CHAPTER ONE

LINEAR EQUATIONS AND THEIR INTERPRETIVE APPLICATION

1.1 LINEAR EQUATION.

EQUATION - A mathematical statement that says two algebraic expressions are

equal. E.g. y = 2x + 3
- Is convenient and concise way of representing relationship
between quantities such as sales and advertising, profit and
time, cost and number of units manufactured, and so on.

Equations are used to model or represent real word situation.

Algebraic Expression - a mathematical statement indicating that numerical

quantities are linked by mathematical operations. E.g.
x+2, 2x + y
In algebraic expressions a letter always stands for a number. Therefore, we add,
subtract, multiply, divide and perform other mathematical operations on a letter.
In algebraic expression value or variables separated by + or – signs. These values
which are separated by + or – are called Terms. Terms are often called
monomials (mono = one). If an expression has more than one term, it is called
polynomials (poly = many). The letters in an algebraic expression are called
variables/ unknowns.

Linear Equations - are equations with a variable and a constant with degree one.
- are equations whose terms (the part separated by +, -, =
signs) are a constant, or a constant times one variable to the
first power.
- Linear equations are equations whose slope is constant
through out the line.

E.g. 2x - 3y = 7 - degree 1
- Constant 7
- Terms 2x &3y separated by the minus sign
However, 2x + 3xy = 7 is not a linear equation; b/c 3xy is a constant times the
product of two variables. No X2 terms, no y terms & no XY terms are allowed.

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The general notation of a linear equation is Y = mx + b,
Where, m = slope
b = y-intercept.
It is worth noting that this formula or notation holds true for all lines that are not
parallel to the y-axis. A vertical line is represented by the equation X=a. In cost
out put relationship, b is the fixed cost, and m is the marginal cost. The cost is
increases by the rate of the amount of the slope, m.

Slope (M) =
y
 
rise / fall )

Y y
2 1
 if X1 # X2
x run X x
2 1

Slope measures the steepness of a line. The larger the slope the steeper the line is
both in value & in absolute value. A line’s slope number tells us how much the
line falls (or rises) for a stated change in x. Slopes can assume 4 different values:
negative, positive, 0 and undefined.

 The line that is parallel to the X- axis is the gentlest of all lines, m= 0
 The line that is parallel to the Y - axis is the steepest of all lines, m = 

The slope of a line is defined as the change taking place along the vertical axis
relative to the corresponding change taking place along the horizontal axis, or,
THE CHANGE IN THE VALUE OF Y RELATIVE TO A ONE - UNIT CHANGE
IN THE VALUE OF X.
In linear equation of Y= mx + b, the coefficient of the independent variable is the
slope of the line and the constant that stands alone is the vertical (y) intercept.
That is, Dependent variable = (slope x independent Variable) + Intercept.

Intercepts - Those points at which the graph of a line, L, crosses the axes are
called intercepts. The X-intercept is the point at which the line crosses the X-axis
and it is found at (X, 0) and the Y-intercept is the point at which the y-axis is
crossed. Its coordinate is at (0, y).

DEVELOPING THE EQUATION OF A STRAIGHT LINE

There are at least three way of developing the equation of a line, these are:
1. The slope - intercept form
2. The slope - point form
3. Two-points form.

2
 1. THE SLOPE-INTERCEPT FORM
This way of developing the equation of a line involves the use of the slope and
the intercept to formulate the equation. Often the slope and y-intercept for a
specific linear function are obtained directly from the description of the situation
we wish to model.
E.g. Slope=10
Y-intercept=20

A line that has a slope of 10 and a y-intercept of 20 has the following equation:
Y=10x +20

2. Suppose the fixed cost (set up cost) for producing product x be Birr 2,000. After
setup it costs Birr 10 per x produced. If the total cost is represented by y:
1. Write the equation of this relationship in slope intercept form.
2. State the slope of the line and interpret this number.
3. State the y-intercept of the line and interpret this number.
3. A Salesman has a fixed base salary of Br 200 a week. In addition, he receives a
sales commission that is 20 percent of his total Birr values of sales. State the
relationship between the salesman’s total weekly salary and his sales for the
week. Answer: Y = 0.2x + 200

2. THE SLOPE - POINT FORM

The equation of a non-vertical line, L, with slope, m that passes through the point
(x, y is: Y-Y1 = m (X-X1).

Slope = 4, point (1, 2), the equation becomes Y = 4X-2

2. A salesman earns a weekly base salary plus a sales commission of 20% of his total
weekly sales. When his total weekly sales total Birr 1000, his total salary for the
week is Birr 400. Derive the formula describing the relationship between total
salary and sales. Answer: Y = 0.2x = 200
3. If the relationship between total cost and the number of units made is linear, and
if cost increases by Birr 7 for each additional unit made, and if the total cost of 10
units is Br 180, find the equation of the relationship between total cost (Y) and
number of units made (x). Answer: 7x + 110

3. TWO - POINTS FORM

Two points completely determine a straight line and, of course, they determine
the slope of the line.

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 Hence we can first compute the slope, and then use this value of slope (m)
together with either point in the point-slope form: Y-Y 1 =m (X-X1) to generate the
equation of a line. Alternatively, the following formula can also be used: (Y-Y 1) =
y 2  y1
(X - X1)
x x 2  x1
E.g.
1. (1, 10) (6, 0)
0  10 10
First, find the slope =   2 , then use the Slope-point form.
61 5

Y-Y1 = M (X-X1) = Y-10 = - 2 (X-1)

Y-10 = -2X + 2
Y = -2X + 2
2. A sales man has a base salary and, in addition, receives a commission, which is a
fixed percentage of his sales volume. When his weekly sales are Birr 1000, his
total salary is Birr 400. When his weekly sales are Birr 500, his total salary is Birr
300. Determine his base salary and his commission percentage and express the
relationship between sales and salary in equation form. Answer: Y = 0.2x + 200
3. A printer quotes the price of Birr 1,400 for printing 100 copies of a report and Birr
3000 for printing 500 copies. Assuming a linear relationship what would be the
price for printing 300 copies? Answer: Birr 2,200.

Horizontal and Vertical Lines

Horizontal lines are lines whose slope is zero. These lines are parallel to the X-
axis. Vertical lines are lines whose slope is undefined. These lines are parallel to
the Y-axis. When the equation of a line is to be determined from two given
points, it is a good idea to compare corresponding coordinates because if the y
values are the same the line is horizontal, and if the x values are the same the line
is vertical.

Example
a) Given the points (3, 6) & (8, 6) - the line through them is horizontal because
both y-coordinates are the same (6). The equation of the line becomes y=6.
b) Given the points (5, 2) and (5, 12), the line that passes through them is
vertical, and its equation is x = 5. If we proceed to apply the point - slope
12  2 10
procedure, we would obtain    , and if m =  the line is vertical and
55 0
the form of the equation is: x = constant.

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 Parallel and Perpendicular Lines
Two lines are parallel if the two lines have the same slope, and two lines are
perpendicular to each other if the product of their slopes is - 1 or the slope of one
is the negative reciprocal of the slope of the other. However, for vertical and
horizontal lines, (they are perpendicular to each other), this rule of m 1 . m2 = -1
doesn’t hold true.

Example:
1. Y= 2x-10 and Y=2x+14 are parallel.
3 2
2. Y= x +10 and Y = x +100 are perpendicular to each other.
2 3

Lines through the Origin

Any equation in the variables x and y that has no constant term other than zero
will have a graph that passes through the origin. Or, a line that passes through
the origin has an x-intercept and a y-intercept of (0,0). These lines are expressed
in the form Y = mx.

1.2. APPLICATIONS OF LINEAR EQUATIONS

1.2.1. LINEAR COST-OUT PUT RELATION SHIPS - VC, FC, TC, AC, MC, TR,
TP:
TR line

TR TC line
T
C TC= VQ+FC
TP
T TR = PQ
F G T = TR - TC
= PQ - (VQ + FC)
A = Q (P-V) + FC
Where Q = units
produced in cost & units
sold in revenue.
B C D Q no of units
(product)

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Interpretation of the graph
1. The vertical distance AB, FC, GD is the same because fixed cost is the same at
any level of output.
2. There is no revenue with out sales (Because total revenue passes through the
Origin), but there is cost with out production (Because of total fixed cost) and
the total cost function starts form A and doesn’t pass through the Origin.
3. Up to point T, total cost is greater than total revenue and results in loss while
at point T, TR = TC = Break even (zero profit), and above point T, TR >TC and
results in profit.
4. TFC remains constant regardless of the number of units produced, given that
there is no any difference in scale of production. That is there is no either
expansion or contraction of the business.
5. As production increases, TVC increases at the same rate and MC = V only in
linear equations.
6. As production increases TC increases by the rate equal to the V = MC.
7. Unit variable cost V is the same through out any level of production, however
AFC decreases when Q increases and ultimately ATC decreases when Q
increases because of the effect of the decrease in AFC.
8. As Q increases TR increases at a rate of P and AR remains constant.
TR p. Q
AR =   AR  P  in linear functions.
Q Q
1.2.2. BREAK EVEN ANALYSIS
BEP (Break even point) is the point at which there is no loss or profit to the
company. It can be expressed either in terms of production quantity or revenue
level depending on how the company states its cost equation.

Manufacturing companies usually state their cost equation in terms of quantity

(because they produces and sell) where as retail business state their cost equation
in terms of revenue (because they purchase and sell)
Case 1. Manufacturing Companies
Consider a company with equation TR = PQ
TC= VQ + FC

At BEP, TR = TC where:
PQe = VQe + FC Qe = break even quantity
PQe - VQe = FC FC = fixed cost
Qe (P-V) = FC P = unit selling price
FC
Qe = V= unit variable cost
P V

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 Assumptions of Breakeven Analysis
1. Selling price is constant throughout the entire relevant range [relevant range –
is the limit of cost-driver activity within a specified relationship between costs
and the cost driver is valid].
2. Costs are linear over the relevant range.
3. In multi-product companies, the sales mix is constant.
4. In manufacturing firms, inventories do not change (Units produced = Units
sold).
5. Expenses may be classified in to variable and fixed categories. Total variable
expenses vary directly with activity level. Total fixed expenses do not change
with activity level.
6. Efficiency and productivity will be unchanged.

Example
1. A manufacturing company has a fixed cost of 10,000 and a
unit variable cost of Birr 5. If the company can sell
what it produces at a price of Birr 10,

a. Write the revenue and cost and profit equations

b. Find the breakeven point in terms of quantity and sales volume.
c. Interpret the results.
d. Show diagrammatically the TR, TC, TP, BEP, TFC & TVC
The Effect Of Changing One Variable Keeping Others Constant on BEP
Case 1: Fixed Cost

Assume for the above problem FC is decreased by Br 5,000, citrus paribus.

5,000
TC = 5Q + 5,000 Qe1 = = 1,000 units
5
TR = 10Q
 FC  Qc  
Therefore,   FC & Qehave direct relationship
 FC  Qc  
Case 2 - Unit variable cost

Assume for the above problem unit variable cost decreased by Birr 1, citrus
paribus

10,000
TC = 4Q + 10,000 Qe 2

6
= 1,667 units

7
 TR=10Q

V  Qc  
Therefore,  V & Qe have direct relationship
V  Qe  

Case 3- Selling Price

Assume for the above problem selling price is decreased by Birr 1, Citrus
Paribus.
TC = 5Q + 10,000  Qe  10,4000  2 ,500 units
3

TR = 9Q

P  Qe 
Therefore,  P & Qe have indirect relationship
P  Qe 
In the above example if a company can’t produce and sell 5,000 units it has the
following options:
- Decreasing FC
a) Decreasing unit variable cost
b) Increasing the unit selling price
If the organization is faced between cases two and three, it is preferable to
decrease the unit variable cost because if we increase the selling price, the
organization may loose its customers; and also decreasing the FC is advisable.
Finding the Quantity level that involves profit or loss.
FC  0
BEP = , Any Q is related to the cost, profit, ---
Pv
  TR  TC
= PQ - (VQ + FC)
= Q (P-V) - FC
  Q( P  V )  FC
FC    Q( P  V )
FC  
 Q  For any quantity level.
P V
Example
1. For the above manufacturing company, (example one), if it wants to make a
profit of Birr 25,000, what should be the quantity level? Answer: 5,000 units. This
tells us when there is a profit; the quantities produced and sold have to be
greater than the break-even quantity.

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2. If it expects a loss of Birr 5,000, what will be the quantity level? Answer: 1,000
units. * When there is less, the quantity produced and sold should be less than
the BEQ.
Case 2 - Retail (Merchandise) Businesses.
Break even Revenue = BEQ x P
Assume a business firm with product A has the following cost and revenue
items.
Purchase cost of A = 100 Br
Selling price = 150 Br

Markup= Selling price - Cost = 150-100=50.

Mark up can be expressed:
i. As a function of cost, the mark-up is 50/100 = 50%

ii. As a function of retail price, the mark up is 50 150  33.3% , it is also called
margin.
100%  33.3%  66.6%  67%
  
The cost of goods sold =
sellingprice m arg in cos tofgoodssold

Selling expense = 1 percent of the selling price = 0.01x

So, the total cost equation becomes:
Y=0.68x + FC; Where X = sales revenue, and
Y = total cost.

The above 68% is interpreted as, Out of the 100% selling price 68% is the variable
cost of goods purchased and sold.
To get the break-even sales volume level, we equate the total cost, Y with the
sales volume level, X as Xe = Y = X, Y = mx + b
X = mx + b
X – mx = b
X (1 – m) = b
Xe = b
1 – m; Where m= unit variable cost /Birr of sales.
Example
1. Suppose a retail business sells its commodities at a margin of 25% on all items
purchased and sold. Moreover, the company uses a 5% commission as selling
expense and Birr 12,000 as a fixed cost. Find the break-even revenue for the retail

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 business after developing the TC equation. Answer: Y = 0.8x + 12,000 and X e =
Birr 60,000. It is interpreted as; when the company receives Birr 60,000 as sales
revenues, there will be no loss or no profit.
2. It is estimated that sales in the coming will be Birr 6000 and that fixed cost
will be Br 1000 and variable costs Birr 3,600. Develop the total cost equation, and
find the breakeven revenue. Answer: Y = 0.6x + 1000; Xe = Birr 2,500.
3. A company sold 80,000 units earning a profit of Birr 90,000. The Total
purchasing Cost of the product is Birr 400,000. Moreover, the company incurred
a commission expense (additional cost) of Birr 40,000 at 5% rate. (Hint:
commission expense is calculated as a percentage of sales). Develop the total
cost equation and find the break-even revenue. Answer: Y = .55x + 270,000; Xe =
Birr 600,000.

The break-even revenue method is useful, because we can use a single formula
for different goods so far as the company uses the same amount of profit margin
for all goods. However, in breakeven quantity method it is not possible and
hence we have to use deferent formula for different items.

When the break-even revenue equation is for more than one item it is impossible
Xe
to find the break-even quantity. It is only possible for one item. By Qe =
P
where
Xe = break-even revenue.
P= Selling price.
Qe = break-even quantity.

Given that the company purchases and sells single product, to change the cost
equation in terms of revenue in to a cost equation in terms quantity we have to
multiply price by the coefficient of X that is m. To change the cost equation in
terms of quantity in to a cost equation in terms revenue we divide the unit
variable cost, V, by the corresponding unit selling price.
ASSIGNMENTS
1. ABC’ company’s cost function for the next four months is C= 500,000 + 5q.
Required:
a) The break-even dollar volume of sales if the selling price is Birr 6 per unit.
b) What would be the company’s cost if it decided to shut down operations for
the next four months?
c) If, b/s of a strike, the most the company can produce is 100,000 units, should it
shut down? Why or why not?

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2. In its first year, “ABOL BUNA” Company had the following experience.
Sales = 25,000 units Selling price = Birr 100
Total variable cost = Birr 1,500,000 TFC = Birr 350,000
Required:
a) Develop revenues, cost, and profit functions for the company in terms of
quantity.
b) Find the break-even point in terms of quantity.
c) Convert the cost equation in terms of quantity in to a cost equation in terms
of revenue.
d) Find the break-even revenue.
e) If profit had been Birr 500,000 what would have been the sales volume
(revenue) and the quantity of sales.
f) What would have been the profit if sales were Birr 2,000,000?
3. A retail co plans to work on a margin of 44% of retail price
and to incur other variable costs of 4%. If it expects
fixed cost of Birr 20,000,
a) Find the equation relating total cost to sales.
b) Find the profit it sales are Birr 60,000.
c) Find the breakeven revenue.
d) If profit is Birr 15,000, what should be the revenue level?
e) If the company has only one item at a price of Birr 15 per unit, how do you
convert the cost equation in terms of revenue in to a cost equation in terms
of quantity?
4. A small home business is set up with an investment of Birr
1,000,000 for equipment. The business manufactures a
product at a cost of Birr 60 per unit. If the product
sells for Birr 140, how many units must be sold before
the business breaks even?
5. A certain car model cost Birr 20,000 with a gasoline engine
and Br 25,000 with a diesel engine. The number of
miles per gallon of fuel for cars with these two engines
is 25 and 30, respectively. Assume that the price of
both types of fuel is Birr 1.50 per gallon.
Required:
a) Drive the equation for the cost of driving a gasoline powered car.
b) Drive the equation for the cost of driving a diesel powered car.
c) Find the break-even point, that is, find the mileage at which the diesel-
powered car becomes more economical than the gasoline powered car.
6. A firm manufactures and markets a product that sells for
Birr 20 per unit. Fixed costs associated with activity

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 total Birr 40,000 a month, while variable cost per unit
is Birr 10. A maximum of 10,000 units can be
produced and sold.
Required:
a) Drive the TR, TC and Total profit functions.
b) Sketch the TR, TC and Total profit functions in the same coordinate system.
c) What is the Break-even point (in terms of quantity and sales volume)?
d) Drive the new TC, Total profit functions given that FC is increased by Birr
10,000 a month, and calculate the new break-even point.
e) Drive the new TC and Total profit functions given that unit variable costs is
decreased by 20% and calculate the new Break-even point.
f)Drive the new TR and Total profit functions given that the unit selling price
increases by 20% and calculate the new break-even point.
g) What is the relationship that you may inter from BEP& FC, P& BEP and V&
BEP?
h) Assume selling prince increases by 10% and at the same time V increases by
10% what is the effect of these changes on the BEP - calculate the new break-
even point. What lesson can we drive from this?
i) Suppose there is no any change in FC, V and P, What is the maximum profit
the firm can generate, and at what level of output?
j) Keeping P and FC constant, what is the maximum unit variable cost for the
firm to break even (at its maximum out put level)?
k) Keeping all things as they are, what is the quantity level at which the
company:
i. Makes a profit of Birr 100,000?
ii. Looses Birr 10,000?
l) Had there been no capacity limitation, how would your answer have changed
in part (i)?

CHAPTER TWO

Matrix Algebra and its applications

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Algebra - is a part of mathematics that deals with operations (+, -, x÷).
Matrix is A RECTANGULAR ARRAY OF REAL NUMBERS ARRANGED IN M
ROWS AND N COLUMNS. Like sets, it is symbolized by a BOLD FACE
CAPITAL LETTER enclosed by brackets or parentheses as:
a

a a
11 12


1n

A  a a21 a
22  in which
2n
 
a am1 a
m2  mn

aij are real nos.

Each number appearing in the array is said to be AN ELEMENT or

COMPONENT, of the Matrix. Elements of a matrix are designated using A
LOWERCASE FORM OF THE SAME LETTER USED TO SYMBOLIZE THE
MATRIX IT SELF. These letters are subscript, as aij, to give the row and column
location of the element with in the array. The first subscript always retirees to
the row location of the element; the second subscript always refers to its column
location. Thus, component aij is the component located at the intersection of the
ith row and the jth column.

The number of rows, m, and the number of columns, n, of the array give its
ORDER, or its DIMENSIONS, mxn (read “m by n”) = A mxn or [aij] (mxn).
Example: The following are examples of matrices
1 7 
 

This is a 3 x 2 matrix
 
A  5 3 
 
4 2
 

ELEMENT
a12= 7
a21 = 5
a32 = 2
a23 = X - Because is a 3 x 2 matrix.
1 5 9 15
2 6 10 20
  This is a 4 x 4 matrix Elements X = 45 x32 = 7
44
3 7 11 30
 
4 8 12 45

IMPORTANCE OF MATRICES

Matrices provide a most convenient vehicle for organizing and storing

large quantities of data. Because the basic idea is to organize the data, we

13
 cannot over emphasize the importance of the location of each number
with in the matrix. It is not simply a matter of putting numbers in to
rows and columns; each row-column location with in each matrix carries
with it special interpretation; a matrix is, in essence, a tool for organizing
vast quantities of data. Matrices are used to represent complex systems
and operations by compact entities.

Matrix representations are possible

- Transportation matrix
- Distance matrix
- Cost matrix
- Brand switching

TYPES OF MATRICES

1. VECTOR MATRIX - is a matrix which consists of either one row or one column.
That is, it is an mx1 or a 1 x n matrix.
1.1. Row vector = is a 1 x n matrix
E.g. W = [-1, 0, 6]
1.2 Column Vector - is a mx1 matrix
 2

E.g. B =
5 
 
 7
 
 0

The transpose of an mxn matrix denoted A -t is an nxm matrix whose rows are the
columns in A (in the same order) and whose columns are the rows in A (in the
same order).
1 1 
2 3 10  
4 7

 
-t
If then A =
2 5 8 
   
A  4 5 6 11  A   
  3 6 9 
 
7 8 9 12  10 11 12 
   

Note that aijt = aij

The transpose of a row vector is a column vector and the transpose of a column
vector is a row vector.

2. Square Matrix - is a matrix that has the same number of rows and columns. It is
also called an nth order matrix.
1 0
E.g. 2x2, A  
0


1

.
 

3. NULL (ZERO) MATRIX - is a matrix that has zero for every entry. It is generally
denoted by Omn. In matrix operations it is used in much the same way that the

14
 number zero is used in regular algebra. Thus, the sum of a zero matrix and any
matrix gives that given matrix and the product of a zero matrix and any matrix
equals that given matrix.
4. IDENTITY MATRIX - a square matrix in which all of the primary diagonal
entries are ones and all of the off diagonal entries are zeros. Generally it is
denoted as In. Primary diagonal represents: a11, a22, a33, a44, --- ann entries.

1 0 1 0 0 0

I2 = , I4 =
0 0
A    1 0
A   
0 1
0 0 1 0
 

 
 0 0 0 1

The product of any given matrix and the identity matrix is the given matrix it
self. That is, A x I = A and I.A = A. Thus, the identity matrix behaves in matrix
multiplication like the number 1 in an ordinary arithmetic.
5. SCALAR MATRIX - is a square matrix where elements on the primary diagonal
are the same and the rest zeros.
NB: An Identity matrix is a scholar matrix, but a scalar matrix may not be an
identity matrix
6. DIAGONAL MATRIX- a square matrix where elements on the primary diagonal
are consecutive and others zeros.
7. EQUAL MATRICES -Two matrices A & B, are said to be equal only if they are of
the same dimensions and if each element in A is identical to its corresponding
element in B; that is, if and only if a ij = bij for every pair of subscripts i and j. If A
= B, then B = A; or if A≠B, then B ≠A.

1 2 1 2
A  
3


4

is equal to B = A  
3


4

   

1 2 4 2
However; A  
3


4

is not equal to C = A  
3


1

   

Even though they contain the same set of numerical values, A and C are not
equal because their corresponding elements are not equal; that is, a 11 ≠ C11 and so
on.

MATRIX OPERATIONS (ADDITION, SUBTRACTION, and

MULTIPLICATION)

Matrix Addition (subtraction)

Two matrices of the same dimensions are said to CONFORMABLE FOR
ADDITION. The addition is performed by adding corresponding elements from

15
the two matrices and entering the reset in the same row-column position of a
new matrix [element-wise addition].

If A and B are two matrices, each of size mxn, then the SUM of A and B is the
mxn matrix C whose elements are:
Cij = Aij + bij for i = 1, 2, ------- m
j = 1, 2, -------- n.

Laws of Matrix Addition

The operation of adding two matrices that are conformable for addition has these
two basic properties:
1. A + B = B + A ---- The commutative law of matrix addition.
2. (A+B) +C = A+ (B+C) -------- the associative law of matrix addition.

