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Kausik Chaudhuri

Most economic and financial problems require the simultaneous choice of several

variables. A consumer chooses what quantities of different commodities to purchase.

A profit-maximising producer selects amounts of different inputs, as well as the level

o output. Therefore, most economic activities involve functions of more than one

independent variable. We, however, concentrate on the two-variable cases.

Let us consider a function y = f(x1, x2) defined on a set S in the x1x2-plane, where the

variables xi; i = 1; 2 are all independent of one other, i.e. each varies without affecting

others. To measure the effect of a change in a single independent variable on the

dependent variable in a multivariate function, the partial derivative is needed. Our

next question: what is partial derivative?

The partial derivative of y with respect to x1 measures the instantaneous rate of change

of y with respect to x1 while x2 is held constant. It is written as:

∂y ∂f

, , f x1 ( x1 , x2 ), f1/ ( x1 , x2 ), f x1 , y x1 .

∂x1 ∂x1

Similarly, the partial derivative of y with respect to x2 measures the instantaneous rate

of change of y with respect to x2 while x1 is held constant. It is written as:

∂y ∂f

, , f x 2 ( x1 , x2 ), f 2/ ( x1 , x2 ), f x 2 , y x 2 .

∂x2 ∂x2

= lim = lim

∂xi ∆xi → 0 ∆xi ∆xi → 0 ∆xi

If these limits exist, our function is differentiable with respect to all arguments.

In the two variable cases, we then can define partial derivative as:

∂y ∆y f ( x1 + ∆x1 , x2 ) − f ( x1 , x2 )

= lim = lim

∂x1 ∆x1 → 0 ∆x1 ∆x1 → 0 ∆x1

∂y ∆y f ( x1 , x2 + + ∆x2 ) − f ( x1 , x2 )

= lim = lim

∂x 2 ∆x 2 → 0 ∆x2 ∆x 2 → 0 ∆x2

Partial differentiation with respect to one of the independent variables follows the

same rules as ordinary differentiation while the other independent variables are

treated as constant.

Example

Solution

and then take the derivative of the x term, holding the y term constant:

∂z ∂

= ( 4 x 3 + xy + y )

∂x ∂x

d d d

= (4 x3 ) + y ( x) + ( y)

dx dx dx

= 3( 4 x 2 ) + y(1) + 0

= 12 x 2 + y

and then take the derivative of the y term, holding the x term constant:

∂z ∂

= ( 4 x 3 + xy + y )

∂y ∂y

d d d

= (4 x3 ) + x ( y ) + ( y )

dy dy dy

= 0 + x(1) + 1

= x +1

Partial derivatives follow the same basic patterns as the rules of differentiation.

a) Product Rule

Given

z = u ( x, y )v( x, y )

∂z ∂v ∂u

= u ( x , y ) + v( x , y )

∂x ∂x ∂x

∂z ∂v ∂u

= u ( x , y ) + v( x , y )

∂y ∂y ∂y

Example

∂z

= (3 x + 6)( 4) + ( 4 x + 7 y )(3) = 12 x + 24 + 12 x + 21 y = 24 x + 21 y + 24

∂x

∂z

= (3 x + 6)(7 ) + ( 4 x + 7 y )(0) = 21x + 42

∂y

b) Quotient Rule

Given

z = u ( x, y ) / v( x, y ); v( x, y ) ≠ 0

∂u ∂v

v( x , y ) − u( x, y )

∂z ∂x ∂x

=

∂x [v( x, y )]2

∂u ∂v

v( x , y ) − u ( x , y )

∂z ∂y ∂y

=

∂y [v( x, y )]2

Example

Given z = (3x+5y)/(4x+7y), by the quotient rule:

∂z ( 4 x + 7 y )(3) − (3 x + 5 y )( 4) 12 x + 21 y − 12 x − 20 y y

= = =

∂x [4 x + 7 y ]2

[4 x + 7 y ]2

[4 x + 7 y ]2

∂u ∂v

v( x , y ) − u ( x, y )

∂z ∂y ∂y ( 4 x + 7 y )(5) − (3 x + 5 y )(7 ) −x

= = =

∂y [v( x, y )]2 [4 x + 7 y ]2 [4 x + 7 y ]2

z = [u ( x, y )]n

∂z ∂u

= n[u ( x, y )]n −1

∂x ∂x

∂z ∂u

= n[u ( x, y )]n −1

∂y ∂y

Example

∂z

= 4(x 3 + 5 y 2 )4 −1( 3 x 2 ) = 12 x 2(x 3 + 5 y 2 )3

∂x

∂z

= 4(x 3 + 5 y 2 )4 −1( 10 y) = 40 y(x 3 + 5 y 2 )3

∂x

Second Order Partial Derivatives

Given a function y = f(x1, x2), the second–order (direct) partial derivative signifies that

the function has been differentiated partially with respect to one of the independent

variables twice while the other independent variable has been held constant. We can

define it as:

∂2 y ∂

= f xi x j ( x1 ,.., xn ) = f x ( x1 ,.., xn ), i , j = 1,2,.., n

∂xi ∂x j ∂x j i

∂2 y ∂

= f x1x1 ( x1 , x2 ) = f x ( x1 , x2 )

∂x12 ∂x1 1

2

∂ y ∂

= f x 2 x2 ( x1 , x2 ) = f x ( x1 , x2 )

∂x22 ∂x2 2

f x1 with respect to x1 while x2 is held constant. On the other hand, f x 2 x 2 measures

the rate of change of the first-order partial derivative f x 2 with respect to x2 keeping x1

as fixed.

The cross partial derivatives indicate that first the primitive function has been partially

differentiate with respect to one independent variable and then partial derivative has

in turn been partially differentiated with respect to the other independent variable. It

implies:

∂2 y ∂

= f x1x 2 ( x1 , x2 ) = f x ( x1 , x2 )

∂x2 ∂x1 ∂x2 1

∂2 y ∂

= f x 2 x1 ( x1 , x2 ) = f x ( x1 , x2 )

∂x1∂x2 ∂x1 2

So, a cross partial measures the rate of change of a first – order partial derivative with

respect to the other independent variable.

Given the definition of the cross partial derivatives, we have the following

proposition:

If at least one of the two partials is continuous, then f x1 x 2 = f x 2 x1 .

Example

Given, z = 2 x 3 + xy + 3 y 4 , calculate (a) the first; (b) the second, and (c) verify

Young’s Theorem.

(a)

∂z

zx = = 6x2 + y

∂x

∂z

zy = = x + 12 y 3

∂y

(b)

∂2z

z xx = = 12 x

∂x 2

∂2 z

z yy = = 36 y 2

2

∂y

(c) To verify Young’s theorem, we need to evaluate the cross partial derivatives.

∂2z ∂ ∂z ∂

z xy = = ( ) = (6 x 2 + y ) = 1

∂y∂x ∂y ∂x ∂y

∂2z ∂ ∂z ∂

z yx = = ( ) = ( x + 12 y 3 ) = 1

∂x∂y ∂x ∂y ∂x

Necessary Condition

has a stationary point at x* = (x*1, x*2). This implies all f x′ should vanish at x*.

i

Therefore, the first-order necessary conditions (FONCs) states:

f x′i = 0

f x′1 ( x1 , x2 ) = 0

f x′2 ( x1 , x2 ) = 0

Example: Profit Maximisation

with K as the capital input and L as the labour input. The price per unit of output p =

1, the cost per unit of capital is 0.65 and the wage rate is 1.2. Find only the possible

values of K and L that maximise profits.

Solution

π ( K , L ) = pQ − rK − wL

= 1[80 − ( K − 3) 2 − 2( L − 6)2 − ( K − 3)( L − 6)] − 0.65K − 1.2 L

π L/ ( K , L ) = −4( L − 6) − ( K − 3) − 1.2 = 0 ⇒ −4 L + 24 − K + 3 − 1.2 = 0

2 K + L = 11.35 (1)

K + 4 L = 25.8 (2)

2 K + L − 2 K − 8 L = 11.35 − 51.6

− 7 L = −40.25

L = 5.75

2 K + 5.75 = 11.35

2 K = 5 .6

K = 2 .8

Sufficient Condition

point is that f//(x) ≤ 0 for all x in I. The function f is then called “concave”.

point is that f//(x) ≥ 0 for all x in I. The function f is then called “convex”.

For functions of two variables, we can extend the above involving the second-order

partial derivatives.

Suppose that (x01, x02) is a stationary point for a C2 – function y = f(x1, x2) in a convex

set S.

′′ ( x1 , x2 ) ≤ 0, f 22

f11 ′′ ( x1 , x2 ) ≤ 0, f11

′′ ( x1 , x2 ) f 22 ′′ ( x1 , x2 )]2 ≥ 0

′′ ( x1 , x2 ) − [( f12

′′ ( x1 , x2 ) ≥ 0, f 22

f11 ′′ ( x1 , x2 ) ≥ 0, f11

′′ ( x1 , x2 ) f 22 ′′ ( x1 , x2 )]2 ≥ 0

′′ ( x1 , x2 ) − [( f12

Note, if a twice differentiable function y = f(x1, x2) satisfies the inequalities in (a)

throughout a convex set S, it is called concave, whereas it is called convex if it

satisfies the inequalities in (b) throughout S.

