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CHAPTER

3

TRANSVERSALITY CONDITI

ONS

OINT

FOR

VARIABLE-

ENDP

PROBLEMS

The

calculus

differential

Euler

equation-the

of

basic

necessary

normally

two

and

condition

a

in the

varia-tions-is

equation

with

fixed

second-order

constants.

points,

the

containing

initial

arbi-trary

terminal

For

problems

 two given boundary conditions provide sufficient information to definitize the two arbitrary constants.

But

to

the

discretionary

if

initial

or

terminal

then

the

the

at time

of

point

is

variable

(subject

will

the

no

PT

In

choice),

a boundary

case,

for

preceding

condition

if

faces

the

problem.

 be missing. Such will be dynamic monopolist of externally imposed price

choice

as an integral

part

instance,

chapter

can treat

T ,and

the optimization

that case, the boundary condition P(T) = PT will no longer be available, and the void must be filled by a

transversality condition. In this chapter we shall develop the transversality conditions appropriate to various types of variable termi-nal points.

3.1

THE

GENERAL

CONDITION

For expository

convenience,

TRANSVERSALITY

we shall assume that only

the terminal point is variable. Once we learn to deal with that, the technique is easily extended to the case of a variable initial point.

The

Variable-Terminal-Point

objective

is

to

Problem

Our new

Maximize

or minimize

Yy] = /*~(t,y, yf) dt

0

(3.1)

y(0)

= A

(A given)

subject

to

and

Y ( ~)=Y T

( T ,~~f r

This

that

"free"

choice

although

to the problem.

optimal

differs

the

from

the

time

previous

and

version

terminal

of

the

state

problem

a

y,

part

in

terminal

T

are now

of

the

that

in the sense that

T

is

process.

free, only

they

It

have

is

to

become

be

understood

of

T

positive

values

are relevant

To

develop

the

necessary

conditions

for

an

 extremal, we shall, as before, employ a perturbing curve p(t), and use the variable E to generate neighboring
 paths for comparison with the extremal. First, suppose that T * is the known optimal terminal time. Then any value of T in the immediate neighborhood of T* can be
 expressed as where E represents a small number, and AT
 represents an arbitrarily chosen (and fixed) small change in T. Note that since T* is known and AT is a prechosen
 magnitude, T can be considered as a function of E ,T(E) with derivative 7 r n The same E is used in conjunction with the perturbing curve p(t) to generate neighboring paths of the extremal y*(t): However, although the p(t) curve must still satisfy the condition p(0) = 0 [see (2.2)1 to force the neighboring paths to pass through the fixed initial point, the other condition-p(t) I = 0-should now be dropped, because y,
 is free. By substituting (3.4) into the functional V[y], we get a function V(E) akin to (2.121, but since T is a function of E by (3.2), the upper limit of integration in the V function will also vary with E:

(3.5)

~( c=

kT'"~[t, y*(t)

+ rp(t), y*'(t)

+ rpf(t)] dt

 Y(t> ~'( t Our problem is to optimize this V function with respect to E. definite integral (3.5) falls into the general form of (2.10).

The V/d~ is therefore,

by

(2.111,

on the

right closely resembles the one encountered in (2.13) arlier development of the Euler equation. In fact, much of the rocess leading to (2.17) still applies here, with one exception.

[Fyrp(t)];f

in (2.16) does not vanish

since

in the present

we have

problem,

that

in (2.171,

value

p(T) z 0. With this amendment

= [F,,],=,p(T),

[Fy,p(t)],=,

assumed

result

to the earlier

term in (3.6)

=

[ [

p(t)

1

Fy - -F'!

dt + [FY*],=,p(T

 can also write Second term in (3.6) = [Fit=, AT
 these into (3.6), and setting d V / d ~= 0, we obtain the new p(t)[Fy - :FYr] dt + [Ff]t=T~(T)+ [F]~=TIT = 0

three

terms

on the left-hand

its own arbitrary

element:

side

of

(3.71, each

contains

p(t) (the

entire

perturbing

 curve) in the (T) (the terminal value on the perturbing curve) in the second arbitrarily chosen change in T) in

the third. Thus we cannot offsetting or cancellation of terms. Consequently, in order tocondition (3.7), each of

the three

terms

must

individually

be set o

 T FIGURE FIGURE 3.1 3.1 Step ii To this end, we first get rid of the arbitrary quantity p(T) by transforming it into terms of AT and AyT-the changes in T and y,, the two principal variables in the variable-terminal-point problem. This
 can be done with the help of Fig. 3.1. The AZ' curve represents a neighboring path obtained by perturbing the AZ path by ~p(t ),with E set equal to one for
 convenience. Note that while the two curves share the same initial point because p(0) = 0, they have different

heights

perturbing

the vertical

at

t

y,

can

11,

resulting

be

also

the

AZ'

