EC115 - Methods of Economic Analysis

Spring Term, Lecture 10

Constrained Maximisation IV:
Lagranges Function
Renshaw - Chapter 16
University of Essex - Department of Economics

Week 25

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

1 / 23

Topics for this week

The Lagrange Multiplier Method: Basics

The Lagrange Multiplier Method: Application
The Lagrange Multiplier Method:Second Order
Conditions

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

2 / 23

The Lagrange Multiplier Method: Basics 1

The Lagrange multiplier methods objective is similar to

the substitution method in that it helps us convert a
constrained optimisation problem into an unconstrained
optimisation problem.
The difference is that instead of substituting the
constraint in the objective function, we build a new
function by adding the constraint using the so-called
Lagrange multiplier.

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

3 / 23

The Lagrange Multiplier Method: Basics 2

Lets start from our usual problem and lets write it in the
most general way:
max U = U(x, y )
x,y

s.t. g (x, y ) = 0
We start from here and we build a completely new function
that includes both the objective function and the constraint

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

4 / 23

The Lagrange Multiplier Method: Basics 3

This new function is called the Lagrangian and is given by:

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

5 / 23

The Lagrange Multiplier Method: Basics 3

This new function is called the Lagrangian and is given by:

L(x, y , ) = U(x, y ) g (x, y ),
where is a completely new term called the Lagrange
multiplier. In the next slides we will treat this multiplier as
a variable.

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

5 / 23

The Lagrange Multiplier Method: Basics 4

So our function L is a function of three variables: x, y

and .
This implies that if we want to find a maximum, we
have to maximize with respect to all three variables.
Hence the first order conditions will be given by three
equations

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

6 / 23

The Lagrange Multiplier Method: Maximizing the Lagrangian Function

First Order Conditions:

L(x, y , )
=0
x
L(x, y , )
=0
y
L(x, y , )
=0

at x = x , y = y and = .

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

7 / 23

The Lagrange Multiplier Method: Maximizing the Lagrangian Function

So given the lagrangian function:

L(x, y , ) = U(x, y ) g (x, y ),
the first order conditions are:
L(x, y , )
U(x, y )
g (x, y )
=0

=0
x
x
x
L(x, y , )
U(x, y )
g (x, y )
=0

=0
y
y
y
L(x, y , )
= 0 g (x, y ) = 0

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

8 / 23

The Lagrange Multiplier Method: Maximizing the Lagrangian Function

Note that the third first order condition is simply the

constraint itself, written in the implicit way.
In order to find our optimal x , y and we have to solve
the previous system of three equations in three unknowns.
This goal can be achieved making use of the fact that all
the equations are equal to 0 and hence equal to each other.

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

9 / 23

The Lagrange Multiplier Method: Application

In order to understand the properties of this maximization
method, lets see an example
Consider again the consumers problem:
max U(x, y ) = x 1/2 y 1/2
x,y

s.t. px x + py y = m.
The lagrangian of this problem is given by:
L(x, y , ) = x 1/2 y 1/2 (px x + py y m).

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

10 / 23

The first order conditions are given by:

(A) :

1
L(x, y , )
= 0 x 1/2 y 1/2 px = 0,
x
2

(B) :

L(x, y , )
1
= 0 x 1/2 y 1/2 py = 0,
y
2

(C ) :

L(x, y , )
= 0 px x py y + m = 0.

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

11 / 23

So if we rearrange equations (A) and (B) we can rewrite

them as :
1 1/2 1/2
y = px
2x

1 1/2 1/2
y
2x

= py

We can then simplify the two equations into a unique one

as:
1 1/2 1/2
y
px
2x
=
(1)
1 1/2 1/2
py
y
2x

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

12 / 23

But:

and of course

1 1/2 1/2
y
2x
1 1/2 1/2
y
2x

U/x
U/y

px
px
=
py
py

so that (1) is just the explicit way to write:

U/x
px
=
U/y
py

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

(2)

Week 25

13 / 23

Remember that (2) is a compact way to write equations A

and B from our original system which can now be rewritten
as:

px
U/x

U/y
py

m px x py y = 0
which is exactly:

px

MRS = p
y

mp x p y =0
x
y
Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

14 / 23

Remember that (2) is a compact way to write equations A

and B from our original system which can now be rewritten
as:

px
U/x

U/y
py

m px x py y = 0
which is exactly:

px

MRS = p
y

mp x p y =0
x
y
Doesnt it look familiar?!?!
Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

14 / 23

Now we can finally solve our system. So:

U/x
px

U/y
py

m px x py y = 0
implies

y
px

=
x
py

m px x py y = 0

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

15 / 23

Solving in our usual way the first equation implies that:

y
px
=
x
py

px x = py y .

In addition, (C) implies that at the solution to the first

order conditions:
px x + py y = m.
Combined we find that:
m
px x = py y =
=
2

x =

m
,
2px

y =

m
.
2py

which are our standard results.

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

16 / 23

How about ?
So far we have found x and y . How about the
optimal value of our third variable, ?
Well, once we have found x and y finding is trivial.
If we consider for example equation (A) of our initial
system we have:
1 1/2 1/2
x
y px = 0
2

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

17 / 23

So that if we substitute in:

m
m
x =
and y =
2px
2py
we obtain:
1
px =
2

m
2px

and so:
=

Domenico Tabasso

1/2 

m
2py

1/2

1
1
2 px1/2 py1/2

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

18 / 23

How about ?
So =

1
1
2 px1/2 py1/2

Fine, but what is the economic meaning of the lagrange

multiplier, ?
It measures the marginal change in the maximum utility
the consumer can get when the constraint is weakened
or strengthened.
Which means: it tells us how the maximum utility
changes when we change m.

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

19 / 23

Here, the maximum utility the consumer can get is:


1/2 
1/2
m
m
U(x , y ) =
2px
2py
m
= 1/2 1/2
2px py
b x , py , m)
= U(p
b x , py , m) is the indirect utility function that we
where U(p
studied last week.

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

20 / 23

b with respect to income, m,

Partially differentiating U
gives:
b x , py , m)
U(p
1
= 1/2 1/2 = .
m
2px py
Note that throughout we have assumed that we are at
an interior solution: this property of will not
typically hold when we are at a corner solution.

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

21 / 23

Second Order Conditions

It is quite messy to write down the second order
conditions for a maximum of a constrained
maximisation (or constrained minimisation) problem.
Suppose that we wish to solve:
max F (x, y ) s.t. G (x, y ) = 0.
x,y

Define the lagrangian:

L(x, y , ) = F (x, y ) G (x, y )
Suppose that (x = x , y = y , = ) solve the first
order conditions for optimizing the lagrangian.
Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

22 / 23

The second order conditions for (x = x , y = y ) to be

a maximum of the original constrained maximisation
problem are then:
I

G
x

6= 0;

G
y

6= 0;

G 2
x

2L
x 2

G
x

 G  
y

2L
xy

G
y

2 

2L
y 2

0;

where all partial derivatives are evaluated at

(x = x , y = y , = ).

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

23 / 23

The second order conditions for (x = x , y = y ) to be

a maximum of the original constrained maximisation
problem are then:
I

G
x

6= 0;

G
y

6= 0;

G 2
x

2L
x 2

G
x

 G  
y

2L
xy

G
y

2 

2L
y 2

0;

where all partial derivatives are evaluated at

(x = x , y = y , = ).
Evidently very messy: we can happily forget about
them!

Domenico Tabasso

(University
Lectureof10Essex
- Spring
- Department
Term
of Economics)

Week 25

23 / 23