Optimization in Economic Theory Second Edition BY AVINASH K. DIXIT OXFORD UNIVERSITY PRESSOsi University Press, Walton Street, Oxford OX? 6DP Ovfand New York Toronto Delhi Hombay Cuesta Madras Karachi Peraing Java Singapore Hone Kong Toke ‘Nairobi Dares Salaam Cape Town Meliowne Auetland and asselted companies ‘Berlin Inada Osford is atrade mark of Ovfrd University Press Pubiishd nthe United Stes nv Oxford University Press Ne York Avinash K Dit 1990 ie pabhisod 1990 aperivak eprnte (90, 1991 (38) Allright reserved opr of this publication maybe reproduced, stordindreticul yr orton, ams formor bans meas ‘lecinmt. mec lune phon, recondng orohereise, witha! ‘he prior pcan of Oxford Unversity Pree Tsk wl jee the canton that sal tb way oftrade on viernive hele, 2-0, red oat otheregeeratated ‘is te pubte's pe onset inform of nding cove? cenier thant stich ii publsher al witht asia condi Inlaid biped nt he subsequent purchase? Iii Library Celine in Pablication Data Dis Avinash, K Oprimicaion economic theory 1 Esonomies Opinion Tide 28001515 1SBNO-19-877211-4 ISBN 0-19-877210-6 (PAK) and, ibrar of Congres Cataloging in Publication Data Data no avalable Typeset by A. K. Dir using TEX Pet and Bound Groat Brainy Baas ta, ‘Gudford and King's Lon PREFACE ‘Making optimal use of scarce resources, that is, maximizing subject to constraints, is the central theme of economies. But students of ‘economics axe often taught the mathematies of constrained maxi- ‘ization as a branch of mathesuaties, and its economic applications follow separately. An integrated treatment that relates the math fematies to the economics from the beginning has the potential for providing a quicker and deeper understanding. This book aims to give such an exposition. Temphasize economic intuition rather than mathematical rigor. Proofs of the mathematical theorems are structured to bring out points of economic interest and facilitate economic applications. The illustrative examples and exercises are also chosen for their economic interest and usefulness. ‘The first edition of this book was published in 1976. The een- tral aim of the book is still valid, but the subject hins changed great deal over the years. Therefare I have revised the text very substantially. A chapter on uncertainty, with some treatment of topies like Snance and asymmetric information, is now indispens- able. [have added such a chapter, and have also expanded the chapter on dynamic programming to treat uncertainty. ‘Most chapters have been thoroughly rewritten, and many new examples and exercises added. One innovation deserves special mention. When the first edition was written, the main mode of ex- position in elementary and intermediate microeoonomnies was geo- metric, based on the tangency between a budget line and an indif- ference curve, oF a cost line and a production isoquant. Nowadays this shibboleth of tangeney seems lese prevalent. Thevefore I have used a starting-point that is simpler and economically space intu- itive, namely the search for costless improvements through ‘arbi- ‘rage’ operations. This allows an integrated treatment of tangency and comer optima, and its intuition extends much mote readily to situations involving time, uncertainty ete. In the years since the frst edition of this book was published, the mathematical training of economics students his improved sub- stantially. [have taken advantage of this by going a little deeper into some topics, letting the pace pick up in the last three chap- ters, and sketching the proof of the central result of constrained maximization the Kuhn Tucker theres ~ in a mathematical ap- pendix. But the book remains aimed at the majority of economiesvi Preface students in the last two years of undergraduate studies o the first year of graduate work, not the small minority who plan to become ‘uathematical economists, ‘The main use of the book is as a supplementary text inn crocconomies courses at the intermediate and advanced levels, Tt can be used as the main text, but should then be supplemented by fother books or articles, inchiding those listed for fusther reading at the end of each chapter. Short courses on consumer and pro- ducer behavior ean be based on chapters 1-8. Chapters 9 snd 10 are independent of each othe. Therefore courses that include op- timization over time but not uncertainty can omit chapter 9 and parts of 11. Conversely, those that include uncertainty but not time can omit chapters 10 and 11 ‘The examples ae fully solved out as far as the main line of reasoning is concerned, but some details are omitted. ‘The exer- ‘isos contain further development of the theory in the text, as well ‘as applications. The examples and exercises are an integral part of learning from the book, and I urge readers to work carefully through them. T thank many readers who gave me useful suggestions for im proving on the first edition, Among them, Pete Kyle deserves special mention, Tasn very grateful to Richard Quandt for reading the entize manuscript of the second edition with great eare and pointing out several errors, [also thank Barry Nalebuff and Carl Shapiro for reading several chapters. Peter Kenen’s Lav says that there is always at least one more typo than yor think, and I retain responsibility for the errors that rexnain. Princeton AKD. December 1989 CONTENTS 1. Introduction 2, Lasgrange’s Method 3, Extensions and Generalizations 4, Shadow Prices 5, Maximum Value Punetions 6. Convex Sets and Their Separation 7. Concave Programming 8. Second-Order Conditions 9. Uncertainty 10. Time: The Maxinum Principle IL. Dynamic Progeaaming Appendix ~ Kuhn-Tucker Theorera Index 10 4 40 35 69 86 105 122 M5 162 asl 1871 Introduction Feonomics has been defined as the study of making the best use of scarce resources, that is, of maximization subject to constraints ‘The criterion being maximized, and the constraints imposed on the choiee, vary from one context to the next: houseliolds’ co sumption and labor supply, firms’ production, and governments? swolicies, But all constrained maximization problems have a com mon mathematical structure, which in turn generates @ common economic intuition for them. This book sims to outline the math ‘matics and develop the intuition ‘The standard model of consumer's choice provides a good point of departure. The basie concepts are a budget line and a set of indifference curves. ‘The points on the budget line represent all affordable combinations of two goods. The family of indifference ‘curves represents the objective, namely to reach as high a curve as possible, The optimum is where an indifference curve is tangential to the badget line, Figure 1.1 shows the failiar picture Tn this chapter I shall develop this model further, using, ver~ bal and geometric arguments, but with an eye toward the math- ematical sharpening and generalization that will occupy us in later chapters. Tt helps to give a little algebraic content to the various mag- nitudes in