EC400 Slides Lecture 6

EC400 Part II, Math for Micro: Lecture 6
Leonardo Felli
NAB.SZT
16 September 2010
SOC with Two Variables and One Constraint
Consider the problem:
max f (x1 , x2 )
x1 ,x2
s.t. g1 (x1 , x2 ) ≤ b.
The bordered Hessian matrix is:

∂g ∂g
 
 0 ∂x 1 ∂x2 
 
 ∂g ∂ 2f 2 ∂2f ∂2g
∗ ∂ g

B=
 − λ − λ∗ 
 ∂x1 ∂x12 ∂x12 ∂x1 ∂x2 ∂x1 ∂x2 


 ∂g 2
∂ f ∂2g ∂2f ∂ 2f 
− λ∗ ∗ 
2
−λ 2
∂x2 ∂x1 ∂x2 ∂x1 ∂x2 ∂x2 ∂x2
Leonardo Felli (LSE, NAB.SZT) EC400 Part II, Math for Micro: Lecture 6 16 September 2010 2 / 31
The leading principal submatrixes are:
 
∂g
 0 ∂x1 
B1 = (0), B2 =  ∂g ∂ 2 f 2 , B3 = B
∗ ∂ g 
− λ
∂x1 ∂x12 ∂x12
The sufficient SOC are:

|B2 | < 0 (sign of (−1)1 ) which is always satisfied, and
|B3 | > 0 (sign of (−1)2 ).
Consider now the problem:
max f (x1 , x2 , x3 )
x1 ,x2 ,x3
s.t. g (x1 , x2 , x3 ) ≤ b
The bordered Hessian matrix is:

∂g ∂g ∂g
 
0

 ∂x 1 ∂x2 ∂x3 

 ∂g ∂L ∂L ∂L 
 
 ∂x1 ∂x12 ∂x1 ∂x2 ∂x1 ∂x3
 

H=  ∂g

 ∂L ∂L ∂L  
 ∂x
 2 ∂x1 ∂x2 ∂x22 ∂x2 ∂x3 

 
 ∂g ∂L ∂L ∂L 
∂x3 ∂x1 ∂x3 ∂x2 ∂x3 ∂x32
The leading principal submatrixes are:
 ∂g 
0
 ∂x1 
H1 = (0), H2 = 
 ∂g

∂L 
∂x1 ∂x12
∂g ∂g
 
0

 ∂x1 ∂x2 

 ∂g ∂L ∂L 
H3 =  , H4 = H
 
 ∂x1 ∂x12 ∂x1 ∂x2 
 
 ∂g ∂L ∂L 
∂x2 ∂x1 ∂x2 ∂x22
The sufficient SOC are then |H2 | < 0 (always satisfied), |H3 | > 0 and
|H4 | < 0.
Maximum Value Functions
Profit functions and indirect utility functions are example of maximum

value functions, whereas cost functions and expenditure functions are
minimum value functions.
Definition
Let x(b) be a solution to the problem of maximizing f (x) subject to
g (x) ≤ b, the corresponding maximum value function is then
v (b) = f (x(b))
A maximum value function is non decreasing.
The Interpretation of the Lagrange Multiplier
max f (x)
x∈Rn
s.t. g1 (x) ≤ b1∗
..
.
gk (x) ≤ bk∗ .
Let b∗ = (b1∗ , ..., bk∗ ) and x1∗ (b∗ ), ..., xn∗ (b∗ ) denote the optimal
solution and let λ1 (b∗ ), ..., λk (b∗ ) be the corresponding Lagrange
multipliers.
Theorem
Assume that, as b varies near b∗ , x1∗ (b∗ ), ..., xn∗ (b∗ ) and λ1 (b∗ ), ..., λk (b∗ )
are differentiable functions and that x ∗ (b∗ ) satisfies the constraint
qualification.
Then for each j = 1, 2, ..., k :
∂
f (x ∗ (b∗ )) = λj (b∗ )
∂bj
Proof:
We prove it in the case of a single equality constraint, with f and g

functions of two variables.
The Lagrangian is
L(x, y , λ; b) = f (x, y ) − λ(h(x, y ) − b)
The solution satisfies for all b:

∂L ∗
0 = (x (b), y ∗ (b), λ∗ (b); b)
∂x
∂f ∗ ∂h
= (x (b), y ∗ (b)) − λ∗ (b) (x ∗ (b), y ∗ (b)),
∂x ∂x
and
∂L ∗
0 = (x (b), y ∗ (b), λ∗ (b); b)
∂y
∂f ∗ ∂h
= (x (b), y ∗ (b)) − λ∗ (b) (x ∗ (b), y ∗ (b)),
∂y ∂y
Furthermore, since h(x ∗ (b), y ∗ (b)) = b for all b:
∂h ∗ ∗ dx ∗ (b) ∂h ∗ ∗ dy ∗ (b)
(x , y ) + (x , y ) =1
∂x db ∂y db
Therefore, using the chain rule, we have:
df (x ∗ (b), y ∗ (b))
db
∂f ∗ ∗ dx ∗ (b) ∂f ∗ ∗ dy ∗ (b)
= (x , y ) + (x , y )
∂x db ∂y db
∗ (b) ∗

∗ ∂h ∗ ∗ dx ∂h ∗ ∗ dy (b)
= λ (b) (x , y ) + (x , y )
∂x db ∂y db
∗
= λ (b).
Economic Interpretation:
Lagrange multiplier can be interpreted as a ‘shadow price’.
For example, in a firm profit maximization problem, Lagrange

multipliers tell us how valuable another unit of input would be to the
firm’s profits.
Alternatively, they tell us how much the firm’s maximum profit

changes when the constraint is relaxed.
Finally, they identify the maximum amount the firm would be willing
to pay to acquire another unit of input.
Recall that
L(x(b), y (b), λ(b)) = f (x(b), y (b)) − λ(b)(g (x(b), y (b)) − b)

= f (x(b), y (b))
So that
∂ d
L(x(b), y (b), λ(b); b) = f (x(b), y (b); b) = λ(b)
∂b db
Envelope Theorem
What we have found is simply a particular application of the envelope

theorem, which says that
∂ d
L(x(b), y (b), λ(b); b) = f (x(b), y (b); b)
∂b db
max f (x1 , x2 , ..., xn )

x1 ,x2 ,...,xn
s.t. h1 (x1 , x2 , ..., xn , c) = 0
..
.
hk (x1 , x2 , ..., xn , c) = 0.
Let x1∗ (c), ..., xn∗ (c) denote the optimal solution and let
µ1 (c), ..., µk (c) be the corresponding Lagrange multipliers.
Suppose that x1∗ (c), ..., xn∗ (c) and µ1 (c), ..., µk (c) are differentiable
functions and that x ∗ (c) satisfies the constraint qualification.
Then for each j = 1, 2, ..., k :

∂ d
L(x ∗ (c), µ(c); c) = f (x ∗ (c); c)
∂c dc
Notice: in the case hi (x1 , x2 , ..., xn , c) = 0 is hi0 (x1 , x2 , ..., xn ) − c = 0,
then we are back to the previous case:

∂ d
L(x ∗ (c), µ(c); c) = f (x ∗ (c), c) = λj (c)
∂c dc
but the statement is more general.
Proof:
We prove it for the simpler case of an unconstrained problem.
Let φ(x; a) be a continuous function of x ∈ R n and a scalar a.
For any a, consider the maximization problem of max φ(x; a). Let
x ∗ (a) be the solution of this problem and a continuous and
differentiable function of a.
We will show that

d ∂
φ(x ∗ (a); a) = φ(x ∗ (a); a)
da ∂a
By the chain rule we have:
d X ∂φ dx ∗ ∂φ ∗
φ(x ∗ (a); a) = (x ∗ (a); a) i (a) + (x (a); a)
da ∂xi da ∂a
i
Since by the first order conditions:

∂φ ∗
(x (a); a) = 0, ∀i
∂xi
We then get:
d ∂φ ∗
φ(x ∗ (a); a) = (x (a); a)
da ∂a
Intuitively, when we are already at a maximum, changing slightly the
parameters of the problem or the constraints, does not affect, up to a
first order, the value of the maximum function through changes in the
solution x ∗ (a), because of the first order conditions
∂φ ∗
(x (a); a) = 0
∂xi
This is a local result, when we use the envelope theorem we have to

make sure though that we don’t jump to another solution in a
discrete manner.
Implicit Function Theorem
In economic theory, once we pin down an equilibrium or a solution to

an optimization problem, we are interested in how the exogenous
variables change the value of the endogenous variables.
The key tool used in this endeavor is the Implicit Function Theorem.
We have been using the Implicit Function Theorem throughout

without stating and explaining why we can use it.
Implicit Function Theorem
The Implicit Function Theorem assures us of the condition under which a
set of simultaneous equations:
F 1 (y1 , ..., yn ; x1 , ..., xm ) = 0

F 2 (y1 , ..., yn ; x1 , ..., xm ) = 0
.. .. (1)
. .
F n (y1 , ..., yn ; x1 , ..., xm ) = 0
defines a set of implicit functions:
y1 = f 1 (x1 , ..., xm )
y2 = f 2 (x1 , ..., xm )
.. .. (2)
. .
yn = f n (x1 , ..., xm )
In other words, the conditions of the Implicit Function Theorem
guarantee the existence of these implicit functions even though we
may not be able to write these functions in an explicit form.
Consider (1).
Assume that the functions F 1 , .., F n all have continuous partial

derivatives with respect to all x and y variables.
Assume also that at a point (y0 , x0 ) satisfying (1) the determinant of

the (n × n) Jacobian w.r.t. the y -variables is not 0.
In other words, assume that:
∂F 1 (y0 , x0 ) ∂F 1 (y0 , x0 ) ∂F 1 (y0 , x0 )

···

∂y1 ∂y2 ∂yn

∂F 2 (y0 , x0 ) ∂F 2 (y0 , x0 ) 2 0 0
∂F (y , x )

···
|J| = ∂y1 ∂y2 ∂yn 6= 0,

.. .. .. ..

. . . .

∂F n (y0 , x0 ) ∂F n (y0 , x0 ) n 0 0
∂F (y , x )
···
∂y1 ∂y2 ∂yn

Theorem (Implicit Function Theorem)
Then there exists an m−dimensional neighborhood of x0 in which the
variables y1 ..., yn are functions of x1 , ..., xm according to the f i
functions as in (2) above.
The definitions in (2) are satisfied at x0 and y0 .
They also satisfy (1) for every vector x in the neighbourhood, thereby
giving (1) the status of a set of identities.
Finally, the functions f i are continuous and have continuous partial

derivatives with respect to all the x variables.
Derivatives of Implicit Functions
It is then possible to find the partial derivatives of the implicit

functions without having to explicitly solve for the y variables.
This is because in the neighborhood in question the equations (1)

have a status of identities, we can then take the total differential of
each of these and write dF j = 0.
When considering only dx1 6= 0 and setting the rest dxi = 0, the
result, in matrix notation, is:
∂F 1 ∂F 1 1   ∂y
∂F 1
   
∂y1 ∂y2 · · · ∂F
∂yn ∂x1
1
∂x1
 ∂F 2 ∂F 2 2   ∂y2
∂F 2
· · · ∂F
  
∂yn   ∂x1
 ∂y
 1 ∂y2 ∂x1
   
 = −
 .. .. .  . ..

..
. ..   ..
  
