Producers, Consumers, and Partial Equilibrium

Optimization

Introduction

Part I provides comprehensive coverage of the mathematics directly used to study optimization in the economic theories of Parts 2–4. The goal is to provide a unified and complete reference for this branch of the mathematics, with particular attention to assembling somewhat inaccessible proofs in a standardized notation and style. Notation used throughout the text is also introduced in Part I.

The implications of constrained optimizing behavior are the behaviors of parameterized optima as the parameter changes. Hence the effect of parameter variation on the optimization problem is central. The concept of an inactive constraint is an organizing principle introduced in Chapter 1. A constraint is inactive if a local change in the parameter does not affect feasibility of an optimal choice. In this circumstance there is a full envelope relationship over the parameter space between the optimal value function and the underlying objective functions. This envelope relationship describes many of the consequences of the behavioral postulate and is a rich source of refutable hypotheses in the neoclassical economic theories of producer and consumer choice. Standard necessary calculus conditions are another source of implications. Continuity and homogeneity imply further properties of optima.

Chapter 2 reconsiders these properties when the constraint is active and binding. The standard calculus conditions become stationarity of a Lagrangian function and semidefiniteness properties of its Hessian. It is no longer assured that a full envelope relationship exists, but the tangency part of that relationship is preserved. These properties provide the input to investigating how optimal choices vary with the parameter using classical comparative statics.

Chapter 3 establishes many properties of convex functions. It is not explicitly about optimization but convexity plays an important role in optimization environments and leads to many properties of optima in economic theory.

Chapter 1

Properties of a Maximum

Abstract

The properties of a parameterized constrained optimum are developed. Conditions sufficient for continuity are provided by the Maximum Theorem. Implications of continuity for the graph of a correspondence are proven. Calculus conditions necessary for an optimum are developed and related to principal minors of the Hessian. Euler’s Theorem gives an important characterization of homogeneity. A Generalized Envelope Theorem proves the relationship between optimal value functions for a more- versus less-constrained optimum. The concept of an active constraint is introduced, leading to the standard envelope theorem as the special case of an inactive constraint.

Keywords

Optimization; Upper and lower semi- and hemi-continuity; Graph; First and second order conditions; Semidefinite matrices and principal minors; Homogeneity; Generalized Envelope Theorem; Active constraint

Chapter Outline

1.1 Continuity

1.2 Graphs and Continuity

1.3 Definite and Semidefinite Matrices

1.4 Derivatives

1.5 Homogeneity

1.6 Envelope Properties

1.7 Notes on Properties of Minima

1.8 Notes

1.9 Exercises

References

This chapter develops general properties of an optimal choice correspondence and an optimal value function, both considered in terms of their dependence on a parameter. The following notation is used throughout:

is a nonempty space of choice variables (e.g., consumption quantities, production plans).

is a nonempty space of parameters (e.g., prices, income).

is the decision-maker’s objective (e.g., utility, profit).

• Γ : Θ → 2X is the decision-maker’s constraint correspondence that defines the values of x available to the decision-maker for each θ ∈ Θ (2X denotes the power set of X, the set of all subsets of X; as we are interested in meaningful optimization problems we shall generally assume without comment that Γ(θ) is nonempty for every θ ∈ Θ).

is the optimal value function ).

• x* : Θ → 2X is the optimal choice correspondence (e.g., demands, supplies), formally defined as x*(θ) = {x ∈ Γ(θ) : f(x;θ) = f*(θ)} (possibly empty).

denotes an arbitrary feasible value of x when the parameter is θdenotes an arbitrary optimal choice of x when the parameter is θ.

The behaviors of the set x*(θ) and the function f*(θ) as θ changes are the consequences of the behavioral postulate that a decision-making unit chooses x to maximize f within the limitations imposed by Γ. These properties are the refutable hypotheses of the positive theory. In the neoclassical theory of producer or consumer choice these are responses of quantities demanded or supplied; or profit, cost or utility levels; to changes in prices or endowments. Characterizing x* and f* is similar to, but a bit different from, solving a maximization problem. Often extreme value problems are solved using conditions that first derivatives equal zero and second derivatives take on particular signs. However, it is taken as a maintained hypothesis that the decision-making unit chooses x to maximize f. We want to know: Given that x is chosen to maximize, what properties are possessed by the chosen value(s) of x and the resulting optimized value of f? Solving the optimization problem is not the main concern, as the decision-making unit will solve that problem, by assumption. The concern, rather, is the consequences of that optimizing behavior.