= T

because

The

p(T) #

0 by

construction

of

the

But

p(T),

direct

of

the

by

in

T

=

E

curve.'

distance

from

altered

curve

magnitude

measures

perturbation.

the

amount

if

AT

shown

change

as

ZZ',

the

by

should,

inasmuch

since

out

EAT (= AT

> 0, be

extended

to

 2".2 As a result, yT is further pushed up by the vertical distance between Z' and 2". For a small AT, this second

change

the total

in

y,

can be

change

in y,

approximated

from

point

Z

by

to point

y'(T) AT. Hence,

Z"

is

Rearranging

this

relation

allows

us to express

p(T) in

 terms of AyT and AT:3 '~echnically, the point T on the horizontal axis in Fig. 3.1 should be labeled T*. We are omitting the * for simplicity. This is justifiable because the result that this discussion is leading to-(3.9)-is a transversality condition, which, as a standard practice, is stated in terms of T (without the *) anyway. '~lthough we are initially interested only in the solid portion of the AZ path, the equation for that path should enable us also to plot the broken portion as an extension of AZ. The perturbing curve is then applied to the extended version of AZ.

~ h resulte

3

3.1.

in (3.8) is valid

even

if

E

is

not

set equal

to one

as

in

Step iii

dropping the first term in (3.7), we finally arrive at the

desired general transversality condition

Using (3.8) to eliminate

p(T) in (3.7), and

Fig.

 This condition, unlike the Euler equation, is relevant only to one point of time, T .Its role is to take the place

of

the

missing

terminal

condition

in the

present

problem.

 Depending on the exact specification of the terminal line or curve, however, the general condition (3.9) can be written in various specialized forms.
 3.2 SPECIALIZED TRANSVERSALITY CONDITIONS In this section we consider five types of variable terminal points: vertical terminal line, horizontal terminal line, terminal curve, truncated vertical terminal line, and truncated horizontal terminal line. Vertical Terminal Line (Fixed-Time-Horizon Problem) The vertical-terminal-line case, as illustrated in Fig. 1.5a, involves g fixed T .Thus AT = 0, and the first term in (3.9 ) drops out. But since Ay, is arbitrary and can take either sign, the only way to make the second term in (3.9) vanish for sure is to have Fy r= 0 at t = T .This gives rise to the transversality condition which is sometimes referred to as the natural boundary condition Horizontal Terminal Line

(Fixed-Endpoint Problem)

For the horizontal-terminal-line case ,as illustrated in

have

Ay, = 0 but AT is arbitrary. So

automatically drops out, but the first does not. Since AT

is arbitrary, the only way to make the first term vanish for sure is to have the bracketed expression equal to zero Thus the transversality condition is

Fig. 1.5b ,the situa-tion is exactly reversed;

we

term

now

the second

in (3.9

It

might

F(t

capital

be

useful

to

give

an

economic

let

,where

interpretation

interpret

represents

to

(3.10 ) and

as

a

(3.11) .To f ix ideas,

profit

function

taking

us

y

net

,y ,y')

stock, and y' entails

represents

resource

away from the current profit-making busines

operation, so as to build up capital which will enhance future profit. Hence there exists a tradeoff between current profit and future profit. At any time t, with a

given capital stock y, a specific investmen decision-say, a decision to select the investment rate yl,--will result in the current profi F(t, y, y',). As to the effect of the investment decision on future profits, i enters through the intermediary of capital. The rate of

capital accumulation

value

F(t, y, y',) to see the overall (current as well as future

profit implication of the investment decision. The

imputed (or shadow) value to the firm of a unit of

is measured by the derivative Fy,.This means that if we

is y',;

if we can convert

that into a

profi

measure,

then we can add it to the current

capita

decide

to leave

(not

use

up) a unit

of

capital

at the

 terminal time it will entail a negative value equal to -Fyg.Thus, at t = T, the value measure of y', is -y', Fyto.Accordingly, the overall profit implication of the decision to choose the investment rate y', is F(t, y, y',) - yb Fyg.The gen

eral expression

Now

for this

is

we can interpret

F - y'Fy,, as in (3.11).