Example: Utility Maximisation

In this example, suppose the utility function of a consumer is described by: U = xyz.

This implies that consumer derives utility from consuming x, y and z units of three

commodities. The prices per unit of the three commodities are 1, 3 and 5 respectively

and we assume that the income of the consumer equals 108. We also assume that the

consumer saves nothing. Find the only possible maximum value of the utility of the

consumer.

Solution

Note given the prices and the income of the consumer, we get x + 3y + 4z = 108

So, x = 108 – 3y – 4z.

Substituting value of x in the utility function, we obtain:

U = (108- 3y - 4z)yz = 108yz – 3y2z -4yz2

As a first-order necessary condition for maximisation (optimisation) we set Uy = 0 and

Uz = 0.

∂U ∂

Uy = = (108 yz − 3 y 2 z − 4 yz 2 ) = 0

∂y ∂y

U y = 108 z − 6 yz − 4 yz 2 = 0 ⇒ z (108 − 6 y − 4 z ) = 0

⇒ 6 y + 4 z = 108 as z > 0

Similarly

∂U ∂

Uz = = (108 yz − 3 y 2 z − 4 yz 2 ) = 0

∂z ∂z

U z = 108 y − 3 y 2 − 8 yz = 0 ⇒ y(108 − 3 y − 8 z ) = 0

⇒ 3 y + 8 z = 108 as y > 0

6 y + 4 z = 108 (1)

3 y + 8 z = 108 (2)

12 y + 8 z − 3 y − 4 z = 216 − 108

9 y = 108

y = 12

U y = 108 z − 6 yz − 4 z 2

U yy = −6 z

U z = 108 y − 3 y 2 − 8 yz

U zz = −8 y

U y = 108 z − 6 yz − 4 z 2

U yz = 108 − 6 y − 8 z

U yyU zz − (U yz ) 2 = 48 yz − (108 − 6 y − 8 z )2

Given the budget constraint, we get, x = 108 – 3(12) – 4(9) = 36

So, utility attains the maximum value at 3888 with x = 36, y = 12 and z = 9. However,

we note that we could not directly apply the theorem.

need to distinguish between local and global extreme points. A global extreme point

is a local extreme point however, the converse is not true.

Definition

There exists a positive number ε such that f(x1, x2) ≤ f(x01, x02) for all (x1, x2) in S that

lie inside the circle with centre (x01, x02) and radius ε. If the inequality is strict, for (x1,

x2) ≠ (x01, x02), then (x01, x02) is a strict local maximum point.

Similarly, there exists a positive number ε such that f(x1, x2) ≥ f(x01, x02) for all (x1, x2)

in S that lie inside the circle with centre (x01, x02) and radius ε. If the inequality is

strict, for (x1, x2) ≠ (x01, x02), then (x01, x02) is a strict local minimum point.

The first-order conditions are necessary for a differentiable function to have a local

extreme point. However, a stationary point does not have to be a local extreme point.

A stationary point can be neither a local maximum nor a local minimum point, and

this is known as a saddle point of f.

A saddle point (x01, x02) is a stationary point with the property that there exits points

(x1, x2) arbitrarily close to (x01, x02) with f(x1, x2) < f(x01, x02) and there also exist such

points with f(x1, x2) > f(x01, x02).

The stationary points of a function can thus be classifies into following categories:

(i) Local maximum points (ii) Local minimum points (iii) Saddle points

We can use the second-derivative test to examine whether a given stationary point if

of type (i), (ii) or (iii). In this case, (functions involving two variables) the cross

second-order partials must be considered along with own second-order derivatives.

We use the following theorem to classify the stationary points in most cases.

domain S, and let (x01, x02) be an interior stationary point of S for f(x1, x2). We define:

// 0 0 // 0 0 // 0 0

A = f11 ( x1 , x2 ), B = f12 ( x1 , x2 ) and C = f 22 ( x1 , x2 )

a) If A < 0 and AC – B2 > 0, then (x01, x02) is a strict local maximum point.

b) If A > 0 and AC – B2 > 0, then (x01, x02) is a strict local minimum point.

saddle point.

Example

Find the stationary point and classify them when f(x,y) = x3 – 8y3 + 6xy + 1

Solution

f1/ ( x, y ) = 3( x 2 + 2 y ) = 0 and f 2/ ( x, y ) = 6( −4 y 2 + x ) = 0

x2 + 2 y = 0

− 2 y = x2

− 4y2 + x = 0

x = 4y2

x = ( −2 y )( −2 y )

x(1 − x 3 ) = 0

Either x = 0 or (1 − x 3 ) = 0 ⇒ x = 1

If x = 0 then y = 0.

If x = 1 then y = -1/2

//

f11 ( x, y ) = 6 x

//

f 22 ( x, y ) = −48 y

//

f12 ( x, y ) = 6

(0, 0) 0 6 0 -36 Saddle Point

(1, -1/2) 3 6 24 66 Local Minimum

Linear Models with Quadratic Objectives

We will consider some more economic applications of optimisation theory when there

are two variables.

Example

The profit function of a firm is π(x, y) = px + qy – ax2 - by2, where p and q are the

prices per unit and ax2 + by2 are the costs of producing and selling x units of the first

good and y units of the second good.

(a) Find the values of x and y that maximize profits. Denote them by x* and y*.

Verify that the second order conditions are satisfied.

(b) Define π*(p, q) = π*( x*, y*). Verify that δπ*(p, q)/δp = x* and δπ*(p, q)/δq = y*

Solution

(a) The first-order necessary conditions for profit maximisation problem are:

∂π p

π 1/ = = p − 2ax = 0 ⇒ x =

∂x 2a

∂π q

π 2/ = = q − 2by = 0 ⇒ y =

∂y 2b

//

π 11 = −2 a < 0

//

π 22 = −2b < 0

//

π 12 =0

// // // 2

π 11π 22 − (π 12 ) = 4ab > 0

(b)

π * ( p, q ) = px* + qy* − ax*2 − by*2

p q p q

= p( ) + q ( ) − a ( ) 2 − b( ) 2

2a 2b 2a 2b

p2 q2

= +

4a 4b

∂π * p

= = x*

∂p 2a

∂π * q

= = y*

∂q 2b

Example

Each of two firms produces its own brand of a commodity, denoted by x and y, and

these are sold at prices p and q per unit respectively. Each firm determines its own

price and produces exactly as much as is demanded. The demand for each brands are

given by:

x = 29 - 5p + 4q y = 16 + 4p – 6q

Firm A has total costs 5 + x, whereas firm B has total costs 3 + 2y.

(a) Initially, the two firms cooperate in order to maximise their combined profits.

Find the prices (p, q), the production levels (x, y) and the profits for firm A

and firm B.

(b) Then cooperation breaks down, with each producer maximising its own

profit, taking the other’s price as given. If q is fixed, how will firm A choose

p? If p is fixed, how will firm B choose q?

(c) Under the assumptions in part (b), what constant equilibrium prices are

possible? What are the production levels and profits in this case?

Solution

(a) In this case, firms cooperate to maximise profits. Hence, profit can be defined

as the sum of total revenues earned by two firms minus the total costs faced by

them.

π = px + qy − (5 + x ) − (3 + 3 y )

= p( 29 − 5 p + 4q ) + q(16 + 4 p − 6q )

− (34 − 5 p + 4q ) − (35 − 8 p + 12q )

= 29 p − 5 p 2 + 4 pq + 16q + 4 pq − 6q 2

− 34 + 5 p − 4q − 35 + 8 p − 12q

= 26 p + 24q − 5 p 2 − 6q 2 + 8 pq − 69

∂π

= 26 − 10 p + 8q = 0 ⇒ −5 p + 4q = −13 (1)

∂p

∂π

= 24 − 12q + 8 p = 0 ⇒ 2 p − 3q = −6 (2)

∂q

We use equation (1) and (2) to solve for p and q. We get p = 9 and q = 8.

(b) In this case, cooperation breaks down. Each of two firms maximises its own

profit taking the other’s price as given.

π A = px − (5 + x )

= p( 29 − 5 p + 4q ) − (34 − 5 p + 4q )

= 29 p − 5 p 2 + 4 pq − 34 + 5 p − 4q

= 34 p − 5 p 2 + 4 pq − 4q − 34

π B = qy − (3 + 2 y )

= q(16 + 4 p − 6q ) − (35 + 8 p − 12q )

= 16q + 4 pq − 6q 2 − 35 − 8 p + 12q

= 28q − 6q 2 + 4 pq − 8 p − 35

The first-order necessary condition for profit maximisation (note firms are taking

other firm’s price as given (as a constant)) gives:

∂π A

= 34 − 10 p + 4q = 0 ⇒ 5 p = 2q + 17 (1)

∂p

∂π B

= 28 − 12q + 4 p = 0 ⇒ 3q = p + 7 (2)

∂q

Firm B’s profit = (12)(4) – 3 – 24 = 21

Let z = f(x, y) be a continuous, finite-valued function for all points (x, y) within a

closed and bounded region R in the xy-plane. The Extreme Value Theorem states that

the function z = f(x,y) is then guaranteed to have both an absolute maximum point and

an absolute minimum point when restricted to the region R.

