CHAPTER

3
TRANSVERSALITY
CONDITI
ONS FOR VARIABLEENDP
OINT PROBLEMS
The Euler

calculus

equation-the

equation

differential
For

problems

two

given

But

to

the

if

to discretionary
be missing.
dynamic
externally

choice

definitize

initial

or

Such

will

monopolist
imposed

as an

and

be
of

in the

second-order

two arbi-trary

initial

terminal

constants.
points,

the

conditions

provide

sufficient

two

arbitrary

constants.

the

terminal

choice),

condition

normally

containing

with fixed

boundary

information

necessary

basic

varia-tions-is

of

then
the

point

is

variable

(subject

a boundary condition
case, for instance, if

the preceding

price at time

T and

chapter

can treat

integral part of the optimization

faces

will
the

no

the PT

problem.

In

case,

that

longer

be

the boundary

condition

P(T)

available,

the

must

transversality

condition.

the transversality
of variable

and

In this chapter

conditions

we

PT will
filled

by

no
a

shall develop

to various

appropriate

types

For expository

TRANSVERSALITY

we

convenience,

the terminal point is variable.

that, the technique
variable

=
be

termi-nal points.

THE GENERAL
CONDITION

3.1

void

shall
Once

is easily extended

assume that only

we learn to deal with
to the case of a

initial point.

The Variable-Terminal-Point

Problem Our new

objective is to

Maximize

Yy]

or

minimize

/*~(t,y, yf) dt (3.1)

subject to

=A

y(0)

(A given)

~)= Y T

and

Y(

This differs

from the previous

that the terminal

"free"

in the

optimal
although

time

sense that
process.

choice

version

and terminal

they have
It

is

to

be

~~f r

the problem

state

become

T is free, only positive values

to the problem.

of

(T

y,

a part

understood
of

are

in

are now
of

the
that

relevant

the
necessary
conditions
for
an
we shall, as before, employ a perturbing curve
p(t), and use the variable
E
to generate neighboring
paths for comparison with the extremal. First, suppose
that T * is the known optimal terminal time. Then any
value of T in the immediate neighborhood
of T* can be
expressed as
To

develop

extremal,

where

represents

an

represents

arbitrarily

small

number,

in T. Note that since T* is known and AT is

magnitude,

can

and

AT

chosen (and fixed) small change

as a

be considered

function

prechosen
of

with derivative

E T(E)

7 rn

The

perturbing

same E
curve

the extremal

is used in conjunction

p(t) to generate

although

condition

p(0)

to

pass

condition-p(t)

paths of

y*(t):

However,
paths

with the

neighboring

the

0 [see

through
I

p(t)

curve must

(2.2)1
the

0-should

to force

fixed initial

now

still satisfy
the

point,

be dropped,

the

neighboring
the other

because

y,

is free. By

get

substituting

(3.4) into the functional

to

V(E) akin

function

(2.121,

(3.2),

the

upper

the V function will also

vary

with

function

of

by

but

limit

V[y],

since

of

integration

we
a
in

E:

~(c=

(3.5)

kT'"~[t, y*(t)

+ rp(t), y*'(t) + rpf(t)]

dt

~'(t

Y(t>

Our problem

to

is

is to optimize

this V function with respect

E.

definite

integral (3.5) falls into the general form of (2.10).

The V/d~is therefore,

by (2.111,

on
right

closely

resembles

of the rocess

the

one

encountered

of the Euler equation.

arlier development

leading

the

in (2.13)

In fact, much

to (2.17) still applies here, with

one

exception.
[Fyrp(t)];f in (2.16) does not vanish

value [Fy,p(t)],=,
p(T)

[F,,],=,p(T),

[ [
p(t)

Fy

in the present

since

we

- -F'!

dt

also write
Second term in (3.6)

problem,

have assumed

that

to the earlier result in (2.171,

0. With this amendment

term in (3.6)

can

[Fit=, AT

[FY*],=,p(T

these

into (3.6), and setting

dV/ d

~=

0,

we

obtain

the

new

p(t)[Fy

- :FYr]

three terms

its

own

curve)

on

dt

[Ff]t=T~(T)

the left-hand

arbitrary

element:

side of (3.71, each contains

p(t) (the entire

in the (T) (the terminal value

curve) in the second

[F]~=T
IT= 0

arbitrarily

on

chosen

perturbing

the perturbing
change

in T) in

we cannot offsetting or cancellation

terms. Consequently, in order tocondition (3.7), each
the three terms must individually be set o
the third. Thus

of
of

Step ii

To

AyT-the
be

in

convenience.
initial

heights

the

done

represents
AZ
path

same

at t

perturbing

can

first

resulting

in
the

and

help

neighboring

Note

that

point

because

y,,

T because

curve.'

