QARSAM ILYAS ROLL NO 7

TOPIC LAGRANGE MULTIPLIER BRIEF INTRODUCTION, EXAMPLE AND ECONOMIC APPLICATION

INTRODUCTION
"What

could be more fundamental to economic theory

than the idea of constrained optimisation? Even the most elementary definitions of economics are based on solving problems of scarcity and choice - on satisfying unlimited wants with limited resources. The Lagrange technique provides a tool for solving such problems"

WHAT ARE LAGRANGE MULTIPLIERS ..........

Constraints are used in the formation of a Lagrangian Equation, an equation used to maximize some objective given constraints. In the Lagrangian function, the constraints are multiplied by the variable , which is called the Lagrangian multiplier.

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.

WHAT ARE LAGRANGE MULTIPLIERS.........

Lagrange

!"#$%"$er& are a

e#'() !&e) *(r

!"#$+ar$a,"e -a"-!"!&.

I# -( ,$ne& #'e !&e (* Der$+a#$+e& an) #'e #e-'n$.!e& !&e) #( &("+e L$near Pr(gra $ng

- /!&# a n! ,er

DIAGRAMMATICALLY

LAGRANGE THEORM
F

The values of x*, y* and * which maximise the function L(x,y,) will necessarily provide the solution x*,y* which maximises f(x,y) subject to g(x,y) = c. Let f and g satisfy Lagranges Theorem, and f will have a minimum or maximum subject to the constraint g(x,y)=c. To find the minimum or maximum of f while satisfying the constraint.

Solving x(x,y)=gx(x,y) fy(x,y)=gy(x,y) f (x,y)= the objective function g(x,y)=constraint

THE SIGNIFICANCE OF LAGRANGE MULTILIER

T'$& -an ,e e0#en)e) #( -(n#ra$n#&. (re #'an 1 +ar$a,"e& an)

C(n&#a$n# -an ,e &("+e) 2$#'(!# a&&$g$n$ng n! er$-a" +a"!e #( 3. = dM \dK = change in M resulting from a 1-unit increase in k

EXAMPLE.......
GO4ERNMENT USES TAXES AS LAGRANGE MULTIPLIER f(x) be the total net effect on the population's happiness. total gas consumption g(x) Constraint g(x)=c

CONTINOUED........
Tax is of $20\Gallon f(x) + (-20) g(x) By adjusting the size of the tax (the Lagrange multiplier), the government can indirectly adjust total consumption g(x) until it is at the desired level, g(x)=c

LAGRANGE MULTIPLIER IN ECONOMETRICS

It was first used in econometrics by R. P . Byron in 1968 and 1970 in two articles T. S. Breusch and A. R. Pagan published in 1980 an influential exposition of applications of the LM test to model specification in econometrics.

CONTINOUED...........
To perform an LM test only estimation of the parameters subject to the restrictions is required. The LM testing principle has found wide applicability to many problems of interest in econometrics.

LM TEST FOR SERIAL CORRELATION

The test belongs to the class of asymptotic (large sample) tests known as Lagrange multiplier (LM) tests. Unlike the Durbin-Watson statistic for AR(1) errors, the LM test may be used to test for higher order and is applicable whether or not there are lagged dependent variables.

LM TEST
Yt = 1 + 2 X2t + 3 X3t + t .......... (1) and we suspect a second order autoregressive scheme: t = 1 t-1 + 2 t-2 + t .............. (2) Then the mode cou d !e written as: Yt = 1 + 2 X2t + 3 X3t + 1 t-1 + 2 t-2 + t .............. (3)

LM TEST
I* 2e e&#$ a#e) #'e e.!a#$(n a&, Y# 5 6 7 1 X1# 7 8 X8# 7 # ........... 9:; 1 +ar$a,"e 2$#' ' )egree& (* *ree)( 9SSRR = SSRU ; 1' ?1R nR1 5 TR1 a&< ............... 9>;

LM TEST STATISTICS
E&#$ a#e #'e restricted e.!a#$(n an) re#a$n #'e re&$)!a"& 9e#;< 1. U&e #'e re&$)!a"& 9e#; a& #'e )e%en)en# +ar$a,"e *(r #'e unrestricted regre&&$(n $n an auxiliary regression@ e# 5 6 7 1 X1# 7 8 X8# 7 6 e#=6 7 1 e#=1 8. TaAe TR1 an) -( %are $# 2$#' #'e re"e+an# -r$#$-a" +a"!e *(r 1 2'ere #'e )egree& (* *ree)( , ', $& #'e (r)er (* #'e a!#(regre&&$+e &-'e e. The null hypothesis of the test is, Ho: no autocorrelation. We reject the null hypothesis if TR2 > 2h critical value.

CONCLUSION
When solving constraint extrema problems in economics the bulk of constraint conditions may be expressed explicitly, so the reason to use the Lagrange multipliers method would seem to be too sophisticated regardless of its theoretical aspects. With a view to the crucial importance of the economic interpretations of Lagrange multipliers is the use of the method primarily preferred. Concrete applications of the presented interpretation principle may be developed inmany economic processes.