Ch.

13

Further Topics in Optimization

13.1 Nonlinear Programming and KuhnTucker Conditions 13.2 The Constraint Qualification 13.3 Economic Applications 13.4 Sufficiency Theorems in Nonlinear Programming 13.5 Maximum-value Functions and the Envelope Theorem 13.6 Duality and the Envelope Theorem 13.7 Some Concluding Remarks
1

6.5 Digression on Inequalities and Absolute Values: Rules of inequalities Absolute values and inequalities (pp. 136-139)
addition and subtraction by k a > b result in a k > b k multiplication and division by k if k > 0, 0 then h a > b results l in i ka k > kb if k < 0, then a > b results in ka < kb squaring a > b (b0) results in a2 > b2 /n/ absolute value (-n < /n/ < n)
2

13.1 Nonlinear Programming and KuhnTucker Conditions Step 1: Effect of non-negativity restrictions Step 2: Effect of inequality constraints Interpretation of the Kuhn-Tucker conditions diti Example 1 & 2

13.1 Nonlinear programming and Kuhn - Tucker conditions step1 : local maximum conditions " Examining the solution" Polya 1) Z = f (x ) Let 1 ) is 1st derivative of Z with respect to x1 , f (x
* x1 is the equilibrium value of an endogenous variable, and * 1 ) is their product called complementary slackness such that x1 f (x

1st derivative equilibrium value complementary slackness Familiar interior maximum (local max is w/in the feasible range ) 2) 1 ) = 0, f (x
* > 0, and x1 * 1)= 0 x1 f (x * Conclusion : K - T cond. (1) reveals a dependence of Z* on x1

L l boundary Local b d maximum i (hi h than neighbors (higher i hb in i feasible f ibl range) ) 3) 4) 5) 1 ) < 0, f (x 1 ) > 0, f (x
* x1 = 0, and * 1)= 0 x1 f (x

Local boundary minimum (lower than neighbors in feasible range) Boarder boundary max or min (local max or min at the boarder of feasible range ) 1 ) = 0, f (x
* x1 = 0, and * 1)= 0 x1 f (x * Conclusion : K - T conds. (2 - 4) reveal an independence of Z* from x1 * x1

= 0, and

* 1)= 0 x1 f (x

Eqs. (2) and (3) together 6)

3

1 ) 0, f (x

* x1 0, and

* 1)= 0 x1 f (x

* Conclusion : K - T cond. (6) reveals either a dependence or independence of Z* to x1

13.1 Nonlinear programming and Kuhn - Tucker conditions Multiple - constraint Kuhn - Tucker conditions for a maximum (p. 409) marginal Z x j = f x j (1 )g x j (2 )hx j 0 Z i = ri g x j nonnegative xj 0 complementary slackness x jZxj = 0

13.1 Nonlinear programming and Kuhn - Tucker conditions Step 1 : Complementary Slackness 1) 2) 3) 4) Z = f (x1,x2 ) + 1 [r1 g (x1,x2 )] + 2 [r2 h(x1,x2 )]

( )

i 0

i Z i = 0
Y

Z x1 = f x1 (1 )g x1 (2 )hx1 = 0, or Z x1 = f x1 (1 )g x1 (2 )hx1 < 0, L or Z 1 = r1 g ( x1,x2 ) = 0, Z 1 = r1 g ( x1,x2 ) > 0, L

* * x1 Z x1 = 0 > 0, and x1

* * x1 = 0, and x1 Z x1 = 0

* * 1 > 0, and 1 Z 1 = 0

0 Figure 1

0 Figure 2

0 Figure 3

5)
5

* * 1 = 0, and 1 Z 1 = 0

13.1 Nonlinear programming and Kuhn - Tucker conditions Step 2 : Effect of inequality constraints (maximum) pp. 404 - 405 1) 2) 3) 4) = f ( x1 ,x2 ,x3 ) maximize s.t. s.t. s.t.
* * * solve for x1 ,x2 ,x3 , *

13.1 Nonlinear programming and Kuhn - Tucker conditions Step 2 : Effect of inequality constraints (maximum) pp. 404 - 405 " Find an auxilliary problem if an immediate connection cannot be obtained" Polya Z = f (x1,x2 ,x3 ) + 1 [r1 g (x1,x2 ,x3 ) s1 ] + 1 [r2 h(x1,x2 ,x3 ) s2 ] 5) 1 = Z x 2 = Z x 3 = Z s 1 = Z s 2 = Z 1 = Z 2 = 0 Zx 6)

g 1 (x1,x2 ,x3 ) r1 x1,x2 ,x3 0

g 2 (x1,x2 ,x3 ) r2

7) 8) 9) 9)

j = f x j (1 )g x j (2 )hx j 0, Zx i = i 0, Zs

x j 0, and si 0, and

x jZ xj = 0 i = 0 si Z s

" Find an auxilliary problem if an immediate connection cannot be obtained" Polya 1 ) = f ( x1 ,x2 ,x3 ) maximize 2) 3) 4) 5) 6) 7) 8) 9) g 1 (x1,x2 ,x3 ) + s1 = r1 s.t. s.t. g 2 (x1,x2 ,x3 ) + s2 = r2

i = ri g i x j si = 0, where (i = 1,2), ( j = 1,2,3) Z si = r1 g i x j ,

( )

Given that

( )

i = i Zs

x1,x2 ,x3 , s1 , s 2 0 s.t. solve for Z = f (x1,x2 ,x3 ) + 1 [r1 g (x1,x2 ,x3 ) s1 ] + 1 [r2 h(x1,x2 ,x3 ) s2 ] 1 = Z s 2 = Z 1 = Z 2 = 0 Z x1 = Z x2 = Z x3 = Z s Z x j = f x j ( )g x j ( )hx j 0, x j 0, and si 0, and x jZxj = 0 si Z s i = 0 i 0, Zs i = 0 Z

