EC115 - Methods of Economic Analysis

Spring Term, Lecture 10

Constrained Maximisation IV:
Lagranges Function - Examples
Renshaw - Chapter 16
University of Essex - Department of Economics

Week 25

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

1 / 26

Example 1
Lets start with a very simple example, just to warm up.
A firm has to maximize the output under the total cost
constraint TC=100. The maximization problem is given by
max Q(K , L) = 2K + KL
K ,L

s.t. 100 = 2K + 2L
where the cost of capital and and that of labour are given
by w = r = 2.
Find the optimal K and L using the Lagrangian method.
Find also .
Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

2 / 26

First Step: Write down the Lagrangian function

L = Q(K , L) (TC (K , L))

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

3 / 26

First Step: Write down the Lagrangian function

L = Q(K , L) (TC (K , L))
And so in this case:
L = 2K + KL (2K + 2L 100)

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

3 / 26

Second Step: Write down the First Order Conditions

L
= 0 2 + L 2 = 0
K

(1)

L
= 0 K 2 = 0;
L

(2)

L
= 0 100 2K 2L = 0

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

(3)

Week 25

4 / 26

Third Step: Solve the First Order Conditions.

From equations (1) and (2) we have
2 + L = 2
K = 2

(1)
(2)

The right-hand sides of both equations are identical (= 2),

so the left-hand must also be equal to each other. Hence
2+L=K

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

5 / 26

Now our problem only consists in two equations:


2+L=K
2K + 2L = 100
So substituting K = 2 + L form the first equation into the
second one we get:
4 + 2L + 2L = 100
=
L = 24

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

6 / 26

So L = 24 and we know that K = 2 + L: we can obtain

K = 26.
How about ?
Form the second first order condition we have:
2 = K
=

K
2

= 13

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

7 / 26

Example 2

Note that sometimes very simple changes can make our

solution very complicated! Consider for example
1

max Q(K , L) = 2K + 2K 2 L
K ,L

s.t. 100 = 2K + 2L
and proceed to the maximization following exactly the
same steps as before.

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

8 / 26

Write down the Lagrangian function

1

L = 2K + 2K 2 L (2K + 2L 100)
and the FOCS:
1
L
= 0 2 + K 2 L 2 = 0
K
1
L
= 0 2K 2 2 = 0;
L
L
= 0 100 2K 2L = 0

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

(1)
(2)
(3)

Week 25

9 / 26

Solve the First Order Conditions.

In this case simply taking the ratio between eq. (1) and
eq.(2) is not very helpful since if we do it we end up with:
1

2 + K 2 L
1

2K 2

2
2

where the left-hand side can not be simplified. Lets see if

we can find another way to solve these equations.

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

10 / 26

From equation (1) and (2) we have

1

2 + K 2 L = 2

(1)

2K 2 = 2

(2)

The right-hand sides of both equations are identical (= 2),

so the left-hand must also be equal to each other. Hence
1

2 + K 2 L = 2K 2

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

11 / 26

Multiplying everything by K 2 we can get:

1

2K 2 + L = 2K 4
from which we can obtain that
1

L = 2K 4 2K 2

(4)

Dont forget we have another equation to play with, the

third first order condition.
2K 2L + 100 = 0

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

12 / 26

Solving the constraint for L we get:

L = 50 K
which we can substitute in eq. (4), obtaining:
1

2K 4 2K 2 = 50 K

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

13 / 26

OK, now we have one (complicated, sorry /) equation in

one unknown. We can try to solve it.
1

50 K 2K 4 + 2K 2 = 0
1

K + 2K 4 2K 2 = 50

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

14 / 26

OK, now we have one (complicated, sorry /) equation in

one unknown. We can try to solve it.
1

50 K 2K 4 + 2K 2 = 0
1

K + 2K 4 2K 2 = 50
Scary!

