Sample 7

Managerial Economics
Unit Titles
1
Introduction to Managerial Economics
The Theory of the Consumer
The Theory of the Firm
Competitive and Monopolistic Markets
Strategic Behaviour and Oligopoly
Bargaining and Private Information
The Optimal Provision of Incentives
Financial Investment, Capital Structure and Corporate Control
Managerial Economics
Unit 1
Contents
Page
What this unit is about
The Main Concepts in Microeconomics
Optimisation in Economic Analysis
Properties of Objective Functions and Feasible Sets
Properties of Solutions
11
Constrained Optimisation: the Lagrange Method
12
Comparative Statics and the Envelope Theorem
14
Conclusions
17
Revision Exercise
17
References
20
MANAGERIAL ECONOMICS
What this unit is about

This first unit introduces you to the main methods of microeconomics and managerial economics. We see how we can formulate problems of optimisation under
constraints, which are central to this course. After explaining the language and the
main concepts of microeconomics, we look at the role of optimisation in economic
analysis. We derive some general methods for solving optimisation problems and for
analysing the characteristics of the solutions. This unit lays the foundations for the
analysis in the course.
What you will learn
The scope of microeconomics;

The nature of managerial economics;
What is meant by adverse selection;
The meaning of moral hazard;
How to define an economic commodity;
What is a price;
Who are economic agents;
The characteristics of a market;
The meaning and properties of objective function;
The definition and use of a feasible set;
When a solution to an optimisation problem exists;
When is the solution a global optimum;
When is the solution unique;
How to use the Lagrange method;
The nature of Lagrange multipliers;
What is meant by comparative statics, or sensitivity analysis;
What is the envelope theorem.
Readings
Gravelle and Rees, Microeconomics, Chapter 1 and Appendices A-G, I and J.
Milgrom and Roberts, Economics, Organization and Management, Chapter 1
UNIVERSITY OF LONDON
UNIT ONE
1 Introduction to Managerial Economics

Welcome to this course in managerial economics. In this course we will study the
way individual economic units firms, consumers, managers etc. should go about
making their decisions. In order to address this question, we have to be more precise
about what the objectives of individual economic units are: what do they seek to
achieve, and what are their aims? We also have to be precise about the context in
which the economic units operate: what are the variables under their control? And
what constraints do they face?
Economic agents do not operate in a social vacuum. A crucial aspect of their
behaviour includes their interactions with other agents. On the one hand, this can
create new opportunities for individuals. Agents must rely on others in pursuing their
own interests. This may be achieved either by explicit co-operation or by their
understanding of the other agents selfish pursuit of their own best interests.
On the other hand, the need to interact with other agents can place severe constraints
on individual agents behaviour. They will not always be able to get their own way
and will be forced to accommodate the other agents needs. Sometimes, economic
agents may try to behave in a strategic fashion. They will try to anticipate the others
reactions to their own actions, and will therefore endeavour to make decisions which
turn to their best advantage, given that their actions could influence the other agents
choices and behaviour. One way agents can achieve this aim is by entering into some
form of contract, which explicitly or implicitly takes into account other agents
motivations and seeks to exploit their economic incentives in order to induce them to
perform.
In general, thus, we have to examine:
how individual agents behave;

what is their motivation;
what are the constraints they face; and
how they interact with other agents in the economy.
An important issue in managerial economics arises when agents have imperfect

