs and Q will be indefinite.
2 3
Example 2.8 Numerical examples. Consider A =
. Since |A1 | = 2 and
3 7
2 4
|A2 | = 5, A is positive definite. Consider B =
. Since |B1 | = 2 and
4 7
|B2 | = 2, B is indefinite.
2.11.6
Finally we can put all the ingredients together. A continuous twice differentiable
function f on an open convex subset U of Rn is concave on U if and only if the Hessian
D2 f (x) is negative semi-definite for all x in U . The function f is a convex function if
and only if D2 f (x) is positive semi-definite for all x in U .
Therefore, we have the following result:
Proposition 5
Second order sufficient conditions for global maximum (minimum) in Rn
Suppose that x is a critical point of a function f (x) with continuous first and second
order partial derivatives on Rn . Then x is:
a global maximiser for f (x) if D2 f (x) is negative (positive) semi-definite on Rn .
a strict global maximiser for f (x) if D2 f (x) is negative (positive) definite on Rn .
The property that critical points of concave functions are global maximisers is an
important one in economic theory. For example, many economic principles, such as
marginal rate of substitution equals the price ratio, or marginal revenue equals marginal
cost are simply the first order necessary conditions of the corresponding maximisation
problem as we will see. Ideally, an economist would like such a rule also to be a
sufficient condition guaranteeing that utility or profit is being maximised, so it can
provide a guideline for economic behaviour. This situation does indeed occur when the
objective function is concave.
26
2.12
We are now in a position to formalise the necessary and sufficent first order conditions
for solutions to the COP. Consider once again the COP:
max g(x)
s.t. h(x) k
x x.
where g : x R, x is a subset of Rn , h : x Rm , and k is a fixed m-dimensional
vector.
We impose a set of the following assumptions, CC:
1. The set x is convex.
2. The function g is concave.
3. The function h is convex (these are assumptions CC from before), and
4. The functions g and h are differentiable.
Consider now the following conditions, which we term the Kuhn-Tucker conditions:
1. There is a vector Rm such that the partial derivative of the Lagrangian:
L(k , , x) = g(x) + [k h(x)]
evaluated at x is zero, in other words:
L(k , , x)
= Dg(x ) Dh(x ) = 0.
x
2. The Lagrange multiplier vector is non-negative:
0.
3. The vector x is feasible, that is, x x and h(x ) k .
4. The complementary slackness conditions are satisfied, that is,
[k h(x )] = 0.
The following theorem is known as the Kuhn-Tucker (K-T) Theorem.
Theorem 5
Assume CC.
i. If z is in the interior of Z and satisfies the K-T conditions, then z solves the
COP.
ii. If the constraint qualification holds (there exists a vector z0 Z such that
h(z0 ) k ), z is in the interior of Z and solves the COP, then there is a vector
of Lagrange multipliers q such that z and q satisfy the K-T conditions.
27
Proof. We first demonstrate that under CC and for non-negative values of Lagrange
multipliers, the Lagrangian is concave. The Lagrangian is:
L(k , q, z) = g(z) + q[k h(z)].
Take z and z 0 . Then:
tg(z) + (1 t)g(z 0 ) g(tz + (1 t)z 0 )
th(z) + (1 t)h(z 0 ) h(tz + (1 t)z 0 )
and thus with q 0, we have:
g(tz + (1 t)z 0 ) + qk qh(tz + (1 t)z 0 )
tg(z) + (1 t)g(z 0 ) + qk q(th(z) + (1 t)h(z 0 )).
It follows that:
L(k , q, tz + (1 t)z)
= g(tz + (1 t)z 0 ) + q[k h(tz + (1 t)z 0 )]
t[g(z) + q(k h(z))] + (1 t)[g(z 0 ) + q(k h(z 0 ))]
= tL(k , q, z) + (1 t)L(k , q, z 0 ).
This proves that the Lagrangian is concave in z. In addition, we know that g and h are
differentiable, therefore also L is a differentiable function of z. Thus, we know that if
the partial derivative of L with respect to z is zero at z , then z maximises L on Z.
Indeed the partial derivative of L at z is zero, and hence we know that if g is concave
and differentiable, h is convex and differentiable, the Lagrange multipliers q are
non-negative, and
Dg(z ) qDh(z ) = 0
then z maximises the Lagrangian on Z. But then the conditions of the Lagrange
sufficiency theorem are satisfied, so that z indeed solves the COP. We have to prove
the converse result now. Suppose that the constraint qualification is satisfied. The COP
now satisfies all the conditions of the Lagrange necessity theorem. This theorem says
that if z solves the COP, then it also maximises L on Z, and satisfies the
complementary slackness conditions, with non-negative Lagrange multipliers, as well as
being feasible. But since partial derivatives of a differentiable function are zero at the
maximum, then the partial derivatives of L with respect to z at z are zero and
therefore all the Kuhn-Tucker conditions are satisfied.
Remark 3 (Geometrical intuition) Think of the following example in R2 . Suppose
that the constraints are
1. h1 (z) = z1 0.
2. h2 (z) = z2 0.
3. h3 (z) k .
Consider first the case in which the point z0 solves the problem at a tangency of
h3 (z) = k and the objective function g(z) = g(z0 ). The constraint set is convex, and by
the concavity of g it is also the case that:
z : z R2 , g(z) g(z0 )
28
2.13
2.13.1
In this section we return to our initial interest in maximum (minimum) value functions.
Profit functions and indirect utility functions are notable examples of maximum value
functions, whereas cost functions and expenditure functions are minimum value
functions. Formally, a maximum value function is defined by:
Definition 12
If x(b) solves the problem of maximising f (x) subject to g(x) b, the maximum
value function is v(b) = f (x(b)).
You will remember that such a maximum value function is non-decreasing.
Let us now examine these functions more carefully. Consider the problem of maximising
f (x1 , x2 , . . . , xn ) subject to the k inequality constraints:
g(x1 , x2 , . . . , xn ) b1 , . . . , g(x1 , x2 , . . . , xn ) bk
where b = (b1 , . . . , bk ). Let x1 (b ), . . . , xn (b ) denote the optimal solution and let
1 (b ), . . . , k (b) be the corresponding Lagrange multipliers. Suppose that as b varies
near b , then x1 (b ), . . . , xn (b ) and 1 (b ), . . . , k (b) are differentiable functions and
that x (b ) satisfies the constraint qualification. Then for each j = 1, 2, . . . , k:
j (b ) =
f (x (b )).
bj
Proof. (We consider the case of a binding constraint, and for simplicity, assume there is
only one constraint, and that f and g are functions of two variables.) The Lagrangian is:
L(x, y, ; b) = f (x, y) (g(x, y) b).
29
0 =
L
(x (b), y (b), (b); b)
y
f
=
(x (b), y (b), (b))
y
h
(b) (x (b), y (b), (b))
y
0 =
h x (b) h y (b)
(x , y )
+
(x , y )
= (b)
x
b
y
b
= (b).
The economic interpretation of the multiplier is as a shadow price. For example, in the
application for a firm maximising profits, it tells us how valuable another unit of input
would be to the firms profits, or how much the maximum value changes for the firm
when the constraint is relaxed. In other words, it is the maximum amount the firm
would be willing to pay to acquire another unit of input.
2.14
Recall that:
L(x, y, ) = f (x, y) (g(x, y) b)
so that:
d
f (x(b), y(b); b) = (b) = L(x(b), y(b), (b); b).
db
b
Hence, what we have found above is simply a particular case of the envelope theorem,
which says that:
d
30
d
f (x (c); c) = L(x (c), (c); c).
dc
c
Note: if hi (x1 , x2 , . . . , xn , c) = 0 can be expressed as some h0i (x1 , x2 , . . . , xn ) c = 0,
then we are back at the previous case, in which we have found that:
d
d
f (x (a); a) =
f (x (a); a).
da
a
Apply the chain rule:
X f
d
x
f
f (x (a); a) =
(x (a); a) i (a) +
(x (a); a)
da
x
a
a
i
i
=
f
(x (a); a)
a
f
since x
(x (a); a) = 0 for all i by the first order conditions. Intuitively, when we are
i
already at a maximum, changing slightly the parameters of the problem or the
constraints, does not affect the optimal solution (but it does affect the value at the
optimal solution).
2.15
Solutions to activities
31
32
2.16
1. A household has a utility u(x1 , x2 ) = xa1 xb2 where a, b > 0 and a + b = 1. It cannot
consume negative quantities of either good. It has strictly positive income y and
faces prices p1 , p2 > 0. What is its optimal consumption bundle?
2. A household has a utility u(x1 , x2 ) = (x1 + 1)a (x2 + 1)b where a, b > 0 and a + b = 1.
It cannot consume negative quantities of either good. It faces a budget with strictly
positive income y and prices p1 , p2 > 0. What is its optimal consumption bundle?
2.17
33
= 0.
Plugging this into the constraint (that holds with equality when > 0),
x1 =
ay
,
p1
x2 =
by
.
p2
As all the conditions are satisfied, we are assured that this is a solution. To get that
maximum value function, we plug the solution into the objective function to get:
b
v(p1 , p2 , y) = aa bb pa
1 p2 .
34
Plugging this into the budget constraint (that holds with equality when 0 > 0):
ay + ap2 bp1
,
p1
b
= aa ba p1
1 p2 .
x1 =
0
x2 =
by ap2 + bp1
p2
This is a solution only if both x1 and x2 are non-negative. This happens if and only
if:
ap2 + bp1 ap2 bp1
y > max
,
.
a
b
35
Consider now the case of 1 > 0 implying that x1 = 0. In this case we must have
that x2 = y/p2 implying that 2 = 0, as the consumer might as well spend all his
income on good 2. From the first order conditions we have:
a
y
b
+1
0 =
p2
p2
a
bp1 ap2 ay
y
1 =
+1
.
p2
p2
This is part of a solution only if 1 0, i.e. if and only if y (bp1 ap2 )/a and in
that case the solution is x1 = 0 and x2 = y/p2 . Similarly, if y (bp1 + ap2 )/a, the
solution is x1 = y/p1 and x2 = 0.
36
Chapter 3
The consumers utility maximisation
problem
3.1
The aim of this chapter is to review the standard assumptions of consumer theory on
preferences, budget sets and utility functions, treating them in a more sophisticated
way than in intermediate microeconomics courses, and to understand the consequences
of these assumptions through the application of constrained optimisation techniques.
3.2
Learning outcomes
3.3
Essential reading
This chapter is self-contained and therefore there is no essential reading assigned. But
you may find further reading very helpful.
3.4
Further reading
37
3.5
Preferences
3.5.1
Preferences
Consumer theory starts with the idea of preferences. Consumers are modelled as having
preferences over all points in the consumption set, which is a subset of Rn . Points in Rn
are vectors of the form x = (x1 x2 . . . xn ) where xi is the consumption of good i. Most
treatments of consumer theory, including this chapter, assume that the consumption set
is Rn+ that is the subset of Rn with xi 0 for i = 1, . . . , n.
If x and y are points in Rn+ that a consumer is choosing between:
x y means that the consumer strictly prefers x to y so given a choice between
x and y the consumer would definitely choose y
x y means that the consumer is indifferent between x to y so the consumer
would be equally satisfied by either x or y
x y means that the consumer weakly prefers x to y that is either x y or
x y.
3.5.2
Assumptions on preferences
38
3.6
3.6.1
39
Definition 14
The budget line is the set of points with p1 x1 + p2 x2 + + pn xn = m and xi 0
for i = 1, . . . , n.
Definition 15
The budget set is the subset of points in Rn+ satisfying the budget constraint. In
formal notation it is:
{x : x Rn+ , p1 x1 + p2 x2 + + pn xn m}.
3.7
3.7.1
Definition 16
The consumers problem stated in terms of preferences is to find a point x in Rn+
with the property that x satisfies the budget constraint, so:
p1 x1 + p2 x2 + + pn xn m
and:
x x
for all x in Rn+ that satisfy the budget constraint.
40
3.7.2
The difficulty with expressing the consumers problem in terms of preferences is that we
have no techniques for solving the problem. However preferences can be represented by
utility functions, which makes it possible to define the consumers problem in terms of
constrained optimisation and solve it using the tools developed in the previous chapter.
Definition 17
A utility function u(x) which takes Rn+ into R represents preferences if:
u(x) > u(y) implies that x y
u(x) = u(y) implies that x y
u(x) u(y) implies that x y.
The following result and its proof are beyond the scope of this course, but the result is
worth knowing.
Theorem 6
If preferences satisfy the completeness, transitivity and continuity assumptions they
can be represented by a continuous utility function.
Varians Microeconomic Analysis proves a weaker result on the existence of a utility
function in Chapter 7.1. Again this is beyond the scope of this course.
3.7.3
One of the standard points made about consumer theory is that the same set of
consumer preferences can be represented by different utility functions so long as the
order of the numbers on indifference curves is not changed. For example if three
indifference curves have utility levels 1, 2 and 3, replacing 1, 2 and 3 by 2, 62 and 600
does not change the preferences being represented because 1 < 2 < 3 and 2 < 62 < 600.
However replacing 1, 2 and 3 by 62, 2 and 600 does change the preferences being
represented because it is not true that 62 < 2 < 600. The language used to describe this
is that the utility function is ordinal rather than cardinal, so saying that one bundle of
goods gives higher utility than another means something, but saying that one bundle
gives twice as much utility as the other is meaningless.
This can be stated more formally.
Theorem 7
If the utility function u(x) and the function b(x) are related by u(x) = a(b(x)) where
a is a strictly increasing function, then b(x) is also a utility function representing the
same preferences as u(x).
41
As there are many different strictly increasing functions this result implies that any set
of preferences can be represented by many different utility functions.
Proof. As a is strictly increasing and u represents preferences:
b(x) > b(y) implies that u(x) > u(y) which implies x y
Activity 3.4 Suppose that f is a function taking Rn+ into R, and the term f is
defined by f (x) f (y) implies that xf y. Explain why the relationship given by
f is complete, reflexive and transitive.
Activity 3.5
3.8
3.8.1
Definition 18
The consumers utility maximisation problem is:
max u(x)
s.t. p1 x1 + p2 x2 + + pn xn m
x Rn+ .
Note that this has the same form as the constrained optimisation problem in the
previous chapter. The previous chapter showed you how to solve the consumers
problem with the Cobb-Douglas utility function u(x1 , x2 ) = xa1 xb2 and the utility
function u(x1 , x2 ) = (x1 + 1)a (x2 + 1)b .
42
Definition 19
The solution to the consumers utility maximisation problem is uncompensated
demand. It depends upon prices p1 , p2 , . . . , pn and income m. The uncompensated
demand for good i is written as:
xi (p1 , p2 , . . . , pn , m)
or using vector notation as xi (p, m) where p is the vector (p1 p2 . . . pn ).
Notation x(p, m) is used for the vector of uncompensated demand
(x1 (p, m) x2 (p, m) . . . xn (p, m)).
The notation x(p, m) suggests that uncompensated demand is a function of (p, m),
which requires that for each value of (p, m) there is only one solution to the utility
maximising problem. This is usually so in the examples economists work with, but it
does not have to be, and we will look at the case with a linear utility function where the
consumers problem has multiple solutions for some values of p.
Recall from Chapter 1 the definition of the maximum value function as the value of the
function being maximised at the solution to the problem.
Definition 20
The indirect utility function is the maximum value function for the consumers
utility maximisation problem. It is written as:
v(p1 , p2 , . . . , pn , m)
or in vector notation v(p, m) where:
v(p, m) = u(x(p, m)).
There are two important results linking preferences and utility functions.
Theorem 8
If preferences are presented by a utility function u(x) then the solutions to the
consumers utility maximising function in terms of preferences are the same as the
solutions to the consumers problem in terms of utility.
Theorem 9
If two utility functions represent the same preferences the solutions to the consumers
utility maximisation problem are the same with the two utility functions but the
indirect utility functions are different.
These results are not difficult to prove, the next learning activity asks you to do this.
43
3.8.2
The nonsatiation assumption on preferences is that for any x and y in Rn+ , if x > y,
that is xi yi for all i and xi > yi for some i, then x y. If the preferences are
represented by a utility function u, this requires that if x > y then u(x) > u(y), so the
utility function is strictly increasing in the consumption of at least one good, and
non-decreasing in consumption of any good. In intuitive terms, the assumption says
that more is better, so a consumer will spend all available income.
Proposition 6
If the nonsatiation condition is satisfied any solution to the consumers utility
maximising problem satisfies the budget constraint as an equality.
Proof. To see this, suppose that the budget constraint is not satisfied as an equality so:
p 1 x1 + p 2 x2 + + p n xn < m
and increasing consumption of good i increases utility so if > 0:
u(x1 , x2 , . . . , xi + , . . . , xn ) > u(x1 , x2 , . . . , xi , . . . , xn ).
As p1 x1 + p2 x2 + + pn xn < m if is small enough the point (x1 , x2 , . . . , xi + , . . . , xn )
satisfies the budget constraint and gives higher utility that (x1 , x2 , . . . , xi , . . . , xn ) so
(x1 , x2 , . . . , xi , . . . , xn ) cannot solve the consumers problem.
Activity 3.6
Activity 3.7
Activity 3.8 Find the indirect utility function for the Cobb-Douglas utility
function u(x1 , x2 ) = xa1 xb2 .
Activity 3.9 The objective of this activity is to solve the consumers utility
maximising function with a linear utility function 2x1 + x2 subject to the constaints
p1 x1 + p2 x2 m, x1 0 and x2 0. Assume that p1 > 0, p2 > 0 and m > 0.
(a) Draw indifference curves for the utility function u(x1 , x2 ) = 2x1 + x2 . What is
the marginal rate of substitution?
(b) Assume that p1 /p2 < 2. Use your graph to guess the values of x1 and x2 that
solve the maximising problem. Which constraints bind, that is have
hi (x1 , x2 ) = ki where hi is constraint function i. Which constraints do not bind,
that is have hi (x1 , x2 ) < ki ? Does the problem have more than one solution?
(c) Assume that p1 /p2 = 2. Use your graph to guess the values of x1 and x2 that
solve the maximising problem. Which constraints bind? Which constraints do
not bind? Is there more than one solution?
44
(d) Assume that p1 /p2 > 2. Use your graph to guess the values of x1 and x2 that
solve the maximising problem. Which constraints bind? Which constraints do
not bind? Does the problem have more then one solution?
(e) Explain why the Kuhn-Tucker conditions are necessary and sufficient for a
solution to this problem.
(f) Write down the Lagrangian for the problem. Confirm that your guesses are
correct by finding the Lagrange multipliers associated with the constraints for
Activities 3.63.8. Does the problem have more than one solution?
Activity 3.10
3.9
Solution to activities
45
46
Figure 3.3: The effect of changes in prices and income on the budget line.
An increase in p1 to p01 shifts the budget line from CE to CD. The budget line
becomes steeper.
A decrease in p2 to p02 shifts the budget line from CE to BE. The budget line
becomes steeper.
47
u(x)
> 0 for i = 1, . . . , n
xi
m
p1
m
x2 (p1 , p2 , m) = b
p2
x1 (p1 , p2 , m) = a
48
Figure 3.4: Utility maximisation with u(x1 , x2 ) = 2x1 + x2 and p1 /p2 < 2.
The third line here follows from the second line because a + b = 1.
Solution to Activity 3.9
The objective of this activity is to solve the consumers utility maximising function with
a linear utility function 2x1 + x2 subject to the constraints p1 x1 + p2 x2 m, x1 0 and
x2 0. Assume that p1 > 0, p2 > 0 and m > 0.
(a) The indifference curves for the utility function u(x1 , x2 ) = 2x1 + x2 are parallel
straight lines with gradient 2 as shown in Figure 3.4. The marginal rate of
substitution is 2.
(b) From Figure 3.4 if p1 /p2 < 2 the budget line is less steep than the indifference
curves. The solution is at x1 = m/p1 , x2 = 0. The constraints p1 x1 + p2 x2 m and
x2 0 bind. The constraint x1 0 does not bind. There is only one solution.
(c) From Figure 3.5 if p1 /p2 = 2 the budget line is parallel to all the indifference
curves, and one indifference curve coincides with the budget line. Any (x1 , x2 ) with
x1 0, x2 0 and p1 x2 + p2 x2 = m solves the problem. If x1 = 0 the constraints
x1 0 and p1 x1 + p2 x2 m bind and the constraint x2 0 does not bind. If
x2 = 0 the constraints x2 0 and p1 x1 + p2 x2 = m bind and the constraint x1 0
does not bind. If x1 > 0 and x2 > 0 the constraint p1 x1 + p2 x2 m binds and the
constraints x1 0 and x2 0 do not bind. There are many solutions.
49
(d) From Figure 3.6 if p1 /p2 > 2 the budget line is steeper than the indifference curves.
The solution is at x1 = 0, x2 = m/p2 . The constraints p1 x1 + p2 x2 m and x1 0
bind. The constraint x2 0 does not bind. There is only one solution.
(e) The objective 2x1 + x2 is linear so concave, the constraint functions p1 x2 + p2 x2 , x1
and x2 are linear so convex, the constraint qualification is satisfied because there
are points that satisfy the constraints as strict inequalities, for example
x1 = m/2p1 , x2 = m/2p2 . Thus the Kuhn-Tucker conditions are necessary and
sufficient for a solution to this problem.
(f) The Lagrangian is:
L = 2x1 + x2 + 0 (m p1 x1 p2 x2 ) + 1 x1 + 2 x2
= x1 (2 0 p1 + 1 ) + x2 (1 0 p2 + 2 ).
The first order conditions require that:
2 = 0 p1 1
1 = 0 p2 2 .
Checking for solutions with x1 > 0 and x2 = 0, complementary slackness forces
1 = 0, so 0 = 2/p1 > 0 and 2 = 0 p2 1 = 2p2 /p1 1. Thus non-negativity of
multipliers forces p1 /p2 2. Complementary slackness forces x1 = m/p1 . The point
x1 = m/p1 , x2 = 0 is feasible. Thus if p1 /p2 2 the point x1 = m/p1 , x2 = 0 solves
the problem. If p1 /p2 < 0 this is the unique solution.
Checking for solutions with x1 = 0 and x2 > 0, complementary slackness forces
2 = 0, so 0 = 1/p2 and 1 = 0 p1 2 = p1 /p2 2. Thus non-negativity of
multipliers forces p1 /p2 2. Complementary slackness forces x2 = m/p2 . The point
x1 = 0, x2 = m/p2 is feasible. Thus if p1 /p2 2 the point x1 = 0, x2 = m/p2 solves
the problem. If p2 < p1 /2 this is the only solution.
If p1 /p2 = 2, and 0 = 2/p2 = 1/p2 , then 1 = 2 = 0, so solutions with x1 > 0 and
x2 > 0 are possible. As 0 > 0 complementary slackness forces p1 x1 + p2 x2 = m. In
this case there are multiple solutions.
Solution to Activity 3.10
Finding the indirect utility function for the utility function u(x1 , x2 ) = 2x1 + x2 , if
p1 /p2 < 2 then x1 (p1 , p2 , m) = m/p1 and x2 (p1 , p2 , m) = 0 so
v(p1 , p2 , m) = 2x1 + x2 = 2m/p1 .
If p1 /p2 = 2, any x1 , x2 with x1 0, x2 0 and x2 = (m p1 x1 )/p2 solves the problem,
so:
m
2m
(m p1 x1 )
=
=
.
v(p1 , p2 , m) = 2x1 +
p2
p2
p1
If p1 /p2 > 2, then x1 (p1 , p2 , m) = 0 and x2 (p1 , p2 , m) = m/p2 so
v(p1 , p2 , m) = 2x1 + x2 = m/p2 .
This is a perfectly acceptable answer to the question, but the indirect utility function
can also be written more concisely as:
2m m
.
,
v(p1 , p2 , m) = max
p1 p2
50
Figure 3.6: Utility maximisation with u(x1 , x2 ) = 2x1 + x2 and p1 /p2 > 2.
51
Learning outcomes
By the end of this chapter, you should be able to:
outline the assumptions made on consumer preferences
describe the relationship between preferences and the utility function
formulate the consumers problem in terms of preferences and in terms of utility
maximisation
define uncompensated demand, and to interpret it as the solution to a constrained
optimisation problem
define the indirect utility function, and to interpret it as a maximum value function.
3.10
When answering these and any other examination questions be sure to explain why
your answers are true, as well as giving the answer. For example here when you use
Lagrangian techniques in Question 2 check that the problem you are solving satisfies
the conditions of the theorem you are using, and explain your reasoning.
1. (a) Explain the meaning of the nonsatiation and transtivity assumptions in
consumer theory.
