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Joshua Gans, "Comparative Statics Made Simple: An Introduction to Recent Advances," Australian Economic Papers, June 1996, pp.81-93.

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*

by

Joshua S. Gans School of Economics University of New South Wales Sydney, NSW 2052 E-Mail: J.Gans@unsw.edu.au

First Draft: 17th March, 1995 This Version: 16th October, 1995

This paper is a survey of the new methods of comparative statics analysis developed recently by Topkis, Milgrom, Roberts and Shannon. The basic theorems are presented here and an application to environmental policy is discussed in this context. Journal of Economic Literature Classification Numbers: A10, C60, Q38. Keywords: comparative statics, monotonicity, supermodularity.

I am grateful to Susan Athey, Kevin Fox, Maxim Engers, Robin Stonecash and two anonymous referees for their very helpful comments on earlier versions of this paper. All responsibility for errors and views expressed lie with me.

*

I. Introduction Comparative statics are much like the “before and after shots” one sees in advertisements for weight reduction, hair replacement, or silverware polishing. One looks at the decided level of a variable before the change in a parameter and then compares it with the level after the change. But unlike advertisements, the comparative statics that

economists consider are theoretical. They are predictions that need to be confirmed by real world evidence. It is often the case, however, that such confirmation is not forthcoming. Predictions are usually all policy-makers have available before they are required to act. In such situations, it becomes critical to understand the particular assumptions comparative static predictions are based upon. Such assumptions can then themselves become the heart of policy debates, with evidence regarding their reasonableness brought to the fore. Formal economic theory enters the fold to lay bare the critical assumptions that drive the conflicting predictions that arise in less formal discussions. As an example of these less formal discussions, consider the Rio Climate Change Treaty that committed Australia to a reduction in the level of Greenhouse Gases to 1990 levels by the year 2000. This goal gives rise to several comparative statics questions regarding what instruments might be effective in achieving this change. Specifically, would the addition of a carbon tax reduce the quantity of Greenhouse gases generated by Australian industry? What about a subsidy to producers to switch to less Greenhouse gas intensive technologies (i.e., based on solar or wind power)? Or an education campaign on consumption? Each of these comparative statics questions asks: if there is a change in some parameter out of the control of individual decision-makers, how does this change the levels of variables they decide upon? Normally, there is an assumption that decision-makers act rationally, but this need not be the case (see Milgrom and Roberts, 1994). Also,

sometimes the question is phrased in terms of variables arising out of market interactions of agents, most obviously prices, rather than a less aggregated measure.

2 In the past, however, formal theory has suffered from two critical problems in analysing comparative statics. First, the predictions derived are often based on

assumptions that are divorced from everyday presumptions on peoples’ tastes or firms’ technology. These assumptions seem to arise out of the technical need for a mathematically precise construction rather than the substantive issues at hand. But, more importantly, these formal predictions have been relatively inaccessible even to those trained in undergraduate economics. Hence, these predictions are far removed from the intuitions commonly used in economic analysis. They add little to debates that ought to focus on the key relevant issues turning predictions one way or another. Those days, however, are in the past. The purpose of this paper is to lay out a new set of tools that are the results of recent formal theory. These tools provide a general method of using formal theory to understand the key substantive assumptions underlying economic intuitions. But, more importantly, these tools are accessible. With just a little calculus and even less algebra they allow economists to formalise arguments themselves and focus on the critical assumptions that drive a comparative static prediction. This can be done because the mathematics of the new results are very closely aligned with the intuitions economists and others use in everyday discussions of policy.

II. A Little Notation Although these new tools for comparative statics analysis are not technically difficult to use, some notation and reacquaintence with what constitutes optimising behaviour is required. When choosing rationally, economic agents are generally assumed to be choosing some variable from a choice set to maximise a given payoff function. Therefore, suppose that an agent makes a choice x from a set of feasible choices X. Each element x of X can be considered to be made up of many dimensions. To make this simple, one can imagine that x is a vector of I component choice variables, i.e., x ≡ ( x1 ,..., x I ) . So x may represent a bundle of commodities in consumer theory or an

3 allocation of factors as in the theory of the firm. In turn, the choice set, X, can represent a budget set (given prices and income) in consumer theory or the feasible technological alternatives in the theory of the firm. For any choice of x, it is assumed that the agent receives a payoff

**π ( x ) ≡ π ( x1 ,..., x I ) . This is termed the agent’s objective function and it might be a utility
**

function, a profit function, or expectations of these. A rational economic agent is assumed to choose variables from the choice set that maximises their objective function. In notation, the agent solves: Maximise x ∈X π ( x ) (P).