Figure 1.1. Write I for the consumer’s inoney income, x and pe foc the prices of the two goods, and zy aud 1 for their quantities. The budget line, where the expenditnze exactly equals ucome, can then be expressed by the equation may tree (2) ‘The consumer's preferences over the amounts 2 and 2 of these goods are sepresented by a numerical scale, called the utility function, This assigns to each bundle (21,72) of goods & nun ber U(rs,22), called its utility level. In any comparison among, alternative bundles, the preferred bundle is the one that receives the highest utility number, Along an indifference eusve, all points2 Optimization in Economic Theory indifference ‘optimum, choice budget Tine Fig. 1.1 ~ The consumer's optimum choice ‘must have the same utility number. Therefore such a curve has an equation U(x1,22) = constant a2) ‘The exposition of the theory now proceeds by calculating the slopes of the budget line and the indifference curve. For tangency between the two, the slopes imust be equal. I shall do this soon. But let ine begin with a much simpler and more intuitive approach, ‘The Arbitrage Argument ‘The idea is to have the consumer start with any trial allocation of bis budget, and contemplate a change. If this leads to a bundle of goods that he rates higher on his utility seale, then it is to be adopted as a new trial allocation, Onec a bundle is found that cannot be bettered in this way, it will be the optimum allocation, a will be the one actually consuined. Thus the impossibility of ‘an improvement will serve as the test of optimality ‘The change does not en merely a reallocation of some amount of money from the purchase any additional expenditures; it is Introduction. 3 ‘fone good to the other. Ifthe initial allocation is not optimal, this ‘an raise the consumer's utility. When the consumer has made the Ibest choice and reached his personal equilibrium, such opporta ities for doing better with no net increase in expenditure vanish. is has a close parallel in financial markets. Ontside a market ceili un, participants ean make ‘arbitrage’ profits ata zero net donthy, taking advantage of discrepancies in prices of the same asvet in different markets. In equilibrium there ae no such opportun- ities. In fact the very process of people seeking arbitrage profits Iwings about the equilivium. I shall exploit this intuitive parallel labeling this whole fine of reasoning the “abitrage arguinent’ au the resulting optimality condition the ‘no rbitrage condition” If goods are indivisible, these changes aust oceu in diserte sieps. However, itis oft @ good approximation to suppose that oods are pevfectly divisible. Then t fintesimal amounts, oF what economists call maeginnl adjustments ven for sceningly indivisible goods, sch as ears or other large asumer durables, there are dinuensions of qty ete. that allow continnons adjustment. In any event, seh ssarginal changes ave hiages can oceur it in- the subject of our analysis in thin bovk “The standard syusbol for “a sinall (manginal, infsitesimal) claange in the variable 2” dz, This i not to be thought of as the product of two variables d and 2, mt an entity dein its own fight. ‘The use of such infinitesimal magnus ean be justified Figorosly, but for the must part Tokall use them in a loose heuts {ie way. Where you doubt s statement involving infitesimals, or are unsure Thave used thens correctly, you shoul rowork the ag cat ssing proper calculus method, starting with a finite change Asrand then going tothe linit av Ae +0 First suppose tat inital location of tie bulge has postive amounts 35 and of both goody. Now eontenplat a sonal ari trage operation, or a marginal relocation ofa small but postive suinount of come df from goo 2 to good 1. In physical tees, this means buying dI/p, units wiore of good 1 and dI/pz units less of good 2. Let MU, and MU; denote the nneginal tities ofthe toro goods. This means that a stall change dry in the quantity of good I changes tity by MU dn, nts and snilanly MUs dea for good 2. When the quantities of hoth goods are changing, the two effects ean be added together, so the change in uility is MU; dry + MUzdry 3)4 Optimization in Economie Theory Iu ater chapters I shall express this more rigorously using partial derivatives and Taylor series, but the simple statement will sullice here. The important point is that any one marginal adjust: rnient is so small that any changes in the marginal utilities then selves during its course can be neglected. Of course if many sueh narginal adjustments are strung together, the marginal utilities will change gradually over this sequence, In particular, if 2 rises end/or x falls, MU2/MUy will fall; this is the principle of the diminishing marginal rate of substitution in consumption. But for the moment Lam speaking of just one marginal adjustment. ‘The effect of the arbitrage operation on utility is then easy to compute. The increase of dI/py in the quantity of good 1 raises utility by MU dI/p,, while the decrease of dI/py in the quow of good 2 lowers utility by MU; dT/p,. The net increase in utility is therefore (MU fp — MUz/p2) a. If this expression is positive, the consumer will eaery out Ys reallocation and try further reallocations in the same direction. If the initial consumption bundle is optimam, therefore, the expres: sion cannot be positive. This is a part of the nno-arbitrage’eriterion of optimality. Since dI was chosen positive, we can divide by it ‘and write the criterion as (MU, Jp — MU2/p2) <0. (aa) Now suppose the etiterion is uot met, that is, suppose the left-hand side expression in (1.4) is > 0. Therefore some switch of expenditure toward good 1 is desirable. How far should this process go? Recall that as 21 increases and 22 decreases, MU; will gradually fall relative to MU, Eventually a point will be reached sthere the expression in (1.4) is zero, and no facther move jn this direction ean raise the consumer's utility level Next consider a reallocation in the opposite dvection, This will switch the signs in all the above arguments. If the initial allocation is optinmim, we must have (MU; /p, ~ MUz/p2) > 0. (3) If this is false, that is, if the expression is <0, then the process of increasing x and decreasing 21 will be carried out until the ‘expression reaches zero, Introduction 8 We can combine the two criteria of optimality of the initial consumption bundle into one: ifthe allocation (11,72), with both ‘quantities positive, is optinmum, thes the marginal utilities at this ie amust satisfy MU; /p1 = MUa/ps (16) "his is the overall ‘no-arbitrage’ condition. ‘The economic interpre: tion is that at the optimum the consumer should be indifferent hetween allocating the marginal unit of money to the one good or he other ‘The Tangency Condition Using Calculus Phe more complex but more commonly used way to derive the same vunudition of optimality is based on the tangency of the budget line (1.1) and the indifference curve (1.2), Write the equation of the Indget line a5 = (Lp2) ~ 21 (ps/p2). ‘Vhwu we see at once that the slope of the line is (pa /ps) in numerical value, The slope of the indifference curvo is the marginal rate of substitution (MRS) in consumption, and it equals the ratio of the ‘lites (MU; MU), A heutistic derivation of this is a= follows, Ifa marginal iss of dy units of good 1 is just compensated hoy the marginal gain of dza units of good 2, then the marginal rate of substitution (RS) is the ratio dra/dzy. But the exact offset vf the gain can be written as an equation in utility units snanginal MU d2y = MU; des, MRS =dra/ley MU /MUs. (az) Incidentally, note the reversal of the subscripts 1 and 2 between Ute mumerator and the denominator of the two ratios, This is not ‘typographical error; that is how the ratios are velated, as you east see by cross-multiplying to get back to the equation just above, At the optimum, the slope of the indifference curve (the mar- inal rate of substitution in consumption) is equal to the slope of the budget line (the price ratio). Therefore MU,/MU2 = pals (8)6 Optimization in Beonomic Theory This is equivalent to the optimality criterion (1.6) we derived. before. However, the verbal argument underlying (1.6) has some advantages over the geometry of (1.8). Corner Solutions ‘The arbitrage argument is somewhat easier to adapt to the case where one of the goods is not bought at all. Since this occurs fat one end or the other of the budget line, such optima are often called comer solutions. Suppose all income is spent on good 2 in the initial allocation, so xy = 0 and r2 = I/p2. Now of the two directions sf improvement, namely trying to ineyease x, and to decrease it, onily the former is possible. Therefore only the criterion (1.4) corresponding to this test survives. Since x, cannot de decreased any further, the argument leading to (1.5) cannot be made, The economic interpretation of (1.4) holding for the consumption bundle (0, /p2) is equally simple: even the first little unit of income spent on good 1 does not bring enough utility benefit to mntch that from the last unit spent on good 2 Marginal Utility of Income ‘The second advantage of the azbitrage argument is even more im portant. Retum to the situation where both goods are initially ought, and the eriterion (1.6) for optimality. Now suppose our consuiner is given an extra amount d/ of ineome to spend. He could spend it all on good 1, buy (df/p1) more units oft and achieve an additional (MU; d1/p,) units of uility. Or he could spend it all fon good 2, when his utility would increase by (AfU, di /p2) units. But the two increments to utility are equal by (1.6). Therefore at the margin the allocation of the infinitesimal amownt df of extra income to good 1, of good 2, oF indeed any mixtute of the two, is @ ratter of indifference to the consumer. Then we cai call the util ity increment per unit of marginal addition to income simply the marginal wility of income, without hothering to specify how the :narginal addition to the income is spent. Write \ for this marginal utility of income. Then the dF units of extra income raise utility by AAI units, Equating this to the two other ways of writing the same uliity gain in terms of spending on each of the two goods, wwe Rind d MU, |p. = MU2/p2. 9) Introduction 7 We sce that the common valwe of the two sides in the opti- tality criterion (2.6) has a very useful cconoric interpretation — it is the marginal utility of income. 4 very similar interpretation is possible for the no-arbitrage conditions in all constrained opti ‘uicstion problems; [shall explain this in greater detail and snify it muder the concept of Lagrange multipliers or shadow prices Many Goods and Constraints he generalization of the nnalysis to cover eases where there are several goods, some of which may not be bought at all, is equally easy. Suppose there are n goods, with prices (p,,p2y.--Pa) and jquntities (21, 22,...2n)- For all goods bought in positive amounts tl the optimum, the ratio of marginal ntility to price must have mon value, which ean then be interpreted as the marginal nlilty of income A. For all goods not bought, the ratio of marginal ulilty to price snust be smaller than, or at best equal to, this vale, In symbols, for any good 4, ita >0, wed es tnt van {ep eet (1.10) The method can also be extended to allow several constraints. We needl a separate ) for each constraint, and it can be interpreted us the marginal utility of relaxing that constraint, T shall diseuss this in Chapter 3 Non-binding Constraints a consumer theory, but will prove very important lly, consider an extension that is not of great relevance in some other ap: plications. Picture a consumer with aa income 50 Inege that he is satiated, and fails to spend it all. ‘The budget equation (1.1) should be replaced by an inequality Posi t pam <1. We can bring this within the scope of the above theory simply by defining a new good 23, ‘unspent income’, which has price equal8 Optimization in Economie Theory to one and yields no utility. (Note that I am not talking of saving, which enables a non-satiated consumer to spend more on desired goods in the future, but of totally useless unspent income.) The Duddget equation becomes Pin + para tay = \dwehave MU} = 0, Since we are supposing that the consumer is choosing a positive amount of 2, (1.10) for i= $ gives A= 0. This makes intuitive sense: if the consumer does not even spend all the income he has, then the marginal wtility of an inerement to income should be zero. In tuen, we can use this in (1.10) corresponding to the other goods, aud obtain MU; =0 for i = 1 and 2, Thus these goods are consumed at a level that yields zero marginal utility, that is, to the point of satiation. We started on a simple and intuitive excursion into a con: sumer's choice problem, using nothing but the computation of ‘ar Ditrage’ gains and losses from marginal adjustments and building them into criteria of optimality. This has already brought 1s to a very important general way of characterizing optima subject to constraints, In faet (1.10) is nothing but a form of a basic result of the theory of optimization subject to constraints, namely the Kuhn-Tucker Theorem, The extension to the case of a satiated consumer is an instance of the general principle known as Comple: mentary Slackness. In the chapters that follow, I shall gradually develop the general theory in a more systematic way, making use of the ealeulus, to develop and to sharpen the intuitive ideas in troduced here Preliminary Reading To read this book with ease and profit, you should be farnil iar with the basic concepts of elementary or intermediate micro economics: transformation curves and indifference eurves, margi- nal calculations done verbally or geometrically, ete. WF you need, to acquire this background, any good introductory economics or intermediate microeconomics textbook will serve. T mention just ‘one of each kind WILLIAM J. BauMOL and ALAN S, BLINDER, Economics Principles and Poliey, Chicago: Harcourt Brace Jovanovich, 4th. eda., 1987. Introduction 9 HAL R. VARIAN, Intermediate Microcconomies, New York: Norton, 1987, The mathematics needed is at the college calculus level. You will noed knowledge of partial derivatives right away in Chapter 2. Vector and matrix notation, with simple sums and products of dese entities, appears in Chapter 3, Some concepts of convex- ity axe developed in the book ax needed. Definite matrices and saundtatie forms are required in Chapter 8, and some elementary integration in Chapters 9 to 11 "Those who weed to acquire some of these mathematical tech niques have the choice of proper mathematics books, mathematics Innoks designed for economists, and economics books which explain ‘the mathematics along the way. Here once again is one example of wach Kind. SERGE LANG, Calculus of Several Variables, Berlin: Springer: Verlag, 3rd edn., 1987, chs. 1-6, 13-16. ALPHA C, CHIANG, Fundamental Methods of Mathematical Beonomies, New York: McGraw-Hill, 3rd edn, 1984, ehs. 4, 5, 7, 8 ALAsDaih SMITH, A Mathematical Introduction to Economies, Oxford, UK: Blackwell, 1982.2 Lagrange’s Method Statement of the Problem Let us begin the development of the subject to constraints, using a setting very close to the consumer choice model of Chapter 1. Suppose the choice variables are 2, and 22. Ushall write them more compactly as a vector 2 arranged in a column, aS (2). Initially, I shall use vectors only to abbreviate lists of components: actual operations with vectors and matrices will appear gradually We will need notation that distinguishes between the general vector x and some particular value of such as the optimum, while remembering the family resemblance between the two: both are vectors of choice variables. I shall generally use the symbol F to denote the optimum value of the general variable x. ‘The -neral theory of optimization components of 2 will be written Z) ete ‘The function to be maximized, called the objective function, is F(x), The constraint is a general non-linear ene (2) 1) where Gis function and ca given constant. The model of Chapter 1 was a special case of this: F was the utility function, G was a linear function showing the expenditure, Ga)=pintprre, and ¢ was income, If it helps, you can now think of @ as a more gcneral now-linear expenditure or eost fanction, such as would arise if the consumer faced a quaattity diseount or premium price sched- ule, With this notation, the problem in this chapter is to find we value # that maximizes F(x) subject to G(x) = ¢ Lagrange’s Method u ‘The Arbitrage Argument As we did in Chapter 1, start with a trial point and an infinitesimal siyuge, Let the particular trial point be 2, and the infinitesimal oe a= (%) We want (+ dz) to satisfy the constraint, and see if it yields a higher value of the objective function, Since the change in is infinitesimal, we can approximate the changes in values in functions of x by the first-order linear terms in their Taylor series. Let subscripts on # function denote ity partial derivatives with respect to the indicated argument; for example F, is OF/Ox). We must remember that in general each partial derivative is itself a function of the whole vector x. Only in the special case where F is linear will the pactial derivatives be constants; only in the special ease where F is additively separable (function of 21 plus a function of zz) will F, be independent of irz and vice versa. Thus we shioald write the pattial derivatives as Inetions F(x) and F(z). When these are evaiusted at our initial tsial point £, their values will be written Fi(z) and F,(2). ‘The first-order Taylor approximation of the change in F(x) 1s a result of the infinitesimal move from the general point x to ride is F(z) = F(x + ds) — Fle) = Ala) de + Rlz)dra (22) Observe the similarity with the expression for the change in util: ity (1.3) of Chapter 1; the marginal utilities that were motivated there by economic intuition are simply the partial derivatives of the utility function with respect to the amounts of the two goods consumed There is a similar expression for the change in Gt) G(x) = Gale) dey + Ga(x) dea (23) in Chapter 1, the partial derivatives of @ were simply the prices If we now think of G asa more general non-linear outlay or expen= dituse fanction, the partial derivatives are the marginal prices of the respective commodities.2 Optimization in Beonomie Theory Now we can modify the arbitrage argument of Chapter 1 to apply to the new more general setting. Start at a point # where the constraint (2.1) olds, and consider a change dz such that (2-+dz) also satisfies the constraint, Then @G(2) = 0. Using (2.8) with the particular initial point, we have Gi(@) dry = ~G,(2) dro. Call the common value of these two sides de. Then our arbitrage consists of reallocating an amount de inthe value of the funetion G(x) away from zy and towed 1, Fit suppose G,(2) and G,(z) are both non-zero. Then dx =defG(z), and — dry = de/G(z) ‘The resulting change in the value of the objective function is foxnd by substituting into (2.2) as AP (z) = [Fi(@)/@\(8) — Fel 23/Gxl)) de (24) If the bracketed expression is non-zero, then F(2) ean be in: creased by choosing de to have the same sign as that of the brack- ‘ted expression, AS before, we can turn this around te find a no-arbitrage condition that holds when 2 is the optimum choice So long as neither 2 nor 2 has hit some natural boundary such, fas zero, then changes de of either sig are possible. If x is opti um, then uo such change should be capable of increasing F(z) Therefore the bracketed expression in (2.4) should be zero, or Fy(2)/G,(2) = Fx(2)/Cx(2). (25) This is the analog of the condition (1.6) of the previous chapter. Note the exact statement: if the optimum choice is 2, then it satisfies (2.5). I have not established any implication the other ‘way round, so there is no guarantee that a solution to (2.5) is the optimum. ‘This is the difference between necessary and suficient conditions, and I will discuss it in more detail later in this chapter If # lies at some natural boundary, for example if one of 21 and Fy is zero when both must be non-negative, then only one sided changes de are meaningful, and we get an inequality that Lagrange's Method 13 orrespouds to (14) and (1.5). [shall not consider this case in this chapter, but shall return to it in the next. As in Chapter 1, let us define A to be the cesamon value of ‘he two sides in (2.5). Then we ean write that equation as a set of {owe equations Fy) = Gz), 12. (28) Remember that the 3 of Chapter 1 could be interpreted as the ‘wouginal utility of income, In the same way, the A just introduced har out to be the rate at which the optimum value of F(2) re- svenuls to. change in c. T shall develop this interpretation and jcations in Chapter 4. ‘The main topic im the rest of this »ter involves