* * * * * * x1 ,x2 ,x3 , s1 ,s2 ,

then (8) and (9) can be combined w/o reference to si or its derivative as 8) si 0, and i 0, s i i = 0 8) si 0, i 0, and si i = 0 8) ri g i x j 0,

( ) ( )

i 0, and

[r g (x )]
i i j i

=0

(i = 1,2) ( j = 1,2,3)

Kuhn - Tucker conditions expressed in terms of Lagrangian function Z j = f x j (1 )g x j (2 )hx j 0, x j 0, and j = 0 7) Zx x jZx 8)
7

ri g i x j 0,

i 0, and

[r g (x )]
i j

=0
8

13.1 Nonlinear programming and Kuhn - Tucker conditions pp. 404 - 405 Results from the auxilliary problem when an immediate connections could not be obtained Given Lagrangian function Z with inequality constraints Z = f ( x1,x 2 ,x3 ) + 1 [r1 g (x1 ,x2 ,x3 ) s1 ] + 1 [r2 h(x1,x2 ,x3 ) s 2 ] 5)
* * * ,x2 ,x3 ,& Z * such that K - T conditions are met, Solve for the maximum equilibrium values x1

13.1 Nonlinear programming and Kuhn - Tucker conditions Multiple - constraint Kuhn - Tucker conditions for a maximum (p. 409) marginal Z x j = f x j (1 )g x j (2 )hx j 0 Z i = ri g x j nonnegative xj 0 complementary slackness x jZxj = 0

7) 8)

j = f x j (1 )g x j (2 )hx j 0, Zx
i

( j = 1, 2, 3) Where (i = 1, 2 ), Applying the results from the auxilliary problem to the original problem Given Lagrangian function Z with inequality constraints
10) 11) 12) 13) 14) Z = f ( x1,x2 ,x3 ) + 1 [r1 g (x1,x2 ,x3 )] + 1 [r2 h( x1,x2 ,x3 )] Z x j = f x j (1 )g x j (2 )hx j 0, Z i = ri g x j 0, Z x j = f x j (1 )g x j (2 )hx j 0, Z i = ri g i x j 0,
i

ri g x j 0,

( )

x* j 0, and

* i

0, and

i * i ri g (x j ) = 0

x* jZ xj = 0

( )

i 0

i Z i = 0
Y

* * * ,x2 ,x3 ,& Z * such that K - T conditions are met, Solve for the maximum equilibrium values x1

( ) ( )

x* j 0, and

x* jZxj = 0

* i

0, and

* i Z i = 0 (for maximum)
x* jZxj = 0

0 Figure 1

0 Figure 2

0 Figure 3

x* j 0, and

* i 0, and

* i Z i = 0 (for minimum )
9 10

13.1 Nonlinear programming and Kuhn - Tucker conditions Multiple - constraint Kuhn - Tucker conditions for a minimum (p. 410) Zxj marginal = f x j (1 )g x j (2 )hx j 0 nonnegative xj 0 complementary slackness x jZxj = 0

13.1 Nonlinear programming and Kuhn - Tucker conditions Step 2 : Effect of inequality constraints Given Z = f (x1,x2 ) + 1 [r1 g (x1,x2 )] + 2 [r2 h(x1,x2 )]

Z i = ri g x j

( )

i 0

i Z i = 0

2 Z 2 = (2 )(r2 h(x1,x2 )) = 0

1Z 1 = (1 )(r1 g (x1,x2 )) = 0

Algorithm

either (2 ) = 0 or r2 h(x1,x 2 ) = 0

either (1 ) = 0 or r1 g (x1,x2 ) = 0

Logic of the trial and error strategy either r1 g (x1,x2 ) > 0, then 1 = 0 and r1 is not a constraint or
0 Figure 1 X 0 Figure 2 X 0 Figure 3 X

r2 h(x1,x2 ) > 0, then 2 = 0 and r2 is not a constraint

where is the marginal utility of budget money (income) (p. 407)

11

12

13.1 Nonlinear programming and Kuhn - Tucker conditions Step 2 : Effect of inequality constraints 1) Z = f (x1,x2 ) + 1 [r1 g (x1,x2 )] + 1 [r2 h(x1,x2 )] Algorithm : a) b) c) d) e) f) g) Check to see if it is possible to solve for an endog. var. immediately. If K - T conditions met, then stop. Else

13.1 Example 1 p. 406 Suppose that a ration has been imposed on commodity x equal to X 0 . Then the consumer would face a second constraint below. 1) 2 - 3) 4) 5) 6 - 9) 10) 11) 12) 13) 14)
13

U = U (x,y ) x&y 0

maximize and x X 0 s.t. s.t.

Px x + Py y B,

let (1 ) = 0, solve for (x1 , x 2 , 2 ), use Z x1 , Z x 2 ,&Z 2 . If K - T conditions met, then stop. Else conclude that r2 h(x1 ,x2 ) > 0, i.e., not a constraint and solve for (x1 , x 2 , 1 ), use equations Z x1 , Z x 2 ,&Z 1 . Check if K - T conditions met. (They should be met by now.) repeat procedure by letting (2 ) = 0, and

Z = U ( x,y ) + 1 B-Px x-Py y + 2 ( X 0 x ) U = xy, B 100, Z x = y 1 2 = 0; Z y = x 1 = 0; Z 1 = 100-x-y = 0; Z 2 = 40 x = 0; Z = xy + 1 (100-x-y ) + 2 (40 x ) Px &Py = 1, 1 = y 2 ; 1 = x; 100 = x + y,

where X 0 40 ,
* 1 = 20 * 1 = 40

y* = 60; x* = 40
14

13.1 Example 2, minimization problem (p. 410) Let us apply the Kuhn - Tucker conditions to solve a minimization problem below 1) 2) 3) 4) let 5) 6) 7) 8) 9) let 5) 6) 7) 8) 9) C = (x1 4 )2 + (x 2 4 )2 2x1 + 3x 2 6; and 3 x1 2 x2 12 x1 , x 2 0 minimize s.t. s.t.

