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QARSAM ILYAS ROLL NO 7

A brief introduction to Lagrange Multipliers and its economic Application

LAGRANGE M L!I"LIER
"What could be more fundamental to economic theory than the idea of constrained optimisation?Even the most elementary definitions of economics are based on solving problems of scarcity and choice - on satisfying unlimited wants with limited resources.The Lagrange technique provides a tool for solving such problems"

HISTORY

#ospe$ Louis Lagrange %is met$od of Lagrange multipliers& for dealing 'it$ problems of constrained optimisation& subse(uentl) appeared in a number of mat$ematics te*ts+ Its ,alue in economics 'as recognised b) "aul Samuelson '$o used it e*tensi,el) on $is pat$-brea.ingboo. /0oundations of Economic Anal)sis/+ It $as per,aded economic anal)sis e,er since+

1ONS!RAIN!S IN E1ONOMI1S++++
Consumers and businesse men are rational who strive to maximize their utility. Consumers have limited income for buying the goods and services they desire, and firms have only limited land, labor and capital for producing their products. The Lagrangian multiplier provides a quantitative way resolve the issue of constraint.

2E0INA!ION
In mat$ematical optimi3ation& t$e met$od of Lagrange multipliers is a strateg) for finding t$e local ma*ima and minima of a function sub4ect to e(ualit) constraints+ In economics t$ere are plent) of problems t$at re(uires optimi3ation of some (uantit) under some constraints and Lagrange multipliers arise naturall) in t$is fields

IDENTIFICATION

LAMBDA: The Lagrange multiplier represented in the equation by the !ree" letter lambda #$% Lambda is the marginal value associated with rela&ing a constraint.

5$at6s so special about Lagrange Multipliers7

Lagrange Multipliers can sol,e more comple* problems+ is ust an artificial variable that lets us compare the directions worrying about the magnitudes.

Lagrange multipliers can be used in linear and non-linear problems+ 2eri,ati,es are used to sol,e t$ese Lagrange Multipliers

DIAGRAMMATICALLY

LAGRANGE8S !%EORM
Let f and g have continuous first partial derivatives such that f has an e&tremum at a point #&' y'% on the smooth constraint curve g#& y%(c.

ME!%O2S O0 LAGRANGE M L!I"LIER++++++

Let f and g satisfy Lagranges T e!re"# and f $i%% a&e a "ini"'" !r "a(i"'" s')*e+t t! t e +!nstraint g,(#y-.+/ To find the minimum or ma&imum of f while satisfying the constraint use the following steps.........

S!E"S !O SOL9E LAGRANGE M L!I"LIER


Sol,e t$e s)stem of e(uations: f*;*&)<=>g*;*&)< f);*&)<=>g);*&)< f ;*&)<= t$e ob4ecti,e function g;*&)<=constraint E,aluate f at eac$ solution point& t$e largest ,alue )ields t$e ma*imum of f sub4ect to t$e constraint g;*&)<=c& and t$e smallest ,alue )ields t$e minimum of f sub4ect to t$e same constraint+

)*+,- L*!.*/!E 01LT,2L,E. E3*02LE 45W !56E./0E/T 1+E+ T*3E+ *+ L*!.*/!E 01LT,2L,E.

E?AM"LE+++++
!ow much gasoline a person buy affects his happiness. "#f he buy too little gasoline then he can$t go anywhere, but if he buy too much then he didn$t have money left to eat.% Let$s measure net happiness in dollars& the benefit to him minus the cost of the gas. #f x is a vector giving each person$s annual gasoline consumption, let f"x% be the total net effect on the population$s happiness. f"x% is maximized when each person separately buys the amount of gasoline that ma'es her happiest. (nfortunately, then the total gas consumption g"x% is too high, causing pollution.

1ON!INO E2+++++
To 'eep g"x%)c while still ma'ing happiness f"x% as high as possible, impose a gasoline tax. #f the tax is *+,-gallon, people$s free choices will maximize not f"x% but rather f"x% . "/+,% g"x%. 0eople who li'e to drive still buy more gas than people who don$t, but everyone buys less than s-he did before. 1y ad usting the size of the tax "the Lagrange multiplier%, the government can indirectly ad ust total consumption g"x% until it is at the desired level, g"x%)c. 2ne can determine from c in advance what the tax should be.

THE COBB0DO1GLAS 1TILITY F1NCTION ECONOMIC A22LICATION OF LAGRANGE M1LTI2LIER

THE COBB0DO1GLAS 1TILITY F1NCTION


A +!ns'"er as 3455 t! s6end !n t$! +!""!dities# t e first !f $ i+ +!sts 375 6er 'nit and t e se+!nd 385 6er 'nit/ C!))0D!'g%as 'ti%ity f'n+ti!n 1,(# y-. 955(5/4 y5/:

1O@@ 2O GLAS !ILI!Y 0 N1!ION


tilit) 0unction: u ;*&)<= 955(5/4 y5/:

5$ere * represents t$e units of * consumed ;at ABC per unit< and ) represents t$e units of ) consumed ;at ADC per unit<+ !$e total spending of * and ) is limited to AECC '$ic$ is t$e income of consumer+ @udget constraint t$at BC* F DC) = ECC+ So to set t$is up++++ t$e ,ariables are *& )& >

E?AM"LE 1ON!INO E2+++++++++


9/ f(.;g( 7/ fy.;gy 8/ g. +!nstraint 7&-'.8 y'.8 9:' ( <&-'.8 y'.8 ( <y( 8& 4(05/: y5/: 75

:(5/4 y05/4 . 85 75( < 85y . 455 8&'.7 y-'.7 9;' ( $

8&'.7 y-'.7

or y ( 89<&

1ON!INO E SOL9ING++++++++++
+ubstituting this into the third equation we will get :'& = ;' #89<&%(7'' than &(>? and y ( ? That is to ma&imi@e utility the consumer should buy >? units of the first commodity and ? units of the second.

B1DGET CONSTRAINT AND O2TIMAL INDIFFERENCE C1R=E

A grap$ s$o'ing t$e relations$ip bet'een t$e optimal indifference cur,e ;*& )< = 1& '$ere 1 = ;GH& H< and t$e budgetar) constraint BC* F DC) = ECC& is s.etc$ed in 0igure

THAN> YO1