(b) Suppose that preferences can be represented by a utility function u(x1 , x2 ). Do
these preferences satisfy the transitivity assumption?
(c) Assume that the derivatives of the utility function u(x1 , x2 ) are strictly
positive. Do the preferences represented by this utility function satisfy the
nonsatiation assumption?
(d) Continue to assume that the derivatives of the utility function u(x1 , x2 ) are
strictly positive. Is it possible that the solution to the consumers utility
maximisation problem does not satisfy the budget constraint as an equality?
2. (a) Define uncompensated demand.
(b) Define the indirect utility function.
(c) A consumer has a utility function u(x1 , x2 ) = x1 + x2 where 0 < < 1. Solve
the consumers utility maximisation problem.
(d) What is the consumers uncompensated demand function for this utility
function?
(e) What is the consumers indirect utility function for this utility function?
52
3.11
As with any examination question you need to explain what you are doing and why.
2. (d) The uncompensated demand functions for the consumers utility maximisation
problem with u(x1 , x2 ) = x1 + x2 are:
1
1
p
x1 (p1 , p2 , m) = 1 m
p1 1 + p2 1
1
1
p
x2 (p1 , p2 , m) = 2 m.
p1 1 + p2 1
(e) The indirect utility function is:
v(p1 , p2 , m) =
p1 1
p2 1
1
m .
53
54
Chapter 4
Homogeneous and homothetic
functions in consumer choice theory
4.1
The aim of this chapter is to review the important concepts of a homogeneous function
and introduce the idea of a homothetic function. Homogeneity is important for
consumer theory because for any utility function the uncompensated demand and
indirect utility functions are homogeneous of degree zero in prices and income.
Homotheticity is a weaker concept than homogeneity. Assuming that the utility
function is either homogeneous or homothetic has very strong implications for
indifference curves, marginal rates of subtitution and uncompensated demand which are
explored in this chapter.
4.2
Learning outcomes
4.3
Essential reading
55
4.4
Further reading
4.5
4.5.1
Homogeneous functions
Definition
Definition 21
A function f (x1 , x2 , . . . , xn ) taking Rn+ into R is homogeneous of degree d in
(x1 , x2 , . . . , xn ) if for all (x1 , x2 , . . . , xn ) in Rn+ and all numbers s > 0:
f (sx1 , ssx2 , . . . , sxn ) = sd f (x1 , x2 , . . . , xn ).
Using vector notation x for (x1 , x2 , . . . , xn ), so (sx1 , sx2 , . . . , sxn ) = sx, this equation
can be written as:
f (sx) = sd f (x).
4.5.2
The most important cases are homogeneity of degree zero and homogeneity of degree
one. As s0 = 1, f (x1 , x2 , . . . , n) is homogeneous of degree zero if for all s > 0:
f (sx1 , ssx2 , . . . , sxn ) = f (x1 , x2 , . . . , xn )
so multiplying all components of (x1 , x2 , . . . , xn ) by the same number s > 0 has no effect
on the value of the function. Using vector notation this says that:
f (sx) = f (x).
As s1 = s a function is homogeneous of degree one if for all s > 0:
f (sx1 , ssx2 , . . . , sxn ) = sf (x1 , x2 , . . . , xn )
so multiplying all components of (x1 , x2 , . . . , xn ) by s has the effect of multiplying the
function by s. Using vector notation this equation says that:
f (sx) = sf (x).
56
Activity 4.1 For each of the following functions state whether or not it is
homogeneous in (x1 , x2 ). If the function is homogeneous say of what degree.
(a) ax1 + bx2
(b) (ax1 + bx2 )2
(c) ax21 + bx2
(d) cx31 + dx21 x2 + ex1 x22 + f x31
(e) (cx31 + dx21 x2 + ex1 x22 + f x31 )/(ax1 + bx2 )3
(f) x1 x 2 . Assume that > 0 and > 0, do not assume that + = 1.
(g) c ln x1 + d ln x2 .
4.6
4.6.1
Theorem 10
Uncompensated demand and the indirect utility function are both homogeneous of
degree zero in prices and income, that is for uncompensated demand for any number
s > 0:
xi (sp1 , sp2 , . . . , spn , sm) = xi (p1 , p2 , . . . , pn , m) for i = 1, . . . , n
or in vector notation:
x(p, m) = x(sp, m)
and for the indirect utility function:
v(sp1 , sp2 , . . . , spn , sm) = v(p1 , p2 , . . . , pn , m)
or in vector notation:
v(sp, sm) = v(p, m).
In words this says that when all prices and income are multiplied by the same positive
number s the solution to the consumers utility problem does not change and neither
does the level of utility. The next learning activity asks you to explain why this is so.
57
4.6.2
Monotonicity in income
Proposition 7
For any utility function the indirect utility function is non-decreasing in income m.
With nonsatiation the indirect utility function is strictly increasing in m.
Proof. From Chapter 1 a maximum value function is non-decreasing in the level of the
constraint k. For the consumers utility maximisation problem the maximum value
function is the indirect utility function v(p1 , p2 , m), and the level of the constraint is m,
so the general result implies at once that indirect utility is non-decreasing in m. Now
assume that the consumer is not satiated and income rises from m to m0 . Nonsatiation
implies that:
p1 x1 (p1 , p2 , m) + p2 x2 (p1 , p2 , m) = m
so:
p1 x1 (p1 , p2 , m) + p2 x2 (p1 , p2 , m) < m0
making it possible to increase both x1 and x2 by a small amount to x01 and x02 without
violating the budget constraint so:
p1 x01 + p2 x02 m0
and because of nonsatiation:
u(x01 , x02 ) > u(x1 (p1 , p2 , m), x2 (p1 , p2 , m)) = v(p1 , p2 , m).
As (x01 , x02 ) is feasible with income m0 , the solution to the consumers problem with
income m must give utility v(p1 , p2 , m) which cannot be smaller than u(x01 , x02 ), so:
v(p1 , p2 , m0 ) u(x01 , x02 ).
Taken together the last two inequalities imply that:
v(p1 , p2 , m0 ) > v(p1 , p2 , m).
Monotonicity in prices
Proposition 8
With any utility function the indirect utility function is non-increasing in prices.
With nonsatiation the indirect utility function is strictly decreasing in the prices
of good i if the consumer purchases a strictly positive amount of the good, that is
xi (p1 , p2 , m) > 0.
58
Proof. Suppose that the price p1 of good 1 falls from p1 to p01 . As x1 (p1 , p2 , m) 0 and
p01 < p1 this implies that:
p01 x1 (p1 , p2 , m) + p2 x2 (p1 , p2 , m)
p1 x1 (p1 , p2 , m) + p2 x2 (p1 , p2 , m).
Thus (x1 (p1 , p2 , m), x2 (p1 , p2 , m)) is feasible with prices p01 and p2 and income m so gives
utility no greater than the utility from the solution to the consumers problem with
prices p01 and p2 and income m which is v(p01 , p2 , m) so:
v(p01 , p2 , m) u(x1 (p1 , p2 , m), x2 (p1 , p2 , m)) = v(p1 , p2 , m).
Thus if p01 < p1 then v(p01 , p2 , m) v(p1 , p2 , m). Now suppose that x1 (p1 , p2 , m) > 0 and
the consumer is not satiated which implies that:
p01 x1 (p1 , p2 , m) + p2 x2 (p1 , p2 , m)
< p1 x1 (p1 , p2 , m) + p2 x2 (p1 , p2 , m) = m.
Then at prices p01 and p2 and income m there is a feasible point (x01 , x02 ) with
x01 > x1 (p1 , p2 , m) and x02 > x2 (p1 , p2 , m) so:
v(p01 , p2 , m) u(x01 , x02 ).
Nonsatiation implies that:
u(x01 , x02 ) > u(x1 (p1 , p2 , m), x2 (p1 , p2 , m)) = v(p1 , p2 , m).
From the last two inequalities v(p01 , p2 , m) > v(p1 , p2 , m). A similar argument applies to
good 2.
Activity 4.2
(a) What happens to the budget set and the budget line when p1 , p2 and m are all
multiplied by 2?
(b) What happens to the budget set and the budget line when p1 , p2 and m are all
multiplied by s > 0?
(c) What happens to uncompensated demand when p1 , p2 and m are all multiplied
by s > 0?
(d) How does utility change when p1 , p2 and m are all multiplied by s > 0?
(e) Suppose that the annual inflation rate is 50%, the prices of all goods increase by
50% and your income increases by 50%. Does the inflation make you better off
or worse off? Is real world inflation like this?
Activity 4.3 The indirect utility function from the Cobb-Douglas utility function
with a + b = 1 is u(x1 , x2 ) = xa1 xb2 is:
a b
a b
v(p1 , p2 , m) =
m.
pa1 pb2
Confirm that this function is homogeneous of degree zero in (p1 , p2 , m), increasing in
m and decreasing in p1 .
59
4.7
Given the definition of a homogeneous function it is important to have notation for the
derivatives of a function f at the point (sx1 , sx2 , . . . , sxn ). This is done by defining
fi (z1 , z2 , . . . , zn ) by:
f (z1 , z2 , . . . , zn )
fi (z1 , z2 , . . . , zn ) =
zi
which is the derivative of f (z1 , z2 , . . . , zn ) with respect to variable i. This notation
makes it possible to state and prove the following theorem.
Theorem 11
If the function f taking Rn+ into R is homogeneous of degree s and differentiable
then for any (x1 , x2 , . . . , xn ) in Rn+ and any s > 0:
fi (sx1 , sx2 , . . . , sxn ) = sd1 fi (x1 , x2 , . . . , xn ).
(4.1)
(4.2)
60
f (z1 , z2 , . . . , zn )
f (1, x1 , x2 , . . . , xn )
= sd
zi
xi
so dividing by s:
f (z1 , z2 , . . . , zn )
f (1, x1 , x2 , . . . , xn )
= sd1
zi
xi
where zi = sxi for i = 1, . . . , n. Using notation fi (z1 , z2 , . . . , zn ) for
(f (z1 , z2 , . . . , zn ))/(zi ) this becomes:
fi (sx1 , sx2 , . . . , sxn ) = sd1 fi (x1 , x2 , . . . , xn ).
Activity 4.4 The Cobb-Douglas utility function u(x1 , x2 ) = xa1 xb2 with a + b = 1 is
homogeneous of degree one. Find the partial derivatives of the Cobb-Douglas utility
function u(x1 , x2 ) = xa1 xb2 where a + b = 1 and confirm that the function and its
derivatives satisfy Theorem 11.
4.8
4.8.1
61
2/3 1/3
4.8.2
Figure 4.1 shows the lines that are tangent to the indifference curves at points on the
same ray. In the figure it looks as if lines on the same ray have the same gradient. This
is indeed the case. The gradient of the tangent line is M RS where M RS is the
marginal rate of substitution, given by:
M RS =
u1 (x1 , x2 )
u2 (x1 , x2 )
62
4.8.3
Intermediate microeconomics uses the indifference curve diagram to show that the
solution to the consumers problem is at a point where the budget line is tangent to the
indifference curve, so the marginal rate of substitution is equal to the price ratio. As
Figure 4.1 shows with a homogeneous utility function the marginal rate of substitution
is the same at all points along a ray, so if income changes but prices do not change
uncompensated demand moves along the ray. Thus if income doubles the demand for
each good doubles but the ratio of consumption of good 2 to consumption of good 1
does not change. More generally any change in income affects the quantity of goods
being consumed. This is a very strong condition; it says for example that if income
doubles then both consumption of salt, and consumption of housing space double;
whereas in fact as people get richer their pattern of consumption changes. In particular
homogeneous utility functions imply that there are no inferior goods.
In fact this result on the pattern of consumption does not rely on the tangency
condition, as the next result shows.
Theorem 13
If the utility function is homogeneous then for all prices (p1 , p2 , . . . , pn ) and income
m > 0:
xi (p1 , p2 , . . . , pn , m) = mxi (p1 , p2 , . . . , pn , 1) for i = 1, 2, . . . , n
or in vector notation:
x(p, m) = mx(p, 1).
In words this says that to find the consumption of goods at any level of income m, find
the consumption when m = 1 and then multiply by m.
Proof. Suppose the result is not true, that is there are prices p and income m, for
which x(p, m) 6= mx(p, 1), that is mx(p, 1) does not solve the utility maximising
problem with income m. As x(p, 1) solves the problem with income 1, it must satisfy
63
(4.3)
4.9
4.9.1
Homothetic functions
Homogeneity and homotheticity
64
Definition 22
A function f from Rn+ into R is homothetic if it has the form:
f (x) = q(r(x))
where r is a function that is homogeneous of degree one and q is a strictly increasing
function.
Proposition 9
Any homogeneous function of degree d > 0 is homothetic.
Proof. If f (x1 , x2 , . . . , xn ) is homogeneous of degree d > 0 so for any s > 0:
f (sx1 , sx2 , . . . , sxn ) = sd f (x1 , x2 , . . . , xn )
let:
r(x1 , x2 , . . . , xn ) = (f (x1 , x2 , . . . , xn ))1/d
which implies that:
r(sx1 , sx2 , . . . , sxn ) = (f (sx1 , sx2 , . . . , sxn ))1/d
1/d
= sd f (x1 , x2 , . . . , xn )
= s (f (x1 , x2 , . . . , xn ))1/d
= sr(x1 , x2 , . . . , xn )
so r(x1 , x2 , . . . , xn ) is homogeneous of degree one and:
f (x1 , x2 , . . . , xn ) = q(r(x1 , x2 , . . . , xn ))
where q(r) = rd so q is a strictly increasing function of r.
4.9.2
Indifference curves are the level sets of the utility function, so an indifference curve is a
set of the form:
(x1 , x2 ) : (x1 , x2 ) R2+ , u(x1 , x2 ) = u0 .
Now suppose that the utility function u(x1 , x2 ) is homothetic, so:
u(x1 , x2 ) = q(r(x1 , x2 ))
where q is a strictly increasing function and r is a function that is homogeneous of
degree one. Thus u(x1 , x2 ) = u(x01 , x02 ) implies that q(r(x1 , x2 )) = q(r(x01 , x02 )) which as q
is strictly increasing requires that r(x1 , x2 ) = r(x01 , x02 ), so if u0 = q(r0 ) the sets:
(x1 , x2 ) : (x1 , x2 ) R2+ , u(x1 , x2 ) = u0
(x1 , x2 ) : (x1 , x2 ) R2+ , r(x1 , x2 ) = r0
65
are the same. Thus any indifference curves associated with the homothetic utility
function u is also a level set of the homogeneous function r(x1 , x2 ). Diagrams of the
indifference curves and level sets for homothetic and homogeneous utility functions look
the same, although the number associated with each indifference curve is different for
the two functions u and r.
4.9.3
The fact that the indifference curves for homothetic and homogeneous indifference
curves are the same implies that the geometric properties of the two diagrams are the
same. In particular homothetic utility functions should share with homogeneous utility
functions the property that moving along a ray the marginal rate of substitution does
not change. This is indeed so. The formal result is:
Theorem 14
Suppose u is a homothetic function from R2+ into R, so:
u(x1 , x2 ) = 1(r(x1 , x2 ))
where q is strictly increasing, and r is homogeneous of degree one. Suppose also that
the functions q and r are differentiable, and that for all (x1 , x2 ) in R2+ , q 0 (r(x1 , x2 )) >
0 and r2 (x1 , x2 ) 6= 0. Then u2 (x1 , x2 ) 6= 0, u2 (sx1 , sx2 ) 6= 0 and:
u1 (sx1 , sx2 )
u1 (x1 , x2 )
=
u2 (x1 , x2 )
u2 (sx1 , sx2 )
that is the marginal rate of substitution is homogeneous of degree zero in (x1 , x2 ).
Proof. as u(x1 , x2 ) = q(r(x1 , x2 )) the chain rule implies that:
u1 (x1 , x2 ) = q 0 (r(x1 , x2 ))r1 (x1 , x2 )
u2 (x1 , x2 ) = q 0 (r(x1 , x2 ))r2 (x1 , x2 ).
(4.4)
(4.5)
From the assumptions of q 0 and r2 the terms in the second equation are not zero and
division gives:
u1 (x1 , x2 )
q 0 (r(x1 , x2 ))r1 (x1 , x2 )
r1 (x1 , x2 )
= 0
=
.
(4.6)
u2 (x1 , x2 )
q (r(x1 , x2 ))r2 (x1 , x2 )
r2 (x1 , x2 )
This argument applies to all points in R2+ . In particular it applies to (sx1 , sx2 ) so:
u1 (sx1 , sx2 )
r1 (sx1 , sx2 )
=
.
u2 (sx1 , sx2 )
r2 (sx1 , sx2 )
(4.7)
66
4.9.4
Theorem 13 says that if the utility function is homogeneous then for all prices
(p1 , p2 , . . . , pn ) and income m > 0:
xi (p1 , p2 , . . . , pn , m) = mxi (p1 , p2 , . . . , pn , 1) for i = 1, 2, . . . , n
or in vector notation:
x(p, m) = mx(p, 1).
A similar result applies to homothetic functions.
Theorem 15
If the utility function is homothetic then for all prices (p1 , p2 , . . . , pn ) and income
m > 0:
xi (p1 , p2 , . . . , pn , m) = mxi (p1 , p2 , . . . , pn , 1) for i = 1, 2, . . . , n
or in vector notation:
x(p, m) = mx(p, 1).
Proof. Given the definition of a homethetic function if the utility function u(x) is
homothetic u(x) = q(r(x)) where q is a strictly increasing function and r is
homogeneous of degree one. Then from Theorem 7 r(x) is also a utility function
representing the same preferences as u(x). From Theorem 9 the solutions to the utility
maximising problem with utility function u(x) are the same as the solutions to the
utility maximising problem with utility function r(x). As r(x) is homogeneous Theorem
13 implies that the solutions satisfy:
x(p, m) = mx(p, 1).
Thus uncompensated demand with both homogeneous and homothetic utility functions
has the property that the proportions in which goods are consumed do not change as
income increases with prices remaining the same.
Activity 4.6 For each of the following functions state whether or not it is
homothetic in (x1 , x2 ).
(a) cx31 + dx21 x2 + ex1 x22 + f x31
(b) (cx31 + dx21 x2 + ex1 x22 + f x31 )/(ax1 + bx2 )3
(c) x1 x2 where > 0 and > 0, do not assume that + = 1
(d) ln x1 + ln x2 where > 0, > 0.
67
Activity 4.7 Find the marginal rate of substitution for the utility function
u(x1 , x2 ) = (x1 + 1)a (x2 + 1)b . Is this utility function homothetic?
4.10
Solutions to activities
68
aa bb
pa1 pb2
m
so:
aa bb
(sm)
v(sp1 , sp2 , sm) =
(sp1 )a (sp2 )b
a b
a b
s
a b
a b
= a+b
m=
m = v(p1 , p2 , m)
a
b
s
p 1 p2
pa1 pb2
69
a
axa1 xb
= a1 b12 =
b
bx1 x2
x2
x1
70
= ln
x1+ x2+
+
+
= ( + ) ln x1 x2
.
The function:
x1+ x2+
is homogeneous of degree one, the function ( + ) ln r is strictly increasing so
ln x1 + ln x2 is homothetic.
Solution to Activity 4.7
With the utility function u(x1 , x2 ) = (x1 + 1)a (x2 + 1)b :
M RS =
=
u
x1
u
x2
a(x2 + 1)
.
b(x1 + 1)
From Theorem 14 if the function u(x1 , x2 ) = (x1 + 1)a (x2 + 1)b were homothetic the
M RS would be homogeneous of degree zero in (x1 , x2 ), which it is not. For example at
(1, 2) the M RS is 2a/3b, whereas at (2, 4) the M RS is 3a/4b.
A reminder of your learning outcomes
By the end of this chapter, you should be able to:
state the definitions of homogeneous and homothetic functions
explain why the uncompensated demand and indirect utility functions are
homogeneous of degree zero in prices and income
determine when the indirect utility function is increasing or non-decreasing in
income and decreasing or non-increasing in prices
explain the relationship between the homogeneity of a function and its derivative
describe the implications of homogeneous and homothetic utility functions for the
shape of indifference curves, the marginal rate of substitution and uncompensated
demand.
71
4.11
Note that many of the activities of this chapter are also examples of examination
questions.
1. (a) Define the terms homogeneous and homothetic.
(b) Are all homogeneous functions homothetic?
(c) Are all homothetic functions homogeneous?
(d) Suppose a consumer has a homogeneous utility function, income doubles, but
prices do not change. What happens to uncompensated demand?
(e) Suppose a consumer has a homothetic utility function, income does not
change, but prices fall by 50%. What happens to uncompensated demand?
2. Which of the following statements are true? Explain your answers.
(a) Uncompensated demand is homogeneous of degree zero in prices and income.
(b) The indirect utility function is homogeneous of degree one in prices and
income.
(c) All utility functions are homogeneous.
(d) All homogeneous utility functions are homothetic.
72
Chapter 5
Quasiconcave and quasiconvex
functions
5.1
The aim of this chapter is to introduce the ideas of quasiconcavity and quasiconvexity,
show why they are important for consumer and producer theory, and to show that the
Kuhn-Tucker Theorem applies to maximisation problems with a quasiconcave objective
function and quasiconvex constraint functions.
5.2
Learning outcomes
5.3
Essential reading
This chapter is self-contained and therefore there is no essential reading assigned. But
you may find further reading very helpful.
73
5.4
Further reading
5.5
5.5.1
Definitions
Concavity and convexity
Convex sets, concave functions and convex functions were defined in Chapter 1. The
definitions are given again here as foundations for the new ideas of quasiconcavity and
quasiconvexity. Informally a set is convex of any straight line joining two points in the
set lies entirely within the set. The formal definition is:
Definition 23
A subset U of Rn is convex if for all x and y in U and for all t [0, 1]:
tx + (1 t)y U.
A function is concave if a straight line joining any two points on its graph lies entirely
on or below the graph. Formally:
Definition 24
A real-valued function f defined on a convex subset U of Rn is concave if for all x
and y in U and for all t [0, 1]:
f (tx + (1 t)y) tf (x) + (1 t)f (y).
A function is convex if a straight line joining any two points on its graph lies entirely on
or above the graph. Formally:
Definition 25
A real-valued function f defined on a convex subset U of Rn is convex if for all x
and y in U and for all t [0, 1]:
f (tx + (1 t)y) tf (x) + (1 t)f (y).
74
5.5. Definitions
5.5.2
75
Figure 5.2: Level sets for a quasiconcave function u(x) and a quasiconvex function f (x).
Activity 5.1 Prove that for any quasiconvex function f (x) the function f (x) is
quasiconcave.
Activity 5.2
Activity 5.3
5.6
5.6.1
Figure 5.1 shows a function that is quasiconcave but not concave, so quasiconcavity and
concavity are not equivalent properties. The following theorem shows that concavity
and convexity are respectively stronger than quasiconcavity and quasiconvexity.
Theorem 16
All concave functions are quasiconcave and all convex functions are quasiconvex.
Proof. If f is a concave function, f (x1 ) y and f (x2 ) y then if t [0, 1]:
f (tx1 + (1 t)x2 ) tf (x1 ) + (1 t)f (x2 )
tf (y) + (1 t)f (y) = f (y)
so:
f (tx1 + (1 t)x2 ) f (y)
which is what is needed to imply that f is quasiconcave. If f is convex then f is
concave, so f is quasiconcave which implies that f is quasiconvex.
76
5.6.2
Producer theory works with production functions f (K, L) which give output as a
function of inputs K (capital) and L (labour). For example the Cobb-Douglas
production function is f (K, L) = K L where > 0 and > 0. One important aspect
of a production function is returns to scale.
77
Definition 28
A production function f (K, L) has increasing returns to scale if for any s > 1,
f (sK, sL) > sf (K, L).
A production function f (K, L) has constant returns to scale if for any s > 1,
f (sK, sL) = sf (K, L).
A production function f (K, L) has decreasing returns to scale if for any s > 1,
f (sK, sL) < sf (K, L).
As an example of returns to scale consider the Cobb-Douglas production function
f (K, L) = K L defined on R2+ where > 0 and > 0. Do not assume that
+ = 1. Then:
f (sK, sL) = (sK) (sL) = s+ K L = s+ f (K, L).
If s > 1, s+ > s if + > 1, s+ = s if + = 1, and s+ < s if + > 1, so:
The Cobb-Douglas production function K L function has increasing returns to
scale if + > 1.
The Cobb-Douglas production function K L function has constant returns to
scale if + = 1.
The Cobb-Douglas production function K L function has decreasing returns to
scale if + < 1.
There is an important link between returns to scale and concavity.
Proposition 10
If the production function f (K, L) has f (0, 0) = 0 and is concave then it has
decreasing or constant returns to scale.