13.1 Example 2 (p. 410) Kuhn - Tucker conditions Assume Z 1 = Z x1 = Z x 2 = 0, Z 2 < 0 , therefore x1 , x 2 ,&1 > 0, 2 = 0. 1) 2) 3) Z 1 = 6 - 2x1 3x 2 0 Z x1 = 2 x1 8 21 0 Z x2 = 2 x 2 8 31 0

Z = (x1 4 )2 + (x 2 4 )2 + 1 (6 - 2x1 3x 2 ) + 2 ( 12 + 3 x1 + 2 x2 )

2 = 0, Z 2 > 0

Z x2 = 2(x 2 4 ) 31 + 22 = 0; Z 1 = 6 - 2x 1 3x 2 = 0; Z 2 = 12 + 3 x1 + 2 x 2 > 0; x2 = 6 5 ,
* x1

Z x1 = 2(x1 4 ) 21 + 32 = 0;

1 = x1 4 = 2 3 (x2 4); 3 3 2 x2 4 = 2 3 (x2 4) 1 = 2 3 (x 2 4);

x1 = 3 3 2 x 2

(13 6)x2 = 5 3

3 2 x2 = 2 3 x2 5 3 x2 = 5 3 (6 13)

Use eq.s (1), (2), & (3) to solve for 1 , x1 , and x 2 6 2 3 0 6 3 0 2 6 0 2 3 1 6 2 2 8 0 2 0 , J x1 = 2 8 0 , J x2 = 2 2 x1 = 8 , J 1 = 8 3 0 8 3 0 8 2 8 0 2 3 8 2 x2 J = 26 , J 1 = 56 , J x1 = 48 J x2 = 20 56 28 48 24 20 10 = <0 = >0 = >0 x1 = x2 = 26 13 26 13 26 13 (1 , 2 , x1 , x2 ) do not meet the K - T conditions for a minimum (p. 410).

= 6 5,

1 < 0 2 = (2 3)(x1 4)
x1 = 3 3 2 x 2 = 3 3 2 (6 5); x1 = 2 3 x2 + 4 = 3 3 2 x 2 ;

1 = 0, Z 1 > 0

Z x1 = 2(x1 4 ) 21 + 32 0; Z 1 = 6 - 2x 1 3x 2 0;

Z x2 = 2(x 2 4 ) 31 + 22 0;

2 = ( x 2 4 )

1 =

Z 2 = 12 + 3 x1 + 2 x 2 0; x2 = 6 5 ,
* x1 = 6 5,

(2 3 3 2)x2 = 1

2 > 0
15 16

13.1 Example 2 (p. 410) Kuhn - Tucker conditions Assume Z x1 , Z x 2 ,& Z 2 = 0, Z 1 < 0 , therefore x1 , x 2 ,&2 > 0, 1 = 0. (1) ( 2) (3) Z 2 = 12 + 3 x1 + 2 x2 0 Z x1 = 2 x1 8 + 32 0 Z x2 = 2 x2 8 + 22 0

13.2 The Constraint Qualification Irregularities at boundary points The constraint qualification Linear constraints Exercises 1, 3, 4

Use eq.s (1), (2), & (3) to solve for 2 , x 1 , and x 2 12 3 2 0 12 2 0 3 12 0 3 2 2 12 3 2 0 x = 8 , J = 8 2 0 , J = 3 8 0 , J = 3 2 8 x1 x2 1 2 2 0 2 x2 8 8 0 2 2 8 2 2 0 8 J = 26 , J 2 = 32 , J x1 = 56 J x2 = 72 32 16 56 28 72 36 = >0 = >0 = >0 x1 = x2 = 26 13 26 13 26 13 (1 , 2 , x1 , x2 ) meet the K - T conditions for a minimum (p. 410).

2 =

17

18

13.2 The constraint qualification : Irregularities at boundary points Example 1 (p. 412) Maximize subject to and x1 & x2 0 Z = x1 + - x 2 + (1 - x1 )3 Z x1 = 1 3 (1 x1 )2 0

= x1
x 2 - (1 - x1 )3 0

13.2 The constraint qualification : Irregularities at the boundary points Example 2 (p. 413) Maximize = x1 subject to and where x 2 - (1 - x1 )3 0 2x1 + x2 2

Z = x1 + 1 - x 2 + (1 - x1 )3 + 2 (2 - 2x1 x2 ) Z x1 = 1 31 (1 x1 )2 22 0 Z 1 = -x 2 + (1 - x1 ) 0
3

x1 & x2 0

x1 = 1 at a max (see fig.13.2). However, x1Z x1 = 1 3 (1 1)2 = 1 when it should equal zero. Reason : on an inflection point or cusp
19

Z x2 = 1 2 0 Z 2 = 2 - 2x1 x2 0

1 1 x1 = 1, x 2 = 0 , 1 = , 2 = 2 2
20

13.2The Constraint Qualification

Example 3, p. 414 The feasible region of the problem contains no cusp Maximize = x2 -x subject to 10-x12-x2 0 and x1 2, where x1 , x 2 0 Z = x2-x12 + 1 10-x12-x2 + 2 ( 2 + x1 )
3 2 1