The terms closed and bounded have distinct mathematical meanings. A point (a,b) is

called an interior point of a set S in the plane if there exists a circle centred at (a,b)

such that all points strictly inside the circle lie in S. A set is an open set if it consists

only of interior points. The point (a,b) is called a boundary point of a set S if every

circle centred at (a,b) contains points of S as well as points in its compliments. A

boundary point of S does not necessarily lie in S. If S contains all of its boundary

point, then S is called a closed set.

The typical problem will be given with a series of constraints, which are usually

inequalities, and boundary points occur where one or more of these inequalities

satisfied with equality.

bounded region in the xy-plane. However, the set of constraints x ≥ 0, y ≥ 0, 2x + y ≥ 6,

x + y ≥ 4 form an unbounded region.

In general, if g(x, y) is a continuous function and c is a real number, then the sets

are all closed. However, if we replace ≥ by >, or ≤ by <, or = by ≠, then the

corresponding set becomes open.

We state the Extreme-Value Theorem formally:

Suppose the function f(x, y) is continuous throughout a non-empty, closed and

bounded set S in the plane. Then there exists both a point (a, b) in S where f attains a

minimum and a point (c, d) where f attains a maximum:

We set the following procedures to find the maximum and minimum values of a

differentiable function f(x, y) defined on a closed, bounded set S in the plane.

b) We then find the largest and the smallest value of f on the boundary of

S, along with the associated points. We may want to divide the

boundary into several parts, and find the largest and the smallest value

in each part of the boundary.

c) We compute the values of the function at all the points found in a) and

b). The largest function value is the maximum value of f in S. The

smallest function value is the minimum value of f in S.

Example

f ( x, y ) = x 2 + 2 y 2 − x, S = {( x, y ) : x 2 + y 2 ≤ 1}

Solution

points satisfy the two equations:

f1/ ( x, y ) = 2 x − 1 = 0

f1/ ( x, y ) = 4 y = 0

So (x, y) = (1/2, 0) is the stationary point that lie in the interior of S with f(1/2, 0) =

-1/2.

of f(x, y) is determined by:

g ′( x ) = −1 − 2 x = 0 at x = −1 / 2

We also note g(-1) = 2 and g(1) = 0. So (-1,0) and (1,0) are also optimality

candidates.

c) We compare the values of f at all these points.

f(-1, 0) = 2

f(1, 0) = 0

Therefore, we conclude that f has maximum 9/4 at (−1/2, √3/2) and at (−1/2,

−√3/2). The minimum is −1/4 at (1/2, 0).

Example

f ( x, y ) = 3 + x 3 − x 2 − y 2 , S = {( x, y ) : x 2 + y 2 ≤ 1 and x ≥ 0}

Solution

points satisfy the two equations:

f1/ ( x, y ) = 3 x 2 − 2 x = 0 ⇒ x(3 x − 2) = 0

f1/ ( x, y ) = 4 y = 0

So (x, y) = (2/3, 0) is the stationary point that lie in the interior of S along and at

the boundary point (0, 0).

Hence f(0, y) = 3 – y2. This is largest when y = 0 and smallest when y = ±1.

Along the edge, x2 + y2 = 1, x ∈ [0, 1], hence f(x, y) = 2 + x3. This is strictly

increasing, smallest at x = 0 and largest at x = 1.

Therefore, we conclude that f has maximum 3 at (0, 0) and at (1, 0). The minimum

is 2 at (0, 1) and at (0, -1).

Example

f ( x, y ) = x 2 + y 2 + xy − 5 x − 4 y + 1, S = {( x, y ) : 0 ≤ x ≤ 4,0 ≤ y ≤ 4}

Solution

points satisfy the two equations:

f1/ ( x, y ) = 2 x + y − 5 = 0

f1/ ( x, y ) = 2 y + x − 4 = 0

So (x, y) = (2, 1) is the stationary point that lie in the interior of S and f(2,1) = -6.

we get a square with vertex points (0,0), (0,4), (4,0) and (4,4). By direct

evaluation we have the following functional values:

f(0, 0) = 1 f(4, 0) = -3 f(0, 4) = 1 f(4, 4) = 13

f(4, y) = 16 + y2 + 4y - 20 - 4y + 1 = y2 – 3.

The derivative of f(4, y) with respect to y, 2y and setting that equal to zero, we get

y = 0.

f(x, 4) = x2 + 16 + 4x – 5x - 16 + 1 = x2 – x + 1.

The derivative of f(x, 4) with respect to x, 2x -1 and setting that equal to zero, we get

x = ½ and f (1/2, 4) = ¾.

f(0, y) = y2 - 4y + 1.

The derivative of f(0, y) with respect to y, 2y - 4 and setting that equal to zero, we get

y = 2 and f (0, 2) = -3.

f(x, 0) = x2 - 5x + 1.

The derivative of f(x, 0) with respect to x, 2x - 5 and setting that equal to zero, we get

x = 5/2 and f (5/2, 0) = -21/4.

(c) We compare the values of f at all these points. We have a total of eight. We

see the maximum value of the function is 13 at (4, 4) while the minimum value is

-6 at the point (2,1).

Reading

Knut Sydsaeter, Peter Hammond (2006), Sections 13.1 – 13.5, pp 463 - 492

Constrained Optimisation

Because resources are scarce, all optimisation problems in economics are problems of

constrained optimisation: maximising or minimising some objective function subject

to one or more constraints, for example, maximising profits subject to the state of

technical knowledge and exogenous prices or demand function. Minimising the cost

of producing some exogenous level of output subject to the state of technical

knowledge and input prices (the production manager’s problem) is another example.

Finding the bundle of goods that maximises an individual’s utility subject to his or her

budget constraint can also act as a constrained optimisation problem.

Let us motivate this further in terms of the production manager’s problem. You have

been hired to run a factory producing a commodity; that is, you are in charge of

production of that commodity. On your day one, the old guy that you are replacing

describes to you the state of knowledge for producing the commodity. That is, he

explains that you will need labour and/or capital to produce, and explains how many

units can be produced at every possible nonnegative amount of labour and capital.

Every morning when you get to work you read the daily newspaper to determine the

going rate for labour and capital, w and r. The minute you put down the paper, the

marketing department calls to tell you how many units need to be produced that day.

Each day your goal is to hire the amount of labour and capital that minimises the cost

of producing whatever number you were told to produce. Or at least this is what we

are going to assume is you goal. Your problem is the production manager’s problem.

Your choice variables (the endogenous variables) are the amount of labour, l, and

capital k to hire. However, you are constrained by the number you must produce q,

input prices, w and r, and the state of technical knowledge for producing widgets. So,

your exogenous variables are q, w, and r. There are lot of ways to describe the state of

technical knowledge for production, one of which is the production function:

constraints, namely, input prices and number of units of output. We can state this as:

min c = wl + rk subject to q = f ( k , l )

To find a solution, we make use much use of a method, known as the Lagrange

multiplier method. Let us introduce the method in a general way.

Consider first the problem of minimising or maximising a function f(x, y) when x and

y are restricted to satisfy an equality constraint g(x, y) = c. In the production

manager’s problem, note that g(x, y) = c is nothing but q = f(k, l). We state the

problem as:

In the first step of the Lagrange multiplier method, we introduce a Lagrange

multiplier, denoted by λ, which is associated with the constraint g(x, y) = c. In the

second step, we define the Lagrangian function L by:

L(x, y) = f(x, y) - λ [g(x, y) – c] (2)

Note the expression [g(x, y) – c] equals zero when the constraint is satisfied. In that

case, L(x, y) = f(x, y) for all (x, y) that satisfies the constraint g(x, y) = c.

and equate the partial derivatives to zero as a first-order necessary

condition for optimisation.

L/2 ( x, y) = f 2/ ( x, y) − λg2/ ( x, y) = 0

g( x, y) = c

Step 4: We solve the above three equations obtained in Step 3 for three

unknowns x, y and λ.

Example

Solution

L( x, y ) = x 2 + 3 xy + y 2 - λ ( x + y − 100)

and equate the partial derivatives to zero as a first-order necessary

condition for optimisation.

L1/ ( x, y ) = 2 x + 3 y − λ = 0

L/2 ( x, y ) = 3 x + 2 y − λ = 0

x + y = 100

2x + 3y = λ

3x + 2 y = λ

x + y = 100

Step 4: We solve the above three equations obtained in Step 3 for three

unknowns x, y and λ.