Proof. Suppose that s > 1 so 0 < 1/s < 1. Then concavity of f (K, L) implies that:
1
1
f (K, L) = f
(0, 0)
(sK, sL) + 1
s
s
1
1
f (sK, sL) + 1
f (0, 0)
s
s
1
=
f (sK, sL)
s
so f (sK, sL) sf (K, L). This result means that limiting attention to concave
production functions rules out increasing returns to scale, which are an important
economic phenomenon. However production functions can be quasiconcave without
being concave. If + > 1 the Cobb-Douglas production function has increasing
returns to scale, so is not concave. However it is quasiconcave because:
K L = q(r(K, L))
78
b =
+
a =
5.6.3
The complexity assumption for consumer theory, stated in terms of preferences, is that
the set of points preferred to y, that is:
x : x Rn+ , x y
is convex. The convexity assumption on preferences is equivalent to a requirement that
for any utility function u(x) representing the preferences the set:
x : x Rn+ , u(x) u(y)
is convex. But this is the condition that the utility function be quasiconcave. Thus
quasiconcavity of the utility function is the natural concavity requirement for consumer
theory.
Activity 5.4
Find the first and second derivatives and draw a graph of the function:
1 2
f (x) = exp x
2
Activity 5.5
line.
Consider the function f (x) = exp 12 x2 defined on the entire real
79
Activity 5.6 Consider the function f (x) = exp 12 x2 defined on the interval
[0, ), that is the set of real numbers with x 0.
(a) Is the function concave or convex?
(b) Is the function quasiconcave?
(c) Is the function quasiconvex?
5.7
5.7.1
Theorem 18 proved in this chapter says that, as shown in Figure 5.3, the line which is
the tangent at x to the set on which the quasiconcave function g(x) g(x ) does not
cross the boundary of the set. Similar conditions apply to quasiconvex functions. The
results are important because they imply that the Kuhn-Tucker Theorem applies to
optimisation problems with a quasiconcave objective function and quasiconvex
constraint functions provided the derivatives of the objective function are not all zero.
The formal statement of the theorem comes next, followed by a discussion of the
geometric interpretation of the theorem, and then the proof.
80
Theorem 18
i. If g is a differentiable quasiconcave function defined on a convex subset of Rn ,
g(x) g(x ) and at least one of the partial derivatives of g(x) at x is not zero
then:
n
X
g(x )
(xi xi )
0
xi
i=1
or in vector notation:
(x x )Dg(x ) 0.
ii. If h is a differentiable quasiconvex function defined on a convex subset of Rn ,
h(x) h(x ) and at least one of the partial derivatives of h(x) at x is not zero
then:
n
X
h(x )
0
(xi xi )
xi
i=1
or in vector notation:
(x x )Dh(x ) 0.
iii. If g is a differentiable quasiconcave function defined on a convex subset of Rn ,
g(x) > g(x ) and at least one of the partial derivatives of g(x) at x is not zero
then:
n
X
g(x )
(xi xi )
>0
xi
i=1
or in vector notation:
(x x )Dg(x ) > 0.
5.7.2
Interpreting Theorem 18
In R2 Theorem 18 says that if g is quasiconcave, not all the derivatives of g(x) at x are
zero, and g(x) g(x ) then:
x1
g(x )
g(x )
g(x )
g(x )
+ x2
x1
+ x2
.
x1
x1
x1
x1
(5.1)
This means that all the points with g(x) g(x ) the line has to be tangent to the set at
x , as shown in Figure 5.3 where the tangent is the solid straight line and the set is the
shaded area. The set is convex because g(x) is quasiconcave. Another way of looking at
the result is that is a line is tangent at x to the set on which g(x) g(x ) the line may
touch the boundary of the set at other points, but it cannot cross the boundary.
Part 2 of the theorem gives the corresponding result for quasiconvex functions, and part
3 states that if g(x) > g(x ) the inequality in (5.1) is strict. The difference between the
first and third parts of the theorem is that the inequalities are weak in the first part and
strict in the third part.
81
5.7.3
Proof of Theorem 18
The first part of the theorem is proved as Theorem 2.5.4 of Sydster et al.. If you do
not have Sydster, here is a proof for R2 that works with Figure 5.3.
Proof. Consider a point y with g(y) g(x ) as shown in Figure 5.3. Because g is
quasiconcave and g(y) g(x ) all points of the form ty + (1 t)x with 0 < t < 1 lying
on the dashed line joining y and x satisfy:
g(ty + (1 t)x ) g(x ).
(5.2)
As:
(tyi + (1 t)xi ) xi = t(yi xi )
if:
n
X
(xi xi )
i=1
g(x )
<0
xi
(5.3)
((txi + (1 t)xi ) x1 )
i=1
n
X
= t
(xi xi )
i=1
g(x )
xi
(5.4)
g(x )
xi
< 0.
Because g is differentiable, close to x :
g(x) g(x ) +
n
X
i=1
(xi xi )
g(x )
.
xi
Recall that by assumption at least one of the partial derivatives of g at x is not zero in
which case this approximation implies that if x is close enough to x and:
n
X
(xi xi )
i=1
g(x )
<0
xi
(5.5)
then g(x) < g(x ). If t is small enough ty + (1 t)x is close enough to x for this to
apply, so (5.4) implies that or small enough t:
g(ty + (1 t)x ) < g(x ).
But this contradicts (5.2) which follows from the quasiconcavity of g and the
assumption that g(y) g(x ). So (5.4) cannot hold if g(y) g(x ). As (5.4) is a
consequence of (5.3), (5.3) cannot hold if g(x) g(x ) which proves the result. Part 2 of
the theorem on quasiconvex functions follows from part 1 because if h is quasiconvex
then h is quasiconcave, so part 1 implies that if h(x) h(x ):
n
X
i=1
82
(xi xi )
h(x )
0.
xi
Multiplying these inequalities by 1 gives part 2. For part 3 of the theorem note that
from part 1 that g(x) > g(x ) implies that:
n
X
i=1
(xi xi )
g(x )
0
xi
so what is needed is to rule out the possibility that there is a point z with g(z) > g(x )
and:
n
X
g(x )
(zi xi )
= 0.
xi
i=1
Figure 5.3 illustrates a point z satisfying this equation. Because g is differentiable small
changes in x result in small changes in g(x), so as g(z) > g(x ), all points x close enough
to z, that is inside the dotted circle around z in Figure 5.3, have g(x) > g(x ). But as
Figure 5.3 shows this includes points on the opposite side of the tangent line, which
satisfy (5.5) but have g(x) > g(x ). This is impossible, given part 1 of the theorem.
Activity 5.7
(a) Show on a graph the set on which x21 + x22 25. Is this set convex? Is the
function f (x1 , x2 ) = x21 + x22 quasiconcave or quasiconvex?
(b) Find the equation of the line that is tangent to the set at the point (3, 4). Show
the line on your graph.
(c) Is there any point on this tangent line with x21 + x22 < 25?
(d) The point (3, 4) solves the problem of maximising the function a1 x1 + a2 x2
subject to x21 + x22 25 for some values of a1 and a2 . Find these values.
83
5.8
Theorem 19
Suppose that the function g defined on the convex subset U of Rn is quasiconcave
and differentiable, and that the derivatives of g at x are not all zero. Suppose also
that the functions h1 , . . . , hm defined on U are quasiconvex and differentiable. Then
the Kuhn-Tucker conditions are sufficient for x to solve the problem of maximising
g(x) on U subject to hj (x) kj for j = 1, . . . , m. The conditions are:
i. The first order conditions are satisfied at x , that is there is a vector Rm
such that the partial derivatives of the Lagrangian:
L(k , , x) = g(x) + [k g(x)]
m
X
= g(x) +
j [kj hj (x)]
j=1
g(x ) X hj (x )
j
= 0 for i = 1, 2, . . . , n
xi
xi
j=1
or in vector notation:
L(k , , x)
= Dg(x ) Dh(x ) = 0.
x
ii. The multipliers are non-negative, that is j 0 for j = 1, . . . , m, or in vector
notation 0.
iii. The vector x is feasible, that is x U and hj (x ) kj for j = 1, . . . , m or in
vector notation h(x ) k .
iv. The complementary slackness conditions are satisfied, that is j [kj hj (x )] = 0
for j = 1, . . . , m or in vector notation [k h(x )] = 0.
Proof. Suppose that the theorem does not hold, that is there is a point x in U with
g(x > g(x )) and hj (x) kj for j = 1, 2, . . . , m. The x are not all zero; thus part 3 of
Theorem 18 implies that as g(x > g(x )):
n
X
(xi xi )
i=1
g(x )
> 0.
xi
84
(xi
xi )
hj (x )
j
= 0.
xi
(5.6)
This equality also holds if all the derivatives of hj at x are zero. If hj (x ) = kj , then
hj (x ) = kj , so if the derivatives of hj at x are not all zero the non-negativity of
multipliers and part 2 of Theorem 18 imply that:
n
X
hj (x )
(xi xi ) j
0.
x
i
i=1
From the last two expressions:
n
X
i=1
(xi xi )
m
X
hj (x )
j
xi
j=1
!
0.
(5.7)
n
X
n
m
X
X
hj (x )
g(x )
(xi xi )
=
(xi xi )
j
xi
xi
i=1
i=1
j=1
!
.
But (5.6) and (5.7) state that the left-hand side of this equation is strictly positive,
whereas the left-hand side is not positive, which is impossible. As (5.6) and (5.7) follows
from the assumption this contradiction implies that the result holds.
5.9
Solutions to activities
85
86
Figure 5.5: The circle on which x21 + x22 25 and its tangent at (3, 4).
f (3, 4)
f (3, 4)
+ (x2 4)
= 0.
x1
x2
f (3, 4)
=8
x2
87
5.10
5.11
m
=
+ p1
m
=
.
+ p2
x1
x2
88
You solve the problem using exactly the same Lagrangian techniques given in
Chapter 2 for the solution of the consumers problem with the utility function
u(x1 , x2 ) = xa1 xb2 where a > 0, b > 0 and a + b = 1. However the theorems on
optimisation in Chapter 2 work with a concave objective function and convex
constraint functions. If + > 1 the objective function is quasiconcave but not
concave. So you need to appeal to theorems on optimisation with quasiconcave and
quasiconvex functions.
You need to state that the objective function is quasiconcave and explain why.
(This is covered in Example 5.2). The constraint function is linear so concave and
b
quasiconcave. The partial derivative u/x1 = axa1
1 x2 > 0. Thus the Kuhn-Tucker
conditions are sufficient for a solution. You then find values of x1 , x2 and the
multiplier that satisfy the Kuhn-Tucker conditions.
2. (a) As in Question 1 you need to name the theorem you are using, and check that
the conditions hold. Here you are solving a constrained minimisation problem
of minimising K + L with a constraint K 3 L2 q. You can turn this into a
constrained maximisation problem with a constraint by multiplying by 1
so the objective is K L and the constraint is K 3 L2 q. The objective
is linear so concave and quasiconcave. From the previous question the function
K 3 L2 is quasiconcave, so K 3 L2 is quasiconvex. Hence this is a problem of
maximising a quasiconcave function subject to a quasiconvex constraint. The
partial derivatives of the objective are not zero. Thus the Kuhn-Tucker
conditions are sufficient for a solution. The Lagrangian is:
L = K L + (1 + K 3 L2 ).
The first order conditions are:
L
= 1 + 3K 2 L2 = 0
K
L
= 1 + 2K 3 L = 0
L
so:
3K 2 L2 = 1
2K 3 L = 1
which implies that:
2K
=1
3L
so K = (3/2)L. The first order conditions cannot be satisfied if = 0, so > 0
and complementary slackness implies that the constraint K 3 L2 q must be
satisfied as an equality so q = K 3 L2 . As K = (3/2)L this implies that:
3/5
2
L=
q 1/5
3
and as K = (3/2)L:
2/5
3
K=
q 1/5 .
2
89
These values of K and L are feasible and satisfy the first order conditions.
From the first order conditions the multiplier = (1/2)K 3 L1 > 0 so the
multiplier is nonnegative. Complementary slackness is satisfied because the
constraint is satisfied as an equality. Thus the Kuhn-Tucker conditions are
satisfied so this is a solution to the problem. The minimum cost of production
is:
3/5 2/5 !
2
3
q 1/5 .
K +L=
+
3
2
(b) This is the same problem as before except for the additional constraint that
This constraint is linear so quasiconvex. From the argument in the
K K.
previous question all the conditions of the Kuhn-Tucker theorem with
quasiconcave objective and quasiconvex constraints are satisfied. The
Lagrangian is:
K).
L = K L + (q + K 3 L2 ) + (K
If = 0 this is the same as the Lagrangian for the previous question, and :
2/5
3
q 1/5
K=
2
3/5
2
L=
q 1/5
3
solve the Kuhn-Tucker conditions for the new problem provided K is feasible,
so:
which requires that K K,
2
2
5.
K
q
3
is satisfied
The complementary slackness condition on the constraint K K
because = 0.
5 this solution is not feasible. Looking for a solution
However if q > (2/3)2 K
the constraint K 3 L2 q is satisfied as an equality if:
with K = K,
3/2 .
L = q 1/2 K
The first order condition for L is:
1 + 2K 3 L = 0
which implies that:
1
1 3/2 1/2
K
q
=
2K 3 L
2
so the multiplier is non-negative. The first order condition for K is:
=
1 + 3K 2 L2 = 0
so:
90
3 5/2 1/2
= 3K 2 L2 1 = K
q 1.
2
2 2
3
91
92
Chapter 6
Expenditure and cost minimisation
problems
6.1
This chapter introduces the consumers expenditure minimisation problem, and derives
the properties of its solution (compensated demand) and minimum value function (the
expenditure function). It shows that the firms cost minimisaton problem is
mathematically the same as the consumers expenditure minimisation problem. The
solution to the firms cost minimisation problem (conditional factor demand) and the
minimum cost function (the cost function), have the same mathematical properties as
compensated demand and the expenditure function. Finally, the chapter explores the
close relationship between the solutions to the consumers utility maximisation and
expenditure minimisation problems, and shows that Roys identity and the Slutsky
equation derive from this relationship.
6.2
Learning outcomes
93
6.3
Essential reading
This chapter is self-contained and therefore there is no essential reading assigned. But
you may find further reading very helpful.
6.4
Further reading
6.5
6.5.1
Any intermediate microeconomics textbook will show you how to decompose the effects
of a change in the price of good 1 into income and substitution effects, as shown in
Figure 6.1. The substitution effect takes the consumer from A to B. A is the original
point where the original budget line with gradient p1 /p2 is tangent to the indifference
curve with utility x and B is a point on the same indifference curve as A, which is
tangent to a budget line with gradient p01 /p2 where p01 is the new price of good 1. The
income effect is the move from B to C, which results from a downward shift of the
budget line with gradient p01 /p2 .
94
6.5.2
Diagrams are helpful in understanding income and substitution effects, but it is also
useful to have a mathematical formulation. This is done by considering the consumers
expenditure minimisation problem where the objective is to minimise the consumers
total expenditure p1 x1 + p2 x2 on R2+ subject to the constraint that the consumer has
utility of at least u so u(x1 , x2 ) u. Throughout this chapter the notation u(x1 , x2 )
indicates a function whereas u is a number, the level of the constraint. We also assume
that x1 0 and x2 0.
This is a minimisation rather than a maximisation problem, with a rather than in
the constraint. However it is straightforward to turn this into the standard form for
constrained optimisation problems, maximising a function, with a constraint by
multiplying the objective and constraint by 1, so the problem is to maximise
p1 x1 p2 x2 subject to u(x1 , x2 )
u, x1 0 and x2 0.
Figure 6.2 illustrates the problem. The constraint requires that utility is u or more. The
diagram shows the indifference curve with utility u(x1 , x2 ) = u. Points on the
indifference curve have utility u. Under the nonsatiation assumption, points above the
indifference curve provide greater utility than u while points below the indifference
curve provide lower utility than u. The parallel straight lines L1 , L2 , L3 and L4 all have
gradient p1 /p2 . The solution to the expenditure minimisation problem is at the point
A on the lowest budget line that meets the indifference curve. This is on the budget line
L2 . The dotted budget line L1 gives a higher level of expenditure than L2 , the dashed
budget lines L3 and L4 do not meet the indifference curve so have utility less than u.
The minimum amount of money e that the consumer has to spend to get utility u can
be seen from the points where the budget line L2 meets the x1 -axis, which is e/p1 , or
the point where L2 meets the x2 -axis, which is e/p2 .
95
Definition 29
Compensated demand is the solution to the problem of minimising expenditure p1 x1 +
p2 x2 on R2+ subject to the utility constraint u(x1 , x2 ) u. It is a function of prices
p1 and p2 and the utility level u. Compensated demand for goods 1 and 2 is written
as h1 (p1 , p2 , u) and h2 (p1 , p2 , u).
Compare this with uncompensated demand which is the solution to the problem of
maximising utility u(x1 , x2 ) on R2+ subject to the budget constraint p1 x1 + p2 x2 m.
It is a function of prices p1 and p2 and income m. Uncompensated demand for goods 1
and 2 is written as x1 (p1 , p2 , m) and x2 (p1 , p2 , m).
When prices change but u does not the consumer stays on the same indifference curve,
so the change in compensated demand is the substitution effect. The change in
uncompensated demand reflects both the income effect and the substitution effect.
6.5.3
96
u or more, and in particular it cannot be more expensive than (x01 , x02 ). Thus:
p1 x1 + p2 x2 p1 x01 + p2 x02 .
For the same reason:
p01 x01 + p2 x02 p01 x1 + p2 x2 .
Adding these inequalities gives:
p1 x1 + p2 x2 + p01 x01 + p2 x02 p1 x01 + p2 x02 + p01 x1 + p2 x2
which after rearrangement gives:
p01 (x01 x1 ) p1 (x01 x1 )
or:
(p01 p1 )(x01 x1 ) 0.
This inequality cannot hold if both p01 > p1 and x01 > x1 , that is if an increase in the
price of good 1 from p1 to p01 increases compensated demand for good 1. Thus an
increase in the price of good 1 must either decrease or leave unchanged compensated
demand for good 1.
Activity 6.1
function
97
(f) Write down the Lagrangian for the problem. Confirm that your guesses are
correct by finding the Lagrange multipliers associated with the constraints in
(b), (c) and (d). Does the problem have more than one solution?
(g) Write down the compensated demand functions for this utility function.
Confirm that these functions are homogeneous of degree zero in prices, and that
compensated demand for a good is a decreasing function of its price.
6.6
6.6.1
6.6.2
Monotonicity in utility
It follows from the general result that a maximum value function is non-decreasing in
the level of the constraint k. Here the level of the constraint is u. If (x1 , x2 ) solves the
consumers expenditure minimisation problem for u and (x01 , x02 ) solves the problem for
u0 > u, then (x01 , x02 ) satisfies the constraint u(x01 , x02 u). Thus (x01 , x02 ) satisfies the
constraint for the problem of minimising the cost of getting utility u which implies that
e(p1 , p2 , u) p 1x01 + p 2x02 = e(p1 , p2 , u0 ).
The stronger result that the expenditure function is increasing in u, so if u < u0 then
e(p1 , p2 u) < e(p1 , p2 , u) can be established provided compensated demand (x01 , x02 ) at
utility u0 has one or both of x01 > 0 or x02 > 0 and utility is a continuous function of
(x1 , x2 ). In this case u(x01 , x02 ) u0 > u, so starting with consumption (x01 , x02 ) it is
possible to reduce expenditure whilst still having utility above u. This implies that the
cheapest way of getting utility u must be less than the cheapest way of getting utility
u0 , so e(p1 , p2 , u)< e(p1 , p2 , u).
Monotonicity in prices
Intuitively, when the price of a good increases it costs more to get the same level of
utility. However a consumer who does not buy the good can maintain the same level of
98
utility at the same expense so the result is that the expenditure function is
non-decreasing in prices.
To see why this is so think about a fall in the price of good 1 from p1 to p01 whilst the
price of good 2 does not change. The expenditure function is the minimum cost of
getting utility u at prices (p1 , p2 ). At prices (p1 , p2 ) this is done by buying h1 (p1 , p2 , u)
and h2 (p1 , p2 , u).
When prices change to (p01 , p2 ) it is still possible to obtain utility u by buying
h1 (p1 , p2 , u) and h2 (p1 , p2 , u), at a cost of:
p01 h1 (p1 , p2 , u) + p2 h2 (p1 , p2 , u)
which implies that e(p01 , p2 , u) the minimum cost of getting utility u at these prices
cannot be more than p01 h1 (p1 , p2 , u) + p2 h2 (p1 , p2 , u) so:
e(p01 , p2 , u) p01 h1 (p1 , p2 , u) + p2 h2 (p1 , p2 , u).
As we require that h1 (p1 , p2 , u) 0 and p01 < p1 it follows that
p01 h1 (p1 , p2 , u) p1 h1 (p1 , p2 , u) so:
p01 h1 (p1 , p2 , u) + p2 h2 (p1 , p2 , u)
p1 h1 (p1 , p2 , u) + p2 h2 (p1 , p2 , u) = e(p1 , p2 , u).
Putting these inequalities together gives:
e(p01 , p2 , u) e(p1 , p2 , u)
so when the price of good 1 falls the expenditure function cannot rise, or put another
way the expenditure function is non-decreasing in p1 . A similar argument establishes
that the expenditure function is non-decreasing in p2 .
Homogeneity
We have already seen that the compensated demand function is homogeneous of degree
zero in prices meaning that if s > 0:
h1 (sp1 , sp2 , u) = h1 (p1 , p2 , u)
h2 (sp1 , sp2 , u) = h2 (p1 , p2 , u).
This implies that the expenditure function is homogeneous of degree one in prices,
meaning that if s > 0, e(sp1 , sp2 , u) = se(p1 , p2 , u). This means that if all prices are
multiplied by s, for example s = 2, so prices double then the cost of maintaining a
particular level of utility also doubles. To see why this is, note that as compensated
demand is homogeneous of degree zero in prices:
e(sp1 , sp2 , u) =
=
=
=
99
Concavity
Theorem 20
The expenditure function is concave in prices. This means that for any (p01 , p02 ) and
(p001 , p002 ) if:
(p1 , p2 ) = t(p01 , p02 ) + (1 t)(p001 , p002 )
where 0 t 1, then:
te(p01 , p02 , u) + (1 t)e(p001 , p002 , u) e(p1 , p2 , u).
This is illustrated in Figure 6.3 which shows the expenditure function as a function of
p1 with p2 being held constant at p2 .
Proof. Suppose that (x01 , x02 ), (x001 , x002 ) and (x1 , x2 ) are the cheapest ways of getting
utility u at prices (p01 , p02 ), (p001 , p002 ) and (p1 , p2 ). Thus:
p1 x1 + p2 x2 = e(p1 , p2 , u).
As (x01 , x02 ) is the cheapest way of getting utility u at prices (p01 , p02 ) and (x1 , x2 ) is a way
of getting utility u:
p01 x01 + p02 x02 = e(p01 , p02 , u) p01 x1 + p02 x2 .
Similarly:
p001 x001 + p002 x002 = e(p001 , p002 , u) p001 x1 + p002 x2 .
Multiplying the first of these inequalities by t and the second by 1 t, recalling that t
100
because
(p1 , p2 ) = t(p01 , p02 ) + (1 t)(p001 , p002 ) = (tp01 + (1 t)p001 , tp02 + (1 t)p002 ).
Shephards Lemma
Another important property of the expenditure function, called Shephards Lemma, is
that if the expenditure function has partial derivatives with respect to prices they are
equal to compensated demand, that is:
e(p1 , p2 , u)
= h1 (p1 , p2 u).
p1
(6.1)
Proof. Suppose that the price of good 2 is fixed at p2 and that the price of good 1
changes from p1 to p1 . Suppose that (x1 , x2 ) is the cheapest way of getting utility u at
prices (p1 , p2 ). Because (x1 , x2 ) is the cheapest way of getting utility u at prices (p1 , p2 )
it is also a way of getting utility u at prices (p1 , p2 ) so:
p1 x1 + p2 x2 = e(p1 , p2 , u) p1 x1 + p2 x2
= p1 x1 + p2 x2 + (p1 p1 )x1
= e(p1 , p2 , u) + (p1 p1 )x1 .
Thus:
e(p1 , p2 , u) e(p1 , p2 , u) (p1 p1 )x1 .
If p1 > p1 this implies that:
e(p1 , p2 , u) e(p 1 , p2 , u)
x1 .
p1 p1
If the expenditure function has a derivative with respect to p1 at the point (p1 , p2 , u) the
left-hand sides of these inequalities tend to the derivative as p1 tends to p1 . The only
way this can happen is if the derivative is x1 .