1 3 7 9  7 9 
eg 
2


4

+ 
8


 10

= 
10


 6

     

Given that two matrices do have the same dimension, the way we subtract a
matrix from another matrix is the same as the way we add two matrices.

Matrix Multiplication

A. Matrix Multiplication by a Constant (Scalar Multiplication)

A matrix can be multiplied by a constant by multiplying each component in the
matrix by a constant. The result is a new matrix of the same dimensions as the
original matrix.

If K is any real number and A is an mxn matrix, then the product KA is diffident
to be the matrix whose components are given by k times the corresponding
component of A; that is,
KA= [Kaij] (mxn).

E.g. If X = [6 5 7], then 2X = [(2x6) (2x5) (2x7)]

2X = [12 10 14]
Laws of Scalar Multiplication
The operation of multiplying a matrix by a constant (a SCALAR) has the
following basic properties. If x and y are real numbers and A and B are mxn
matrices, conformable for addition, then:
1. XA = AX
2. (X+Y)A = XA+YA

16
 3. X (A+B) = XA + XB
4. X (YA) = XY (A)

B. Vector-by-Vector multiplication
In multiplying two vectors always a row vector is written in the first position and
the column vector in the second position. Each component of a row vector is
multiplied by the corresponding component of the column vector to obtain a
result known as PARTIAL PRODUCT. The sum of all partial products is called
INNER/DOT PRODUCT of two vectors, and this is a number not a vector. In
other words, Vector- by- Vector results in a real number rather than a matrix.

E.g. Consider the product (AB) of the following row and column vectors.
 2

A  3 6 ’ B=
5 
4 2  
 7
 
 0

3x2=6
4 x 5 = 20 partial products
-2 x 7 = -14
6x0=0
12 Inner/Dot Product

C. Matrix by Matrix Multiplication

If A and B are two matrices, the product AB is defined if and any if the number
of columns in A is equal to the number of rows in B, i.e., if A is an m x n matrix, B
should be an n x b. If this requirement is met, A is said to be CONFORMABLE to
B FOR MULTIPLICATION. The matrix resulting from the multiplication has
dimensions equivalent to the number of rows in A and the number of columns in
B.

Matrix by matrix multiplication indicates a row by column multiplication, where

the entry in the ith row and jth column of the product AB is obtained by
multiplying the entries in the ith row of A by the corresponding entries in the j th
column of B and then adding the results. That is, to obtain the entry in the i th row
and jth column of the product AB, use the ith raw of A and the jth column of B in
the following form:

The first element in the raw is multiplied by the first element in the column; the
second element in the row is multiplied by the second element in the column and
so on until the nth row element is multiplied by nth column element. These

17
products are then summed up to obtain the single number that is the product of
the two vectors.

If A is a matrix of dimension n x m (which has m columns) and B is a matrix of

dimensions p x q (which has p rows) and it m is different from p, the product AB
is not defined. That is, multiplication of matrices is possible only if the number of
columns of the first equals the number of rows of the second.

If A is of dimension n x m and if B is of dimension m x p, then the product A.B is

of dimension n x p.

Example
2 3 4  1 7
A  
6

9

7

B= 0


8 


  5 1 

A.B = (2x-1) + (3x0) + (4x5) (2x7) + (3x8) + (4x1)

= 18 42

= (6x-1) + (9x0) + (7x5) (6x7) + (9x8) + (7x1)

= 29 121

18 42 
AB = 29
 121


AB = (-1x2) + (7x6) = 40
 40 60 45

(0x3) + (8x9) = 72 AB =  48


72 56 


16 24 27 

Special Properties of Matrix Multiplication

1. The Associative and distributive laws of ordinary algebra apply to matrix

multiplication. Given three matrices A, B and C, which are conformable for
multiplication,
 A (BC) = (AB) C -------------------- Associative law, not C (AB).
 A (B+C) = AB + AC -------------- Distributive law
 (A+B) C = AC + AB -------------- Distributive law

2. The commutative law of multiplication does not apply to matrix

multiplication. For any two real numbers X and Y, the product XY is always
identical to the product YX. But for two matrices A and B, it is not generally

18
 true that AB equals BA. (In the product AB, we say that B is pre multiplied by
A and that A is post multiplied by B). In many instances for two matrices A
and B, the product AB may be defined while the product BA is not defined, or
vice versa.

In some special cases, AB does equal BA. In such special cases A and B are said to
Commute.

3. The product of two matrices can be the zero matrix even though neither of the
two matrices them selves is zero matrix! We cannot conclude from the result
AB = 0 that at least one of the matrices A or B is a zero matrix.
3 0 0 0 0 0 

A = 2


0 0
0 
, B = 7


10 4


, AB =
1 0  8 3 2 
0 0 0
0 0 0
 

0 0 0


4. We cannot, in matrix Algebra, necessarily conclude from the results AB = AC

that B = C, even if matrix A is not equal to a zero matrix. Thus the
CANCELLATION LAW does not hold, in general, in matrix multiplication.

1 3  4  1 1 2
A
 2


 6

,B 
2

5



,C 3
2


4

     

10 14 
AB = AC = 
 20


 28

but B ≠ C.
 

The Multiplicative Inverse of a Matrix

If A is a square matrix of order n, then a square matrix of its inverse (A -1) of the
same order n is said to be the inverse of A, if and only if AA-1 = I = A-1A.
Two square matrices are inverse of each other if their product
is the identity matrix: I = AA-1 = A-1A.

Not all matrices have an inverse. In order for a matrix to have

an inverse, the matrix must, first of all, be a square
matrix. Still not all square matrices have inverse. If a
matrix has an inverse, it is said to be INEVITABLE or
NON-SINGULAR. A matrix that doesn’t have an

19
 inverse is said to be SINGULAR. An inevitable matrix
will have only one inverse; that is, it a matrix does
have an inverse, and that inverse is unique.
In short:
 Inverse of a matrix is defined only for square matrices
 If B is an inverse of A, then A is also an inverse of B.
 Inverse of a matrix is unique.
 If matrix A has an inverse, A is said to be inevitable and not all square
matrices are inevitable.
1 1
E.g. eg 
1


1

 

Finding the Inverse of a Matrix

Let us begin by considering a tabular format where the square matrix. A

is augmented with an identity matrix of the same order, as [A/I]. This
process is called ADJOINING.
Now, if the inverse matrix A -1 were known, we could multiply the matrices on
each side of the vertical line by A-1, as [AA-1/A-1I]

Then, because AA-1 = I and A-1 I = A-1, we would have [I/A-1]. We do not follow
this procedure, because the inverse is not known at this juncture; we are trying to
determine the inverse. We instead employee a set of permissible row operations
on the augmented matrix [A/I] to transform A on the left side of the vertical line
in to an identity matrix (I). As the identity matrix is formed on the left of the
vertical line, the inverse of A is formed on the right side. The allowable
manipulations are called ELEMENTARY ROW OPERATIONS. These
Elementary Row Operations are operations permitted on the row of a matrix.

In a matrix Algebra there are 3 types of row operations.

I. ANY PAIR OF ROW IN A MATRIX MAY BE INTERCHANGED
/EXCHANGE OPERATIONS/. INTERCHANGING ROWS.
ii. A row can be multiplied by any non-zero real number /Multiple
operations/. The multiplication of any row by a non-zero number.
iii. A multiple of any row can be added to any other row /Add-A-Multiple
operations/. The addition /subtraction of (a multiple of) one row
to/from) another row.

20
 4 3 2   2 6 7

E.g. 1. A
 2

6

7

,B 4


3 2 


= interchanging
   

rows

4 3 2  8 6 4
2. A
 2

6

7

B= A
 2

6

7

= multiplying the first
   

row by 2.

4 3 2  4 3 2 
3. A
 2

6

7

B= 
6

12

11

= Multiplying the first row by
   

2 and add to 2nd row.

Theorem on row operations

A row operation performed on product of two matrices is equivalent to row
operation performed on the pre-factor.

Consider the following AB = C

 1 3 1 2 
2 9 13 
A
2

3 4



B= 1


1 


C, = 13
 19 

  2 3 

Interchange R1 with R2

2 4 1 2 
3 13 19 
A
1

2

3

B= 1


1 


C, = 9
 13 

  2 3 

Basic Procedures to Find the Inverse of a Square Matrix

1. To get ones first in a column and next zeros (within a given column)
2. To get zeros first in a matrix and next ones.

Ones First: Try to set ones first in a column and then zeros of the same column.
G0 from left to right
Zeros First: Find the off diagonal zeros first, and following this obtain ones on
the main diagonal. It can simplify the work involved in hand calculation by
avoiding fractions until the last step.

21
 Matrix Applications

Solving Systems of Linear Equations

1. n by n systems
Systems of linear equations can be solved using different methods. Some are:
 Elimination method for 2 variable problems (equations).
 Matrix method
i. Inverse method
ii. Cramer’s rule – using determinants (independent study)
iii. Gaussian Method.

Inverse Method

To solve systems of linear equations using the inverse method the coefficient
matrix should be inevitable, and it involves the following steps:
1. Put all equations in a matrix form (square matrix form).
2. Find the inverse of the coefficient matrix.
3. Multiply the inverse with right hand side values (vector of constants)

2. X+Y = 2
2x + 2y 4

The inverse method provides us with unique solution, or no solution and infinite
solution (without separating them).

Gaussian Method: developed by Karl F. Gauss (1771-1855)

Solving systems of linear equations using the Gaussian method involves the
following steps:
1. Write all equations in a matrix form.
2. Change coefficient matrix in to identity matrix and apply the same
commentary row operations on the vector of constants
3. The resulting value (of the RHS vector) will be the solution.

Ax = B
Ix = C
x=C
The Gaussian Method helps us to obtain:

22
  Unique solution
 No. Solution
 Infinite solution
E.g. 1. 2x + 3y = 4 2. x + y = 2 3. x + y = 5
x + 2y = 2 2x + 2Y = 4 x+y=8

2 3   4

 1

2
 
 2
IX = c
X=C

Therefore, Gaussian method makes a distinction between no solution and infinite

solution, unlike the inverse method.

Summarizing our results for solving an “n” by “n” system, we start with matrix
(A/B), and attempt to transform it in to the matrix (I/C).
One of the three things will result:

1. An n by n matrix with the unique solution; e.g.

1 0 0 10
 
0 1 0 5
0 0 1 3 


2. A row that is all zeros except in the constant column, indicating that there are no
solutions; e.g.

1 0 0 3
 
0 1 0 5
0 0 0 7


3. A matrix in a form different from (1) and (2), indicating that there are an
unlimited number of solutions. Note that for an n by n system, this case occurs
when there is a row with all zeros, including the constant column; e.g.

1 0 2 5
 
0 1 3 3
0 0 0 0 


2. M by n linear systems

23
 The mxn linear systems are those systems where the number of rows (m) and
number of columns (n) are unequal or it is the case where the number of
equations (m) and the number of variables (n) are unequal. And it may appear as
m>n or m<n.
2.1 Linear equations where m>n
To solve an m by n systems of equations with m>n, we start with the matrix
(A/B), and attempt to transform it in to the matrix (I/C). One of the three things
will result:

1. An n by n identity matrix above m-n bottom rows that are all zeros, giving the
unique solution
E.g.

2. A row that all zeros except in the constant column, indicating that there are no
solutions.
E.g.

3. A matrix in a form different from (a) and (2), indicating that there are an
unlimited number of solutions.

E.g.

2.2. Linear equations where m<n

Our attempt transform (A/B) in to (I/C) in the case where m<n will result in:
1. A row that is all zeros except in the constant column, indicating that there are
no solutions. Or

2. A matrix in a form different from (2), indicating that there are an unlimited
number of solutions.

“EVERY SYSTEM OF LINEAR EQUATIONS HAS NO SOLUTION, EXACTLY

ONE SOLUTION OR INFINITELY MANY SOLUTIONS.”

WORD PROBLEMS

24
 Steps

1. Represent one of the unknown quantities by a letter usually x and express

other unknown quantities if there is any in terms of the same letter.
2. Translate the quantities from the statement of the problem in to algebraic form
and set up an equation.
3. Solve the equation (equations) for the unknown that is represented by the
letter and find other unknowns from the solution.
4. Check the findings according to the statement in the problem.

Example.

1. The weights (in pounds) of six people before taking a weight reduction
program were 350, 249, 260, 195, 275, and 295. The weights of these same people
after the weight reduction program are 345, 200, 220, 140, 200, and 230,
respectively. Summarize this information in a (6 by 2) matrix.

2. A manufacturing firm which manufactures office furniture finds that it has the
following variable costs in dollars.
Desks Chairs Tables Cabinets

Assume that an order of 5 desks, 6 chairs, 4 tables and 12 cabinets has just been
received. What are the total material, labor and overhead costs associated with
the production of ordered items? Answer: Birr 1,710.

3. Olympus manufacturing company produces two types of boats: one-person

and two-person models. The company has two plants x and y at different parts
of the country. In both plants, there are two departments, fabricating and
finishing. A one-person boat requires 4-labor hr in the fabricating department
and 1 labor hr in the finishing department. The two-person boat requires 6-labor
hr in the fabricating department and 1.5-labor hr in the finishing department.
Suppose the hourly rates of labor cost in the fabricating and finishing
departments be Br 8 and Br 6 respectively at plant x, and Br 7 and Br 4 at plant Y.
Using matrix algebra, find the labor cost of making one unit of each product at
each of the two plants. Interpret the results.

25
 Answer:
Product
Plant One person Two person

X 38 57

Y 32 48

4. Asrat Carpet Company has in inventory 1,500 square yards of wool and 1,800
square yards of nylon for the manufacture of carpeting. Two grades of carpeting
are produced. Each roll of superior grade carpeting requires 20 sq. yards of wool
and 40 square yards of nylon. Each roll of quality-grade carpeting requires 30
square yards of wool and 30 square yard of nylon. If Asrat would like to use all
the material in inventory, how many rolls of superior and how many rows of
quality carpeting should be manufactured? Answer: 15 and 40.

5. A manufacturer is costing out one product line which consists of three

different models, A, B, and C. These models are assembled from three types of
parts, 1,2 and 3. The manufacturer would like to produce such quantities of the
three models as to completely deplete the inventory of parts of hand, in the final
production run. Each model a uses one unit of part 1, three units of part 2, and
two units of part 3. Each unit of model B uses one unit of part 1, two units of part
2, and one unit of part 3. Each model C uses two units of part 1, and three units
of part 3. Inventory records show that there are on hand 1,500 units of part 1 and
1,900 units each of part 2 and 3. How many of each model should the
manufacturer plan to produce? Answer: 100, 800, and 300.

6. Alemayehu invested a total of 10,000 in three different savings accounts. The

accounts paid simple interest at an annual rate of 8 percent, 9 percent and 7.5
percent respectively. Total interest earned for the year was Br 845. The amount in
the 9 percent account was twice the amount invested in the 7.5 percent account.
How much did Alemayehu invest in each account? Br 1,000, Br 6,000 and Br
3,000

7. A person invests in A, B and C rated bonds. The average yield is 8% on A

bonds, 6% on B bonds, and 7% on C bonds. Twice as much is invested in C bonds
as B bonds. Moreover, the total annual return for all three types of bonds in Br.
2800. How much is invested in each type of bond if the total investment is
a. 37,500? Answer: Br 22,500, 5,000 and 10,000
b. 40,000? Br 10,000, 10,000 and 20,000

26
 8. A certain manufacturer produces two products, P and Q. Each unit of product
P requires in its production 20 units of raw material A and 10 units of raw
material B. Each unit of product Q in its production requires 30 units of raw
material A and 50 units of raw material B. There is a limited supply of 1200 units
of raw material A and 950 units of raw material B. how many units of product P
and Q can be produced if we are to exhaust the supply of raw materials?
Answer: 45 and 10.

9. Attendance records indicate that 40, 000 people attended the 12 th African
Youth championship at its opening ceremony at the Addis Ababa Stadium. Total
ticket receipts were Br 1, 750,000. Admission prices were Br 37.5 for the second
class and Br 62.5 for the first class. Determine the number of people who
attended the opening ceremony at first class and second class. Answer: 30,000
and 10,000.

10. A mixture containing X pounds of ingredient A, Y ponds of ingredient B and

Z pounds of ingredient C is to be made. The mixture is expected to have a weight
of 5 pounds and contain 1500 units of vitamin and 2,500 units of calories. The
vitamin and caloric content of the three ingredients is given below.

Determine how many pounds of each ingredient should in the 5-pound mixture.
Answer: Unlimited solution.

11. Two departments of a firm A and B need different amounts of the same product.
The following table gives the amounts of the products needed by the
department.

Two suppliers, Abebe and Tefera supply these three products with the unit-
selling price given below:

ABEBE TEFERA
Steel 300 280

Plastic 150 100

Wood 150 200

27
Required:
a) Use matrix multiplication to find how much these two orders will cost at
the two suppliers.
b) From which supplier should each department make its purchase? Answer:
Department A from Tefera, and Department B from Abebe.

MARKOV CHAINS

Concept, Model and Solutions

This model is a forecasting model. It is probabilistic/ stochastic model. A

Russian mathematician called Andrew Markov around 1907 developed this
model.

Markov chains are models which are useful in studying the evolution of certain
system over repeated trials. These repeated trails are often successive time
periods where the state (out come, condition) of the system in any particular time
period cannot be determined with certainty. Therefore, a set of transition
probabilities is used to describe the manner in which the system makes transition
from one period to the next. Hence, we can predict the probability of the system
being in a particular state at a given time period. We can also talk about the long
run/equilibrium, steady state.

System - which we want to study, machine, and person

Trials - successive time period any convenient length of time day, week, month,
year, etc.
State/out come, condition - the system can have various number of out comes.
Transition probabilities - set of input data, and are assumed to be constant.
Long/stead state - the system cannot change any more. There is the same
probability between n and n + 1 period after the long period.

The necessary assumptions of the chain are:

1. The system has a finite number of states - the out comes of the system should
be finite.
2. The system condition/outcome, state in any given period depends on its state
in the preceding period and on the transition probabilities
3. The transition probabilities are constant over time.
4. Changes in the system will occur once and only once each period.
5. The transition period occurs with regularities.

28
6. The states are both mutually exclusive and collectively exhaustive.
7. The system is a closed one, that is, there will be no arrival or exits from the
system.

Information flow in the Analysis

The Markov model is based on two sets of input data

 The set of transition probabilities.
 The existing or initial or current conditions or states.

The Markov process, therefore, describes the movement of a system from a

certain state in the current state/ time period to one of n possible states in the
next stage. The system move in an uncertain environment all that is known is the
probability associated with any possible move or transition. This probability is
known as transition probability symbolized by P ij. It is the likelihood that the
system which is currently in state i will Smoke to state j in the next period.

From these inputs the model makes two predictions usually expressed as
vectors:
1. The probabilities of the system being in any state at any given future time
period.
2. The long run / equilibrium, steady state probabilities.

The set of transition probabilities are necessary for both predictions (time period
n, and steady state), but the initial state is needed for only the first prediction.

In put data Predictions/ outcomes

Set of transition
Probabilities Steady states/ long run states

About past

29
 Current/initial state The probability of the system
being in any state at any given
time

About today

MARKOV CHAIN ANALYSIS USED AMONG OTHER THINGS IN MARKET

SHARE ANALYSIS. THE EXAMPLE BELOW SHOWS THIS.

1. Currently it is known that 80% of customers shop at store 1 and 20% shop at
store 2. In reviewing a past data suppose we find that out of all customers who
shopped at store 1 in a given week 90% remain loyal for the next week (store one
again), 10% switch to store 2. Out of all customers who shopped at store 2, in a
given week 80% remain loyal for the next week (store 2 again), 20% switch to
store 1. What will be the proportion of customers shopping at store 1 and 2
a) in each of the next two weeks?
b) in the long run?

Lets denote Store 1 by 1 and Store 2 by 2.

V12= (.8 .2) - initial state/ current state probability matrix.

To next weekly shopping period

From one week S1 S2

S1 0.9 0.1

S2 0.2 0.8

 The sum of rows in the transition matrices should be one.

 We have to be consistent in writing the elements.

P11, P22, P33, P44 ---------------------Pnn that represent the primary diagonal show
loyalty. Others switching.

30
Markov Chain Formula

nth state of a Markov Chain.

Vij (n) = Vij (n-1) x p, or Vij (n) = Vij (0) x (P) n.

Or
Vij (n) = Vij (0) x (P) n.
Where: P = transition matrix
Vij (n) = Vector for period n.
Vij (n-1) = vector for period n-1.

V12 (0) = (.8 .2)

V12 (1) = V12 (0) x P
 .9 .1
 
= (.8 .2) 
 .2


.8


= (.8 x .9) + (.2x.2) (.8x.1) + (.2x.8)

= .72 + .04 .08 +. 16
= 0.76 .24

V12(1) = (.76 .24)

V12(2) = V12(1) x P
= V12(1) x P
= (.76 .24)
 .9 .1
 
= (.8) .2) 
 .2


.8

=(0.732 .268)
b. In the long run (V1 V2) (n) = (V1 V2) (n+1)
n p n+1
 .9 .1
 
(V1 V2) 
 .2


.8

= (V1 V2)
0.9V1 + .2V2 = V1
.1V1 + .8V2 = V2
V1 + V2 = 1
-.1V1 + .2V2 = 0 
 one is the - ve of the other.
.1V1 + -.2V2 = 0 

.9V1+.2(1-V1) =V1
.9V1 + .2 - .2V1 = V1
.7V1 + .2 = V1
.2 = .3V1

31
V1 = 2/3
V2 = 1 - V1
= 1 - 2/3
V2 = 1/3

In short, the switching over the sum of the switching gives us the long run state.

To

S1 S2

From S1 .9 .1

S2 .2 .8

V1= V2 =

= =

2 1
(V1 V2) =  
3 3

In the long run 67 of the customer will shop in store 1 and 33% in store 2.
Prediction: Long run - only the transition matrix.
At specified time - the transition matrix and state vector.
Hence, unless the transition matrix is affected, the long run state will not be
affected. Moreover, we cannot know the number of years, weeks, or periods to
attain the long run state, point but we can know the share.

Absorbing Markov Chain

It is a special type of Markov chain in which at least one of the states eventually
doesn’t lose members. We call such a state absorbing because it can absorb
members from other states, but doesn’t give up any of its members.

For example, if we take the above example and change the transition matrix

32
 S1 S2
S1 1 0
S2 .2 .8
The state S1 (store 1) in absorbing

In short:
Consider a Markov chain with n different states {S1, S2, and S3 --- Sn}.
The ith state Si is called absorbing if Pii = 1. Moreover, the Markov chain is called
absorbing if it has at least one absorbing state, and it is possible for a member of
population to move from any non-absorbing state to an absorbing one in a finite
number of transitions.

Remark: Note that for an absorbing state Si, the entry on the main diagonal p
must be Pii = 1 and all other entries in the ith row must be 0.

E.g. a.

E.g. b.

33
 S1 .5 1 5 0 0 
 
fro m  S 2
 0 1 0 0
The second state is absorbing.
0 0 .4 6 
S 3 
S 4 0 0 5 .5 
However the corresponding Markov chain is not observing. Because there is no
way to move from state 3 or state 4 to state 2.

A Markov chain is absorbing it has at least one absorbing state, and if from every
state it is possible to go to an absorbing state (not necessarily in one step).

Exercises

1. A division of the ministry of public health has conducted a sample survey

on the public attitudes towards the use of condoms. From the results of the
survey the department concluded that currently only 20% of the population uses
condoms and every month 10% of non-users become users, where as 5% of users
discontinue using.
Required

a. Write the current transition matrices.

b. What will be the percentage of users from total population just after two
months?
c. What will be the proportion of the non users and users in the long run?

Solution

Let. U - Stands for users, and N- stands for nonuser

1. Initial state VUN (0) = 0.2 0.8

To the next month

From one month Users (U) Non Users (N)

Users (U) .95 .05

Non Users (N) .10 .90

34
2. V (1) UN = V (0) UN x P
 .95 .05
= 0.2 0.8  .10 .90
=
(0.27 0.73)

V (2) UN = V (1) UN x P
 .95 .05
= 0.27 0.73  .10 .90
= (.3295 0.6705)

3. VU VN = (? ?)

switchtoU switchtoN
Switchtou  SwitchtoN Switchtou  SwitchtoU
VU = VU =
.1 .05
  0.65   0.33
.15 .15

VU VN = 0.67 0.33
VUN (n) = 0.67 0.33

2. A city has two suburbs: suburb x and suburb y. Over the past several years, the
city has experienced a population shift from the city to the suburbs, as shown in
the table below.
To the next year
From City (C) Suburb x (X) Suburb y (Y)
one year City (C) .85 .07 .08
Suburb x (X) .01 .96 .03
Suburb y (Y) .01 .02 .97

In 20xo, the city had a population of 120,000, suburb x had a population of 80,000,
and suburb by had a population of 50,000. Assuming that the population in the
metropolitan area remains constant at 250,000 people,
a. How many people will live in each of the three areas in 20X2?
b. How many people will live in each of the three areas in the long run?