An element of the choice set that solves this problem is called an optimum and is denoted by x * . Note that there may be more than one x * that solves this problem. But just observing that a particular choice is an optimum is not very interesting in and of itself. It becomes interesting when the context in which it is determined is considered. That is, there are a variety of parameters, not under the control of the agent, that influence the agent’s choices. For instance, relative prices determine the mix of goods a consumer purchases and government taxes may determine the level of factors a firm employs. These external or exogenous parameters are denoted here by θ which again can be of many dimensions, i.e., θ ≡ (θ1 ,...,θ J ) . So θ may be a list of prices, policies or even the actions of other agents. And like choice variables, not all parameters can possibly arise. Thus, it is assumed that such parameters come from a set Θ. When one studies comparative statics, one is interested in the qualitative properties of the optimum (or optimal set) that the agent chooses. That is, one is interested in how the optimal choices, x * , vary with θ: What are the properties of π ( x;θ ) and X that mean that the level of a good demanded falls with a rise in its price, that labour supplied rises with the wage, or that output will fall in the face of an increase in taxes? Determining such qualitative relationships is the heart of economic theory. Of particular interest, however,

4 are the situations when these qualitative relationships are monotone. That is, when will the optimising choice move monotonically upwards or downwards in response to an increase in a parameter? Working out what it means to move up or down for an economic variable is sometimes easy and sometimes not. It is easy when the choice variable and parameter in question are real numbers or integers, e.g., the consumption of apples and the price of apples. It is not easy when one talks of changes in technology or institutions. For the purposes of this paper, I will confine attention to easy cases noting here that all the tools to follow can be readily applied to more difficult cases.1 Therefore, it is assumed that the choice set and parameter spaces are some subsets of the (extended) real numbers. notation: X ⊂ ℜ I and Θ ⊂ ℜ J . The potential for multiple optima also causes conceptual difficulties for what one means by monotone increasing or decreasing. Once again, the tools of comparative statics can deal with this by introducing a definition of what it means for sets to move upwards or downwards (see Milgrom and Shannon. 1994). Here, however, to simplify matters, I will assume that if multiple optima exist then the agent always chooses the level of the variable associated with the highest real number (or an arbitrary one from the set of these). Finally, just so there is no confusion: x * (θ ) is monotone nondecreasing when In

**θ > θ ′ implies that x * (θ ) ≥ x * (θ ′) . It is monotone nonincreasing when θ > θ ′ implies
**

that x * (θ ) ≤ x * (θ ′) . With strict inequalities, these are monotone increasing and decreasing respectively. When either of these cases (nondecreasing or nonincreasing) hold, then the problem at hand displays what has been called “monotone comparative statics” by Milgrom and Shannon (1994). The task of the rest of this paper is to state a number of simple theorems that show the precise and very intuitive conditions on objective functions and choice sets that generate monotone comparative statics.

1

This is unlike more traditional tools of comparative static analysis which are confined to the analysis of choice variables that are perfectly divisible. For more on this, see Milgrom and Shannon (1994).

5 Before turning to these theorems, it is worthwhile to digress upon the methodological premises underlying this approach. If one could actually solve the

optimising problem, such as (P), for the function x * (θ ) , then it would be easy to check whether (P) displayed monotone comparative statics or not. However, it is rare to have enough information about objective functions and choice sets to be able to do this. Indeed, many objective functions, such as utility functions, are very artificial constructs and not something one would expect to have precise information about. It is a more reasonable expectation that qualitative conditions are available about the structure of these problems. So while one may not know the magnitude of the marginal returns to changing a choice variable, one may know that these returns will be greater or smaller if a parameter is higher or lower. And the tools for comparative statics tell us that this is the only sort of

information one needs. So, as economists, we can back away from restrictive assumptions on the forms of functions and sets. When one is deriving comparative statics -- itself, in essence, a qualitative exercise looking at the directions rather than magnitudes of change -one need only have qualitative information.

III. Optimisation with One Choice Variable In order to build intuition about what drives a comparative static result, it is a good starting point to consider situations in which there is one choice variable. In notation, the agent chooses a single variable x from X ⊂ ℜ. Also, for simplicity, suppose that the agent is maximising an objective function that is composed of a benefit minus a cost:

π ( x;θ ) = B( x;θ ) − C( x ) . 2

The intuition that guides comparative statics is a familiar one to economists. When the marginal benefit to an activity is increased and there is no change in marginal cost, more

2

In principle, of course, the cost function C(.) could be a function of the parameter, or both benefits and costs could be influenced by other parameters. In the application below this is the case. What is important for the intuition here is that the parameter under examination interacts with benefits or costs but not both. The theorems below will, for the most part, hold for more general payoff functions.