Downward sloping compensated demand again
We have already seen in Section 6.1.3 of this chapter that the compensated demand
curve cannot gradient upwards, that is compensated demand is a non-increasing
function of price. We established this with a simple direct argument. There is another
way of showing the same thing with the result we have just got. As:
e(p1 , p2 , u)
= h1 (p1 , p2 , u)
p1
101
Find the expenditure function for the Cobb-Douglas utility function u(x1 , x2 ) = xa1 xb2
where a > 0, b > 0 and a + b = 1. Make sure that the function you write down
depends only on the parameters of the utility function a and b, the level of utility u
and prices p1 and p2 . Confirm that the expenditure function has the properties listed
in the previous section.
Activity 6.4
Find the expenditure function for the linear utility function u(x1 , x2 ) = 2x1 + x2 .
Make sure that the function you write down depends only on the level of utility u
and prices p1 and p2 . Confirm that the expenditure function has the properties listed
in the previous section.
6.7
6.7.1
The problem
The firms cost minimisation problem is to minimise rK + wL on R2+ subject to
f (K, L) q where K is the input of capital with price r, L is the input of labour with
price w, f (K, L) is the production function, giving output as a function of inputs, and q
is the required level of output. The sample examination questions for Chapter 5 ask you
to solve cost minimisation problems.
Conditional factor demand
The solution to the firms cost minimisation problem gives the levels of inputs which
minimise the cost of producing q when input prices are r and w. The solution is called
conditional factor demand, written as K(r, w, q) and L(r, w, q).
102
6.7.2
6.8
6.8.1
Figure 6.4 shows a point x lying on the indifference curve with utility u that is also on
the tangent budget line p1 x1 + p2 x2 = m so p1 x1 + p2 x2 = m. In this diagram the point
x is the solution both to the problem of minimising expenditure p1 x1 + p2 x2 on R2+
subject to the utility constraint u(x1 , x2 ) u and to the problem of maximising utility
u(x1 , x2 ) on R2+ ) subject to the budget constraint p1 x1 + p2 x2 m. The diagram
suggests that at appropriate levels of income and utility the two problems have the
same solution. This holds provided that the utiilty function satisfies two of the standard
assumptions, one of which is continuity. Continuity has a formal defintion, but for the
purposes of this proof it is enough to know that a utility function is continuous if small
changes in x result in small changes in u(x).
103
Figure 6.4: Duality of the utility maximisation and expenditure minimisation problems.
Theorem 21
Suppose that p1 x1 + p2 x2 = m and u(x1 , x2 ) = u. Suppose also that the utility
function u(x) is continuous and the consumer is not satiated. Then:
If x solves the problem of maximising utility u(x) on R2+ subject to p1 x1 +
p2 x2 m then x also solves the problem of minimising expenditure p1 x1 + p2 x2
subject to u(x) u.
If x solves the problem of minimising expenditure p1 x1 +p2 x2 subject to u(x)
u then x also solves the problem of maximising utility u(x) subject to p1 x1 +
p2 x2 m.
Proof. Suppose that x0 solves the problem of maximising utility subject to the
constraint p1 x1 + p2 x2 m and has utility u(x0 ) = u. Nonsatiation then implies that
p1 x01 + p2 x02 = m. Suppose also that x0 does not solve the problem of minimising
p1 x1 + p2 x2 subject to u(x1 , x2 ) u, which implies that there is a point y as shown in
104
6.8.2
(6.2)
(6.3)
(6.4)
and:
Proof. From Theorem 21 the solution (x1 (p1 , p2 , m), x2 (p1 , p2 , m)) to the utility
maximising problem also solves the expenditure minimising problem with utility:
u = u(x1 (p1 , p2 , m), x2 (p1 , p2 , m)) = v(p1 , p2 , m)
(6.5)
105
so:
x1 (p1 , p2 , m) = h1 (p1 , p2 , u)
x2 (p1 , p2 , m) = h2 (p1 , p2 , u).
(6.6)
(6.7)
6.9
6.9.1
Roys identity
The statement of Roys identity
6.9.2
(6.8)
where v(p1 , p2 , m) is the indirect utility function and e(p1 , p2 , u) is the expenditure
function. Another way of writing this is to define a new function g(p1 , p2 ,u) by:
g(p1 , p2 ,u) = v(p1 , p2 , e(p1 , p2 , u))
so (6.8) becomes:
g(p1 , p2 , u) = u.
106
(6.9)
This equation holds for all values of (p1 , p2 , u) so if both sides of this equation are
differentiated with respect to p1 holding p2 and u constant the derivatives are equal.
The derivative of the right-hand side is zero, so this implies that:
g(p1 , p2 , u)
= 0.
p1
The next step is to find this derivative. You may be able to see at once that using the
chain rule and (6.9) this derivative is:
g(p1 , p2 , u)
v(p1 , p2 , m) v(p1 , p2 , m) e(p1 , p2 , u)
=
+
.
p1
p1
m
p1
(6.10)
If this step is not clear to you take it on trust at this stage, we will come back to it.
Putting the last two equations together gives:
v(p1 , p2 , m) v(p1 , p2 , m) e(p1 , p2 , u)
+
= 0.
p1
m
p1
(6.11)
6.9.3
The objective here is to provide an explanation, if you need it, of why (6.10) follows
from (6.9) using the chain rule. Any calculus textbook will tell you what the chain rule
is. For functions of a single variable the chain rule says that if v is a function of y and y
is a function of z, then thinking of v as a function of z:
dv
dv dy
=
.
dz
dy dz
This notation gets confusing when working with functions of many variables. It is better
to define a new function g(z) by g(z) = v(y(z)) and write this as:
dg
dv dy
=
.
dz
dy dz
The chain rule for many variables says that if v is a function of the vector
y = (y1 , . . . , yn ), y is a function of the vector z = (z1 , . . . , zn ), and g(z) = v(y(z)) then:
g
v y1
v y2
v yn
=
+
+ +
.
zi
y1 zi
y2 zi
yn zi
107
(6.12)
108
6.10
6.10.1
x1 (p1 , p2 , m).
p1
p1
m
6.10.2
(6.13)
(6.14)
From the discussion of the chain rule in Section 6.5.3 treating v(p1 , p2 , e(p1 , p2 , u)) as a
function of p1 , p2 and u and differentiating with respect to p1 gives:
v(p1 , p2 , m) v(p1 , p2 , m) e(p1 , p2 , u)
+
.
p1
m
p1
Exactly the same argument establishes that treating x1 (p1 , p2 , e(p1 , p2 , u)) as a function
of p1 , p2 and u and differentiating with respect to p1 gives
x1 (p1 , p2 , m) x1 (p1 , p2 , m) e(p1 , p2 , u)
+
.
p1
m
p1
(6.15)
The derivatives in (6.14) and (6.15) must be the same, because they are the derivatives
of the two sides of (6.13). Thus:
x1 (p1 , p2 , m) x1 (p1 , p2 , m) e(p1 , p2 , u)
h1 (p1 , p2 , u)
+
=
.
p1
m
p1
p1
As argued in the course of deriving Roys identity, Shephards Lemma implies that
when m = e(p1 , p2 , u):
e(p1 , p2 , u)
= h1 (p1 , p2 , u) = x1 (p1 , p2 , m).
p1
Substituting this in the previous equation and rearranging gives the Slutsky equation.
109
Activity 6.7 We have just proved the Slutsky equation for the effect of a change in
the price of good 1 on demand for good 1. Use a similar argument to find the effect
of a change in the price of good 2 on demand for good 1.
6.11
Solutions to activities
As p1 , p2 , a, b, x1 and x2 are all strictly positive any value of that satisfies these
equations must also be strictly positive, so the constraint xa1 xb2 u must bind. This is
intuitive, if xa1 xb2 > u it is possible to reduce x1 and x2 a little while still satisfying the
utility constraint which reduces expenditure, so x1 and x2 cannot solve the problem.
110
(6.16)
which is the tangency condition that the marginal rate of substitution is equal to the
bp1
x1 . As the constraint binds:
price ratio. This implies that x2 = ap
2
xa1 xb2 = u.
Substituting x2 =
bp1
x
ap2 1
(6.17)
bp1
x1
ap2
b
= u.
(6.18)
Now:
xa1
bp1
x1
ap2
b
=
bp1
ap2
b
xa+b
1
=
bp1
ap2
b
x1
bp1
x
ap2 1
ap2
bp1
b
u
gives:
x2 =
bp1
ap2
a
u.
ap2
bp1
b
u = pb
1
ap b
2
ap b
h1 (p1 , p2 , u)
2
= bpb1
u < 0
1
p1
b
so compensated demand for good 1 is decreasing in its price p1 . A similar argument
applies to good 2.
111
Figure 6.6: Expenditure minimisation with u(x1 , x2 ) = 2x1 + x2 and p1 /p2 < 2.
112
Figure 6.8: Expenditure minimisation with u(x1 , x2 ) = 2x1 + x2 and p1 /p2 > 2.
113
Looking first for conditions under which the point x1 = u/2, x2 = 0 is a solution;
the point is feasible and satisfies the constraints 2x1 + x2 u and x2 0 as
equalities, so complementary slackness is satisfied for these constaints. The
constraint x1 0 is satisfied as a strict inequality, so complementary slackness is
satisfied if 1 = 0. The first order conditions are satisfied if 0 = p1 /2 and
2 = p2 0 = p1 p1 /2 so non-negativity of the multiplier 2 is satisfied if
p1 /p2 2.
Thus if p1 /p2 2 the point x1 = u/2, x2 = 0 with multipliers 0 = p1 /2, 1 = 0
and 2 = p1 p1 /2 satisfies the Kuhn-Tucker conditions so solves the problem.
Now look for solutions with x1 > 0, x2 > 0 and 2x1 + x2 = u. The point is feasible.
Complementary slackness is satisfied if 1 = 2 = 0. The first order conditions are
satisfied if 0 = p1 /2 = p2 , so this cannot be a solution unless p1 /p2 = 2. The
constraint 2x1 + x2 = u is satisfied as an equality so complementary slackness is
satisfied for this constraint. The multiplier 0 > 0.
Thus if p1 /p2 = 2 any point with x1 > 0, x2 > 0 and 2x1 + x2 = u with multipliers
0 = p1 /2 = p2 , 1 = 0 and 2 = 0 satisfies the Kuhn-Tucker conditions so solves
the problem.
Finally look for conditions x1 = 0, x2 = u is a solution; the point is feasible and
satisfies the constraints 2x1 + x2 u and x1 > 0 as equalities, so complementary
slackness is satisfied for these constraints. The constraint x2 > 0 is satisfied as a
strict inequality, so complementary slackness is satisfied if 2 = 0. The first order
conditions are satisfied if 0 = p2 and 1 = p1 20 = p1 2p2 so non-negativity of
the multiplier 2 is satisfied if p1 /p2 2.
Thus if p1 /p2 the point x1 = 0, x2 = u with multipliers 0 = p2 , 1 = p1 2p2
and 2 = 0 satisfied the Kuhn-Tucker conditions so solves the problem.
The problem has more than one solution if p1 /p2 = 2.
(g) The compensated demand functions are:
If p1 /p2 < 2, h1 (p 1, p2 , u) = u/2, h2 (p1 , p2 , u) = 0.
If p1 /p2 > 2, h1 (p 1, p2 , u) = 0, h2 (p1 , p2 , u) = 0.
If p1 /p2 = 2, there are many values of x1 and x2 that solve the problem, as a
function can take only one value for each value of its arguments, the compensated
demand function does not exist for these prices.
As demand depends only on the price ratio p1 /p2 it is homogeneous of degree zero
in p1 and p2 because (sp1 )/(sp2 ) = p1 /p2 for any s > 0.
An increase in prices from p1 to p01 does affect compensated demand if either
p1 /p2 < p01 /p2 < 2 or 2 < p1 /p2 < p01 /p2 . If p1 /p2 2 < p01 /p2 demand for x1 is
either u/2 or somewhere between 0 and u/2 before the price change and 0 after the
price change, then it does not increase following the price increase. If
p1 /p2 < 2 p01 /p2 demand for x1 is u/2 before the price change. This demand for
good 1 does not increase when its price increases. A similar argument applies to
good 2 and its price p2 .
114
ap2
bp1
b
u + p2
bp1
ap2
a
u.
This is a perfectly good answer to the problem of finding the expenditure function.
However, the formula can be made to look much simpler by doing some algebra as
follows:
b
a
ap2
bp1
e(p1 , p2 , u) = p1
u + p2
u
bp1
ap2
"
b
a #
bp1
ap2
+ p2
u
= p1
bp1
ap2
a
b
b
b b a
a
a
= p1 p1 p2
+ p1 p2 p2
u.
b
a
1b
1a
Because a + b = 1, p1 pb
= pa1 and p2 pa
= pb2 so:
1 = p1
2 = p2
a
b
b
a b a
a b
e(p1 , p2 , u) = p1 p2
+ p1 p2
u
b
a
a
a b
b
=
+
pa1 pb2 u.
b
a
115
p21
2 e(p1 ,p2 ,
u)
p2 p1
p1 p2
2 e(p1 ,p2 ,
u)
p22
a
ab ba pb1
pb2 u ab ba pb
1
1 p2 u
=
a
b a a a1
ab ba pb
p
p
a
b
p
1
2
1 2
2
p2 p1 p2
b a b1 a1
.
= a b p1 p2
p1 p2 p21
1 p2 u
p1
b
ap2
=
u = h1 (p1 , p2 , u)
bp1
e(p1 , p2 , u)
= aa ba pa1 pa
2 u
p2
a
bp1
=
u = h2 (p1 , p2 , u)
ap2
so Shephards Lemma is satisfied.
Solution to Activity 6.4
[The expenditure function with a linear utility function]
With the utility function u(x1 , x2 ) = 2x1 + x2 :
116
e(p1 , p2 , u) =
p01 p1
2
u > 0.
p1
e(p1 , p2 , u) = p2
u > 0.
2
e(p1 ,p2 ,
u)
p1
e(p1 ,p2 ,
u)
p1
= 0 = h1 (p1 , p2 , u) and
e(p1 ,p2 ,
u)
p2
p1
u,
2
= h1 (p1 , p2 , u) and
= 0 = h2 (p1 , p2 , u).
= u = h2 (p1 , p2 , u).
117
1 p2 u
b
ap2
u
=
bp1
x1 (p1 , p2 , m) = a
which is indeed compensated demand for good 1. (Note that this argument uses the fact
that 1 a = b.) Similarly:
m
aa bb pa1 pb2 u
=b
p2
p2
a 1b a b1
= a b p1 p2 u
= aa ba pa1 pa
u
a 2
bp1
=
u.
ap2
x2 (p1 , p2 , m) = b
Also when m = e(p1 , p2 , m) = aa bb pa1 pb2 u the indirect utility function is:
aa bb aa bb pa1 pb2 u
m
v(p1 , p2 , m) = a b a b =
p1 p2
pa1 pb2
= a0 b0 u = u
a b
118
Thus:
v(p1 , p2 , m)
= aaa bb pa1
pb
1
2 m
p1
v(p1 , p2 , m)
b
= aa bb pa
1 p2
m
so:
am
= x1 (p1 , p2 , m)
p1
as required.
Solution to Activity 6.7
From Proposition 22:
x1 (p1 , p2 , e(p1 , p2 , u)) = h1 (p1 , p2 , u)
(6.21)
(6.22)
The next step is to find the derivative of x1 (p1 , p2 , e(p1 , p2 , u)) with respect to the price
of good 2. Using the chain rule in the same way as in the original derivation of the
Slutsky equation this is:
x1 (p1 , p2 , m) x1 (p1 , p2 , m) e(p1 , p2 , u)
+
.
p2
m
p2
(6.23)
The derivatives in (6.22) and (6.23) must be the same, because they are the derivatives
of the two sides of (6.21). Thus:
x1 (p1 , p2 , m) x1 (p1 , p2 , m) e(p1 , p2 , u)
h1 (p1 , p2 , u)
+
=
.
p2
m
p2
p2
Shephards Lemma implies that when m = e(p1 , p2 , u):
e(p1 , p2 , u)
= h2 (p1 , p2 , u) = x2 (p1 , p2 , m).
p2
Substituting this in the previous equation and rearranging gives the Slutsky equation:
x1 (p1 , p2 , m)
h1 (p1 , p2 , u) x1 (p1 , p2 , m)
=
x2 (p1 , p2 , m).
p2
p2
m
119
6.12
Note that many of the activities for this chapter could also be examination
questions.
1. (a) Define the firms conditional factor demand and the cost function and explain
their relationship.
(b) Prove that conditional factor demand is homogeneous of degree zero in input
prices.
(c) Is the cost function homogeneous in prices? If so, of what degree?
(d) Find the conditional factor demand and cost function for the production
function:
f (K, L) = (K + L )1/ .
(Assume that 0 < < 1.)
2. (a) Define the indirect utility function v(p1 , p2 , m).
(b) Define the expenditure function e(p1 , p2 , u).
(c) Define the compensated demand function.
(d) What is the relationship between the derivative:
e(p1 , p2 , u)
p1
and the compensated demand function?
(e) Write down and derive Roys identity.
120
6.13
1. (d) The conditional factor demand functions for the production function
f (K, L) = (K + L )1/ are:
K =
L =
r1/(1)
1/
1/
q.
(r/(1) + w/(1) )
w1/(1)
(r/(1) + w/(1) )
(1)/
q.
121
122
Chapter 7
Dynamic programming
7.1
Learning outcomes
By the end of this chapter and the relevant reading, you should be able to:
formulate a Bellman equation for the general dynamic maximisation problem
solve general dynamic problems by using the envelope theorem and factoring out
the Bellman value function to obtain the intertemporal optimality conditions
(Euler equations)
apply backward induction to explicitly solve for the sequence of Bellman value
functions in a finite horizon maximisation problem
explain the logic of the guess and verify approach to the solution of infinite
horizon maximisation problems
use the above methods in case of multiple state and control variables.
7.2
Essential reading
Sydster, Knut, Peter Hammond, Atle Seierstad, Arne Strm Further Mathematics
for Economic Analysis. Chapter 12.
7.3
Further reading
7.4
Introduction
In this chapter we study the solution techniques for the dynamic optimisation problems
in discrete time, traditionally known as dynamic programming problems. We use these
techniques to analyse the central problem of macroeconomic dynamics: the optimal
consumption/saving decision, complicated by habit formation, durable goods, and
variable labour supply.
123
7. Dynamic programming
7.5
Suppose you are stranded on an uninhabited island with nothing but gingerbreads to
eat. You have to survive for T < periods (say, days), denoted t = 0, 1, 2, . . . , T . At
the beginning of your stay you are endowed with k > 0 gingerbreads. Gingerbreads are
storable (do not perish easily), so in any given day a gingerbread that is not eaten can
be saved for later. Your period t utility is given by ut (ct ) and is potentially time-varying
(this may take the form of exponential discounting considered in the next section or
other
PT forms). Your intertermporal utility for the duration of your stay on the island is
t=1 ut (ct ). In mathematical terms the objective you face on the island is to maximise
the intertemporal utility as follows:
max
{ct }
T
X
ut (ct )
t=1
s.t.
ct = k
ct 0 t T.
Let us introduce a new variable called capital, with the interpretation of the amount of
gingerbreads left on a given date. This capital evolves according to a simple equation: if
at the end of period t 1 you have kt gingerbreads left, then in period t you eat ct of
those and store kt+1 = kt ct . In the terminology of dynamic programming, kt is the
state variable and ct is the control variable for this problem.
With the new set of state variables the problem can be equivalently rewritten as to
maximise the intertemporal utility subject to the conditions kt+1 = kt ct for all
t = 0, 1, 2, . . . , T (the evolution equations for capital), k1 = k (the initial condition),
and non-negativity constraints for all ct and kt :
max
{ct }
T
X
ut (ct )
(7.1)
t=1
s.t. kt+1 = kt ct t T
kt , ct 0 t T
kT +1 0.
k1 = k,
In what follows we will often omit the non-negativity constraints for ct and kt as they
are straightforward. We will, however, retain the last of these constraints, kT +1 0, as
it prevents consuming non-existent gingerbreads and in general ensures that the rest of
the non-negativity constraints are actually satisfied.
If T is finite, then one way to solve the problem is to use the Lagrange method you
learned in Chapter 2 of this guide, setting up the Lagrangian:
L=
T
X
t=1
ut (ct ) +
T
X
t (k1 ct kt+1 ) + T +1 kT +1
t=1
124
approach to the solution of this simple problem. To grasp the main idea behind the
approach imagine that the optimal consumption plan denoted by {c1 , c2 , . . . , cT } has
been already computed. Consider what happens if at the end of some intermediate
period < T you have forgotten the rest of the original optimal plan {c +1 , . . . , cT }.
You would have to reoptimise the revised objective:
max
{ct }
T
X
ut (ct )
t= +1
s.t. kt+1 = kt ct t = + 1, . . . , T
k +1 given k +1 0.
Notice that k +1 is uniquely determined by your original plan {c1 , c2 , . . . , c } prior to
the period + 1. The question is, would you be able to uncover the remainder of this
original consumption plan {c +1 , c +2 , . . . , cT }? To pose the question even more starkly,
suppose you are still in possession of the original plan {c +1 , c +2 , . . . , cT } but decide
that you might improve on it (after all your past decisions are not binding for the
present). Would you be able to do so?
Suppose you alter yourP
plan by choosing a sequence {
cP
T } distinct from
+1 , . . . , c
T
T
ut (ct ) +
t=1
T
X
ut (
ct ) >
t= +1
T
X
ut (ct )
t=1
which contradicts the assumption that {c1 , c2 , . . . , cT } was a maximising sequence for
(7.1).
Thus the important realisation emerges:
Proposition 11
Holding {c1 , c2 , . . . , c } fixed, the sequence {c +1 , . . . , cT } maximises
subject to the capital constraints.
PT
t= +1
ut (ct )
Definition 30
Define the value function V () as:
V (k , ) = max
{ct }
T
X
ut (ct )
t=
s.t. kt+1 = kt ct
kt , ct 0 t T
kT +1 0, k given.
Then, using the asterisk notation for the optimal consumption sequence and omitting
125
7. Dynamic programming
the constraints:
V (k1 , 1) = max
{ct }
T
X
ut (ct ) =
t=1
ut (ct )
t=1
T
X
ut (ct ) +
ut (ct ) =
T
X
ut (ct ) + max
ut (ct )
t= +1
t=1
t= +1
t=1
T
X
ut (ct ) + V (k +1 , + 1)
t=1
( T
X
max
k +1=k
P
t=1 ct
)
ut (ct ) + V (k +1 , + 1) .
t=1
The last step involves the realisation that by altering the first few elements of the
sequence c1 , . . . , c you change the amount of capital left for subsequent bins (or periods
in the intertemporal interpretation). The Bellman value function summarises the
information about the future utility of consumption given the level of the state variable
and the notion that the future consumption choices will be made optimally even from
the present point of view.
Proposition 12
Optimality principle for the Bellman value function:
(
)
X
V (k1 , 1) = max
ut (ct ) + V (k +1 , + 1)
(7.2)
t=1
s.t. k +1 = k c .
Notice that the Bellman value function takes two arguments: the state variable and the
time period. V (k, 1) and V (k, T 1) are admittedly vastly different things for any
T > 2, since to survive on any given amount of food for a day or for a year is very
different.
The special case of (7.2) for two consecutive periods is known as the Bellman equation.
Definition 31
The Bellman equation for problem (7.1), for any period t:
V (k, t) = max {u(ct ) + V (k ct , t + 1)} .
ct
Example 7.1
V (k1 , 1) = max c1 {u(c1 ) + V (k2 , 2)}
k2 = k1 c1 .
(7.3)
Let us apply the envelope theorem to this equation: denoting by 2 the Lagrange
126
7.6
T
X
t u(ct )
t=1
T
X
t u(ct )
t=
(7.4)
Here the production uses only one factor, capital, but it is easy to incorporate more factors (for
example labour), although at the expense of having more than one control variable. You will see examples
of this in the exercises for this chapter.
127
7. Dynamic programming
What can we do with this equation? Taking the first order conditions for maximum
yields:
u0 (ct ) = V 0 (kt+1 , t + 1).
(7.5)
This seems to be of limited use, however, since the functional form of the sequence of
functions V (k, 1), V (k, 2), . . . , V (k, T ) is not known prior to solving the problem. To
overcome this difficulty, a few different approaches exist. One can either factor out (get
rid of) V () from (7.5) or attempt to find V () explicitly.