13.3 Economic Applications War-time rationing Peak-load pricing Examples 1 & 2

Z x1 = 2 x1 6 1 10-x12-x2 x1 + 2 Z 1 = 10-x12-x2 x1 = 2, x2 = 6,

Z x 2 = 1 3 1 10-x12-x2 Z 2 = 2 + x1

(2,6)Z x

= 1 31 10-22 -6 = 1, when it should equal zero

21 22

1 = 1 ,

2 = 4

13.3 Example 1 (p. 419) War - time rationing Assume the utility function and constraints given below (1) (2) (3) (4) (5) ( 6) (7 ) U = xy 2 Px x + P y y B cx x + cy y C x, y 0 maximize objective function subject to budget constraint, coupon constraint, and nonnegative quantity of x, y constraint

13.3 Example 1 (p. 419) War - time rationing K - T conditions (1) ( 2) (3) ( 4) Solve for Z x = y 2 1 22 0 Z y = 2 xy 1 2 0 Z 1 = 100 x y 0 Z 2 = 120 2 x y 0
* * x*, y*, 1 , 2

x0 y0

xZ x = 0 yZ y = 0 1 Z 1 = 0 2Z 2 = 0

1 0 2 0

Z = xy 2 + 1 B Px x -P P y y + 2 C c x x c y y Z = xy 2 + 1 (100 x y ) + 2 (120 2 x y ) Z x = y 1 22 0 Z 1 = 100 x y 0

2

L Lagrangian i Lagrangian

consistent w/ the K - T conditions

Let the values of B = 100, Px = Py = 1, C = 120, c x = 2 and c y = 1 1st order conditions for a maximum assoc. w/ inequality constraints Z y = 2 xy 1 2 0 Z 2 = 120 2 x y 0
23

Strategy #1 (aka trial and error) Let Z x = Z y = Z 1 = 0, Z 2 0, such that x > 0, y > 0, 1 > 0, * 2 =0
* Solve for x * , y* , and 1

If the results are consistent w/ K - T stop, if not

Strategy #2
* Let Z x = Z y = Z 2 = 0, Z 1 0, such that x > 0, y > 0, 2 > 0, 1 =0

* * Solve for x*, y*, 1 , 2 consistent w/ the K - T conditions

Solve for x * , y* , and * 2

24

13.3 Example 1 (p. 419) War - time rationing : strategy #1 Assume Z x = Z y = Z 1 = 0, and Z 2 0, therefore x, y, & 1 > 0, * 2 = 0. 1
st

13.3 Example 1 (p. 419) War - time rationing : strategy #2

* Assume Z x = Z y = Z 2 = 0, and Z 1 0, therefore x, y, & 2 > 0, 1 = 0. * 1st order conditions assuming 1 = 0.

order conditions assuming * 2

2

= 0. y = 1
2

1) Z x = y

1 2* 2

=0 Z 1

* 1) Z x = y 2 1 2 2 = 0 * 2) Z y = 2 xy 1 2 = 0

y 2 = 22

2) Z y = 2 xy 1 * 2 =0 3) ) Z 1 = 100 x y = 0 4) Z 2 = 120 2 x y 0 Solving for y , x , x * = 331 3 > 0

* 1 * 2 * * * * * 1 , and

1 = 2 xy
x = 100 y

2 = 2 xy
x = 60 1 2 y

3) Z 1 = 100 x y 0 4) Z 2 = 120 2 x y = 0 Solving for y * , x * , * 2 , and Z 1

y 2 2(100 y ) y = 0

y 200 + 2 y = 0

y * = 66 2 3 > 0

y 2 4(60 1 2 y ) y = 0 x = 20 > 0
* 1 * 2 * *

3 y 240 = 0

y * = 80 > 0 Z 1 = 0

* 2 = 2(331 3)66 2 3 4445 > 0

( , , x , y )do not meet the K - T conditions for a maximum (p. 410).

25

Z 2 = 13.2 < 0 inconsistent w/ eq. (4)

( , , x , y ) meet the K - T conditions for a maximum (p. 410).

*

* 2

= 2(80 )20 = 3200 > 0

26

13.3 Example 2 (p. 423) Peak - load pricing : strategy 1 Suppose the average revenue functions during peak and off - peak hours are as given below. To produce a unit of output per half - day requires a unit of capacity costing 8 cents per day. The cost of a unit of capacity is the same whether it is used a peak time only, or off - peak also. In addition to the cost of capacity, its costs 6 cents in operating costs (labor and fuel) to produce one unit per half day (both day and evening). (1) (2) (3) (4) (5) P1 = 22 - 10 -5 Q1 avg. revenue at peak P2 = 18 - 10 Q 2 avg. revenue at off - peak MC1 = b + c = 14 MC 2 = b = 6 constraint 1 constraint 2 [b = 6, c = 8]
-5

13.3 Example 2 (p. 423) Peak - load pricing : strategy 2 Suppose the average revenue functions during peak and off - peak hours are as given below. To produce a unit of output per half - day requires a unit of capacity costing 8 cents per day. The cost of a unit of capacity is the same whether it is used a peak time only, or off - peak also. In addition to the cost of capacity, its costs 6 cents in operating costs (labor and fuel) to produce one unit per half day (both day and evening). (1) (2) (3) (4) (5) P1 = 22 - 10 -5 Q1 avg. revenue at peak P2 = 18 - 10 -5 Q 2 avg. revenue at off - peak MC1 = b + c = 14 MC 2 = b = 6 constraint 1 constraint 2 [b = 6, c = 8]

