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Constrained Optimization

In economics, many mathematical problems involve agents maximizing a function subject to some constraints. A classic example is utility maximization: consumers maximize their utility subject to a budget constraint. If we consider economics to be the study of decision making (making optimal choices) in the face of scarcity (constraints) then it is clear that constrained optimization problems are very important for the discipline. This note will present the Lagrangian method for solving constrained maximization problems.

1.1

Structure of the Problem

We will consider constrained optimization problems with two choice variables, x1 and x2 (consumption goods ).1 There is an objective function (utility function ) that the decision maker wants to maximize subject to a constraint function (budget constraint ). We will include in the function to represent variables that the decision maker does not choose. Examples are income and prices. We can write the problem as follows: max f (x1 , x2 ; )
x1 ,x2

s.t.

g (x1 , x2 ; ) =

In order to solve a problem of this type, we can set up the Lagrangian: = f (x1 , x2 ; ) + [ g (x1 , x2 ; )] If we take the rst order conditions of the Lagrangian objective function with respect to x1 , x2 and we will have three equations in three unknown functions: (x1 ) : (x2 ) : () : g (x1 , x2 ; ) f (x1 , x2 ; ) = x1 x1 f (x1 , x2 ; ) g (x1 , x2 ; ) = x2 x2 g (x1 , x2 ; ) =

We can then solve these three equations for x1 (), x2 () and (). Notice that the solution is a collection of functions.
We will only consider one equality constraint and we will not worry about requirements such as x1 , x2 0. To be more formal we would have to be aware of these additional constraints.
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Figure 1: Utility Maximization Problem

1.2

Example: Utility Maximization

In this example there are two consumption goods: c1 and c2 . The consumer maximizes their utility subject to a budget constraint. We map the problem to the general form as follows: x1 , x2 c1 , c2 f (x1 , x2 ; ) u(x1 , x2 ) = ln c1 + (1 ) ln c2 g (x1 , x2 ; ) = p1 c1 + p2 c2 = y = (p1 , p2 , y ) We can write the new problem as: max ln c1 + (1 ) ln c2
c1 ,c2

s.t.

p 1 c1 + p 2 c2 = y

In words, the problem is to maximize our utility function, keeping in mind the fact that we have limited income to spend. We take as given market prices for the two goods as well as our current income. Graphically, we can represent the utility function as an indierence curve. If we x a level of utility, u any point on the indierence curve represents combinations of c1 and c2 that achieve utility u . If we increase u we will have a new indierence curve which will be to the northeast of the old one. Therefore, utility is increasing as the indierence curves move up and to the right. The slope of the indierence curve is given by 2 : c2 dc2 1 = u(c = c ,c ) 1 2 dc1 (1 )c1
c2 u(c1 ,c2 )

We can also rearrange the budget line to plot it on the graph: c2 = y p1 c1 p2 p2

This is the red line on the graph. The solution to the problem is the highest utility we can achieve on the budget line. The slope of the budget line is 1 . It is apparent that the solution involves the slope of the indierence p p2 curve being equal to the slope of the budget line. Thus, we would hope our Lagrangian method gives us: p1 c2 = (1 )c1 p2 The Lagrangian is: = ln c1 + (1 ) ln c2 + [y p1 c1 p2 c2 ] The FOC: = p1 c1 1 = p2 c2 p 1 c1 + p 2 c2 = y Dividing equation 1 by equation 2 leads to: c2 p1 = (1 )c1 p2
2

(1) (2) (3)

See Professor Lloyd-Ellis math notes on the total derivative and the examples therein

This is precisely the condition we required from the graphical solution. Therefore, the Lagrangian method seems to be giving us an answer that makes sense. We can solve this for: c1 (p1 , p2 , y ) = y , p1 c2 (p1 , p2 , y ) = (1 )y , p2 (p1 , p2 , y ) = 1 y

The Interpretation of the Lagrange Multiplier

The Lagrangian method is useful as it gives us a standard way to solve constrained optimization problems. As well, the Lagrange multiplier has an economic interpretation. In words, the multiplier is the value, in utility to the decision maker of relaxing the constraint by a marginal amount. This is a result of the Envelope Theorem. What is it that I mean by relaxing the constraint? In words, all this means is that I give you an extra little bit of income. Therefore, the multiplier tells us what the value of a little more income is (given that we are behaving optimally). To see this in our example, we have to put the optimized consumption functions into the utility function and take the derivative with respect to income: V (p1 , p2 , y ) = ln (1 )y (1 ) y +(1 ) ln = ln y + ln +(1 ) ln p2 p2 p1 p2

This implies that the derivative is: V (p1 , p2 , y ) 1 = = (p1 , p2 , y ) y y This result is intuitive. For low levels of income the value of an additional bit of income is very high, however, as income increases the value of extra income decreases.