The

set

ZZ',

measures

from the perturbation.

also be altered

by

AZ'

the amount

This

curve

by perturbing

to

curves

the

one

for

share

the

0, they have different

p(T) # 0 by construction
magnitude

and

principal

problem.

equal

the two

p(0)

AT

of

two

3.1. The

of Fig.

while

the arbitrary

the

path obtained

~p(t ),
with

by

get rid of

it into terms

variable-terminal-point

with

the vertical distance

y,

we

end,

changes

variables

can

this

p(T) by transforming

quantity

3.1
3.1

FIGURE
FIGURE

of

p(T),

the direct

But

the
by

change

in

inasmuch

EAT (= AT

of

shown

as

since

>

11, the AZ' curve should, if AT

0, be extended out to
2".2 As a result, yT is further pushed up by the vertical
distance

between

Z ' and 2". For

small AT, this second

change

y, can

in

be approximated

the total change in

Rearranging

terms

allows

y'(T) AT. Hence,

by

Z to point

from point

this relation

Z" is

us to express

p(T) in

and

AyT

of

y,

AT:3

'~echnically,

be

labeled

the

because

justifiable

to-(3.9)-is
practice,

we are

portion

the

the

initially

result

the

that

condition,

path

3.1 should

in Fig.

simplicity.

discussion

This

is

as
anyway.

which,

the *)

is

leading
standard

only in the solid portion of the AZ

should

extension

axis

for

this

T (without

interested

for that

as an

horizontal

omitting

in terms of

path, the equation

broken

are

transversality

is stated

'~lthough

on

point

T*. We

enable

us

to plot

also

the

The perturbing

curve

is then

is not set equal to

one as

in Fig.

AZ.

of

applied to the extended version of AZ.

~hresult
e

even

in (3.8) is valid

if

3.1.

Step iii

Using (3.8) to eliminate

dropping the first term in (3.7),

desired general transversality

This

condition,

only to

one

unlike

point

of the missing

of

the

p(T) in (3.7), and

we

finally arrive at the

condition

Euler

equation,

is

relevant

time, T Its role is to take the place

terminal

condition

in the present

problem.

Depending

or curve,
written

on

the exact

however,

in various

of the terminal

specification

the

general

specialized

(3.9)

condition

line

can

be

forms.

SPECIALIZED TRANSVERSALITY
CONDITIONS

3.2

In

this

we

section

terminal

points:

terminal

line,

consider

vertical

types

five

terminal

curve,

terminal

terminal line, and truncated

variable

of

line,

horizontal

truncated

horizontal

vertical

terminal

line.

Vertical Terminal Line

(Fixed-Time-Horizon Problem)
The

vertical-terminal-line

1.5a, involves

term

can

fixed

either

This

gives

case, as

rise

which is sometimes

for

AT

Thus

since

sure

illustrated

referred

to

condition

Horizontal Terminal Line

(Fixed-Endpoint Problem)

as

Fig.
first

is arbitrary

and

make

is to have

to the transversality

in
the

0, and

Ay,

way to

sign, the only

term in (3.9) vanish

T

out. But

in (3.9 )drops

take

the second

Fy r= 0 at

condition

the natural boundary

For

the

Fig. 1.5b

Ay,

the situa-tion is exactly

0 but

AT

is arbitrary.

drops

is arbitrary,

the only

sure

way to

Thus the transversality

might

,,

to

useful

y')

as a

capital stock, and y'

entails

current

so as to

build

future profit. Hence

profit

capital

stock

decision-say,
yl,--will

result

up

y, a

busines

tradeoff

any

between

is y',;

if

on

F(t,

y, y',).

rate

As to the

future profits,

we can convert

that into

add it to the current

(current

as

well

as

profi

future

decision. The

a unit of
means that

value to the firm of

by the derivative

time t, with

of capital. The rate of

of the investment

(or shadow)

is measured

resource

taking

profi

decision

measure, then we can

F(t, y, y',) to see the overall
imputed

y
net

investmen

specific

enters through the intermediary

implication

us

let

where

to select the investment

decision

value

economic

ideas,

capital which will enhance

there exists

effect of the investment

profit

an

function

profit-making

in the current

capital accumulation

zero

represents

current profit and future profit. At

given

. ,

give

represents

the

term vanish
equal to

condition is

be

in
have

term in (3.9

expression

F(t

operation,

we now

make the first

interpret

from

illustrated

to (3.10 ) and (3.11) To f ix

interpretation

away

as

So the second

is to have the bracketed

It

reversed;

out, but the first does not. Since AT

automatically
for

case

horizontal-terminal-line

Fy,.This

capita
if

we

decide to leave (not

use

up)

unit of capital at the

terminal time

it will entail

negative

equal to

value

measure

of y',

decision

to choose the investment

is -y',

Fyto.
Accordingly,

-Fyg.Thus, at t

the overall profit

rate y',

T, the value

implication

is F(t, y, y',)

of the

yb Fyg.The gen

for this is F - y'Fy,, as in (3.11).