Z=P 1Q1 + P2 Q2 b(Q1 + Q2 ) cK + 1 ( K Q1 ) + 2 ( K Q2 ) = 22 - 10 -5 Q1 Q1 + 18 - 10 -5 Q 2 Q2 6(Q1 + Q2 ) 8K + 1 ( K Q1 ) + 2 ( K Q2 )

2 = 22Q1 - 10 -5 Q1 + 18Q2 - 10 -5 Q 2 2 6Q1 6Q2 8 K + 1 ( K Q1 ) + 2 ( K Q2 )

) (

Z=P 1Q1 + P2 Q2 b(Q1 + Q2 ) cK + 1 ( K Q1 ) + 2 ( K Q2 ) = 22 - 10 -5 Q1 Q1 + 18 - 10 -5 Q 2 Q2 6(Q1 + Q2 ) 8 K + 1 ( K Q1 ) + 2 ( K Q2 )

2 = 22Q1 - 10 -5 Q1 + 18Q2 - 10 -5 Q 2 2 6Q1 6Q2 8 K + 1 ( K Q1 ) + 2 ( K Q2 )

) (

1st derivatives of eq. 5 wrt the choice variables Q1 , Q2 , 1 , 2 , K and assuming Z Q1 = Z Q2 = Z 1 = Z K = 0, Z 2 0, therefore Q1 , Q2 , 1 , K > 0, 2 = 0. ( 6) ( 7) (8) (9) (10) (11) (12) (13) Z Q1 = 22 2 *10 -5 Q1 6 1 = 0 Z Q2 = 18 2 *10 -5 Q2 6 2 = 0 Z 1 = K Q1 = 0 Z 2 = K Q2 0 Z K = 8 + 1 + 2 = 0 22 (2)10
-5 * Q1

1st derivatives of eq. 5 wrt the choice variables Q1 , Q2 , 1 , 2 , K and assuming Z Q1 = Z Q2 = Z 2 = Z K = 0, Z 1 0, therefore Q1 , Q2 , 2 , K > 0, 1 = 0. ( 6) ( 7) (8) (9) (10) (11) (12) (13) Z Q1 = 22 2 *10 -5 Q1 6 1 = 0 Z Q2 = 18 2 *10 -5 Q2 6 2 = 0 Z 1 = K Q1 0 Z 2 = K Q2 = 0 Z K = 8 + 1 + 2 = 0
* 22 (2 )10 -5 Q1 =6

22 (2 )10 -5 Q1 = 6 + 1 = 0 18 (2 )10 -5 Q2 = 6 K = Q1 K Q2 1 = 8

22 (2 )10 -5 Q1 = 6 18 (2 )10 -5 Q2 = 6 + 2 K Q1 K = Q2 2 = 8

Solve for 1 , Q1 , Q2 , K with eq. (6), (7), (8) and (10). = 14

* Q1 = (14 22) (2)10 -5 = (8)50,000 = 400,000 * Q2 = (6 18) (2 )10 -5 = (12 )50,000 = 600,000

Solve for 1 , Q1 , Q2 , K with eq. (6), (7), (9) and (10).

* Q1 = (6 22) (2 )10 -5 = (14 )50,000 = 1,200,000 * Q2 = (14 18) (2 )10 -5 = (4 )50,000 = 200,000

if 2 = 0, then (1 , 2 , Q1 , Q2 , K ) do not meet the K - T conditions for a maximum (p. 410).

27

if 1 = 0, then (1 , 2 , Q1 , Q2 , K ) do not meet the K - T conditions for a maximum (p. 410).

28

13.3 Example 2 (p. 423) Peak - load pricing : strategy 3 K = Q1 = Q 2 Suppose the average revenue functions during peak and off - peak hours are as given below. To produce a unit of output per half - day requires a unit of capacity costing 8 cents per day. The cost of a unit of capacity is the same whether it is used a peak time only, or off - peak also. In addition to the cost of capacity, its costs 6 cents in operating costs (labor and fuel) to produce one unit per half day (both day and evening). (1) where (2) (3) (4) (5)

13.3 Example 2 (p. 420) Peak - load pricing (1) (2) (3) (4) (5) (6) P1 = 22 - 10 -5 Q1 MR 1 = b + c = 14 P2 = 18 - 10 -5 Q 2 MR 2 = b = 6 Avg. revenue at peak constraint Avg. revenue at off - peak constraint

= P1Q1 + P2Q2 b(Q1 + Q2 ) cK maximize profit fnct.

b = 6, c=8 b and c : per unit operating and capital cost resp. avg. revenue at peak avg. revenue at off - peak s.t. peak load capacity constraint s.t. off - peak load capacity constraint P1 = 22 - 10 -5 Q1 P2 = 18 - 10 -5 Q 2 Q1 K Q2 K

Z = P1Q1 + P2Q2 b(Q1 + Q2 ) cK + 1 ( K Q1 ) + 2 ( K Q2 ) Lagrangian = 22 - 10 -5 Q1 Q1 + 18 - 10 -5 Q 2 Q2 6(Q1 + Q2 ) 8 K + 1 ( K Q1 ) + 2 ( K Q2 )

2 = 22Q1 - 10-5 Q1 + 18Q2 - 10 -5 Q 2 2 6Q1 6Q2 8 K + 1 ( K Q1 ) + 2 ( K Q2 )