1.1 Continuity

Continuity is a basic attribute of how an optimum responds to changes in the parameters of the optimization problem. Consideration of continuity requires that we first define upper and lower semicontinuity of functions, and analogous continuity concepts applicable to correspondences.

Definition 1.1

, and x⁰ ∈ S.

1. ϕ is upper semicontinuous at x⁰ if, for every sequence xi ∈ S and for every δ > 0:

2. ϕ is lower semicontinuous at x⁰ if, for every sequence xi ∈ S and for every δ > 0:

3. ϕ is continuous at x⁰ if ϕ is both upper and lower semicontinuous at x⁰.

4. ϕ is upper semicontinuous, lower semicontinuous, or continuous on S if ϕ is upper semicontinuous, lower semicontinuous, or continuous at every x ∈ S, respectively.

Fig. 1.1 illustrates these concepts.

Fig. 1.1 Semicontinuous functions. In panel (A), ϕ is upper but not lower semicontinuous at x ⁰ . In panel (B), ϕ is lower but not upper semicontinuous at x ⁰ .

A useful property of semicontinuous functions is that an envelope of any collection of semicontinuous functions is itself semicontinuous.

Theorem 1.1

and G is a set of functions from S . If every ϕ ∈ G is upper semicontinuous at x⁰ ∈ S is upper semicontinuous at x⁰.

Proof

Fix δ > 0 and consider any sequence xi in S that converges to x⁰. By definition of the (finite) infimum, there exists ϕ ∈ G such that:

Using upper semicontinuity of ϕ, there exists a positive integer I (depending on ϕ) such that:

Hence:

by definition of the infimum, so:

Note that an analogous result holds for any collection of functions that are lower semicontinuous at a point: The supremum of such a collection is lower semicontinuous at that point.

When postulating maximizing behavior, care must be exercised to think about whether a maximum exists (x* nonempty) because, if not, then any properties established for the maximizing choice are vacuous. The following theorem establishes the standard sufficient conditions for existence of a maximum.

Theorem 1.2

Existence of a Maximum

Fix θ ∈ Θ. If Γ(θ) is nonempty, closed and bounded; and f(x;θ) is an upper semicontinuous function of x on Γ(θ); then x*(θ) is nonempty.

Proof

As Γ(θ) is nonempty, by definition of the supremum there exists a sequence xi ∈ Γ(θ(even when a supremum is infinite). As Γ(θ) is bounded, xi [1, p. 205]. x⁰ ∈ Γ(θ) because Γ(θ) is closed. Fix δ > 0 and use upper semicontinuity of f at xfor i therefore yields f*(θ) ≤ f(x⁰;θ) + δ. As this holds for every δ > 0, letting δ ↓ 0 yields f*(θ) ≤ f(x⁰;θ). The opposite inequality holds by definition of the supremum, whence f*(θ) = f(x⁰;θ).

Note that this result implies f*(θ) is finite. None of the conditions stated in the theorem are necessary except that the feasible set be nonempty (see Exercise 3). Concern also sometimes arises with whether a maximum is unique (x* a singleton). The convexity concepts presented in Chapter 3 are needed to study uniqueness. Sufficient conditions for uniqueness are that f is a strictly concave function of x and Γ is a convex set (see Exercise 3.7 of Chapter 3).

Fig. 1.2 illustrates continuity concepts for correspondences.

