Task for 25-07-2023

Question 1: Explain the relevance of Envelope Theorem in Economics. Does the theorem
hold good for production function exhibiting CRS?
Answer: The Envelope Theorem is a significant finding in mathematical economics that aids
economists in understanding the marginal impact of changes in economic variables on the
optimization problem of a corporation. In particular, the theorem offers a method for
determining a parameter's marginal value in an optimization problem without having to redo
the entire problem.
The Envelop Theorem states that the partial derivative of the optimal value function with
respect to a parameter is equal to the partial derivative of the objective function with respect
to that parameter, evaluated at the optimal values of the decision variables.  
The Envelope Theorem is particularly relevant in the context of production theory, where it
can be used to analyse the effects of changes in input prices or technology on a firm's optimal
production decisions. For example, the theorem can be used to calculate the marginal effect
of a change in the price of labour on a firm's optimal level of output, without having to re-
solve the entire optimization problem.
Regarding the applicability of the Envelope Theorem to production functions exhibiting
constant returns to scale (CRS), the theorem still holds true. In fact, the Envelope Theorem is
valid for any optimization problem where the objective function and the constraints are
differentiable and satisfy certain regularity conditions. The CRS property of the production
function does not affect the validity of the theorem, as it is a property of the production
function itself and not of the optimization problem.
In other words, the Envelope Theorem allows us to calculate the marginal effect of a change
in labour cost on the optimal level of profit without having to re-solve the entire optimization
problem. This is useful because it saves time and computational resources, and it allows us to
quickly analyse the effects of different economic variables on a firm's optimization problem.
Let us now work through a numerical example to illustrate the application of the Envelope
Theorem in production theory with constant returns to scale.
Suppose we have a firm with the following production function that exhibits constant returns
to scale:
[ Q = 3 *square root of L * square root K.

where:
Q = output quantity,
L = labor input,
K = capital input.
The firm faces a market price (P) of the output at Rs.10 per unit, a wage rate (w) of Rs.9 per
unit of labor, and a rental rate of capital (r) at Rs.6 per unit of capital.

The firm's profit function (Pi) is given by:

Π=P⋅Q−w⋅L− r⋅K
We want to find the optimal values of labor (L*) and capital (K*) that maximize profit (Pi),
and then use the Envelope Theorem to calculate the marginal effect of a Rs.1 increase in the
wage rate (w) on the optimal profit level.

Step 1: Maximize the Profit Function

Step 2: Calculate the Optimal Profit
Step 3: Use the Envelope Theorem to Calculate the Marginal Effect of a Change in (w)
They are as shown :
So, the marginal effect of a Rs.1 increase in the wage rate (w) on the optimal profit level is
Rs.291. This means that if the wage rate increases by Rs.1, the firm's optimal profit will
decrease by Rs.291 without having to re-solve the entire optimization problem.

Question 2: Explain Roy's Identity and Sheppard's Lemma with appropriate mathematical
exposition.
 Answer: Roy's Identity:

Roy's Identity is a result that relates the Marshallian demand function to the indirect utility
function. The Marshallian demand function gives the optimal amount of a good that a
consumer will demand at a given price and income, while the indirect utility function gives
the maximum utility that a consumer can achieve given a set of prices and income.
Roy's Identity states that the partial derivative of the Marshallian demand function with
respect to the price of a good is equal to the negative of the partial derivative of the indirect
utility function with respect to the price of that good, divided by the income of the consumer.
Mathematically, we can express Roy's Identity as follows:

∂xi (p, w)/∂pi = -∂v (p, w)/∂pi/w

where xi (p, w) is the Marshallian demand for good i, v (p, w) is the indirect utility function,
pi is the price of good i, w is the consumer's income, and the partial derivatives are taken with
respect to the price of good i.

The intuition behind Roy's Identity is that when the price of a good increases, the consumer
will demand less of that good, which will decrease their utility. The negative sign in the
equation reflects this inverse relationship between price and quantity demanded, while the
division by income captures the fact that the consumer's budget constraint also affects their
demand for the good.

 Sheppard's Lemma:

Sheppard's Lemma is a result that relates the elasticity of demand to the curvature of the
indirect utility function. The elasticity of demand measures the responsiveness of quantity
demanded to changes in price, while the curvature of the indirect utility function measures
the degree of substitutability between goods.
Sheppard's Lemma states that the elasticity of demand for a good is equal to the negative of
the partial derivative of the natural logarithm of the Marshallian demand function with
respect to the natural logarithm of the price of that good. Mathematically, we can express
Sheppard's Lemma as follows:

εi (p, w) = -∂ln xi (p, w)/∂ln pi

where εi (p, w) is the elasticity of demand for good i, ln is the natural logarithm, xi (p, w) is
the Marshallian demand for good i, and the partial derivative is taken with respect to the
natural logarithm of the price of good i.

The intuition behind Sheppard's Lemma is that the elasticity of demand depends on the slope
of the demand curve, which in turn depends on the curvature of the indirect utility function.
When the indirect utility function is more curved, the demand curve is steeper, which implies
a higher elasticity of demand. Conversely, when the indirect utility function is less curved,
the demand curve is flatter, which implies a lower elasticity of demand.