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LECTURE 2: THE MEANING OF THE MULTIPLIERS

Reference: Pemberton & Rau Section 18.1

Consider the following problem:


maximise f ( x, y ) subject to g ( x, y )  0 (A)
Let the constrained maximum for this problem be at x  x * and y  y * .

Now consider the following variant with the same objective function:
maximise f ( x, y ) subject to g ( x, y )  b , (B)
where b is a constant.
The constrained maximum value of f ( x, y ) will now, in general, depend on b, and we
denote it by v(b) . We note that v(0)  f ( x*, y*) .
Define
H ( x, y )  f ( x, y )  v( g ( x, y )) .
Choose any point ( x, y ) and let b  g ( x, y ) . Then f ( x, y )  v(b) and so H ( x, y )  0 . But
g ( x*, y*)  0 and f ( x*, y*)  v(0) , so H ( x*, y*)  v(0)  v(0)  0 . Therefore H is
maximised at ( x*, y*) .
By the composite function rule,
H f g
  v( g ( x, y )) .
x x x
Hence, at the point ( x*, y*) we have
f g
 v(0) 0
x x
and similarly
f g
 v(0) 0.
y y
Setting   v(0) , we obtain the Lagrange multiplier rule for problem (A):
f g f g
  0,  0
x x y y
where  can be interpreted as the rate of response of the maximal value of f to
variations in the right-hand side of the constraint. The result generalises to problem (B) to
give:
Proposition For problem (B), let v(b) be the constrained maximum value of f, and let 
be the Lagrange multiplier at the optimum. Then   v(b) .

This proposition provides the marginal interpretation of the Lagrange multiplier.

Economic applications
Recall the utility-maximisation problem of Lecture 1:
maximise U ( x1 , x 2 ) subject to p1 x1  p 2 x 2  m.
The optimal levels of x1 , x 2 can be written

x1  f 1 ( p1 , p 2 , m), x 2  f 2 ( p1 , p 2 , m)
and the functions f 1 , f 2 are called the consumer's demand functions. If we substitute
these into the utility function, we get the maximum level of utility subject to this budget
constraint V ( p1 , p2 , m) . This is known as the indirect utility function. Then the
marginal interpretation of the Lagrange multiplier of the consumer’s problem is that
V
 .
m
Similarly, we may consider the firm’s cost minimisation problem
minimise w1 x1  w2 x2 subject to F ( x1 , x2 )  q.
The firm’s cost function C ( w1 , w2 , q) is defined to be the minimum level of cost subject to
the output constraint. Then, using the marginal interpretation of the multiplier, we get
C
 .
q

Exercises: Pemberton & Rau 18.1.1-18.1.3

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