writing (2.6) in a way that easily extends to more yeneral settings, and provides a method for finding +, But Grst a couple of necessary digressions, Constraint Qualification What happens if say G,(#) is zero? Now #1 can be changed slightly without affecting the constraint. If Fj (2) is not zero, itis desirable lo so, For example, if F(z) is pesitive, then F(x) can be in- creased by raising 2). This goes on until either Fy(2) drops to zero, ‘8 Gy(z) becomes non-zero. In the cousumption interpretation, a consumer will go on using more of a free good either until he is salinted, of until the marginal unit of the good is no longer free. ‘Therofore if G,(2) is zero and z is optinnum, then F,(2) must be 210, too. We can define the ratio of these two zeros as we please, imud there is no harin in defining it so that (2.5) is satisfied. What if Gi(z) and Gx(2) are both zero? This might mean Hint both goods ate free, and should be consumed to the point of satiation. But there is a more ominous possibility arising from the tunizks of algebra and calculus. Take the budget line (1.1) of the previous chapter, and write its equation as (pity + Pete — 1)? = 0. ‘his is an unnecessarily complicated way of writing (2.1), but the two are mathematically fully equivalent, and we should see if the change makes any difference, Let G(z) be the function on the left-hand side of this. Then Gil2)= 3p (ray + p22 —1),M4 Optimization in Boonomée Theory which is always zero when = satisfies the budget constraint, The same is true for G,(2r). Goods are not free at the margin, and yet thir quantities have zero effect on the constraint function, In such a case, our method runs into trouble, ‘The formal mathernatical theory eops out and simply refuses to deal with such eases by assuming a condition called a Constraint Qualification, In the present instance that simply amounts to ns: suming that at least one of G,(7) and Gz(2) is non-zero. If this is not true in a particular application, then conditions like (2.6) may be invalid there. Luckily, failure of the Constraint Qualifi- cation is rarely a problem in practice. In the rare cases where it arises, it can usually be circumvented by writing the algebraic form of the constraint differently, as with the budget constraint above, But students of the subject should not forget the problem alto- gether; it is a favorite source of trick questions in examinations. If something strange seems to be going wrong when you try the stan- dard methods, you should check to see if the problem violates the Constraint Qualification. But I shall omit further mention of this complication except in the formal statements and mathematical proofs The Tangency Argument ‘The second digression relates the arbitrage argument to the tan- gency condition more familiar from elementary economics texts Tn Chapter 1 we saw an alternative way to obtain the condition (1.6), based on the tangency of the budget line and an indifference curve, The same can be done for (2.5). Figure 2.1 shows the story Along the curve G(r) = ¢, we have dG(2) = 0, aud from (2.3) we can calculate the slope of the tangent to the curve at 2 as dg /dzy = ~G\(2)/Gn(2). 7) Note the reversal of the subseripts, exactly as in Chapter 1. Note also that if G,(z) = 0 the eurve is vertical; this is not a serious problem, If both Gi(2) and G,(z) are zero, the slope is not well defined, and the methoel may run into & problean as was explained just above. In most economic applications, @ is an increasing fanetion of both arguments. Then Gi(z) and Ga(2) are botl pos itive, drz/d2, along the curve is negative, and we have the usual downward sloping transformation frontier for the constraint. Lagrange's Method 6 agent Fig. 2.1 ~ The tangeney solution A contour of the objective function F, tnt is, a curve of equal values F(z), runs through the point x. The slope of the tangent tw the contour at this point is similarly calculated: dry dey = —Fi(2)/ Plz). (238) ‘Once again, in most economic applications, F is an increasing, func tion and the contour (indifference curve) is downward sloping, If is optimum, the two curves must be matually tangential, Unt is, have the same slope, at this point, quating the two expressions, we have Fla\/Falz) = Gil2V/G(2), (29) which is equivalent to (2.5). Necessary vs. Sufficient Conditions Recall what the above argument established: if # maximizes F(z) subject to G(x) = e, then (2.5) holds, In other words, the condition16 Optimization in Beonomic Theory (2.5) is a logical consequence of the optimality of 2. Therefore it is called a uccessary condition for optimality. To be more precise, since it involves the first-order derivatives of the functions F and G, itis called the first-order necessary condition, In searching for an optimum, the first-order necessary eondl tion helps to narrow down the search, The necessary conditions were established starting with an assumed known optiznum 2. But wwe turn the story around by treating the components 4 atd #2 1as unknowns, and the constraint (2.1) and the necessary condition (2.5) as two equations that will deterasine them, ‘Typically, there isa whole continuous range of values of 2 satisfying the constraint (2.1), But there are only a few values of %, and if we are lucky, just one, that also satisfies the condition (2.5) If we know from separate reasoning that our probles indeed hhas a solution, and wo find that there is a unique = satisfying the constraint and the first-order necessary condition, then it must be the solution we seek. If there are multiple solutions to (2.1) and (2.5) taken together, then all are candidates for optimality as far fas the present analysis is coucemed, and some other methiod must be used to find the correct solution. Even then, the first-order necessary condition (2.5) will have eut down quite drastically the nuaber of candidate points we need to examine, ‘The main reason that the first-order necessary condition does not always lead us to the right solution is that the sane first-order consition is also necessary for the problem of minimizing the saa function F(z)subject to the same constraint G(s) =e. Minimizing, F(2) is the same as maximizing —F(z). By the same reasoning 1s that leading to (2.8), we can find the slope of a contour of this funetion: dzz/dr, = -[-F(2))/[-Fa2)] ~Fi(a)/Fale) Equating the value of this at F to (2.7), we get (2.9) again, There is also the point that to obtain the condition, we asked if the value F(x) could be improved by making small changes in 2. If not, then 2 is better than the comparison points in a small neighborhood, or it yields a local peak of F(z). Now a function ean in general have several such local peaks, and several local troughs too, The same first-order necessary condition will be true at all these points. Only one will give a true or global maximum, Lagrange's Method 7 Finally, either ® maximum or a minimum implies (2.5) but vat vice versa. Therefore the condition