6 of that activity will be undertaken by an optimising agent. In the above case, the benefit to increasing x is: (for x > x ′) B( x;θ ) − B( x ′;θ ) ≡ ∆B(θ ) . Note that marginal cost ( C( x ) − C( x ′) ) does not change as θ changes. So if for any higher

**θ , ∆B(θ ) has a higher value, then x * (θ ) will be monotone nondecreasing. In this case,
**

raising the parameter directly raises the marginal net return to doing x. Hence, after the parameter change, doing more of x will result in higher payoffs. It is instructive to compare this monotone reasoning with more traditional methods of conducting comparative statics. Suppose that B and C are twice continuously

differentiable and that Bxx < 0 and Cxx > 0 , 3 so that the objective function is globally concave. Then an interior optimal choice is the solution to the first order condition: Bx ( x * ;θ ) = Cx ( x * ) . One could be tempted to reason then as follows: suppose that θ was increased. Then if Bxθ ≥ 0, the left hand side of the above equation would be higher then the right hand side. However, since the cost function is convex, raising x actually results in an increase in marginal cost. Hence, after the parameter change, the optimum, x * , is higher.4 This traditional reasoning is unsatisfactory because it focuses us on the convexity of the cost function and away from the assumption that marginal benefits are higher as the parameter is raised. The convexity assumption was made to justify the use of

manipulations of the first order condition. For an interior optimum to exist, the first order condition must hold and will do so provided the appropriate boundary and continuity assumptions are made. Local concavity of benefits and convexity of costs, ensures that the condition is indeed a maximum (rather than a minimum or inflection point). The convexity and concavity assumptions, therefore, seem innocuous and, hence, at first blush there seems little reason to worry about using it.

3 4

Subscripts here denote partial derivatives. Use of the implicit function theorem leads to similar reasoning, as is demonstrated in the Appendix.

7 But, to emphasise, these conditions play no actual role in guaranteeing the existence of an optimum -- the continuity and boundary conditions are sufficient for that (Milgrom and Shannon, 1994). They are only necessary to validate the traditional analysis, but with it raises the importance of such assumptions in our intuition. Moreover, from a formal point of view, the traditional approach cannot deal with situations in which optima are not characterised by local concavity of benefits or convexity of costs. While this might not seem restrictive when dealing with a single variable case, as I will demonstrate later for a simple two variable case, concavity assumptions become unnecessarily restrictive and traditional analyses based on them quite cumbersome. In contrast, monotone reasoning does not require any assumptions on the convexity of costs or the concavity of benefits making the methods easier to apply and interpret. Moreover, this reasoning does not require that the objective function be continuous or differentiable, or that the choice variable x be divisible. To formalise the monotone methods approach to comparative statics, I will maintain the assumption that choice variables are divisible and that objective functions are continuously differentiable. The monotone methods approach involves assumptions

regarding the qualitative relationship between a parameter and the objective function or constraint sets. As discussed above, these often amount to assumptions on the interaction between the parameter and the marginal return to an activity. To see this, I need to introduce the following terms. A continuously differentiable function f ( x;θ ) is said to have nondecreasing (increasing) differences if fxθ ≥ 0 ( fxθ > 0) and f ( x;θ ) has nonincreasing (decreasing) differences if fxθ ≤ 0 ( fxθ < 0).5 Suppose then that the

benefit function, B(.), above has nondecreasing differences in ( x;θ ) . Then it is also true that the payoff function, π (.) has nondecreasing differences in ( x;θ ) . 6 This means that

5

The conditions here imply that the function f has nondecreasing (increasing) differences according to the precise definition of Milgrom and Shannon (1994). That is, let ∆f ( y ) ≡ f ( x ′, y ) − f ( x , y ) . Then f has nondecreasing (increasing) differences in (x;y) if, for any x ′ > x and y ′ > y, ∆f ( y ′ ) ≥ ( > ) ∆f ( y ) . 6 This is because π xθ = Bxθ .

8 raising θ , raises the marginal return to doing more of x. Intuitively, one might suppose that this is sufficient to ensure that the optimal choice would not fall with θ . So long as the constraint set does not change it turns out that this reasoning is correct and it holds for conditions on general payoff functions such as π(.). Theorem 1 (Topkis). Suppose that X = ℜ . If (i) π (.) has nondecreasing differences in ( x;θ ) and (ii) X does not vary with θ , then x * is monotone nondecreasing in θ . If the solution is guaranteed to be an interior one, then increasing differences implies that x * is monotone increasing in θ . Conversely, when π has nonincreasing (decreasing) differences, x * will be monotone decreasing in θ . .7 Thus, the theorem confirms that it is marginal returns rather than assumptions of concavity or convexity that matter for monotone comparative statics. Note, however, the condition on the constraint set. If the constraint set moves in response to a change in an exogenous parameter, then it is critical that its movement reinforces the conditions on the objective function. If changing θ raised the marginal returns to x but shifted X “downwards” so that higher levels of x became infeasible, then x * might be “forced” to fall despite the change in marginal returns. Such situations are possible in consumer theory when a change in relative prices shifts the budget set. To keep things simple for this paper, I have ruled out such possibilities.8 Before showing how this theorem is applied, it is useful to note an extension that deals explicitly with payoff functions that take the form of benefits minus costs, as above.