) (

Z = P1Q1 + P2 Q2 -b(Q1 + Q2 ) cK + 1 (K Q1 ) + 2 (K Q2 ) Lagrangian Z = 22 - 10 -5 Q1 Q1 + 18 - 10 -5 Q 2 Q2 -6(Q1 + Q2 ) 8 K + 1 (K Q1 ) + 2 (K Q2 )

1st derivatives of eq. 5 wrt the choice variables Q1 , Q2 , 1 , 2 , K and assuming K = Q1 = Q2 = Q and Z Q1 = Z Q2 = Z 1 = Z 2 = Z K = 0, therefore 1 & 2 > 0 (6) (7 ) (8) (9) (10) (11) (12) (13) (14) (15) Z Q1 = 22 2 *10 Q1 6 1 0 Z Q2 = 18 2 *10 -5 Q2 6 2 0 Z 1 = K Q1 0 Z 2 = K Q2 0 Z K = 8 + 1 + 2 0
-5

) (

22 (2 )10 Q = 6 + 1
-5

Lagrangian

18 (2 )10 -5 Q = 6 + 2 K =Q K =Q 2 = 8 1

* * Solve for 1 , 2 , and Q* with eq. (6), (7) and (10).

Q* = (6 + 1 22) (2 )10 -5 = (16 1 )50,000 = 800,000 50,0001 Q* = (6 + 8 1 18 ) (2 )10-5 = (4 + 1 )50,000 = 200,000 + 50,0001 50,000 1 1 800,000 50,000 1 Q = 200,000 J = 100,000 J 1 = 600,000 J Q = 50,000,000,000
* * * 2 = 2, P 1 = 17, P2 = 13

1st order conditions for a maximum assoc. w/ inequality constraints 1 1 (7) Z Q1 = Q1 + 16 1 = 0 ZQ2 = Q2 + 12 2 = 0 50000 50000 Z 1 = K Q1 = 0 Z 2 = K Q2 = 0 Z K = 8 + 1 + 2 = 0

If K = Q1 = Q 2 , then (1 , 2 , Q1 , Q2 , K ) do meet the K - T conditions for a maximum (p. 410).

* * * 1 = 6, Q * = K = Q1 = Q2 = 500,000 and

29

30

13.4 Sufficiency Theorems in Nonlinear Programming The Kuhn-Tucker sufficiency theorem: concave programming The Arrow-Enthoven sufficiency theorem: quasi concave programming quasi-concave A constraint-qualification test none

13.5 Maximum-value Functions and the Envelope Theorem The envelope theorem for unconstrained optimization The profit function Reciprocity R i it condition diti The envelope theorem for constrained optimization Interpretation of the Lagrange multiplier none
31 32

13.5 Maximum - value functions and envelope theorem The envelope theorem for unconstrained optimization 1) 2) 3) 4) 5) 6) 7) U = f (x,y, ) x* = x * ( ); f x ( x, y , ) = f y ( x, y , ) = 0 maximize FOC equilibrium solutions

13.5 Maximum - value functions and envelope theorem The envelope theorem for constrained optimization 1) 2) 3) 4) 5) 6) 7) 8) 9) 10) 11) 12) 13) 14) U = f (x,y; ) g (x,y; ) = 0 maximize s.t. Lagrangian FOC

V( ) = f x * ( ), y * ( ), max. value function dV d = f x x + f y y + f total differential fx = fy = 0 dV d = f eq.(2)

y * = y * ( )

Z = f (x,y; ) + (0 g (x,y; )) Z x = f x g x = 0

Z y = f y g y = 0 x * = x * ( );

Z = g (x,y; ) = 0

V( ) = U * = f x * ( ), y * ( ), f x = g x ; f y = g y

y * = y * ( );

* = * ( ) equil. solutions
max. value function total differential eqs. (4 - 5) max. value constraint total differential

dV d = f x x * + f y y * + f g x * ( ), y * ( ), 0

The mvf or indirect objective function traces out all the maximum values of the objective function as the parameters vary. (C & W, p. 428) At the optimum, as varies with x and y allowed to adjust, the derivative dV d gives the same result as if x * and y* are treated as constants, i.e., only the direct effect of on the objective function matters exogenous variable need be considered
33
* *

g x x* + g y y* + g 0

g x x* + g y y* + g 0

) (

dV d = ( f x g x ) x * + f y g y y * + f g = Z

multiply by

(C & W, p. 429). Conclusion : only the direct effects of a change in an

The mvf or indirect objective function traces out all the maximum values of

the objective function as the parameters vary (C & W, p. 428). The Lagrangian

function replaces the objective function in deriving the i.o.f. of constrained U (p. 433)
34

13.5 Maximum - value functions and envelope theorem The envelope theorem to interprete the Lagrange multiplier 1) 2) 3) 4) 5) 6) 7) 7) 8) 9) 10) 14) U = f (x,y ) g (x,y ) = c maximize s.t. Lagrangian FOC

13.5 Maximum - value functions and envelope theorem The envelope theorem for profit function & Hotelling' s lemma 1) 2) 3) 4) 5) 6) 7) 8) 9 11)

Z = f (x,y ) + (c g (x,y )) Z x = f x g x = 0 Z y = f y g y = 0 Z = c g (x,y ) = 0

= Pf (K , L ) wL rK L = Pf L w = 0 K = Pf K r = 0

maximize FOC equilibrium solutions max. value function partial differential

= fx gx = f y gy
x * = x * (c ); V (c ) = Z * (c ) = f x* (c ), y * (c )

+* (c ) c g x* (c ), y * (c )

dV dc = dZ * dc = ( f x g x ) x * c + f y * g y y * c +(c g (x,y )) * c + * dV dc = dZ * dc = * total differential

y * = y * (c );

* = * (c ) equil. solutions

L* = L* (w, r , P ); K * = K * (w, r , P )

))

max value function max.