we can interpret the transversality condition (3.11) to mean
problem with a free terminal time, the firm should

eral expression
Now

in

select

(current

and

T,

future)

opportunities

profit

advantage
addition,
[

T such that
will, at t

capital

decision to invest

no

In other

profit.

should

have

of by the optimally

can

(3.10)-which

-FY,],=, = O-instructs
capital.

problem,

chosen

to maximize

in order

terminal time. In

by leaving

all the

fully taken

be writ-ten

any

the firm to avoid

In other words, in

overal

words,

equivalently

of profit that will be incurred

terminal

been

and accumulate

any

longer yield

ever

as

sacrifice

positive

free-terminal-state
in the interva

profit

[0, T ] but not beyond, the firm should, at time T, us

the capital it

that

up

all

accumulated.

Terminal Curve
With

terminal

1.5c, neither
neither

term

arbitrary

AyT

curve

nor

yT

AT

in (3.9)

= +(T),as
is

drops

AT, the terminal

So it is possible to eliminate

illustrated

assigned

a zero

value,

out. However, for

curve
Ay,

implies

that

in Fig.

Ay,

q S=AT.

in (3.9) and combine the

two terms into the form

[F -y1FYp
Since AT

is arbitrary,

F,vqS]t-TAT

we can

so

small

deduce the transversality

condition

two

cases,

which

in the terminal

point

(either

Unlike

unknown

the

last

involve

y,

or

single

TI, the

y,
purpose.
The transversality condition (3.12) only provides one; the
other is supplied by the equation y, = +(T 1.
case

terminal-curve

Truncated

Vertical

The usual

case

specidixes

(3.9) to

When

are

level

of

types of
the

is truncated-restricted

by

restriction

in that event the

basic

there

are

values

both

take

ymi nis

= 0,

the terminal

a minimum permissible
y-the
optimal solution can have two possible
outcome: y,* > ymi nor y,* = ymin If y,* > ymin

is, it is nonbinding.

can

for this

Terminal Line

yT 2 ymi where

terminal

The

to determine both

needed

of vertical terminal line, with AT

the line

condition

us

requires

and T. Thus two relations

reason

either

automatically

satisfied;

Thus, the transversality

same as

for

admissible
above

is

and

is

(3.10):

this

is

that,

neighboring
below

sign.

that

condition

y,*,

under

paths

so

Therefore,

this

outcome,

with

terminal

that Ay,

the

= y, - yT*

only

way

to

only
2

y,*

admits

paths

means

arbitrary

that
E

condition

in

p(T )

dV / d

inequality

as

maximization

in

has

the

but

the

Fig

3.1)

that

its

curve

have

0 would

transversality

in the

first-order

changed

to

conditions.*

type

of

For

an
a

inequality

is

= T A ~~0

0, (3.15) implies condition

(3.14)

for~,*=~,

and (3.16),

we may

summary statement of the

a maximization problem

condition

for

(3.17)

[F~)],=,
5 0

YT* 2

write

the

transversality

Ymi

- ~rnln)[~Y']t=T=
[for maximization

to be

to

The nonnegativity

be

[Fy,]t=TsO

following

y,

completely

restricted

the

roots

hand,

values

should become

(3.16)
Combining

is

3.1 Ay,

in Fig

Kuhn-Tucker

problem

longer

perturbing

[F y l
]t

And since Ay,

the other

terminal

no

is

must

O-

(3.15)

(YT*

as

= 1 in
means

~
=

for, and (3.13

Ay,

the

(3 .13)-which

condition

called

>

(E

turn

on

with

negative)

Assuming

terminal value

mean

that

or

(positive

nonnegative.

