Avery and Miller Applied Microeconomic Theory: Chapter 2 ver: March 2014

2.9.1 The Envelope Theorem

(())
The result that = can also be derived using a general result called the Evelope The-
orem. The envelope theorem is useful when you are interested in how the optimized
value of the objective function of an optimization problem changes as you change an
(())
exogenous variable. For example, the previous derivation, where we analyze is such
a case. In principle, determining how the optimized value of the objective function changes as
you change an exogenous variable can be quite complicated because the exogenous variable might
aect both the objective function and one or more of the constraints, and the optimal values of
the endogenous variables will change as the exogenous variable is changed as well. Consider the
following maximization problem:

max ( ) (2.16)

( ) 0, = 1

where is a vector of endogenous variables, is an exogenous variable, and ( ) 0 is one of

constraints. Suppose we write down the Lagrangian for this problem,

X
= ( ) ( ( )) , (2.17)
=1

where represent the Lagrange multipliers for the problem. Let () denote the solution to
the problem as a function of . That is, for any choice of , () represents the choices of that
maximize ( ) subject to the constraints. Due to the fact that = (0 ) is optimal when
= 0 , you might imagine that is almost optimal for s near 0 , and that there would be little
improvement from choosing () instead of when is close to 0 . This is, in fact, true, and it
is what drives the envelope theorem, which essentially says that we can ignore the dependence of
() on when computing the impact on the objective function of changing .

Theorem 10 The Envelope Theorem: Consider a constrained optimization problem like (2.16)
with Lagrangian (2.17).

( ) ( ) X ( )
= | = | .

=1
That is, the total derivative of the optimized value of the objective function with respect to an
exogenous variable is equal to the partial derivative of the Lagrangian evaluated at the optimal
solution to the optimization problem.

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Avery and Miller Applied Microeconomic Theory: Chapter 2 ver: March 2014

Proof. The proof of the envelope theorem mimics the derivation from the previous section.
We provide a proof for the case where there is a single constraint and that constraint binds. It
makes use of two facts: the optimality of () and the fact that the constraint holds as an identity.
()
The first-order condition for the optimization problem implies that = ()
. Note these

are partial derivatives with respect to , not . If the constraint holds as an identity, we have
P (()) ()
( () ) 0. Dierentiating this with respect to yields: = . Begin

with ( () ), and totally dierentiate this with respect to :

( () ) X ( () ) ( () )
= +

X
( ) ( () )
= +

X ( ) ( () )
= +

( () ) ( )
=

This completes the proof. Note how the steps of using the first order condition and then the
dierentiated form of the constraint mirror the steps above. This proof technique arises in a
number of circumstances.

To get a sense of the intuition underlying the Envelope Theorem, consider Figure 2.15, which
is a stylized representation of the impact on a firms cost of increasing the cost of labor. At wage
rate 0 , the firms cost as a function of labor is ( 0 ), and the firm minimizes cost by choosing
labor quantity 0 . When the cost of labor increases to 00 , we expect there to be two eects. First,
the cost of the labor the firm is already using increases. This is represented by the upward shift
in the curve from ( 0 ) to ( 00 ). Second, we expect the firm to use less labor, since it has
become more expensive relative to other inputs. This is represented by the movement in the point
that minimizes cost leftward from 0 to 00 .
What can we say about the relative size of these two eects? If the firm continued to use the
same amount of labor after the wage increase, its cost would shift upward by (00 0 ) 0 , i.e., in
proportion to the size of the wage change. On the other hand, if the firm reduces its labor use
from 0 to 00 , its savings is roughly proportional to the slope of the cost curve times the change in
, (0 00 ) (00 0 ). The envelope theorem says that, since the firm chose labor in order to set
the derivative of the cost function equal to zero initially, (0 00 ) is likely to be very small, and
so the additional savings from changing is going to be negligible relative to the direct impact of

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Avery and Miller Applied Microeconomic Theory: Chapter 2 ver: March 2014

Figure 2.15: The Envelope Theorem

the wage increase on the cost of labor. The derivation of the envelope theorem just restates this
point using derivative.29
Using the envelope theorem,
( ( )) = can be proved easily. The Lagrangian for the
UMP is:
= () ( ) ,

and so the envelope theorem states:

( ( ))
= | = .

Application of the Envelope Theorem is so simple that the chief challenge is in figuring out
when you are facing a problem to which it can be applied. Here, the key thing to keep in mind
is that the envelope theorem is useful when you are interested in how the optimized
value of the objective function of an optimization problem changes as you change an
exogenous variable.
29
The term envelope theorem derives from application of this idea to the dierence between short-run cost
curves, where some factors are fixed, and long-run cost curves, where all factors are variable. If all factors are chosen
optimally to begin with, then the change in short-run average cost from increasing output is the same as the change
in long-run average cost, since the additional indirect savings from adjusting the factors that are fixed in the short
run is small. Thus, the long-run average cost curve is the lower envelope of the short-run average cost curves.

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