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constraint. For example

Maximize z = f (x, y)

For this kind of problem there is a technique, or trick, developed for this kind of problem

known as the Lagrange Multiplier method. This method involves adding an extra variable to

the problem called the lagrange multiplier, or .

We then set up the problem as follows:

1. Create a new equation form the original information

L = f (x, y) + (100 x y)

or

L = f (x, y) + [Zero]

L

x

= fx = 0

L

y

= fy = 0

L

= 100 x y = 0

3. In most cases the will drop out with substitution. Solving these 3 equations will give

you the constrained maximum solution

Example 1:

Suppose z = f (x, y) = xy. and the constraint is the one from above. The problem then

becomes

L = xy + (100 x y)

Now take partial derivatives, one for each unknown, including

L

x

=y=0

L

y

=x=0

L

= 100 x y = 0

Starting with the first two equations, we see that x = y and drops out. From the third

equation we can easily find that x = y = 50 and the constrained maximum value for z is

z = xy = 2500.

1

Example 2:

Maximize

u = 4x2 + 3xy + 6y 2

subject to

x + y = 56

Set up the Lagrangian Equation:

Lx = 8x + 3y = 0

Ly = 3x + 12y = 0

L = 56 x y = 0

8x + 3y = 3x + 12y

x = 1.8y

56 1.8y y = 0

y = 20

therefore

x = 36 = 348

A firm produces two goods, x and y. Due to a government quota, the firm must produce

subject to the constraint x + y = 42. The firms cost functions is

The Lagrangian is

L = 8x2 xy + 12y 2 + (42 x y)

The first order conditions are

Lx = 16x y = 0

Ly = x + 24y = 0

L = 42 x y = 0 (1)

x = 25 y = 17 = 383

2

Example of duality for the consumer choice problem

Example 4: Utility Maximization

Consider a consumer with the utility function U = xy, who faces a budget constraint of

B = Px x + Py y, where B, Px and Py are the budget and prices, which are given.

The choice problem is

Maximize

U = xy (2)

Subject to

B = Px x + Py y (3)

The Lagrangian for this problem is

Z = xy + (B Px x Py y) (4)

The first order conditions are

Zx = y Px = 0

Zy = x Py = 0 (5)

Z = B Px x Py y = 0

Solving the first order conditions yield the following solutions

B B B

xM = 2Px

yM = 2Py

= 2Px Py (6)

Minimize

Px x + Py y (7)

Subject to

U0 = xy (8)

The Lagrangian for the problem is

Z = Px x + Py y + (U0 xy) (9)

The first order conditions are

Zx = Px y = 0

Zy = Py x = 0 (10)

Z = U0 xy = 0

Solving the system of equations for x, y and

1

h Py U0 2

x = Px

1

h Px U0 2 (11)

y = Py

12

h = PUx P0 y

3

Application: Intertemporal Utility Maximization

Consider a simple two period model where a consumers utility is a function of consumption

in both periods. Let the consumers utility function be

U(c1 , c2 ) = ln c1 + ln c2

where c1 is consumption in period one and c2 is consumption in period two. The consumer

is also endowments of y1 in period one and y2 in period two.

Let r denote a market interest rate with the consumer can choose to borrow or lend

across the two periods. The consumers intertemporal budget constraint is

c2 y2

c1 + = y1 +

1+r 1+r

1

dU = dc1 + dc2 = 0

c1 c2

Rearrange to get

dc2 c2

=

dc1 c1

dc2

The MRS is the Absolute value of dc1

:

c2

MRS =

c1

substitute into the budget constraint

y2 c1 (1 + r)

y1 + = c1 + = (1 + )c1

1+r 1+r

y2

y1 + 1+r

c1 =

(1 + )