Solution.

Let C stands for the city

35
X stands for the suburb X.
Y stands for the Suburb y. C= 120,000 - 120,000/250,000 = 0.48
x = 80,000 - 80,000/250,000 = 0.32
y = 50, 000 - 50,000/250,000 = 0.20
250,000 1.00

Initial state V(0)cxy (0.48 0.32 0.20)

The transition matrix. From one year

P=

 
 
.85 .07 .08
V(1)cxy = V(0)cxy x p (.48 .32 .20)  .01 .96 .03
 
 .01 .02 .97

V (1)cxy = (.4132 .3448 .2420)

 
 
 .85 .07 .08
V(2)cxy = (.4132 .3448 .2420)  .01 .96 .03
 
 .01 .02 .97
V(2)cxy = (.3571 .3648 .2781)

Thus, in 20X2, 89,275, 91,200 and 69,525 people will live in the city, suburb x and
suburb y respectively.

longrun
b. n p n+1
 .85 .07 .08
 
(Vc Vx Vy)  .01 .96 .03 (Vc Vx Vy)
 
 .01 .02 .97

.85C + .01x + .01y = C

.07C + .096x + .02y = x
.08C + .03X + .97y=y

36
 c + x + y =1 Vc Vx Vy = 1
-.15C + .01x + .01y = 0
.07c - .0yx + .02y = 0
.08C + .03x - .03Y = 0
X = 1-C-Y

.07 - .04 (1-c-y) + .024 = 0

.07 - .04 + 0yc + 04y) + .02y = 0
(.07c + .0yc) - 04 + (04y + .02y) = 0
.11c+.06y - .0y = 0 --- .08c - .03 (1-c-y) + .03y = 0
.08c - .03 + 03c + 03y + .03y = 0
(.08c - .03c) + 03 + (03y + .03y) = 0
.05C +.03 - .06y = 0 --- (2)
.11c + .06y - .4 = 0

.05C - .06Y + .03 = 0

.16C - .01 = 0
.16C = .01
.01
C=
.16
C = 0.0625 .11 (.0625) + .06y - .06y - .04 = 0
.006875 + .06y - .04 = 0
.06y = .033125
y = 0.5521

C+X+y = 1
.0625+x+.5521=1
0.6146+x=1
X = .3854

(Vc Vx Vy) = (.0625 .3854 .5521)

In the long run 15,625, 96,350 and 138,025 people will live in the city suburban X
and suburban respectively.

3. A population of 100,000 consumers makes the following purchases during a

particular week: 20,000 consumers make the following purchases during a
particular week: 20,000 purchase Brand A, 35,000 Brand purchase B and 45,000
purchase neither brand. From a market study, it in estimated that of those who
purchase Brand A, 80% will purchase it again next week, 15% will purchase
Brand B next week, and 5% will purchase neither brand. Of those who purchase
B, 85% will purchase it again next week, 12% will purchase brand A next week,

37
 and 3% will purchase neither band. Of those who purchased neither brand, 20%
will purchase as A next week, 15% will purchase Brand B next week, and 65%
will purchase neither band next week. If this purchasing pattern continues, will
the market stabilize? What will the stable distribution be? Yes Y A Vb Vc =
(.4 .5 .1)

4. In a certain college class, 70% of the students who receive an “A” on the current
examination will receive an “A” on the next examination. Moreover, 10% of the
students who do not receive an “A” on the current examination will receive an
“A” on the next examination. Assuming that this pattern continues, what is the
stable matrix?
VA VA1 = (.25 .75)

5. A vigorous television advertising campaign is conducted during the football

season to promote a well-known brand X shaving cream. For each of several
weeks, a survey is made and it is found that each week 100% of those using
brand X continue to use it. It is also found that of those not using brand x, 20%
switch to brand X while the other 80% continue using another band.

a. Write the transition matrix, assuming the transition percentages continue hold
for succeeding weeks.
b. If 20% of the people are using brand X at the start of the advertising campaign,
what percentage will be using brand X one week later? Two weeks later?
c. What portion of the market will be using brand X area the end of the season,
assuming the transition matrix remains the same? Find the Steady-state
matrix)

soln.

A.

B . V(n)xx1 = V(0)xx1p = (.2 .8)

V(n)xx1 = (.36 .64)

V(2)xx1 = V(1)xx1xp = (.36 .64)

= (.488 .512)

38
C. Vx = =1

Vx' = =0

CHAPTER III

INTRODUCTION TO LINEAR PROGRAMMING

Linear Programming- is an optimization method, which shows how to

allocate scarce resources such as money, materials or time and how to do
such allocation in the best possible way subject to more than one limiting
condition expressed in the form of inequalities and/or equations.
It enables users to find optimal solution to certain problems in which the
solution must satisfy a given set of requirements or constraints.

Optimization in linear programming implies either maximization (such as profit, revenue, sales,
and market share) or minimization (such as cost, time, and distance) a certain objective function.

39
 It implies that in LP we cannot max/min two quantities in one model. It involves linearly related
multi-variate functions, i.e., functions with more than one independent variable.

The goal in linear programming is to find the best solution given the
constraints imposed by the problem; hence the term constrained
optimization.

Linear programming Models (LPM)

Linear Programming (LP) models are mathematical representations of LP problems. Some LP

models have a specialized format, whereas others have a more generalized format. Despite this,
LP Models have certain characteristics in common. Knowledge of these characteristics enables us
to recognize problems that are amenable to a solution using LP models and to correctly formulate
an LP model. The characteristics can be grouped into two categories: Components and
Assumptions. The components relate to the structure of a model, whereas the assumptions reveal the
conditions under which the model is valid.

Components Assumptions
1. Objective function 1. Linearity
2. Decision variables Model 2. Divisibility Model
3. Constraints Structure 3. Certainty Validity
4. Parameters & RHSV 4. Non-negativity

Components of LP model

1. The Objective Function- is the mathematical or quantitative expression of the objective

of the company/model. The objective in problem solving is the criterion by which all decisions
are evaluated. In LPMs a single quantifiable objective must be specified by the decision maker.
For example, the objective might relate to profits, or costs, or market share, but to only one of
these. Moreover, because we are dealing with optimization, the objective will be either
maximization or minimization, but not both at a time.

2. The Decision Variables - represent unknown quantities to be resolved for. These

decision variables may represent such things as the number of units of different products to be
sold, the amount of Birr to be invested in various projects, the number of ads to be placed with
different media.

Since the decision maker has freedom of choice among actions, these decision variables are
controllable variables.
3. The constraints - are restrictions which define or limit the feasibility of a proposed
course of action. They limit the degree to which the objective can be pursued.
Atypical restriction embodies scarce resources (such as labor supply, raw materials, production
capacity, machine time, storage space), legal or contractual requirements (e.g. Product standards,

40
 work standards), or they may reflect other limits based on forecasts, customer orders, company
policies etc.
4. Parameters - are fixed values that specify the impact that one unit of each decision
variable will have on the objective and on any constraint it pertains to as well as to the numerical
value of each constraint.

 The components are the building blocks of an LP model. We can better understand their
meaning by examining a simple LP model as follows.

Example:

Maximize: 4X1 + 7X2 + 5X3 (Profit) ________________ objective function

Subject to:
2X1 + 3X2 + 6X3  300 labor hrs
5X1 + X2 + 2X3  200 lb raw material A System contents
3X1 + 5X2 + 2X3  360
X1 = 30 Individual
X2  40 constraints
X1, X2, X3  0  Non-negativity constraints.

System constraints – involve more than one decision variables.

Individual constraints – involve only one decision variable.
None-negativity constraints specify that no variable will be allowed to take on a negative value.
The non-negativity constraints typically apply in an LP model, whether they are explicitly stated
or not.
Assumption of LP Models

1. Linearity. The linearity requirement is that each decision variable has a linear impact on
the objective function and in each constraint in which it appears. Following the above example,
producing one more unit of product 1 adds Br. 4to the total profit. This is true over the entire
range of possible values of X 1. The same applies to each of the constraints. It is required that the
same coefficient (fro example, 2 lb. per unit) apply over the entire range of possible value so the
decision variable.

2. Divisibility. The divisibility requirement pertains to potential values of decision

variables. It is assumed that non-integer values are acceptable. For example: 3.5 TV sets/hr would
be acceptable  7 TV sets/2hrs.

3. Certainty. The certainty requirement involves two aspects of LP models.

i) With respect to model parameters (i.e., the numerical values) – It in assumed that these
values are known and constant e.g. in the above example each unit of product 1
requires 2lab his is known and remain constant, and also9 the 300 lab/hr available is
deemed to be known and constant.

II) ALL THE RELEVANT CONSTRAINTS IDENTIFIED AND

REPRESENTED IN THE MODEL ARE AS THEY ARE.

41
4. Non-negativity. The non-negativity constraint is that negative values of variables are
unrealistic and, therefore, will not be considered in any potential solution; only positive values
and zero will be allowed.

Formulating LP Models

Once a problem has been defined, the attention of the analyst shifts to formulating a model. Just
as it is important to carefully define a problem, it is important to carefully formulate the model
that will be used to solve the problem. If the LP model is ill formulated, ill-structured, it can
easily lead to poor decisions.

Formulating linear programming models involves the following steps:

1. Define the problem/problem definition

* To determine the # of type 1 and type 2 products to be produced per mother so as to
maximize the monthly profit given the restrictions.
2. Identify the decision variables or represent unknown quantities
* Let X1 and X2 be the monthly qualities of Type 1 and type 2 products

3. Determine the objective function

* Once the variables have been identified, the objective function can be specified. It is
necessary to decide if the problem is a maximization or a minimization problem and the
coefficients of each decision variable.

Note: a. The units of all the coefficients in the objective function

must be the same. E.g. If the contribution of type 1 is in terms of Br
so does for type 2.
b. All terms in the objective function must include a variable
each term have to have 1 variable.
c. All decision variables must be represented in the objective function.

4. Identifying the constraints

- System constraints - more than one variable
- Individual constraints - one variable
- Non-negative constraints

Example

1. A firm that assembles computer and computer equipment is about to start production of two new
microcomputers. Each type of micro-computer will require assembly time, inspection time and
storage space. The amount of each of these resources that can be devoted to the production of
microcomputers is limited. The manger of the firm would like to determine the quantity of each
microcomputer to produce in order to maximize the profit generated by sales of these
microcomputers.

Additional information

42
In order to develop a suitable model of the problem, the manager has met with design and
manufacturing personnel. As a result of these meetings, the manger has obtained the following
information:

Type 1 Type 2

Profit per unit Birr 60 Birr 50

Assembly time per unit 4hrs 10hrs
Inspection time per unit 2hrs 1hr
Storage space per unit 3cubic ft 3cubic ft

The manager also has acquired information on the availability of company resources. These
weekly amounts are:

Resource Resource available

Assembly time 100hrs
Inspection time 22hrs
Storage space 39 cubic feet

The manger also meet with the firm’s marketing manger and learned that demand for the
microcomputers was such that whatever combination of these two types of microcomputer is
produced, all of the output can be sold.

Required: Formulate the Linear programming model.

Solution:

Step 1: Problem Definition

- To determine the number of two types of microcomputers to be produced (and
sold) per week so as to maximize the weekly profit given the restriction.

Step 2: Variable Representation

- Let X1 and X2 be the weekly quantities of type 1 and type 2 microcomputers,
respectively.

Step 3: Develop the Objective Function

Maximize or Zmax = 60X1 + 50X2

Step 4: Constraint Identification

System constraints: 4X1 + 10X2  100hrs Assembly time

2X1 + X2  22hrs inspector time
3X1 + 3X2  39 cubic feet Storage space

Individual constraint No
Non-negativity constraint X1, X2  0

43
 In summary, the mathematical model for the microcomputer problem is:

Zmax = 60X1 + 50X2

Subject to: 4X1 + 10X2  100
2X1 + X2  22
X1 + 3X2  39
X1, X2  0

2. An electronics firm produces three types of switching devices. Each type involves a two-step
assembly operation. The assembly times are shown in the following table:

Assembly time per Unit (in minutes)

Section #1 Section #2
Model A 2.5 3.0
Model B 1.8 1.6
Model C 2.0 2.2

Each workstation has a daily working time of 7.5 hrs. The manager wants to obtain the greatest
possible profit during the next five working days. Model A yields a profit of Birr 8.25 per unit,
Model B a profit of Birr 7.50 per unit and Model C a profit of Birr 7.80 per unit. Assume that the
firm can sell all it produces during this time, but it must fill outstanding orders for 20 units of
each model type.

Required: Formulate the linear programming model of this problem.

Solution:

Step 1. Problem definition

To determine the number of three types of switching devices to be produced and sold for
the next 5 working days so as to maximize the 5 days profit.

Step 2. Variable representation

Let X1, X2 and X3 be the number of Model A, B and C switching devices respectively, to
be produced and sold.

Step 3. Develop objective function

Zmax: 8.25X1 + 7.50X2 + 7.80X3

Step 4. Constraint identification

2.5X1 + 1.8X2 + 2.0X3  2250 minutes Ass. time station 1 System

3.0X1 + 1.6X2 + 2.2X3  2250 minutes Ass. time station 2
X1  20 Model A
X2  20 Model B Individual constraint

44
 X3  20 Model C
X1, X2, X3 0 Non negativity

In summary:

Zmax: 8.25X1 + 7.50X2 + 7.80X3

: 2.5X1 + 1.8X2 + 2.0X3  2250 minutes
3.0X1 + 1.6X2 + 2.2X3  2250 minutes
X1  20 model A
X2  20 model B
X3  20 model C
X1, X2, X3  0 non negativity

3. A diet is to include at least 140 mgs of vitamin A and at least 145 Mgs of vitamin B. These
requirements are to be obtained from two types of foods: Type 1 and Type 2. Type 1 food
contains 10Mgs of vitamin A and 20mgs of vitamin B per pound. Type 2 food contains 30mgs of
vitamin A and 15 mgs of vitamin B per pound. If type 1 and 2 foods cost Birr 5 and Birr 8 per
pound respectively, how many pounds of each type should be purchased to satisfy the
requirements at a minimum cost?

Vitamins
Foods A B
Type 1 10 20
Type 2 30 15

Solution:

Step 1. Problem definition

To determine the pounds of the two types of foods to be purchased to make the diet at a
minimum possible cost within the requirements.

Step 2. Variable representation

Let X1 and X2 be the number of pounds of type 1 and type 2 foods to be purchased,
respectively.

Step 3. Objective function

Cmin: 5X1 + 8X2

4. Constraints

10X1 + 30X2  140 System constraints

20X1 + 15X2  145
X1, X2  0 non-negativity constraints.

45
4. A farm consists of 600 hectares of land of which 500 hectares will be planted with corn, barley and
wheat, according to these conditions.

(1) At least half of the planted hectar should be in corn.

(2) No more than 200 hectares should be barley.
(3) The ratio of corn to wheat planted should be 2:1

It costs Birr 20 per hectar to plant corn, Birr 15 per hectar to plant barley and Birr 12 per hectar to
plant wheat.

a. Formulate this problem as an LP model that will minimize planting cost

while achieving the specified conditions.

Solution:

Step 1. Problem definition

To determine the number of hectares of land to be planted with corn, barley and wheat at
a minimum possible cost meeting the requirements.

Step 2. Decision variable representation

Let X1 be the number of hectares of land to be planted with corn, X 2 be the number of
hectares of land to be planted with barley, and X 3 be the number of hectares of land to
be planted with wheat.

Step 3. Objective function

Cmin = 20X1 + 15X2 + 12X3

Step 4. Constraints
X1 + X2 + X3 = 500
X1  250
X2  200
X1 – 2X2 =0
X1, X2, X3  0

In summary

Cmin: 20X1 + 15X2 + 12X3

: X1 + X2 + X2 = 500
X1 – 2X2 =0
X1  250
X2  200
X1, X2, X3 0

Solution Approaches to Linear Programming Problems

There are two approaches to solve linear programming problems:

1. The Graphic solution method

46
 2. The Algebraic solution/ simplex algorithm method

A. The Graphic Solution Method

It is a relatively straightforward method for determining the optimal
solution to certain linear programming problems. It gives as a clear
picture. This method can be used only to solve problems that involve two
decision variables. However, most linear programming applications
involve situations that have more than two decision variables, so the
graphic approach s not used to solve them.

E.g.: 1. Solving the micro-computer problem with graphic approach

Zmax = 60X1 + 50X2

: 4X1 + 10X2  100
2X1 + X2  22
3X1 + 3X2  39
X1, X2  0
Steps:

1. Plot each of the constraints and identify its region – make linear inequalities linear
equations.
2. Identify the common region, which is an area that contains all of the points that
satisfy the entire set of constraints.
3. Determine the Optimal solution- identify the point which leads to maximum benefit
or minimum cost.

24
22 2X1 + X2 = 22

20

16

3X1 + 3X2 = 39
12
(0, 13) E
8
(5, 8) D 4X1 + 10X2 = 100
4 (9, 4) C

47
 (0, 0) A 4 8 B 12 16 20 24 28

To identify the maximum (minimum) value we use the corner point approach or the extreme point
approach. The corner point/extreme point approach has one theorem: It states that;

For problems that have optimal solutions, a solution will occur at an extreme, or corner
point. Thus, if a problem has a single optimal solution, it will occur at a corner point. If it
has multiple optimal solutions, at least one will occur at a corner point. Consequently, in
searching for an optimal solution to a problem, we need only consider the extreme points
because one of those must be optimal. Further, by determining the value of the objective
function at each corner point, we could identify the optimal solution by selecting the
corner point that has the best value (i.e., maximum or minimum, depending on the
optimization case) at the objective function.

Determine the values of the decision variables at each corner point. Sometimes, this can be done by
inspection (observation) and sometimes by simultaneous equation.
Substitute the value of the decision variables at each corner point.
After all corner points have been so evaluated, select the one with the highest or lowest value
depending on the optimization case.

Points Coordinates How Determined Value of Objective function

X1 X2 Z = 60X1 + 50X2
A 0 0 Observation Birr 0
B 11 0 Observation Birr 660
C 9 4 Simultaneous Birr 740
equations
D 5 8 Simultaneous Birr 700
equations
E 0 10 Observation Birr 500

Basic solution
X1 = 9
X2 = 4
Z = Birr 740

After we have got the optimal solution, we have to substitute the value of the decision variables
into the constraints and check whether all the resources available were used or not. If there is an
unused resource we can use it for any other purpose. The amount of unused resources is known
as SLACK-the amount of the scarce resource that is unused by a given solution.
The slack can range from zero, for a case in which all of a particular resource is used, to the
original amount of the resource that was available (i.e., none of it is used).

48
 Computing the amount of slack
Constraint Amount used with X1 = 9 Originally Amount of slack
and X2 = 4 available (available – Used)
Assembly time 4(9) + 10(4) = 76 100 hrs 100 – 76 = 24 hrs
Inspection time 2(9) = 1 (4) = 22 22 hrs 22 – 22 = 0 hr
Storage space 3(9) + 3(4) = 39 39 cubic ft 39 – 39 = 0 cubic ft

Constraints that have no slack are some time referred to as binding

constraints since they limit or bind the solution. In the above case,
inspection time and storage space are binding constraints; while assembly
time has slack.

Knowledge of unused capacity can be useful for planning. A manager may

be able to use the assembly time for other products, or, perhaps to
schedule equipment maintenance, safety seminars, training sessions or
other activities.

Interpretation: The Company is advised to produce9 units of type 1 microcomputers and 4 units
of type 2 microcomputers per week to maximize his weekly profit to Birr 740; and in do so the
company would be left with unused resource of 24-assembly hrs that can be used for other
purposes.

2. Solving the diet problem with graphic approach

Cmin: 5X1 + 8X2
10X1 + 30X2  140
20X1 + 15X2  145
X1 , X 2 0

16

12
20X1 + 15X2 = 145
(0, 9.67) A
8

10X1 + 30X2 = 140

4 B (5, 3)

C (14,0)
4 8 12 16 20

49
 Points Coordinates How Determined Value of the objective function
X1 X2 Z = 5X1 + 8X2
A 0 9.67 Observation Birr 77.30
B 5 3 Simultaneous Birr 49
equations
C 14 0 Observation Birr 70

Basic solution: X1 = 5 pounds

X2 = 3 pounds
C = Birr 49

Interpretation: To make the diet at the minimum cost of Birr 49 we have to purchase 5 pounds of
Type1 food and 3 pounds Type 2 food.

If there is a difference between the minimum required amount and the optimal solution, we call
the difference surplus: That is, Surplus is the amount by which the optimal solution causes a 
constraint to exceed the required minimum amount. It can be determined in the same way that
slack can: substitute the optimal values of the decision variables into the left side of the constraint
and solve. The difference between the resulting value and the original right-hand side amount is
the amount of surplus. Surplus can potentially occur in a  constraint.

B. The Simplex Algorithm/Algebraic Solution Method

The simplex method is an iterative technique that begins with a feasible

solution that is not optimal, but serves as a starting point. Through
algebraic manipulation, the solution is improved until no further
improvement is possible (i.e., until the optimal solution has been
identified). Each iteration moves one step closer to the optimal solution. In
each iteration, one variable that is not in the solution is added to the
solution and one variable that is in the solution is removed from the
solution in order to keep the number of variables in the basis equal to the
number of constraints.

The optimal solution to a linear programming model will occur at an

extreme point of the feasible solution space. This is true even if a model
involves more than two variables; optimal solutions will occur at these
points. Extreme points represent intersections of constraints. Of course, not
every solution will result is an extreme point of the feasible solution space;
some will be outside of the feasible solution space. Hence, not every
solution will be a feasible solution. Solutions which represent intersections
of constraints are called basic solutions; those which also satisfy all of the
constraints, including the non-negativity constraints, are called basic

50
 feasible solutions. The simplex method is an algebraic procedure for
systematically examining basic feasible solutions. If an optimal solution
exists, the simplex method will identify it.

The simplex procedure for a maximization problem with all  constraints consists of the
following steps.

1. Write the LPM in a standard form: when all of the constraints are written as equalities,
the linear program is said to be in standard form. We convert the LPM in to a standard form by
applying the slack variables, S, which carries a subscript that denotes which constraint it applies
to. For example, S1 refers to the amount of slack in the first constraint, S 2 to the amount of slack in
the second constraint, and so on. When slack variables are introduced to the constraints, they are
no longer inequalities because the slack variable accounts for any difference between the left and
right-hand sides of an expression. Hence, once slack variables are added to the constraints, they
become equalities. Furthermore, every variable in a model must be represented in the objective
function. However, since slack does not provide any real contribution to the objective, each slack
variable is assigned a coefficient of zero in the objective function.

Slack = Requirement – Production, surplus = Production – Requirement

Taking the microcomputer problem its standard form is as follows:

Zmax = 60X1 + 50X2 Zmax = 60X1 + 50X2 + 0S1 + S2 + 0S3

: 4X1 + 10X2  100 : 4X1 + 10X2 + S1 = 100
2X1 + X2  22 2X1 + X2 + S2 = 22
3X1 + 3X2  39 3X1 + 3X2 + S3 = 39
X1, X2  0 X1, X2, S1, S2, S3  0

2. Develop the initial tableau: the initial tableau always represents the “Do Nothing”
strategy, so that the decision variables are initially non-basic.

a) List the variables across the top of the table and write
the objective function coefficient of each variable jut above it.
b) There should be one row in the body of the table for
each constraint. List the slack variables in the basis column, one per
raw.
c) In the Cj column, enter the objective function
coefficient of zero for each slack variable. (Cj - coefficient of variable j
in the objective function)
d) Compute values for row Zj
e) Computer values for Cj – Zj.