might be satisfied at os th tieifhborhood. As a simple example, consider F{2) = 2° wher eisalar, We have F"(0) = 0, but « =O gives neither & maximum (2). ly distinguish such eases, any point satisfying the first-order sini is one of the stationary points. To locate it among these ‘inulcates, we need some other test. Such tests typically rely on the eurvatixe, oF the second-order derivatives, of the functions. In Figure 2.1 the curvatutes of the contours of F and G have been hoon correctly for # maximum, ‘Thas the curve Glz) = © gets ‘atten as zy decreases and zy increases along it; the economic in- texpretation is that the marginal rate of transformation of zy into 1 limiishes as more and more of such a transformation is earried is neither a maximum nor a minimum, even in a small hot n minimnan of ¥y conditions is called a stationary point, The true opti vit, Similarly, the contour of F shows a diminishing marginal rate uulstitution, lists involving curvatures or second-order derivatives are the subject of Chapters 6-8. These tests differ from the first-order eon- ‘lions of this chapter in another Way: af such a condition holds, then the point in question is a maximum, at least in comparison with neighboring points; the condition ensures optimality. There- 1w such @ condition is called a second-order sufficient condition, Lagrange’s Method Now let us express the first-order necessary condition (2.6) in a way that is easy to remember and use, This is called Lagrange's Metliod after its inventor, Note that we want to use the condition Iu solve for the optimum #. We introduced A as the common vale nif the two sides in (2.5), s0 i€ is just as much unknown as the vptinuim 2, That is, we have to determine it as an integral past of ‘hw solution. In the meantime, call it an undetermined Lagrange susltipliee, Define a new function, called the Lagrangian, L(2,) = Flr) + Ale~ G2) (220) Ni at (that L is also a function of ¢, and of any other parameters pear in the functional forms of F and G, Such arguments uf L-will be shown explicitly only when they are important in the sles18 Optimization in Economic Theory Denote the partial derivatives of L by L,=0L/02;, Ly =AL/0a ‘Then Lian Fiz) -AGjlz), Late.) G2), ‘The first-order necessary condition (2.6) becomes just Ly = 0 for j = 1 and 2, and the constraint (2.1) simply Ly = 0. Then we ‘can state the result of the whole argument so far into a simple statement Lagrange’s Theorem: Suppose 7 is a two-dimensional vector, ¢ is a scalar, and F and G functions taking scalar values. Define the function L as in (2.10). If x maximizes F(z) subject to Gl2) with no other constraints (such as non-negativity), and if G,(z) ¢ O for at least one j, then there is a value of A stich that Lyz,A)=0 for j=1,2 LA(2,)= en) Remember that the theorem provides necessaty conditions for optimality. In other words, it starts with a known optimum 2, and establishes that it must satisfy (2.11). But in practice, mich of the use of the theorem is in helping us narrow down the search for an initially unknown optimum. We regard (2.11) as three equations for the three unknowns #), #2, and A, The equations are generally non-linear and neither existence nor uniqueness of the solution is guaranteed. If the conditions have no solution, the reason may he either that the maximization problem itself has no solution, or that the Constraint Qualifieation fails and the first-order conditions are inapplicable. If the conditions have multiple solutions, we need the second-order conditions to arbitrate between the candidate sol tions, But in most of our applieations, the problems will be well posed enough that the first-order necessary conditions take ws to the unique soltion. I shall now develop some examples that use Lagrange's method, and offer some exercises for you to attempt similar solutions. After you have gained soune experience of prob: lems with two vasiables and one constraint, you will be ready for the extensions considered in the next chapter Lagrange’s Method 19 While the notation keeps the theoretical developments clear ly distinguishing the general point from the particular optimum, 1 becomes cumbersome in applications where we are searehing for ‘aw unknown optimum, Therefore we often drop the bar on x in ‘nulitions like (2.11) when using thesn in particular contexts, such ‘ws the examples below. Examples Heumple 2.1: Preferences that Ingly Constant Budget Shares Consider a consumer choosing between two goods and y, with prices p and q respectively. (The notation x), 2 ete iu the theoretical part because it generalizes more easily to several sls and constraints, but the x, y notation is simpler in examples With just two goods.) His income is I, so the budget constraint is was used Suppose the utility funetion is U ay) =a In(z) +B Inly), (212) where a, B axe positive constants and hy a sithuns, Write the Lagrangian jes natural og L(xy,d) =a In(z) +8 Infy) +A [1 pa ay Newall that dn()/di + waulitions (2.11) become 1s. Therefore the first-order ne AL/Oz= 0/2 ~rp=0, OL Jy = Bly —dg=0, aul OL/O\=1—p2~qu=0. Tu solve these, substitute for x, y from the first two into the hand, ‘This gives A= (a4 Sil, (213)20 Optimization in Economie Theory sand then al al weap YEG ew ‘These are the demand functions, namely the solutions for the opti- suwuin quantities in terms of the prices, income and the given para micters a, 8. ‘We can write them alternatively as a w_b ats" To atf pe ae (2.15) In other words, for the utity fanetion specified, the shares of in- come spent on the two goods are constants, This is @ convenient property, and one that is sometimes close enough to reality. In the initial exploration of theoretical models, this specification is often the crucial simplification that yields eoncrete results that suggest the directions for further analysis and testing. Therefore this fane tion isa favorite of economists Note that in (2.18) the marginal utility of income is inversely proportional to the income, This might seem a natural conseqitence of the intuitively appealing idea of diminishing marginal utility. But that is a treacherous concept; see Exercise 2.1 below. Bzomple £.2: Guns vs. Butter Consider an economy with 100 units of labor. It ean produce guns © or butter y. To produce + guns, it takes 2? units of labor; Tikewise y* units of labor are needed to produce y guns. Therefore the economy's resource constraint is ay? = 100. Geometsically, you can easly see that the production possibility frontier is a quarter-citce. The objective function to be maximized is Flz,y) = ar + by. where a, 6 are given positive constants ‘To solve this problem, form the Lagrangian U2,y,d) = a2 + by +9 (100-2? —y?), Tagrange's Method a he first-order conditions are OL/Oz = a~2dx ab/ay =6-2Ay =0, aLjar = 100 — Substitute from the first two into the third to get ays 100 = (a? + 8)/(4)*), A= (a? 467)'/2/20, The 10 a/fa? +88)", 10 d/(a? +B), (2.16) You can think of a, b as the