knowledge of the characteristics of the other agents (adverse selection), or when they
cannot compel the other agents to behave in a given way (moral hazard). For
instance, an insurance company may be unable to observe the exact class of risk of
its prospective customers. If it were to offer a standard contract to all its prospective
clients, high-risk individuals might form a disproportionate number of its customers.
This would be a case of adverse selection. A possible way out is for the insurance
company to offer a range of different contracts to its customers, with different
premia and penalty structures. If the range of contracts has been optimally designed,
high-risk customers will prefer one type of contract, and low-risk customers another.
The insurance company will therefore be able to separate high- from low-risk
customers by offering a range of contracts, and by letting customers choose.
Another example might be an employer who wants to elicit a high level of effort
from its employees. This would be a case of moral hazard. The employer could
achieve its aim by creating suitable incentives in the form of performance-related
pay, appropriate promotion schemes, etc. which reward higher effort.
CENTRE FOR FINANCIAL AND MANAGEMENT STUDIES
The approach to managerial economics which we study in this course relies very
closely on microeconomic analysis. Indeed, we could define managerial economics
as that branch of microeconomics which helps develop a rational decision making
approach in management. We deal with individual behaviour and motivation,
explore how agents may interact with each other, and analyse how best they could
design contracts in order to elicit the desired behaviour from other agents. So, for
instance, we look at the optimal production decisions of firms, or at the design of
labour contracts between an employer and its employees.
1.1
The Structure of this Course
The outline of this course is as follows. This unit illustrates the main ideas in microeconomics and managerial economics and reviews the theory of mathematical
optimisation which we use in this course. Unit 2 deals with the theory of the
consumer. We look at how rational agents can maximise their individual welfare,
given the constraints they face. Unit 3 presents the theory of the firm. We analyse the
structure of technology in the short and in the long run, and consider the optimal
output supply by firms. In the next units we move on from individual consumers and
firms to consider how they interact in markets. In Unit 4 we look at competitive
markets and monopoly, and in Unit 5 we explore oligopolistic markets. In dealing
with the latter, we make extensive use of game theory, which studies how agents can
behave strategically. Unit 6 considers the important issue of how agents should
behave when they have imperfect knowledge of the characteristics of other agents or
of how they will behave. Unit 7 examines how agents can devise economic mechanisms to elicit information from other agents, and how they can design optimal
contracts which induce the other agents to provide the required incentives. Unit 8
brings together the methods of the previous units and applies them to issues in
financial investment, capital structure and corporate control.
You have been given the following textbooks, which constitute the main readings for
this course:
Hugh Gravelle and Ray Rees (2004) Microeconomics, 3rd edition, Prentice-Hall,
Harlow;
Paul Milgrom and John Roberts (1992) Economics, Organization and Management,
Prentice-Hall, Inc., Englewood Cliffs (New Jersey).
Gravelle and Rees cover all the main topics in microeconomics, including the more
recent and advanced topics in the economics of imperfect information and incentives. Milgrom and Roberts deal specifically with the issues of optimal organisation,
co-ordination, motivation, and incentives that are crucial for modern managerial
economics. You will see that Gravelle-Rees and Milgrom-Roberts are very different
in their approach: the first one is more formal in its arguments and more mathematical, whereas the second makes more use of examples and applications. The two
textbooks complement each other quite well, and by studying them both you will
experience a useful range of approaches to microeconomics and managerial economics
It is useful at this point for you to stop and read the first chapter, Does
Organization Matter? in Milgrom and Roberts. This chapter is an introduction to the
problems of business organisation, and explains why the compensation and ownerUNIVERSITY OF LONDON
UNIT ONE
ship structure of firms can be an important determinant of their performance. In this

chapter, the authors clearly illustrate the importance of economic decisions in
business organisations. They introduce a number of useful concepts:
co-ordination within a company and with outside suppliers;

performance-related pay systems;
the ratchet effect;
the role of information; and
incentives,
which will be fundamental to our analysis in the later units of this course.
2 The Main Concepts in Microeconomics

This section introduces the main ideas and concepts in microeconomics. The basic
notion is that of a commodity, which constitutes the object of production and
exchange in economics. The concept of commodity should be interpreted in a broad
sense, including both goods and services. It is important to note that the exact
definition of commodity must specify its physical characteristics, the location where
the commodity is available and the date when it is made available. Thus, a commodity could be a car, of a particular make and type, in Paris, on a given date. The same
car, on the same date, but in Mexico City, should be regarded as a different commodity.
Another example of a commodity may be given by the consultancy services
provided by a financial analyst, with a given educational and professional background, in Hong Kong, on a given date. The consultancy services provided by that
same analyst in Hong Kong, but on a different date, should be regarded as a different
commodity.
The second main concept in microeconomics is price. The price of commodities
measures the terms at which the commodities can be traded with one another. It is
customary to express prices in terms of monetary units of accounts, such as Singapore dollars or South African rands. In microeconomics, the main notion is that of
relative price between two commodities lets call them commodity A and commodity B. The relative price between A and B is the number of units of B which
have to be given up in order to purchase one unit of A. For example, if the monetary
price of commodity A is 200 Singapore dollars, and the monetary price of commodity B is 50 Singapore dollars, then the relative price of A in terms of B is 4, since we
have to give up 4 units of B in order to purchase one unit of A.
An important assumption which is often made in microeconomics is that agents do
not suffer from money illusion: if all monetary prices were suddenly to double, the
real decisions of agents would be unaffected. This is because the relative prices
between commodities would still be the same, reflecting the fact that the terms at
which commodities are traded with one another have not changed.
The third main concept is that of economic agents. In traditional microeconomics,
these are usually classified as consumers and firms. We shall analyse the behaviour
of consumers in Unit 2, and the behaviour of firms in Unit 3. Consumers must
allocate their limited resources among the different commodities they can purchase,
and firms employ inputs such as capital and labour to produce output. In the
traditional analysis, firms are seen as individual decision makers. In the more recent
microeconomic theory and in managerial economics, however, it is usually acknowledged that firms are complex organisations, and that the individual agents attached to
a firm may each have different goals in mind. It is therefore necessary to explore
how firms behave, given the possible conflicts of interest between the members of
the organisation. We address these and related issues in Units 6, 7 and 8.
The fourth main concept is that of a market. By this we mean the place where
economic commodities are traded. It is important to note that a market is not
necessarily a formal market place. Trade occurs whenever agents engage in an
exchange of commodities, irrespective of whether this exchange is regulated or not.
Also, trade does not require exchange of money: Barter, for instance, is a form of
trade. An important issue in microeconomics is to analyse how markets work, and
how agents behave in markets. In markets with a large number of participants,
individuals often have very little power to alter the conditions of exchange. A small
shopkeeper in a large town may have limited control over the prices charged for its
goods, because higher prices could mean losing most of its customers: they could
just walk away and buy from the rival shops. By contrast, the only shopkeeper in a
remote village could wield some market power, in the sense of enjoying some
latitude in setting prices. Its customers would not be able easily to walk away from
the shop and purchase the commodities somewhere else, if no rival shop were
available. An important component of this course is the analysis of how markets
work, and how agents can behave strategically in a market setting. We explore
market behaviour in Units 4 and 5.
Please now stop and read pages 1-6 from Gravelle and Rees, Chapter 1, section
A. The textbook introduces the main concepts in microeconomic analysis (commodities, price, economic agents and markets), and illustrates them by means of
examples. We shall constantly be referring to these concepts in this course, so it is
essential that you are thoroughly familiar with them. In addition, I should like you to
pay special attention to the discussion of markets and of economic agents.
3 Optimisation in Economic Analysis