7

The theorem can be generalised to require only ordinal conditions on payoffs. Therefore, it holds for situations when an increase in a parameter raises the ratio of marginal benefits to marginal costs as opposed to their difference. For the complete ordinal theory of comparative statics see Milgrom and Shannon (1994) and Milgrom (1994). 8 See Milgrom (1994) for a clear discussion of such issues.

9

Corollary 1 (Milgrom and Shannon). Suppose that the conditions of Theorem 1 hold and that π ( x;θ ) = B( x;θ ) − C( x ) . Then the following two statements are equivalent: (i) B has nondecreasing (increasing) differences in ( x;θ ) 9,10 (ii) x * is monotone nondecreasing (increasing) in θ , for all C. So while Theorem 1 provides a sufficient condition for monotone comparative statics, its corollary provides a much stronger result that nondecreasing differences is the least restrictive assumption we can place to generate monotone comparative statics. No weaker assumption will do the trick.11

Application: Environmental Policy To see how these results can be used, consider the situation of a government trying to regulate pollution at the level of the firm. Suppose a firm produces two outputs -- its intended good, y, and a pollutant, p. The firm has available two inputs -- oil, z, and other physical inputs (e.g., capital and labour), x. The government has several instruments at its disposal: (i) it can tax production of p at a rate of τ; (ii) it can tax the use of oil at rate µ; (iii) it can tax final output at a rate of α; or (iv) it can promote the use of “environmentally friendly technologies,”by raising ϕ (the efficiency of oil in production) and φ (an abatement technology) Under these assumptions a typical firm maximises: max ( x , z ) (1 − α ) y − (1 + µ ) Pz z − Px x − τp = (1 − α ) f ( z, x;ϕ ) − µPz z − Px x − τg( z;φ ) where P z and P x are the prices of oil and the other input respectively, f is the production function of y and g is the production function of p. It is assumed that marginal products are non-negative ( fz , fx ≥ 0 ) and that using more oil raises pollution levels ( gz > 0).

9

The

If π ( x ;θ ) = B( x ) − C( x ;θ ) then the corollary holds when (i) is replaced with a condition that C have nonincreasing (decreasing) differences in ( x ;θ ) . 10 The equivalence holds here because of our previous stated assumptions on the choice set and the differentiability of the objective function. Then a non-negative cross partial derivative is necessary and sufficient for nondecreasing differences to hold in the sense used by Milgrom and Shannon (1994). 11 Condition (i) in the corollary is what is termed by Milgrom (1994) as a critical sufficient condition. It is not a necessary condition because there could exist particular functional forms for the objective function so that the comparative static may still hold for some changes in parameters even when this condition is

10 technologies are assumed to be environmentally friendly. That means that they improve the marginal productivity of oil in producing y ( fzϕ > 0), reduce the absolute level of p produced ( gφ < 0), and reduce the marginal impact of oil on emissions ( gzφ < 0). The key comparative statics questions regard what happens to the use of z and x and the level of pollution when there are changes in the governmental variables. Since only single variable maximisation has been discussed thus far, suppose that for the moment, x is fixed (i.e., it can only be changed in the long-run). In this case, to provide sufficient conditions for comparative statics using Theorem 1 and necessary conditions using Corollary 1, amounts to the same thing -- looking at the signs of mixed partial derivatives. That is, Raising Output Tax Rate, α Oil Tax Rate, µ Emission Tax Rate, τ Production Technology, ϕ Abatement Technology, φ Comparative Static decreases z * decreases z * decreases z * increases z * increases z * Relevant Condition

π zα = − fz < 0 π zµ = − Pz < 0 π zτ = − gz < 0 π zϕ = (1 − α ) fzϕ > 0 π zφ = −τgzφ > 0

Therefore, quite natural assumptions lead to the results that the taxation variables reduce the quantity of oil used in production and hence, reduce both intended output and pollution. However, the use of environmentally friendly technologies encourages the use of oil, while having an ambiguous effect on the level of pollution.12 The point here is that the mathematics of these results make transparent the intuition behind them. Each of the taxation variables has the effect of lowering the marginal return to using more oil, or raising its marginal cost and hence, one would expect less oil to be

not satisfied. This is demonstrated in the Appendix. Nonetheless, it is the least restrictive qualitative assumption that could be made.