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

14 / 26

Example: Cost Minimisation

Suppose the board of directors of a competitive firm
has set a production target of Q0 and asks the chief
executive officer (CEO) of the firm to meet the target
at the minimum cost.
Suppose the firms technology be described by the
Cobb Douglas function:
Q = F (K , L) = K 1/4 L1/2
How do we solve the CEO problem when the prices of
labour and capital are given by w > 0 and r > 0?
We can apply any of our solution techinques to solve
this problem. This time we use the Lagrange multiplier
method.
Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

15 / 26

The problem can be expressed as:

min TC (K , L) = wL + rK
L,K

s.t. Q0 = K 1/4 L1/2

In this case the objective function is given by:

TC = wL + rK .
This describes all the combinations of K and L such
that at prices w and r they give the same total cost,
TC .
In this case we say that TC = wL + rK describes an
iso-cost line:
w
TC
K = L+
.
r
r
Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

16 / 26

The lagrangian function is given by:

L(L, K , ) = wL + rK + (Q0 K 1/4 L1/2 )
The first order conditions are:
1
L(K , L, )
= r K 3/4 L1/2 = 0,
K
4
L(K , L, )
1
= w K 1/4 L1/2 = 0,
L
2
L(K , L, )
= Q0 K 1/4 L1/2 = 0,

at K = K , L = L and = .
Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

17 / 26

Note that the first two equations generate the tangency

condition:
MPL
w
MRTSL,K =
=
MP
 K r


1 3/4 1/2
w
1 1/4 1/2
K L
/
K
L
= .
=
2
4
r
The third equation requires that the targeted output
level met:
Q0 = (K )1/4 (L )1/2 .

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

18 / 26

From the tangency condtion:

w 
w
K
= K = L
2 =
L
r
2r
Using the constraint:
  w 1/4
 1/4

1/2
3/4 w
Q0 = L
(L ) = (L )
2r
2r

Solving for L and K we obtain:

 1/3
2r
4/3
L = Q0
,
w
 

w
K =L
2r
 2/3
4/3 w

= K = Q0
2r
Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

19 / 26

Substituting into the expression for total costs we get

the minimised total cost:
3 4/3
TC = wL + rK = 2/3 Q0 w 2/3 r 1/3 .
2
Now consider the effect of increasing the wage rate:
L
1
4/3
= 21/3 Q0 w 4/3 r 1/3 < 0,
w
3
K
2 2/3 4/3 1/3 2/3
= 2
Q0 w
r
> 0.
w
3
If we increase w from w1 to w2 then L goes down, K
goes up: we substitute capital for labour.
Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

20 / 26

Also note that from the first order conditions:

4/3

4r (K )3/4
4r [Q0 (w /(2)r )2/3 ]3/4
=
=
4/3
(L )1/2
[Q0 (2r /w )1/3 ]1/2

1/3

= 24/3 Q0 w 2/3 r 1/3 .

This is the same as the marginal cost of production at

Q0 using cost minimising input choices, i.e. TC

Q0 .

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

21 / 26

Example: Profit Maximisation

Now suppose the board of directors of a competitive
firm wants to maximise profits and asks the CEO of the
firm to perform this task by choosing the appropriate
levels of labour and capital.
In this case the CEOs constraint is the firms
technology. Suppose this is described by the Cobb
Douglas function:
Q = F (K , L) = K 1/4 L1/2
How to solve the CEO problem when the price of the
good the firm sells is p and the prices of labour and
capital are given by w > 0 and r > 0?
Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

22 / 26

We could use an unconstrained maximisation approach

in which we we want to maximise:
(Q, K , L) = pQ wL rK
and we substitute out the constraint and then solve the
problem:
max (K , L) = pK 1/4 L1/2 wL rK .
K ,L

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

23 / 26

Alternatively we could use a constrained maximisation

approach and maximise profit (equals revenue minus
cost) subject to output equaling sales:
max pQ wL rK s.t. Q = F (K , L).

Q,K ,L

Using the Lagrange Multiplier Method then we solve

the following problem:
max L(Q, K , L, ) = pQ wLrK +(Q K 1/4 L1/2 )

Q,K ,L,

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

24 / 26

The first order conditions are then:

L
Q
L
B:
K
L
C:
L
L
D:

A:

= p = 0,
 
1
= r +
K 3/4 L1/2 = 0,
4
 
1
K 1/4 L1/2 = 0,
= w +
2
= Q K 1/4 L1/2 = 0.

Denoting the solution as

(Q = Q , K = K , L = L , = ) then from A we get
= p.
Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

25 / 26

Substituting into B and C gives:

 
 
1
1
3/4 1/2
p
K
L = r, p
K 1/4 L1/2 = w .
4
2
Then:
1/2

L
so:
K
and:

1/2

pK 1/4
4rK 3/4
=
,
=
p
2w

p2
=
8rw

p4
K =
64r 2 w 2

p 2 K 1/2
p4
L =
=
4w 2
32rw 3

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

26 / 26