7.6.1
(7.6)
where V 0 (k, t) denotes the derivative of the value function for time period t with respect
to the capital argument k. Notice that since V (k, t) and V (k, t + 1) are in general
distinct functions, their derivatives are likewise different. Recall the FOC from (7.5) and
the fact that they hold for all t, therefore can be shifted back one period:
u0 (ct ) = V 0 (kt+1 , t + 1)
u0 (ct1 ) = V 0 (kt , t).
(7.7)
Combining the three equations (7.5), (7.6) and (7.7) allows us to factor out both
occurrences of V 0 :
u0 (ct1 ) = u0 (ct ) f 0 (kt ).
This is known as the Euler equation.
One can get a nice economic interpretation of the equation by rewriting it as:
u0 (ct1 )
= f 0 (kt ).
u0 (ct )
This way the marginal rate of substitution in consumption on the left is equated to the
marginal rate of transformation of the consumption good on the right.
Infinite horizon (T = )
Now consider solving:
max
{ct }
t u(ct )
(7.8)
t=1
128
1) = V (k,
1000) = V (k,
t) k,
t. This
same infinite lifespan ahead. Formally, V (k,
implies that instead of a sequence of different value functions as in the finite horizon
case, there is only one value function with the single argument being capital: V (k).
The Bellman equation for (7.8) is written in exactly the same way as before:
V (kt ) = max{u(ct ) + V (f (kt ) ct )}
ct
and the factoring out procedure may be likewise replicated to yield the Euler equation:
u0 (ct1 )
= f 0 (kt ).
0
u (ct )
Notice that the Euler equations in both the finite and infinite horizon cases are
This
identical. Moreover, they are independent of the initial level of capital in t = 1, k.
is because the Euler equations are inherently about the differences in consumption
across adjacent periods, and they do not give any information about the level of
consumption (this point will be more clearly seen in the exercises).
Activity 7.1
variables.
The point of this problem is to think about the correct set of state
max
T
X
t u(ct ct1 )
t=1
7.6.2
Method 2. Finding V .
129
7. Dynamic programming
Example 7.2
AkT
1
1+
= 0.
cT 1
AkT1
Activity 7.2
s.t.
T
X
t=1
T
X
log at
at = k
t=1
at 0 t.
(a) Set up the Bellman equation.
(b) Solve by backward induction.
130
(7.9)
Activity 7.3
s.t.
T
X
t=1
T
X
1
1 + at
at = k
t=1
at 0 t.
Propose the quickest method of solving this problem. Solve it. Be very careful! (Hint:
check the SOC.)
s.t.
T
X
t=0
T
X
t=0
t u(ct )
ct
= W0
(1 + r)t
ct 0.
Assume that the utility function is twice differentiable and strictly concave (u00 < 0).
(a) In light of what you learned solving Activity 7.3 above, what is your intuition
about the solution?
(b) Derive the Euler equations. Was your intuition correct?
(c) For what values of r and can you obtain an exact answer without knowing the
functional form of u?
(d) Now assume that u(ct ) = ct . Provide the complete solution to the problem for
any and r.
Guess and verify approach for the infinite horizon case
When T = one cannot start in the last period and work backwards, since there is no
last period. Another possibility is to just guess a solution, and then verify that it is
correct. In practice, this method works only for a limited class of problems, where
utility/production functions are logarithmic, exponential or polynomial, but this is
enough for our purposes. The main idea is best grasped by means of an example.
131
7. Dynamic programming
Example 7.3
t log ct
t=0
(7.10)
ct
Akt ct
1 + F t
Notice that there are still unknown bits (F ) in this equation, however, we can still
substitute it into the evolution equation:
kt+1 = Akt ct =
AF
k .
1 + F t
Step 2. Here we verify our guess. If it was correct, then (7.10) should hold for
V (k) = E + F log k both on the left- and right-hand side:
AF
E + F log kt = log ct + E + F log
k
1 + F t
A
AF
= log
+ E + F log
+ (1 + F ) log kt .
1 + F
1 + F
This should hold as an identity (for all kt ). Hence, gather the similar terms on the
RHS and the LHS (constants apart from logs) and solve for E, F :
F = (1 + F )
A
AF
+ E + F log
.
E = log
1 + F
1 + F
132
1
1
E =
log A(1 ) +
log A .
1
1
F =
The mere fact that we are able to find the parameter values that make the Bellman
equation an identity confirms that our initial guess was correct.
The consumption on the optimal path is given by:
c=
A
k = (1 )Akt
1 + F t
a function of the current level of the state variable. This is called a policy function.
How does one hazard a guess for a value function? There are some empirical
regularities in that power utility functions generally result in power value functions,
polynomials in polynomials, logs in logs, exponentials and the like. However, beyond
these simple classes of functional forms your luck is likely to be very thin.
Fortunately, the examination questions wont make you hazard guesses that are
impossible to crack!
Another observation concerns over and underparamterisation. To overparameterise
the objective in the preceding example would mean, for instance, to add an extra
term Gk to the guess and work through the algebra as above. If we did so we would
necessarily have found that G = 0, though (check that you understand why). On the
other hand, underparameterising the guess by omitting a term that belongs there,
say, E would result in the failed identity in the last step of the calculation: there
would exist no value of F that would make the Bellman equation hold for all k.
Activity 7.5 Consider the intertemporal optimisation problem of an individual
endowed with wealth W0 and period 0 and no labour income. The individual gets
coupon payments on bank balance, at a gross interest rate R:
max
X
t=0
c1
t
1
t
133
7. Dynamic programming
T
X
t u(ct , st+1 )
t=1
The FOC w.r.t. to the new purchases of both non-durables and durables are:
uc (ct , st+1 ) = Vb (bt+1 , st+1 )
us (ct , st+1 ) pt Vb (bt+1 , st+1 ) + Vs (bt+1 , st+1 ) = 0.
(7.11)
(7.12)
Meanwhile two applications of the envelope theorem generate (here Vb and Vs stand
for partial derivatives of the value function):
Vb (bt , st ) = Vb (bt+1 , st+1 )(1 + r)
Vs (bt , st ) = (1 )[us (ct , st+1 ) + Vs (bt+1 , st+1 )].
Shift (7.11) back one period and combine it with (7.13):
uc (ct1 , st ) = Vb (bt , st )
uc (ct , st+1 ) = Vb (bt+1 , st+1 ).
Combine with (7.13):
uc (ct1 , st )
Vb (bt , st )
=
= (1 + r).
uc (ct , st+1 )
Vb (bt+1 , st+1 )
134
(7.13)
(7.14)
This is the usual Euler equation, which says that the marginal rate of
intertemporal substitution should equal the relative price of consuming across
time.
(7.12) implies:
us (ct , st+1 ) + Vs (bt+1 , st+1 ) = pt Vb (bt+1 , st+1 ) = pt uc (ct , st+1 )
while substituting this into (7.14):
Vs (bt , st ) = (1 )pt uc (ct , st+1 )
and back into (7.12):
us (ct , st+1 ) pt Vb (bt+1 , st+1 ) + (1 )pt+1 uc (ct+1 , st+2 ) = 0.
Substitute the Vb (bt+1 , st+1 ) term from (7.11) and uc (ct+1 , st+2 ) from the Euler
equation above:
us (ct , st+1 ) pt uc (ct , st+1 ) + (1 )pt+1
uc (ct , st+1 )
=0
(1 + r)
7.7
Solutions to activities
135
7. Dynamic programming
V (, t + 1)
V (, t + 1)
.
wt+1
ct
V (, t)
u0 (ct ct1 ).
wt
max
T
X
log at
t=1
s.t.
T
X
at = k
t=1
at 0 t.
(a) Rewrite in the dynamic programming form.
V (k1 , t) =
at ,kt+1
s.t. kt+1 = kt at ,
at 0, kt 0.
136
k
t
T
and:
1) = T log
V (k,
k
.
T
T +k
1 + Tk
The maximum is achieved by setting any one a = k and at = 0 for t 6= , yielding:
1
+ (T 1).
1+k
Solution to Activity 7.4
max
s.t.
T
X
t=0
T
X
t=0
t u(ct )
ct
= W0
(1 + r)t
ct 0.
(a) One might be tempted to guess that the optimal solution involves perfect
smoothing; ct = constant.
(b) The Euler equation:
u0 (ct1 )
= (1 + r).
u0 (ct )
Consumption need not be constant in general.
137
7. Dynamic programming
(c) Only for = 1/(1 + r) one can obtain the exact answer:
u0 (ct1 ) = u0 (ct )
implies ct1 = ct for all concave u().
(d) u(ct ) = ct . For 1/(1 + r) either c0 = W0 and the rest are zero, or cT = W0 and
the rest are zero. For = 1/(1 + r) any sequence of ct 0 is a maximising sequence.
Solution to Activity 7.5
max
X
t=0
c1
t
(1 )
c1
+ V (R[W c]) .
(1 )
(b) Guess:
V (W ) =
Then:
V (W ) = max
c
AW 1
.
1
(R[W c])1
c1
+ A
) .
(1 )
1
FOC:
c = AR1 (W c)
W
c =
.
1 + (AR1 )1/
(c) Verify:
AW 1
1
=
1
1
W
1+B
1
W 1 1 1+B
1
+ AR
1
1
1
Denote:
B = (AR1 )1/ .
From here one can solve for A:
1
A = (1 + B)
+B
1
1
1+B
1
A(1 + B)1 = 1 + B
A1/ = 1 + (AR1 )1/
A1/ = 1 1/ R(1)/ .
Thus:
c=
138
W
= W [1 1/ R1/1 ].
1 + (AR1 )1/
7.8
1. Solve:
max
s.t.
4
X
(4dt td2t )
t=1
4
X
dt k.
t=1
A complete solution consists of V (kt , t) and policy functions for each time period.
Take special care when dealing with corner solutions.
2. Bob has to read M pages of Simon and Blume in T days (1 < T < ). If on day t
he reads pt pages, then his disutility on that day is 2pt + p2t . There is no
discounting. Thus, Bob solves the following dynamic optimisation problem: choose
{p1 , p2 , . . . , pT } to minimise subject to:
T
X
(2pt + p2t )
t=1
s.t.
T
X
pt = M
t=1
pt 0, t = 1, 2, . . . , T.
139
7. Dynamic programming
t (ln ct + ln ct1 )
t=0
ct ,lt
Kt lt1
Ct .
(a) Convert the problem intoPan intertemporal optimisation problem with infinite
horizon (of the like max
t=1 u(Xt ) etc.).
(b) Make a guess about the functional form of V (Kt ) (Hint: notice the two logs in
the per-period utility). Write down the FOC w.r.t. Ct , simplify, and show that
the optimally chosen consumption-output ratio Ct /Yt is independent of Kt .
(c) Write down the FOC w.r.t lt and simplify.
(d) Substitute the optimal solutions Ct , lt found under the assumption that your
guess was correct into the Bellman equation. Verify your guess. Find
parameters (if any) that make your guess consistent.
(e) Complete the solution by providing experssions for the policy functions.
5. Consider the following model: an immortal gardener Firth characterised by CARA
preferences and living in a cherry orchard. Firth obtains utility from admiring
140
cheery blossoms bt and from consuming cherry jam, ct ; he discounts the future with
a constant factor (0, 1). By preparing jam, Firth has to sacrifice cherries that
otherwise would have given rise to more trees and more blossoms next year. If no
jam is made this year, cherry trees multiply by two. Firth likes the jam twice as
much as observing the blossoms. Thus the optimisation problem amounts to
choosing a jam-preparation sequence ct to maximise:
X
1 bt
ct
t
max
e e
{ct }
2
t=0
s.t. bt+1 = 2bt ct
b0 given.
X
t=0
ct
1
ebt
2
subject to the above constraints. Define control and state variables. Set up the
Bellman equation (be especially careful about the appropriate set of arguments
of the function V ()).
(b) Make a guess about the functional form of V (). Write the first order
conditions for the optimisation problem and obtain the policy function (up to
undetermined coefficients).
(c) Substitute the policy function back into the Bellman equation and verify your
guess. Find parameter values that are consistent with the guessed functional
form. Write down the resulting value function V () and the policy function.
7.9
1. Starting in period 4:
max{4d4 4d24 }
s.t. d4 k4
yields d4 = min{k4 , 1/2}. Hence:
V (k4 , 4) = max{1, 4k4 (1 k4 )}.
To avoid dragging the max with us into preceding periods, the fact that it is never
optimal to set d4 > 1/2 can be grasped by the constraint k4 1/2.
Period 3:
max{4d3 3d23 + 4(k3 d3 ) 4(k3 d3 )2 }
s.t. d3 + k4 k3
1
k4 .
2
141
7. Dynamic programming
One can again conjecture that there will be a maximum level of d3 , which is
obtained by:
2
arg max(4d3 3d23 ) = .
3
The maximum values of d3 and d4 sum up to the maximum useful level of k3 :
2/3 + 1/2 = 7/6. One proceeds to find an interior and a corner solution:
4
3
7
k3 , k4 = k3 k3 <
7
7
6
1
7
2
, k4 =
k3 .
=
3
2
6
d3 =
d3
13
6
13
.
6
Summing up:
d1 =
if k1 <
25
,
6
12
k1 ,
25
d2 =
d3 =
4
k1 ,
25
d4 =
otherwise:
d1 = 2,
142
6
k1 ,
25
d2 = 1,
2
d3 = ,
3
1
d4 = .
2
3
k1
25
2. Consider:
min
{pt }T
1
s.t.
T
X
(2pt + p2t )
t=1
T
X
pt = M
t=1
pt 0, t = 1, 2, . . . , T.
The minimisation problem is equivalent to maximising:
max
{pt }T
1
T
X
(2pt + p2t ).
t=1
Define mt as the number of pages left to read at the beginning of period T and
define the Bellman value function as:
V (m, ) = max
{pt }T
1
s.t.
T
X
[(2pt + p2t )]
t=
t = pt = m.
s.t. m +1 = m p .
(a)
V (m, T ) = (2m + m2 )
V (m, T 1) = max{(2pT 1 + p2T 1 ) + V (m pT 1 , T )}
pT 1
143
7. Dynamic programming
Verifying:
m
V (m, ) = (T + 1) 2
+
T +1
m
T +1
2 !
= max{(2p + p2 ) + V (m p , + 1)}
p
(
2 !)
m
p
m
+
.
= max (2p + p2 ) (T ) 2
p
T
T
p =
m
.
T +1
m
T +1
2 !
which is the same as the LHS. Hence, the Bellman equation is satisfied.
3. (a)
V (kt , ct1 ) = max{ln ct + ln ct1 + V (kt+1 , ct )}
s.t. ct + kt+1 Akt .
(b)
V (kt , ct1 ) = E + F ln kt + G ln ct1
max{ln ct + ln ct1 + E + F ln(Akt ct ) + G ln ct }.
The FOC is:
F
G
1
+
= 0.
ct Akt ct
ct
1 + G
Ak .
1 + G + F t
(c)
E + F ln kt + G ln ct1 = ln ct + ln ct1 + E + F ln(Akt ct ) + G ln ct
F
1 + G
= (1 + G + F ) ln A + F ln
+ (1 + G) ln
1 + G + F
1 + G + F
+(1 + G + F ) ln kt + ln ct1 .
G =
1 +
.
1
F
1 + G
E = (1 + G + F ) ln A + F ln
+ (1 + G) ln
1 + G + F
1 + G + F
1 +
=
ln A + (1 + )
ln() + (1 + ) ln(1 ).
1
1
F = (1 + G + F ) =
144
4. (a)
max
t [ln Ct + b ln(1 lt )]
t=1
=0
Ct
Yt C t
Ct
1
=
Yt
k + 1
1 lt
Yt Ct l
Y
Yt
k
= (1 )
= (1 )
l
l
lt
b
k
Yt
+
(1 ) = 0
1 lt
Yt Ct lt
lt
k (1 ) Yt
=
1 lt
b
Yt C t
1
b
Ct
=
1
+1
lt
k (1 )
Yt
k
b
+1
k (1 ) k + 1
=
=
b
+ 1.
(k + 1)(1 )
(d) Substituting the values from (b) and (c) into the Bellman equation:
V (Kt ) = ln Ct + b ln(1 lt ) + ( + k ln Kt+1 )
Yt
K t lt1
Ct =
=
k + 1
k + 1
1
1
Kt+1 = Kt lt
1
k + 1
1
b
b
1 lt = 1
+1
=
.
(k + 1)(1 )
b + (1 )(k + 1)
145
7. Dynamic programming
V (Kt ) = ln(k + 1) + ln Kt + (1 ) ln lt
+b{ln b ln[b + (1 )(k + 1)]} +
k [ln(k ) ln(k + 1) + ln Kt + (1 ) ln lt ]
= + + K ln Kt .
Consistency requires:
(1 + K ) = K
K =
as well as:
1
ln 1
+ 1
ln 1
=
1
1
b ln b ln b + 1 + ln(1 ) + 1
ln()
=
.
1
b ln b ln b +
1
1
1
1
b(1 ) + 1
1 + 1 (1 )
Ct
1
=
= 1
Yt
1 + 1
Ct = (1
)Kt lt1
= Ct = (1
)Kt
1
b(1 ) + 1
ct
1 bt
ct 2bt
e e
.
2
ln()
.
2
(c)
1
bt
= e e ebt
2
p
1
= 2 ebt ebt .
2
146
1
.
1
+
2
p
1
= 2 + 4 2 + 2 + .
2
= 2
147
7. Dynamic programming
148
Chapter 8
Ordinary differential equations
8.1
Learning outcomes
By the end of this chapter and the relevant reading, you should be able to:
explain the notions of an ordinary differential equation and of the family of
solutions
solve first order separable differential equations in closed form
solve homogeneous and non-homogeneous second order differential equations in
closed form
conduct the stability analysis of a steady state
linearise non-linear system of differential equations around a steady state
draw phase portraits for one- and two-dimensional differential equations
use the logic of rational expectations to analyse dynamical systems in
macroeconomics.
8.2
Essential reading
8.3
Further reading
8.4
Introduction
149
8.5
8.5.1
Definition 32
An ordinary differential equation (ODE) is given by:
y = F (y, t).
Example 8.1
(8.1)
Notice that (8.2) solves (8.1) for any constant c. As we will see later, ODEs have
families of solutions rather than unique solutions. The solution family (8.2) is
one-dimensional and parameterised by a single parameter c.
ODEs may involve higher order derivatives of the unknown functions, for example:
d2 y
dy
= 3 2y + 2.
2
dt
dt
Definition 33
An equation involving higher order derivatives of the unknown function of a single
variable t:
y [j] = F t, y, y,
. . . , y [j1]
is called a jth order ODE.
150
In order to reduce clutter in the formulae, it is customary to use the following notation
for first, second, and higher order derivatives of a function of a single argument:
y +
dy
,
dt
y +
d2 y
,
dt2
3
... d y
y + 3.
dt
8.5.2
Stationarity
Definition 35
Consider a first order ODE:
y = F (y, t).
The equation is called autonomous or stationary if t is not an explicit argument of
the right-hand side:
y = F (y).
Otherwise, the equation is time-dependent, for example:
y = t2 y.
We have already seen the stationary equation x = x with the parameterised solution
x = cet . The coefficient at x can be time-varying: x = (t)x, in whichcase the
Rt
equation is non-stationary, but the solution can be found as x = c exp 0 (s) ds as
long as (s) can be integrated in closed form (verify this).
151
8.5.3
Staying within the class of linear equations, a harder problem is posed by equations
with extra additive terms:
x = a(t)x + b(t).
Equations with a term b(t) are often called non-homogeneous (even for b(t) constant).
Whenever a(t) and b(t) explicitly depend on t, the equation is non-stationary.
A solution to a non-homogeneous equation is found as a sum of a general solution,
which is the solution to the homogenised equation x = a(t)x and a particular solution,
which is an arbitrary solution to the original non-homogeneous equation, and is most of
the time guessed. Here is an example of solving a non-homogeneous but stationary
equation in the context of a bank balance problem.
Example 8.2 You are planning your finances for the next sixty years. For the first
thirty years, interest rates are 6% per annum. For the next thirty years, they are 8%
per annum. Assume that you save continuously at a rate of 600 per year and the
interest is compounded continuously. How much will accumulate at the end of 60
years?
Denote current account balance at t by y(t). The equations for the evolution of the
bank balance can be written for the two separate time periods as follows:
y = 0.06y + 600 for t [0, 30]
y = 0.08y + 600 for t [30, 60].
The general solution for the homogeneous part of the first equation is y(t) = c0 e0.06t .
Guess a particular solution as y(t) = b = constant.
y = 0 = 0.06b + 600 b = 10000. So:
y(t) = c0 e0.06t 10000 for t [0, 30].
To find the constant c0 , impose:
y(0) = c0 10000 = y0 c0 = y0 + 10000.
Hence:
y(30) = (y0 + 10000)e1.8 10000.
For t [30, 60], a particular solution is y(t) = b2 = constant. Substituting into the
ODE, 0 = 0.08b2 + 600 b2 = 7500. The general solution of the homogeneous
equation is c1 e0.08t . Thus:
yt = c1 e0.08t 7500 for t [30, 60].
Impose the initial condition:
y(30) = c1 e2.4 7500 = (y0 + 10000)e1.8 10000
c1 = (y0 + 10000)e0.6 2500e2.4 .
This yields the expression for y(t) for t [30, 60], y(t) = c1 e0.08t 7500. Evaluate at
60:
y(60) = (y0 + 10000)e4.2 2500e2.4 7500
31628.39 + y0 66.6863.
152
8.5.4
Separable equations
Definition 36
A differential equation y = F (y, t) is called separable if the RHS can be written as
a product:
y = F (y, t) = g(y)h(t).
Examples of separable equations:
y = y 2 t1/2 ,
y =
ln t
,
y
y = y 2 + 1.
y = y 3 +
t.
dy
=
y2
which can be integrated in closed form as:
Z
cos t dt.
1
= sin t + c
y
where c is an arbitrary constant of integration. Simplifying this:
y=
1
.
c sin t
Notice that integrating and inverting negative powers of y assumes that y = 0, but
additionally it is easy to check that y 0 also solves the original equation (8.3).
Remark See Example 24.8 in Simon and Bume, Mathematics for Economists (W.W.
Norton, 1994).
153
Activity 8.1
(a) y = t, y(0) = 2
(b) y = 3y, y(0) = 10
(c) y = y(2 3y), y(0) = 4
(d) ty(t)
= y(1 t). Find the solution passing through the point (t, y) = (1, 1/e).
8.6
8.6.1
x + x + x = 0.
(8.4)
154
(8.5)
The family of solutions has two degrees of freedom. In many applications one has to
find a unique solution to satisfy certain conditions, for example, initial conditions for
the function itself and its derivative: x(t0 ) = x0 , x0 (t0 ) = z0 . These conditions exhaust
the two degrees of freedom and lead to a unique solution of k1 , k2 . Alternatively, one
may have to deal with a Cauchy (boundary values) problem: x(t0 ) = x) , x(t1 ) = x1 .
Remark See also example 24.13 in Simon and Blume, Mathematics for Economists
(W.W. Norton, 1994).
Real equal roots
Suppose r1 = r2 , then the family of solutions is given by:
x(t) = k1 er1 t + k2 ter1 t .
(8.6)
Notice the term t premultiplying the second term. We know k1 er1 t is a valid solution to
the ODE, so it suffices to verify k2 ter1 t :
x = k2 r1 ter1 t + k2 er1 t
x = k2 r12 er1 t + k2 r1 er1 t + k2 r1 er1 t
= k2 r12 ter1 t + 2k2 r1 er1 t .
x + x + x =
=
=
=
The last equality follows from the fact that for a double root:
r=
( 2 4)1/2
= .
2
2
8.6.2
x + x + x = g(t).
(8.7)
To characterise the family of solutions suppose that at least one solution is known,
xp (t). This will serve as a particular solution.
155
x + x + x = 0
is called the general solution of (8.7) and is given by (8.5) or (8.6).
We claim that the entire family of solutions to (8.7) is given by xp (t) + xg (t). To verify
this, substitute into (8.7):
(xp + xg ) + (xp + xg ) + (xp + xg )
= (
x + xp + xp ) + (
g + xg + xg )
= g(t) + 0 = g(t).
How does one go about finding xp (t)? Sometimes this is purely a matter of luck with
the method of undetermined coefficients. In general, one conjectures a sufficiently
flexible parameterised functional form resembling the function on the RHS of (8.7): for
k (t), a polynomial of the same degree.
example for a polynomial g = k (t) try xp (t) =
t
For an exponential function g = e try xp (t) = ket , for a logarithmic g = log t a
generously parameterised guess is xp = t2 log t + c1 t log t + c2 log t + c3 t + c4 . Notice that
overparameterisation is not a problem for the method, as the coefficients that should
not have been there will come out as zeros upon imposing the identity (think: why?).