In microeconomics, the assumption is often made that agents behave in a rational
fashion. This means that, when making their decisions, they consider all the possible
alternative courses of action, rank them according to their preferences, and finally
choose the action which they prefer best. Thus, a consumer seeking to maximise her
utility given her total income will consider all the possible uses of her income, will
rank these uses according to the utility she derives from each of them, and finally
will choose the use which yields the highest utility (Unit 2). Similarly, a firm might
seek to maximise its profit given technology and input prices and given a demand
curve for its output or output price, and will decide on the levels of labour and
capital it employs (Units 3 and 4).
Formally, the process of choice can be modelled as an optimisation problem faced
by the economic agent. There is a well-defined objective function that the agent
seeks to maximise by optimal choice of the decision variables. The context in which
choices take place is modelled as a set of constraints on individual behaviour. Thus,
the objective function of consumers is their utility function, which they seek to
UNIT ONE
maximise; their choice variables are the quantities of the various commodities which
are consumed, and their choice must satisfy the budget constraint which requires that
their expenditure cannot exceed their total income. The objective function of the firm
is the value of its profits; its choice variables are the quantity of inputs employed
(capital and labour), the output supplied and the price of its output (unless the firm is
operating under perfect competition), and its constraints are the level of technology
and the demand for its output by consumers.
The general method of microeconomics is therefore to model individual choice
as a problem of optimisation under constraints. This approach is very general, and it
is easily extended to the more recent topics in microeconomics and managerial
economics, such as the economics of imperfect information. Consider, for example,
the case of an employer who wants to elicit a higher level of effort from its employees. Its objective function are its profits, its choice variables the remuneration system
offered to its employees, and its constraints the response of its employees (who can
be thought of as rational and optimising agents in their turn, seeking to maximise
their own welfare given the remuneration scheme offered). The problem can be
fairly complicated, but the basic structure is quite straightforward, and always
involves optimisation under constraints.
Note that optimisation may involve either a maximisation or a minimisation problem.
Examples of the latter case are the minimisation of costs of a firm, or the minimisation of the risk faced by a financial investor. In this course we shall encounter many
examples of both maximisation and minimisation. The same methods can be applied
to both cases.
It is now a good moment to stop and read pages 6-11 from Gravelle and Rees,
Chapter 1, sections A and B.
Note how these authors pay special attention to the assumption of rationality in
economics. Please read these sections carefully, making notes on the important
points as you read. Read also with attention the analysis of the economic and social
framework of choice theory in section B. The structure of an optimisation problem in
economics is explained by Gravelle and Rees in Appendix A, pages 65759, and you
should read these pages as well. Note in particular how the set of constraints is
described by Gravelle and Rees as the feasible set. Pay special attention also to the
definitions of choice variables and of the objective function, and to the economic
examples which are provided.
4 Properties of Objective Functions and

Feasible Sets
In the previous section, we saw that the general method of microeconomics is to
model the choice problem as a programme of optimisation under constraints. It is
therefore necessary to be able to establish whether the problem we are considering
does have a solution, whether the solution is unique, and how the characteristics of
the solution depend on the parameters of the problem. For instance, when we look at
consumption behaviour, it is important to establish whether there is a combination of
commodities which maximises the utility of the consumer (existence of the solution),
and whether other combinations exist which yield the same level of utility so that the
consumer is indifferent between them (uniqueness of the solution). Even without

knowing the exact functions involved in the optimisation problem, it is usually
possible to say something about the solution. The reason for this is that economic
theory suggests that the functional forms in a microeconomic decision problem must
satisfy some given properties, and this in turn could lead to guaranteeing that the
problem has a unique solution with some important additional characteristics.
The main properties we are looking for in the solution to a microeconomic optimisation problem are:
whether it exists;
whether it is a global solution;
whether it is unique.
These properties are explained in the textbook by Gravelle and Rees. Please
stop now and read the relevant pages in the book before continuing with the rest of
this text. These are pages 660-62 from Appendix B; be sure to make careful notes on
these properties as you read this section.
Existence of a solution is clearly a crucial feature of the optimisation problem, yet it