,
,
.
,
.
.
,
,

neigh-boring

This

= y,,,,

The other outcome,

y,*.

of

Fy,= 0 at t

(3.13) is to have

satisfy

~oan
r

Chiang,

explanation
Fundamenta

of

of the Kuhn-Tucker
conditions, see Alpha C
Methods of Mathematical Economzcs, 3d ed

McGraw-Hill, New York, 1984, See. 21.2

If the problem

is instead

to minimize

sign in (3.15) must be reversed,

inequality

transversality

condition becomes

(3.17')

[FY*]t=T
2 0

YT*

V, then the
and the

2Ymin

-~rnin)[Fy#]~=
=0

(YT*

[for minimization
The tripartite

complicated,

on

below

hand,

then

range,

permissible

we

with

set

just

maximum
deadline.
similar

discussed.
following

y,*

[F,,],,,

yT* 2 ymin

solved. If y,*

y,

optimal

condition

= y,,,

Horizontal
terminal

permissible
The

to

and

the

the [Fy#1,=,

value. If

<

lies

fails to reach

treating

in

)or

(3.17

as

the problem

fixed terminal point Cl", ymin

horizontal

restriction

yT*

terminal line. So, in order to satisfy

the truncated

Truncated
The

we can try

is satisfied, and the problem

other

complementary-slackness

(3.17')

one

restriction

the

the

zero on
the

seem

in (3.14) first, and check the resulting

then the terminal

y,,,

(3.17 )or (3.17' )may

but its

is not. In practical problem solving,

application
condition

condition

V]

of

analysis

the

By

Terminal Line
line

time
of

truncated

analogous

transversality

may

be

for

by

the

represents

completing

such
vertical

reasoning,
condition

truncated

T,,

where

situation
terminal

we
for

task-a

is

very

line

gust

can derive the

a maximization

prob-lem:

[F

(3.18)

(T

maximization

T,,)

V, the first

,,

- Y 'F ~~]I~0
[F- ytFY.],=, = 0

- T,,)

to

inequality

Fig.

terminal

T*

IT,,

V]

of

the curve with the shortest

(0 ,l )and
the line
y

EXAMPLE
1 Find
between
the point

Referring

3.2,

curve

we

y(T)

see

that

to the shortest-distance

-T

this

is

Minimize

ny]= /*(I +
0

subject to

y(0)

and

y(T)

=2

distance

in Example

y12)1'2

dt

t.

problem

but otherwise

problem

Sec. 2.2. Here, the problem is to

[for

[F

[for minimization

is

(T*

similar

be changed, and the transversality

(3.18')

with

is to minimize

in (3.18) must
condition

-~~F~~]~~
T*IT,,,
LO

- y1FY,] =

V]

of

the problem

If

[F

it is

4 of

t
1

It has previously

integrand,

extremal,

FIGURE

been shown that with the given

with two arbitrary

To

y(0)

determine

transversality

=a t + b

(1

constants

1,

we can

and

readily

other

condition

y")1/2

can

(- 1

b.

From the initial

determine

constant,
condition (3.12). Since
the

the transversality

(at t

straight-line

say,
y*

condition

equation yields

the Euler

3 2

that

a, we resort
we have

be written

b = 1.
to the

as

- yl)rl(l + yr2)-l"

Multiplying

through

by

(1

y'2)1/ 2and

simplifying

.,

we can

reduce

T) But

=a

the

this equation

extremal

at all values of

actually

to the form yt = 1(at t =

has a constant slope, y*'

t Thus, we must have a = 1. And

the extremal is therefore

y*(t)
As

shown

in Fig.

=t

3.2, the

1
extremal

,-

is

.
.
a

straight

Moreover

meets

the terminal

line

at the point

that

(
1;)
we note that the slopes of the terminal line
and the extremal are, respectively
1and
1 Thus the
two lines are orthogonal (perpendicular) to each other.
What the transversality
condition does in this case is to

line

require the extremal to be orthogonal to the terminal line

EXAMPLE

Find the extremal of the functional

FIGURE 3 3

with boundary

have

y(0)

conditions

we

free. Here

horizontal

1,

y, =

10, and T

terminal line

as

depicted

in Fig. 3.3.