2 x + 3 y = 3x + 2 y

−x+ y=0

x + y = 100

Example

Suppose that U(x, y) is a utility function for a society, with x denoting the economic

activity level and y the level of pollution. Let U(x, y) be defined for all x > 0, y > 0

by:

U ( x, y ) = ln( xα + yα ) − ln yα (1)

We also assume that the level of pollution y depends on the activity level by the

equation:

y 3 − ax 4 − b = 0 (2)

Use Lagrange’s method to find the activity level that maximizes U(x, y) subject to the

constraint given by equation (2).

Solution

L( x, y ) = ln( xα + yα ) − ln yα - λ ( y 3 − ax 4 − b )

and equate the partial derivatives to zero as a first-order necessary

condition for optimisation.

1

L1/ ( x, y ) = (αxα −1 ) + 4aλx 3 = 0

α α

x +y

1 1

L/2 ( x, y ) = (αyα −1 ) − (αyα −1 ) − 3λy 2 = 0

xα + y α yα

L/λ = y 3 − ax 4 − b = 0

αxα −1

= −4aλx 3 (A)

α α

x +y

1 1

(αyα −1 ) − (αyα −1 ) = 3λy 2

α α α

x +y y

1 1

αyα −1 ( α α

−

α

) = 3λy 2

x +y y

yα − xα − yα

αyα −1[ α α α

] = 3λy 2

(x + y )y

− xα

αyα −1[ α α α

] = 3λy 2

(x + y )y

α xα

− = 3λy 2 (B)

α α

y( x + y )

y 3 − ax 4 − b = 0 (C)

Step 4: We solve the above three equations obtained in Step 3 for three

unknowns x, y and λ.

αxα −1

xα + yα 4 aλ x 3

− =−

αxα 3λy 2

y ( xα + yα )

y 4ax 3

− =−

x 3y2

3 y3

x4 =

4a

3y3

Substituting x 4 = in (C), we get

4a

y 3 − ax 4 − b = 0

3 y3

y 3 − a( )−b = 0

4a

y 3 = 4b

y = 3 4b

3y3 4ax 4

On the other hand, note x 4 = implies that y 3 = .

4a 3

From (C), we get:

4ax 4

− ax 4 − b = 0

3

ax 4 = 3b

3b

x4 =

a

3b

x=4

a

Suppose, we get x* and y* as the solutions of x and y when we solve the problem. Note

x* and y* depend on c: x* = x* (c) and y* = y* (c). We assume that they differentiable

functions of c.

Given this, the associated value of function f(x, y) also depends on c. Therefore, we

get:

We call f*(c) as the optimal value function.

df * (c ) = df * ( x* , y* )

= f1/ ( x* , y* )dx* + f 2/ ( x* , y* )dy*

= λg1/ ( x* , y* )dx* + λg 2/ ( x* , y* )dy*

= λ[ g1/ ( x* , y* )dx* + g 2/ ( x* , y* )dy* ]

g ( x* (c ), y* (c )) = c

g1/ ( x* , y* )dx* + g 2/ ( x* , y* )dy* = dc

Therefore, we get:

df * ( c )

λ (c ) =

dc

The above defines the rate at which the optimal value of the objective function

changes with respect to changes in the constraint constant c. Economists refer λ as

the shadow price of the resource (c).

What does the shadow price mean in utility maximisation? It is essentially the ‘utility

value’ of relaxing the budget constraint by one unit (e.g., one £).

What does the shadow price mean in profit maximisation? It is essentially the ‘profit

value’ of relaxing the budget constraint by one unit (e.g., one £).

What does the shadow price mean in cost maximisation? It is essentially the ‘cost

value’ of relaxing the budget constraint by one unit (e.g., one £).

Example

a) Using the Lagrange method and find the quantities demanded for the two goods.

b) Suppose income increases from 100 to 101. What is the exact increase in the

optimal value of U(x, y)? Compare the value found in a) for the Lagrange multiplier.

a) L( x , y ) = x + y - λ ( x + 4 y − 100)

1

/ 1 −2

L1( x, y ) = x − λ = 0

2

1

L/2 ( x, y ) = 1 − 4λ = 0 ⇒ λ =

4

x + 4 y = 100

Then

1 1

1 −2 1 − 1

x = ⇒x 2 = ⇒x=4

2 4 2

From x + 4 y = 100, we get y = 24

b) Note if income has changed from 100 to 101, then the new budget constraint is:

x + 4y = 101

The first-order necessary conditions in terms of L1/ ( x, y ) and L/2 ( x, y ) will be the

same as stated in a). Therefore, the values of λ and x remain unchanged. However,

the equilibrium y increases from 24 to 97/4 (note the new budget constraint).

The exact increase in the optimal value of U(x, y) (∆U): 105/4 – 26 = ¼. This is same

as the value of the Lagrange multiplier λ. But what is the reason behind it?

There is exact equality here because U is linear in one of the variables – in which one

that I leave as an exercise for you to decide!!!

Lagrange’s Theorem

Suppose that f(x, y) and g(x, y) have continuous partial derivatives in a domain A

of the xy-plane, and that (x0, y0) is both an interior point of A and a local extreme

point for f(x, y) subject to the constraint g(x, y) = c. Suppose further that g/1(x0, y0)

and g/2(x0, y0) are not both 0. Then there exists a unique number λ such that the

Lagrangian function

Under the hypotheses of Lagrange’s theorem, the Lagrange multiplier method for the

problem

gives necessary conditions for the solutions. However, we need to make sure that we

really have obtained the solutions. If the constraint set is closed and bounded, then

the extreme value theorem guarantees that a continuous function will attain both the

maximum and the minimum over this set. There may be situations where the first-

order necessary conditions will give more than one points as solutions. We need to

check amongst them which one gives f its highest (maximisation problem) and lowest

value (minimisation problem). The sufficient conditions help us to achieve this task.

We start with Concave/Convex Lagrangian.

Concave/Convex Lagrangian

Suppose, we get x* and y* as the solutions of x and y when we solve the problem:

then the Lagrangian function L(x, y) = f(x, y) – λ [g(x, y) - c] is stationary at (x*, y*).

But it does not guarantee that L(x, y) attains a maximum (minimum) at (x*, y*).

Suppose, (x*, y*) happens to maximise L(x, y) among all (x, y). Then we can write:

L(x*, y*) = f(x*, y*) – λ [g(x*, y*) - c] ≥ f(x, y) – λ [g(x, y) - c] for all (x, y)

If (x*, y*) also satisfies the constraint g(x*, y*) = c. Then we obtain f(x*, y*) ≥ f(x, y)

for all (x, y) such that g(x, y) = c. In this case, we claim that (x*, y*) is really the

solution for the maximisation problem.

Suppose, (x*, y*) happens to minimise L(x, y) among all (x, y). Then we can write:

L(x*, y*) = f(x*, y*) – λ [g(x*, y*) - c] ≤ f(x, y) – λ [g(x, y) - c] for all (x, y)

If (x*, y*) also satisfies the constraint g(x*, y*) = c. Then we obtain f(x*, y*) ≤ f(x, y)

for all (x, y) such that g(x, y) = c. In this case, we claim that (x*, y*) is really the

solution for the minimisation problem.

Note a stationary point for a concave (convex) function maximises (minimises) the

function. Therefore, we get the following result:

Consider the problem: min(max) f(x, y) subject to g(x, y) = c, and suppose (x*, y*) as a

stationary point for the Lagrangian L(x, y). We assume L(x, y) as a C2-function and

(x*, y*) lies in a convex set S.

/

L11 ( x, y ) ≤ 0, L/22 ( x, y ) ≤ 0, and L11

/

( x, y ) L/22 ( x, y ) − [ L12

/

( x, y )]2 ≥ 0

then (x*, y*) solves the maximization problem.

/

L11 ( x, y ) ≥ 0, L/22 ( x, y ) ≥ 0, and L11

/

( x, y ) L/22 ( x, y ) − [ L12

/

( x, y )]2 ≥ 0

then (x*, y*) solves the minimisation problem.

Note under result 1, the Lagrangian is concave and under result 2, the Lagrangian is

convex.

Example

Consider an individual consuming positive amounts x and y of two goods X and Y

respectively. The individual wants to minimise the total expenditure on purchasing

the goods. Price per unit of good X is p and that of Y is q. However, the individual

wants to attain a certain level of utility given by the utility function: U = Axαyβ with

α > 0, β > 0 and α + β ≤ 1. Therefore, the individual wants to minimise expenditure

given by px + qy subject to U = Axαyβ . Explain why the Lagrangian is convex, so

that a stationary point of the Lagrangian must minimize expenditure.

Solution

L = px + qy − λ ( Axα y β − U )

∂L

= p − λαAxα −1 y β = 0

∂x

∂L

= q − λβ Axα y β −1 = 0

∂y

∂L

= U − Axα y β = 0

∂λ

∂2L

/

L11 = = −λα (α − 1) Axα − 2 y β

2

∂x

∂2L

L/22 = 2

= −λβ ( β − 1) Axα y β − 2

∂y

∂2L

/

L12 = = −λα ( β − 1) Axα −1 y β −1

∂x∂y

/

Note from above we can infer that: L11 > 0 , L/22 > 0 , provided λ > 0.