the transversality

condition

(3.11) to mean that

in a problem with a free terminal time, the firm should

select

capital

(current and future) profit. In other words, all the profit opportunities should have been fully taken advantage of by the optimally chosen terminal time. In addition, (3.10)-which can equivalently be writ-ten as [ - FY,],=, = O-instructs the firm to avoid any sacrifice of profit that will be incurred by leaving a positive

terminal capital. In other words, in a free-terminal-state problem, in order to maximize profit in the interva [0, T ] but not beyond, the firm should, at time T, us up all

the capital it ever accumulated.

a

T

such that

a decision

t

=

T, no

longer

to

invest

yield

any

and

accumulate

overal

will, at

Terminal

Curve

With

1.5c,

a terminal

neither

curve

AyT nor

yT = +(T),as illustrated

AT

is

assigned

a

zero

in Fig.

value,

so

 neither term in (3.9) drops out. However, for a small arbitrary AT, the terminal curve implies that Ay, qS=AT.

So it is possible to eliminate Ay, in (3.9) and combine the

two

terms

Since

AT

into the form

[F -y1FYp + F,vqS]t-TAT

= 0

is arbitrary,

we can deduce

the transversality

 condition Unlike the last two cases, which involve a single unknown in the terminal point (either y, or TI, the terminal-curve case requires us to determine both y, and T. Thus two relations are needed for this purpose.

The transversality condition (3.12) only provides one; the

other is supplied by the equation y, = +(T 1.

Truncated

Vertical

Terminal

Line

 The usual case of vertical terminal line, with AT = 0, specidixes (3.9) to

When the line is truncated-restricted by the terminal condition yT 2 ymi where yminis a minimum permissible

level

types

possible

> ymi nor y,*

of

of

y-the

outcome:

optimal

y,*

solution

can

have

two

y,*

= ymin .If

> ymin

 the terminal restriction is automatically satisfied; that is, it is nonbinding. Thus, the transversality condition is in that event the same as (3.10): The basic reason for this is that, under this outcome, there are admissible neighboring paths with terminal values both above and below y,*, so that Ay, = y, - yT* can take either sign. Therefore, the only way to

satisfy

(3.13) is to have

The

other

outcome,

Fy,= 0 at

t = T

y,*

= y,,,,

on the

other

hand,

 only admits neigh-boring paths with terminal values y, 2 y,*. This means that Ay, is no longer completely
 arbitrary (positive or negative) ,but is restricted to be nonnegative. terminal value Assuming the p(T ) > 0,as perturbing curve in Fig .3.1,Ay, r to 0 have would mean that E 2 0 ( E = 1 in Fig .3.1) .The nonnegativity of E , in turn ,means condition (3 .13)-which has that the transversality its roots in the first-order condition d V / d ~= O- must be changed to an inequality as in the Kuhn-Tucker conditions.* For a maximization called for, and problem (3.13 ,the should I type become of inequality is (3.15) [ F y l] t =T A I~~0 And since Ay, 2 0, (3.15) implies condition (3.16) [Fy,]t=TsO for~,*=~,
 Combining (3.14) and (3.16), we may write the following summary statement of the transversality condition for a maximization problem (3.17) [F~)],=,5 0 YT* 2 Ymi (YT* - ~rnln)[~Y']t=T= [for maximization of V 4 ~ o anr explanation of the Kuhn-Tucker conditions, see Alpha C Chiang, Fundamenta Methods of Mathematical Economzcs, 3d ed

McGraw-Hill,

New

York, 1984, See. 21.2

inequality sign in (3.15) must be reversed, and the transversality condition becomes

If

the

problem

to

minimize

V, then

(3.17')

[FY*]t=T2 0

(YT* -~rnin)[Fy#]~== 0

YT* 2Ymin

[for minimization

The

tripartite

complicated,

but its

condition

(3.17 )or (3.17' ) may

the

of

V]

seem

practical problem solving, we can try the [Fy#1,=, = 0

condition in (3.14) first, and check the resulting yT* value. If yT* 2 ymin then the terminal restriction is satisfied, and the problem solved. If y,* <

application is not. In

 y,,, on the other hand, then the optimal y, lies below the permissible range, and [F,,],,, fails to reach zero on the truncated terminal line. So, in order to satisfy
 the complementary-slackness condition in (3.17 ) or (3.17') we just set y,* = y,,, treating the problem as

one with

a fixed

terminal

Truncated

Horizontal

point

Cl", ymin

Terminal

Line

 The horizontal terminal line may be truncated by the restriction T 5 T,,, where T,, represents a maximum permissible time for completing a task-a
 deadline. The analysis of such a situation is very similar to the truncated vertical terminal line gust discussed. By analogous reasoning, we can derive the following transversality condition for a maximization
 prob-lem: (3.18) [ F -~ ~ F ~ ~ ] ~T*IT,,,~,L O