51
 Sol/n Cj 60 50 0 0 0
basis X1 X2 S1 S2 S3 RHSV Øj = bj/xj (aij)
S1 0 4 10 1 0 0 100 100/4 = 25
S2 0 2* 1 0 1 0 22 22/2 = 11
S3 0 3 3 0 0 1 39 39/3 = 13
Zj 0 0 0 0 0 0
Cj-Zj 60 50 0 0 0 0

Entering variable Pivot column Pivot row

* Pivot Element

3. Develop subsequent tableaus

3.1. Identify the entering variable - a variable that has a largest
positive value is the Cj – Zj raw.
3.2. Identify the leaving variable - Using the constraint coefficients or substitution rates
in the entering variable column divide each one into the corresponding quantity
value. However do not divide by a zero or negative value. The smallest non-
negative ratio that results indicate which variable will leave the solution.

4. Find unique vectors for the new basic variable using row operations on the pivot
element.

Sol/n Cj 60 50 0 0 0
basis X1 X2 S1 S2 S3 RHSV Øj = bj/xj (aij)
S1 0 0 8 1 -2 0 56 56/8 = 7
X1 60 1 1/2 0 1/2 0 11 11/. 5 = 22
S3 0 0 3/2 0 -3/2 1 6 6/1.5 = 4
Zj 60 30 0 30 0 660
Cj-Zj 0 20 0 -30 0 0
Leaving variable

Entering Variable

Sol/n Cj 60 50 0 0 0
basis X1 X2 S1 S2 S3 RHSV Øj = bj/xj (aij)
S1 0 0 0 1 6 -16/3 24
X1 60 1 0 0 1 -1/3 9
X2 50 0 1 0 -1 2/3 4
Zj 60 50 0 10 40/3 740
Cj-Zj 0 0 0 -10 -40/3

Optimal solution: X1 = 9
X2 = 4
S1 = 24 hrs
Z = Birr 740

5. Compute the Cj – Zj raw

6. If all Cj – Zj values are zeros and negatives you have reached optimality.
7. If this is not the case (step 6), rehear step 2to5 until you get optimal solution.

52
“A simplex solution is a maximization problem is optimal if the Cj – Zj row
consists entirely of zeros and negative numbers (i.e., there are no positive
values in the bottom row).”

Note: The variables in solution all have unit vectors in their respective
columns for the constraint equations. Further, note that a zero appears is
raw c - z in every column whose variable is in solution, indicating that
its maximum contribution to the objective function has been realized.

Example 2
A manufacturer of lawn and garden equipment makes two basic types of
lawn mowers: a push-type and a self-propelled model. The push-type
requires 9 minutes to assemble and 2 minutes to package; the self-
propelled mower requires 12 minutes to assemble and 6 minutes to
package. Each type has an engine. The company has 12 hrs of assembly
time available, 75 engines, and 5hrs of packing time. Profits are Birr 70 for
the self-propelled models and Birr 45 for the push-type mower per unit.
Required:
1. Formulate the linear programming models for this problem.
2. Determined how many mower of each type to make in order to maximize the total profit
(use the simplex procedure).

Solution:
1.
a) To determine ho many units of each types of mowers to produce so as to
maximize profit.
b) Let X1 - be push type mower.
X2 - be self-propelled mower.
c) Determine the objective function
Zmax = 45X1 + 70X2
d) Identify constraints
9X1 + 12X2  720 minutes Assembly time
2X1 + 6X2  300 minutes packing time
X1 + X2  75 engines Engines
X1, X2  0

In summary:
Zmax = 45X1 + 70X2
: 9X1 + 12X2  720
2X1 + 6X2  300

53
 X1 + X2  75
X1, X2  0
2.
a. Write the LPM in a standard form

Zmax = 45X1 + 70X2 + OS1 + OS1 + OS3

: 9X1 + 12X2 + S1 = 720
2X1 + 6X2 + S2 = 300
X1 + X2 + S3 = 75
X 1, X 2, S 1, S 2, S 3  o

b. Develop the initial tableau – in LP matrices are commonly called tableaus

Sol/n Cj 45 70 0 0 0
basis X1 X2 S1 S2 S3 RHSV Øj = bj/xj (aij)
S1 0 9 12 1 0 0 720 720/12 =60
Leaving
S2 0 2 6 0 1 0 300 300/6 =50
variable
S3 0 1 1 0 0 1 75 75/1 = 75
Zj 0 0 0 0 0 0
Cj-Zj 45 70 0 0 0

Entering variable

c. Develop the subsequent tableaus

- Identify the entering variable
- Identify the leaving variable

Sol/n Cj 45 70 0 0 0
basis X1 X2 S1 S2 S3 RHSV Øj = bj/xj (aij)
S1 0 5 0 1 -2 0 120 120/5 = 24 Leaving
variable
X2 70 1/3 1 0 1/6 0 50 50/. 333 =150
S3 0 2/3 1 0 -1/6 1 25 25/.666 = 75
Zj 70/3 70 0 70/6 0 3500
Cj-Zj 65/3 0 0 -70/6 0
Entering variable

Sol/n Cj 45 70 0 0 0
basis X1 X2 S1 S2 S3 RHSV Øj = bj/xj (aij)
X1 45 1 0 1/5 -2/5 0 24
X2 70 0 1 -1/15 3/10 0 42
S3 0 0 0 -2/15 1/10 1 9
Zj 45 70 13/3 3 0 4020
Cj-Zj 0 0 -13/3 -3 0
Optimal solutions: X1 = 24 units
X2 = 42 units
S3 = 9 engines
Z = Birr 4020

54
 Interpretation: The Company is advised to produce 24 units of push type
mowers and 42 units of self-propelled mowers so as to
realize a profit of Birr 4020. In doing so the company
would be left with unused resource of 9 engines which
can be used for other purposes.

3. A firm produces products A, B, and C, each of which passes through assembly and inspection
departments. The number of person hours required by a unit of each product in each department
is given in the following table.
Person hours per unit of product
Product A Product B Product C
Assembly 2 4 2
Inspection 3 2 1

During a given week, the assembly and inspection departments have available at most 1500 and
1200 person-hours, respectively. if the unit profits for products A, B, and C are Birr 50, Birr 40,
and Birr 60, respectively, determine the number of units of each product that should be produced
in order to maximize the total profit and satisfy the constraints of the problem.
Answer: 0 unit of product A, 0 unit of product B, 750 units of product C, unused inspection time
of 450 hours, and a maximum profit, Z ,of Birr 45,000.

4. The state chairman of a political party must allocate an advertising budget of birr 3,000,000
among three media: radio, television, and newspapers. The expected number of votes gained per
birr spent on each advertising medium is given below.

Expected votes per Birr spent

Radio Television Newspapers
3 5 2
Since these data are valid with in the limited amounts spent on each medium, the chairman has
imposed the following restrictions:
 No more than Birr 500,000 may be spent on television ads.
 No more than Birr 1,200,000 may be spent on radio ads.
 No more than Birr 2,400,000 may be spent on television and newspaper ads combined.
How much should be spent on each medium in order to maximize the expected number of votes
gained?
Answer: Birr 500,000 should be spent on radio ads.
Birr 1,200,000 should be spent on television ads.
Birr 1,200,000 should be spent on newspaper ads.
Slack in the budget constraint is Birr 100,000.
Z = 9,900,000 is the maximum expected number of votes gained.

Some special Issues in LP

1. Unbounded solutions

55
 A solution is unbounded if the objective function can be improved without
limit. The solution is unbounded if there are no positive ratios in
determining the leaving variable. A negative ratio means that increasing a
basic variable would increase resources! A zero ratio means that increasing
a basic variable would not use any resources. This condition generally
arises because the problem is incorrectly formulated. For example, if the
objective function is stated as maximization when it should be a
minimization, if a constraint is stated  when it should be, or vice versa.

2. Multiple optimal solutions

The same maximum value of the objective function might be possible with
a number of different combinations of values of the decision variables.
This occurs because the objective function is parallel to a binding
constraint. With simplex method this condition can be detected by
examining the Cj – Zj row of the final tableau. If a zero appears in the
column of a non-basic variable (i.e., a variable that is not in solution), it can
be concluded that an alternate solution exists.

E.g. Z = 60X1 + 30X2

4X1 + 10X2  100
2X1 + X2  22
3X1 + 3X2  39
X1, X2  0
The other optimal corner point can be determined by entering the non-
basic variable with the C - Z equal to zero and, then, finding the leaving
variable in the usual way.

3. Degeneracy
In the process of developing the next simplex tableau for a tableau that is
not optimal, the leaving variable must be identified. This is normally done
by computing the ratios of values in the quantity column and the
corresponding row values in the entering variable column, and selecting
the variable whose row has the smallest non-negative ratio. Such an
occurrence is referred to degeneracy, because it is theoretically possible for
subsequent solutions to cycle (i.e., to return to previous solutions). There
are ways of dealing with ties in a specific fashion; however, it will usually
suffice to simply select one row (variable) arbitrarily and proceed with the
computations.

56
 Limitations of linear programming
1. In linear programming uncertainty is not allowed, i.e., LP methods are applicable only
when values for costs, constraints, etc. are known, but in real life such factors may be unknown.
2. According to the LP problem, the solution variables can have any value, whereas
sometimes it happens that some of the variables can have only integral values. For example, in
finding how may machines to be produced; only integral values of decision variables are
meaningful. Except when the variables have large values, rounding the solution to the nearest
integer will not yield an optimal solution. Such situations justify the use of Integer Programming.
3. Many times, it is not possible to express both the objective function and constraints in
linear form.

CHAPTER FOUR
MATHEMATICS OF FINANCE

People generally earn money because they want to spend it. If they save
it, rather than spend it in the period in which it was earned, it is usually
because they want it to spend in the future. However, for most people
present consumption is more desirable than future consumption if only
because the future is so uncertain. "Live and be merry, for tomorrow we
may die," is a rationale used over the ages to justify the urge to buy now
rather than deferring gratification to the future. For this reason, most of
us would rather have a dollar today than a dollar a year from today, and
must be given something extra to get us to defer gratification.

Looking at the transaction from the borrower's perspective, there are

consumers and businesses (not to mention the deficit-ridden
government) who really need that dollar today and who are willing to
promise to pay back more than that dollar in the future. Businesses can
invest borrowed funds in capital to create profits which are (hopefully)
more than sufficient to repay the borrowed funds (principal) plus
INTEREST. Consumers and governments borrow for various reasons but
are expected to have income in the future sufficient to repay principal
and interest. Simply put, the basic concept of mathematics of finance is
that money has time value. That is, a bird at hand worth two in the
forest.

Interest is the price paid for the use of a sum of money over a period of
time. It is the charge for exchanging money now for money later.

A savings institution pays interest to a depositor on the money in the

savings account since the institution has use of those funds while they

57
are on deposit. Or, a borrower pays interest to a lending agent for use of
that agent’s fund over the term of loan.

Interest - Simple interest.

- Compound interest.

SIMPLE INTEREST-
When we borrow money the money borrowed or the original sum of
money lent (borrowed or invested) is called the principal. (The principal
remains fixed during the entire interest period). Interest is usually
expressed as a percentage of the principal for a specified period of time
which is generally a year. This percentage is termed the interest rate.
If interest is paid on the initial amount only and not on subsequently
accrued interest, it is called simple interest.
However, if the interest for each period is added to the principal in
computing the interest for the next period, the interest is called
compound interest.
The sum of the original amount (principal) and the total interest is the
future amount or maturity value or Amount. A = P + I
Simple interest is generally used only on short term notes often of
duration less than one year. The concept of simple interest, however,
forms the basis for compound interest concepts.

Simple interest is given by the formula:

I = Prt
Where P= principal amount/ original amount borrowed or invested
r = Simple interest rate per year (expressed in decimal)
t= duration of the loan or investment in years
I = amount of interest in Birr.
If a sum of money, P is invested at a simple interest its value increases
by the same amount each year. Therefore, there is a linear relationship
between amount and time.
Taking P= principal, r = rate of interest, t = time in years and A =
amount, their relationship is as follows:

I = Prt --------------------------- 1
A=P+I
= P + Prt
A = P (1+rt) ----------------------2
P= I --------------------------- 3
rt

58
 P= A
1  rt            4
r = I              5
Pt
t = I pr                6

Example:
1. Mr. X wanted to buy a leather sofa for his new family room. The cost
of the sofa was Birr 10,000. He was short of cash and went to his local
bank and borrowed Birr 10,000 for 6 months at an annual interest rate
of 12%. Find the total simple interest and the maturity value of the loan.
Solution
I = Prt A = P+I
. x 12
 10,000x 012 = 10,000 + 600
= Birr 600 = Birr 10,600 or

A = P (1+rt)

= 10,000 (1.06) = Birr 10,600

2. How long will it take if Birr 20,000 is invested at 5% simple interest to

double in value?
Solution. I=A-p
t= = 40,000 - 20,000
I
P = 10,000 BIRR = 20,000
r = 5% rp
20,000
A = Birr 40,000
105x 20,000
t=?  20 years

3. At what interest rate will Birr 6,000 yield 900 Birr in 5 years time?
Solution.
t=
P = Birr 6,000
r = Birr 900
=
t = 5 years
r =? = 3% annual rate

4. How much money must Mr. Z has to invest today at 6% simple interest if
he is to receive Birr 3,100 as an amount in 4 years?

59
 Solution. A
P
P = Birr? 1  rt
A = 3,100 Br 3,100
=
t = 4 years 1 .06x 4
r = 6%  Birr 2,500
When time over which interest is paid is given in months, t is simply the
number of month divided by 12. If time is given as a number of days,
then one of two methods of computing t may be used:
# ofdays
 Ordinary interest year - uses a 360 - day year - t
360
When time is determined in this way, the interest is called ordinary
simple interest.
 Exact time- uses a 365-day year = t = or a 366 for leap year.
Interest computed in this way (using exact time) is called exact simple
interest.

5. Find the interest on Birr 1,000 at 5% for 45 days.

Solution
1. Using ordinary Interest year:
p = Birr 1,000 I = prt
r = 5% 45
= 1,000 x .05 x
t = 45 days 360
I= Birr 6.25

2. Using exact time:

I = Prt Always ordinary simple
45 interest is grater than
= 1,000 x .05 x
360 exact simple interest.
= Birr 6.16

Compound Interest
If the interest which is due is added to the principal at the end of each
interest period, then this interest as well as the principal will earn
interest during the next period. In such a case the interest is said to be
compounded. The result of compounding interest is that starting with
the second compounding the account earns interest on interest in
addition to earning interest on principal.

The sum of the original principal and all the interest earned is the
Compound Amount. The difference between compound amount and the
original principal is the Compound interest.

60
 The compound interest method is generally used in long-term borrowing.
There is usually more than one period for computing interests during the
borrowing time. The time interval between successive conversions of
interest in to principal is called the interest period or conversion
period or compounding period, and may be any convenient length of
time. The interest rates are always given as annual percentages; no
matter how many times the interest is compounded per year. Hence,
interest rate must be converted in to or adjusted to the appropriate
interest rate per conversion period (i) for computational purposes; and we
use the number of conversion periods as time.

The i is equal to the stated annual interest rate /nominal rate (r) divided
r
by the number of conversion periods in one year (m) = i = .
m
Conversion # of conversions per year, m

Daily 365
Monthly 12
Quarterly 4
Semi annually 2
Annually 1

Example:

1. What are the compound amount and compound interest at the end of one
year if Birr 10,000 is borrowed at 8% compound quarterly?
Solution
P = Birr 10,000 total # of conversions = 4
r = 8% t = one year
Total number of conversion periods (m) = 4 times = quarter
r 8%
i= . = = 2%
m 4

Original principal Birr 10,000

Add: interest for the first quarter, I =
10,000 x .02 200
Principal at the end of first quarter 10,200=10,000(1.02)1
Add: Interest for the second quarter,
10,200 x .02 204
Principal at the end of second quarter 10,404 = 10,000 (1.02)2
Add: Interest for the third quarter,
10,404x.02 208.08
Principal at the end of third quarter 10,612.08=10,000(1.02)3

61
 Add: Interest for the fourth quarter,
10,612.08 x .02 212.2416
Principal at the end of fourth quarter Birr 10,824.3216 = 10,000(1.02)4
(Amount at the end of the year)

If we summarize the above computations, we will discern a pattern that

leads to a general formula for computing compound interest:
1st quarter: S = 10,000 (1.02)1
2nd quarter: S = 10,000 (1.02) (1.02) = 10,000 (1.02) 2
3rd quarter: S = 10,000 (1.02) (1.02) (1.02) = 10,000 (1.02) 3
4th quarter: S = 10,000 (1.02) (1.02) (1.02) (1.02) = 10,000 (1.02) 4

In general, the compound amount can be found by multiplying the

principal by (1+i) n where i is the interest rate per conversion period and
n is the total number of conversion periods.

In Short, Amount with compound interest is calculated as:

r
A = P (1 +  tm
= P (1 + i) n
m
Where:
A = compound amount, after n conversion periods.
P = principal
r = stated annual rate of interest
m = number of conversion periods a year
t = total number of years
I = r/m = interest rate per conversion period
n = mt = Total number of conversion periods.
So, for the above question, the amount is equal to
A = P (1 + I) n
= 10,000 (1.02)4
= 10,824.3216 Birr

Compound interest = compound amount - original principal

= 10,824.3216 - 10,000
= Birr 824.3216

using logarithm Rules of log

A = 10,000 (1.02)4 1. log aa = 1
log A = log 10,000 + log (1.02)4 2. logmp = p logm
= log 10,000 + 4 log 1.02 3. logmn = logm + logn
= 4 + 4 (0.0086) 4. logm/n = logm - logn
= 4+ 0.0344
log A = 4.0344
A = antilog 4.0344

62
 = 10,824.30

Logarithms and Anti Logarithms for the Solutions of Equations.

1. ax = b 2x = 5
logax = logb log2x = 5
xloga = logb xlog2 = log5
log b log
5
x= x=
log a log 2

2. abx + c = d 4(3x) + 10 = 17
abx = d-c 4(3x) = 17-10
dc 4(3x) = 7
bx =
a 3x = 1.75
dc log3x = log1.75
logbx = log --- k
a xlog3 = log1.75
xlogb = logk log1.75
logb x=
x= log 3
logb
x3 = 1,000
3. x3 = a logx3 = log1000
logx3 = loga 3logx = log1000
3 log x log a log1000
 logx 
3 3 3
a k
log 3 3
x
log = logx =
3
3 logx = 1
x = antilogk x = antilog1
= 10
4. a = b(c+x)d 100 = 25(1+x)4
(c+x)d = a/b (1+x)4 = 100/25
log(c+x)d = loga/b log(1+x)4 = log4
dlogc+x = loga-logb 4log1+x = log4
 log a  log b  log1+x = log 4/4
logc+x =  k
 d  log1+x = 0/150515
logc+x = k 1+x = antilog0.150515
c+x = antilogk 1+x = 1.4142
x = antilogk-c x=0.4142

2. Find the compound amount compound interest resulting from the

investment of Birr 1000 at 6% for 10 years,
2.1. Compounded annually.

63
Solution
P = Birr 1,000 A = p(1+i)n
t = 10 years = 1,000 (1.06)10
m=1 = Birr 1,790.85
r = 6%
A =? Compound interest = Compound amount - principal
i = 6% = 1,790.85 - 1000
n = 10 = 790.85 Birr

2.2. Compounded semiannually.

Solution
P = Birr 1,000 A = p(1+i)n
r = 6% = 1,000 (1.03)20
m=2 = Birr 1,806.11
t = 10 years Compound interest = compound amount - principal
i = 3% = 1,806.11 - 1000
n = 20 = Birr 806.11

2.3 compounded quarterly.

Solution
P = Birr 1,000 A = 1,000 (1.06)40
r = 6% = Birr 1,814.02
m=4
t = 10 years Compound interest = compound amount - principal
i = .015 = 1814.02 - 1000
n = 40 = Birr 814.02

2.4. Compounded monthly.

Solution
P = Birr 1000 A = 1,000 (1.005) 120
r = 6% = 1,819.40 Birr
t = 10 years
m=12 Compound interest = compound amount - principal
i = .005 = 1,819.40 - 1000
n = 120 = 819.40 Birr

2.5. If compounded weekly

Solution
P = Birr 1000 A = 1,000 (1.0012)520
r = 6% = 1,821.49 Birr
t = 10 years
m=52 Compound interest = compound amount - principal

64
 i = .0012 = 1821.49 - 1000
n = 520 = Birr 821.49

2.6. Compounded daily

P = Birr 1000 A = 1,000 (1.0001644)3650
r = 6% = 1,822.03
t = 10 years
m=365 Compound interest = compound amount - principal
i = .01644% = 1,822.03 - 1000
n = 3650 = Birr 822.03

2.7. Compounded hourly

P = Birr 1000 A = 1,000 (1.00000685)687,600
r = 6% = 1,822.12 Birr
t = 10 years
m= 8760 Compound interest =compound amount - principal
i = .000685% = 1,822.12 - 1000
n = 87600 = Birr 822.12 Birr

2.8. Compounded continuously (instantaneously).

(1+i) n = (1+r/m) mt
 1  1
f(x) =  1   x if x approaches infinity  1   x becomes closer to 2.71828 =
 x  x
e
Let m/r = x as m x 

r/m = 1/x = m = rx

P = Birr 1000 A = Pert

r = 6% = 1,000 e.06x10 = 1000 e.6
t = 10 years = Birr 1,822.12
m=infinite compound interest = compound amount - principal
1,822.12 - 1000 = Birr 822.12
3. How long will it take to accumulate Birr 650 if Birr 500 is invested at
10% compound quarterly?
Solution
P = 500 A = p(1+i)n
A = 650 650 = 500 (1.025)n
r = 10% 1.3 = (1.025)n

65
 i=2.5% log1.3= log(1.025)n
m=4 log 1.3 log 1.025
 n
log 1.3 log 1.025
t=? n/m = log 1.3
n=
n =? 10.625 quarters log 1.025
= 10.625 quarters

4. Birr 2000 is deposited in an account. After one year of monthly

compounding, the balance in the account is Birr 2,166. What is the
annual percentage rate for this account?

Solution
P = Birr 2,000 A = p(1+i)n
A = Birr 2,166 2166 = 2000 (1+i)12
r =? 1.083 = (1+i)12
i=r/12 log1.083= log(1+i)12
t=1 =12log1+i
m = 12 log 1.083
 log 1  i
12
0.0028857 = log1+i
anti log .0028857 = 1+i
1.0066667 = 1+i
.0066667 = i
.006667 x 12 = r = i x m
= 8% = r
5. A person deposits Birr 10,000 in a savings account that pays 6%
compounded semi-annually. Three years later, this person deposits an
additional Birr 8,000 in the savings account. Also, at this time, the
interest rates changes to 8% compounded quarterly. How much money is
in the account 5 years after the original Birr 10,000 is deposited?
Solution

3 years 2 years

P= Birr 10,000

10,000(1.03)6 Birr 11,940.52

8,000.00
Birr 19,940.52

19,940.52(1.02)8
Birr 23,363.49
Present Value

66
 Frequently it is necessary to determine the principal P which must be
invested now at a given rate of interest per conversion period in order
that the compound amount A be accumulated at the end of n conversion
periods. This process is called discounting and the principal is now a
discounted value of a future income A.

A = P (1+i) n dividing both sides by (1+i) n leads to

A
P= = p = A (1+i)-n
(1  i ) n
Present values of a compound amount:

P = A (1+i)-n
Where:
p = principal / present value
A = compound amount (or future value)
i = interest rate per conversion period
n = total number of conversion periods
Example:
1. Find the present value of a loan that will amount to Birr 5,000 in four
years if money is worth 10% compounded semi annually.
Solution.
A = 5,000 Birr P = A (1+i)-n
t = 4 years = 5,000 (1.05)-8
m=2 = Birr 3,384.20
r = 10%
P =?
2. How much must be deposited now in an account paying 6% compounded
monthly in order to have just 20,000 Birr in the account 4 years from
now?
A = 20,000 Birr P = A (1+i)-n
t = 4 years = 20,000 (1.005)-48
m = 12 = Birr 15,742
r = 6%
P =?

3. If money worth 14% compounded semi-annually, would it be better to

discharge a debt by paying Birr 500 now or Birr 600 eighteen months
from now?
Solution:
We can solve this problem in two ways:
1) By finding the PV of 600 and compare it with 500
2) By finding the FV of 500 and compare it with 600.