Activity 8.2
(a) y 00 y 0 6y = 0
(b) 2y 00 + 3y 0 2y = 0
(c) y 00 3y 0 + 2y = 0
(d) y + 14y + 13y = t
(e) y 00 3y 0 + 2y = ex
(f) y 00 3y 0 + 2y = (x + 1)2 .
Activity 8.3
8.6.3
Phase portraits
So far we focused on solving ODEs in closed form. This, however, is often not possible.
Instead we could learn a lot about the behaviour of a model described by an ODE in
purely qualitative terms. Consider a non-linear equation:
x = (1 x)x(x + 1).
156
(8.8)
1
(where well-defined) and x(t) 0
1 + ce2t
(verify this).
1
1 + ce2(t+s)
= p
1 + (ce2s )e2t
1
.
1 + ce2t
In the applied context a researcher might be interested in the behaviour of the system
when restarted at a particular point.
Definition 37
To restart system at y0 at time t0 means to analyse the solution with an initial
value condition y(t0 ) = y0 .
If x denoted, say, national debt level, it would be meaningful to ask what would happen
to a country that initially had neither debt nor foreign assets. The diagram depicts the
constant solution x 0, thus we would expect that foreign asset position to prevail.
However, if the country at any given time starts with a small but positive level of
debt, it would asymptotically converge to the level given by 1 (unspecified unit). If the
debt level is negative (the country is a net creditor to the rest of the world), it is
expected to fall to 1; if the debt level is above 1 in absolute value, it is expected to
157
regress back to either positive or negative steady state 1 (the above statements do not
follow from any actual model of foreign debt and are purely for illustrating the concept
of qualitative analysis). Clearly the diagram helps uncovering important qualitative
properties of the model, but it is also quite redundant in doing so. It would be easier to
observe the sign of the function on the RHS, f (x) = (1 x)x(x + 1) to achieve the same
end, as made evident by Figure 8.2. The arrows show the direction in which the system
should evolve according to the differential laws of motion (this is the synonym for the
ODE).
To make the same information even more succinct, omit the graph of the function f (),
leaving only the indication of its sign (embodied in the arrows). We have Figure 8.3.
This figure is the phase diagram of the stationary equation (8.8). The space of the
values taken by the endogenous variable (the unknown function of time) is called the
phase space.
8.6.4
Figures 8.2 and 8.3 above highlighted a special nature of certain points in the phase
space. At points 0 and 2 the system described by (8.8) is expected to rest forever.
Recall that we call the constant solutions steady states, and we extend the use of the
term to the actual constant values these solutions take. In many applications it is of
interest whether the system is expected to return to a steady state if it accidentally
leaves it (in the formal language of the theory of ODEs, we are interested in the
behaviour of the system restarted at various points away from the steady state, to see
158
8.7
Systems of equations
We speak about systems of equations whenever there are two or more interdependent
differential equations, for example:
x = F (x, y, t)
y = G(x, y, t).
Systems of the first order equations are particularly important in the analysis because
higher order equations can be tranformed into (systems of) lower order equations as
shown below.
Consider the single equation:
y = F (y,
y, t).
(8.9)
8.7.1
(8.10)
(8.11)
Without loss of generality, assume 6= 0 and express y through x and x from the first
equation.
x x
.
(8.12)
y=
x x
x x
= x + y = x +
.
159
Substituting the resulting expression for y into (8.11), we obtain a second-order linear
equation in x, which we know how to solve:
x ( + )x
+
x = 0
x ( + )x + ( )x = 0.
The characteristic values are:
r1,2 =
p
2 + 2 + 2 4( )
.
2
c1 r1 er1 t c2 r2 er2 t r1 t r2 t
+
c1 e c2 e
=
c1
c2
r1 t
r2 t
=
(r1 )e + (r2 )e .
y =
Since c1 and c2 are arbitrary constants, we can multiply both expressions by to get an
equivalent representation:
x = (c1 er1 t + c2 er2 t )
y = c1 (r1 )er1 t + c2 (r2 )er2 t .
In vector notation:
x
y
= c1
r1
r1 t
+ c2
r2
er2 t .
ri a
160
Activity 8.4
8.7.2
x = y
The
y = x.
x = c1 et + c2 et
y = c1 et c2 et .
How would the contours traced by individual solutions (x(t), y(t)) look like, if projected
onto (x, y) plane? It helps to notice that:
2c1
xy
= et =
2c2
x+y
hence:
(x y)(x + y) = 4c1 c2 = constant.
For an arbitrary value of the constant this equation describes a phase curve traced by a
given solution. As known from geometry, the curves defined by a quadratic equation like
this are hyperbolae (see Figure 8.4). The arrows show the direction in which the
solution is evolving through time. Notice that exactly two phase curves are straight
lines (the diagonals): they correspond, respectively, to the cases when c1 = 0 and c2 = 0.
Also notice that along the negative sloped diagonal the system is converging toward
the steady state at the origin (limt+ x(t) = limt+ y(t) = limt+ c2 et = 0), while
along the positive sloped diagonal, the system is diverging (x = y = c1 et +).
Stability of steady states (linear systems)
Having a phase portrait helps determine the stability properties of steady state(s).
Inversely, knowing the possible cases with respect to the stability properties helps
sketching an accurate phase portrait. Let us investigate the analytics of the stability
and describe possible genera of steady states.
x = x + y + u
y = x + y + v.
Steady state (x0 , y0 ):
x = x0 + y0 + u = 0
y = x0 + y0 + v = 0.
Stable if a solution with initial point in a neighbourhood of (x0 , y0 ) converges to (x0 , y0 ).
161
x
y
r1 t
= c1~v1 e
r2 t
+ c2~v2 e
+
x0
y0
.
(8.13)
162
t+
8.8
163
By the continuity principle, the solution to this approximate equation will be very close
to the true solution.
Linearisation is mostly done around steady states. Then f (x0 ) = 0. (Why?)
x = f 0 (x )(x x ).
Since the solution of the linearised equation is close to the true one, the stability
property is verified by observing the sign of the linear coefficient in f:
x is stable f 0 (x ) < 0.
Two-dimensional case:
x
y
=
F (x, y)
G(x, y)
F (x, y)
F (x, y)
F (x, y) F (x0 , y0 ) +
(x x0 ) +
(y y0 ).
x x0 ,y0
y x0 ,y0
Now, for both functions F and G:
F (x, y)
F (x, y)
F (x, y) F (x0 , y0 ) +
(x x0 ) +
(y y0 )
x x0 ,y0
y x0 ,y0
G(x, y)
G(x, y)
G(x, y) G(x0 , y0 ) +
(x x0 ) +
(y y0 ).
x x0 ,y0
y x0 ,y0
At any steady state F (x0 , y0 ) = G(x0 , y0 ) = 0:
F (x, y)
F (x, y)
(x x0 ) +
(y y0 )
F (x, y)
x x0 ,y0
y x0 ,y0
G(x, y)
G(x, y)
G(x, y)
(x x0 ) +
(y y0 )
x x0 ,y0
y x0 ,y0
or:
F (x, y) a(x x0 ) + b(y y0 )
G(x, y) c(x x0 ) + d(y y0 )
(x,y)
which highlights the fact that coefficients such as a = Fx
164
8.9
This is perhaps the topic that is least covered in textbooks. The skills for studying
rational expectations dynamics are usually passed on in classes and tutorial meetings by
means of examples. Here is one such example.
8.9.1
Phase portrait
In what follows we will illustrate how the ODE theory can help us trace the effects of
either unanticipated or pre-announced fiscal expansion in a typical macroeconomic
model. The model is described by the following equations:
yt
mt pt
pt
rt
=
=
=
=
rt + ft
(IS)
yt Rt
(LM)
(yt y)
(Phillips curve)
[rt (Rt pt )]
(no arbitrage)
All the economic variables in this sytem and used in logs, in fact it is a long-followed
convention to denote levels of variables, such as output Y , by uppercase letters, and
their logs by lowercase ones, for example, y = log Y . yt stands for the (log of) potential
output, pt is the log of the price level, mt is the log of the money stock, Rt is the
nominal short-term interest rate (on bonds), rt is the real long-term interest rate (on
business shares), and ft is the log of net public expenditure. Coefficients , , , and
are positive constants, further, assume for simplicity / = .
The IS equation captures the negative response of investment to the higher long-term
yield and the positive response of aggregate demand to the fiscal stimulus. The LM
equation describes the equilibrium in the money/bond market. It is assumed that the
aggregate price level pt can only change slowly (prices are sticky), without
discontinuous jumps. The rate of change in the price level is given by the Phillips curve
as increasing in the output gap, the discrepancy between the actual and potential
output.1 Finally, the last equation is the condition ensuring that no windfall profits
could be made exploiting gaps between the yields on bonds and shares.
1
If you are curious about why this is a reasonable assumption, consider the fact that the price level
165
There are four endogeneous variables in this model: yt , Rt , rt , pt . However, only the
latter two variables enter the equilibrium equations with their time derivatives. We
want to reduce the dimensionality of the system to analyse a system of pure differential
equations. To do that we begin by factoring out yt , Rt :
pt = (rt + ft y)
rt
mt pt
= [rt (Rt pt )] = rt +
y .
Thus we end up with a system in two equations and two unknowns, p and r. The above
system is called a dynamical system. ft and mt are exogenous variables, and although
potentially time-varying, they are not forced to evolve due to equilibrium conditions of
the problem (the same actually goes for y). We will consider the equilibrium dynamics
for preset fixed values of f and m, thus omitting the time subscript until we explicitly
consider an experiment with a change in either variable. Our first objective is to draw
the phase diagram of the system on the plane (space p, r). One familiar possibility is to
solve the equations explicitly, however, a heuristic method discussed below achieves the
same ends with fewer calculations and is at the same time more insightful. We proceed
to draw the two stationary paths, or loci of points on the phase plane, where either
p = 0, or r = 0. The expressions for these are given by:
p = 0
rt = 0
f y
pt m
rt =
+ y.
rt =
(8.14)
(8.15)
One of the stationary paths is horizontal, the other is upward-sloping as evident from
the expressions.
The next step involves graphing the differential laws of motion. Consider point X. Since
this point is located below the locus p = 0, its r coordinate is lower than on the locus.
With a slight stretch of notation, we denote this fact by r|X < r|p=0
. Consequently, it
must be that:
p|
X = (r|X + f y) > (r|p=0
+ f y) = 0.
This allows us to conclude that the ODE solutions passing through point X must have
increasing price level. We capture this graphically with an arrow pointing to the right
in the direction of increasing p.
Now, compare point X with point Z directly above it, lying on the r = 0 locus. X and
Z have identical p coordinate, but r|X < r|Z .
mp
mp
y < r|Z +
y = 0.
r|
X = r|X +
Hence, the interest rate along the ODE solutions passing through point X must be
declining. We capture this graphically with an arrow pointing downwards, . As a
result we have two arrows protruding from X. We can likewise repeat the same
is actually an average of a multitude of individual prices of goods. These individual prices may of course
change discontinuously reacting to events, but if only a small fraction of these are adjusted at any given
moment, the average will evolve slowly. The lower the proportion of individual price setters who adjust
their prices, the greater the degree of inertia the aggregate price level displays.
166
Figure 8.5: Phase diagram of the macroeconomic model with sticky prices.
167
procedure for any point on the plane, however, a simple realisation is that as long as
points lie on the same side of a locus r = 0, they have the same sign of r,
and as long as
points lie on the same side of a locus p = 0, they have the same sign of p.
Hence we can
easily put arrows corresponding to the laws of motion in all four quadrants of the plane
divided by the two stationary paths.
Observing the directions of laws of motion provides us with an idea of the stability
properties of the solutions to the system of equations (dynamical system, for short).
The saddle path can only pass through the Southwestern and Northeastern quadrants
of the plane (where the arrows pointing towards the steady state are consistent with the
graphed laws of motion). Likewise, the divergent path must pass through the
Northwestern and Southeastern quadrants and have a negative slope. This only permits
a rough sketch as the exact slope of the stable and unstable arms cannot be deduced
from the arrows. However, this is sufficient for most purposes if we concentrate on
qualitative analysis. Even though it may seem somewhat non-rigorous, in reality this
heuristic method of sketching the two separatrices has never failed anyone (provided one
draws the arrows correctly).
The rest of the phase curves are added to the diagram in a straightforward fashion as
hyperbolae stretched on the rays of the separatrices, with the motion indicated by the
tiny arrows, away from the saddle path and towards the divergent path. This marks the
end of the mathematical preliminaries, from now on the analysis becomes distinctively
and essentially economic.
Let us see what happens to the system if there is a permanent fiscal expansion,
corresponding to an increase in f . For concreteness denote the time of the change by
t = 0.
First analyse the expressions for the stationary paths (8.14) and (8.15). Only the first
one is affected by the change in f : the corresponding locus shifts up. The new steady
state E 0 is located above and to the right of the old one O. However, if at t = 0 the
system is still at E, what is the adjustment dynamics? The mathematics of the ODEs
supplies us with a huge family of solutions, however, it does not suggest which solution
the system will actually trace when subjected to a shock like an increase in f . Two
important factors come into play to determine that: the jumping/slow-moving nature of
the endogeneous variables and the implications of rationality of the markets at all
points in time.
Slow-moving and jump variables
We have already highlighted the slows and inertial movement of the price index pt . In
the economics jargon this is called a slow-moving or a crawler variable. It cannot be
changed instantly, in zero time. In contrast, the other variable, the yield (interest rate)
on shares r can adjust immediately. The reason is that unlike markets for physical
goods with a lot of price inertia, stock exchanges resemble perfect markets much more,
so the prices of all shares can change instantaneously (for example, on receipt of good
news reports), thereby altering the yield. These particular assumptions are not set in
stone for the whole body of economics. In a different macromodel that does not assume
price rigidities the price level may be a jump variable. The mathematical modelling is
driven by the need to best capture a specific economic environment or phenomenon.
168
Among natural candidates for crawler variable in other contexts is capital stock, which
adjusts slowly for natural reasons (since this is a stock variable equal to the sum of the
flow investments, which are finite). On the other hand, an exchange rate in a flexible
exchange rate regime is a jump variable, it may change abruptly if the market sees as
reason for that.
Returning to the case of fiscal expansion, what does the fact that p is a crawler variable
imply for the adjustment dynamics? Merely that whichever phase curve is going to
describe the dynamics, at t = 0 it must be that p0 = p|E , in other words, the price level
cannot adjust immediately from its pre-expansion steady state level. On the other hand,
r can jump, and hence there are no restrictions at all on r0 .
Imposing the assumption of rational expectations
Consider Figure 8.6. The adjustment dynamics are still undetermined: from E, the
system may possibly jump to points A, B or C (among many others), thereafter
proceeding along very different phase curves. We will put forward an argument, which
shows that only a jump to the new saddle path is consistent with the rationality of the
economic agents.
For suppose not, and the system jumps to point A. If the system makes no further
discontinuous jumps, the joint evolution of r and p in the future will degenerate into
r +, p 0. The fact that the real rate of return on stocks r grows without bound
implies that the prices of stocks explode (grow faster than the exponential rate). This
means that in finite time the stocks will be worth more that the entire planetary
169
economy, and sooner or later stock holders will want to cash in to consume their gains,
only to find out that nobody would want to buy the stocks at that price. This is the
familiar end of a bubble scenario. The stock price will then have to adjust back to
realistic values, so the system will evolve along a different phase curve. However,
changing phase curves in the future is not allowed due to the no expected arbitrage
argument. A discontinuous adjustment in r and stock prices at a certain time t will
mean that there are arbitrage opportunities (an arbitrageur would like to sell stocks
short just prior to their devaluation and then buy them low right after the price crash).
Since the agents are rational, everyone would like to do the same thing, but that is
impossible as the aggregate supply of stocks is positive. Consequently, the price crash
would have to happen earlier than at t. The argument is prevented by attempts to
arbitrage it away leading to an earlier crash. The only time when the stock prices (and
consequently, r) may jump, is t0 . Why? Because we are dealing with an unexpected
fiscal policy change. No one expected it, hence, no one could arbitrage it away.
An argument along the same lines applies to a possible jump to point C. Along the
respective phase curve the prices of stocks are expected to shrink to zero. This would
have implied that a discontinuous price adjustment was expected in the future, which is
ruled out by the rational expectations argument.
To summarise, the only possible ODE solution that the system may assume at t0 is the
one in which it jumps onto the saddle path (point B). From there on the system
gradually moves to the new steady state E 0 (see diagram), asympototically reaching it
in infinity. Notice that the adjustment is discontinuous from E to B, and continuous
thereafter (from B to E 0 ).
A pre-announced expansion
The adjustment dynamics are different if the expansion is anticipated in advance.
Suppose the actual change in f does not come until t1 , but the market learns this news
at t0 < t1 . We will have two distinct phases:
t0 < t < t1 : the system obeys the differential laws of motion associated with the
old steady state E
t > t1 : the system obeys the differential laws of motion associated with the new
steady state E 0 .
The above means that if the system jumps up at t0 along the vertical line by any
distance (remember that p is still a crawler variable so not allowed to adjust
discontinuously), it will still be subject to the old system of ODEs and will have to
travel along the respective phase curves. The rational expectations argument, on the
other hand, implies that at t1 the system must be on the new saddle path. Moreover,
no discontinuous jumps in r are allowed after t0 . There is a unique adjustment path
(shown in bold) that satisfies all requirements (see Figure 8.7). The system would jump
to a point B roughly halfway between the old steady state and the new saddle path,
then travel along the (divergent) phase curve passing through B, arrive to a point on
the new stable arm exactly at t1 and then gradually move towards the new steady state
as before. The adjustment trajectory and the point B are unique. If the jump is too
small, say to point A, then by the time t1 the system will only have reached point A0 off
170
the saddle path, requiring a yield adjustment which cannot happen as explained in the
preceding subsection. Likewise, if the jump is too large, the system will travel too fast
and cross the saddle path before t1 (not depicted) again violating the no-arbitrage
requirement.
How do we know that the adjustment path through B exists? That it is unique? There
is no way to prove this graphically as the argument is essentially about the speed of
travel along the phase curves, while the phase diagram is unsuitable for gauging speed.
Formally, we need to apply two boundary conditions to our system of ODEs, one is that
pl0 = p|E and that rt1 satisfies the equation for the new saddle path. As we know, the
general family of solutions to ODEs is two-dimensional, the two boundary conditions
are necessary and sufficient to pick a unique solutions out of this family.
Activity 8.6 Consider a small developing open economy in which the official
foreign exchange market is over-regulated, and as a result the official, pegged
exchange rate coexists with the parallel rate freely determined in a black market.
The official rate applies to transactions authorised by the government, and in
practice (since the official rate may be set at an unrealistic level) means that
exporters are expected to bring in the hard currency proceeds and surrender some
proportion of these to the authorities at the official rate (they can repatriate the
171
remaining proceeds via the black market). All private transactions are made in the
black market. Agents are rational, and hold both domestic and foreign-currency
balances in their portfolios. Domestic output consists of a single exportable good
and is constant. The model is described by the following log-linear equations:
mp
m
p
R
=
=
=
=
s
R + (1 )d, 0 < < 1
s + (1 )e, 0 < < 1
(s e)
(8.16)
(8.17)
(8.18)
(8.19)
where m denotes the nominal money stock, d is (constant) domestic credit, R is the
stock of net foreign reserves of the central bank, p is the domestic price level, e is the
(exogenous) official exchange rate, and s is the black market (parallel) exchange
rate. (8.16) is the money demand equation (notice that s is the parallel depreciation
rate). (8.17) defines the domestic money stock (akin to M2) as a weighted average of
domestic credit and foreign reserves. (8.18) indicates that the price level depends on
the official and parallel exchange rates (suppose, the state imports certain goods and
sells to the public at subsidised prices, while the rest of the consumption basket
reflects the true cost of imports s). Finally, (8.19) describes the behaviour of
reserves. The negative effect of the black market premium (the difference between
the official and the parallel exchange rates) on reserves results from its impact on
under-invoicing of exports. The higher the parallel rate is relative to the official one,
the greater will be the incentive to falsify export invoices and to divert export
proceeds to the black market.
(a) Solve the system of (8.16) to (8.19) to obtain a system of ODEs in s, R. Draw
stationary paths and determine the steady state. Argue which endogenous
variable should be a jump variable and which a predetermined variable.
(b) Using the characteristic polynomial of the ODEs, analyse the stability properties
of the steady state. Graph stable/unstable arms of the system of ODEs.
(c) Suppose the system is initially in steady state. Consider an impact of
unanticipated domestic credit expansion (permanent increase in d). Analyse the
transition dynamics, draw time paths of all endogenous variables.
(d) (More difficult.) How would your answer to (c) change if the expansion was only
temporary and after some time period T , d went back to its initial level?
(e) Suppose the system is initially in steady state. Consider an impact of a
devaluation of the official exchange rate e. Analyse the transition dynamics,
draw time paths of all endogenous variables. (Warning: the details of the
adjustment depend on the relative position of the saddle path and the
stationary loci. In your solution, proceed under the assumption that the new
saddle path cuts below the old steady state.)
(f) (More difficult.) How would your answer to (e) change if the devaluation was
announced in advance (actual increaase in e happened T periods after the
announcement)? Draw detailed dynamics diagrams. Describe adjustment in
words.
172
8.10
Solutions to activities
d =
t2
+ c.
2
t2
t2
+ c = c y = 2 + .
2
2
t=0
(b) y = 3y, y(0) = 10. Separable equation, or just recall linear first order equation:
y(t) = ce3t .
ce3t t=0 = c = 10 y = 10e3t .
Solution to Activity 8.1
(a) y = y(2 3y), y(0) = 4. Separate the terms:
dy
= dt
y(2 3y)
Z
Z
dy
=
dt
y(2 3y)
Z
dy
=
y(2 3y)
=
=
=
=
1 3y + 2 3y
dy
2 y(2 3y)
Z
Z
1
dy
3 dy
+
2 (2 3y) 2
y
Z
Z
1 du 1
dy
+
(letting u = 2 3y, du = 3dy)
2 u
2
y
1
1
ln |y| ln |u| + c
2
2
1 y
ln
+ c.
2 2 3y
Z
Hence:
1 y
ln
+c = t
2 2 3y
y
2 3y = |K| exp 2t
y =
2Ke2t
1 + 3Ke2t
for K R.
173
1
e
y = Ktet , K = 1.
1
y(x) = Aex + Be2x + ex .
6
174
1 6x
(e + 10e5x ).
11
x = x + 2y
.
y = y + 2x + et
First solve the homogeneous system: the characteristic values are = 1, 3. So, by
repeated substitution:
x(t) = c1 e3t + c2 et
y(t) = c1 e3t c2 et .
Look for a particular solution xp = c3 et , yp = c4 et . Substituting into the system:
x p = c3 et = c3 et + 2c4 et = (c3 + 2c4 )et
y p = c4 et = c4 et + 2c3 et + et = (c4 + 2c3 + 1)et .
Solve for c3 , c4 to make these identities: c3 = 1/2, c4 = 0. Complete solution:
1
x(t) = c1 e3t + c2 et et
2
y(t) = c1 e3t c2 et .
Solution to Activity 8.5
(a)
x(8 4x 2y) = 0
.
y(8 2x 4y) = 0
Solutions:
x = 0, y = 0
x = 0, y = 2
y = 0, x = 2
4
x=y= .
3
175
(b)
x = 8x 4x2 2xy = F (x, y)
y = 8y 2xy 4y 2 = G(x, y)
F
x
G
x
= 8 8x 2y
= 2y
F
y
G
y
= 2x
= 8 8y 2x.
y
3
3
3
8
4
16
x
y
G(x, y)
3
3
3
4
3
4
.
3
Characteristic polynomial 2 + 32
+ 64
has two negative roots (8/3 and 8).
3
3
(c) (0, 0) is totally unstable. (2, 0) and (0, 2) have saddle-path property. (4/3, 4/3) is
locally unstable steady state.
176
(d)
=
=
=
s
R + (1 ), 0 < < 1
s + (1 )e, 0 < < 1
(s e).
(8.20)
(8.21)
(8.22)
(8.23)
(a) Factor out the other two endogenous variables m and p to get:
1
(1 )e (1 )d
[s R] +
R = s + e.
s =
(8.24)
(8.25)
s is the natural candidate for the jump variable (its a market price), while R is
predetermined (reserves are depleted/accumulated only gradually).
(b) Characteristic polynomial of the ODEs:
2
= 0.
There are two real-valued roots, one of them positive, one negative, hence the
steady state is semi-stable or saddle-path stable.