Fig. 1.2 Hemicontinuous correspondences. In panel (A), Φ is upper hemicontinuous at x ⁰ because any convergent sequence in the shaded area (i.e., in the graph of Φ ) converges to a point in the shaded area ( Φ includes the vertical boundary). But Φ is not lower hemicontinuous at x ⁰ because, for a sequence x i converging to x ⁰ from the left, there is no corresponding sequence y i in the shaded area such that y i converges to y ⁰ . In panel (B), the vertical boundary is omitted from Φ , and Φ is lower hemicontinuous at x ⁰ because y ⁰ is not in Φ ( x ⁰ ). But Φ is not upper hemicontinuous at x ⁰ because there are sequences in the shaded area that converge to ( x ⁰ , y ⁰ ), which is not in the shaded area.

Definition 1.2

, Φ : S → 2T, and x⁰ ∈ S.

1. Φ is upper hemicontinuous at x⁰ if, for every pair of sequences xi ∈ S and yi ∈ T:

2. Φ is lower hemicontinuous at x⁰ if, for every sequence xi ∈ S:

3. Φ is continuous at x⁰ if Φ is both upper and lower hemicontinuous at x⁰.

4. Φ is upper hemicontinuous, lower hemicontinuous, or continuous on S if Φ is upper hemicontinuous, lower hemicontinuous, or continuous at every x ∈ S, respectively.¹

The following three results culminate in the Maximum Theorem, which gives sufficient conditions for an optimum to respond continuously to changes in the parameter.

Theorem 1.3

Assume:

1. Γ is upper hemicontinuous at θ⁰ ∈ Θ.

2. Γ(θfor some ϵ > 0.

3. f is upper semicontinuous at (x;θ⁰) for every x ∈ Γ(θ⁰).

Then f* is upper semicontinuous at θ⁰.

Proof

Consider xi ∈ Γ(θ⁰) such that xi → x⁰. Setting θi = θ⁰ for every i and using upper hemicontinuity of Γ at θ⁰ yields x⁰ ∈ Γ(θ⁰). That is, Γ(θ⁰) is closed. This set is also bounded and nonempty, and f(x;θ⁰) is upper semicontinuous on Γ(θ⁰). Hence f*(θ⁰) is finite by Theorem 1.2.

Now suppose f* is not upper semicontinuous at θ⁰. Then there exists δ such that:

then there exists xi ∈ Γ(θi. If f*(θibecause Γ(θi) is nonempty), there exists xi ∈ Γ(θi) such that:

As Γ(θi[1, p. 205]. By upper hemicontinuity of Γ at θ⁰, x⁰ ∈ Γ(θ⁰). Hence:

Thus:

, this violates upper semicontinuity of f at (x⁰;θ⁰).

Theorem 1.4

Assume:

1. Γ is lower hemicontinuous at θ⁰ ∈ θ.

2. f is lower semicontinuous at (x;θ⁰) for every x ∈ Γ(θ⁰).

3. f*(θ⁰) is finite.²

Then f* is lower semicontinuous at θ⁰.

Proof

Fix δ that converges to θ⁰. By definition of the (finite) supremum, there exists x⁰ ∈ Γ(θ⁰) such that:

By lower hemicontinuity of Γ at θ⁰, there exists xi ∈ Γ(θi) such that xi → x⁰. By lower semicontinuity of f at (x⁰;θ⁰), we have:

By definition of the supremum, f*(θi) ≥ f(xi;θi). Hence:

Theorem 1.5

Maximum Theorem

Assume:

1. Γ is continuous at θ⁰ ∈ Θ.

2. Γ(θfor some ϵ > 0.

3. f is continuous at (x;θ⁰) for every x ∈ Γ(θ⁰).

Then f* is continuous at θ⁰ and x* is upper hemicontinuous at θ⁰.

Proof

Continuity of f* at θ⁰ follows immediately from Theorems 1.3 and 1.4 (using the argument in Theorem 1.3 to establish that f*(θ⁰) is finite).

that converges to θ⁰ and a corresponding sequence xi ∈ x*(θi(if any). Suppose x* is not upper hemicontinuous at θ⁰. That is, suppose x⁰∉x*(θ⁰). As Γ is upper hemicontinuous at θ, we have x⁰ ∈ Γ(θ⁰). Hence:

is strictly positive. As f* is lower semicontinuous at θ⁰:

That is, for i large:

As xi ∈ x*(θi), f(xi;θi) = f*(θi). Hence:

This contradicts upper semicontinuity of f at (x⁰;θ⁰).

