Extra Handout #2: The Importance of Lambda

This is meant to clarify some of the confusion related to the interpretation of lambda (the Lagrange multiplier) in a constrained optimization problem. Constraints play an important role in Economics without the budget constraint (or at least a credit card limit), consumers would be able to purchase anything they want. Without a production possibility frontier (PPF), firms could produce any level of output desired. Mathematically, these constraints are used in the formation of a Lagrangian Equation, an equation used to maximize some objective given constraints. There is considerable use of lambda in this courses online detailed texts (for starters see Chapter 5, pg. 4 and Chapter 6, pg. 15). This handout will illustrate: i. The importance of lambda to environmental economics ii. How to calculate lambda iii. The intuitive and mathematical interpretation of lambda iv. How lambda varies when the constraint is modified v. How lambda can be used by regulators to determine an optimal tax level Definition of lambda : Lamba is the marginal value associated with relaxing a constraint. Since this value is not expressed or contracted upon in a market, it is often called the shadow value or shadow price of the constraint. Example (1) A single consumer and a budget constraint Suppose that a single consumer wants to maximize utility given their budget constraint. Total Utility = U (X, Y) = 2XY Price of X = Px = $2 Price of Y = Py = $1 Income = I = $30 The consumer wants to maximize U(X,Y)=2XY subject to the income constraint. To solve the problem, we set up a Lagrangian Equation.
L = 2 XY + ( 30 2 X Y ) Taking the first order conditions yields the following:

L / X = 2Y 2 = 0 L / Y = 2 X = 0 L / = 30 2 X Y = 0

Up to here, this probably looks familiar from previous courses. You have probably solved these before by setting 2Y=4X, solving for X and Y, and ignoring ?. This is fine if all you are concerned with is the optimal X and Y. However, sometimes knowing the value of ? is important. Solving this, we get X=7.5 and Y=15. Solving for the maximum utility gives U(7.5,15)=2*7.5*15=225.

Using either of the first equations, we can solve for ? (the Lagrange multiplier). At the maximum utility, ?=15. This can be interpreted as the shadow value of the constraint. This means that if income were increased by one dollar (from $30 to $31), then total utility could increase by 15 units. Equivalently, marginal utility at (7.5,15) is 15 units. Can the value of ? change? This is important for people with the same utility function, but with different income levels, the value of ? (in this case: the shadow value of extra income) is different. To see this, assume that everything stays the same from the previous example, except that income is doubled to 60. At this income level, X=15 and Y=30. Total utility is U(15,30)=2*15*30=900. Solving for ? shows that the shadow value of the income constraint is 30. So, if income increased from 60 to 61, total utility would increase by 30 units (marginal utility at (15,30) is 30 units). Back to Environmental Questions The preceding example may seem silly, but the concept of a shadow value is important in all fields of economics. For example, if there is an industry that earns a benefit from being able to pollute, knowing the shadow value at the optimal pollution level can help regulators in determining the optimal policy to control pollution. It may be helpful to think of the benefit to a firm from polluting as foregone abatement costs; instead of as a smirking entrepreneur who gets thrills by seeing the sky above their plant become filled with smog. For a firm to lower pollution at a constant output level requires investment in abatement technology. Not having to invest in this technology can save the firm a lot of money. Example (2) A Polluting Firm Suppose the following: Y = total output, P = price of output, X = total input, W = price of input, and Z = pollution. Suppose that Y = f(X) is the production function, and that Z = g(X) is the pollution generation function. The idea is that using the input (X) produces output, but it also produces pollution. If there is a social (external) cost associated with pollution, the firm will not take the externality into account without regulation. First, we will solve this in a general form, then use a specific example. No regulation on pollution A firm wants to choose X to maximize the following:
Max[ P * f ( X ) W * X ] Calculating the first order condition, the firm will use X (the input) and produce where P*f(X) = W.

Regulation on pollution Suppose that a regulator wants to limit the amount of pollution. This regulation sets a maximum on the total pollution (Z) the firm is allowed to emit, where the maximum is at M. A firm will want to solve the following: Max[ P * f ( X ) W * X ]s.t .[g (X ) M ]