1) A = 600 2) P = 500
t = 18 months = 1.5years t = 1.5 years

67
 m=2 m=2
r = 14% r = 14%
p =? A =?
-n
P = A(1+i) A = P(1+i)n
-3
= 600 (1.07) = 500 (1.07)3
= Birr 489.78 = Birr 612.52
Since 489.78 < 500, it is better to Since 612.52 > 600, it is better to
pay the debt after 18 months. pay the debt after 18 months.

4. How much should be deposited in an account paying 8% compounded

quarterly in order to have a balance of Birr 8,000 nine years from now?
Solution:
A = Birr 8,000 P = A (1+i)-n
t = 9 years = 8,000(1.02)-36
n = 36 = 3,921.79 Birr
m=4
i=2%
r = 8%
P =?

Present value with continuous compounding

Equivalent Rates
Some times it is helpful to convert interest rates from, for example, a
compounded quarterly basis to a compounded annually basis, from a
compounded quarterly basis to compounded monthly basis, etc. this is
easily accomplished as long as we understand the concept of equivalent
interest rates, which is defined as follows:
If at the beginning of a specified time period, the same amount of
money is invested at various rates so that the resulting
compound amounts are equal at the end of the time period, then
the interest rates are equivalent rates.
Although we can use any length time period, we usually use a 1-year
time interval. Thus, if Birr P is invested at annual rate r compounded m
times a year, and another Birr P is invested at annual rate s
compounded k times a year, then the rates are equivalent as long as
P (1 +r/m) m = P (1 +s/k) k

68
 Dividing both sides of the above equation by P gives the equivalent rates
equation which can be solved for either r or s, depending on which the
unknown.
Use this equation to find equivalent rates: (1 +r/m) m = (1 +s/k) k
1. What rate compounded monthly is equivalent to 8% compounded
quarterly?
Solution
(1+r/12)12 = (1+.08/4)4
= (1.02)4, solving for r, we take the 12th root of each side
to obtain, (1+r/12) = ((1.02)4)1/12
= (1.02)3
r/12 = (1.02)3 -1
= 1.006622 -1
r/12 = .006622
r = 12(.006622)
r = .079476
= 7.95%

2. What nominal annual rate of interest converted monthly corresponds to

16% converted quarterly?
Solution

(1+r/12)12 = (1+.16/4)4
= (1.04)4, solving for r, we take the 12th root of each side to
obtain, (1+r/12) = [(1.04)4]1/12
= (1.04)1/3
r/12 = (1.04)1/3 -1
= 1.013159404 -1
r/12 =. 013159404
r = 12(013159404)
r = .157912845
= 15.79%

Or, using logarithms

(1.04)4 = (1+i) 12
Log (1.04)4 = log (1+ i) 12
4 log (1.04) = 12 log (1+i)
4 (0.017033339) = 12 log (1+ i)
0.068133357 = 12 log (1 + i)
0.0056778 = log 1+ i
Antilog .0056778 = (1+ i)
1.0131594 = 1+i
.1031594 = i
r=mxi

69
 = 12 x .0131594
= 15.79%

A stated rate of 15.79% compounded monthly would earn interest

equivalent to that earned with a stated rate of 16% compounded
quarterly.

Effective Rate
Obviously, for a stated annual interest rate, the amount of interest
accumulated depends upon the frequency of conversion. This is because
interest which has been earned subsequently earns interest it self.
When interest is compounded more than once a year, the stated annual
rate is called a Nominal Rate. The effective rate corresponding to a given
nominal rate r converted m times a year is the simple interest rate that
would produce an equivalent amount of interest in one year. Effective
rates are, therefore, the simple interest rates that would produce the
same return in one year had the same principal been invested at simple
interest without compounding.
If P = Principal, A = Amount, r = nominal rate, m = number of conversion
periods per year, the compound interest for one year on principal p is,
I=A-P
= p (1 + r/m) m - p
Compound int erest I
The effective rate of interest is (re)=  . From the above
principal P
statement:
I = p (1 + r/m) m - p
= P [(1+r/m) m - 1) Divide both sides by p

I/p =

re =
= (1+i) m - 1
In continuous compounding case:
A = Pert for one year A = Per
I=A-P
= Per - p, multiplying both sides by 1/p
1/p x I = P (er-1) x 1/p
re = er-1

70
 Effective rates are used to compare competing interest
rates offered by banks and other financial institutions.

Example:
1. What is the effective rate of money invested at 6% compounded
quarterly?
Solution.
R = 6% re = (1+r/m)m-1
m=4 .06 4
= (1+ ) -1
4
= (1.015)4 -1
= 6.14%

2. An investor has two opportunities to invest his money. The first

investment opportunity (opp A) pays 15% compounded monthly and the
second investment opportunity (opp B) pays 15.2%% compounded
semiannually. Which is the better investment, assuming all else is
equal.

Solution
Nominal rates with different compounding periods cannot be compared
directly. We must first find the effective rate of each nominal rate and
then compare the effective rates to determine which investment will yield
the larger return.
:
Effective rate for inv. opp. A Effective rate for inv. opp. B
re= (1+r/m)m - 1 re= (1+r/m)m - 1
12 2
 115  115
1   1 1   1
 12   12 
= =
(1.0125)12  1 (1.076) 2  1
16.075% 15.778%

Since the effective rate for A is greater than the effective rate for B,
Investment opportunity A is the preferred investment.

3. A bank states that the effective interest on savings accounts that earn
continuous interest is 10%. Find the nominal rate.
Solution.
re = er-1
.10 = er-1
1.1 = er
ln 1.1 = lner
ln1.1 = rlne
ln1.1 = r (1)

71
 9.531% = r
ANNUITIES
An annuity is a sequence of EQUAL, PERIODIC PAYMENTS. The
payments may be made weekly, monthly, quarterly, semi-annually,
annually or for any fixed period of time. The time between successive
payments is called the PAYMENT PERIOD for an annuity. Each payment
is called PERIODIC PAYMENT or PERIODIC RENT, and it is denoted by
R. The time from the beginning of the first payment period to the end of
the last period is called the TERM of an annuity. If payments are made at
the end of each time interval, then the annuity is called an ORDINARY
ANNUITY. If payments are made at the beginning of the payment period,
it is called an ANNUITY DUE.

Geometric Series and Annuities

Geometric Series
A geometric progression is a sequence of numbers where each term after
the first term is found by multiplying the previous term by a fixed
number called the Common ratio, r. It has the form
a + ar + ar2 + ar3 +...+ arn-1.

Each term is a constant multiple, r, of the preceding term. If S n denotes

the sum of the first n terms of a geometric series, then
Sn = a + ar + ar2 + ar3 +...+ arn-1.

An alternative formula for evaluating Sn is derived as follows. Take the

equation Sn = a + ar + ar2 + ar3 +...+ arn-1 and multiply both sides by r to
obtain rSn = ar + ar2 + ar3 +...+ arn-1

Now consider both equations:

Sn = a + ar + ar2 + ar3 +...+ arn-1

rSn = ar + ar2 + ar3 +...+ arn-1 + arn
Subtracting the second equation from the first, we would get
Sn - rSn = a - arn

Factoring both sides of this last equation gives us

Sn (1 – r) = a (1- rn)
Hence,

(Valid only if r ≠ 1.)

72
 If r = 1, then Sn = arn. If the common ratio in a geometric progression is
less than 1 in modulus, (that is -1 < r <1), the sum of an infinite number
of terms can be calculated. This is known as the sum to infinity,
Provided -1 < r < 1

ORDINARY ANNUITY

An ordinary annuity is a series of equal periodic payments in which each

payment is made at the end of the period.
In an ordinary annuity the first payment is not considered in interest
calculation for the first period (because it is paid at the end of the first
period for which interest is calculated) and the last payment doesn’t
qualify for interest at all since the value of the annuity’s computed
immediately after this last payment is received.
AMOUNT (FUTURE VALUE) OF AN ORDINARY ANNUITY
The amount (future value) of an ordinary annuity is the sum of all
payments plus all interests earned.

EXAMPLE
1. What is the amount of an annuity if the size of each payment is Birr 100
payable at the end of each quarter for one year at an interest rate of 4%
compounded quarterly?
Solution
Periodic payment (R) = Birr 100
Payment interval = conversion period = quarter
Nominal (annual rate), r, = 4%
Interest rate per conversion period (i) = r/m = 4%/4 = 1%
Future value of (sum of) an annuity =?
Term one year

1,2,3,4 - End of the quarter

Now 1 2 3 4
0 100Birr 100 Birr 100 Birr 100 Birr

Birr 100

Birr 100 (1.01)1

Birr 100 (1.01)2

73
 Birr 100 (1.01)3

Birr 100 (1.01)4

A = Birr 406.04

Compound interest = Amount - R (n)

= 406.04 - 100(4)
= Birr 6.04
Taking
R = amount of periodic payment
I = interest rate per payment period
n = total number of payment periods
A = Future value (Amount) of an O. Annuity at the end of its term.

Last payment R
The second payment from the last R(1+i)1
The third payment from the last- R(1+i)2
|
The second payment R(1+i)n-2
The first payment R(1+i)n-1

A = R + R (1 + i) 1 + R (1+i) 2 + ------ + R (1+i) n-2 + R (1+i) n-1 -------- (1)

Multiplying each side of the equation by 1+i, we obtain

A (1+i) = R (1+i) + R (1+i) 2 + R (1+i) 3 + ---- + R (1+i) n-1 + R (1+i) n --- (2)

Then subtracting the first equation from the second equation, we have
A (1+i) = R (1+i) + R (1+i) 2 + ------ + R (1 + i) n-1 + R (1+i) n
- A = R + R (1+I) 1 + R (+i) 2 + ---- + R (1+i) n-1
A (1+i) - A = R (1+i) n-R
A [1+i-1] = R [(1+i) n-1]

A (i) = R [(1+i) n-1] dividing both sides by i, we have, A =

(1 + i) n -1]
= future value factor.
i

For the above example: A = 100 = Birr 406.04

2. A newly married couple are both working and decide to have Birr 1000 at
the end of a month for a down payment on a home. The account earns
12% compound monthly. How large a down payment will they have saved
in three years?

74
 Solution
R = Birr 1000 Compound interest = A - R(n)
t = 3 years. = 43,076.88 - 36,000
m = 12 = 7,076,88 Birr
n = 36
r = 12%
i=1%
A =?

3. A person deposits Birr 200 a month for four years in to an account that
pays 7% compounded monthly. After the four years, the person leaves
the account untouched for an additional six years. What is the balance
after the 10 year period?
Solution
R = Birr 200 A4 = 200 [(1 + .07)48 – 1]
t = 4years 0.07/12
m = 12 = 200 (55.20924)10
r = 7% = 11,041.85 Birr
After the end of the fourth year, we calculate compound interest rate
taking Birr 11,041.85 as principal compounded monthly for 6 years.
P = 11,041.85 Birr A10 = 11,041.85 (1 + .07)72
t = 6years 12
m = 12 = 11,401.85 (1.5201)
I = 7% = Birr 16,784.77
A10 =?
4. A person deposits Birr 500 a year for 10 years in to an account that pays
6% compounded annually. After 10 years the person transfers the money
into another account that pays 8% compounded quarterly. The money is
left in the second account for 8 years. What is the balance after the 18-
year period?

Solution.
For the first 10 years:
R = Birr 500 A10 = 500 [(1.06)10 – 1]
t = 10years .06
m=1 = 500 (13.180795)
r = 6% = Birr 6590.40
A10 =?

For the next 8 years, Birr 6590.40 is taken as single deposit (Principal) in
an account which pays 8% compounded quarterly.

P8 = A10 = Birr 6950.40

t = 8years A18 = A10 (1 +i) n

75
 m=4 = 6950.40 (1.02)32
r = 8% = 6950.40 (1.88454)
A18 =? A18 = Birr 12,419.87

The balance after 18 years is Birr 12,419.87 out of which Birr 7,419.87
(Birr 12,419.87 – Birr 5000) is interest earned.

Sinking Fund- Increasing Annuity

A Sinking fund is a fund in to which equal periodic payments are made
in order to accumulate a specified amount at some point in the future.
Sinking funds are generally established in order to satisfy some financial
obligation or to reach some financial goal.
If the payments are to be made in the form of an ordinary annuity, then
the required periodic payment into the sinking fund can be determined
by reference to the formula for the a mount of an ordinary annuity. That
is, if
A = R [(1+i) n –1]
i
Then A____
R = [(1+i) n - 1]
i

R=

Example:
1. What monthly deposit will produce a balance of Birr 100,000 after
10 years? Assume that the annual percentage rate is 6% compounded
monthly. What is the total amount deposited over the 10-year period?
Solution.

A = Birr 100,000 R=A[ i ]

(1+i)n – 1
t = 10years
m = 12 = 100,000 [ .005 ]
120
(1.005) – 1
r = 6% = 100,000 (0.006102)
R =? = Birr 610.21

The total amount deposited over the 10-yr period is 120 (610.21) = Birr
73,225.

76
2. Mrs. X has a saving goal of Birr 25,000 which she would like to
reach 10 years from now. During the first five years she is financially
able to deposit only Birr 100 each month into the savings account. What
must her monthly deposits over the last five years be if she is to reach
the goal? The account pays 12% interest compounded monthly.

Solution.

For the first five years

R = 100 A60 = 100 [(1.01)60 - 1]
t = 5years 0.01
m = 12 = 100 (81.6697)
r = 12% = Birr 8166.97
A60 =?

For the last five years:

The amount at the end of the first 5 years (Birr 8,166.97) serves as single
principal and it earns interest for the next five years.

A = 8,166.97 (1.01)60
= Birr 14,836.90

To determine the periodic payment we subtract 14,836.90 Birr from

Birr 25,000 to obtain the amount of an ordinary annuity for the
last five years.

A60 = Birr 25,000 – Birr 14,836.90

= 10,163.10

R2 = 10,163.120 X .01___
(1.01)60 – 1
= Birr 124.44

The proper R is (if normally deposited the same amounts)

R = 25,000 [ .01 ]
(1.01)120 – 1
= Birr 108.68

3. XYZ Company purchased a tract of land under a purchase

agreement which requires a payment of Birr 500,000 plus 5% interest
compounded annually at the end of 10 years. The company plans to
setup a sinking fund to accumulate the amount required to settle the

77
land purchase debt. What should the quarterly deposit into the fund be if
the account pays 15% interest, compounded quarterly?

Solution.
First we have to find the total debt at the end of five years as

A = P (1+i) n i = 5%
10
= 500, 000 (1+0.05)
= Birr 814,447.31

The amount is taken as Future Value of an Ordinary annuity with r =

15% Compounded quarterly for 10 years

A40 = Birr 814,447.31 R = 814,447.31

t = 10 years
m=4 = 9,088.80 Birr
r = 15%
i= 3.75%
R =?
Sinking Fund Schedule
The accumulation of value in a sinking fund is illustrated by a sinking
fund schedule.
Example: A business man wishes to set aside semiannual payments to
purchase machinery after two years (two years from now). The
machinery's estimated cost is Birr 5000. Each payment earns interest at
12%compounded semiannually.
a) Find the semiannual payment
b) Find the total interest earned
c) Prepare a sinking fund schedule

Solution

A = Birr5000 a) R=

t = 2 years =

m=2 = Birr 1,142.96

r = 12% b) Interest = Amount - R (n)
i= 6% = 5000 - 1,142.96(4)
n= 4 = Birr 428.16
R=?
c)
Payment Payment (R) Interest* Total
number

78
 1 Birr 1,142.96 Birr 0 Birr 1,142.96
2 Birr 1,142.96 Birr 68.58 Birr 2,354.50
3 Birr 1,142.96 Birr 141.27 Birr 3,638.73
4 Birr 1,142.96 Birr 218.32 Birr 5000.01
Birr 428.16
* Interest = balance x i

Present Value of an Ordinary Annuity

The present value of an ordinary annuity is the amount of money today,
which is equivalent to the sum of a series of equal payment in the future.
It is the sum of the present values of the periodic payments of an
annuity, each discounted to the beginning of an annuity. The present
value represents the amount that must be invested now to purchase the
payment due in the future.
In short, PV of an ordinary annuity can be computed in two ways:
(1) Discounting all periodic payment to the beginning of the term
individually.
(2) Discounting the amount of an ordinary annuity to the beginning of
the term.
Example
1. What is the PV of an annuity if the size of each payment is
Birr 200 payable at the end of each quarter for one year and the interest
rate is 8% compounded quarterly?

Solution.
R = Birr 200 r = 8%
m=4 t = 1yr
P =?

P______________________________________________________A

0 1 2 3 4
196.10 = 200 (1.02)-1 _ _ _ 200
192.23 = 200 (1.02)-2 _ _ _ _ _ _ _ _ _ _ 200
188.46 = 200 (1.02)-3 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 200
184.77 = 200 (1.02)-4 _ __________________________
Birr 761.56

Equivalently: Find the FV of the ordinary annuity using the formula A =

R [(1+i)n - 1]

A = 200 [(1.02)4 - 1]
.02

79
 = Birr 824.32

Discount this future value to the present value taking it as single FV.

P = 824.32 (1.02)-4
= 761.56

We have seen that the future value of an ordinary annuity after n

payment periods is A = R [(1+i) n - 1], and also we have seen that the PV
of a lamp sum investment after n periods with interest rate i per period
is: P (1+i) n

The future value of an annuity and the future value of the lamp sum
payment should be equal at the end of n periods; thus,

P (1+i) n = R [(1+i) n -1] Dividing both sides by (1+i) n gives

i
P = R [1 – (1+i)-n]
i
Or
If we multiply the FV of an O. annuity by the compound discount factor
we have the present value of an annuity.

P = R [(1+i) n -1] (1+i)-n

i
= R [(1+i) n (1+i)-n –1 (1+i)-n]
i
= R [(1+i) 0 – 1 (1+i)-n]
i

Using the above formula; the PV of the former example is computed

as:

R = Birr 200 P = R [1 – (1+i)-n]

r = 8% i
m=4 = 200 [1 – (1.02)-4]
t = 1yr .02
P =? = 200 (3.08773)
= Birr 761.55

2. What is the cash value of a car that can be bought for

Birr 200 down payment and Birr 82 a month for 18 months, if
money is worth 12% interest compounded monthly?
Solution.

80
 Cash Value = down payment + PV of an O. annuity
= 200 + 82[1 – (1.01)-18]
.01
= 200 + 82(16.39827)
= 200 + 1,344.658
= Birr 1,544.658

3. How much should you deposit in an account paying 6%

compounded quarterly in order to be able to withdraw Birr 1000 every 3
months for the next 3 years?
Solution.
R = Birr 1000 PV = 1000[1 – (1.015)12]
t = 3years .015
m=4 = 1000(10.9075)
r = 6% = Birr 10, 907.50
PV =?

4. What is the present value of an annuity of seven payments of Birr 1000

each made at the end of each quarter with an interest rate of 12%
compounded monthly?
Solution

Since we have quarterly payment periods and monthly interest periods,

we must change the interest rate to coincide with the quarterly payment
periods. Specifically, we must find the equivalent interest rate
compounded quarterly corresponding to 12% compounded monthly and
use it as r (i). Using the equivalent rate formula, we have
(1 +r/4)4 = (1 +.12/12)12
(1+ r/4)4 = (1.01)12
r/4 = (1.03)3 - 1  i = .030301

R = Birr 1000
i = .030301
n=7
P =?

= = Birr 6,223.22

5. A business person's debt is payable as follows: Birr 2,000 1 year from

now and Birr 5,000 5 years from now. The business person wants to
repay the debt as follows: a Birr 1,000 payment now, a Birr 2,000
payment 2 years from now, a Birr 1,000 payment 3 years from now, and
the last payment 4 years from now. If the interest rate is 12%
compounded annually, find the amount of the last payment.

81
 Amortization- Decreasing Annuity
Amortization means retiring a debt in a given length of time by equal
periodic payments that include compound interest. After the last
payment, the obligation ceases to exist-it is dead-and it is said to have
been amortized by the payments.
In amortization our interest is to determine the periodic payment, R, so
as to amortize (retire) a debt at the end of the last payment. Solving the
PV of ordinary annuity formula for R in terms of the other variables, we
obtain the following amortization formula:

Where:
R = periodic payment
P = PV of loan
i= interest rate per period
n = number of payment periods

Example
1. Suppose you borrow Birr 5000 from a bank and agree to repay the
loan in five equal installments including all interests due. The bank’s
interest charges are 5% compounded annually. How much should each
annual payment be in order to retire the debt including the interest in 5
years?
Solution.
PV = Birr 5000 R = 5000[ .05 ]
-5
t = 5years 1 – (1.05)
m=1 = 5000(.230975)
r = 5% = Birr 1,154.87
R =? Interest = (1,154.87 X 5) – 5000
= Birr 774.35

2. At the time of retirement, a person has Birr 200,000 in an

account that pays 12% compounded monthly. If he decides to
withdraw equal monthly payments for 10 years, at the end of which
time the account will have a zero balance, how much should he
withdraw each month?
Solution.

PV = Birr 200,000 R = 200,000 [ .01 ]

t = 10years 1 – (1.01)-120

82
 m = 12 = 200,000(0.014347)
r = 12% = Birr 2,869.42
R =?

3. An employee has contributed with her employer to a

retirement program for 20 years a certain amount twice a year. The
contribution earns an interest rate of 10% compounded semi
annually. At the date of her retirement the total retirement benefit
is Birr 300,000. The retirement program provides for investment of
this amount at an interest rate of 10% compounded semi annually.
Semi-annual payments will be made for 20 years to the employee
or her family in the event of her death.
1. What semi-annual payment should she make?
2. What semi-annual payment should be made for her?
3. How much interest will be earned on Birr 300,000 over the 40
years?
Solution.
Retirement plan

Employment period Retirement period

Pay Receive
0 20 40
R =? A = Birr 300,000
A = 300,000 PV = 300,000
t = 20 years t = 20 years
m=2 m=2
r = 10% r = 10%
R1 =? R2 =?

R = A[ i ] R2 = P20 [ i ]
(1+i) n –1 1 – (1+i)-n

= 300,000 ( .05 ) = 300,000 ( .05 )

(1.05)40 – 1 1 – (1.05) -40

= Birr 2483.45 = Birr 17,483.45

Interest earned = (R2 x 40) - (R1 x 40)

= (17,483.45 x 40) - (2483.45 x 40)
= (15,000 x 40)
= Birr 600,000

4. Eden signed a loan for Birr 10,000. The loan is to be repaid with equal
yearly payments for the first three years and equal yearly payments twice

83
as large for the next four years. If the interest rate is 12% compounded
annually, find the yearly payments. Assume each payment is made at the
end of each year.

Solution
Draw the time line as follows.

0 1 2 3 4 5 6 7
x x x 2x 2x 2x 2x

Observe that x denotes the first three annual payments and 2x denotes
the remaining payments. Then we choose a comparison payment. If the
comparison point chosen is to be the end of the third year, then the
annuity consisting of three payments of x Birr each must be brought
forward to the comparison point. This done by multiplying x by the
future value factor of an ordinary annuity. Also, the annuity consisting of
four payments of 2x Birr each must be brought back to the comparison
point. This done by multiplying 2x by the present value factor of an
ordinary annuity. Finally, Birr 10,000 must be brought forward to the
comparison point by multiplying it by future value factor of a single
deposit. Hence, the equation of value is,

x(3.374400) + 2x(3.037349) = 10,000(1.404928)

Solving for x, we have
3.3744x + 6.074698x = 14,049.28
x = Birr 1,486.84

AMORTIZATION SCHEDULE
Ato Abebe borrowed Birr 7000. The loan plus the interest is to be repaid
in equal quarterly installments made at the end of each quarter during a
2 year interval. The interest rate is 16% compounded quarterly.
a) Find the quarterly payment
b) Find the interest accumulated
c) Prepare an amortization schedule

Solution

84
P = Birr 7000 a)

r = 16%, i = 4%

m=4

t = 2 years, n = 8 R = Birr 1,039.69

R =?
b) Interest accumulated = R (n) - A
= 1,039.69(8) - 7,000
= Birr 1317.52

c) Amortization schedule
Payment payment Interest Principal Balance
No. reduction
0 Birr
7,000.00
1 Birr Birr 280.00 Birr 759.69 6,420.31
1,039.69
2 1,039.6 249.61 790.08 5,450.23
9
3 1,039.6 218.01 821.68 4628.55
9
4 1,039.6 185.14 854.55 3774.00
9
5 1,039.6 150.96 888.73 2885.27
9
6 1,039.6 115.41 924.28 1960.99
9
7 1,039.6 78.44 961.25 999.74
9
8 1,039.6 39.99 999.74 0.00
9
Birr
1,317.56

Mortgage Payments
In atypical house purchase transaction, the home-buyer pays part of the
cost in cash and borrows the remained needed, usually from a bank or a
savings and loan association. The buyer amortizes the indebtedness by
periodic payments over a period of time. Typically, payments are monthly
and the time period is long-30 years is not unusual.
Mortgage payment and amortization are similar. The only differences are
- The time period in which the debt/loan is amortized/repaid

85
 - The amount borrowed.
- In mortgage payments m is equal to 12 because the loan is repaid
from monthly salary, but in amortization m may take other values.
In Mortgage payments we are interested in the determination of monthly
payments.
Taking A = total debt
R = monthly mortgage payment
r = stated nominal rate per annum
n = 12 x t
R can be determined as follows:

Or

Similarly

Example:
1. Mr. X purchased a house for Birr 115,000. He made a 20% down
payment with the balance amortized by a 30 yr mortgage at an annual
interest of 12% compounded monthly.

a) What is the amount that Mr. X should pay

monthly so as to retire the debt at the end of the 30 th yr?
b) Find the interest charged.