/

L11 ( x, y ) L/22 ( x, y ) − [ L12

/

( x, y )]2

= λ2αβ (α − 1)( β − 1) A 2 x 2(α −1) y 2( β −1) − λ2α 2 ( β − 1) 2 A 2 x 2(α −1) y 2( β −1)

= λ2αβ A2 x 2(α −1) y 2( β −1) [1 − (α + β )] ≥ 0

satisfied.

We sometimes are interested in conditions that are sufficient for local extreme points

of f(x, y) subject to g(x, y) = c. We would start with an example to show that the

Lagrange-multiplier method does not always provide the solution to an optimization

problem. Consider the problem:

Note the restriction:

( x-1)3 − y 2 = 0 ⇒ ( x-1)3 = y 2 ⇒ x ≥ 1

If x = 1, then y = 0 and x2 + y2 = 1

Now we form the Lagrangian and set the first-order partial derivatives to be equal to

zero as a first-order necessary condition for minimisation (optimisation) problem

L( x, y ) = x 2 + y 2 − λ[( x − 1)3 − y 2 ]

∂L

= 2 x − 3λ ( x − 1) 2 = 0

∂x

∂L

= 2 y + 2λy = 0

∂y

∂L

= ( x − 1)3 − y 2 = 0

∂λ

From the first first-order condition, we can state that it is not satisfied for x = 1. So

the Lagrange-multiplier method is not able to detect the solution (1, 0).

which we state as follows:

We consider the problem local min(max) f(x, y) subject to g(x, y) = c and suppose that

(x*, y*) satisfies the first-order necessary conditions:

f1/ ( x, y ) = λg1/ ( x, y ), f 2/ ( x, y ) = λg 2/ ( x, y )

We define

// //

D( x, y , λ ) = ( f11 − λg11 )( g 2/ ) 2 − 2( f12

// //

− λg12 ) g1/ g 2/ + ( f 22

// //

− λg 22 )( g1/ ) 2

Now

(A) If D(x*, y*, λ) > 0 then (x*, y*) solves the local minimisation problem.

(B) If D(x*, y*, λ) < 0 then (x*, y*) solves the local maximisation problem.

The conditions on the sign of D(x*, y*, λ) is known as the local second-order

conditions.

Our question: Can we express D(x*, y*, λ) in some other way? The answer is yes.

If we note the expression, we can express the determinant D(x*, y*, λ) as:

0 g1/ ( x, y ) g 2/ ( x, y )

D( x, y , λ ) = − g1/ ( x, y ) /

f11 //

( x, y ) − λg11 ( x, y ) /

f12 //

( x, y ) − λg12 ( x, y )

g 2/ ( x, y ) /

f 21 //

( x, y ) − λg 21 ( x, y ) /

f 22 //

( x, y ) − λg 22 ( x, y )

evaluated at (x*, y*).

/ // / //

f11 ( x, y ) − λg11 ( x, y ) f12 ( x, y ) − λg12 ( x, y )

/ // / //

f 21 ( x, y ) − λg 21 ( x, y ) f 22 ( x, y ) − λg 22 ( x, y )

is the Hessian of the Lagrangian function. Hence, the determinant of D(x*, y*, λ) is

called a bordered Hessian as its borders part from 0 are the first-order partial

derivatives of g.

In case of optimisation problem with one constraint [g(x, y) = c], with two variables

[(x, y)], we can express the determinant alternatively as:

0 g1/ ( x, y ) g 2/ ( x, y )

D( x, y , λ ) = − g1/ ( x, y ) /

L11 ( x, y ) /

L12 ( x, y )

g 2/ ( x, y ) L/21 ( x, y ) L/22 ( x, y )

/

Note L12 ( x, y ) = L/21( x, y ) (recall Young’s theorem)

0 g1/ ( x, y ) g 2/ ( x, y )

D( x, y , λ ) = − g1/ ( x, y ) /

L11 ( x, y ) /

L12 ( x, y )

g 2/ ( x, y ) L12

/

( x, y ) L/22 ( x, y )

/

( x, y )

− g 2/ ( x, y ) g1/ ( x, y ) L12

/

( x, y ) + [ g 2/ ( x, y )]2 L11

/

( x, y )

= [ g 2/ ( x, y )]2 L11

/

( x, y ) − 2 g1/ ( x, y ) g 2/ ( x, y ) L12

/

( x, y ) + [ g1/ ( x, y )]2 L/22 ( x, y )

We note that the above expression is same as the one that we have obtained earlier as:

// //

D( x, y , λ ) = ( f11 − λg11 )( g 2/ ) 2 − 2( f12

// //

− λg12 ) g1/ g 2/ + ( f 22

// //

− λg 22 )( g1/ ) 2

Example

The preferences of a consumer over two goods x and y are given by the utility

function: U(x, y) = (x + 1)(y + 1) = xy + x + y + 1. The prices of goods x and y are 1

and 2, respectively, and the consumer's income is 30. What bundle of goods will the

consumer choose? Does it satisfy second-order conditions?

Solution

The Lagrangian function is:

∂L

= y +1− λ = 0

∂x

∂L

= x + 1 − 2λ = 0

∂y

∂L

= x + 2 y − 30 = 0

∂λ

From the first equation, we get λ = y +1 and we substitute the value of λ in the second

equation. We obtain:

x – 2y – 1 = 0 (1)

x + 2y – 30 = 0 (2)

We solve equations (1) and (2) for x and y. We obtain x = 31/2 and y = 29/4.

To check whether this solution really maximizes the objective function, let us apply

the second-order sufficient conditions. The second-order conditions involve the

bordered Hessian:

0 g1/ ( x, y ) g 2/ ( x, y )

D( x, y , λ ) = − g1/ ( x, y ) /

L11 ( x, y ) /

L12 ( x, y )

g 2/ ( x, y ) L12

/

( x, y ) L/22 ( x, y )

0 1 2

= −1 0 1

2 1 0

= −[0(0 − 1) − 1(0 − 2) + 2(1 − 0)]

= −[2 + 2]

= −4 < 0

Therefore, the solutions x = 31/2 and y = 29/4 satisfies the second order conditions an

represents the bundle demanded by the consumer.

Simple Rule

examine whether the determinants alternate their sign. For a local maximum, even

and odd-numbered minors have opposite signs: (D2 < 0 and D3 > 0 and so on). For the

local minimum, the determinants of principal minors should have the same sign (D2 >

0 and D3 > 0 and so on). We would in deal with this in detail when we deal with the

optimisation problem with more than two variables.

Reading

Knut Sydsaeter, Peter Hammond (2006), Sections 14.1 – 14.4, pp 503 - 519

Carl Simon and Lawrence Blume (1994), Section: 18.1 – 18.2 pp 411- 424

Constrained Optimisation

More Variables and More Constraints

Constrained optimisation problem in economics often involve more than just two

variables. Consider the problem involving n variables and m constraints:

max (min) f(x1,….., xn) subject to gj(x1,….., xn) = bj ; j = 1, 2,…., m < n (1)

f is called the objective function, g1, g2,… , gm are the constraint functions, b1, b2,..,bm

are the constraint constants. The difference n - m is the number of degrees of freedom

of the problem. Note that n is strictly greater than m.

variables as functions of the other n - m independent variables, we can eliminate m

variables in the objective function, thus the initial problem will be reduced to the

unconstrained optimization problem with respect to n - m variables. However, in

many cases it is not technically feasible to explicitly express one variable as function

of the others.

1 2 m 1 ∂g j

We assume that f and g , g ,…., g are C functions and the Jacobian ( J = ), i =

∂xi

1,2,…, n and j = 1,2,…,m have the full rank, rank (J) = m. Associating a Lagrange

multiplier λj with the constraint, we write the Lagrangian as:

m

L( x1 ,..., xn , λ1,... , λm ) = f ( x1 ,..., x n ) − ∑ λ j [ g j ( x1 ,..., x n ) − b j ]

j =1

What are the necessary conditions for the solutions of (1)?

We partially differentiate L with respect to x1,…., xn, λ1,…, λj and set all the partials

to be equal to zero. This gives us:

= − ∑ λj = 0, i = 1,2,..., n

∂xi ∂xi j =1 ∂ x i

∂L( x1 ,..., xn , λ1 ,..., λ m )

= − g j ( x1 ,..., xn ) + b j = 0, j = 1,2,..., m

∂λ j

unknowns. If we face the problem with only one constraint, then we will have n +1

equations to solve for n + 1 unknowns.

important that rank (J) = m and the functions are continuously differentiable.

It is crucial at this juncture to explain the Jacobian (J). We explain it in terms of the

following example.

subject to the constraint x2 + ay2 = 1 where x > 0, y > 0 and a is a positive parameter.

