The Lagrangian Method in Economics

History

The Lagrangian method (also known as Lagrange multipliers) is named for Joseph Louis Lagrange (1736-1813), an Italian-born mathematician. His Lagrange multipliers have applications in a variety of fields, including physics, astronomy and economics.

Significance

A key theory in Neoclassical economics, the basis of most mainstream economic thought, is that consumers and businesses are rational actors who strive to maximize their utility. On the consumer side, this means obtaining the highest level of satisfaction from goods and services that a given consumer values highly. For businesses, maximum utility means maximizing profit. Economists recognize that individuals and firms have unlimited wants, but only finite resources for satisfying those wants. Consumers have limited income for buying the goods and services they desire, and firms have only limited land, labor and capital for producing their products. These limited resources, then, present constraints. The challenge, then, is how to achieve maximum satisfaction or profit within given constraints. Another challenge for firms is that of minimizing production costs while still meeting expected levels of output. The Lagrangian method provides a way to quantitatively resolve these issues, which some economists refer to as matters of constrained optimization.

Function

The Lagrangian method applies differential calculus, involving the calculation of partial derivatives, to issues of constrained optimization. The owner of a business, for example, can use this technique to maximize profit or minimize costs given that the business has only a certain amount of money to invest. A hypothetical consumer, who, for example, derives utility from collecting books and CDs, could use this method to determine how to obtain the optimal number of books and CDs, given that he or she has only $100 of disposable income to spend.

Identification

The Lagrange multiplier, represented in the equation by the lowercase Greek letter lambda (), represents the rate of change in utility relative to the change in the budget constraint. In economics, this is known as the marginal value or marginal utility, the increase in utility gained from an increase in the budget constraint.

Effects

Based on the results of a Lagrangian analysis, an individual or firm has an empirical basis for making decisions on continued utility maximization within changes to the external constraints. A price increase for a favorite good, for example, may lead a consumer to purchase a lower quantity of that item or to work more hours to earn more income to afford the higher price.

How is Calculus Used in Economics?

Although introductory economics courses, such as those most college students must complete in the course of their studies, involve little math, an in-depth study of economics requires a rigorous understanding of mathematics, including calculus. Calculus provides the language of economics and the means by which economists solve problems. Calculus is especially significant in illustrating what a leading economist calls a key principle of economics

Identification

As an advanced branch of mathematics, calculus focuses heavily on functions and derivatives. Functions examine the relationship between two or more variables, or entities that take on different values. Mathematicians and economists often use letters, such as X and Y, to symbolize particular variables. If the value of Y changes as the value of X changes, then the two variables have a functional relationship. Derivatives, meanwhile, consider the rate of change in one variable relative to the change in another. Functions and derivatives relate to relevant concepts in economics.

Function

Economic research often uses calculus to examine functional relationships. An example includes the relationship between the dependent variable income and various predictors, or independent variables, such as education and experience. If average income rises as years of education and work experience increase, then a positive relationship exists between the variables, namely that income is a function of education and experience. Differential calculus, the process of obtaining derivatives, enables economists to measure the average change in income relative to a single year's increase in education and/or experience.

Effects

Derivatives in calculus, or the change in one variable relative to the change in another, are identical to the economic concepts of marginalism, which examines the change in an outcome that results from a single-unit increase in another variable. Marginal changes relate to an important principle in economics: the notion that people tend to think at the margin, according to Harvard economist Greg Mankiw, author of "Principles of Economics," a popular textbook in college economics courses. Mankiw writes that economists use the term "marginal changes" to describe small, incremental changes, such as incremental changes in work hours or factory output.

Benefits

Calculus, by determining marginal revenues and costs, can help business managers maximize their profits and measure the rate of increase in profit that results from each

increase in production. As long as marginal revenue exceeds marginal cost, the firm increases its profits.

Significance

The amount of interest to be paid on a loan, whether for a home, motor vehicle or capital equipment for a business, is an important consideration for households and firms. Calculus provides a means for determining the amount of interest paid over the life of a loan.