cannot always be taken for granted. Some mathematical problems simply do not
have a solution. Hence, when setting up an economic problem we must always check
whether a solution exists. The good news is that sometimes the properties of the
objective function and of the constraints do ensure that a solution exists (this will be
discussed further in the next section of this unit).
But even when a solution exists, we cannot always be sure that it is a global solution,
i.e. that it achieves a maximum (or a minimum, depending on the problem) over the
whole range of feasible values for the decision variables. Figure B.1 in Gravelle and
Rees shows an example of a function f(x) which has a local, but not a global
optimum at x**. When solving an optimisation problem, it is therefore necessary to
check that the solution is a global, rather than simply a local solution to the problem.
Finally, it is important to establish whether the solution to the optimisation problem
is unique, or whether there could exist several choices of the decision variables
which yield the same value of the objective function, and therefore are equivalent for
the optimising agent. Although there are no theoretical problems in principle with
the latter case, i.e. when there are multiple solutions, there could be difficulties when
it comes to predicting the behaviour of the economic agents. In fact, if the agent is
indifferent as between a number of alternative courses of action, it could be impossible to predict with certainty what the outcome of its actions will be. Sometimes it is
possible to anticipate that agents will choose one of these actions over the others
for instance, in problems which involve co-ordination by many agents, there could
be a focal equilibrium, that is, an action to which all agents co-ordinate their
behaviour. Thus, when driving a car, keeping to the right side of the road is the focal
equilibrium in France, whereas keeping to the left is the focal equilibrium in the UK.
In a number of cases, however, it could be quite difficult to predict the action of
agents when there are multiple solutions to the individual optimisation problem.
We are going to look at the issues of existence, unicity, and the global property of
solutions in the next section. We will see there that, for a large class of problems in
UNIT ONE
microeconomics, it is possible to prove that a solution exists, is unique, and is indeed

a global optimum. The conditions for this to be true lie in the properties of the
objective function and of the set described by the constraints the feasible set.
The main properties which an objective function can satisfy are:
Continuity
Concavity
Quasi-concavity
Gravelle and Rees give precise mathematical definitions of the above properties. An
intuitive graphical account can be obtained from the examples of Figures 1.1 1.3,
shown here:
FIGURE 1.1
CONTINUITY
g(x)
f(x)
(a)
(b)
Part (a) of Figure 1.1 shows a function f(x) which is continuous, whereas part (b)
shows a discontinuous function. In Figure 1.2, part (a) gives an example of a
concave function, whereas part (b) displays a function which is not concave.
FIGURE 1.2 CONCAVITY
f(x)
g(x)
(a)
(b)
10
Finally, part (a) of Figure 1.3 shows a quasi-concave function (note that now we
have two choice variables, x1 and x2), while part (b) displays a function which is not
quasi-concave.
FIGURE 1.3
QUASI-CONCAVITY
f(x ,x )
g(x ,x )
1 2
(a)
1 2
(b)
The main properties of the feasible set are:
Non-emptiness. The feasible set is non-empty if it contains at least one element.

This implies that the constraints of the optimisation problem do not contradict
each other.
Boundedness. The feasible set is bounded if it is not possible to go to infinity,
while still remaining in the set.
Closedness. The feasible set is closed if it contains its boundaries.
Convexity. The feasible set is convex if, for any two points in the set, the straight
line connecting them lies entirely within the set. This implies that the feasible set
must have no holes.
If the feasible set is both closed and bounded, it is said to be compact. The textbook
by Gravelle and Rees contains further explanations and examples of the above
properties. It is often possible to verify that these properties are actually satisfied in a
large number of problems analysed in applied microeconomics and managerial
economics. This turns out to be quite useful, since in these cases we can be more
precise about the nature of the solutions to the optimisation problem. We shall
consider this point more fully in the next section.
Please now stop and read pages 66268 from Appendix B of Gravelle and
Rees. It is very useful to go through all the examples in the textbook, and to pay
particular attention to the counter-examples and to the intuitive graphical interpretation of the properties of the objective function and of the feasible set. As you read
the textbook, it is very useful to think of examples of functions you already know
(for instance, from any previous courses in mathematics), and check whether they
satisfy the properties set out in your textbook
UNIT ONE
11
5 Properties of Solutions
Section 4 has illustrated some of the possible properties of the objective function and
the feasible set. Our reason for considering those properties is that, when they are
satisfied for a particular optimisation problem we can be more precise about the
characteristics of the solutions of that problem. In particular, we have the following
results (Gravelle and Rees, Appendices C-E).
Weierstrass Theorem
An optimisation problem always has a solution if:
the objective function is continuous; and

the feasible set is non-empty and compact.
Global Optima
A local maximum of an optimisation problem is always a global maximum if:
the objective function is quasi-concave; and