1.2 Graphs and Continuity

Associated with any correspondence Φ : S → 2T is the set of domain/range pairs that lie in the correspondence. This set is called the graph of Φ:

The shaded areas in Fig. 1.2 are the graphs of the illustrated correspondences. When a correspondence is singleton-valued (i.e., a function), the graph is the set of pairs in the domain/range space taken on by the function. As suggested by Fig. 1.2A, when the domain and range are subsets of Euclidean spaces upper hemicontinuity is equivalent to the graph being closed.

Theorem 1.6

, and Φ : S → 2T. Then Φ is upper hemicontinuous on S if and only if grΦ ).

Proof

Consider a sequence (xi, yi) ∈ S × T that converges to (x⁰, y⁰) ∈ S × T. Assume Φ is upper hemicontinuous. If (xi, yi) ∈grΦ then yi ∈ Φ(xi), so y⁰ ∈ Φ(x⁰) by upper hemicontinuity. That is, (x⁰, y⁰) ∈grΦ, so grΦ is closed. Conversely, assume grΦ is closed. If yi ∈ Φ(xi) then (xi, yi) ∈grΦ, so (x⁰, y⁰) ∈grΦ because grΦ is closed. That is, y⁰ ∈ Φ(x⁰), so Φ is upper hemicontinuous.

When a function is real-valued there are two additional sets associated with the function that are sometimes useful in economic models. These are the epigraph of the function, consisting of the pairs in the domain/range space that lie on or above the function, and the hypograph of the function, consisting of the pairs in the domain/range space that lie on or below the function.

Definition 1.3

. The epigraph and hypograph of ϕ are, respectively:

Fig. 1.3 illustrates these concepts for the function in Fig. 1.1A. As suggested by the figure, upper (lower) semicontinuity of a function is equivalent to its hypograph (epigraph) being closed.

Fig. 1.3 Epigraph and hypograph. The shaded area in panel (A) is the epigraph of ϕ ; the shaded area in panel (B) is the hypograph of ϕ . Note that the vertical boundary is part of the hypograph but not part of the epigraph.

Theorem 1.7

. ϕ is upper (lower) semicontinuous on S if and only if hypϕ (epiϕ).

Proof

Fix x⁰ ∈ S and assume first that ϕ is upper semicontinuous at x⁰. Consider any δ > 0 and any sequence (xi, yi) → (x⁰, y⁰) with (xi, yi) ∈hypϕ. By upper semicontinuity:

And yi ≤ ϕ(xi), so:

to obtain y⁰ ≤ ϕ(x⁰) + δ. Then let δ ↓ 0 to obtain y⁰ ≤ ϕ(x⁰). That is, (x⁰, y⁰) ∈hypϕ(y⁰), so hypϕ is closed.

Conversely, assume hypϕ is closed. If ϕ is not upper semicontinuous at x⁰ then there exists a sequence xi → x⁰ in S and a δ > 0 with the property: to each i there corresponds ki ≥ i for every iis a subsequence of xi, and therefore converges to x⁰. hypϕ closed therefore yields (x⁰, ϕ(x⁰) + δ) ∈hypϕ. But this means ϕ(x⁰) ≥ ϕ(x⁰) + δ, a contradiction.

It is straightforward to mimic this proof to show that ϕ is lower semicontinuous if and only if epiϕ is closed.

If y is fixed and a slice of the epigraph is taken consisting of the x-values for that fixed y, the result is the lower contour set of the function at y:

Similarly, a slice of the hypograph for fixed y is called the upper contour set of ϕ at y:

The lower (upper) contour set at y is empty if ϕ is everywhere above (below) y; and is the entire domain S if ϕ is everywhere below (above) or equal to y. Varying y in these definitions yields correspondences that relate a value in the range of the function to the set of domain points at which the function is either below or above that value, respectively. We might aptly call these the lower and upper contour correspondences and their range is 2S. It is plain from the definitions that the graph of Vϕ is the hypograph of ϕ and the graph of Lϕ is the epigraph of ϕ. Combining Theorems 1.6 and 1.7 therefore yields relationships between semicontinuity of a function and hemicontinuity of its contour correspondences.