Solution
Selling price = Birr 115,000 r = 12% i= 1%
Down payment (20%) 23,000 m = 12
Mortgage (A) Birr 92,000 t = 30yrs n= 360
R =?

= 92,000 (.010286125)
= Birr 946.32

86
 Interest = Actual payment – Mortgage (loan)
= (946.32 X 360) - 92000
= Birr 340,675.20 – 92,000
= Birr 248,675.20

2. Mrs. Y purchased a house for Birr 50,000. She made an amount of

down payment and pay monthly Birr 600 to retire the mortgage for 20
years at an annual interest rate of 24% compounded monthly.

Required: Find the mortgage, down payment, interest charged, and the
percentage of the down payment to the selling price.

Solution.
Selling price = Birr 50,000 Mortgage (A) = R [1- (1+i)-n]
Down payment =? i
Mortgage (A) =? = 600 [1- (1.02)-240]
R = Birr 600 0.02
r = 24% i = 2% = Birr 29,741.13
m = 12 Down payment = Selling price – mortgage
t = 20 n = 240 = 50,000 – 29,741.13
= Birr 20,258.87
Interest charged = actual payment- mortgage
= 600 x 240 - 29,741.13
= 144,000 - 29741.13
= Birr 114,258.87

Percentage of down payment =

=
= 40.52%
3. Mr. Z has taken out a Birr 60,000, 20 year, 24% mortgage on his
home.
a. How much will he pay each month to discharge this
mortgage?
b. How much of the first payment is for interest and by how
much does it reduce the balance owed?
c. How much of the second payment is for interest and by how
much does it reduce the balance owed?

Solution.
a.
Mortgage (A) Birr 60,000
r = 24% i = 2%
m = 12

87
 t = 20 years n = 240

= 60,000(.020174
= Birr 1,210.44
b. Interest = 60,000 X .02
= Birr 1,200
Reduction from the balance owed = Monthly payment – Interest
= 1210.44 – 1200
= Birr 10.44

c. Interest = (60,000 – 10.44) x .02

= Birr 1199.79

Reduction from Balance owed = 1210.44 – 1199.79

= Birr 10.65

4. Ato Tefera purchased a house for Birr 250,000. He made a 20% down
payment, with a balance to be amortized by a 30-year mortgage at
annual interest rate of 12% compounded monthly.

a. Determine the amount of his monthly mortgage payment

b. What is the total amount of interest Ato Tefera will pay over the life
of the mortgage?
c. Determine the amount of the mortgage Ato Tefera will have paid
after 10 years.
d. What will be Ato Tefera's equity in the house at the end of 10
years?

88
 Solution
Selling price = Birr 250,000 b. Interest=?
Down payment(20%)= 50,000 = total payment - mortgage
Mortgage Birr 200,000 = 2,057.23 x 360 -
r = 12% i = 1% 200,000
m = 12 = 740,602.80 - 200,000
t = 30 years n = 360 = Birr 540,602.80

a. R =? c. After 10 years there will remain

(20 x 12) = 240 monthly payments of
Birr 2,057.23 to be made. The
amount of the mortgage that is still
unpaid at this time is the PV of this
series of payments, that is;
= Birr 2,057.23

d. Equity in house = down

= Birr 186,836.43.
payment + paid amount
Thus after 10 years Ato Tefera will
= Birr 50,000 + 13,163.57
have paid Birr 13,163.57 (Birr
= Birr 63,163.57
200,000 - 186,836.43) against the
principal amount of the mortgage.

5. Andinet and Florence are looking to purchase a home. They found one
that they like that costs Birr 150,000. They can get a 30-year mortgage
at 9% and plan to make a down payment of 20% of the selling price.
a. What will be their monthly mortgage payment?
b. When Andinet and Florence go to the bank, they are offered an
annual percent rate of 6% if they take a 15-year loan rather than one
for 30 years. Andinet and Florence are skeptical because they can't
afford to make twice the payment calculated for 30 years. In actual
fact, how much would their payment be if they repaid the mortgage in
15 years?
c. Andinet is 25 years old and wants to be a millionaire by the time he is
50. He is planning to put aside a sum of money at the end of each
year sufficient to accumulate a million Birr in 25 years using an
interest rate of 10%. How much must he put aside?
d. Considering your answer in part c above, suppose Andinet can only
put aside Birr 10,000 per year. How high a rate of return must he
realize to achieve his goal?

89
 CHAPTER 5
elements and applications of calculus

Calculus is the Branch of mathematics that concerns it self with the rate of
change of one quantity with respect to another quantity.

6.1Differential Calculus

- Broadens the concept of slope - rates of change

There are two core concepts which lie down the foundation for differential
calculus. These are: Limits and Continuity.

Limits: In calculus there is often a concern about the limiting value of a

function as The independent variable approaches some specific value, a, this
limiting value when it exists is called a limit.

Notation:
Lim f (x) = L
Xa

A function f has a limit L (where L is some real number) as x approaches a if the

values of the dependent variable f (x) differ arbitrarily little from L for all values
of X which lie very close to a. The limit as X approaches a is symbolized:
Lim f (x) = L
Xa
N.B.
 The concept of the limit of a function as x approaches a should not be confused
with the concept of the values of a function at x = a
 The limit as x approaches a may exist, and the function many or may not
be defined at a.

90
 The function may be defined at a, and the limit may or may not exist.
 The limit as x approaches a may exist, and the function may be defined at
a and their values may, or may not be the same.
 Generally, x can approach a from either of two directions, through values
that are less than a or through values that are greater than a.
 The limit L must be a finite number.

The limit f (X) does not depend on the values of f (x) at X = a. Whether
Xa
or not the function, f(x) is defined at x = a doesn’t affect the limit or its existence
or non existence at x = a. In other words, lim f (x) = L
xa
means that the values of f (x) approach, with out necessarily being equal to L, as
X approaches, without necessary being equal to, a

E.g. Left-Hand and Right-Hand Limits

When the variable x approaches the value x=a but always remains less than a, we
say x is approaching a from the left. If the values of f(x) gets closer and closer to a
real number L as x approaches a from the left, we call L the LEFT-HAND LIMIT
and employ the symbolism

Lim f(x) = L
Xa

Only those values of X to the left of a are used to compute the left hand limit.

E.g. Lim (x+3)

X3
We might compute f (2.9) = 5.9, f(2.99) = 5.99, -------------- f (2.999---) = 5.999 --------.
Clearly, the values of f (X) are getting closer and closer to the number 6, and we
write.
L- = lim (x+3) = 6

X3

Similarly, the RIGHT-HAND LIMT of a function f as x approaches a is the value

L+, which f(X) converges on as x approaches the point X = a from the right, but
always, remains greater than a. We symbolize this limit as
Lim f(x) = L+
xa+

91
 Only those values of X to the right of a on the number line are used to obtain the
right - hand limit. We might compute the limit
L+ = lim (x+3) = 6
x3+
by evaluating f (3.1), = 6.1 f(3.01) = 6.01 f(3.001) = 6.001 ----, f (3.00001) = 6.000001.
A function f has a limit L as X approaches a only if the left - hand and the right-
hand limits are equal. Their common value is the limit of f as x approaches a
Here (L- = 6) = (L+ = 6) = L , and we write lim (x + 3) = 6
x3
EXERCISES

Find the limits for the following functions; if it exists

1. Lim (X2 - 1)
x2

X 1.91.991.9991.9999 0 2.00012.0012.01 2.1

F(x)2.612.96012.9960012.999600013.00400013.004001 3.0401 - 3.41
L- 3 , L+ = 3
Lim (x2 - 1) = 3
x2
/X /
2. Lim
X x -0.1 -0.01 -0.001 0.001 0.01 0.1
X0 f(x) -1 -1 - 1 1 1

L+ is not equal to, so Limit does not exist.

3. Lim X x -0.1 -0.01 -.000001 0.001 0.01 0.1

X0 f(x)    0.032 0.1 0.32

Lim f(x) = 0 In such case priority should be given for the domain to
x0 determine either the right/ left hand limit is relevant. For lim
X , since the values of x are restricted to non-
x0
negative numbers, the left hand limit is not relevant.

4. F(x)

Lim f(x) =?
X4

92
 Lim f (x) x 3.9 3.99 3.999 3.9999 4.001 4.01 4.1
X4 f(x) 0.1 0.01 0.001 0.0001 0.001 0.01 0.1
- +
L =0 L = 0 =L

Lim f(x) = 0 limit exist; but the function doesn’t exist at 4 because the point x4
is not in the domain of the fun.

Limit Properties
Assuming that the two limits exist:

1. Limit of a Constant
The limit of a constant function is the constant value.
2. Limit of a Sum or a Difference
The limit of a sum or difference is the sum or difference of the
individual limits, provided that these limits exist.
3. Limit of a Constant Times a Function
The limit of a constant times a function is the constant times the limit
of the function, provided that the limit exists.
4. Limit of a Function to a Power
The limit of a function raised to a power is the power of a limit
provided that the limit does exist.
5. Limit of a Product
The limit of a product is the product of the limits provided that these
limits exist.
6. Limit of a Quotient
The limit of a quotient is the quotient of the limits provided that the
limits exist and the denominator is not zero.

Continuity of a Function
The continuity of a function can be determined at a specific point or over an
interval.

Continuity at a point
A function is said to be continuous at a point when there exists no gap at that
point. At the point of discontinuity we can’t find marginal functions (MR, MC---)
 A function f is continuous at x = a if and only if all these conditions apply
to f at a:

93
 1. f(a) is defined (that is, the domain of a f includes x = a)
2. Lim f(x) exists
xa
3. Lim f(x) = f (a) whether x approaches a from the left or right.
X a
Geometrically, a function, f is seen to be continuous at a point x=a when there is
nether a hole nor a gap in the graph of f at x = a

If any one of the three requirements specified above is not satisfied, the function
is f is said to be discontinuous at x = a.

Four cases of discontinuity

1. A function f may be discontinuous because the value of f at x = a is not defined,

although the limit of f as x approaches a exists.
x2  4
E.g. f(x) = is not defined at x=2 and the fun is discontinued at x=2
x2

2. A function f may be discontinuous because the limit as x approaches a does not

exist.

L  10
E.g. F(x) = L+ is different from L-
2 x

 3x  5 
L  20
The limit doesn’t exist as x approaches a if the function has different right hand
and left hand limits at that point.
The graph of the function has a vertical gap at x=5. Such a vertical gap always
indicates discontinuity of the function at this point. This type of discontinuity is
often called JUMP DISCONTINUITY.

3. A function may be discontinues because the limit of f as x approaches a is not the

value of f at x=a.

E.g. f(x) =
x

1

is discontinuous at x = 3. This is because lim f(x) = 3 is not equal to f (3) = 1

x3
4. Another type of discontinuity exists. A function is said to have an infinite
discontinuity at x=a if f(x) becomes arbitrarily large positive or negative as xa-
or xa+.

 
E.g. f(x) = 1/x lim 1/x = - and lim 1/x = + hence
x0- x0+

94
 Lim 1/x doesn’t exist, nor is f (0) defined.

Continuity of a function over an interval

A function is said to be continuous over an interval if its graph has no Break,

jumps, or holes in that interval inclusive [ ] or exclusive ( ). Alternatively, a
continuous function has a graph which can be drawn without lifting the pencil
from the paper over that interval.
 A function f is continuous over an open interval if it is continuous at each
number in that interval.
 A function f is continuous on a closed interval [a, b] provided the
following conditions are satisfied:
1. f is continuous over the open interval (a, b)
2. f (x) f (a) as xa from with in (a, b)
3. f (x) f(b) as xb from with in (a, b)

Continuity properties

1. Constant function
If f(x) = K where K is a constant, then f(x) is continuous for all x. In other words, a
constant function is continuous for all values of x.

2. Power functions
Functions of the form f(x) = xn and g(x) = , where n is a positive integer, are
continuous over all values of x of their respective domains.

3. Sum, difference and product

If f(x) and g(x) are continuous at a point, then f(x) + g(x), f(x) - g(x), and f(x) .g(x)
are continuous over that point.

4. Quotient
If f(x) and g(x) are continuous at a point, then f(x)/g(x) is continuous at that point
provided that g(x)0 at that point.

Any polynomial function is continuous at all values of x. Any rational function is

continuous at all values of x, where its denominator does not equal to zero.

Exercises
1. Technic, Inc. manufactures electronic circuitry for computers. For a particular
unit, there is a variable cost of Birr 4 per unit and a fixed cost of Birr 8,000 for the

95
 first 10,000 units produced. If the number of units manufactured exceeds 10,000,
the fixed cost increases by Birr 1,000.
a. Define the cost function. Answer:
b. Where is the cost function discontinuous? Answer: Since the graph has a
Break at x= 10,000, then C(x) is discontinuous at x=10,000.
2. One million Birr is deposited in to a savings account for 1 year at 12%
compounded quarterly. If interest is added at the end of each quarter
a. Find the account's balance for each quarter. Answer: Birr 1,030,000,
1,060,900, 1,092,720, and 1,125,508.81.
b. Where is the graph discontinuous? Answer: The graph is discontinuous at
the end of the first, second, third and fourth quarters.

Continuity and Differentiability

The relationship between continuity and differentiability is that: A function
differentiable at x=a is continuous at x=a. that is, differentiability implies
continuity. But the converse of the preceding statement is not true; continuity
doesn't imply differentiability. In other words, it is possible for a continuous at
x=a but not differentiable at x=a.

Intuitive development of the concept of derivative

In studying the relationship between variables our primary concern would be to

observe the manner in which the value of one variable (the dependent variable)
is changed with given increases or decreases in the value of the other variable
(the independent variable). This analysis of how the value of the dependent
variable responds to changes in the value of the controllable independent
variable leads us to a study of RATES OF CHANGE and eventually to the study
of DERIVATIVES. For a linear function each one unit change in x has the same
effect on the value of y, no matter what the value of x is, we call this slope and
remains constant for a linear function, whose graph is a straight line. This
property is not the case for non-linear functions, i.e., the slope changes from one
value of x to another. Hence, when the relationship between x and y is depicted
by a non-linear function, the effect that a one-unit change in one unit of x has up
on the value of y is it self a function of x.

Because the slope is not a constant, it is not logical to speak of the “slope” of non
linear functions as we did for a linear function. We instead may speak of the
AVERAGE RATE OF CHANGE BETWEEN TWO POINTS (ARC), or
INSTANTANEOUS RATE OF CHANGE AT A POINT (IRC)

96
 Average pate of change (ARC) between two points
Average Rate of Change (ARC) of a function f over an interval x to x+x is given
by the change in f(x) divided by the change in X; that is,
f ( x ) f ( x  x )  f ( x )
ARC = 
x x

E.g. At the same instant that a test driver begins his journey around a truck, a
stopwatch is started. The function is given by Y = f(x) = 10x 2 (x>0) expresses the
total distance, y (in miles) traveled by the driver during the first x hours. Thus,
during the first 3 hrs, the driver has traveled a total distance of Y= f (3) = 10(3) 2 =
90 miles.

During the first 5 hours, the driver has traveled a total distance of Y = f(5) = 10(5) 2
= 250 miles

We now pose the following question:

What is the driver's average speed during the time interval between the end of the third
hour and the end of the fifth hour?

Since the driver has traveled 90 miles during the first 3 hours and 250 miles
during the first 5 hours, he has traveled
y = 250 - 90 = 160 miles
during the time interval x = 5 - 3 = 2. Dividing by the length of the time interval,
we have

as the average
speed or the average rate of change of distance with respect to time. Note that the
average speed is the slope of the straight line, L, passing through points (3,90)
and (5,250)of the graph of Y = f(x)=10x2. Such a straight line intersecting the graph
in at least two points is called a secant line.
In general the slope of the secant line passing through two points of the graph of
a function is the average rate of change of that function over the respective
interval. Note that the secant line passes through the points (x,f(x)) and (x+x,
f(x+x)). Thus, the average rate of change of the function Y= f(x) over the interval
from x to x+x is given by the expression

97
 ARC =

This ratio is called a difference quotient. It gives the slope of the secant line
passing through (x, f(x)) and (x+x, f(x+x)).

The general procedure for determining a formula for the difference quotient is:
1. Replace x with x+x to obtain f(x+x))
2. Subtract f(x) from the result of step 1 to obtain y = f(x+x)- f(x)
3. Divide the result of step 2 by x (and simplify) to obtain a formula for
difference quotient . This result gives a formula for
the average rate of change for the given function f(x) as we move from
x to x+x.
Example
1. Compute the difference quotient of the function defined by Y = f(x) = 10x2
Step 1. Replace x with x+ x
f (x+x) = 10(x+x )2
= 10[x2 +2x(x) + (x) 2]
= 10x2 +20x(x) + 10(x) 2
Step 2. Subtract f(x) from the result of step 1
= f(x+x) - f(x)
= 10x2 +20x(x) + 10(x) 2 - 10x2
= 20x(x) + 10(x) 2
Step 3. Divide the result of step 2 by x

= 20x + 10x

Using this general formulation, we can determine the ARC for f(x) = 10x 2
between any two points.

Exercises
1. The total revenue R, gained from selling x units of a product is given by
R(x) = -0.2x2 + 8000x (0<x<20,000)
a. Determine the formula for the average rate of change of sales volume with
respect to x. Answer: -0.4x-.2(x)+ 8,000

98
 b. Use the result of part [a] to determine the average rate of change of sales
revenue with respect to x as x changes from x= 10,000 to x = 14,000.
Answer: 3,200.
c. Interpret the result of part b. Answer: As x changes from x=10,000 to x=
14,000, an additional unit sold yields Birr 3,200 of sales revenue, on the
average.
2 The total cost, C of producing x units of a product is given by
C(x) = 3x2+ 80,000 [0, 100]
a. Find the average rate of change of cost with respect to x. Answer:6x+3x
b. Determine the average rate of change of cost with respect to x as x
changes from x=50 to x=55. Answer:315
c. Interpret your result. Answer: As x changes from x=50 to x= 55, an
additional unit produced costs Birr 315, on the average.
3. The profit, P (in millions of Birr), gained from selling x (in thousands) units of a
product is given by: P(x) = -0.1x2+4x-30 [10<x<30]
a. Find the average rate of change of profit with respect to x. Answer:-0.2x -
0.1x+4
b. Determine the average rate of change of profit with respect to x as x
changes from x=12 to x=15. Answer: Birr 1,300,000
c. Interpret your result. Answer: As x changes from x=12,0000 to x= 15,000,
an additional unit sold yields Birr 1,300, on the average

Instantaneous Rate of Change (IRC)

The instantaneous rate of change of a function is a rate of change, not over an
interval of a finite length, but at a point.

In the previous section we discussed the relationship between the distance, Y (in
miles), traveled by a driver and the time elapsed, x (in hours). These two
quantities are related by the equation Y= f(x) = 10x 2 (x>0), and the formula for
the average rate of change of Y with respect to X over the interval x to x +x is
given by = 20x +10(x).

The average rate of change of Y with respect to x when x changes from one value
to the other is determined by substituting those values of x. Now let's ask one
question: What the speed of the car at x=3? This result is called instantaneous
speed or instantaneous rate of change of Y with respect to x at x=3. It is
determined by first calculating a formula for the instantaneous rate of change of
Y with respect to x at point (x, f(x). This formula is determined by calculating the

99
average rate of change = 20x+10(x) letting x get very small (i.e.,
we let x0) to obtain 20x. This result, 20x, is called the derivative of the
function f(x) =10x2 and is denoted by f'(x). Thus, the derivative f '(x) = 20x gives
the formula for the instantaneous rate of change of Y with respect to x at any
point (x, f(x)) of the function defined by Y= f(x) =10x2.

Therefore, the instantaneous rate of change or the derivative of Y with respect to

x is the limit of the average rate of change as x0(provided this limit exists).

This is written as f '(x) = Lim as x0.

Graphically, the derivative is the slope of the straight line tangent to the graph of
the function at (x, f(x)).

The slope of the tangent line at any point x on the x axis represents the
instantaneous rate of change of the function f at that point.
The IRC of f at any point x is the limit of the ARC of f over the interval from x to
x+x as x approaches zero; that is
f ( x )
IRC = Lim
x
X 0
f ( x  x )  f ( x )
= Lim
x
X0 if this limit exists.
= Derivative of f(x)

The Derivative
The IRC is also called the derived function or the derivative. The derivative of a
df ( x) df
function f is that function, commonly denoted f ', f '(x), D xf(x), , or Y'
dx dx
Dxy, , whose function value at any x in the domain of f is given by f '(x) = lim
f ( x) f ( x  x)  f ( x)
= lim , if that limit exists.
x x
x0 x0

The process of determining the derivative of a function is termed

Differentiation. In order for the derivative to exist, the difference quotient
f ( x) / x must have a limit as x0. At each x where this limit does exist, the
function is said to be differentiable.

100
 Differentiability
A function is said to be differentiable at a point if its derivative exists at that
point. For a derivative to exist at a specified value of X,
a. Its graph must have a unique non vertical tangent line at that point.
b. It must have no sharp corner at that point.
c. The function must be continuous at that point.
d. The function must be defined at that point.

Rules of Differentiation
Differentiation by direct application of the limit formula, f('x) = is
sometimes awkward and cumbersome. Therefore, functions should be classified
in to certain groups according to their behavior, so that the process of finding a
derivative when applied to these groups follows a definite formula.
A few of the more commonly used rules are:
1. Constant Function Rule
Derivative of a constant function is zero
f(x) = k e.g. f(x) = 10 - horizontal straight line
f '(x) = 0 f '(x) = 0
2. Power Rule
The derivative of a variable raised to the constant power, n, where n is any real
number and n0, is equal to the power n multiplied times the variable raised to
the power n-1.
F(x) = Xn e.g. f(x) =X3 f(x) = x2 f(x) =X
n-1 2
F '(x) = n x f '(x) = 3x f '(x) = 2x f '(x) = 1
F (x) =
1 1/ 2 1 1
F '(x) = x = x
2 2 2 x
3. Constant Multiplier Rule
The derivative of a constant times a function is the constant times the derivative of
the function.
F(x) = kg(x)
f1(x) = k. g '(x) E.g. f(x) = 5x3 f(x) = 3x
1 2 2
f (x) = 5.3x = 15x f ' (x) =3

4. Sum or Difference Rule

The derivative of the sum (or difference) of two functions is the sum (or
difference) of their respective derivatives.
F(x) = [g(x) + h(x)]

101
 f '(x) = [g '(x) + h'(x)] E.g. F(x) = 6x4 - 5x2 f(x) = 3x
3-
f '(x) = 24x 10x f ' (x) =3
5. Product Rule
The derivative of a product is the deviate of the first factor multiplied by the
second, plus, the first factor multiplied by the derivative of the second.
H(x) = [f(x). 8 (x)] E.g. f(x) = (2x2-5) x+3)
h '(x) = [f '(x).g(x)] + [f(x) x g '(x)] f '(x) = [(4x) .(x+3)] + 1 (2x2-5)
= 4x2 + 12x + 2x2-5
= 6x2 + 12x -5
6. Quotient Rule
The derivative of a quotient is the denominator times the derivative of the
numerator, minus the numerator times the derivative of the denominator, all
over the denominator squared.