The
this

general

problem

solution

path (Sec. 2.2, Example

the Euler

equation

been found to be

for

quadratic

1)

y(0) = 1, we have c, = 1. But the other constant

must be defini-tized with the help of the transversality

Since

c,

of

has previously

condition (3.11) Since F

that condition

ty'

+ y'2+

so

that

F,,

becomes

ty'+y12 -yp(t

+ 2y')

(at t

+ 2y1

which

time.

the general

still

cannot

- T/2 +
knowing

y, = 10

we

is

c, =

make

use

of

negative

value,

c, =

we

and

However,

the information

solution,

setting

we

cl without

of

that

c, =

terminal line). Substituting

expression

equation

T/2

T and

take the stipulated

value

of

end

are therefore rt 6. Rejecting the

up with T* = 6. Then it follows

3, and the extremal is

This time path is shown in Fig. 3.3. As

the transversality

a zero

slope

Example
into

the

T/2

That

differentiate

set

value

specific

slope at the

obtain the equation

The solution values

that

that

1 into the general

letting the resulting

10,

follows

the

.
,
.
,
=

0 at

y*'(t), then
result

we

(horizontal

a zero
condition, we

The

determine

find

y'

to have

this

to get

the value of

To

c2

meet

To

= 0.
c, = 0; it

y*'(T)

or

is required

solution

let

-y'2

extremal

terminal

and

to

reduces

is, the

an

condition
extremal
horizontal

condition,

at the

the extremal

terminal

point

1, where the transversality

orthogonality

the

requirement,

by

attains

(6, 101 Unlike

condition

pre-sent example
share
a common
slope
terminal line at t = T.
in

required

indeed

the

in

translates

transversality

dictates
with

that
the

the
given

to the Dynamic Monopoly

Application
Let

us now consider
as a problem

the

monopolist

variable

terminal

terminal
line

transversality

for

assign

P,

thus

in this discussion

parameters,

state

condition

Evans

with

model

P,,.

With

truncated,
specific

the

of

dynamic

fixed terminal time T but

the

is (3.17) For

otherwise

Model

the

appropriate

simplicity,

numerical

solution

vertical

we

values

expressions

become too unwieldy.

Let the cost function and demand function be

C
[i.e., a

= &, p =

&Q2

0,y

+ 1000
=

1000]

Then the profit function becomes

which implies that

This is the derivative

needed

in the transversality

condition.
Since the postulated

parameter

values

the ch

and particular

integral [see (2.3611

rl,r,=rt0.12

= 14 ;

shall

to the

yield

will

the general solution of the Euler equation is

(3.20)

= Ale0

P*(t)

+ A2e-0

12'

12'

14:
If

we

assume

further

to be

conditions

and

to (2.371, the constants

then, according
should,

the boundary

P,=15;

P,=11$

=2

A, and

A,

in the fixed-

terminal-point

problem,

have the values

(after

rounding):

A,
The

reader

constants
produce

can

into

A,

6.933

verify

(3.20

that

Now

adopt

the transversality

normalizing,

The

-9.933

substitution

P*(2)

condition

(3.171

to

two

errors)

15;
as required.

state PT

variable terminal

these

of

rounding

from

OF VARIATIONS

in (3.19) equal

expression

does (apart

the terminal price

PART 2: THE CALCULUS

solution

we

zero at

10. Using

set

first

the

2. Upon

this yields the condition

P(T) term

here

refers

P*(t) in (3.20) evaluated

PYT) is the derivative

point of time. That is,

to the general

at t

=T =

of (3.20) evaluated

2. And the

at the

same

Thus, (3.21)

can

more

be rewritten

To solve for A, and A,,

with-the conditim

condition

obtained

from (3.20) by setting

as

need to couple this

governs

that

A, +A2

to Po

result

we

specifically

the initial point,

-3

=0

and equating

11% The solution values of

the

A, and A,

turn out to be (after rounding):

A,
giving

us

4.716

we

find that

the stipulated

fixed

P*(2)

restriction,

terminal
T

point

to

that

attain

14.37. Since this does meet

the problem

inflation-unemploymen

inflation,

-7.716

whether this solution satisfies

PT >_ 10. Setting t
T
2 in

The Inflation-Unemployment
The

the definite solution

It remains to check
the terminal speci-fication

(3.22)

A,

and

Tradeoff

t problem

requires

value

is s01ved.

in Sec.

Again
2.5

the expected
of

zero at

has

rate of

the

given

terminal

ask:

time

What will

as a

vertical

:
T(T

terminal

if

may

0. It

happen

be

the terminal

to

interesting

comes

condition

line instead?

From (2.47), the general solution of

the Euler

equation is

The initial condition, still assumed to be

= 0 in the

requires

~(0=) >

C b y Mting

(3.24)

=T
a vertical terminal line at the given T
now must use the transversality condition

0,

general solution) that

With

A,

however,

we

[Fyr]t=T= 0.

form

In the tradeoff

model, this takes

+ ap"

the

(3.25)

(at t

F,,

e-Pt

T which

can

be satisfied

parentheses

can

is

if and only

zero.

if the expression

Thus, the transversality

be written (after simplification)

where

The

T(T) and

obtained

from

T'(T) expressions
the general

solution

in the

condition

as

are,

ffp"j
= --1+ ap2
of

course, to

~*(tand
)

its

be

derivative,

both

evaluated

at t

Using (3.231,

we can

thus give condition (3.25') the specific form

(3.24) and

When

we

finally

find

(3.25")

are

solved

simultaneously,

the definite values of the constants

A,

and A,:

These

can

be used to turn the general solution into the definite solution.