Solution

L = ax + y − λ ( x 2 + ay 2 − 1)

Differentiation of the Lagrangian Function with respect to x, y and λ gives us the first-

order necessary conditions:

∂L

= F 1 ( x, λ ; a ) = a − 2 xλ = 0

∂x

∂L

= F 2 ( y , λ ; a ) = 1 − 2 yaλ = 0

∂y

∂L

= F 3 ( x, y; a ) = x 2 + ay 2 − 1 = 0

∂λ

Given the system of three equations (formed by the first-order conditions), the

Jacobian (J) takes the following form:

∂F 1 ∂F 1 ∂F 1

∂x ∂y ∂λ

2

∂F ∂F 2 ∂F 2

J =

∂x ∂y ∂λ

∂F 3 ∂F 3 ∂F 3

∂x ∂y ∂λ

− 2λ 0 − 2x

= 0 − 2aλ − 2ay

2x 2ay 0

Note the determinant of the Jacobian is | J | = -8aλ(x2+ay2) = -8aλ < 0 at the optimal

point. We also note that the rank of the Jacobian is 3. Here we have three equations

in three unknowns.

Next we introduce more examples, first with the case of more variables and then with

both more variables and more constraints.

A consumer’s demands x, y, z for three goods X, Y and Z to maximize the utility

function: U ( x, y , z ) = x + y − 1 / z subject to the budget constraint px + qy + rz = m .

Solution

L = x + y − 1 / z − λ ( px + qy + rz − m)

∂L

= 1 − λp = 0 (2)

∂x

1

∂L 1 − 2

= y − λq = 0 (3)

∂y 2

∂L

= z − 2 − λr = 0 (4)

∂z

∂L

= px + qy + rz − m = 0 (5)

∂λ

1

1 −2 q

y − =0

2 p

1

− 2q

y 2 =

p

p2

y=

4q 2

z −2 −

r

=0

p

p

z=

r

Inserting the values of y and z in equation (5) (budget constraint) we obtain the values

of x:

m p r

x= − −

p 4q p

Given p, q and r > 0, we know that y and z > 0. For x > 0, we need that

m p r p2

− − > 0 ⇒ m > pr + .

p 4q p 4q

Note the optimal solutions of x, y and z is the individual demand functions. We

observe that the demand for both goods Y and Z not only depends on their own prices,

but also on the price of good X. An increase in the price of good X (p), leads to an

increase in the demand for good Y as well as in the demand for good Z.

∂y 2p

= >0

∂p 4q 2

∂z 1 −1 / 2 1

= p >0

∂p 2 r

We also note that demand for good X depends on prices of all the three goods, namely

X, Y and Z.

If we substitute the optimal values of x, y and z, in the utility function, then we can

express the utility function as a function of prices of different goods and income of

the consumer, known as the Indirect Utility Function.

z = 1. We denote this as problem (A), where a is a constant.

(b) Find the solution of (A) when a = 5/2. (You can take it as given that the minimum

exists.)

Solution

L = x 2 + y 2 + z − λ1( x 2 + 2 xy + y 2 + z 2 − a ) − λ2 ( x + y + z − 1)

∂L

= 2 x − 2λ1 x − 2λ1 y − λ2 = 0 ⇒ 2 x − 2λ1 ( x + y ) − λ 2 = 0 (6)

∂x

∂L

= 2 y − 2λ1 x − 2λ1 y − λ 2 = 0 ⇒ 2 y − 2λ1 ( x + y ) − λ2 = 0 (7)

∂x

∂L

= 1 − 2λ1 z − λ2 = 0 ⇒ 1 − 2λ1 z − λ2 = 0 (8)

∂z

∂L

= x 2 + 2 xy + y 2 + z 2 − a = 0 (9)

∂λ1

∂L

= x + y + z −1 = 0 (10)

∂λ1

(b) From (6) and (7), we get x = y. Now it is also given that a = 5/2. We use (9)

and (10) to get:

4x 2 + z 2 − 5 / 2 = 0

2x + z − 1 = 0 ⇒ z = 1 − 2x

4 x 2 + (1 − 2 x ) 2 − 5 / 2 = 0

4x 2 + 1 − 4x + 4x 2 − 5 / 2 = 0

8x 2 − 4x − 3 / 2 = 0

4 ± 16 − ( 4)(8)( −3 / 2)

x=

2*8

⇒ x = 3 / 4 or − 1 / 4

Then y = 3 / 4 or − 1 / 4

Given x and y, z = −1 / 2 or 3 / 2

f(x, y, z) = 5/8

f(x, y, z) = 13/8

Comparative Statics

constraints. Consider the problem involving n variables and m constraints:

max (min) f(x1,….., xn) subject to gj(x1,….., xn) = bj ; j = 1, 2,…., m < n (11)

Let x* = (x*1, …., x*n) is a solution of (1) that depends on b1,….,bm. We assume that

each x*i = x*i(b1,….,bm) is a differentiable function of b1,….,bm. The associated value

f* = f*(x*1, …., x*n) is also then a function of b1,….,bm. If we put b = (b1,….,bm), the

resulting value is:

The function f* is called the optimal value function for problem (11). The Lagrange

multipliers associated with x* also depends on b1,….,bm and under certain regularity

conditions, we get the following result:

∂f * (b )

= λ j (b ) (13)

∂b j

The Lagrange multiplier λj is referred as the shadow price or marginal value imputed

to a unit of resource j. If we change b = (b1,….,bm) by db = (db1,….,dbm) and if

db1,….,dbm are small in absolute value, then from (3) we get:

If f(x, y) ∈ C(k) in a set D and (x*, y*) is an interior point of D, f(x*, y*) = b (b is a

constant), and f/y( x*, y*) ≠ 0, then the equation f(x, y) = b defines y as C(k) function of x

dy f x/ ( x, y )

in some neighbourhood of (x , y ), i.e., y = φ(x) and

* *

=− .

dx f y/ ( x, y )

Let us generalise the above in case of the system of m equations with n exogenous

variables (x1,….., xn) and m endogenous variables (y1,….., ym):

f 1 ( x1 ,..., xn , y1 ,..., y m ) = 0

f 2 ( x1 ,..., x n , y1 ,..., y m ) = 0

(15)

.

f m ( x1 ,..., xn , y1 ,..., y m ) = 0

dy j

We want to evaluate . Taking the total differentiation of all fj, we get:

dxi

∂f 1 ∂f 1 ∂f 1 ∂f 1 ∂f 1 ∂f 1

dy1 + dy 2 + ... + dy m = −( dx1 + dx 2 + ... + dx n )

∂y1 ∂y 2 ∂y m ∂x1 ∂x2 ∂xn

∂f 2 ∂f 2 ∂f 2 ∂f 2 ∂f 2 ∂f 2

dy1 + dy 2 + ... + dy m = −( dx1 + dx 2 + ... + dxn )

∂y1 ∂y 2 ∂y m ∂x1 ∂x 2 ∂x n

.

∂f m ∂f m ∂f m ∂f m ∂f m ∂f m

dy1 + dy 2 + ... + dy m = −( dx1 + dx2 + ... + dxn )

∂y1 ∂y 2 ∂y m ∂x1 ∂x 2 ∂xn

We allow only xi to vary keeping all other x to be fixed and divide each remaining

term by dxi. We get:

∂f 1 ∂y1 ∂f 1 ∂y 2 ∂f 1 ∂y m ∂f 1

+ + ... + =−

∂y1 ∂xi ∂y 2 ∂xi ∂y m ∂xi ∂xi

∂f 2 ∂y1 ∂f 2 ∂y 2 ∂f 2 ∂y m ∂f 2

+ + ... + =−

∂y1 ∂xi ∂y 2 ∂xi ∂y m ∂xi ∂xi

.

∂f m ∂y1 ∂f m ∂y 2 ∂f m ∂y m ∂f m

+ + ... + =−

∂y1 ∂xi ∂y 2 ∂xi ∂y m ∂xi ∂xi

We can solve the above system of equations using Cramer’s rule or inversion of

∂y 1 ∂y

matrix for ,…., m . We define the Jacobian matrix of f1,…,fm with respect to

∂xi ∂xi

y1,…,ym as:

∂f 1

∂f 1

. .

∂y1

∂y m

. . . .

J =

. . . .

∂f m ∂f m

. .

∂y ∂ym

1

Suppose f1,…,fm are C(k) –functions in a set D ⊂ Rn+m and let (x*, y*) = (x*1, .., x*n, y*1,

.., y*m) be a solution to (A) in the interior of D. We also suppose that | J | exists at (x*,

y*). Given this (A) defines (y1,…,ym) as C(k) functions of (x1,…,xn) in some

neighbourhood of (x*, y*) and in that neighbourhood:

∂y1 ∂f 1

∂x j ∂x j

.

−1 .

= −J (16)

. .