11 used by the firm (all other factors remaining equal). On the other hand, the technology variables have the opposite effect. One (ϕ) improves the marginal product of oil (i.e., fzϕ > 0) while the other (φ) reduces the marginal costs of oil in generating pollution (i.e., gzφ < 0). This latter variable becomes relevant precisely because pollution is being taxed. If it were not for this, then the firm would not change its oil usage in response to the technological change. Hence, there would be no effect on pollution as opposed to a negative effect.13 Nonetheless, these results depend critically on the fact that x has been fixed. Allowing x to be chosen makes the comparative statics analysis more complicated and in the next section I will show how monotone methods make such analysis quite simple. For the moment, some additional things can be noted. First, one can use the concepts of nondecreasing differences and the like to demonstrate precisely what it means for two actions to be complements or substitutes. Suppose that x were changed as if it were an exogenous parameter. Then what would happen to the optimal amount of oil used? Theorem 1 shows that x and z will be complements (i.e., z * ( x ) is nondecreasing) if raising x does not lower the marginal product of oil (i.e., fzx ≥ 0 ) and that they will be substitutes (i.e., z * ( x ) is nonincreasing) if raising x does not raise the marginal product of oil (i.e., fzx ≤ 0 ). If x were also a choice variable and z were fixed, then x * ( z ) is nondecreasing (nonincreasing), if fzx ≥ 0 ( fzx ≤ 0 ).

12

The form of the profit function here meets the conditions required for Corollary 1 to hold. Therefore, it can be seen that each relevant condition is in fact the weakest that can be imposed to generate each of the stated comparative static results. 13 Note that these parameters can represent any policy instrument that increases the incentives of firms to adopt technologies with these effects. These range from mandated use to subsidisation of research and development. These conclusions on the introduction of “environmentally friendly” technologies and the resulting level of pollution have not to my knowledge been explored or emphasised in the environmental economics literature. One recent discussion by Rosenberg (1989) informally talks of this possibility, however, no general theoretical exploration has been conducted. It should also be noted that if pollution permits were in place, then the total level of pollution could be fixed. Such policies could reverse some of the effects discussed here. However, for a more detailed assessment of this issue see Gans (1995).

12 Using the precise definitions of complements and substitutes, it is possible to analyse a long-standing question regarding the short and long-run demand for oil in response to a price shock. Suppose there is an oil price shock (i.e., Pz rises) and suppose that x is fixed in the short-run. The question posed by Samuelson (1947) and answered affirmatively was whether the long-run adjustment in oil use in response to the oil shock would be greater than the short-run response? (See also Heal and Chichilnisky, 1991) Note first that with x fixed, Theorem 1 tells us that the demand for oil will fall as its price rises (because π zPz = − µ < 0 ). If z and x are complements, then z * ( Pz , x ) is decreasing in Pz and increasing in x. Therefore, the price shock lowers z which in turn causes the firm to wish to lower x.14 This second effect causes a further reduction in the level of oil used. So in the long-run, the demand for oil falls to a lower level than the short-run. But the same conclusion also holds when z and x are substitutes. In this case, z * ( Pz , x ) is

decreasing in Pz and x. Therefore, while the price shock still lowers z, this leads to a longrun increase in x. This, in turn, reduces the long-run demand for oil even further. The point here is that for the cases of complements and substitutes, the long-run adjustment after the price shock exceeds the short-run adjustment. But note that this analysis also indicates that such conclusions are not possible if the production function is such that x and z are sometimes complements and sometimes substitutes. Milgrom and Roberts (1994) show that this can lead to short-run adjustment exceeding long-run adjustments. This case was neglected by standard treatments of this problem (e.g., Varian, 1992) until its analysis using the methods described in this paper.15

14 15

**There is no first order effect of Pz on x since π xP = 0.
**

z

It is also useful to note here that all the comparative statics results here are “global” as opposed to “local.” That is, they do not rely on very small changes in the parameters leading to small changes in choice variables. Thus, the price change here can be a true price shock (i.e., a large discrete change in the price of oil) and the policy changes may represent radical changes in policies such as those that are associated with changes in technology. See Milgrom and Roberts (1994) for more on this distinction.