Now that the terminal state is endogenously

determined,

what value of

solution? To
solution

see

this,

we

T*(T)

(3.23), and evaluate

answer turns out to

of

the given

the result

requirement-driving

to

zero at

from the

(3.26) into the general

at t

be

T*(T)
In view

emerges

substitute

T The

loss function,

this

the rate of expected inflation down

the terminal time-is

not surprising. And

since

the

already

earlier

has

version

target

the

the

of

value

problem

n-

of

to the vertical-terminal-line

switch

set

in

at n-,

Sec.

2.5

0, the

formula-tion does not

modify the result.

EXERCISE
1 For

general

3.2
the

solution

functional

V[yl

j:(t2

to the

Euler equation is y*(t)

= clt

+ yt2)dt, the

+ c2 (see

Exercise 2.2,

Prob. 1).
(a) Find the extremal if the initial condition is y(0)

4 and the terminal

condition is T
(b) Sketch

2, yT free.

diagram showing the initial point, the

terminal point, and the

extremal.
How

change,

if

answer to

will the

condition is altered to: T

3
yT

the preceding

problem

the terminal

2, yT 2 3?

Let the terminal condition in Prob. 1

be changed to:

5, T free.

(a) Find the

new

extremal. What

is the optimal

terminal time T*?

(b) Sketch

diagram showing the initial point, the

terminal line, and the

extremal.
4

general

(a) For

solution

the functional

V[y]

to the

Euler equation is y*(t)

2.2, Prob. 4). Find the

=1
T(y'2/t3) dt,

B
= c,t B

the

c2 (see Exercise

extremal(s)

and

the

if

the

initial

condition

is

y(0)

0,

terminal
condition is yT

(b) Sketch

= 3 - T.

curve

diagram to show the terminal

and

the extremal(s)

The discussion leading to condition (3.16) for

truncated

vertical terminal

on

line is based

>

the assumption that p(T)

0. Show

that if the perturbing

curve

is such that p(T)

condition (3.16) will

the

same

terminal

employed

for

the

truncated

vertical

to derive

line

transversality

condition (3.18)

THREE GENERALIZATIONS

3.3
What

we

have learned

be generalized

A Variable
If

same

line of

reasoning

can

0 instead, the

For the truncated-horizontal-terminal-line problem,

use

<

emerge.

the

transversality

section

can

point

y(0)

transversality

terminal point

Initial Point

initial

condition

about the variable

in three directions.

condition

is

no

longer

then

the

boundary

holds,

and

an

initial

is needed to fill the void. Since the

conditions

be applied,

variable,

developed

mutatis

in

mutandis,

the

preceding

to the

case

of

variable

initial

discussion.

points,

If

points

there

variable,

no

is

has

problem

two

then

need

both

for

the

further

initial

and

transversality

conditions
have to be used to definitize the two
arbitrary constants that arise from the Euler equation.

The Case of Several State Variables

so

functional,

appear

state variables

When several

that the integrand

in the objective

is

F(~,Y~,-.~,Y~,

the general (terminal)

be modified

into

[F - (y;FY;

transversality

(3.9) must

condition

(3.27)

' '

+~n'~y AT
~)

+[Fy{]t=TA~lT
+ "' +[Fy,']t=TA~nTO
It should

be clear

Given

drops out because

has

term

that

n = 1.
a fixed

(3.27) with

terminal

AT

terminal

fixed

in (3.27)

represent

independently

Thus,
in

there

(3.27)

each

cannot

can

term

that

transversality
The

may

expect
be

cancel

all

the
the

determined

any
out

remains

will

another.

give

variable

that

rise

y,

remain,

expressions

arbitrary

presumption

one

of

0 and the jth

terms
A

case

term in (3.27)

any

if

then AyJT

out. For

drops

we

special

time, the first

0. Similarly,

value,

however,

(3.9) constitutes

that

to

quantities.
the terms

Consequently,

to

a separate

the

application

condition.

following

examples

illustrate

of (3.27)

by

2 is

z.