the feasible set is convex.
Uniqueness Theorem
Given an optimisation problem in which the feasible set is convex and the objective
function is non-constant and quasi-concave, a solution is unique if:
the feasible set is strictly convex; or

the objective function is strictly quasi-concave; or
both.
You can find proofs of the above theorems, together with their intuitive interpretation, in the textbook by Gravelle and Rees. The above results are very important,
because they enable us to infer some characteristics of the solutions simply on the
basis of the properties of the objective function and of the feasible set. In particular,
it may not be necessary to solve the problem explicitly in order to know that a
solution exists, that it is a global optimum, and that it is unique.
It is important to note that the theorems presented above lay out sufficient, but not
necessary conditions for the properties to hold. Thus, an optimisation problem may
have a solution even if the conditions of the Weierstrass Theorem do not apply, for
instance when the objective function is not continuous. In other words, if the
conditions of the theorems are satisfied then we can be certain that the respective
properties hold, whereas if the conditions are not satisfied then we cannot say
whether the properties hold or not. In this second case, we must therefore solve the
problem explicitly and check directly whether a solution exists, whether it is a global
rather than a local optimum and whether it is unique.
Fortunately, in a large number of problems in microeconomics and in managerial
economics all the above properties hold. We can therefore be confident about the
solutions having the desired properties.
This is a good moment to stop and read Gravelle and Rees, Appendices C-F,
pages 670-78. The authors deal with the topics presented above, and present proofs
for the theorems. They also discuss the important issue of interior versus boundary
12
optima. The latter occur when the optimum lies on the boundary of the feasible set
i.e., on one of the constraints. You should read carefully what Gravelle and Rees
have to say on this. It is very helpful to follow their mathematical proofs, although
you are required to reproduce the mathematical proofs of these sections.
6 Constrained Optimisation: the Lagrange

Method
The previous section looked at some of the properties of the solution to a constrained
optimisation problem, when the objective function and the feasible set satisfy certain
properties. However, we have not yet developed a general method for finding an
analytical solution. This is the object of the present section. We consider a fairly
general approach to constrained optimisation, and develop a constructive method for
finding the solution.
Suppose that we have n decision variables: x = (x1,x2,...,xn), and the objective
function is:
f(x) = f(x1,x2,...,xn)
(1.1)
where f(x) is a continuous and differentiable function. For instance, the economic
agent could be a consumer who has to decide how to allocate his or her income
among n alternative consumption commodities, (x1,x2,...,xn) are the quantities
consumed of the commodities where f(x) is the consumers utility function.
The optimisation problem is in general subject to a number of constraints. These can
take the form of m<n equality constraints:
g1(x) = g1(x1,x2,...,xn) = b1
(1.2a)
g2(x) = g2(x1,x2,...,xn) = b2
(1.2b)
........................................
gm(x) = gm(x1,x2,...,xn) = bm
(1.2c)
where g1(x), g2(x),..., gm(x) are continuous and differentiable functions, and b1, b2,...,
bm are constant coefficients. For instance, in the consumer example g1(x) = b1 could
be the budget constraint where b1 is income, g2(x) = b2 could be a dietary requirement, etc. We can define the Lagrange function, or simply the Lagrangean for this
optimisation problem as:
L(x1,x2,...,xn,1,2,...m) = f(x1,x2,...,xn) +
j [b j g j (x1 , x2 , ..., xn ) ]
(1.3)
j =1
where 1, 2, ..., m are m additional variables, called the Lagrange multipliers,
associated to the m constraints (1.2a)-(1.2c) as shown in equation (1.3). The firstorder necessary conditions for the optimisation problem are:
m
L f
g j
=
j
=0
x1 x1 j=1
x1
(1.4a)
UNIT ONE
13
L f
g j
=
j
=0
x2 x2 j=1
x 2
(1.4b)
..........................................................
m
L f
g j
=
j
=0
xn xn j=1
x n
(1.4c)
L
= b1 g 1 ( x1 , x2 ,..., xn ) = 0
1
(1.5a)
L
= b2 g 2 ( x1 , x2 ,..., xn ) = 0
2
(1.5b)
and constraints:
..........................................................
L
= bm g m ( x1 , x2 ,..., xn ) = 0
m
(1.5c)
Note that the first-order conditions (1.5a)-(1.5c) simply yield again the constraints
(1.2a)-(1.2c). The system (1.4a)-(1.5c) comprises n + m equations in the n + m
unknowns x1,x2,...,xn,1,2,...m. If the conditions of the Weierstrass and of the
uniqueness theorems are satisfied (see section 6), then the system has a unique
solution: (x1*, x2*, ..., xn*, 1*, 2*,... m*).
The optimal choice of the decision variables is therefore given by (x1*, x2*, ..., xn*).
The Lagrange multipliers ( 1*, 2*,... m*) have an important economic interpretation. We have that
f ( x1*,..., xn *, 1*,..., m )
= 1 *
b1
(1.6a)
f ( x1*,..., xn *, 1*,..., m )
= 2 *
b2
(1.6b)
..........................................................
f ( x1*,..., xn *, 1*,..., m )
= m *
bm
(1.6c)
Hence, the Lagrange multipliers measure the marginal effect on the objective
function of relaxing the respective constraints. Thus, in our consumption example, if
b1 is the income constraint, then *1 measures by how much total utility would
increase, if income were increased by one monetary unit (e.g. 1 US $). We shall rely
extensively on this interpretation of the multipliers in the next units of this course.
The method of constrained optimisation based on the Lagrange function is

explained by Gravelle and Rees, pages 679-84. Please read these pages now.
14
7 Comparative Statics and the Envelope