 . .   . 
∂F n ∂F n ∂F n ∂yn ∂F n
∂y1 ∂y2 ··· ∂yn ∂x1 ∂x1
Finally, since |J| is non zero there is a unique nontrivial solution to

this linear system, which by Cramer’s rule can be expressed as

∂yj |Jj |
= .
∂x1 |J|
Comparative Static
This is for general problems.
Optimization problems have a unique feature: the condition that

indeed |J| =
6 0.
This is because the system of equation that define the implicit

functions is the set of FOC. Then J is simply the matrix of partial
second derivatives of L, similar to the bordered Hessian.
In other words, we can take the maximum value function, or a set of

equilibrium conditions, totally differentiate them and find how the
endogenous variables change with the exogenous ones in the
neighbourhood of the solution.
For example, in the case of optimization with one equality constraint
we get that
F 1 (λ, x, y ; b) = 0
F 2 (λ, x, y ; b) = 0
F 3 (λ, x, y ; b) = 0
is given by
b − g (x, y ) = 0
fx − λgx = 0
fy − λgy = 0
We need to ensure that the Jacobian is not zero and then then we
can use total differentiation.
In other words, we need to ensure that:
∂F 1 ∂F 1 ∂F 1
 
 ∂λ ∂x ∂y 
 
 ∂F 2 ∂F 2 ∂F 2 
|J| = det   6= 0
 ∂λ ∂x ∂x
 

 ∂F 3 ∂F 3 ∂F 3 
∂λ ∂x ∂y
or:
0
−gx −gy

−gx fxx − λgxx fxy − λgxy 6= 0

−gy fxy − λgxy fyy − λgyy
But the determinant of J, is that of the bordered Hessian B.
Whenever sufficient second order conditions are satisfied, we know

that the det of the bordered Hessian is not zero (in fact it is positive).
Now we can totally differentiate the equations:
gx dx + gy dy − 1db = 0
(fxx − λgxx )dx + (fxy − λgxy )dy − gx dλ = 0
(fyx − λgyx )dx + (fyy − λgyy )dy − gy dλ = 0
∂x ∂y ∂λ
At the solution, we can then solve for , , .
∂b ∂b ∂b

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EC400 Part II, Math for Micro: Lecture 6

Consider the problem:

The bordered Hessian matrix is:

The sufficient SOC are:

The bordered Hessian matrix is:

Profit functions and indirect utility functions are example of maximum

A maximum value function is non decreasing.

Consider the problem:

We prove it in the case of a single equality constraint, with f and g

L(x, y , λ; b) = f (x, y ) − λ(h(x, y ) − b)

The solution satisfies for all b:

Furthermore, since h(x ∗ (b), y ∗ (b)) = b for all b:

Lagrange multiplier can be interpreted as a ‘shadow price’.

For example, in a firm profit maximization problem, Lagrange

Alternatively, they tell us how much the firm’s maximum profit

L(x(b), y (b), λ(b)) = f (x(b), y (b)) − λ(b)(g (x(b), y (b)) − b)

What we have found is simply a particular application of the envelope

Consider the problem:

max f (x1 , x2 , ..., xn )

Then for each j = 1, 2, ..., k :

then we are back to the previous case:

but the statement is more general.

We prove it for the simpler case of an unconstrained problem.

Let φ(x; a) be a continuous function of x ∈ R n and a scalar a.

We will show that

Since by the first order conditions:

This is a local result, when we use the envelope theorem we have to

In economic theory, once we pin down an equilibrium or a solution to

We have been using the Implicit Function Theorem throughout

F 1 (y1 , ..., yn ; x1 , ..., xm ) = 0

defines a set of implicit functions:

Assume that the functions F 1 , .., F n all have continuous partial

Assume also that at a point (y0 , x0 ) satisfying (1) the determinant of

The definitions in (2) are satisfied at x0 and y0 .

Finally, the functions f i are continuous and have continuous partial

It is then possible to find the partial derivatives of the implicit

This is because in the neighborhood in question the equations (1)

Finally, since |J| is non zero there is a unique nontrivial solution to

This is for general problems.

Optimization problems have a unique feature: the condition that

This is because the system of equation that define the implicit

In other words, we can take the maximum value function, or a set of

In other words, we need to ensure that:

But the determinant of J, is that of the bordered Hessian B.

Whenever sufficient second order conditions are satisfied, we know

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