( T * - T,,)

maximization

of

V]

[ F - y1FY,]t =,= 0

If

in

the

problem

(3.18) must

is

to

minimize

be changed,

and

V, the

the transversality

first

inequality

[for

 condition is (3.18') [ F - Y 'F ~~]I~0,, T* I T,, (T* - T,,) [F - ytFY.],=, = 0

[for minimization

of

V]

 EXAMPLE 1 Find the curve with the shortest distance between the point (0 ,l ) and the line y = 2 - t. Referring to Fig. 3.2, we see that this is a problem

with

similar

a terminal

to

the

curve y(T) = 2 - T ,but otherwise

Example

shortest-distance

problem

in

Sec.

2.2. Here,

the problem

is

to

Minimize

ny]= /*(I

0

+ y12)1'2

dt

 subject to y(0) = 1 and y(T) = 2 - T

Y

it

4

is

of

1 2

It has previously

been

t

FIGURE

3.2

shown that with

the given

 integrand, the Euler equation yields a straight-line extremal, say,

with

condition

two

y*

=a t + b

arbitrary

constants

a

and

b.

From

y(0) =

1, we

determine

the

that

initial

b

=

1.

 To determine the other constant, a, we resort to the transversality condition (3.12). Since we have the transversality condition can be written as (1 +y")1/2 + (- 1 - yl)rl(l +yr2)-l" = o (at t = T

Multiplying

through

by

(1 + y'2)1/

2and

simplifying

 we can reduce this equation to the form yt = 1 (at t = T).But the extremal actually has a constant slope, y*'
 = a,at all values of t.Thus, we must have a = 1. And the extremal is therefore y*(t) = t + 1 As shown in Fig. 3.2, the extremal is a straight

line that meets the terminal line at the point

line

and the extremal are, respectively+ ,- 1 and +1.Thus the

two lines are orthogonal (perpendicular) to each other. What the transversality condition does in this case is to

require

Moreover ,we note that the slopes

(;,

1;).

of

the

terminal

the extremal

to be orthogonal

to the terminal

line

EXAMPLE

2

Find

the extremal

of

the functional

FIGURE

3.3

with

free. Here we have a horizontal terminal line as depicted

in Fig. 3.3.

boundary

conditions

y(0) =

1, y,

=

10, and

T

The general solution

of

the

Euler

equation

for

this problem has previously been found to be a quadratic

path (Sec. 2.2, Example 1)

Since

y(0) =

1, we

have

c, =

1. But

the

other

constant

c, must

condition

be

defini-tized

(3.11)+ .Since

with

the help

F

= ty'

+ y'2+

of

the transversality

so that

F,,

= t

+ 2y1

that

condition

becomes

which

is,

terminal

reduces

extremal

time.

the

to

is

To

-y'2

=

0

required

meet

this

or

to

y'

=

have

0

at

a zero

condition,

we

t

=

T .That

slope

differentiate

at the

 the general solution to get y*'(t), then set t = T ,and let y*'(T) = 0. The result + is the equation - T/2 + c, = 0; it follows that c, = T/2 .However, we still cannot determine the specific value of cl without knowing the value of T To find make use of the information that y, = 10 T ,we (horizontal terminal line). Substituting and letting c2 = the 1 into the resulting general expression solution, take t c, = T/2 T ,and = value setting the stipulated 10, we obtain the equation

The

negative value, we end up with T* = 6. Then it follows

that c, = 3, and the extremal is

solution

values

of

T

are therefore

rt 6. Rejecting

the

 This time path is shown in Fig. 3.3. As required by the transversality condition, the extremal indeed attains a zero slope at the terminal point (6, 101.Unlike in Example 1, where the transversality condition translates into an orthogonality requirement, the transversality condition in the pre-sent example dictates that the extremal share a common slope with the given horizontal terminal line at t = T.

Application

to the Dynamic

Monopoly

Model

Let

us

now

consider

the

Evans

monopolist

a

variable

as a problem

with

terminal

state

P,

a fixed

2

P,,.

model

of

terminal

With

a

dynamic

time

the

T ,but

<