13 IV. Optimisation with Many Choice Variables The traditional analysis of comparative statics when agents choose many variables is very complicated. Keeping track of effects and ensuring that objective functions and constraint sets are concave is extremely difficult and computationally complex. This is the reason why most analyses confine themselves to the analysis of one or two endogenous variables. It turns out that an application of the methods of comparative statics introduced in the last section can be readily applied to situations when there are many choice variables at the disposal of agents. While it is true that this is more complicated than the single variable case and that it is harder to generate monotone comparative statics, the gains in simplicity and ease of application over traditional analyses are even more pronounced. Suppose now that the agent can select many dimensions of an action, i.e., x1 , x2 ,..., x I . The choice set, X ≡ × i ∈I Xi , now has I dimensions with X i denoting the choice set for variable i. These correspond to the familiar cases when consumers choose a basket of goods, firms choose the levels of many factors, and players use multiple instruments in games. Intuitively, when a parameter changes it might interact with more than one choice variable. But these variables also interact with one another. Therefore, to be able to get a monotone comparative statics all of these effects must reinforce each other. Countervailing forces will mean that a monotone result is unavailable. Nonetheless, the approach here can make precise the reasons for a failure of monotonicity, by showing the analyst where the countervailing effects arise. Then it becomes an empirical matter whether one effect is likely to be larger than another. As in the previous section, what is critical is the impact parameter changes and changes in actions have on the marginal returns to other actions. The concept of

nondecreasing differences formalised the notion that a parameter determined the marginal return to an action. Here, however, for movements in choice variables to reinforce one another, a related concept of how each affects the marginal return of the other is required.

14 Basically, what is required is nondecreasing differences in both directions between every pair of variables. A function f(x,y) is said to be (strictly) supermodular if f has

nondecreasing (increasing) differences in (x;y) and f has nondecreasing (increasing) differences in (y;x). Nonetheless, when f is continuously differentiable this amounts to assuming that fxy ≥ (>)0 for a function to be (strictly) supermodular. Therefore, in

practice, supermodularity turns out to be very similar to nondecreasing differences because one focuses attention on the signs of mixed partial derivatives. Observe too that

supermodularity is very similar to the concept of complementarity discussed earlier. When two choice variables are supermodular in an objective function, raising one raises the marginal return to the other. complementary.16 In problems considered in this section, if there is a change in an exogenous parameter, that change might alter the marginal returns to one or more choice variables. Suppose, however, that it raised (or at least did not lower) the marginal returns to every choice variable. Then unless all those choice variables are complementary, there might be countervailing effects that end up lowering the marginal returns to actions. In such cases the comparative statics derived would be non-monotonic and hence, ambiguous. Therefore, to generate unambiguous comparative statics predictions, all the interactive effects must reinforce one another. Theorem 2 (Topkis). Suppose that Xi ⊂ ℜ , for all i. If (i) π has nondecreasing differences in each ( xi ;θ ) ; (ii) π is supermodular in each ( xi ; x j ), i ≠ j ; and (iii) X does not vary with θ , then each xi* is monotone nondecreasing in θ . Once again this holds for the increasing cases if the solution is an interior one. The reverse holds for nonincreasing (decreasing) differences, so long as π remains supermodular in the choice variables. This is another way of saying that two actions are

16

Note that this is a slightly different use of the word “complementarity” to its price theoretic interpretation. Often it is said that two inputs are complementary if raising the price of one leads to more use of the other. The definition of complementarity here subsumes this commonly used price theoretic interpretation. (See Milgrom and Shannon, 1994)

15 Theorem 2 simplifies considerably the analysis of comparative statics. Previous analyses based on the implicit function theorem involved the construction and inversion of an I dimensional matrix and the addition of restrictive and wholly unnecessary conditions to ensure concavity. Here all that need be done is to examine the pairwise interactions between choice variables and parameters. Thus, using the methods here, one need only find the appropriate mixed partial derivatives and sign them. This makes it possible to analyse complex environments and obtain clean and intuitive results. A stronger theorem is available for situations when payoff functions take the form of a benefit minus costs. Corollary 2 (Athey, Milgrom and Roberts). Suppose that conditions of Theorem 2 hold. In addition, suppose that,

π ( x1 ,..., x I ) = B( x1 ,..., x I ;θ ) − ∑ Ci ( xi ) .

i =1

I

Then the following two statements are equivalent: (i) B is supermodular in each ( xi ; x j ), i ≠ j ; and has nondecreasing differences in each ( xi ;θ ) (ii) Each xi* is monotone nondecreasing in θ , for all Ci. Once again, it can be seen that restrictions such as supermodularity and nondecreasing differences are the minimal assumptions that must be imposed in order to generate monotone comparative statics.