∂

m

y m

∂x ∂f

j ∂x j

Next, we raise the Question: What is the use of Implicit Function Theorem? We

show this in terms of the following example with profit maximisation.

Consider that a firm has the profit function π(l, k) = pf(l, k) - wl - rk where f is the

firm's production function, p is the price of output, l, k are the amount of labour and

capital employed by the firm, w is the real wage and r is the real rental price of

capital. We assume that p, w and r as exogenously given. Assume that the Hessian

matrix of f is negative definite. Prove that if the wage increases by a small amount,

then the firm decides to employ less labour.

Solution

The firm wants to maximise profit by employing optimal l and k. The first-order

conditions are:

pf l (l , k ) − w = 0 F 1 ( l , k ; w) = 0

or

pf k (l , k ) − r = 0F 2 (l , k ; r ) = 0

The Jacobian matrix takes the following form:

∂F 1 ∂F 1

J = ∂l ∂k = p 2 f11 (l , k ) f12 (l , k )

2 f (l , k ) f 22 (l , k )

∂F ∂F 2 12

∂l ∂k

where fij is the second-order partial derivative of f with respect to the jth and the ith

arguments.

J = p2 H > 0

|H| is the Hessian of f. Given that H is negative definite, f11 < 0 and |H| > 0 (which

also implies f22 < 0).

Since |J| ≠ 0, we can apply the implicit-function theorem. Note in this context, l and k

are implicit functions of w. The first-order partial derivative of l with respect to w is:

−1 pf12 (l , k )

∂l 0 pf 22 (l , k ) − pf 22 (l , k ) f 22

=− =− = <0

∂w J 2

p H p H

The above implies that if the wage increases by a small amount, then the firm decides

to employ less labour.

where x = (x1,…., xn) and r = (r1,…., rk)

Suppose that λj = λj(r), j = 1, ..., m are the Lagrange multipliers obtained from the

first-order conditions for problem (1). In this case, let the Lagrangian function be:

m

L(x, r) = f (x, r) - ∑ λ j g j (x, r)

j =1

Under certain conditions, we get the following result known as Envelope Theorem:

∂f * (r) ∂L(x, r)

= , i = 1, …, k (18)

∂ri ∂ri x = x* (r )

a) With a change in ri, the vector r changes and hence f(x, r) changes directly

b) With a change in ri, all the functions (x*1 (r), …., x*n(r)) and therefore f(x*(r),

r) is changed indirectly.

However, the Envelope theorem tells us that we can ignore the second effect as the

effect is negligible.

Note in Example 2, we said that if we substitute the optimal values of x, y and z, in the

utility function, then we can express the utility function as a function of prices of

different goods and income of the consumer, known as the Indirect Utility Function.

We start with this in a general setup.

Let U * ( p1 , p 2 ,.., p n , m) be the indirect utility function, i.e., the maximum utility

obtainable when prices are ( p1 , p 2 ,.., p n ) and the income is m. Given equation (13),

we get:

∂U *

λ= .

∂m

Hence, λ is the rate of change in maximum utility when income changes. λ is called

the marginal utility of income.

∂L ∂L

= λ and = −λxi

∂m ∂pi

Therefore, using the Envelope Theorem (equation (18)), we get:

= =λ

∂m ∂m

∂U * ( p1 ,..., p n , m ) ∂L( p1 ,..., p n , m )

= = −λxi*

∂pi ∂pi

The last expression is known as Roy’s Identity. Roy’s identity tells us that the

marginal disutility of a price increase is the marginal utility of income multiplied by

the optimal quantity demanded.

Example

Solve the utility maximisation problem: max x + a ln y subject to px + qy = m, where

0 ≤ a < m/p. Find the value function f*(a, p, q,m) and compute its partial derivatives

with respect to all the four variables. Check if the results accord with the envelope

result.

Solution

The Lagrangian function is:

L = x + a ln y − λ ( px + qy − m )

1

L/x = 1 − λp = 0 ⇒ λ =

p

a a ap

L/y = − λq = 0 ⇒ y = =

y λq q

ap m

L/ = px + qy − m = 0 ⇒ px = m − qy = m − q( ) = m − ap , so x = − a

λ q p

The value function is:

m ap m

f * ( a , p , q , m) = − a + a ln( ) = − a + a ln a + a ln p − a ln q

p q p

The partial derivatives of the value function with respect to all the four variables give:

∂f *

= ln( ap ) − ln( q )

∂a

∂f * m a ap − m

=− + =

∂p p2 p p2

∂f * a

=−

∂q q

∂f * 1

=

∂m p

Given the Langangian as L = x + a ln y − λ ( px + qy − m)

∂L*

= ln y *

∂a

∂L*

= −λ x *

∂p

∂L*

= −λ y *

∂q

∂L*

=λ

∂m

Note we are able to verify not only the Envelope Theorem as well as Roy’s Identity.

A similar situation arises in case of cost minimisation problem for a firm. Suppose a

firm wants to minimise cost of production subject to a given level of output.

Therefore, the problem can be stated as:

We want to find the values of K and L that minimises the cost of production of Q

units.

L = rK + wL − λ ( F ( K , L ) − Q )

Therefore,

∂L

=K

∂r

∂L

=L

∂w

∂L

=λ

∂Q

∂C *

= K*

∂r

∂L*

= L*

∂w

∂L*

=λ

∂Q

The first two equalities are known as Shephard’s Lemma. Note the last one shows the

rate at which the minimum cost changes with respect to changes in output. Hence, λ

equals the marginal cost. Note in case of consumer optimisation exercise, the

consumer expenditure function can be defined as: E ( p , U ) = min ∑ pi xi ,

{U ( x ) >U }

where U is specified utility level. In this case, Shephard’s Lemma gives demand as a

function of prices and utility, known as the compensated demand curve.

Reading

Carl Simon and Lawrence Blume (1994), Section: 19.1 – 19.3 pp. 448 - 469

Nonlinear Programming

In the classical method for constrained optimization seen thus far, the constraints have

always been strict equalities. Some economic problems call for weak inequality

constraints, however, as when individuals want to maximize utility subject to

spending not more that x pounds, or business seek to minimize costs subject to

producing no less than x units of output.

with inequality constraints. Mathematical programming includes linear programming

and nonlinear programming. In linear programming, the objective function and all

inequality constraints are linear. When either the objective function or an inequality

constraint is nonlinear, we face a problem of nonlinear programming. The nonlinear

programming problem is that of choosing nonnegative values of certain variables so

as to maximize or minimize a given (non-linear) function subject to a given set of

(non-linear) inequality constraints.

Note the above problem involves one inequality constraint. Here we want to want to

find out the largest value attained by f(x, y) in the feasible set S of all pairs (x, y)

satisfying z(x, y) ≤ c. We can think f(x, y) representing the utility function of a

consumer and z(x, y) ≤ c as the budget constraint. In this case, we seek to determine

the largest utility attained by the consumer given that consumption bundles lies in the

in the feasible set S of all pairs (x, y) satisfying the budget constraint.

If we compare (2) and (3), we can say that the direction of inequality at the constraint

is only a convention as the first inequality can be converted to the second one by

simply multiplying it with -1. We can also say that an equality constraint can be

written in terms of two inequality constraints. For example, the constraint z k = ck

can be written as z k ≤ ck and − z k ≤ −c k . A constraint z k ≤ ck is binding at x* if

z k ( x* ) = ck .

Let us examine the problem graphically using (1) with the example of consumer

optimisation problem. Given the price, the consumer can either maximise utility

subject to the budget constraint or minimise expenditure subject to utility constraint.

This implies:

max U ( x ) subject to ∑ p i xi ≤ m or min ∑ p i xi ) subject toU ( x ) ≥ U

where m is the income of the consumer and U is the level of utility that the consumer

wants to attain (pre-specified).

There is no reason to insist that a consumer spend all her wealth, so that her

optimization problem should be formulated with inequality constraints.

We now try to solve this problem. Using an extension of the Lagnrange multiplier

method, due originally to H. W. Kuhn and A. W. Tucker, we solve such problems.

Kuhn-Tucker Conditions

Assuming the functions in (2) are differentiable and if x* is the optimal solution to (2),

it should satisfy the following conditions (the Kuhn-Tucker necessary maximum

conditions or KT conditions):

∂L ∂L

≤ 0, xi ≥ 0 and xi =0

∂xi ∂xi

∂L ∂L

≥ 0, λ j ≥ 0 (complimentary slckness condition) and λ j =0

∂λ j ∂λ j

where

m

L( x1 , x 2 ,..., x n , λ1 , λ 2 ,..., λ m ) = f ( x1 , x 2 ,..., x n ) + ∑ λ j (c j − z j (x1 , x 2 ,..., x n ))

j =1

∂L ∂L

≥ 0, xi ≥ 0 and xi =0

∂xi ∂xi

∂L ∂L

≤ 0, λ j ≥ 0 (complimentary slckness condition) and λ j =0

∂λ j ∂λ j

where

m

L( x1 , x 2 ,..., x n , λ1 , λ 2 ,..., λ m ) = f ( x1 , x 2 ,..., x n ) + ∑ λ j (c j − z j (x1 , x 2 ,..., x n ))

j =1

Example 1:

Solution

L = xy + λ1 (100 − x − y ) + λ 2 ( 40 − x )

∂L

Lx = = y − λ1 − λ 2 ≤ 0, x ≥ 0, xL x = 0

∂x

∂L

Ly = = x − λ1 ≤ 0, y ≥ 0, yL y = 0

∂y

∂L

Lλ1 = = 100 − x − y ≥ 0, λ1 ≥ 0, λ1 Lλ1 = 0

∂λ1

∂L

Lλ 2 = = 40 − x ≥ 0, λ 2 ≥ 0, λ 2 Lλ 2 = 0

∂λ2

Here x = 0 and y = 0 does not make any sense as this would imply U = xy = 0 .