y2 c2 c2

y1 + = +

1+r (1 + r) 1 + r

1

(1 + r)y1 + y2 = + 1 c2

(1 + r)y1 + y2

c2 = 1

+1

4

Method Two: Use the Lagrange Multiplier Method

The Lagrangian for this utility maximization problem is

y2 c2

L = ln c1 + ln c2 + y1 + c1

1+r 1+r

The first order conditions are

L y2 c2

= y1 + 1+r c1 1+r =0

L

C1

= c11 = 0

L

C1

= c2 1+r

=0

1/c1 c2

= = =1+r

/c2 c1 1+r

c2

c2 = c1 (1 + r) and c1 =

(1 + r)

sub into the Budget constraint

y2 c1 (1 + r)

y1 + = c1 + = (1 + )c1

1+r 1+r

y2

y1 + 1+r

c1 =

(1 + )

Similarly, solving for c2 using the first order conditions

y2 c2 c2

y1 + = +

1+r (1 + r) 1 + r

1

(1 + r)y1 + y2 = + 1 c2

(1 + r)y1 + y2

c2 = 1

+1

Problems:

1. Skippy lives on an island where she produces two goods, x and y, according the the

production possibility frontier 200 = x2 + y 2 , and she consumes all the goods herself.

Her utility function is

u = x y3

FInd her utility maximizing x and y as well as the value of

2. A consumer has the following utility function: U(x, y) = x(y + 1), where x and y

are quantities of two consumption goods whose prices are px and py respectively. The

consumer also has a budget of B. Therefore the consumers maximization problem is

x(y + 1) + (B px x py y)

5

(a) From the first order conditions find expressions for x and y . These are the con-

sumers demand functions. What kind of good is y? In particular what happens

when py > B/2?

1 1

4. Skippy has the following utility function: u = x 2 y 2 and faces the budget constraint:

M = px x + py y.

6

REVIEW:Partial Derivative Rules:

U = xy U/x = y U/y =x

U = xa y b U/x = axa1 y b U/y = bxa y b1

a

U = xa y b = xyb U/x = axa1 y b U/y = bxa y b1

U = ax + by U/x = a U/y = b

U = ax1/2 + by 1/2 U/x = a 12 x1/2 U/y = b 12 y 1/2

EXAMPLE: Find the total dierential for the following utility functions

Answers:

U U

1. x 1

= U1 = a x2

= U2 = b

and

dU = U1 dx1 + U2 dx2 = adx1 + bdx2 = 0

If we rearrange to get dx2 /dx1

U

dx2 U1 a

= x

U

1

= =

dx1 x2

U2 b

dx2

The MRS is the Absolute value of dx1

:

a

MRS =

b

U U

2. x 1

= U1 = 2x1 + x2 x 2

= U2 = 3x22 + x1

and

dU = U1 dx1 + U2 dx2 = (2x1 + x2 )dx1 + (3x22 + x1 )dx2 = 0

Find dx2 /dx1

dx2 U1 (2x1 + x2 )

= =

dx1 U2 (3x22 + x1 )

dx2

The MRS is the Absolute value of dx1

:

(2x1 + x2 )

MRS =

(3x22 + x1 )

7

U

iii) x1

= U1 = axa1

1 x2

b U

x2

= U2 = bxa1 xb1

2

and a b1

dU = axa1 b

1 x2 dx1 + bx1 x2 dx2 = 0

Rearrange to get

dx2 U1 axa1

1 x2

b

ax2

= = a b1 =

dx1 U2 bx1 x2 bx1

dx2

The MRS is the Absolute value of dx1

:

ax2

MRS =

bx1

U 1 U 1

iv) c1

= U1 = c1

dc1 = c1

dc1 x2

= U2 = c2

dc2 = c2

dc2

and

dU = dc1 + dc2 = 0

c1 c2

Rearrange to get

dc2 U1 c1 c2

= = =

dc1 U2 c1

c2

dc2

The MRS is the Absolute value of dc1

:

c2

MRS = = (1 + r)

c1

c2

c2 = c1 (1 + r) and c1 =

(1 + r)

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