Application: Environmental Policy Again Now one can return to the effects of environmental policy on firm behaviour but this time relaxing the condition that x is fixed. Looking to the influence of most parameters the issue of whether x and z are complements and substitutes is critical. This depends on the sign of: ≥ 0 fzx ≥ 0 if π zx = (1 − α ) fzx . ≤ 0 fzx ≤ 0 The following results can now be derived:

16 Raising Output Tax Rate, α Oil Tax Rate, µ Emission Tax Rate, τ Production Technology, ϕ Comparative Static decreases z * decreases x * decreases z * decreases (increases) x * decreases z * decreases (increases) x * increases z * increases (decreases) x * increases z * increases (decreases) x * Relevant Conditions

π zα = − fz < 0, π xα = − fα < 0,

fzx ≥ 0

π zµ = − Pz < 0 , π xµ = 0 , fzx ≥ (≤)0 π zτ = − gz < 0, π xτ = 0, fzx ≥ (≤)0

π xϕ = (1 − α ) fxϕ ≥ (≤ )0, fzx ≥ (≤ )0

π zϕ = (1 − α ) fzϕ > 0 ,

Abatement Technology, φ

π zφ = −τgzφ > 0 , π xφ = 0, fzx ≥ (≤)0

Observe that the assumptions required to generate monotone comparative statics are more restrictive than in the single variable case.17 However, in the case of z at least, the

directions of the possible comparative statics are unchanged. Nonetheless, if the additional assumptions underlying those results do not hold, it is possible that the optimal choice of z in response to a parameter change could move in the opposite direction. Consider the case of a change in α. This still causes a first order decrease in z and x. However, if z and x are substitutes (that is, fzx < 0 , contrary to the condition stated in the table), then the decrease in each variable will induce an increase in the other. Such second order effects could outweigh the first and hence, the ultimate result of higher taxes on intended output could be an increase in the use of z and higher unintended pollution. It is worth emphasising here that this additional complexity is relatively small relative to the complexity of conducting similar analyses using traditional methods. In the appendix, I demonstrate the use of traditional analysis so that its limitations can become more transparent. That traditional analysis requires more assumptions and also more algebra and cannot generalise to the non-differentiable, non-convex cases.

17

The table should be read carefully. The comparative statics results on the optimal z as a result of changes in all the parameters but α and ϕ , do not require the assumptions on complementarity or substitutability of z and x in f(.). These are only necessary for the results on the optimal x.

17 In constrast to the analysis in the appendix, the assumptions underlying certain results are laid bare using the methods of this paper (e.g., the criticality of the complements case for changes in α ). This focuses debate on the relevant conditions that determine policy conclusions. More importantly, however, these methods allow a careful

consideration of how the mix of policies contributes to the achievement of the overall goals of policy. As has been demonstrated in this paper in a very simple context, taxes on pollutants and the subsidisation or encouragement of the use of environmentally friendly technologies might be substitutes in achieving a reduction in pollution levels. Therefore, governments should use one or the other policy instrument but not both. Nonetheless, some other policies, such as the multiple use of tax instruments might be complements and such policies ought to be used in conjunction with one another.18

V.

Conclusions -- Monotone Thinking as Economics This paper has barely scratched the surface on the available new theorems on

comparative statics. The single agent optimisation problems have been extended to problems under certainty when agents maximise expected utility (Athey, 1995), to multiperson decision contexts such as games (Milgrom and Roberts, 1990; Milgrom and Shannon, 1994) and to other equilibrium notions (Milgrom and Roberts, 1994). Finally, some of the methods presented here have proved useful beyond simple comparative statics to problems of existence of social choice rules (Gans and Smart, 1995). All of these theorems and the applications of them are indicative of a new focus on monotone thinking in economics. Informal analysis has often described economic

predictions in terms of causes and effects. That is, one hears of an earthquake in Japan causing construction damage, which requires funds for repairs, which will come from Japanese capital overseas, which will flow into Japan pushing up exchange rates etc. The methods described here provide a formal way of understanding such complex webs of

18

For an analysis of the interactions between policy instruments in generating a transition to a market

18 cause and effect. But they do so in a familiar way, by focusing attention on marginal returns rather than unnecessary conditions such as convexity and divisibility. This paper introduces the barest essentials to apply the new tools. The promised fruit will come in terms of new applications and results on previously unanalysable topics.

economy see Gates, Milgrom and Roberts (1995).