Theorem 1.8

. ϕ is upper (lower) semicontinuous on S if and only if Vϕ (Lϕ.

If a correspondence with domain and range that are subsets of Euclidean spaces is singleton-valued then there are relationships between hemicontinuity of the correspondence and continuity of the implied function.

Theorem 1.9

, and Φ : S → 2T is singleton-valued on S. Denote the unique value at x ∈ S by ϕ(x) (i.e., Φ(x) = {ϕ(x)}). Let x⁰ ∈ S.

1. If Φ is upper hemicontinuous at x⁰ and uniformly bounded in a neighborhood of x⁰ then ϕ is continuous at x⁰.

2. If Φ is lower hemicontinuous at x⁰ then ϕ is continuous at x⁰.

3. If ϕ is continuous at x⁰ then Φ is both upper and lower hemicontinuous at x⁰.

Proof

Let xi be an arbitrary sequence in S that converges to x⁰.

. Both of these sequences are contained in grϕ and, by Theorem 1.6, upper hemicontinuity implies grϕ are both elements of grΦ. As ϕ(x⁰) is the only element of Φ(x. Hence ϕ(xi) → ϕ(x⁰).

2. ϕ(x⁰) ∈ Φ(x⁰), so by lower hemicontinuity of Φ there exists yi ∈ Φ(xi) such that yi → ϕ(x⁰). As ϕ(xi) is the only element of Φ(xi), yi = ϕ(xi). Therefore ϕ(xi) → ϕ(x⁰).

3. First consider lower hemicontinuity of Φ by selecting y⁰ ∈ Φ(x⁰). As ϕ(x⁰) is the only element of Φ(x⁰), y⁰ = ϕ(x⁰). The sequence yi = ϕ(xi) has the required properties: yi ∈ Φ(xi) and yi → y⁰. Now consider upper hemicontinuity of Φ by selecting yi ∈ Φ(xi) such that yi → y⁰. As ϕ(xi) is the only element of Φ(xi), yi = ϕ(xi). Therefore y⁰ = ϕ(x⁰) by uniqueness of limits. Hence y⁰ ∈ Φ(x⁰).

1.3 Definite and Semidefinite Matrices

Necessary and sufficient calculus conditions for a maximum involve the matrix of second derivatives of the objective. Before stating these conditions in the next section we must first establish some properties of definite and semidefinite matrices.

Definition 1.4

A real symmetric n × n matrix A is called negative (positive) definite when t⊥At .³ If the defining inequality is weak then A is called negative (positive) semidefinite.

Semidefiniteness or definiteness of a matrix has implications for its entries. For example, choosing t in Definition 1.4 to be the unit vector in direction i reveals that negative semidefiniteness implies the i. Similarly, the diagonal elements of a positive semidefinite matrix are nonnegative, and the diagonal elements of a negative (positive) definite matrix are negative (positive).

be an index set of the rows and columns of the matrix A in Definition 1.4 (J≠∅), and denote by A(J) the submatrix of A obtained by retaining the rows and columns indicated by J and discarding all other rows and columns. A(J) is called a principal submatrix of A, meaning that it is obtained from A be discarding the same rows and columns. We use #J to denote the number of elements in J (number of rows and columns in A(J)), called the order of the principal submatrix. The determinant |A(J)| is called a principal minor of A. The n (of course, An = A).

Theorem 1.10

Assume A is an n × n real symmetric matrix. If A is negative (semi) definite then (−1)#J|A(J. If A is positive (semi) definite then |A(J.

Proof

We prove the result for A negative semidefinite. The other cases are proven analogously.

Because A is real and symmetric, there exists an n × n real matrix U such that U⊥U = In and A = U⊥ΛU, where Λ of A on the diagonal [2, p. 213]. Let t be column i of U⊥. Then Ut is the unit vector in direction i, so:

This is nonpositive because A is negative semidefinite. That is, the eigenvalues of a symmetric real negative semidefinite matrix are nonpositive. Using standard properties of determinants:

Therefore |A| is either zero or has sign (−1)n.