E.g.

[ g ( x ). f 1 ( x )]  [ f ( x ). g1 ( x )]
h(x ) 
[ g ( x )]2
10x 4  10x  15x 4 5x 4  10x
= =
( x 3  1) 2 ( x 3  1) 2

H(x) =
x 2  2x  2x  2x 2 x 2  2x ( x  2)
= = =
(x4 ) x4 x3

7. Chain Rule
If y =f (u) is a differentiable function of u and u= g(x) is a different table function
of x, then
dy dy du
 .
dx du dx

The chain rule states that if y is a function of u and u is a function of x, then the
derivative of y with respect to x (i.e., dy/dx) equals the derivative of y with
respect to u (i.e., dy/du) times the derivative of u with respect to x (i.e., du/dx).

( 6x 2  5)10
E.g. Y = dy/du = 10u9
u
y= f(u) dy/du = 12x

= U10 where U = 6x2 - 5 dy/du = 10u9 (12x)

102
 = 120xu9
= 120x (6x2 - 5)9

Higher - Order Derivatives

If a function f has a derivative for each value of x in some specified interval, then
the derivative function f is defined for that interval. If, in turn, the derivative
function it self has a derivative for points in that interval, this new derivative
function is called the SECOND DERIVATIVE OF the original function, often
denoted f ''(x). Similarly, if f '' has a derivative, we speak of the THIRD
DERIVATIVE of the original function, and note this as f '''(x), and so on.

No new rules of differentiation are needed for higher-order derivatives. One

simply differentiates, and then differentiates again, and again, using the same set
of derivative rules.
Example
F (x) = 3x4+5x3+2x2+3x+10 -1st function (original function.)
F '(x) = 12x3+15x2+4x+3 - First derivative.
'' 2
F (x) = 36x +30x+4 - Second derivative
F '''(x) = 72x+30 - Third derivative
(4)
F (x) = 72 - Fourth derivative
(5)
F (x) = 0 - Fifth derivative

Derivatives are of particular of particular importance because they provide

information about:
1. The rate of change in the value of the function relative to
infinitesimal changes in the value of the independent variable.
2. Where the function is increasing in value and where it is
decreasing.
3. Where the function reaches its maximum and/or
minimum values.
Given a function f which is continuous on some open interval I and differentiable
in that interval:

1. If f '(x) > 0 for all x in the interval, then f is strictly increasing over that interval.
2. If f ' (x) < 0 for all x in the interval, then f is strictly decreasing over that interval.
3. If f '(x) = 0 for all x in the interval, then f is constant over that interval - horizontal
line.

Additional information provided by the second derivative

103
 Just as f ' relates information about the behavior of f, so does f '' relate
information about the behavior of f '. It follows, naturally, that f '' also relates
information about the behavior of f. In the same way, the third derivative f '''
gives information about the second derivative and so on.
We have noted that when the first derivative of a function is positive, the
function is increasing; or when the first derivative is negative, the function is
decreasing. But we often need information about the rate of increase or decrease
and for this information we look to the second derivative of the function. The
second derivative gives the slope of the first derivative.

1. If f '' (x) > 0 the first derivative f ' is an increasing function at X.

2. If f '' (x) < 0 the first derivative f ' is a decreasing function at X.
3. If f '' (x) = 0 the first derivative f ' is a constant function at X.

Thus, the first and second derivatives taken together tell us a great deal more
about the function than does the first derivative alone.

a. If f ' > 0 and f '' > 0, the function f is increasing at an increasing rate. That is,
the slope of f is positive and is getting steeper.
b. If f ' < 0 and f '' > 0, the function f is decreasing at an increasing rate. That
is, the slope of f is negative but is becoming less steep.
c. If f ' < 0 and f '' < 0, the function f is decreasing at an increasing rate. That
is, the slope of f is negative and is becoming steeper.
d. If f ' > 0 and f '' < 0, the function f is increasing at a decreasing rate. That is,
the slope of f is positive but is becoming less steep.
e. If f ' > 0 and f '' = 0, the function f is increasing at a constant rate. That is,
the slope of f is positive and linear.
f. If f ' < 0 and f '' = 0, the function f is decreasing at a constant rate. That is,
the slope of f is negative and linear.

Extreme Values of a function

Geometrically, the maximum and/or minimum values of a function are the high
and/or low points on the function’s graph.

Extreme values of a function are divided in to

- Local/Relative extrema - Maximum & minimum
- Absolute extrema - Absolute maxima and Absolute minima

Local Extrema: - usually for open intervals

104
a. A function f attains a relative/local maximum at x=a if there exists an open
interval I containing a such that f (a) > f(x) for all x in the interval I. That is to
say, a function is considered to achieve a relative maximum at some value of
the independent variable if the value of the function at that point is at least as
large as it is for any other nearby points.
b. A function attains a relative minimum at x=a if there exists an open interval I
containing a such that f(a) < f(x) for all x in the interval I. That is to say, a
function is considered to achieve a relative minimum at some value of the
independent variable if the value of the function at that point is at least as
small as it is for any nearby point.

Because a relative maximum need not be the highest point for the entire graph
but simply a point higher than other points in its immediate neighborhood, a
function may have more than one relative maximum.

Similarly, a relative minimum is minimal only in relation to adjacent points, so a

function may have more than one relative minimum.
Absolute Extrema - usually for closed interval.

a. A function f attains an absolute maximum at x = a if and only if f (a) > f(x)

for all x in the domain of f.
b. A function f attains an absolute minimum at x=a if and any if f (a) < f(x) for
all in the domain.

A point [a, f (a)] is an absolute extremum only if it is the very highest or

lowest, point on the entire curve.

When the domain of f is a closed interval

If the domain of a function is restricted to some closed interval, and if the

function is continuous on that domain, the function necessarily has both an
absolute maximum and an absolute minimum.

The absolute extrema of such functions may occur either at an end point or at an
interior point of the closed interval, or possibly at both. Relative extrema, on the
other hand, are conventionally considered to occur only at interior points of the
domain.
When the domain of f is defined over an open interval (a, b), or if the domain is
unrestricted, then f may or may not have an absolute maximum or an absolute
minimum.

105
 First Derivative Test for Relative Extrema
Relative extrema occurs only at critical points of a function.

A critical point of a continuous function f is a point (x*, f (x)) such that either
a. F '(x*) = 0 or,
b. F ' (x*) does not exist but f(x*) is defined
X* is the Critical Value of x.

In searching for relative extrema we need only consider critical values of x.

Thus, the first step in identifying relative extrema is to determine the set of x
which comprises candidates for extrema; that is we determine x* = {x/f'(x*) = 0 or
f ' (x*) does not exist but f(x*) is defined. However, these are only “candidates”
for extrema; they are not necessarily relative extrema. The next step, thus, is to
determine the character of each member of the X* set. One method of
determining the character of a critical point is known as the First Derivative
Test.

To the immediate left of a maximum point the function is always increasing (that
is, f ' >0) and to the immediate right of a maximum point the function is always
decreasing (that is, f '<0). Hence; THE ALGEBRAIC SIGN OF THE FIRST
DERIVATIVE ALWAYS CHANGES FROM +VE TO - VE AS THE FUNCTION
TRANSVERSES A RELATIVE MAXIMUM POINT (always moving from left to
right along horizontal axis.)

Similarly, to the immediate left of a minimum point the function is decreasing

(that is, f ' < 0), and to the immediate right of a minimum point the function is
always increasing (that is, f '>0). So, THE ALGEBRAIC SIGN OF THE FIRST
DERIVATIVE ALWAYS CHANGES FROM -VE TO +VE AS THE FUNCTION
TRANSVERSES A RELATIVE MIMUM POINT.

If the sign of the first derivative does not change as the function transverses a
critical point, the point is neither a maximum nor a minimum.

Example:
Find the relative maxima and minima of the following functions, if they exist.
1. f (x) = x2 - 4x +4
a. f '(x) = 2x - 4 b. Use f '(x) to determine the behavior of f
2x - 4 = 0 1. f ' (x) < 0 for x <2 - f  when x< 2

106
 2(x-2) = 0 2. f ' (x) > 0 for x>2 - f  when x> 2.
X = 2 - candidate, so that at x=2 there is a relative minimum of f.
2. f(x) = 4x3
a. f ' (x) = 12x2 1. f ' (x) > 0 for x<0 - f  when x< 0
2
12x = 0 2. f ' (x) > 0 for x > 0 - f  when x > 0
x = 0 - candidate +ve +ve

The algebraic sign of f ' does not change as we move from left to right across the
critical point; therefore, the critical point x* 0, is neither a maximum or nor a
minimum.

3. f(x) = 1/x2 The first derivative can never be negative and the function is
undefined at x = 0, so no critical value.
4. f(x)=x2/3

f '(x)= . The first derivative can't be set equal to zero. Though the first

derivative can never be equal to zero, f(x) is defined at x=0. So the critical value is
x=0. Since f '(x) is negative for all values of x to the left of zero and positive for all
values of x to the right of 0, x=0 is a relative minima.
5. f(x)= x3+3x2-72x+9
f '(x)= 3x2+6x-72, setting f '(x)= 0 and solving yields
3x2+6x-72=0
3(x2+ 2x-36) =0
3(x+6) (x-4) =0

Thus, x=-6 and x=4 are critical values. Since there are no values of x at which f '(x)
does not exist, these are the only critical values. Since f '(x)>0 for all nearby values
of x to the left of x=-6 and f '(x) <0 for all nearby values of x to the right of x=-6,
then, by the first derivative test, a relative maximum exists at x=-6. Also, since f
'(x) <0 for all nearby values of x to the left of x=4 and f '(x)>0 for all nearby values
of x to the right of x=4, then, by the first derivative test, a relative minimum exists
at x=4. Computing the corresponding y values we have (-6,333) as relative
maxima and (4,-167) as relative minima.

Second Derivative Test for Relative Extrema

We have seen that the second derivative f '' gives information about the rate of
change of the first derivative f '. If f ''>0 at some point x = a, then f ' is an
increasing function at that point, and the graph of f is Concave upward. Or if f " <

107
o at some point x = a, then f ' is a decreasing function at the point, and the graph
of f is concave down ward.

If an extremum occurs at a point X* where f is concave downward, that

extremum is a maximum. If an extremum occurs it a point X* where f is concave
upward, that extremum is a minimum. These facts lead to a second procedure for
locating local extrema, a procedure referred to as the Second Order Derivative
Test.

The second derivative test for locating relative extrema proceeds as follows:
1. Find the first derivative f ' and the second derivative f "of the function
f.
2. Locate the set of critical values of x.
3. Evaluate the second derivative f '' at each critical value x*
A. If f '' (x*) < 0, then f(x*) is a maximum value of f.
B. If f '' (x*) > 0, then f(x*) is a minimum value of f.
C. If f '' (x*) = 0, then the test is indeterminate - Use 1st derivative test.
Example:
Use the second derivative test to locate the relative extrema
a. f(x) = x2 - 4x - 45
1. f '(x) = 2x - 4, f ''(x) =2
2x = 4
2. X = 2 = critical value
3. 2> 0 - f '' (2) = 2 - the function is concave upward at this point, Hence, the
point (2, f (2)) is a relative minimum point on function f.

b. f(x)= x3 +3x2 + 3x - 5
1. f '(x) = 3x2 + 6x + 3, f '' (x) = 6x + 6
2. 3x2 + 6x + 3 = 0 Use 1st derivative test
(3x+3) (x+1) = 0 x -3 -2 -1 1 2 3
3x=-3, x=-1 f '(x) 12 3 0 12 27 48
x = -1 Critical value +ve +ve
Therefore, No relative extremum.

c. f(x) = x2 - 6x + 7
1. f '(x) = 2x -6 f ''(x) =2
2. 2x - 6=0
x = 3 critical value.
3. f ''(x)= 2 >0, therefore, [3, f(3)] is a relative minimum.

108
 Locating Absolute Maxima and Minima
In locating absolute extrema we must consider whether the function is defined in
a closed interval [a, b] or an open interval (a, b). If the domain is not specified, it
is generally considered to be the set of all real numbers.

When the domain of f is a closed interval- an interval that contains both of its endpoints
A continuous function f defined on a closed interval [a, b] must attain both an
absolute maximum and an absolute minimum at points in [a, b].

If f is continuous on [a, b] with critical values x*1, X*2, --------X*n at interior

points of the interval, the point at which f attains its absolute maximum must be
critical value of x which represents a relative maximum of at one of the end
points of the interval a or b. Similarly, f must attain its absolute minimum either
at one of the interior point critical values which represents a relative minimum or
at a and b.

Thus, to find the absolute maximum and absolute minimum, we evaluate f(x* 1),
f(x*2) ------- f (X*n), f (a) and f (b). The largest of these is the absolute maximum of
f on the interval [a, b]; the smallest of these is the absolute minimum of f on the
interval [a, b]. The other critical values - the other X* - represent relative extrema.
The end points a and b are considered for absolute extrema only, and not as
candidates for relative extrema.

In short, to find the absolute maximum on a closed interval, we follow the

following steps.
1. Find the x coordinates of all the first-order critical points of f in the
interval a<x<b.
2. Compute f(x) at these critical points and at the end points x=a and x=b.
3. Select the largest and smallest values of f(x) obtained in step 2. These are
the absolute maximum and absolute minimum, respectively.

Example
Find the maxima and minima for the function f defined as
1. f(x) = x3 - 7.5x2 +10 0<x<5
f ' (x) = 3x2 - 15x+12 = 0
3x2 - 15x + 12 = 0
x2 - 5x + 4 = 0
(x-4) (x-1) = 0

109
 x* = 4, 1 - critical values. Then compute f(x) at the critical points and end
points.
x 0 1 4 5
f(x) 10 3.5 -46 -52.5

On the interval [0, 5], f(0)= 10 is the absolute maximum and f(5)= -52.5 is the
absolute minimum.
2. f(x)=2x3+3x2-12x-7 [-3,0]
f '(x)= 6x2+6x-12
x2+x-2 =0
(x-1)(x+2)=0
x* = 1, -2, of these, only x=-2 lies in the interval -3<x<0. Then compute f(x) at x=-2
and endpoints x=-3 and x=0.
x -3 -2 0
f(x) 2 13 -7

On the interval [-3, 0], f (-2) = 13 is the absolute maximum and f(0)= -7is the
absolute minimum.

Absolute extrema on open interval

To find the absolute extrema of a continuous function on an open interval, we
evaluate the function at all the critical points and end points that are contained in
the interval. However, before drawing any conclusion, we must find out if the
function actually has relative extrema on the interval. One way to do this is to
use the first derivative to determine where the function is increasing and where it
is decreasing and sketch the graph.

Absolute extrema on intervals containing only one critical point

In reality, many practical optimization problems involve only one first-order

critical point of the function. When this happens, we use the second derivative
test to identify the absolute extremum. Given that a function is continuous over
some interval and only one critical value exists in the interval, then
1. If f ''(x*) < 0, f(x*) is the absolute maximum value of f(x) over the
interval.
2. If f ''(x*) > 0, f(x*) is the absolute minimum value of f(x) over the
interval.
3. If f ''(x*) = 0, the test fails.

110
 The second-derivative test for absolute extrema can be applied to any interval,
whether closed or not. The only requirement is that the function be continuous
and have only one critical point on the interval.

Business Application of Differential Calculus

Marginal Analysis
One important use of the derivative in business and economics involves
marginal analysis MC, MR, MP, and MU.

MC - It is the rate of change in total cost per unit change in production at an

output level of x-units at any production level x (non - linear functions)

Example
1. Suppose the total cost c(x) in thousands of dollars for manufacturing x unit is
given by the function C (x) = 575 + 25x -1/4x2
a. Find the marginal cost at a production level of x units
C' (x) = 25 - 1/2x

b. Find the marginal cost at a product level of 40 units and interpret the result
C ' (40) = 25 - 40/2 = 5,000.

At a production level of 40 units the rate of change of total cost relative to

production is Birr 5000. The cost of producing one more unit at this level of
production (40 units) is approximately 5,000 Birr. The cost of producing the 41st
unit of product.

c. Find the actual cost of producing the 41st unit and compare this cost with the
result found in question 2.

C (41) - C (40) = [575 + 25(41)-41/4] - 575+25(40)-40/4]

= (1025 - 420.25) - (1000 - 400)
= 604.75 - 600
= 4.75 = Birr 4,750

2. The market research department of a company recommends that the company

manufacture and market new transistor radio. After suitable market testing the
research department presents the following demand equation
X = 10,000 - 1000 p (x is demand at Birr/radio)
P = 10 - x/1000

111
 The financial department provides the following cost equation C(x) = 7000 + 2x.
Conduct a marginal analysis for the company

Solution.

C(x) = 7000 + 2x TR= PQ = (10 - x/1000) X

C' (x) = 2 = 10x - x2/1000
MR = R'(x) = 10 - 2x/1000
= 10 - .002x
P(X) = R(x) - C(x)
= 10x - x2/1000 - (7000 + 2x)
= 8x - x2/1000 - 7000
P ' (X) = 8-0.005x

3. A manufacturer’s cost and revenue functions are

C (x) = 3,500 + 200x + 0.2x2 0<x< 100
And
R(x) = 284x - 0.5x2 0<x< 100

Where C(x) and R(x) are in Birr and x is the number of units of product produced
and sold
a. Determine the marginal cost, marginal revenue and marginal profit
functions
b. Compute C(50)and C'(50), R(50) and R'(50), P(50) and P'(50),
R(60) and R'(60), P(60)and P'(60), C(70) and C'(70), R(70)and R'(70), P(70)
and P'(70).
c. Interpret your results.

Solution

R'(x) = 284 - 1x R' (50) = 284-1(50) =234

C '(x) =200+0.4x C'(50) = 200 + 0.4(50) =220
P'(x) = R'(x) - C'(x) P'(50) = 84 - 1.4(50) = 14
= 284-1x - (200 +.4x) R'(60) = 284-1(60) =224
= 84 - 1.4x C'(60) = 200-0.4(60) =224
P'(60) = 84 - 1.4(60) = 0
R'(70) = 284 - 1(70) = 214
C'(70) = 200- 0.4(70) =228
P'(70) = 84 - 1.4(70) = -14

112
 R (50) = 284(50)-.5(502) =Birr12, 950
C (50) = 3500+ 200(50) + .2(502) = Birr14, 000
P (50) = 84(50) - .7(502) - 3500 = Birr (1,050)
R (60) = 284(60)-.5(602) =Birr15, 240
C (50) = 3500+ 200(60) + .2(602) = Birr16, 220
P (50) = 84(60) - .7(602) - 3500 = Birr (980)
R (70) = 284(70)-.5(702) =Birr17, 430
C (50) = 3500+ 200(70) + .2(702) = Birr18, 480
P (50) = 84(50) - .7(502) - 3500 = Birr (1,050)

At a production level of 50 units, the total revenue realized and the total cost
incurred are Birr 12,950 and Birr 14,000, respectively, and a production of one
more unit increases the revenue by Birr 234 and the cost by Birr 220.

At a production level of 60 units, the total revenue realized and the total cost
incurred are Birr 15,240 and Birr 16,220, respectively, and a production of one
more unit increases the revenue by Birr 224 and the cost by Birr 224.

At a production level of 70 units, the total revenue realized and the total cost
incurred are Birr 17,430 and Birr 18,480, respectively, and a production of one
more unit increases the revenue by Birr 214 and the cost by Birr 228.

4. A small machine shop manufactures drill bits that are used in petroleum
industry. The shop manager estimates that the total daily cost (in Birr) of
producing X bits is C(x) = 1,000 + 25x – 0.1x2.
a. Find the daily average cost if x units are produced.
b. Find the average cost per unit if 10 drill bits are produced.
c. Find the marginal average cost function.
d. Find the marginal average cost if 10 drill bits are produced, and
interpret the results.
Solution:
a.

b.

c.

d.

113
A unit increase in production will decrease the average cost per unit by
approximately Birr 10.10 at a production level of 10 units.

114
5. The total profit (in Birr) from the sale of X video cassettes is P(x) = 5x – 0.05x 2 –
450.
a. Find the average profit if x video cassettes are produced and sold.
b. Find the marginal average profit function.
c. Find the average profit per unit if 150 video cassettes are produced and
sold.
d. Interpret the result.
Solution:
a.

b.

c.

d.

A unit increase in production and sales will increase the average profit per
unit by approximately Birr 0.015 (1.5 cents) at a production and sales level
of 150 units.

Optimization Problems
1. A company manufactures and sells x transistor radios per week. If the weekly
cost and demand equations are: C(x) = 5000 + 2x and P = 10-x/1000 [0, 8000]

Find for each week

a. The production level that leads to maximum revenue the maximum revenue.
b. The production level that leads to maximum profit and the maximum profit.
c. The production level that leads to the minimum cost and the minimum cost.

Solution
a. TR = P(x) = 10x - x2/1000 b. Profit (P(x) = R(x) - c(x)
R' (X) = 10- 2x/1000 = 10x - .001x2 - (5000-2x)
= 10-0.002x P(x) = 8x - .001x2-5000
TR get its maximum when P'(x) = 8-.002x
MR=0, so 10-0.002x=0 p(x) gets maximum when P'(x) =0
x = 5000 units 8 = .002x
R' (x) = - .002 - Absolute max. x = 4000 units

115
 R(x) = 10(5000) - 50002/1000 P (4000) = 8(4000)-0.001(40002)-5000
= 25,000 Birr = 11,000 birr, R(x) = 24,000 Birr
(5000, 25,000) = P =Birr 5. (4,000 11,000) Price 6=Birr.

C. If the cost function is a 1st degree equation, the minimum cost is at x= 0

2. The Ethiopian Airlines purchases a particular type of plane at a cost of Birr

1,800,000. The company estimates that the average operating cost is a function of
x, the number of hours of flight time. Average operating cost, stated in Birr per
hour of flight time, is estimated by the function 0(x) = 0.05x - 200

a. Determine how many hours a plane should be flown if the objective is to

minimize the total average cost.
b. What is the minimum total average cost?
Solution
Average operating cost = 0.05x - 200
a. Total operating cost = 0.05x2 - 200x
Total cost = 0.05x2 - 200x + 1,800,000
C¯ (X) = 0.05x2-200x + 1, 800,000
x
= 0.05x - 200 + 1,800,000/x

The total average cost is minimum if C¯ '(x) = 0

C¯ '(x) = 0.05 - 3,600,000/x2
.05 = 3,600,000/x2
.05x2 = 36,000,000
x = 6000 hours.

b. C(x) = .05x -200+1,800,000/x

= .05(6000)-200+1,800,000/6,000
= 300-200+300
= Birr 400

3. A rectangular area of 1,050 square feet is to be enclosed by a fence, and then

divided down the middle by other fence. The fence down the middle costs Birr
0.50 per foot, and the other fence costs Birr 1.50 per running foot. Find the
minimum cost for the required fence.

Solution.
Area of a rectangular polygon = 1050 sq. ft

116
 Area = XY
= 1050 = XY = X = 1050/Y
Cost = (1.50y) 2 + (1.50x) 2 + 0.5y
= 3y +3x+0.5y
= 3.5y + 3x ------------------------------------------- C = 3.5(30) + 3(35)
C(y) = 3.5y + 3 (1050/y) = Birr 210
= 3.5Y + 3150/y
Cost is minimum when C '(y) is =0
C' (y) = 3.5 - 3150/y2
3.5 - 3150/y2= 0
3.5y2 = 3150
y2 = 900
Y = 30feet, X = 35 feet

4. A manufacturer can produce radios at a cost of Birr 2 a piece. The radios have
been selling for Birr 5 a piece, and, at this price, consumers have been buying
4,000 radios a month. The manufacturer is planning to raise the price of the
radios and estimates that for each Birr 1 increase in price, 400 fewer radios will be
sold each month.
a. Express the manufacturer's monthly profit as a function of the price at
which the radios are sold.
b. At what price should the manufacturer sell the radios to maximize
profit?