19

Appendix: Traditional Comparative Statics with Many Variables Looking at the environmental policy problem, using the implicit function theorem, here I will analyse the effects on the optimal choices of oil, z * , and the other input, x * , of a rise in output takes, α. This method of comparative statics assumes that the conditions for an interior optimum exist and then looks at the local behaviour of the optimal choices -- that is, how these optimal choices move for small changes in the exogenous parameter. Consider then the first order necessary conditions for an interior optimum:

**∂π = (1 − α ) fz − µPz − τgz = 0 ∂z ∂π = (1 − α ) fx − Px = 0 . ∂x
**

In order to apply the implicit function theorem, it must be assumed that the determinant of the Jacobian does not equal zero anywhere. That determinant is:

π zz π zx (1 − α ) fzz − τgzz = (1 − α ) fxz π xz π xx

(1 − α ) fzx 2 = (1 − α )2 (( fzz − τgzz ) fxx − fzx ). (1 − α ) fxx

2 2 For this to be non-zero, ( fzz − τgzz ) fxx > fzx or ( fzz − τgzz ) fxx < fzx , for all (z, x). However,

the second condition would not allow the first order conditions to characterise a maximum. Hence, we are forced to use the former which in conjunction with the assumptions that fzz − τgzz < 0 and fxx < 0 to ensure concavity at the optimum. Having made these assumptions, the implicit function theorem can be applied and hence, using Cremer’s rule and simplifying:

**π zx − fz π xx − fx − fx fzx + fz fxx dz * = = < 0 if fzx ≥ 0 2 2 2 dα (1 − α ) (( fzz − τgzz ) fxx − fzx ) (1 − α )(( fzz − τgzz ) fxx − fzx )
**

− fz π zz − fx π zx − fz fzx + fx ( fzz − τgzz ) dx * = = < 0 if fzx ≥ 0 . 2 2 2 dα (1 − α ) (( fzz − τgzz ) fxx − fzx ) (1 − α )(( fzz − τgzz ) fxx − fzx )

20 Given the concavity assumptions, complementarity between z and x is a sufficient but not necessary condition for the signs of these derivatives to be negative. However, such conditions are the easiest to interpret, especially as one moves to three endogenous variables or more. In summary, therefore, to ensure that the optimal choices of z and x fall, locally, with α, the traditional analysis required that (i) fzx ≥ 0 ; (ii) fzz − τgzz < 0; (iii) fxx < 0; and

2 (iv) ( fzz − τgzz ) fxx > fzx . In contrast, the monotone methods approach required only (i) to

provide a sufficient condition for a global comparative static result (using Theorem 2) and tells us that this condition is a necessary condition (using Corollary 2) if we do not wish to impose any additional assumptions such as (ii) to (iv). So monotone methods yields a stronger result with fewer assumptions. Finally, we know from Milgrom and Shannon (1994) that these results will also generalise easily to non-differentiable cases when choice sets are not convex, something that cannot be said for the traditional analysis.

21

References Athey, S. (1995), “Characterising Properties of Stochastic Objective Functions,” Discussion Paper, MIT. Athey, S., P. Milgrom and J. Roberts (1996), Monotone Methods for Comparative Statics Analysis, Princeton: Princeton University Press (forthcoming). Gans, J.S. (1995), “The Promotion of Environmentally Friendly Technologies,” mimeo., University of New South Wales. Gans, J.S., and M. Smart (1995), “Majority Voting with Single-Crossing Preferences,” Discussion Paper, No.95/1, School of Economics, University of New South Wales & Journal of Public Economics (forthcoming). Gates, S., P. Milgrom and J. Roberts (1995), “Complementarities in the Transition from Socialism: A Firm-Level Analysis,” in J. McMillan and B. Noughton (eds.), Reforming Asian Socialism: The Growth of Market Institutions, Ann Arbor: University of Michigan Press. Heal, G., and G. Chichilnisky (1991), Oil and the International Economy, Oxford: Oxford University Press. Milgrom, P. (1994), “Comparing Optima: Do Simplifying Assumptions Affect Conclusions?” Journal of Political Economy, 102 (3), pp.607-615. Milgrom, P., and J. Roberts (1990), “Rationalizability, Learning, and Equilibrium in Games with Strategic Complementarities,” Econometrica, 58 (6), pp.1255-1277. Milgrom, P., and J. Roberts (1994), “Comparing Equilibria,” American Economic Review, 84 (3), pp.441-459. Milgrom, P., and C. Shannon (1994), “Monotone Comparative Statics,” Econometrica, 62 (1), pp.157-180. Rosenberg, N. (1989), “Energy-Efficient Technologies: Past and Future Perspectives,” reprinted in Exploring the Black Box: Technology, Economics, and History, Cambridge: Cambridge University Press, 1994, pp.161-189. Samuelson, P.A. (1947), Foundations of Economic Analysis, Cambridge (MA): Harvard University Press. Shannon, C. (1992), Complementarities, Comparative Statics and Nonconvexities in Market Economies, unpublished Ph.D. Thesis, Stanford University. Topkis, D.M. (1978), “Minimizing a Submodular Function on a Lattice,” Operations Research, 26 (2), pp.305-321. Varian, H. (1992), Microeconomic Analysis, 3rd ed., New York: Norton.

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