Therefore, both x and y has to be nonzero and then this would imply Lx = 0 and Ly = 0.

This implies

y − λ1 − λ 2 = x − λ1 = 0

y − λ2 = x

Now if x ≤ 40 is not binding, then λ2 = 0 and this would imply x = y. Given the budget

constraint, then the trial solution is x = y = 50. But this would violate the

constraint x ≤ 40 and hence the optimal solution for x must be x* = 40. This would

also imply the optimal solution for y must be y* = 60. The optimal values for the

Lagrangian multipliers would be λ1* = 40 and λ*2 = 20 .

Suppose we are dealing with a maximisation problem. The firm wants to maximise

revenue (profit) producing n goods subject to m resource (factor) constraints.

xi is the amount produced of the i-th product; rj is the amount of the j-th resource

available; f is the profit (revenue) function; zj is a function which shows how the j-th

resource is used in producing the n goods. The optimal solution to the maximization

program indicates the optimal quantities of each good the firm should produce. We

define the following:

∂f

fi = : marginal profit (revenue) of product i

∂xi

λj: shadow price of resource j

∂z j

z ij = : amount of resource j used in producing a marginal unit of product i

∂xi

λ j z ij : imputed cost of resource j to produce a marginal unit of product i

∂L ∂f m

The Kuhn-Tucker condition ≤ 0 is nothing but f i = ≤ ∑ λ j z ij . This implies

∂xi ∂xi j =1

that marginal profit of the i-th product cannot be more than the aggregate marginal

∂L

imputed cost of the i-th product. The condition xi = 0 implies that in order to

∂xi

produce product i, the marginal profit must be equal to the aggregate imputed

marginal cost; otherwise the good would not be produced.

∂L

The Kuhn-Tucker condition ≥ 0 states that the total amount of resource j used in

∂λ j

producing all the n goods should not exceed total amount available. The condition

∂L

λj = 0 implies that if a resource is not fully used, then its shadow price equals 0.

∂λj

Consider the problem: max f(x, y) subject to z(x, y) ≤ c and assume that (x*, y*)

satisfies the Kuhn-Tucker necessary conditions for maximum. If the Lagrangian

L(x,y) is concave, then (x*, y*) solves the problem.

Value Function

max f ( x1 ,..., x n ) subject to z j ( x1 ,..., xn ) ≤c j , j = 1,2,..m, x1 ≥ 0,...., x n ≥ 0 (2)

The optimal value of the objective function f(x) depends on c1, c2, …, cm. Then the

function defined as: f * (c) = max{ f ( x ) : z j ( x) ≤c j , j = 1,2,.., m} assigns to each c =

(c1, c2, …, cm) the optimal value of the objective function. It is known as the value

function for the problem. The value function satisfies the following two properties:

∂f * (c)

ii) If exists, then it equals λ j (c) .

∂c j

Note, the value function f * (c) need not be differentiable and can have sudden changes

of slope.

Example 2:

Solution

L = xy + λ (6 − x − y )

∂L

Lx = = y − λ ≤ 0, x ≥ 0, xL x = x( y − λ ) = 0

∂x

∂L

Ly = = x − λ ≤ 0, y ≥ 0, yL y = y( x − λ ) = 0

∂y

∂L

Lλ = = 6 − x − y ≥ 0, λ ≥ 0, λLλ = λ (6 − x − y ) = 0

∂λ

If x > 0 then from the first set of conditions we have y = λ. If y = 0 in this case then λ

= 0, so that the second set of conditions implies x ≤ 0, contradicting x > 0. Hence y >

0, and thus x = λ, so that x = y = λ = 3.

If x = 0 then if y > 0 we have λ = 0 from the second set of conditions, so that the first

condition contradicts y > 0. Thus y = 0 and hence λ = 0 from the third set of condition.

We conclude that there are two solutions of the Kuhn-Tucker conditions, in this case

(x, y, λ) = (3, 3, 3) and (0, 0, 0). Since the value of the objective function at (3, 3) is

greater than the value of the objective function at (0, 0), the solution of the problem is

(3, 3).

Example 3:

Solution

L = x 2 y 2 + λ (2 − 2 x − y)

∂L

Lx = = 2 xy 2 − 2λ ≤ 0, x ≥ 0, xL x = x( 2 xy 2 − 2λ ) = 0

∂x

∂L

Ly = = 2 x 2 y − λ ≤ 0, y ≥ 0, yL y = y( 2 x 2 y − λ ) = 0

∂y

∂L

Lλ = = 2 − 2 x − y ≥ 0, λ ≥ 0, λLλ = λ ( 2 − 2 x − y ) = 0

∂λ

If x > 0 and y > 0 then from the first two set of conditions we get 2xy2 = 2λ

⇒ xy2 = λ and 2x2y = λ. This implies that 2x = y and λ > 0. From the third set of

conditions, we get y = 1 and hence x = ½.

We conclude that there are two solutions of the Kuhn-Tucker conditions, in this case

(x, y) = (1/2, 1) and (0, 0). Since the value of the objective function at (1/2, 1) is

greater than the value of the objective function at (0, 0), the solution of the problem is

(1/2, 1).

Example 4:

Suppose a firm wants to maximize wants to maximise its sales revenue subject to the

constraint that its profit is not less than 10. Let q be the amount of the good to be

supplied in the market. The revenue function is R( q ) = 20q − q 2 and the cost function

is C ( q ) = q 2 + 6q + 2 . Find the sales-maximising quantity for the firm.

Solution

Firm’s problem:

Max

R(q ) subject to

20q − q 2 − q 2 − 6q − 2 ≥ 10 ⇒ −2q 2 + 14q − 12 ≥ 0 ⇒ − q 2 + 7 q − 6 ≥ 0 ⇒ q 2 − 7 q + 6 ≤ 0

and q ≥ 0 .

L = 20q − q 2 − λ ( q 2 − 7 q + 6)

∂L

= 20 − 2q − 2λq + 7λ ≤ 0, q ≥ 0, q( 20 − 2q − 2λq + 7λ ) = 0

∂q

∂L

= − q 2 + 7 q − 6 ≥ 0, λ ≥ 0, λ ( − q 2 + 7 q − 6 ) = 0

∂λ

this implies that 20 − 2q − 2λq + 7λ = 0 .

∂L

If λ = 0, the condition = 0 implies that q = 10, but this is inconsistent

∂q

with − q 2 + 7 q − 6 ≥ 0 . Therefore λ > 0 and this implies that ( −q 2 + 7 q − 6) = 0 .

λ > 0.

Example 5:

constraint px + y ≤ M and x ≥ 0 , y ≥ 0 . It is given that p > 0 and M > 0. Solve this

utility maximisation problem.

Solution

L( x, y ) = x + y + λ ( M − px − y )

1 1

∂L 1 − 2 1 −

= x − λ p ≤ 0, x ≥ 0, x ( x 2 − λ p ) = 0

∂x 2 2

∂L

= 1 − λ ≤ 0, y ≥ 0, y(1 − λ ) = 0

∂y

∂L

= px + y ≤ M , λ ≥ 0, λ ( px + y − M ) = 0

∂λ

1 1 1

1 − 1 − − 1

x ( x 2 − λ p ) = 0 ⇒ x 2 − λ p = 0 ⇒ x 2 = 2λ p ⇒ x =

2 2 ( 2λp ) 2

1 1 1

If λ = 1 , then x = and y = M − px = M − p =M − . This gives a

4 p2 4 p2 4p

1 1 1

solution if y ≥ 0 implying that M − >0⇒M > ⇒ p> .

4p 4p 4M

M 1

If y = 0 , then x = and λ = . This gives a solution if λ ≥ 1 implying that

p 1

2( pM ) 2

1

p≤ .

4M

M 1

( ,0) if p ≤

p 4M

( 1 1 1

,M − ) if p >

4 p2 4p 4M

Reading List

Knut Sydsaeter, Peter Hammond (2006), Sections 14.7 – 14.8, pp. 532 -548

Carl Simon and Lawrence Blume (1994), Section 18.6

Alpha C. Chiang (2005) Chapter 13

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