[F

EXAMPLE
both

The

2, with

1 Assume

,=,

hT

have

Eliminating

get the transversality

AT

the

first

term

individually

compare

should

Suppose
b3

Y,

and

and

in (3.27')

equal to

z,
AzT
and

zero, we

and

[c'lt=a

4 (T )

with (3.10).

that the terminal values

satisfy

of

and

the restrictions
and

z=

we have a pair of terminal curves.

we may expect the following to hold:
Then

AyT=$AT

yT

Ay,

conditions

E 2

for

[FY,],=,Ay,

0, but

[FY,It=, = 0
which the reader

denoted

condition

T is fixed, but

that

we

setting the other two terms

m
e

variables

transversality

free. Then

arbitrary.

state

the

general

- (yrF,,,+ z'F,.)]

[ Fzr],=,AzT

are
are

n =

when

and

and

*(T
For

dz,=#'AT

small AT,

74
PART

2. THE CALCULUS

OF VARIATIONS

Using these to eliminate

Ay,

and Az,

we

in (3.27'),

obtain

AT is arbitrary, the transversality

emerges

condition

als

which the reader

should

compare

With this transversality

curves y, =
conditions

z, =

4(T) and

y(0)

= yo

the terminal

$(T),and the initial

and z(0)

to determine

equations

with (3.12).

condition,

* as

= z,, we now
well

as

have five

the four arbitrary

constants in the two Euler equations.

The Case of Higher Derivatives

When the functional
Y("))

requires

the

high-order

V[y] has the integrand

(termi-nal)

modification.

derivatives

transversality
In

view

in economic

state here the general transversality

of

F(t, y, y', y") only:

y,

F(t,

condition
of

the

..

again

rarity

applications,
condition

y',

we

for the

of

shall

case

The

means

new

symbol

the change

when

it is perturbed.

mean

the difference

at Z "

and

problem

between
the

Ay',

Fig. 3.1, By',

of

AZ

slope

F,,,

/T(y

the

remain

vary,

then the

T.

3 3
For the functional

the

must

0 at t

V[y]

$y12)dt, the general solution

of

path

2. If

term in (3.28)

slope is free to

EXERCISE

at

path

would

AZ"

of the

path

terminal

last term will call for the condition

AyrT

the

of

0, and the last

out. If the terminal

condition,

slope

the slope

the

of

that

then

in this

terminal

In terms

slope

specifies

unchanged,
drops

the

appearing

in the

Euler

equation

is

y*(t)

= it2

+ yy' + +
y'

c,t

c,

(see

Exercise 2.2, Prob. 3).

If

we

terminal
t

have

vertical

initial line at

0 and

vertical

line at

out

1 write

the

transversality

conditions,

and

use

them to definitize
the constants in the general solution.
2

Let

the

vertical

initial line in the

preceding

problem

be

truncated with the

restriction y*(O)

1, but keep the terminal line unchanged.

(a) Is the original solution still acceptable? Why?

(b) Find the

new

extremal.

,
a

In

suppose

z, y',

z') dt,

= B, yT =

A, z(0)

constants).

/:~(t,y,

problem with the functional

that y(0)

= D,T free (A, B, C, D are

many transversality condition(s

C, zT

(a) How

does the problem require? Why?

(b) Write out the transversality

In the preceding problem,

= A, z(0) = B,
y~ = C, and

y(0)

zT

condition(s).

suppose

that

we

have instead

are

$(T),T free (A, B, C

constants).
(a) How

many

transversality

condition(s) does the

problem require? Why?

(b) Write out the transversality

THE OPTIMAL ADJUSTMENT

LABOR DEMAND

3.4

Consider

firm that

encountering

labor

varies

input

the

is

assumed

to

as
essence

well

on

the best speed of

the
of

magnitude
the

labor

Hamermesh."
discussed

in

a paper

by

of

OF

to raise its labor

level

of

after

a cost

that

L. Thus the firm

adjustment
L,

input

L,

0. The adjustment

entail

with L'(t), the rate of change

has to decide

as

has decided

a yet undetermined
a wage reduction at t =

to

Lo

from

of

condition(s)

toward

itself.

adjustment

This

L,
is

problem

The Problem
For simplicity,

let the profit

the general function

in

3.4. The

Fig.

determinant

of

labor

(b

>

>

labor

over

input.

optimal

profit

also

during

but

but

as

also

from

the

to

value

rate

process

it must

an
we

n
t

optimal
have

T*

is
of

the total net

of

choose

changing

the

not

only

the

T*

for

time
both

the

feature

terminal

to note

include not only the

should

at time

is T(L,)~-~ where

all

function.