Theorem
In microeconomics and managerial economics there are two main questions to be
addressed when we regard economic choice as a problem of constrained optimisation. The first question is:
what is the solution to our problem?
The second question, closely related to the first one, is:
how would the solution change, if any of the features which characterise
the economic environment were to change?
For example, we can analyse the choice problem of a household by assuming that the
household endeavours to maximise its utility, given a budget constraint. We shall
return to this problem in Unit 2. The Lagrange multiplier method, illustrated in
section 6 of this unit, enables us to find the optimal choices of consumption commodities for the household, as a function of its income and of the prices of all the
commodities. This answers the first question set out above, to find a solution for our
optimisation problem.
In the context of our example, the second question is:
how would the optimal consumption commodities for the household vary, if
household income changes, or if the commodities prices change?
This question is clearly important for our analysis. The present section explains how
we can address this question, for a fairly general problem in microeconomics or
managerial economics. The remainder of the course will see many applications of
these methods to a variety of examples.
Suppose that the objective function is:
max
(x1, x2)
y = u(x1, x2)
(1.7)
where the function u(x1,x2) must be maximised by choosing the decision variables x1
and x2. Let the constraint be given by:
p1 x1 + p 2 x 2 = m
(1.8)
To fix ideas, u(x1,x2) could be the utility function of an individual, x1 and x2 the
quantities consumed of commodities 1 and 2, m could be income, and p1 and p2 the
prices of the commodities. Then equation (1.8) is the budget constraint. The
Lagrangean for the optimisation problem is:
L = u( x1 , x 2 ) + (m p1 x1 + p2 x 2 )
(1.9)
where is the Lagrange multiplier. As explained in section 6, the first-order

conditions are:
L u ( x 1 , x 2 )
=
p1 = 0
x 1
x 1
(1.10a)
UNIT ONE
15
L u( x1 , x2 )
=
p2 = 0
x 2
x 2
(1.10b)
L
= m p1 x1 p2 x2 = 0
(1.10c)
The system (1.10a)-(1.10c) has three equations in the three unknowns x1, x2 and . If
there is decreasing marginal utility, then condition (b) of the Uniqueness Theorem of
section 5 is satisfied (the objective function is strictly quasi-concave) and the
problem has a unique solution (we shall look at this in more detail in Unit 2). This
solution takes the form:
x1* = x1* ( p1, p2 , m)
(1.11a)
x*2 = x*2 ( p1, p2 , m)
(1.11b)
* = * ( p1, p2 , m)
(1.11c)
that is, the endogenous variables are expressed as a function of the exogenous
variables.
After finding a solution, the question we have to ask ourselves is: what would
happen if the exogenous variables change? For instance, suppose that income m were
to increase: how is this going to affect the optimal choice of x1 and x2? This question
is answered by the comparative statics, or sensitivity analysis. We try to measure the
effects of changes in the exogenous variables (prices and income) on the endogenous
variables (the quantities consumed) by computing the following (partial) derivatives:
x1
,
p1
x1
,
p 2
x1
m
(1.12a)
x 2
,
p1
x 2
,
p 2
x 2
m
(1.12b)
How do we obtain the above derivatives? There are two possible ways to solve this
problem. The first one is simply to obtain explicit solutions for the endogenous
variables, equations (1.11a) (1.11c), and then to compute the partial derivatives.
There is a second method, however, which does not rely on the explicit solutions
(1.11a) (1.11c). In order to implement this method for comparative statics, we
totally differentiate the first-order conditions (1.10a) (1.10c) to have:
2u
2u
dx
+
dx2 p1d = dp1
1
x1x2
x12
(1.13a)
2u
2u
dx1 + 2 dx2 p2 d = dp2
x1x2
x 2
(1.13b)
p1dx1 p2 dx2 = x1dp1 + x2 dp2 dm
(1.13c)
16
The system (1.13a)-(1.13b) above can be solved by substitution to obtain the desired
derivatives. For instance, if we are interested in how the quantities consumed x1 and
x
x
x2 change as the price p1 changes, we need to compute 1 and 2 .
p1
p1
When we look at changes in one exogenous variable, or parameter (in the example
above, the price p1), we must leave the other exogenous variables, p2 and m,
unchanged. In other words, when carrying out comparative statics exercises we
consider changes of one parameter only at a time. In order to find these effects, we
set dp2 = dm = 0 in equations (1.13a)-(1.13c) and solve the system:
2u
2u
dx
+
dx2 p1d = dp1
1
x1x2
x12
(1.14a)
2u
2u
dx1 + 2 dx2 p2 d = 0
x1x2
x 2
(1.14b)
p1dx1 p2 dx2 = x1dp1
(1.14c)
The resulting system (1.14a)-(1.14c) contains the three unknowns dx1 , dx 2 and d ,
and the exogenous variable dp1 . It can be solved to give the derivatives in which we
are interested, that is, dx1 / dp1 and dx 2 / dp1 .
There is also an alternative method to sensitivity analysis for assessing the effects of
changes in the exogenous parameters on the economic agent. This method relies on
the envelope theorem, which says that the total derivative of the objective function
with respect to the parameter is equal to the partial derivative of the Lagrangean,
evaluated at the optimal choice.
To understand what this means, note that the Lagrangean function evaluated at the
optimum is:
L* = u(x1* , x*2 ) + * (m p1x1* p2 x*2 )
= u[ x1* ( p1 , p 2 , m), x 2* ( p1 , p 2 , m)] + *[m p1 x1* ( p1 , p2 , m)
p2 x 2* ( p1 , p 2 , m)]
= u[x1* ( p1 , p2 , m), x2*( p1, p 2 , m)] + * g(x 1*, x*2 , p1 , p2 , m)
(1.15)
using (1.11a) (1.11b), and where we have written the constraint as:
g(x1*, x*2 , p1, p2 , m) = m p1 x1* ( p1 , p2 , m) p2 x2*( p1, p 2 , m)
(1.16)
The envelope theorem thus says that:
du * u *
g
=
+ *
dp1 p1
p1
(1.17)
where the partial derivatives are computed at the optimum.
Turn now to Gravelle and Rees, Appendices I, from page 696 to 700, and J,
pages 708-09. Note that these authors make use of matrix algebra in order to derive
some of their results. If you are familiar with matrix algebra, you will see that it is
UNIT ONE
17
convenient for solving large systems of equations. However, it is not necessary to