177
(c) s = 0 locus shift to the left. The economy responds by instantaneous increase in s
up to a point on the new saddle path directly above the old steady state. From
then on the economy is gradually moving along the saddle path to the new steady
state. RSS falls. No change in sSS . f
(d) For concreteness assume the increase in d happens at time t0 and d goes back at
t1 = t0 + T . The laws of motion pertaining to the system with temporarily high d
are only in force between t0 and t1 jumps so as to be on a phase curve (belonging
178
to the temporary system of ODEs), which at t1 will cross the saddle path
(belonging to the permanent system of ODEs). From then on the economy is
gradually moving along the saddle path to the old steady state.
(e) Devaluation is defined as an increase in e, the official exchange rate. From (8.24)
and (8.25), s = 0 locus shifts to the right, while R = 0 locus shifts up. The details
of adjustment depend on the relative position of the saddle path and the stationary
loci, which we do not make precise here. We proceed under the assumption in
parameters that the new saddle path cuts below the old steady state. In the
aftermath of the devaluation, parallel exchange rate s immediately drops (the
economy must be on the saddle path). From then on the economy is gradually
moving along the saddle path to the new steady state both s and R increasing.
(f) Again, for concreteness assume the devalation is announced at time t0 and actually
happens at t1 = t0 + T . At t0 parallel exchange rate s drops, and between t0 and t1
the system is moving along a phase curve (belonging to the old system of ODEs) so
179
as at t1 to be on the new saddle path, which takes the system to the new steady
state.
180
Chapter 9
Optimal control
9.1
Learning outcomes
By the end of this chapter and the relevant reading, you should be able to:
explain what is meant by an optimal control problem
form a Hamiltonian and produce the full set of necessary conditions for a maximum
in accordance with Pontryagins maximum principle
solve tractable optimal control problems by applying the maximum principle and
the relevant boundary conditions
explain the logic of the Ramsey-Kass-Coopmans model and the Tobins q model
draw phase diagrams for optimal control problems with one control and one state
variable
analyse the adjustment dynamics in dynamic micro-founded macroeconomic
problems.
9.2
Essential reading
9.3
Further reading
9.4
Introduction
In this chapter we study the solution techniques for the optimisation problems in
continuous time, traditionally known as optimal control problems. We apply the
181
9. Optimal control
9.5
9.5.1
We start with an abstract problem involving one control and one state variable, which
have the interpretation of consumption and capital.
Z T
max
f (ct , kt , t) dt
(9.1)
0
s.t. k t = g(ct , kt )
kT 0, k0 given.
We will consider T < . Note that the constraint has to be satisfied for all periods t
( t [0, T )). As in the discrete time case, kt is a state variable, ct is called the control
variable. Form the Lagrangian as if you were doing that for the discrete case:
Z T
[f (ct , kt , t) + t (g(ct , kt ) k t )] dt.
L=
0
RT
Now observe the trick. Integrate the term 0 t k t dt by parts:
Z T
Z T
T
t kt dt = t kt |0 +
t kt dt.
0
(9.2)
Let us assume for now that limtT t kt and limt0 t kt are finite, so that t kt |T0 is a
finite constant:
Z T
Z T
L =
[f (ct , kt , t) + t (g(ct , kt ) k t )] dt +
t kt dt t kt |
0
0
0
Z T
[f (ct , kt , t) + t g(ct , kt ) + t kt ] dt + constant.
=
0
L
L
= 0,
=0
ct
kt
fc () + t gc () = 0
fk () + t gk () = t .
The Hamiltonian is just a way of obtaining the same result without having to go
through the integration by parts reasoning.
Now define the Hamiltonian:
H(ct , kt , t , t) f (ct , kt , t) + t g(ct , kt )
182
(9.3)
(9.4)
where (t) is called a co-state variable (as k is a state variable). In terms of this
functional, the optimality conditions can be written as:
H
= 0,
ct
H
= t .
kt
= fc (ct , kt , t) + t gc (ct , kt ) = 0
= fk () + t gk () = t .
= k.
Finally, notice that at time T , there is no point in hoarding any capital. Therefore,
k(T ) = 0. There exist cases, however, in which the terminal value of the state variable
need not be zero (for example, if the consumer reaches the satiation point after which no
increases in consumption raise utility). The slightly more general condition is written as:
(T )k(T ) = 0.
(9.5)
The co-state variable (t) has an interesting and economically meaningful interpretation
as the marginal value of increasing the state variable at a given point in time t. A quick
exposition of this is contained in the appendix to this chapter.1 The control and state
variable distinction has the same logic as in the dynamic programming case. The
control variable is chosen freely (within an admissible range) in every instant, which
determines the evolution of the state variable. The state variable kt is therefore
predetermined at time t. It is even easier to distinguish the control and state variables
in the optimal control problems because the state variables and only those have an
associated dynamic constraint with k t on the LHS.
This is called the transversality condition that completes the list of necessary conditions
for a maximum. We now state the general theorem that encompasses various
assumptions on the end value k(T ).
Another potential reason for leaving behind non-zero capital k(T ) > 0 could be salvage value (for
example, one may sell the remaining capital on the market for second-hand equipment). We will mention
broader classes of problems with non-zero salvage value in Section 9.5 and observe how the transversality
condition is modified.
183
9. Optimal control
s.t. x t = ut
x0 = 0, x 0.
Necessary conditions for maximum:
Hu = 2ut t = 0
= Hx = et
2 x2 = 0.
The second equation implies = et + k1 for some constant k1 R. Plug this into
the first equation to obtain:
et k1
et k1
xt = + t + k 2
2
2
2
2
where k1 and k2 are unknown constants.
ut =
x0 = 0 implies:
1
+ k2 = 0.
2
2 x2 = 0 implies:
2
2
e
k1
e
k1
1
2
+ 2+
(e2 + k1 )
+ 2 + k2 (e + k1 ) =
2
2
2
2
2
1
=
(e2 + 2k1 + 1)(e2 + k1 ).
2
If x2 = 0, then k1 = (e2 1)/2, 2 = (e2 1)/2 e2 = (e2 1)/2 < 0 which
violates the optimality condition that t 0.
Hence the optimal solution has 2 = 0, k1 = e2 :
xt =
184
1
et e2
+ t+
2
2
2.
You may wonder if there is an analogue of the second order sufficiency conditions for
maximisation as in the Lagrange theory. There are indeed theorems that impose certain
concavity or convexity requirements on the functions f () and g(), (t) or c (t) and x (t)
guaranteeing that the maximum is reached; however, these sufficiency conditions are
very demanding and quite often fail to be met by valid optimal solutions. The appendix
to this chapter gives examples of these conditions, but in the guide we will just use
direct comparison to claim that a given trajectory attains the maximum of the objective
function.
9.5.2
If in the problem (9.1) T = , the optimality condition and the co-state equation are
still necessary conditions for a maximum. Under certain conditions, although not
always, the condition (9.5) extends naturally to the infinite horizon case, T = :
lim (t)k(t) = 0.
While this condition is applicable in a wide variety of regular cases, there are some
exceptions. Examples of the regularity conditions under which the transversality
condition is necessary are mentioned in the appendix to this chapter. In the application
considered in this guide we will not need to impose the condition to reduce the
generality of candidate solutions.
Activity 9.1
(a) Set up the Hamiltonian. Write down the necessary conditions for maximum.
(b) Manipulate the conditions in (a) to obtain a system of first order linear
differential equations in x and the control variable u.
(c) Explicitly solve the system in (b) for the family of solutions of the ODE for x
and u. How many dimensions does this family have?
(d) Which conditions should you impose to identify the particular solution (out of
the family in (c)) that is consistent with the optimality principle?
9.6
Ramsey-Cass-Koopmans model
The model presented in this section has been built in the 1920s by Frank Ramsey to
answer the question of how much a nation should save. It is now the standard prototype
for studying the optimal intertemporal allocation of resources.
Consider an economy populated by Nt people, with Nt growing exponentially at rate n.
The labour force is equal to the population (no labour force participation decisions).
185
9. Optimal control
Output is produced using capital, K and labour (1 unit per agent). There is no
productivity growth.
The output is either consumed or invested:
Yt = F (Kt , Nt ) = Ct + Kt .
For simplicity, we assume that there is no physical depreciation of capital, or that Yt is
net rather than gross output. The production function exhibits constant returns to scale.
We first rewrite the model in per capita terms (the reason for that will become clear in
the end):
Kt
F
, 1 = f (kt ) = ct + k t + nkt
Nt
where lower case letters denote per capita values of variables so that k is the
capital-labour ratio; we assume f (kt ) to be strictly concave and to satisfy the so-called
Inada conditions:
f (0) = 0, f 0 (0) = , f 0 () = 0.
The preferences of the agents for consumption over time are represented by the present
discounted value of utility:
Z
U=
u(ct )e(ts) dt.
s
The function u() is known as the instantaneous utility function, or felicity; u() is
non-negative and a concave increasing function of the per capita consumption. The
parameter is the rate of time preference or the subjective discount rate, assumed to be
strictly positive.
9.6.1
Suppose that a central planner wants at time t = 0 to maximise collective welfare. The
only choice that has to be made at each moment of time is how much the representative
individual should consume and how much it should add to the capital stock to provide
consumption in the future. The planner has to find the solution to the following
problem:
Z
u(ct )et dt
(9.6)
(9.7)
max U0 =
0
Using the maximum principle, the solution is obtained by setting up the Hamiltonian
function:
Ht = u(ct )et + t (f (kt ) ct nkt ).
The variable t is the co-state variable associated with the state variable k. The value of
t , as you recall, is the marginal value (in present value terms) of an additional unit of
capital at time t.
186
(9.8)
(9.9)
(9.10)
ct
= + n f 0 (kt ).
ct
(9.11)
You may recognise the term in parentheses as the Arrow-Pratt coefficient of relative risk
aversion (CRRA). Most of the time we will use the CRRA class of utility functions, for
00
which uu0(c(ctt)c) t = constant = :
f 0 (kt ) n
ct
=
.
ct
(9.12)
In this case the change in consumption is proportional to the excess of the marginal
product of capital (net of population growth) over the discount rate. You can verify
00
that for u(c) = ln c, uu0(c(ctt)c) t 1.
9.6.2
The optimal path is characterised by (9.10), (9.11) and the constraint (9.7). We start
with the steady state. In steady state both the per capita capital stock, k, and the level
of consumption per capita, c, are constant. We denote the steady state values of these
variables by k and c , respectively:
f 0 (k ) = + n
c = f (k ) nk .
Notice, that in the steady state, ultimately, the productivity of capital, and (thus the
real interest rate), is determined by the rate of time preference and n. Tastes and
population growth determine the real interest rate + n, and technology then
determines the capital stock and level of consumption consistent with that interest rate.
187
9. Optimal control
9.6.3
Dynamics
To study dynamics, we use the phase diagram, drawn in (k, c) space. All points in the
positive orthant except the points on the vertical axis, are feasible: without capital,
output is zero, and this positive c is not feasible.
The locus k = 0 starts from the origin, reaches a maximum at a certain level (known by
the special name golden rule), and crosses the horizontal axis at point A where
f (k) = nk. The c = 0 locus is, from (9.12), vertical.
Anywhere above the k = 0 locus, the capital-labour ratio k is decreasing: consumption
is above the level that would just maintain k constant. Similarly, k is increasing at
points below the k = 0 locus. In the case of the c = 0 locus, consumption is increasing
to the left of the locus, where f 0 (kt ) > + n, and decreasing to the right of the locus.
The vertical arrows demonstrate these directions of motion.
The system has three steady states, the origin, point E and point A, however, for any
starting values of k, only the trajectory DD, the saddle path that converges to E,
satisfies the necessary conditions (9.7), (9.10) and (9.11). On all other paths, either
(9.11) eventually fails (phase curves to the left of DD) or the transversality condition is
not satisfied; finally, paths like DD00 can be improved upon in a straightforward fashion
by simply increasing consumption at all times.
The central planners solution to the optimising problem (9.6) is fully summarised by
the path DD. For each initial capital stock, this implies a unique initial level of
consumption. For instance, with initial capital stock k0 , the optimal initial level of
consumption is c0 . Convergence of c and k to c and k is monotone. Notice that the
solution to the optimisation problem (9.6) is stationary in per capita terms, however, it
188
is trending in terms of total levels of capital and consumption, growing at the same rate
as population. Had we not restated the problem in per capita terms, we would have had
to deal with a non-stationary system of non-linear differential equations, an
overwhelming task. By transforming the problem to a stationary one we were able to
use the phase diagram apparatus for the analysis.
9.6.4
Linearisation of the dynamic system (9.12), (9.7) yields further insights into the
dynamic behaviour of the economy. Linearising both equations in the neighbourhood of
the steady state gives:
c = f 00 (k )c (k k )
= (k k )
and:
k = [f 0 (k ) n](k k ) (c c )
= (k k ) (c c ).
The characteristic matrix for the system in (c, k) is given by:
0 f 00 (k )c
.
1 f 0 (k ) n
The characteristic polynomial is:
z(f 0 (k ) n z) + f 00 (k )c = z 2 + (f 0 (k ) + n)z + f 00 (k )c .
Since f 00 < 0, the last coefficient in the polynomial is negative, hence the roots are of
different sign: one root is positive and the other negative. This implies the saddle point
property of the (c , k ) steady state.
Activity 9.2 While discussing the Ramsey model we have analysed the planners
solution. Consider now an individual optimisation problem, in which the resource
constraint is given by k = w + rk c nk (flow of income consists of wage receipts
and interest on shareholdings). Firms produce using production function
F (K, N ) = N f (k) and hire factors of production at wage rate w and interest rate r,
determine in a perfectly competitive market. Set up the Hamiltonians of the
individual optimisation problem and derive optimality conditions. Compare them to
(9.9) and (9.10) above. What do you find?
9.6.5
Now let us introduce government fiscal policy into the standard Ramsey model:
Z
max U0 =
u(ct )et dt
0
s.t. k t = f (kt ) ct
k0 > 0 given
189
9. Optimal control
sHc = 0
Hk
lim kt t
(9.13)
(9.14)
(9.15)
(
c
+
c
)
=
.
t
t
1
ct
t
et ct
Now use (9.14) to factor out t /t :
1
(ct + ct ) = k(t)1
ct
ct
= kt1 .
ct
The steady state values k , c solve:
(k )1 =
c = (k ) g.
Linearising both equations in the neighbourhood of the steady state gives:
c = f 00 (k )c (k k )
= (k k )
where = (1 )(k )2 c , and:
k = f 0 (k )(k k ) (c c )
= (k k ) (c c ).
The k = 0 locus is no longer hump-shaped, it is monotone increasing and is shifted
down by the magnitude of g (see Figure 9.2).
Assume the economy is in steady state. Consider an unanticipated increase in parameter
g from g0 to g1 > g0 . The economy will experience an instantaneous jump down to the
new steady state (consumption falls with unchanged capital stock, see Figure 9.3).
Again, assume the economy is in steady state. Consider instead that the increase in g
happens at t1 > t0 while the news of the future change arrives at t0 . The economy will
experience a smaller jump down, as c decreases, then a temporary increase in the
capital stock and falling consumption until at t1 the economy is on the saddle path with
falling capital and consumption (see Figure 9.4). The adjustment path is unique.
190
191
9. Optimal control
9.6.6
Suppose in an optimal control problem the objective function under the integral is
discounted:
Z T
max
ert f (ct , kt , t) dt.
0
(9.16)
(9.17)
192
9.6.7
Activity 9.3 Consider the optimisation problem of a household that holds two
categories of assets: money and government bonds. Domestic money bears no
interest but the transactions technology is such that holding cash balances reduces
liquidity costs of purchasing consumption goods, which we capture by introducing
real money balances m alongside consumption c in the utility function:
Z
et u(c, m) dt.
max
0
c1
+ ln m.
1
9.7
s.t. k t = it
k0 given
where (k) is the concave monotone increasing profit function (instantaneous profit,
achievable in a given period of time with capital k), and c(it ) is the strictly convex cost
of installing new capital, assumed to satisfy c00 (i) > o, c0 (0) = c(0) = 0.
Using the maximisation principle, the solution is obtained by setting up the current
value Hamiltonian with the (modified) co-state variable qt :
H = (kt ) it c(it ) + qt it .
193
9. Optimal control
Hi = qt 1 c0 (it ) = 0
Hk = 0 (kt ) = rqt qt
lim (ert qt kt ) = 0.
(9.18)
(9.19)
(9.20)
1
c0 (k t ) = qt 1 k t = c0 (qt 1)
qt = rqt 0 (kt ).
9.7.1
(9.21)
(9.22)
Steady state
We start with the steady state in which the capital stock, kt , and the level of the
co-state variable qt are non-zero constants. We denote the steady state values of these
variables by k and q , respectively:
c0 (0) = 0 = q 1
0 = rq 0 (k ).
The co-state variable qt here has the interpretation of the net current value of an extra
unit of capital at time t. It is commonly known in the macroeconomic literature as
Tobins q. The steady state value of Tobins q when the firm should neither invest nor
disinvest, is 1, which is the cost of adding an extra infinitesimal unit of k. Hence the
intutitive interpretation of the steady state as the one in which marginal value of
capital just equals the marginal cost. The steady state value of k is such that the
market return r equals intra-firm return 0 (k ).
9.7.2
Phase diagram
To study dynamics, we use the phase diagram, drawn in (k, q) space. The locus k = 0 is
horizontal at q = q = 1. The q = 0 locus is downward sloping as q = 0 (k)/r on it, and
the profit function is concave, 00 < 0. The arrows demonstrate directions of motion
associated with the differential laws (9.21) and (9.22).
194
Only the saddle trajectory that converges to the steady state satisfies the necessary
conditions (9.18) and (9.20). On all other paths, either the transversality condition is
violated as q , k or arriving at k = 0 the system jumps to the origin
discontinuously violating (9.18).
9.7.3
1
c00 (0)
(q 1)
q r(q 1) 00 (k )(k k ).
The determinant of the characteristic polynomial formed from this system of ODEs is
00 (k )/c00 (0) < 0, implying that one root is positive and the other negative, confirming
the saddle point property.
9.8
In this section we briefly summarise the extensions to the canonic optimal control
problem (9.1). Suppose the state variable (vector) is denoted by x and the control
variable (vector) by u.
Z T
max
f (x(t), u(t), t) dt
0
195
9. Optimal control
There could be both inequality and equality constraints to be satisfied at all point on
the interval [0, T ]:
g(x(t), u(t), t) 0 t
and/or:
h(x(t), u(t), t) = 0 t.
Another kind of constraints are intergral constraints, which can also be written as
inequalities or equalities:
T
(x(t), u(t), t) dt 0
0
and/or:
Z
(x(t), u(t), t) dt = 0.
0
Z
max
f (x(t), u(t), t) dt + F (x(T )) .
The Hamiltonian apparatus can incorporate all of the above mentioned conditions and
modifications as follows:
Recall the discussion of the scrap value of capital at the beginning of Chapter 8.
196
Theorem 24
The necessary conditions for {u(t)} to solve the optimal control problem are as
follows. There exist non-negative functions (t), p1,2 (t), q1,2 (t) such that at each t:
H
u
H
x
H
= 0
=
= x.
=
=
0
0
0
0
= 0
= 0
F
= (T ).
x(T )
The last condition is the generalised transversality condition.
Example 9.2
s.t. Y = y(t)
H = P (y(t))y(t) (t)y(t) + (t)y(t).
197
9. Optimal control
= = 0
Y
y(t) = Y .
Finally, notice that the transversality condition is now:
C 0 (Y (T )) = (T ).
This implies that is invariant with respect to the location index t:
C 0 (Y (T )).
In view of the constant , the pricing equation can be rearranged as follows:
P 0 y + P = M R(t) = (t) + C 0 (Y (T )).
For a closed-form solution example, consider a constant elasticity demand described
by:
P (y) = y , 0 < < 1.
Then:
M R(t) = y + y = (1 )y = (1 )P (t)
(1 )P (t) = (t) + C 0 (Y (T ))
(t) + C 0 (Y (T ))
P (t) =
.
1
The last equation is the pricing rule. Notice that it implies that the price
differentials across locations, in general, do not equal net transport cost differences:
P (t) P (0) =
(t)
> (t).
1
(t) + C 0 (Y (T ))
.
1 1/(t)
198
9.9
Solutions to activities
xt =
ut
t
where r1,2 = 1
6/2.
Verify that xT = 0. For suppose not, then the transversality condition implies T 6= 0:
1 r1 T 1 r2 T
C1 6e C2 6e = 0
3
3
r2 T
= C2 e
= C1 e 6T .
xT =
C1 er1 T
C2
199
9. Optimal control
1
C1
3
x0 = 1
1
6 C2 6 = 1
3
r
C1 C2 =
3
2
<0
2(1 e 6T )
6T
3e
=
<0
2(1 e 6T )
C1 =
C2
so:
t = C1 et+t
6/2
+ C2 ett
6/2
< 0.
6/2
+ C2 eT T
6/2
=0
r
C1 C2 =
3
2
yielding:
C1 =
C2 =
xt =
ut =
eT T 6/2
6
2eT T 6/2+ 2eT 6/2T
eT 6/2 T
6
2eTT 6/2 + 2eT 6/2T
er1 t eT T 6/2 + er2 t eT 6/2T
T 6/2 T
e
eT T 6/2 +
r t T T 6/2
6e 1 e
er2 t eT 6/2T
.
2
eT T 6/2 + eT 6/2 T
u(ct )et dt
(9.23)
s.t. k = w + rk c nk
kt , ct 0, k0 given.
(9.24)
max U0 =
0
The assumption of perfectly competitive markets for both capital and labour implies
that firms equalise marginal returns to factors to their market prices:
F (K, N )
F (K, N )
= r,
= w.
K
N
200
a
lim (t)a(t)
t
=
=
=
=
=
( + r)
r
y + ra c ( + r)m
0.
(b)
= r = ucc (c, m) c.
/
uc (c, m)
Assuming that the utility function takes the form:
u(c, m) =
c1
+ ln m
1
201
9. Optimal control
then:
c
= r =
c
c
1
=
(r ).
c
(c)
um (c, m)
= + r.
uc (c, m)
Assuming that the utility function takes the form
u(c, m) =
then:
m=
c1
+ ln m
1
c
c
=
+r
i
9.10
1. At time t = 0 an oil field contains x barrels of oil. It is desired to extract all of the
oil during a given time interval [0, T ]. Denote the amount of oil left at time t by xt ,
and the extraction rate by ut . Assume that the world market price per barrel of oil
202
is given and equal to et . The extraction costs per unit of time are assumed to be
u2t et . This leads to the profit maximisation problem:
Z T
(ut aet u2t et )ert dt
max
0
s.t. x t = ut
x0 = x.
Explicitly solve the problem for the optimal time profiles xt , ut and t (where t is
the co-state variable).
2. Consider a macroeconomic control problem:
Z
1 2
ax(t) u (t) ert dt
max
2
0
s.t. x t = bx + u
x(0) = x0
where a, r and b are all positive.
(a) Set up the current value Hamiltonian. Write down the necessary conditions for
maximum.
(b) Factor out u(t) to obtain a system of first-order linear differential equations in
x and the co-state variable. (Hint: if you used the canonical Hamiltonian
instead in (a), define the modified co-state variable t = t ert and rewrite the
system in terms of x and to get linear ODEs.) Compute explicitly the family
of solutions to the system. How many dimensions does this family have?
(c) The solution to the optimal control problem is just one of the solutions of the
system of ODEs. Impose the transversality condition to explicitly find the
subfamily of solutions consistent with the optimality principle. What does it
imply about the evolution of ?
(d) Which other condition do you need to impose to obtain the unique solution to
the original optimisation problem? Compute the solution in closed form. Does
it converge to a steady state?
3. A firm has received an order for B units of product to be delivered by time T . It
seeks a production schedule for filling this order at the specified delivery date at
minimum cost, bearing in mind production costs and inventory maintenance costs.
Let x(t) denote the inventory accumulated by time t. Then x(0) = 0 and the firm
must achieve x(T ) = B. The production rate u is the rate of change in the
inventories. The production cost is u2 (t), while the inventory cost is x(t). Thus
the problem is:
Z T
min
[u2 (t) + x(t)] dt
0
s.t. x(t)
= u(t)
x(0) = 0, x(T ) = B.
203
9. Optimal control
s.t. x t = ut
x0 = 0, x1 = 1.
Explicitly solve the problem for the optimal time profiles xt , ut and t (where t is
the co-state variable).
5. Consider the Ramsey model of Section 9.3:
Z
max U0 =
u(ct )et dt
0
204
6. Consider a firms investment problem. Suppose (k) is the amount of profit that
can be earned with the stock of capital k. There is no capital depreciation.