* (w, r , P ) = Pf L* , K * wL* rK * w = L

* w = Pf L L* w + Pf K K * w w L* w r K * w L* w w * w = L* (w, r , P ), * w = (Pf L w) L* w + (Pf K K ) K * w L* * r = K * (w, r , P ), * P = f L* , K *

dV d = ( f x g x ) x* + f y g y y * + f g = Z

The mvf or indirect objective function traces out all the maximum values of the objective function as the parameters vary (C & W, p. 428). The Lagrangian function replaces the objective function in deriving the i.o.f. of constrained U (p. 433).

Equations (9 - 11) are the comparative - static derivatives of profit m.v.f. (eq. (5)), They are also know collectively as Hotelling' s lemma, which is an example of the envelope theorem applied to the profit function, holding L* , K * constant (C & W, p. 430).
35 36

* measures the rate of change of the maximum value of the objective function
the constraint only (C & W, pp 434 - 435). when c changes, and is referred to as the " shadow price"of c, which enters through

13.5 Maximum - value functions and envelope theorem The envelope theorem, reciprocity condition, and comparative statics 1) 2) 3) 4) 5) ) 6) 7) 8) U = f (x,y, ) fx = fy = 0 x * = x * ( ); V ( ) = f x ( ), y ( ),
* *

13.5 Maximum - value functions and envelope theorem The envelope theorem, reciprocity condition, and comparative statics 4) 5) 6) 7) 8) 9) 10) V( ) = f x * ( ), y * ( ), (x,y, ) = f (x,y, ) V( ) f xx H = f yx fx f xy f yy f y f x f y f V
2 H 2 = f xx f yy f xy > 0;

maximize FOC of U y * = y * ( ) equilibrium solutions max. value function diff. bet' n U and U * FOC of

max. value function diff. bet' n U and U * FOC of

x = f x = y = f y = = f V = 0

(x,y, y ) = f (x,y, y ) V( ) f xx H = f yx fx f xy f yy fy f x f y f V

x = f x = y = f y = = f V = 0

H 1 = f xx < 0;

H3 < 0

H 1 = = f V < 0 V ( ) = f x * ( ), y * ( ),

H 1 = f xx < 0;

2 H 2 = f xx f yy f xy > 0;

H3 < 0
37

11) 12) 13)

V = f x x * + f y x * + f V f = f x x * + f y x * > 0 f x x * > 0
38

13.6 Duality and the Envelope Theorem The primal problem The dual problem Duality Roys identity Shephards lemma Examples 1 & 2

13.6 Example 1 Utility maximization, p. 439 <= Consider the consumer with the utility function below, who faces a budget constraint of B and is given prices Px and Py . primal : F(x,y,; B,Px Py ) (1) ( 2) (3) ( 4) U = xy Px x + Py y = B Z = xy + B-Px x-Py y Z = B-Px x-Py y = 0 Z x = y Px = 0 Z y = x Py = 0 Matrix format (5)
39

Maximize utility function

s.t. budget constraint Lagrangian -Px x-Py y = B +y=0 =0

1 t order 1st d conditions diti Px Py + x

0 Px Py

Px 0 1

Py B 1 x = 0 0 y 0

40

13.6 Example 1 Utility maximization, p. 439 <= (5) 0 Px Py Px 0 1 Py B 1 x = 0 0 y 0

* * *

13.6 Example 1 Utility maximization, p. 439 <= Consider the consumer with the maximum value utility function in which

J = 2 Px Py

x * = x(Px ,Py , B), y * = y(Px ,Py , B) (1) ( 2) V Px ,Py , B = U * = x * y* x* = B , 2 Px y* = B 2 Py Roy' s identity (p. 437)

Maximum value utility function

Apply Cramer' s rule to solve for , x , and y B Px ( 6) J = 0 0 (7 ) 0 J x = Px Py (8) 0 J y = Px Py (9) 0 1 Py 1 0 = B

* =

B >0 2 Px Py BPy 2 Px Py B >0 2 Px

(3) ( 4) (5) ( 6)

V Px V B = x m

B B B2 U * = x * y* = 2P = 4 P P x y 2 Px y U Px = UB = B 2 4 Py 16 Px2 Py2 = B2 4 Px2 Py

B Py 0 1 = BPy 0 Px 0 1 0 B 0 = BPx 0

x* =

B 2B = 4 Px Py 2 Px Py B2 4 Px2 Py B 2 2 Px Py B = 2 = B 2 Px B 4 Px Py 2 Px Py

Marshallian ordinary demand curves

y* =

BPx B = >0 2 Px Py 2 Py

(7)

xm =

U Px UB

Check the 2nd order conditions for a max or min. J = H = 2 Px Py > 0, negative definite maximum
41

Solve eq. (4) for B, the maximum utility (8)

1 2 1 2 *1 2 B = 2Px Py U = E Px ,Py , U *

)
42

13.6 Example 2 (p. 440) Cost minimization problem Now consider a consumer with an expenditure function subject to a fixed level of utility U* and prices Px and Py . dual F(x, y, ;U,Px ,Py ) (1) ( 2) (3) E = Px x + Py y xy = U * Z = Px x + Py y + U * xy Minimize expenditure function subject to target level of utility U * Lagrangian U* y Px

13.6 Example 2 (p. 440) Cost minimization problem Now consider a consumer with an expenditure function subject to a fixed level of utility U* and prices Px and Py . dual F(x, y, ;U,Px ,Py ) (5) y= Px U * Px Py y U * Px Py = PxU *1 2 Px1 2 Py1 2 U * Px Py U* U * Py Px

y2 =

y* =

)
x= y= =

( 6)

* =
x* =

1 t order 1st d conditions diti ( 4) Z = U * xy = 0 Z x = Px y = 0 Z y = Py x = 0

(7 )

U * Px Px = Px y Py U U = y 0
* * *1 2

1 2

Px Py

U Px1 2 Py1 2 x

y 0

(8)

H = y

= 2x < 0, positive definite minimum 0

Py x

Note : you can not solve this problem using Cramer' s rule because the J is all endogenous vars.