understand algebra in order to grasp the underlying economics of the optimisation
problem and the structure of the solution. Note also what Gravelle and Rees have to
say about the second-order condition for unconstrained optimisation, on pages 69899. Unfortunately, the mathematical second-order conditions for problems of
unconstrained optimisation with many variables or for constrained optimisation are
quite complicated without the use of matrix algebra, and we shall not look into them.
These are discussed by Gravelle and Rees on pages 700-01, but these are not
compulsory reading.
8 Conclusions
This unit introduces you to the main methods of microeconomics and managerial
economics. You should now see how to formulate problems of optimisation under
constraints, which are central to this course. After explaining the language and the
main concepts of microeconomics, we looked at the role of optimisation in economic
analysis. We derived some general methods for solving optimisation problems and
for analysing the characteristics of the solutions. The Lagrange method for constraint
optimisation was explained, and we demonstrated the use of sensitivity analysis to
explore how the solution varies with the parameters of the problem. We also
discussed the envelope theorem, which shows how the parameters of the problem
can affect the value of the objective function.
The mathematics of this unit could appear to be rather daunting, if you are unfamiliar
with constrained optimisation. However, you should not feel discouraged if you find
some of the concepts or methods obscure. The best way to understand difficult
concepts is to be patient, go over the theory several times, and especially see how the
theory works in practice. We shall certainly see quite a few applications of the theory
in the next units, and I am sure you will feel confident by the end of the course!
Revision Exercise
Consider the problem of maximising the following objective function:
max y = u( x1 , x 2 ) = Ax1 x2
(1.18)
where A > 0, > 0, > 0, subject to the constraint:

p1x1 + p2 x2 = m
(1.19)
(a) Find the optimal values for x1 and x2.

(b) Find how the optimal values for x1 and x2 vary with p1, p2 and m.
(c) Find how the maximised value of the objective function varies with p1, p2
and m.
18
Solution to the Revision Exercise

(a) Write the Lagrangean as:
L = Ax1 x2 + (m p1 x1 p2 x2 )
(1.20)
The first-order conditions are:

( x1 ): A x1 1 x2 = p1
( x2 ): A x1 x2 1 = p2
(1.21a)
(1.21b)
():
(1.21c)
p1 x1 + p2 x 2 = m
Divide (1.21a) by (1.21b) to eliminate :
x2 p1
=
x1 p2
(1.22)
Equation (1.22) can be rearranged to give:
x2 =
p1
x1
p2
(1.23)
If we replace (1.23) into the budget constraint (1.21c) we obtain the optimal choice
for x1:
x1* =
m
= x1* ( p1 , p2 , m)
+ p1
(1.24)
By replacing (1.24) back into the budget constraint (1.21c) we obtain the optimal
choice for x2:
x2* =
m
= x2* ( p1 , p2 , m)
+ p2
(1.25)
Finally, by replacing (1.24) and (1.25) into the first-order condition (1.21a) (or into
(1.21b)) we have:
* =
A
m + 1
( + ) + 1 p1 p2
= * ( p1 , p2 , m)
(1.26)
(b) From (1.24) and (1.25) we obtain:

dx1*
m
=
< 0,
+ p12
dp1
dx2*
= 0,
dp1
dx1*
= 0,
dp2
dx2*
m
=
< 0,
+ p22
dp2
dx1*
1
=
>0
dm + p1
dx2*
1
=
>0
dm + p2
(1.27)
(1.28)
(c) We can use the envelope theorem. The maximised value of the Lagrangean is:
UNIT ONE
19
L = u( x1* , x2* ) + (m p1 x1* p2 x1* )

m m
= A

+
+ p1 + p2

m + 1

m

m

m
A

+
+
( + ) + 1 p1 p2

m +
=A
( + ) + p1 p2
(1.29)
By taking partial derivatives of (1.29) we finally obtain:
u *
+1
m +
= A
p1
( + ) + p1 +1 p2
(1.30a)
u *
+1 m +
= A
p 2
( + ) + p1 p2 +1
(1.30b)
u *

m + 1
=A
m
( + ) + 1 p1 p2
(1.30c)
20
References
Gravelle, Hugh and Ray Rees (2004) Microeconomics, 3rd edition, Prentice-Hall,
Harlow.
Milgrom, Paul and John Roberts (1992) Economics, Organization and Management,
Prentice-Hall, Inc: Englewood Cliffs (New Jersey).

Sample 7

Caricato da

Informazioni sul documento

Titolo originale

Copyright

Formati disponibili

Condividi questo documento

Condividi o incorpora il documento

Opzioni di condivisione

Hai trovato utile questo documento?

Questo contenuto è inappropriato?

Copyright:

Formati disponibili

Sample 7

Caricato da

Copyright:

Formati disponibili

Managerial Economics

Introduction to Managerial Economics

The Theory of the Consumer

The Theory of the Firm

Competitive and Monopolistic Markets

Strategic Behaviour and Oligopoly

Bargaining and Private Information

The Optimal Provision of Incentives

Financial Investment, Capital Structure and Corporate Control

Introduction to Managerial Economics

What this unit is about

Introduction to Managerial Economics

The Main Concepts in Microeconomics

Optimisation in Economic Analysis

Properties of Objective Functions and Feasible Sets

Constrained Optimisation: the Lagrange Method

Comparative Statics and the Envelope Theorem

What this unit is about

What you will learn

The scope of microeconomics;

1 Introduction to Managerial Economics

how individual agents behave;

An important issue in managerial economics arises when agents have imperfect

CENTRE FOR FINANCIAL AND MANAGEMENT STUDIES

The Structure of this Course

ship structure of firms can be an important determinant of their performance. In this

co-ordination within a company and with outside suppliers;

2 The Main Concepts in Microeconomics

3 Optimisation in Economic Analysis

4 Properties of Objective Functions and

consumer is indifferent between them (uniqueness of the solution). Even without

Existence of a solution is clearly a crucial feature of the optimisation problem, yet it

microeconomics, it is possible to prove that a solution exists, is unique, and is indeed

CENTRE FOR FINANCIAL AND MANAGEMENT STUDIES

The main properties of the feasible set are:

Non-emptiness. The feasible set is non-empty if it contains at least one element.

An optimisation problem always has a solution if:

the objective function is continuous; and

A local maximum of an optimisation problem is always a global maximum if:

the objective function is quasi-concave; and

the feasible set is strictly convex; or

6 Constrained Optimisation: the Lagrange

The method of constrained optimisation based on the Lagrange function is

CENTRE FOR FINANCIAL AND MANAGEMENT STUDIES

7 Comparative Statics and the Envelope

where is the Lagrange multiplier. As explained in section 6, the first-order

x*2 = x*2 ( p1, p2 , m)

p1dx1 p2 dx2 = x1dp1 + x2 dp2 dm

CENTRE FOR FINANCIAL AND MANAGEMENT STUDIES

p1dx1 p2 dx2 = x1dp1

= u[x1* ( p1 , p2 , m), x2*( p1, p 2 , m)] + * g(x 1*, x*2 , p1 , p2 , m)

The envelope theorem thus says that:

where the partial derivatives are computed at the optimum.

convenient for solving large systems of equations. However, it is not necessary to

where A > 0, > 0, > 0, subject to the constraint:

(a) Find the optimal values for x1 and x2.

CENTRE FOR FINANCIAL AND MANAGEMENT STUDIES

Solution to the Revision Exercise

The first-order conditions are:

Divide (1.21a) by (1.21b) to eliminate :

Equation (1.22) can be rearranged to give:

(b) From (1.24) and (1.25) we obtain:

L = u( x1* , x2* ) + (m p1 x1* p2 x1* )

x2 = x2 ( p1, p2 , m)

= u[x1* ( p1 , p2 , m), x2( p1, p 2 , m)] + g(x 1, x2 , p1 , p2 , m)