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The envelope theorem concerns how the optimal value for a particular function changes when a parameter of the function changes This is easiest to see by using an example

Suppose that y is a function of x

y = -x2 + ax

For different values of a, this function represents a family of inverted parabolas If a is assigned a specific value, then y becomes a function of x only and the value of x that maximizes y can be calculated

2

Optimal Values of x and y for alternative values of a

Value of a 0 1 2 3 4 5 6 Value of x* 0 1/2 1 3/2 2 5/2 3 Value of y* 0 1/4 1 9/4 4 25/4 9

3

y*

10 9 8 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 7

a

Suppose we are interested in how y* changes as a changes There are two ways we can do this

calculate the slope of y directly hold x constant at its optimal value and calculate y/a directly

To calculate the slope of the function, we must solve for the optimal value of x for any value of a

dy/dx = -2x + a = 0 x* = a/2

Substituting, we get

y* = -(x*)2 + a(x*) = -(a/2)2 + a(a/2)

y* = -a2/4 + a2/2 = a2/4

6

Therefore,

dy*/da = 2a/4 = a/2 = x*

for small changes in a, dy*/da can be computed by holding x at x* and calculating y/ a directly from y

7

y/ a = x

Holding x = x*

y/ a = x* = a/2

The envelope theorem states that the change in the optimal value of a function with respect to a parameter of that function can be found by partially differentiating the objective function while holding x (or several xs) at its optimal value

dy * y {x x * (a)} da a

9

The envelope theorem can be extended to the case where y is a function of several variables

y = f(x1,xn,a)

y/xi = 0 (i = 1,,n)

10

Optimal values for theses xs would be determined that are a function of a

x1* = x1*(a) x2* = x2*(a)

. . .

xn*= xn*(a)

11

Substituting into the original objective function yields an expression for the optimal value of y (y*)

y* = f [x1*(a), x2*(a),,xn*(a),a]

Differentiating yields

dy * f dx 1 f dx 2 f dx n f ... da x1 da x 2 da x n da a

12

Because of first-order conditions, all terms except f/a are equal to zero if the xs are at their optimal values Therefore,

dy * f {x x * (a)} da a

13

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