43

44

13.6 Example 2 (p. 440) Cost minimization problem Now consider the maximum value cost function (1) ( 2) E * = Px x * + Py y * x =
*

13.6 Example 2 duality between Utility max. and Expend. min. Maximize U = xy subject to Px x + Py y = B Z = xy + (B-Px x-Py y ),

Maximum value cost function U * Px y = Py

*

m =

U * Py Px

Px Py U*

B , 2 Px Py Px Py U*

xm =

B , 2 Px U * Py Px

ym =

B 2 Py

Minimize E = Px x + Py y subject to xy = U* (Let U * denote the target utility level)

Solve for E * (3)

*

(should be the same result as eq. 8 on slide 29)

* *

E = Px x + Py y = Px = U * Px Py

U * Py Px

+ Py

) + (U
12

Px Py

12

= 2 U * Px Py

U * Py U * Px U * Px = Px + Py Py (P x )1 2 Py 1 2

12

( )

12

Z = Px x + Py y + U * xy

h =

xh =

yh =

U * Px Py

The Marshallian ordinary demand does not equal the Hickian compensated demand. xm = 1) U * = U * Py B xh = Px 2 Px

12

12 12 Py = 2U *1 2 Px

Shephard' s lemma and Hickian compensated demand curves x = g(Px ,Py , U * ) ( 4) (5) (6) E Px = E Py = E PU =
12 U *1 2 Py 12 Px 12 U *1 2 Px 12 Py 12 12 Px Py

= xh = yh = h

B2 , i.e., the utility function. Solving (1) for B gives (2) 4 Px Py

2) B = 2 Px1 2 Py1 2U *1 2 = Px x + Py y = E ( Px , Py , U * ), i.e., the expenditure function Roy' s identity and the utility function (1) gives Marshallian demand functions. Shephard' s lemma and the expenditure function (2) gives Hickian demand functions.
45 46

U *1 2

12.5 - 3 Comparativ e - static analysis Z = U (x, y ) + (B xPx yPy ) Z = B xPx yPy = 0 Z x = U x Px = 0 Z y = U y Py = 0 Px .dx Py dy = x dPx + ydPy dB Px d + U xx dx + U xy dy = dPx Py d + U yx dx + U yy dy = F ( , x, y; Px , Py , B )

12.5 - 3 Comparative - static analysis Matrix format 0 Px Py 0 Px Py

47

Px U xx U yx Px U xx U yx

Py d x dPx U xy dx = dPx U yy dy 0 Py B 1 U xy x B = 0 0 U yy y B

ydPy 0

dPy

dB 0 0

dPy

48

12.5 - 3 Comparative - static analysis Z = U ( x, y ) + (B xPx yPy ) Z = B xPx yPy = 0 0 Px Py Px U xx U yx Z x = U x Px = 0 0 J x = Px Py Z y = U y Py = 0 1 Py 0 0 U xy U yy

12.5 - 3 Comparative - static analysis Z = U ( x, y ) + (B xPx yPy ) Z = B xPx yPy = 0 0 Px Py Px U xx U yx Z x = U x Px = 0 0 J x = Px Py Py U yy x 0 Z y = U y Py = 0 Py U yy

Comparative statics : the change in x with a change in income (B) Py B 1 U xy x B = 0 0 U yy y B

Comparative statics : the change in x with a change in Px Py Px x U xy x Px = 0 U yy y Px

U xy

J = H = 2 Px PyU xy Py2U xx Px2U yy > 0 x B = 1 Px U xy J Py U yy

J x = PyU xy PxU yy

J = H = 2 Px PyU xy Py2U xx Px2U yy > 0 x Px = x Px U xy 0 + J Py U yy J Py (12.42, p. 379)

(12.39, p. 379)

49

50

12.5 - 3 Comparative - static analysis Z = U ( x, y ) + (B xPx yPy ) Z = B xPx yPy = 0 Z x = U x Px = 0 Py U yy Z y = U y Py = 0 (12.42, p. 379) x x Px U xy 0 = + Px J Py U yy J Py 1) 2) x 1 Px U xy = B J Py U yy x= dB , dPx Px .dx Py dy = x dPx + ydPy dB

Graph: Substitution and Income Effects

Quantity Q2 P0 If the price of Q1 increases, then the change in demand equals the substitution effect (AB) and the income effect (BC).

(12.39, p. 379) (12.44, p. 380)

P0 B A C

0 3) If no income effect, then vector of constants is and x Px = (x Px ) U constant 0 x x x dB < 0 for a normal good if = Px Px U constant B dPx x x dB > P x U constant B dPx (not Giffen good)
51

U0 U1

P1

P1

P0

Quantity Q1

52

Graph: Substitution and Income Effects

Quantity Y -Px1/Py0 If the price of Q1 increases, then the change in ordinary demand equals the sum of the substitution effect (AB) and the income effect (BC). B Y1' Y0 Y1 A C U1 -Px1/Py0 Price X -Px0/Py0 Quantity X U0

P1

P0

Ordinary demand Compensated demand X1 X1' X0

53
Quantity X