weights or social values attached to the two goods, and then (2.16) gives the economy's optimal applies as functions of these weights. Ifboth weights are incscased. iw equal proportions, say doubled, then the optimurn quantities ‘sud y are unchanged. The supplies are homogeneous of degree veto in the values, so only the relative values matter. ‘The supply ‘ofeach good ineseases as its relative value increases. In later work, ‘expecially the chapter on comparative statics, we shall see bow renerally valid such properties are. xercises jercise 2.1: The Cobb-Douglas Utility Function {der the consumer's problem as ix Example 1, but with a dllfesent utility fanction 0 defined by Gaary’ Show that it yields the same constant-budget-share demand fane= tions (2.14) as above, (Hint to simplify the solution proces: eli nuute the Lagrange multiplier between the first-order conditions for the two goods, Tl gives a relation between x and y. Simplify2 Optimization in Beonoméc Theory this as far as possible, and then use it and the budget. constraint to solve for the quantities.) Note that the two utility functions are Hnked Ulz,y) =I B(2,y)}, or (zy) = explU(,y) This illustrates that changing the utili transformation does not affeet the consumer's optimum choice. If ‘observed deimand behavior is all that matters, then the forma of the utility function is indeterminate (and irelevant) to within such transformation, Any properties that depend om the choice of particular form are meaningless. One such is diminishing marginal utility of income, If we write the multiplier for this problem as A to distinguish it from the A of Example 2.1, then you should verify tnt y finetion by any iscreasing, ong ero op If (a+ 8) > 1, then J increases with income, Tn some circumstances, specific forms of the utility function play special roles, This happens when some assumptions about interpersonal comparability are made, or when fonctions that are additively separable across time-petiods or states of the world are used for representing preferences in situations involving time or uncertainty, But in all these cases, the primacy of the special functional forms arises from those other considerations, not from the underlying mechanism of individual choice. When these other considerations are absent, we are free to transform the tility function for computational convenience, Note that changing both a and @ in the same proportions leaves demand snaffected in Example 2.1 a8 well as in Exercise 21, A glance at ‘equations (2.14) or (2.17) shows that it is convenient to choose these proportions so that a+ = 1 Beercise 2.2: The Linear Bzpenditure System Return once again to the consumer of E bout let the utility fanction be modified to U, where ample 2.1, Bay) a In(z— x0) +8 In(y — yor Lagrange’s Method 23 where 2g and yy are given constants, and a +9 = 1. Show that we optimal expenditures on the two goods are linear functions of ieome and prices: pz =al+ Spm —aque, y= 81 Spro + aque. "This slight modification of the utility function brings with it a twush richer range of possible optimum choice. The budget shares nf the two goods can now vary systematically with income and mies, One good can be a necessity and the other a luxury (but hwitler good can be inferior since a and i must be positive to keep tHe iinginal wtilities positive), But the expenditures still have a sunple functional form. For these reasons, this specification was opilar in the early empirical work on consumer demand Barwise £.8: Production and Cost-Minimization Conpider a producer who rents machines IC at r per year and hires Inher L at sage w per year to produce output Q, where Q=VK+vi prose he wishes to produce a fixed quantity Q at minimum wal. Find his factor demand functions, Show that the Lagrange tuuihiplier is given by A= 2wr Q/(w +r). Siuygest an econoinic interpretation for A. Now let p denote the price of output, Suppose the producer aay the quantity of output, and seeks to maximize profi rw that kis optimum outpat supply i Q=plw+r)/(2wr) Holate this to your interpretation of 3. Further Reading Vor supplementary treatments of Lagrange’s method, see Varian (op. cit.}, appendices to chs. 5 and 20, and Smith (op. eit.) ch. 2 urets. 1-4), ch, 4 (sects. 1-3), “The development of the theory in this book is relatively intu- ive and heuristic, There are several textbooks that are mathe twusieally more rigorous; I mention just one MICHAEL D. INTRILIGATOR, Mathematical Optimization and ‘onomic Theory, Englewood Cliffs, NJ: Prentice-Hall, 1971; ch. 1 is hot Lagrange’s method,3 Extensions and Generalizations More Variables and Constraints If there aren choice variables (21,22)...2q), we simply Jet the veetor + have n components, Then (2.11) is extended to j 1,2).2-m, and we have (n+ 1) equations in the (w+ 1) unknowns, nately the n components of 2 and the number A. If there are sn constraints, write them as Gie)se, 112.2, where the functions are identified by superscripts to avoid con: {sion with partial derivatives, which are being denoted by sub- scripts. For the mament, continue to ignore any other restrictions such as non-negativity on the variables. We need m 0, Generalization of tae reasoning in Chapter 1 that led to the inequality condition (1.10) owe gives us positiv AG So Gia) so tlz) Extensions and Generalizations w Unee again Tomit the formal proof. More generally, some components of # may be positive and stlwrs zero, Then an equation like (3.2) should bold for the partial Ulerivative of the Lagrangian with reapect to every component that tw ponitive, and an inequality like the one just above with respect to very component that is 2er0, at the initial point. In other words, ‘ every j, we should have L(z)<0, #20, (33) with at least one of these holding as an equation. In exceptional ewes, both might hold as equations. But the logical possibility that Iwoth inequalities may be striet is ruled ont by te requirements of inaity "The requirement that at least one inequality in (3.7) should hob as an eqwation is sometimes stated more compactly as 3; L,(2)=0. rhe point is that the product can be zero only if at least one of the factors is zero. A pair of matched inequalities like (3.7), not both of which van be strict, is said to show complementary slackness. A single inuquality, say 2) 2 0, is Binding if it holds as an equation, that is, Ar, is at the extrome limit of its permitted range; the inequality is sic to be stack if 2; is positive, and so has some room to maneuver fore hitting an extreme. Each one of the pair of inequalitie (3.7) therefore complen nilck, the other must be binding We can collect all the component inequalities in (3.7) into vec lors, Here I shall use the following notation: x > 0 means that Fy > 0 for ever ponent inequalities is strict; 2 >> 0 means that all the component inequalities are striet, Then (3.7) becomes ints the slackness ia the other: if one is yy J; 2 > O means that at least one of these