C(L').

(a

is

integral),

definite

value of the profit

~,

value

and

profit

free. An- other

time
is that

the capitalized

the

period, which is affected by the choice

Since

sole

to be

time is T(L)

the adjustment,

the problem

net

the

subsumed

in the profit

+ 0)

any

Inasmuch

state and terminal

about

by

illustrated

to be

have

of the firm is to maximize

time

LT,

completing

as

0,

taken

we

L is assumed

0 when L'

The problem

II

is

and demand

Thus the net profit at

profit

<

= b ~ + 'k

C(L')

0, and k

input
because

profit

aspects of production
The cost of adjusting
(3.29)

of the firm be expressed

d L ) with a"(L)

of

in the post-T*

L,

.rr(L,),

and

T, too.

its present

p is the given discount

to be set equal to T*.

that present
value is,

So

the

rate

capitalized

'~aniel S. Hamermesh,
Adjustment

Costs,"

"Labor Demand

American Economic

and the Structure of

Reuiew, September

1989,

pp.

674-689.

FIGURE 3 4

according

to the standard

.rr(L,,.)e-~~/~.The

capitalization

formula,

full statement of the problem is

therefore

(3.30)

subject to

L(0)

and

L(T)=L,

Lo

(Lo given)
(LT>LOfree,T

free
If the last term in the functional

constant,

we

process,
emerge

the optimization
solution

were a

could ignore it in

path

would

because

the

same

either
z(T)-varies
choice
into

account.
earlier

the problem

way.

But

since

with

the

optimal

of

LT and

From

term-call

we must

it

explicitly

take

it

our

discussion
of

T,

that

Bolza,

of the problem

of

Mayer

and

we

have learned that

Thus, by defining

~(t=)--p(L)e-0'
P

SO

that zf(t)

-.rr(L)

-.rr'(L)Lt
P

we can

write the post-T*

e-~

term in (3.30)

as

(3.31')

Substitution

(3.30) yields, after

of (3.31')

into the functional

in

combining

the two integrals, the

new

but equivalent

function

While

this

outside

affects
path,

of

functional
the

only the optimal

nq the

contains

still

integral,

that

term

is

ll value, but

optimal values of

L,

an extra
a constant.

term
So it

not the optimal

and T.

The Solution
To find the Euler equation,

we see

from (3.32) that

Thus, from formula

(2.189,

(3.33)

we get

the condition

Ltr-pL'+

-= o
p'(L)
2b

[Euler equation]
The

both

transversality

transversality

And the condition [F

where

we

means

take

the

conditions
the

provide

determining

and (3.351,

the

the

of

equation, evaluated
obtain

necessary to

Lo

from

problem

must

and

is

satisfy

(3.11).'

The

means

(after

in the

optimal

the

at t

root
to

because
L,.

The

needed
and

path,

definitizing

as

well

as

T. In using (3.34)

that the L '

general

solution

L,

for

is

two

plus the initial condition L(0)

it is understood

derivative
To

information

constants

the arbitrary

(3.10)

square

positive

increase

can

for

this

we

that

- L'FL,],=,

transversality
Lo,

in

free,

that

to

supposed

being

conditions

condition [Fc],,

simplification)

condition

LT and T

Both

twofold.

symbol refers

solution

of

the

to

Euler

T.

specific

quantitative

specify the form of

the profit

solution,
function

it

is

.rr(L)

Since

our

illustrate

terminal

primary

a case

purpose
with

both

of
the

citing

this example

terminal

state

and

is to
the

78

PART

CALCULUS

time free, and to illustrate

shall not delve

EXERCISE

the problem

(3.35), deduce

we

solution.

conditions

(3.34) and

the
of the optimal terminal

state LT* with

to Fig. 3.4.

(b) How would

How would

an

p affect the location of LT*?

increase in

an

increase in b
(c) Interpret

In the preceding

or

k affect

L,*?

your

result in (b). 2

the economic meaning

of

problem,

function be

let the profit

(a) Find the value of

(b) At what

L,*.

a
can you say

L value does a reach

(c) In light of (b), what

L,*

THE

3.4

location

of

of Bolza,

into specific quantitative

the two transversality

1 (a) From

reference

OF VARIATIONS

peak?
about the location

in relation

to the T(L) curve?

3

(a) From

the location

of

the transversality

optimal

graph

of

condition

(3.35), deduce

the

terminal

time

T* with reference

to

the solution
path L*(t).
(b) How would

T*? How would

an

an

increase in k affect the location

of

increase in b affect

T*?