Investment costs c(I) are a function of the investment rate I. The government
administers an investment incentive scheme, refunding a proportion of new
capital installed to the firm (this also means in case of negative investment the
government taxes the firm). The firm seeks to find the investment path I(t) that
maximises the present value of the profit stream over the infinite period:
Z
ert [(kt ) (1 )It c(It )] dt
max
{it }
s.t. k = I
k(0) = k0 .
Assume (k) = ln(1 + k) and c(I) = (eI + eI )/2 1.
(a) Set up the Hamiltonian and write down the necessary conditions for the
maximum. Factor out I to obtain a system of differential equations in k and
Tobins q. (Hint: to solve an equation of the type ex ex = A, define z = ex ,
resulting in z 1/z = A, and multiply by z to obtain a quadratic equation in
z.)
(b) Determine the steady states. Explicitly linearise the system around the steady
state in which Tobins q equals 1 .
(c) Sketch the phase diagram. Discuss briefly the stability properties of the system
in the neighbourhood of that steady state. Indicate where the solution to the
maximisation problem lies in the diagram for any initial level k0 . Argue why
you are ruling out certain divergent paths as potential solutions to the
optimisation problem.
(d) Assume the economy is in steady state with non-zero capital. Consider an
unanticipated increase in the tax credit parameter from 0 to 1 > 0 . Describe
the adjustment trajectory (be explicit about jump variables and crawler
variables).
9.11
1.
Z
max
s.t. x t = ut
x0 = x, xT = 0.
We have:
H = ut ae(r)t u2t e(r)t t ut
Hu = ae(r)t 2ut e(r)t t = 0
= Hx = 0.
205
9. Optimal control
It is desired to extract all of the oil during a given time interval [0, T ] x(T ) = 0.
There is no transversality condition since x(T ) is not free.
t = 0 implies t constant = K1 .
Substitute this into the optimality condition w.r.t. ut to obtain:
ae(r)t 2ut e(r)t = K1
ae(r)t K1
()t K1 (r)t
ut =
e
e
.
=
(r)t
2e
2
2
For xt we have:
K1 (r)t a ()t
e
e
2
2
K1
a
x =
e(r)t
e()t + K2 .
2(r )
2( )
x = u =
K1
e(r)T
2(r )
a
K1
+ K2 = x
2(r ) 2( )
a
e()T + K2 = 0.
2( )
K1 =
K2
So:
e()t
T
(r)
2
( )(e
1)
2( )
[a(eT () eT (r) ) + 2x(eT (r) )( )]
+
2( )(eT (r) 1)
a ()t ( r)(2x 2x a + aeT T ) (r)t
=
e
e
2
2( )(eT (r) 1)
( r)(2x 2x a + aeT T )
=
.
( )(eT (r) 1)
xt =
ut
t
2.
1 2
max
ax(t) u (t) ert dt
2
0
s.t. x = bx + u
x(0) = x0 .
Z
206
(a)
1 2 rt
ax u e + (bx + u)
2
b aert
0.
H =
uert =
=
lim t xt =
Use t = ert t .
(b)
x
t
xt
bx + ert
b aert
bx +
a + (b + r)
a
= C1 e(b+r)t +
b+r
e(b+r)t
a
= C2 ebt + C1
+
.
2b + r (b + r)b
=
=
=
=
(c) The solution to the optimal control problem is just one of the solutions of the
system of ODEs. Impose the transversality condition to explicitly find the
subfamily of solutions consistent with the optimality principle. What does it
imply about the evolution of ?
a rt
e
t = ert t = C1 ebt +
b+r
a rt
a
e(b+r)t
bt
bt
t xt =
C1 e +
e
+
.
C2 e + C1
b+r
2b + r (b + r)b
(2b+r)t
a rt
e
b+r
xt = C2 ebt +
a
.
(b + r)b
x0 = C 2 +
C2
xt
207
9. Optimal control
3.
Z
max
s.t. x(t)
= u(t)
x(0) = 0, x(T ) = B.
(a) H = u2 + x + u.
(b)
Hu = 2u + = 0
Hx = =
x = u.
(c)
(t) = t + K1 .
(d) Use the result in (c) to find the family of solutions for u and x (up to
constants of integration).
2u(t) = (t) = t K1
t K1
u(t) =
Z 2
2 K1 t
t K1
x(t) =
dt =
t
+ K2 .
2
4
2
(e) Impose x(0) = 0, x(T ) = B.
t(t T )
t
+B
4
T
(2t T ) B
u(t) =
+
4
T
T
B
(t) = 2 t.
2
T
x(t) =
4.
H = (2xt et 2xt ut u2t ) + ut
Hu = 2xt 2ut + t = 0
t = Hx = 2et 2ut .
Substitute for ut :
1
x t = ut = t xt
2
t = t 2xt 2et .
208
1 1/2
2 1
characteristic polynomial is r2 and the roots are identical and equal to 0. This
implies xgt = K1 + K2 t, gt = 2(K1 + K2 ) + 2K2 t. To find a particular solution,
assume xpt = et , pt = et and use the method of undetermined coefficients:
1
x t = et = et et
2
t = et = et 2et 2et .
The first identity implies = 0, while the second one
2et 2et 0 = 1. To sum up:
xt = K1 + K2 t et
t = 2(K1 + K2 ) + 2K2 t.
Impose the border conditions x0 = 0, x1 = 1 to obtain:
x0 = K 1 1 = 0
x1 = K1 + K2 e1 = 1.
Hence K1 = 1, K2 = e1 . The complete solution is given by:
xt = 1 + e1 t et
1
2
+ t
t = 2 1 +
e
e
1
t
ut = e + e .
5. (a) Set up the Hamiltonian:
1
Ht = exp(2ct ) + t (kt ct nkt ).
2
Necessary conditions for the consumption/savings path to be optimal are:
Hc = 0 exp(2ct ) = t
Hk = t t = ( + n)t t kt1
lim kt et t = 0.
(9.25)
(9.26)
(9.27)
209
9. Optimal control
kt1 n
.
2
(9.28)
Recalling the capital accumulation equation, we obtain the second equation for
the system of ODEs:
k t = kt ct nkt .
(9.29)
(b) The optimal path is characterised by (9.28) and (9.29) (as well as the initial
condition and the constraint (9.27)). In steady state both the per capita
capital stock, k, and the level of consumption per capita, c, are constant. We
denote the steady state values of these variables by k and c , respectively, and
focus on the steady state with non-zero capital and consumption:
1/(1)
+n
k =
c = (k ) nk .
Linearising both equations in the neighbourhood of that steady state gives:
( 1)(k )2
c =
(k k )
2
k = [(k )1 n](k k ) (c c ).
(c) The central planners solution to the optimising problem is fully summarised
by the saddle path. For each initial capital stock, this implies a unique initial
level of consumption. For instance, with initial capital stock k0 , the optimal
initial level of consumption is c0 .
(d) Both stationary loci are changed, c = 0 shifts to the left, while k = 0 flattens.
The new steady state capital is less than before (since < 1). Without
formally checking the slope of the saddle path, graphically it could be that the
saddle path cuts the old c = 0 locus above or below the old steady state.
Assuming that it does so from below: the economy jumps to the new saddle
path immediately with lower consumption (because c is a jump variable and k
is a crawler variable). Then the capital stock is gradually eroded while
consumption falls still more toward the new steady state.
(e) Similar to (d), but the initial drop in consumption is smaller, and the capital
starts increasing initially before the actual change in the population growth
happens, when the capital and consumption are both declining along the
saddle path.
210
211
9. Optimal control
6.
Z
max
{it }
s.t. k = I
k(0) = k0 .
(a) The current value Hamiltonian with the co-state variable qt is written as:
H = ln(1 + kt ) (1 )It
eIt + eIt
+ 1 + qt It .
2
HI = q (1 )
eI eI
=0
2
1
= rq q
1+k
lim (ert qt kt ) = 0.
Hk =
212
(9.30)
(9.31)
(9.32)
2
2
eI
k
= q1+
= 0
p
= q 1 + + 1 + (q 1 + )2
p
= I = log q 1 + + 1 + (q 1 + )2
(9.33)
q = rq
1
.
1+k
(9.34)
= 0
= 1
= 0
= 1 .
1 r(1 )
1
= 0 k =
.
1+k
r(1 )
i
p
d h
2
log q 1 + + 1 + (q 1 + )
dq
1 + 2(q1+ ) 2
2 1+(q1+r)
p
=
q 1 + + 1 + (q 1 + )2
1/2
1
= p
= 1 + (q 1 + )2
.
1 + (q 1 + )2
Linearising both equations in the neighbourhood of the steady state gives:
1/2
k 1 + (q 1 + )2
(q q ) = q 1 +
q r(q 1 + ) 00 (k )(k k )
1
(k k )
= r(q 1 + ) +
(1 + k )2
= r(q 1 + ) + r2 (1 )2 (k k ).
The determinant of the matrix of coefficients:
r r2 (1 )2
1
0
for this system of ODEs is r2 (1 )2 < 0, implying that one root is positive
and the other negative, confirming the saddle point property.
213
9. Optimal control
(c) To study dynamics, we use the phase diagram, drawn in (k, q) space.
9.12
f (ct , kt , t) dt
0
s.t. k0 = k.
Denote the specific paths of control, state and co-state variables delivering the
maximum by ct , kt and t , respectively. Consider altering the initial level of capital by
a small magnitude a, and the maximum for the modified problem given by V (k0 + a, 0)
214
obtained for ct , kt .
Z
f (c , k , t) dt =
V (k0 , 0) =
[f (c , k , t) + g(c , k ) k ] dt.
(9.35)
Similarly:
Z
t) dt
f (
c, k,
V (k0 + a, 0) =
0
Z
=
t) + g(
+ k]
dt + 0 k0 T kT
[f (
c, k,
c, k)
(9.36)
for the same function (t). Notice, though, that k0 = k0 , k0 = k0 + a. Subtract (9.35)
from (9.36):
Z T
t) f (c , k , t)] dt
V (k0 + a, 0) V (k0 , 0) =
[f (
c, k,
0
Z T
t) + g(
+ k f (c , k , t) g(c , k ) k
] dt
[f (
c, k,
c, k)
=
0
+0 k0 T kT (0 k0 T kT )
Z
=
t) + g(
+ k f (c , k , t) g(c , k ) k
] dt
[f (
c, k,
c, k)
+0 a T (kT kT ).
Under the integral, susbtitute the first order Taylor expansion at every point t:
t) f (c , k , t) + fc (c , k , t)(
f (
c, k,
c c ) + fk (c , k , t)(k k )
g(c , k ) + gc (c , k )(
g(
c, k)
c c ) + gk (c , k )(k k ).
V (k0 + a, 0) V (k0 , 0)
Z T
k k )] dt
[{fc (c , k , t) + gc (c , k )}(
c c ) + {fk (c , k , t) + gk (c , k ) + }(
+0 a T (kT kT ).
By (9.3) and (9.4), both terms under the integral are zero:
fc (c , k , t) + gc (c , k ) = 0
fk (c , k , t) + gk (c , k ) + = 0
and finally, by transversality, either T = 0, or kT = kT = 0, so:
V (k0 + a, 0) V (k0 , 0) 0 a
V (k0 + 1, 0) V (k0 , 0)
= Vk (k0 , 0) = 0 .
lim
a0
a
Thus 0 is the marginal valuation in the optimal program of an extra unit of the state
variable at time 0. The discussion has only considered the initial time period 0. It is
easily shown that t is likewise the marginal value of relaxing the state variable
constraint at time t.
215
9. Optimal control
9.13
Theorem 25
Consider the problem:
Z
max
f (ct , kt , t) dt
(9.37)
s.t. k t = g(ct , kt )
k0 given, kT 0
and suppose that for a triple (ct , kt , t ) the necessary conditions of the maximum
principle are satisfied. Suppose further that maxc H(c, k, , t) has a solution and the
9.14
As mentioned in the footnote on page 172, there are circumstances in which the
transversality condition is not necessary for a solution to an optimal control problem
with no restriction on the terminal value kT . However, as shown by Kamihigashi (2001)
Necessity of Transversality Conditions for Infinite Horizon Problems, Econometrica,
Vol. 69, the transversality condition is necessary if on the optimal path ct can be
written as ct = t (kt , k t , t) (this basically requires that the contraint k t = g(ct , kt ) can
be solved as an equation for ct ) and the function:
f (ct , kt , t) = f (t (kt , k t , t), kt , t)
can be integrated on (0, +) with respect to t. He also shows, that even if the
integrability condition fails, the transversality condition is still necessary if the function
f (t (kt , k t , t), kt , t) is homogeneous of an arbitrary degree in kt and k t . Additionally,
in the context of infinite horizon problems, a sufficient condition for maximum akin to
the transversality condition is given by the following:
lim (t)[k(t) k (t)] 0 for all feasible k(t).
This condition has to be used in conjunction with the regular maximum principle
conditions and the concavity of the Hamiltonian in k, c. See Section 9.11 in Sydster et
al.
216
Appendix A
Sample examination paper
Important note: This Sample examination paper reflects the examination and
assessment arrangements for this course in the academic year 20142015. The format
and structure of the examination may have changed since the publication of this subject
guide. You can find the most recent examination papers on the VLE where all changes
to the format of the examination are posted.
217
Section A
Answer all questions from this section (8 marks each).
1. Answer all parts of this question.
(a) Define concavity for a real valued function.
(b) Define increasing returns to scale for a production function f (K, L), where K
and L are capital and labour.
(c) Prove that if a production function f (K, L) has f (0, 0) = 0 and is concave,
then it cannot have increasing returns to scale.
2. Answer all parts of this question.
(a) Define a homogeneous function.
(b) Define the uncompensated demand functions and the indirect utility function.
(c) Demonstrate that the uncompensated demand functions and the indirect
utility function are homogeneous of degree zero in prices and income.
3. Consider the Ramsey model:
Z
max
u(ct )et dt s.t. k t = f (kt ) ct ,
ct
k0 given.
x1 (p1 , p2 , m).
p1
p1
m
By using duality, prove that the Slutsky equation holds true.
218
Section B
Answer three questions from this section (20 marks each).
6. Consider a consumer with preferences represented by:
u(x1 , x2 ) =
1
1
x1 x2
219
X
t u(ct ct1 )
t=0
= rw(t) + y c(t)
()
et u (c(t)) dt
where > 0 is the consumers discount rate, and u0 (c) > 0, u00 (c) < 0 for all c > 0.
(a) Determine the control and state variables. Hence set up the Hamiltonian.
(b) Show that at the optimum,
220
r
w0
1 erT
Why is this greater than y + rw0 , i.e. the sum of the constant income and the
interest income from the initial wealth? What would c be if w(T ) = w0 instead?
[END OF PAPER]
221
222
Appendix B
Sample examination paper
Examiners commentary
1. Reading for this question
Subject guide, Chapter 5.
Approaching the question
(a) A real valued function f defined on a convex subset U of Rn is concave if for
all x and y in U and for all t [0, 1]:
f (tx + (1 t)y) tf (x) + (1 t)f (y).
(b) A production function f (K, L) has increasing returns to scale if, for any s > 1,
f (sK, sL) > sf (K, L).
(c) Take a concave production function f (k, L) with f (0, 0) = 0. Increasing returns
would imply that for s > 1, f (sK, sL) > sf (K, L). However, by concavity:
1
1
f (K, L) = f
(sK, sL) + 1
(0, 0)
s
s
1
1
f (sK, sL) + 1
f (0, 0)
s
s
1
=
f (sK, sL).
s
Hence:
f (sK, sL) sf (K, L),
which implies either decreasing or constant returns to scale and rules out
increasing returns to scale.
2. Reading for this question
Subject guide, Chapter 4.
Approaching the question
(a) A function f (x1 , x2 , . . . , xn ) is homogeneous of degree d in (x1 , x2 , . . . , xn ) if for
all (x1 , x2 , . . . , xn ) and all s > 0:
f (sx1 , sx2 , . . . , sxn ) = sd f (x1 , x2 , . . . , xn ).
In particular, a function which is homogeneous of degree zero is such that:
f (sx1 , sx2 , . . . , sxn ) = f (x1 , x2 , . . . , xn ).
223
(b) The uncompensated demand x(p, m) is the solution to the consumers utility
maximisation problem. It depends upon prices and income. The indirect utility
function is the maximum value function for the consumers utility
maximisation problem:
v(p, m) = u(x(p, m)).
(c) The uncompensated demand is homogeneous of degree zero in prices and
income because if we multiply all prices and income by the same positive
factor, the budget constraint is unaffected. In more detail:
x(sp, sm) = arg max u(x) s.t. spx = sm
x
= x(p, m).
Also:
v(sp, sm) = u(x(sp, sm))
= u(x(p, m))
= v(p, m).
3. Reading for this question
Subject guide, Chapter 9.
Approaching the question
(a) The Hamiltonian is:
Ht = u(ct )et + t (f (kt ) ct ).
(b) The current value Hamiltonian is:
Ht = u(ct ) t (f (kt ) ct ),
where t = et t .
(c) Optimising the current value Hamiltonian in (b), the co-state equation which
is a necessary condition is given by:
= Hk +
where Hk is the derivative of the current value Hamiltonian with respect to
capital k.
(d) We can write:
Ht = et Ht
and hence optimality conditions are the same. (See page 180 of the subject
guide.)
224
y(0) = A = 0
y 0 (0) = 5A + B = 1.
A = 0
B = 1.
Hence the particular solution is:
y(x) = xe5x .
5. Reading for this question
Subject guide, Chapter 6.
Approaching the question
See page 100 of the subject guide.
225
1
1
x1 x2
s.t. p1 x1 + p2 x2 m, x1 0, x2 0.
1
1
(p1 x1 + p2 x2 m).
x1 x2
r
x2 = x1
p1
.
p2
p1 +
p1 p2
p1 + p1 p2
m
x2 (p1 , p2 , m) =
.
p2 + p1 p2
x1 (p1 , p2 , m) =
p1 +
p1 p 2
p2 +
m
m
p1 + p 2 + 2 p 1 p2
=
.
m
226
p1 p2
(b) The expenditure minimisation problem (or dual problem) for this consumer is:
min p1 h1 + p2 h2
h1 ,h2
s.t.
1
1
u, h1 0, h2 0.
h1 h2
First we notice that the non-negativity constraints cannot bind because this
would give utility equal to which will not meet the first constraint. Hence
the problem reduces to:
1
1
L = p1 h1 + p2 h2
u .
h1 h2
The first-order conditions are:
L
1
= p1 2 = 0
h1
h1
L
1
= p2 2 = 0
h2
h2
1
1
L
=
u = 0.
h1 h2
From the first two conditions we get:
p1
h22
= 2
p2
h1
r
p1
h2 = h1
.
p2
By substituting in the utility constraint we find:
r
1 p2
1
= u
h1 h1 p1
r
1
p2
h1 (p1 , p2 , u) =
1+
u
p1
r r
1
p2
p1
h2 (p1 , p2 , u) =
1+
u
p1
p2
r
1
p1
=
1+
.
u
p2
(c) The expenditure function is:
e(p1 , p2 , u) = p1 h1 (p1 , p2 , u) + p2 h2 (p1 , p2 , u)
r
r
1
p2
1
p1
1+
p1 p 2
1+
= p1
u
p1
u
p2
r
r
1
p2
p1
= p1 1 +
+ p2 1 +
u
p1
p2
1
= (p1 + p2 + 2 p1 p2 ) .
u
227
We verify that:
e(p1 , p2 , V (p1 , p2 , m)) = m
V (p1 , p2 , e(p1 , p2 , u)) = u.
We have that:
1
e(p1 , p2 , u) = (p1 + p2 + 2 p1 p2 )
u
1
(p1 + p2 + 2 p1 p2 )
e(p1 , p2 , V (p1 , p2 , m)) =
V (p1 , p2 , m)
1
m
= m.
Also:
V (p1 , p2 , m) =
V (p1 , p2 , e(p1 , p2 , u)) =
=
=
p1 + p 2 + 2 p 1 p2
m
p1 + p2 + 2 p 1 p2
e(p1 , p2 , u)
p1 + p2 + 2 p 1 p2
1
u p 1 + p2 + 2 p1 p 2
u
as required.
7. Reading for this question
Subject guide, Chapter 2.
Approaching the question
(a) The constrained welfare maximisation problem for this society is:
max W (x, y) = x1a y a
x,y
2x + y
x + 2y
x
y
s.t.
300
450
0
0.
The non-negativity constraint will never bind, because this would give welfare
equal to zero. Hence we will only consider the two technology constraints.
(b) The constraints are convex (linear). The objective function is concave if the
Hessian is negative semi-definite:
a(1 a)xa1 y a a(1 a)xa y a1
2
D =
.
a(1 a)xa y a1 a(a 1)x1a y a2
For the Hessian to be negative semi-definite, we need the two first-order
principal minors to be non-positive:
a(1 a)xa1 y a 0
a(1 a)xa1 y a a(a 1)x1a y a2 a(1 a)xa y a1 a(1 a)xa y a1 = 0 0.
228
=
=
0
0
0
0.
1 a
x.
21a
1 a
x = 450
21a
x = 450(1 a)
1 a
y =
450(1 a) = 225a.
21a
229
=
=
=
0
0
0
0.
=
=
=
=
0
0
0
0.
230
8
9
c1 = 20,000.
240e0.03(6t) dt = 15,544.17.
231
B1 =
a
a
, B2 = 2 .
2b
b
Hence:
a
a
f (x) = A1 ebx + A2 + x2 2 x1 + B3
2b
b
a
a 2
bx
= A1 e
+ x 2 x1 + A02
2b
b
where A02 = A2 + B3 .
ii. Let u = f 0 and solve for u in the first-order differential equation
u0 (x) + bu(x) = ax. The solution is u(x) = A1 ebx + ab x ba2 . Then
integrating this:
f (x) = A01 ebx +
a 2
a
x 2 x + A2 ,
2b
b
a 2
x.
2b
Hence a = 2b.
= R
.
wt+1
ct
ct
wt+1
ct
(B.1)
Shift one period back:
u0 (ct ct1 ) =
u0 (ct1 ct2 ) = R
V (., t)
V (., t)
.
wt
ct1
(B.2)
232
The Euler equation is derived by factoring out the V s. First, applying (B.4) to
(B.1) and (B.2):
V (., t + 1)
+ u0 (ct+1 ct )
wt+1
V (., t)
u0 (ct1 ct2 ) = R
+ u0 (ct ct1 ).
wt
u0 (ct ct1 ) = R
Then Vw(.,t)
and
t
equation:
V (.,t+1)
wt+1
ct
wt ct
Hence the policy function is:
ct
=
1 + B
1 + B + D
wt .
1 + B
1 + B + D
= A + D ln R ln ct1 + (1 + B) ln
wt
1 + B
+D ln wt
wt
1 + B + D
1 + B
RD
= A + (1 + B) ln
+ D ln
1 + B + D
1 + B + D
ln ct1 + (1 + B + D) ln wt .
Equating the coefficients:
B =
D = 1 + B + D
(1 + B)1+B (RD)D
A = A + ln
.
(1 + B + D)1+B+D
233
Solving for D:
1
.
1
Though not required, solving for A gives:
(1 )1 (RD)D
(1 )A = ln
= (1 ) ln (R)/(1) (1 )
1+D
(1 + D)
A = ln (R)/(1) (1 ) .
D=
wt = (1 )wt .
ct =
1 + 1
1
Thus the policy function is independent of in this case.
(d) Substitute into wt+1 = R(wt ct ):
wt+1
= R(wt (1 )wt ) = Rwt ,
and hence:
ct+1 = (1 )wt+1
= (1 )Rwt = Rct .
(t)
=
(t)
= r(t)
w(t)
H
w (t) =
w (t) = rw (t) + y c(t).
(t)
The first answers (i). From the second, (t) = (0)ert . Equating this with the
first:
(0)ert = et u0 (c (t)) u0 (c (t)) = (0)e(r)t
which answers (ii). Then, if = r, u0 (c (t)) = (0), i.e. constant. Given the
strict concavity of u, therefore c (t) is a constant c. This answers (iii).
234
rt
w (t) = Ae
.
r
Given that w(0) = w0 :
A = w0 +
y c
,
r
so:
w (t) = w0 +
y c
r
rt
y c
r
rt
= w0 e +
y c
(ert 1).
r
Now if at T , w(T ) = 0:
y c
r
r
rT
0 = w0 e +
w0 erT = y +
w0 .
(erT 1) c = y + rT
r
(e 1)
(1 erT )
c > y + rw0 as the consumer intends to leave no inheritance. If w(T ) = w0 ,
then c = y + rw0 .
235
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