com LAz)<%, £20, — with complementary slackness, (3.7) it being understood that complementary daekness holds for each sommponent pair in the veetor inequalities (Once again, I summarize the result for future reference:28 Optimization in Beonomie Theory Lagrange’s Theorem with Non-Negative Variables: Suppose + isan n-dimensional vector, ean m-dimensional vector, F a function liking scalar values, G a function taking m-dimensional vector values, and m 0, and the constraint qualification rank G,(2) =m holds, then there is a value of A such that LA(Z,A) $0, #20, with complementary slackness, (3.7) ond 1a(z,A) =0. (36 First-order necessary conditions are supposed to narrow dow: four search for a solution. How does that work in this instance? We start without knowledge of which components of the solution are going to be positive and which ones zero, particular pattern, say #) > 0, 2 =0, 2 > 0, we get Li(z) = 0, 2; = 0, La(z) = 0, assumed pattern leads to a set of n equations from (3.7) may not have a solution at all, and even if they do, it may not satisfy the other inequality conditions required from the pattern, But iffa solution satisfying the requirements exists, then it becomes ‘candidate for the optimum choice, ‘There are 2" pattems of positive and zero components in the n-dimensional veetor 2, We can then repent th every one of these patterns and find other candidates for optimality Then our search narrows down to all these candidates. If we assume a , then from (3.7) In other words, ai These sane exercise for In some applications the search i relatively enay to perfor the simplex method for solving linens programming problems is es sentially a systematic algori But in general the search is too exhaustive and exhausting. If we bad to carry i cout every time, the prospects for walving constrnined optimization problems would be very poor. Luckily many problets of prac tical interest offer short cts or systems for searching among, tk patterns. In most basie contexts of economic theory, we ean mak attern of equntions and inequalities, im for sich a seareb Hood guesses about the Tike Extensions and Generalizations 29 peeved on that basis, and use second-order sufficient conditions us verify that the resulting solution is indeed the optimum, Incquality Constraints Now we can consider more general inequality constraints. ‘This is J considerable economic importance, because sully there is no ‘eanpnlsion to use all of avnilable income or some resouree, and we should determine in the process of solution whether it is optimal os ae it fly. Suppose the frst component in the constraint need only hold vm wn inequality Gz) Sey. We ean fit (ick as the sisinner’s problem of Chapter 1 is into the context discussed before using the same ntroduction of the “unspent income’ variable in the Let us define a new variable any = — GMa). (38) Iu terms ofthe enlarged setof variables, the consiraint has become r-exact equation, The new variable zn ie rest tegative, but we know how to handle that. Write Las the Lagrangian fr the new problem, to distinguish 41 fron the Z of the old one. Then 1d to be non Blais... tating tyes Am) = Fleiss. myAieoss Am) 495 [er = GY(21,.-.29) — tnt +0 A [er -Gia,.-2n) = Uezayeeety Aye Am) Ab Ea All the other first-order conditions are as before, but we have new one with respect to zus1 AL/Arag1=—M SO, Ze41 20, with complementary slackness, Recalt that G(x) = OL/0Ay0 Optimization in Economic Theory Extensions and Generalizations a Therefore the condition can be written Kukn-Tucker Theorem: Suppose « is an n-dimensional vector, 1 nv dimensional veetor, F a function taking scalar values, G a OL/O, 20, 20, (3.tuetion taking m-dimensional vector values. Define with complementary slackness: a form that is nicely symmetsi 1(2,A) = Fla) + Ale~ G(x) | (3.4) with the condition (3.6) for non-negative variables We can similarly allow all constraints to be inequalities. Ifwslwie A is an m-dimensional row vector. Suppose # maximizes do that, there is no reason in general to maintain the restrietion!'(r) subject to G(x) 0, and the constraint. qualifiea: mm 0, then (3.12) gives A= 1/g, and then (8.11) becomes p/q > 00, which is not true. Therefore cannot arise either, The economie reason is that the first small lunit of 2 has infinite marginal utility, so it cannot be optimal to Next consider x > 0 and y = 0. Then from the budget con: straint 2 = I/p, and from (3.11), = a/I. Using this in (3.12), we have 1 < ag/I, ot I< ag. This is n condition on the given parameters of the problem, and they may or may not satisfy it. If they do, the premises of the case are mutually consistent and we fe a candidate for optimality. ‘economies of this is simple Finally, if both 2 and y are positive, (3-11) and (3.12) give a/(p2) == 1/4, 80.2 = ag/p. Then the budget constraint gives y = 1/4 — a. This is logically consistent if 1 > ag. Once again this may or may not be satistied; if i is, we have a candidate for optimality Bztensions and Generalizations 33 This completes the discussion of the eases, Now let us infer swine useful ideas from the procedure and the results. ‘The first thing to note is that six of the eight possible patterns could be ruled out using economic sense; after some experience it is possible soning quite a lot in this way Next, observe that the space of all possible values of p, 4, nd Tis split into two exhaustive and mutually exclusive sets by tus ent down the amount of formal re tlw conditions on the parameters that makc each of the Inst two ‘ses internally consistent, One requires I< ag, while the other requires > aq. In many applications, a similar neat classification will energe, ‘Third, when I= ag, we have A= 1/q. Therefore andy =0; 1-Ag=0 woth inequalities in (3.12) hold as exact equations. When I dis: assed complementary slacknes: following (3.6), 1 mentioned this sibility, and called it an exceptional case, Now we see why: it rive at the special configuration of parameters where the solution 1s just at the point of switehing from one pattern of equations and ickness conditions to another inequalities in the complementazy pisttern Finally, let us restate the optimum choice rule I Taq, 2=ag/p and y=I/q—a To see the solution more clearly, carry out the thought ex eriment of starting at a very low level of income and raising it wrndually. At first, all of income is spent on After a point, the expenditure on z is kept coustant, and all wlditional income is spent on y. We can think of good 2 as an exemplar of a necessity: it has an absolute first claim on income, good x and none on Init once its needs are satisfied, all extra income can go toward ther goods Quasi-inear preferences are usefel when we want to isolate ine sector or industry and wish to avoid the feedback of sllects on the demand for its goods. This is often called “partial ‘wilibriom’; a better name would be ‘industry analysis’, The as siption that changes in income do not affect the demand for the