Now consider an arbitrary principal submatrix A(J), denote by t(J) the vector obtained from t by retaining the rows indicated by J and discarding all others, and consider a vector t consisting of zeros except for the t(J) part. Then t⊥At =t( J)⊥A( J)t( J) ≤ 0 for every nonzero t (i.e., for every nonzero t( J)). Hence A(J) is negative semidefinite. That is, every principal submatrix of a negative semidefinite matrix is negative semidefinite. And A(J) is real and symmetric. Applying the result above about determinants of symmetric real negative semidefinite matrices to A(J) yields (−1)#J |A( J)|≥ 0.

Sometimes it is useful to have a converse to Theorem 1.10. For definite matrices, only the leading principal minors are needed.

Theorem 1.11

Assume A is an n × n real symmetric matrix. If (−1)i|Aithen A is negative definite. If |Aithen A is positive definite.

Proof

of A are nonzero. d1 = a11 = |A1|, which is assumed to be either negative or positive, depending on which case we are studying. d2 is in the (2, 2) position following an elementary row operation, using the first row, that converts a21 to zero. Performing this same row operation on A2 converts the second row of A2 to (0 d2). Elementary row operations do not change the determinant; whence d2≠0 because |A2| > 0. Continuing in this manner shows that all n pivots are nonzero. This means Gaussian elimination factors A as A = LDU, where L is lower unit triangular, U is upper unit triangular, and D on the diagonal [2, pp. 21–23]. Moreover, U = L⊥ because A is symmetric [2, p. 38], so we have A = LDL⊥. Therefore, for any nonzero vector t:

Hence we must show that the pivots of A are all negative (positive) when (−1)i|Ai| > 0 (|Ai.

The signs of the pivots are obtained from the factorization as follows. Partition A as:

and partition L and D conformably:

, so standard properties of determinants yield:

Therefore:

If the principal minors are assumed to alternate in sign, this shows every pivot of A is negative; if the principal minors are assumed to all be positive, this shows every pivot of A is positive.

Combining Theorems 1.11 and 1.10 shows that, if the leading principal minors of a real symmetric matrix follow one of the sign patterns for definiteness, then all of the principal minors follow that sign pattern.

Unfortunately, semidefiniteness cannot be determined by examining only leading principal minors. For example, the leading principal minors of:

are both nonnegative but this matrix is not positive semidefinite. In general, all of the principal minors must be examined to determine whether a matrix is semidefinite. We establish this by first proving a theorem with broader applicability that relies on existence of a definite submatrix. Sufficiency of a sign pattern on all principal minors for semidefiniteness is then an easy corollary.

Theorem 1.12

Assume A satisfying:

is negative (positive) definite.

2. No higher order principal submatrix is negative (positive) definite.

3. Every principal submatrix A(Jsatisfies (−1)#J|A(J)|≥ 0 (|A(J)|≥ 0).

Then A is negative (positive) semidefinite.

Proof

We prove the result for A positive semidefinite first.

then A excludes some rows and (the same) columns. Let P be a permutation matrix that, when symmetrically applied to Aa leading principal submatrix:

Consider an arbitrary column bi from B and the corresponding diagonal element cii from Cfrom item 1 (Theorem 1.10) and the standard formula for the determinant of a partitioned matrix ([3, pp. 137–138]) yields:

means a and b have the same sign). If this is positive then the submatrix under consideration is positive definite (. Now consider any two columns from B and the corresponding 2 × 2 submatrix from C:

for every i, j (including i = j.

exists as a unique positive definite square symmetric real matrix ([and note that:

Therefore, for any t≠0:

.

and A by − Ais positive definite, (2) no higher order principal submatrix of − A is positive definite, and (3) |− A(J)| = (−1)#J|A(J)|≥ 0 for every principal submatrix of − A . The conclusion is − A is positive semidefinite, or A is negative semidefinite.

Corollary