To solve this (a constrained maximization), we use a Lagrangian equation. L = [ P * f ( X ) W * X ] + [ M g ( X )] If the constraint is not binding, then firms produce less than the maximum allowed even with no regulation. In this case (where the constraint isnt binding), the value of ? is ZERO. In the case where the constraint is binding (as it often is with pollution regulation), calculating the first order conditions gives the following: L / X = Pf ' ( X ) W g ' ( X ) = 0 L / = M g ( X ) = 0 So, Pf(X*) = W + ?g(X*) at the optimal value of input use (X*). Knowing this gives the regulator two options to correct the externality. One option is to put a tax on pollution directly (Z), while another option is to put a tax on the input used that creates pollution (X). To calculate the optimal tax on inputs, the regulator wants to change the incentives facing the firm so that their costs reflect the social cost of production. So, the optimal tax on inputs is ? g(X*). At this tax level, the firms marginal cost equals the marginal benefit of producing when the input level is X*. The second option is to tax pollution directly. If the regulator want to tax pollution directly, the optimal tax on pollution is equal to ?. At the point where g(X)=M, ? is the shadow value of the constraint. It is the amount that producers could benefit if they were allowed to pollute M+1 units instead of M. If they are taxed this amount, then the marginal benefit of additional production (and its corresponding additional pollution) is zero. A Specific Example Lets try a specific example to illustrate the idea. Assume that X is an input into the production of a commodity. Let X be chicken feed, W is the price of chicken feed, f(X) is supply of broiler chickens to the market, P is the price of a broiler chicken, and g(X) is the pollution associated with the animal waste. Assume the following: P = $6, W = $1, f(X) = X1/2 , g(X) = X2 . First, if there is no regulation, then the firm chooses X to maximize the following: Profit = 6*X1/2 X Taking the first order conditions gives the following: 3*X-1/2 1 = 0 X-1/2 = 1/3 X=9 At X=9, profit is equal to $9, and pollution is g(9) = 81. Suppose that the regulator has decided that animal waste is a serious environmental problem, and society would be best if there were a maximum level of pollution of M, where M = 16. A firm will want to solve the following: Max[ 6 * X 1 / 2 X ]s.t .[ X 2 16] To solve this (a constrained maximization), we use a Lagrangian equation. L = [ 6 * X 1/ 2 X ] + [16 X 2 ] In the case where the constraint is binding (as it often is with pollution regulation), calculating the first order conditions gives the following:

L / X = 3 X 1/ 2 1 2 X = 0 L / = 16 X 2 = 0 Here, the optimal level of input is X* = 4. This can be solved for using the second equation. Using X* = 4, the first equation can be used to solve for ?. Plugging in X* = 4 gives: 3/2 1 - 8? = 0 8? = ? = 1/16 = 0.063 As mentioned above, there are two options that a regulator could choose. They could tax the pollution directly (Z), or they could tax the input that creates pollution (X). The same level of pollution can be achieved either way, however the tax rate will be different. In this example, a direct tax on pollution will be levied at a rate of $0.063 per unit of animal waste. A tax on the input used that generates pollution will be at a rate of (1/16)*g(4) = (1/16)*8 = $0.50 per unit of chicken feed (X) used. An important thing to realize is that the value of ? will change depending on how binding the constraint is. In the previous example, suppose that instead of setting M = 16 the regulator decides to set a limit of M = 4. In this case, the optimal level of inputs is X* = 2. Using the same first order condition as before gives: 3/v2 1 - 4? = 0 1.12 = 4? ? = 0.280 In this case, since the regulator has chosen a more stringent constraint, the value of ? (the shadow value of the constraint) is higher. It can be interpreted that the value of allowing one additional unit of animal waste to chicken producers is worth more when they are limited to 4 units of animal waste than when they are limited to 16 units of animal waste. With a limit of M = 4, the optimal level of pollution and input tax will change. The optimal pollution tax will be $0.280 per unit of animal waste, and the optimal input tax will be $1.12 per unit of chicken feed (X) used. The first attached graph shows one way of looking at lambda. On the x axis are the inputs; the top line represents profits, and the bottom line represents how lambda changes with different optimal levels of inputs (as determined by the standard M). The relationship of interest is that lambda goes to zero as we head towards the profit maximizing point at 9 units of input. After this point, the constraint is no longer binding, i.e., it has no value, so lambda equals zero. Another way to look at this is through demand for the input, chicken feed. This is described in the second figure. The input demand function at the output price p is described by: W=3X-1/2 where W is an input price that we vary (you should know how to figure this out). We can then graph this function just like any other demand. Note on the graph that at W=1, X=9. If we move up to the demand curve from our optimal X, 4, then we end up at the price 1.5. This is exactly W + Input Tax, which we determined above to be .5.

Lambda and Profits 10 0 M=4, X=2 lambda =.28 M=16, X=4 lambda = .063 1 2 3 4 5 6 7 8 9
1.0 0 2.2 4 3.0 0 3.6 1 4.1 2 4.5 8 5.0 0 5.3 9 5.7 4 6.0 8 6.4 0 6.7 1 7.0 0 7.2 8 7.5 5 7.8 1 8.0 6 8.3 1 8.5 4 8.7 7 9.0 0 9.2 2 9.4 3 9.6 4 9.8 5 10 .05 10 .25 10 .44 10 .63

Lambda and Profits

Input

max profit

Lambda

Profit(X*)

Demand for Chicken Feed

3.5

2.5

2 Price w 1.5 w=1+tax = 1+.5, where input tax is determined by lambda g'(x). X=4 w=1, x=9

0.5

0
0 4 8 16 28 40 80 88 12 20 24 32 36 44 48 52 56 60 64 68 72 76 84 92 96 10 0 10 4 10 8 11 2 11 6

Chicken Feed (Input)