Solution
a. Profit = (number of radios sold) (profit per radio)
Let x denote the price at which the radios will be sold and p(x) the corresponding
profit, and the number of radios sold = 4,000- 400(number of Birr 1 increases)
The number of Birr 1 increases in the price is the difference x-5 between the new
and the old selling prices. Hence,
Number of radios sold = 4000-400(x-5)
= 400[10-(x-)]
= 400(15-x)
The profit per radio is simply the difference between the selling price x and the
cost Birr 2. That is,
Profit per radio = x-2
The profit equation then becomes P(x) = 400(15-x) (x-2)
b. The goal is to find the absolute maximum of the profit function
P(x) = 400(15-x) (x-2) (5<x<15)

117
 To find the critical points, compute the first derivative (using the product and
constant multiple rules) to get
P '(x) = 400[(15-x) (1) + (x-2) (-1)
= 400(15-x-x+2)
= 400(17-2x) which is zero when 17-2x =0 or x= 8.5
Comparing the values of the profit function
P (5) = Birr 12,000 P (8.5) = Birr 16,900 P (15) = 0
At this critical point and at the end points of the interval, we can conclude that
the maximum possible profit is Birr 16,900 which will be generated if the radios
are sold for Birr 8.5 a piece.
4. A rectangular card board poster is to contain a 96 - square-inch rectangular section
of printed material, have a 2-inch border top and bottom, and a 3 - inch border on
each side. Find the dimensions and area of the smallest poster that meets these
specifications.
Solution
A= (y+4) (x+6)
2'
= (y+4) (96+6)
= 64 +24+96/ (y +4) 3' 96 sq inch
= 6y +24 +96 + 384/y 3033
= 6y + 120+ 384/y
A'(y) = 6 - 384/y2
Set A'(y) = 0 xy = 96
2
6 = 384/y 8x = 96
2
y =64 y=8 x = 12
Area = 12 x18 = 216 sq inch
5. Sharp industries produce table knives. Each knife cost Birr 6 to produce
and sells for Birr 9. The quality control manager has determined from past
data that out of x knives that are produced during any given day, the
fraction defective for the day is given by x 2/20,000,000, where 100< x < 1500.
Each defective knife costs the company an additional Birr 20.
Required

a. Determine the equation that gives daily profit, p, as a function of daily

production volume, x.

b. Determine the maximum daily profit and the daily production volume

that yields the maximum daily profit

118
Solution.

a. Profit is the difference between all costs incurred and TR realized, that is

P = TR - TC

= PQ - (VQ + FC + Other costs)

= 9x - (6x + additional cost of the defective knives)

= 3x - (additional cost of the defective knives)

The number of defective knives produced in a day is determined by multiplying

the fraction of defective and the daily production volume. Hence,

Number of defectives = Fraction defective * Daily production volume

= *X

Since each defective costs the company an additional Birr 20, then additional cost

of the defective knives = 20 * =

Thus, the daily profit is given by:

P(x) = 3x - (100< x<1,500)

Critical values: P'(x) = 3 - =0

3= , x2 = 1, 000 (the only critical value)

Test for the absolute extrema using second derivative test

P"(x) =
P"(1000) = -0.06<0
By the second derivative test for absolute extrema, the function P(x) has an
absolute maximum at x = 1000. Hence,
P (1000) = 3(1000)-

119
 = Birr 2000
6. From past experience, an apple grower knows that if the apples are harvested
now, each tree will yield on average 130 pounds and the grower will sell the
apples for Birr 0.64 per pound. However, for each additional week that the
grower waits before harvesting, the yield per tree will increase by 5 pounds,
while the price per pound will decrease by Birr 0.02. How many weeks should
the grower wait before harvesting the apples in order to maximize the sales
revenue per tree? What is the maximum sales revenue per tree?
Solution:
Let x be the number of weeks the grower waits. The sales revenue per tree is
given by R = number of pounds per tree * price per pound
R(x) = (130+5x) (0.64 - 0.02x)
Critical values
Using the product rule we find
R'(x) = (130+5x) (-0.02) + (0.64 - 0.02x) (5)
= 0.6 - 0.2x
0 = 0.6 - 0.2x
0.6 = 0.2x
x=3
Test for absolute extrema (Second derivative test)
R"(x) = -0.2 <0
Absolute maximum is at x = 3
R (3) = [130 +5(3)] [0.64 - .2(3)]
= 145 * 0.58
= Birr 84.10
7. The manager of an ocean resort wants to enclose a rectangular area of beach along
the ocean. There must be at least 500 feet of frontage along the ocean, as
illustrated below. Find the dimensions that maximize the enclosed area if 2,000
feet of fencing are available. Find the maximum area.

Ocean

120
 500 feet x

Objective: To maximize the enclosed Test for absolute extrema using the
area this is given by: second derivative test
A= Length * Width A"(y) = -4
A = (500 + x) y A"(500) = -4 <0
Length of fence = 2000 feet
Y + (500 + x) + Y = 2000 X = 1500 - 2y
2y + 500 + x = 2000 = 1500 - 2(500)
2y + x = 1500 = 500 feet
x = 1500 - 2y Thus, the dimensions of the enclosed area
A = (500 + x) y are 500 + x by y, that is 500 + 500 by 500 =
A(y) = (500 + 1500- 2y) y 1000 by 500
= 2000y - 2y2 (y > 0) Maximum area = 1000 x 500
A'(y) = 2000 - 4y = 500,000 square feet
2000 = 4y
y = 500 feet, the only critical value

8. A travel agency will plan a group tour for group size 25 or larger. If the group
contains exactly 25 people, the cost is Birr 300 per person. However, each
person's cost is reduced by Birr 10 for each additional person above the 25. What
size group will produce the largest revenue for the agency?
Solution
TR = number of people * cost per person
R(x) = (25 +x) * (300 - 10x)
= 7500 + 50x - 10x2
R(x) reaches its maximum when R'(x) = 0
R'(x) = 50 - 20x
50 - 20x = 0
x = 2.5
This means adding 2.5 people produces the highest TR. Since we can't have 2.5
people test the function at either by adding 3 people or 2. That is,
R (25 +3) = 28[300 - 10(3)] = Birr 7560
R (25 +2) = 27[300 - 10(2)] = Birr 7560
Thus, the revenue is maximized at either 27 or 28 people in the group.

9. Minimizing Inventory Cost (Where inventories arrive in lot size of Q)

121
One of the many products sold by a discount store is a special model video
cassette recorder (VCR). Each such VCR costs the store Birr 200. The annual
demand is 200,000 units. Ordering costs are Birr 40 per order, and the annual
holding cost per unit is 8% of the cost of a VCR.

a. Determine the equation for the total annual inventory cost.

b. Determine the order size that minimizes the total annual inventory
cost.
c. Determine the minimum total annual inventory cost.
d. Determine the number of orders placed in a year for this particular
VCR.

Solution

a) The total annual inventory cost is calculated by the following formula:

C = ordering cost + carrying cost

The ordering cost is calculated by multiplying the cost of placing an order by the
number of orders placed in a year. Since 200,000 VCRs orders are placed
annually in quantities of Q VCRs per order, the number of orders per year is
. Thus since the cost of placing each order is Birr 40, we have

Ordering cost = 40 =

The carrying cost is calculated by multiplying the cost of carrying 1 unit in

inventory for a year by the average number of units in inventory. The average
inventory is (0 +Q)/2 = , since the inventory level varies from 0 to Q. Thus, since
the cost of carrying 1 VCR in inventory for a year is Birr 16 (8% of 200), we obtain

Carrying cost = 16 = 8Q

Therefore, the total annual inventory cost is calculated as

C (Q) = 40 + 16

Simplifying, we obtain

122
 C (Q) = + 8Q (Q>0)

b) Calculating C' (Q) and setting it equal to zero gives the critical point.

C'(Q) =

The critical value is obtained by setting C'(Q) =0. Hence, = 0.

Solving for Q2 gives
Q2 = 1,000,000
Q = 1,000 the only critical value.

Applying the second derivative test to Q = 1,000, we have

C"(Q) =

C"(1000) = = 0.016 which is positive. Therefore, by the

second derivative test for absolute extrema, an absolute minimum exists at Q =
1000. Thus, in order to minimize the total annual inventory cost, the store should
order this particular model of VCR in lots of 1000.
C. The minimum annual inventory cost is
C (1000) =
= Birr 16,000.

D. The number of orders placed in a year for this VCR is given by

10. Minimizing Inventory Cost (Where items of inventory are supplied at a

constant rate during a given time interval)

Star Soap and Detergent Inc., manufactures a special type of bath soap, Max. Star
can produce this soap at an annual rate of 480,000 cases. The annual demand is
estimated to be 320,000 cases. It costs Star Birr 400 to set up a production run. The
annual holding cost per case of soap is Birr 12.

123
 a. Determine the equation for the total annual inventory cost for Star.
b. Determine the value of Q that minimizes the total annual inventory cost.
c. Determine the minimum total annual inventory cost.
d. Determine the annual set-up cost.
e. Determine the annual holding cost.

Solution
a. The total annual inventory cost associated with this production lot size inventory
model is given by

C = set-up cost + carrying cost

Where
Q= number of units of inventory manufactured during a production run
D= annual demand rate
P= annual production rate/rate of inflow of inventory in to the stockpile
K= cost of setting up a production run
H= annual holding cost per unit of inventory
P-D= rate of net inflow of inventory in to the stockpile

Simplifying we obtain

b) Calculating C' (Q) and setting it equal to zero gives the critical
point.

C'(Q) =

The critical value is obtained by setting C'(Q) =0. Hence, =0

Solving for Q2 gives
Q2 = 64,000,000
Q = 8,000 the only critical value.

124
 Applying the second derivative test to Q = 8,000, we have

C"(Q) =

C"(8000) = = 0.0005 which is positive. Therefore, by the

second derivative test for absolute extrema, an absolute minimum exists at Q =
8000. Thus, in order to minimize the total annual inventory cost, the store should
produce this particular model of soap in lots of 8000.
c) The minimum annual inventory cost is
C (8000) =
= Birr 32,000.

d. The annual set-up cost is calculated by multiplying the number of times that
star sets up which is 40 (320,000/8,000) by the cost of setting up, Birr 400.
Therefore, the annual set-up cost is Birr 16,000(40x400).
e. The annual holding cost is calculated by multiplying the average inventory by
the annual holding cost of a unit of inventory. Average inventory is further
calculated using the formula . For the star case it is equal to

= 1,333 units. Multiplying the average inventory by the

unit cost of carrying the inventory, we get the annual holding cost. And it is
equal to Birr 16,000 (1333x12).

11. Optimal Price for Maximum Revenue

Owners of Bishangari, a resort village, have 200 seaside cottages which they rent
by the week to summer vacationers. When weekly rent is Birr 400, all units are
occupied throughout the summer months. Owners of the village would like to
increase the rental fee, but experience has indicated that for each Birr 20 per
week increase in rent (above Birr 400), five units will be vacant each week. What
weekly rental fee should be charged to maximize weekly revenue?

Solution:
The quantity to be maximized is revenue, R, each week and is determined by
Revenue = (Number of cottages rented). (Weekly rent per cottage)
The controllable independent variable is the number of Birr 20 increase in rent
put in to effect. Let us denote this as
X = number of Birr 20 increases in weekly rental fee put in to effect

125
 Because after 40 such increases all cottages would be vacant, the value set of x is
restricted to 0< x <40.
The number of cottages rented will be (200 - 5x), while the weekly rental per
cottage is (400+ 20x). Hence, the revenue function is given by
R(x) = (200 - 5x). (400+20x) = 80,000 + 2000x - 100x2 [0, 40]

To find the value of x at which this function reaches a maximum, we differentiate

to obtain R' (x) = 2000 - 200x. Setting the first derivative equal to zero, we find the
critical value of x to be
2000 - 200x = 0
x = 10 (the only critical value)

Then by the second derivative test, we see that R" (x) = -200 is negative for all x
indicating that this extremum is a maximum point on the graph.

To locate absolute maxima or minima, we also consider the endpoints of the

domain of the function. Thus, we evaluate

R (0) = 80,000+200(0) - 100(02) = Birr 80,000

R (10) = 80,000+200(10) - 100(102) = Birr 90,000
R (40) = 80,000+200(40) - 100(402) = Birr 0
Hence, at x = 10 there is an absolute maximum.

With 10 increases of Birr 20 each weekly rental fee for a cottage, the rent would
increase from Birr 400 to Birr 600. The number of cottages rented each week
would decrease by 10*5 = 50, from the present level of 200 down to 150. Revenue
realized would be birr 600*150 = 90,000, and would be at a maximum level.

12. Optimal Price for Maximum Profit

Owners of Bishangari (from the preceding question) wonder whether the
strategy that yields the maximum revenue will also yield maximum profit. Their
weekly cost for cleaning and maintenance on a cottage rented is Birr 90, while
this cost is only Birr 10 on a cottage which is vacant.

Given that the number of cottages rented each week is a function of the number x
of Birr 20 increases in weekly rent(above the present Birr 400),

Number of cottages rented = 200 - 5x

and
Number of cottages vacant = 5x

126
Then the cost (of cleaning and maintenance) function is
C(x) = 90 (200 - 5x) + 10 (5x)
18,000 - 400x

The profit function, thus, is

Profit = Revenue - Cost
P(x) = 80,000 + 2000x - 100x2) - (18,000 - 400x)
62,000 + 2400x - 100x2 [0, 40]
To find the critical values of x for this function, we find the first derivative of P'
(x) = 2400 - 200x, and, setting this equal to zero, solve
2400 - 200x = 0
x = 12
To locate the absolute maximum, we evaluate P(x) at this critical value as well as
at each of the end points of the interval of relevant x values, as
P (0) = 62,000 + 2400(0) - 100(02) = Birr 62,000
P (12) = 62,000 + 2400(12) - 100(122) = Birr 76,400
P (40) = 62,000 + 2400(40) - 100(402) = Birr - 2,000

Thus, at x = 12, there is an absolute maximum for the function.

The profit -maximizing strategy - which is not the same as the revenue
maximizing strategy- would be to increase the weekly rent on each cottage by 12
* Birr 20 = Birr 240,, or from Birr 400 to Birr 640. This would mean that 5(12) = 60
cottages would be vacant each week; only 140 of the 200 cottages would be
occupied. Revenue would total birr 640 * 140 = Birr 89,600. Cost of cleaning and
maintenance would be C (12) 18,000 - 400(12) = Birr 13,200 leaving a weekly
profit of Birr 76,400 (Birr 89,600 - Birr 13,200)

127
 Integral Calculus
Calculus has two main Branches: Differential Calculus - which deals with the
problems of finding the rate at which a known but varying, quantity changes:
and Integral Calculus - which deals with the problem of finding a quantity, given
that we know the rate at which it is changing.

Integral calculus is the reciprocal of the differential calculus. Given the rate of
change f '(x), by integral calculus we can find the original function f(x).

E.g. f(x) = 5
F(x) = 5x +c
F'(x) = 5
Because the derivative of a constant is zero, once an antiderivative of a function
is found, another antiderivative of the same function can be formulated simply
by adding a non-zero constant to the first derivative. Thus, F(x), by it self is not
unique; it is only one member of a family of antiderivatives for some specified
function, each of these antiderivatives for some specified function, each of these
anti-derivatives differing from the others only by an arbitrary constant C. Thus, if
F(x) is an antiderivative of f(x), the general expression F(x) + C is called the
ANTIDERIVATIVE of f(x), or the INDEFINITE INTEGRAL, and is denoted by
the symbol f(x)dx.

Given F(x, an antiderivative of f(x), the indefinite integral of f(x) is defined to be

F(x)+c = f(x)dx read as the indefinite integral of function f(x) with respect
to the variable x.
 - Integral sign
- indicates that the operation of anti differentiation
(integration) is to be performed.
f(x) - Integrand
dx - indicates integration is to be performed with respect to the
variable X.
C - Constant of integration
The process for finding f(x)dx is called indefinite integration.

E.g. Find the indefinite integral for the following

1. f(x) = 10x 2. f(x) = 3x - 10
2
f(x)dx = 5x +c f(x)dx = 3/2x2-10x+c
Find the function that has a slope of 10x 4 at each point and that passes through
the point (2, 74).

128
 f(x) = 10x4
f(x)dx = 10x4dx = 2x5+c Therefore, F(x) = 2x5 + 10
Y = 2(25) + C
74 = (2 x 32) + C
C = 10
Basic Rules for Integration
The determination of anti-derivatives by trial and error is cumbersome. So many
rules for integration have been developed from the corresponding theorems
concerning derivatives. The most common are:

1. Constant Rule
f(x) = K f(x) = 3 f(x) = 0
f(x)dx = Kx+C 3dx = 3x+C 0dx = 0+c =C
2. Power Rule
f(x) = xn f(x) = x f(x) = x2
f(x)dx = ; n1 f(x)dx = +C f(x)dx =
If n = -1, ln x + C
It is because logarithmic functions are not defined for negative values of x.
3. Constant Multiplier Rule
f(x) = kg(x) f(x) = 5x
x2
if f(x) exists, f(x)dx = 5 +C
2

f(x)dx = Kg(x)dx+c = 5( )+C

x2
f(x) = =
2

f(x)dx = x2dx + C

4. Sum or Difference Rule

f(x) = h(x)  g(x) , if h(x) and g(x) exist

f(x) = h(x)dx  g(x)dx

129
 E.g. f(x) = 3x+6

f(x) = 3xdx + 6dx

= ; where C = C1 + C2

5. Product Rule

f(x) = (x+2)2

= x2+4x+4

f(x)dx =

6. Quotient Rule

f(x) =

f(x)dx =

Business Applications of Integral Calculus

Finding Total Functions

Exercises

1. The marginal revenue function for a company product is given by the function

f(x) = 50,000 - x; where x is the number of units produced and sold. Moreover, TR

= 0 when no units are produced and sold. Find the company's TR function.

130
 f(x) - marginal revenue

TR = the integration of MR

= F(x)dx = (50,000 - x)dx

= 50,00dx - xdx

= 50,000x - x2/2 + C

0= 50,000(0) - (0/2) + C

0=C

R(x) = 50,000x - x2/2

2. The function describing the MC of producing a product is f(x) = x+100, where x =

the number of units produced. It is also known that TC = 40,000 Birr when x is

100 units. Determine the total cost function.

Solution.

MC = x + 100

TC = MC

= (X+100) dx

= xdx + 100dx

= x2/2 + 100x + C

40,000 = (1002/2) + 100(100) +C

=15,000 + C

C = 25,000

C(x) = x2/2 + 100x + 25,000

3. The function describing the marginal profit from producing and selling a product

is f(x) = - 6x+750 where x = the number of units produced and sold. Moreover,

when 100 units are produced and sold, total profit equals Birr 25,000. Determine

the total profit function.

Solution

131
 MP = - 6x+750 = -3x2+750x+c

TP = MP dx 25,000 = -3(1002) + 750(100) + C

= (-6x + 750)dx 25,000 = 45,000 + C

= -6xdx + 750dx + C C = -20,000

= -6x/2 + 750x + C P(x) = -3x2+750x-20,000

4. The marginal propensity to save, S'(x), is a function of a nation's income, x (in

billions of Birr), as defined by the equation: S'(x) = .5 - .12x- 1/2 (x>0). If S = 0 when x

= 81, then

a. Find the equation defining total savings, S(x).

b. Find the total savings at a national income of Birr 144 billion.
Solution
S(x) = S'(x) dx S(x) = .5x - .24x1/2 - 38.34
= (.5 - .12x-1/2) dx S(144) = .5(144) - .24(1441/2) - 38.34
= .5dx - .12x-1/2dx = 72 - .24(12) - 38.34
= .5x - .12x (-1/2 +1)/1/2 + C = 72 - 41.22
= .5x - .24x1/2 + C = Birr 30.78 billion
0 = .5(81) - .24(811/2) + C
= 40.5 - 2.16 + C
= 38.34 + C
C = - 38.34
S(x)= .5x - .24x1/2 - 38.34

Definite Integral
Consider a firm producing some commodity. At a production level of x units, the
marginal cost is: C'(x) = 6x + 8. The antiderivative of the marginal cost is: C(x) =
(6x +8) dx
= 3x2 + 8x + C
If we are told that the fixed cost is Birr 600, then we determine the arbitrary
constant to be C=600.Hence, the cost function is: C(x) = 3x2 + 8x + 600.
Suppose we wish to determine the total net change in cost if production rises
from x=10 to x=15. This total net change in cost is determined by evaluating
C (15) - C (10)
Since
C (15) = 3 (152) + 8 (15) + 600 = Birr 1,395

132
 and
C (10) = 3 (102) + 8 (10) + 600 = Birr 980
the total net change in cost is
C (15) - C (10) = Birr 1,395 - Birr 980
= Birr 415.
Thus, as production changes from x=10 to x=15, the total cost increases by Birr
415.
Definition
If f is a bounded function on the interval [a, b] we define the definite integral of f
as:

Where
The numbers a and b are called limits of integration.
F (b) - the value of the antiderivative at x=b.
F (a) - the value of the antiderivative at x=a.
a - lower limit
b - upper limit
the definite integral of f between a lower limit x=a and an upper
limit x=b.
According to this definition the calculation of the definite integral proceeds as
follows:
1. Determine the antiderivative, F(x), of f(x)
2. Evaluate the antiderivative at x=b and at x= a
3. Subtract F(a) from F(b)

There are three basic assumptions in computing a definite integral. These are:
1. continuity over an interval
2. non-negativity
3. antiderivative exists

Example
1. The marginal revenue function is given as f(x) = 10.
a. Find the change in total revenue associated with increasing sales
from 1500 to 1800 units [1500, 1800]
b. Find the incremental revenue from selling 1,500 units.

Solution
a.

133
 = 10x +C

= F (1800) - F (1500)
= 10(1800) + C - [10(1500) + C
= 10(1800) - 10(1500)
= Birr 3,000

b.
= 10x

= F (1500) - F (0)
= Birr 15,000

2. The marginal profit for producing and selling x items is given by f(x) = 600- 5x.
What is the change in total profit if the level of production changes from 40 to 60
units?
Solution

= 600x - 2.5x2
= F (60) - F (40)
= [600(60) - 2.5(602)] - [600(40) - 2.5(402)]
= 27,000 - 20,000
= Birr 7,000

3. A truck carrying natural gas gets stuck at a low underpass and leaks natural gas at
the rate of L'(t) = 10t +20 cubic feet per minute, where t denotes time (in minutes)
elapsed since the gas first began leaking.

a. Find the total amount of natural gas that has leaked during the first five
minutes. Answer: 225 cubic feet.
b. Find the total amount of natural gas that has leaked during the first 10
minutes. Answer: 700 cubic feet
c. Find the total amount of gas that has leaked during the fifth minute. Answer:
65 cubic feet
d. Find the total amount of gas that has leaked during the sixth minute Answer:
75 cubic feet
e. If the amount of natural gas that the truck was carrying was 5,100 cubic feet,
how many minutes will be elapsed before the truck is empty? Answer: 30
minutes

134
 Area problems
The fundamental theorem of calculus allows us to compute the area under the
graph of a continuous non-negative function f(x) over the interval a<x<b by
, where F(x) is an antiderivative of f(x).
To find areas under a curve we employ the following steps.
1. Graph the function
2. Find any x-intercepts
3. Shade the area to be found
4. Note whether the shaded area contains any regions that lie below the
x-axis as well as above the x-axis.
5. Evaluate the appropriate definite integrals

Example
1. Find the area of the region bounded by the lines f(x) = 2x and x = 2, and the x axis.
Solution (2, 4)

Y = 2x

(0, 0) (2, 0)

To compute this area using calculus, apply the integral formula with f(x) = 2x.
Take b = 2 since the region is bounded on the right by the line x=2, and take a=0
since, on the left, the boundary consists of the single point (0, 0), which is part of
the vertical line x=0. You will find, as expected that

2. Find the area of the region bounded by the curve f(x) = -x2 +4x - 3 and the x axis.

Solution
From the factored form of the polynomial f(x) = -x 2 +4x - 3 = - (x-3) (x-), we see
that the x-intercepts of the curve are (1, 0) and (3, 0). From the corresponding

135
graph we see that the region in question is below the curve f(x) = -x 2 +4x - 3 and
extends from x=1 to x=3. Hence,

f(x)

x
0 1 3

The region is bounded by f(x) = -x2 +4x - 3and the x-axis.

Area below the X-Axis

If f(x) < 0 over some interval b <x <c, the corresponding area between the graph
of f(x) and the x-axis lies below the x-axis. The definite integral results
in a value that is the negative of the area, so the absolute value of such a definite
integral gives the area.
Area 1
F(x)

0 a b c x

Area 2

Area = Area 1 + Area 2

Where

136
Area 1 = and Area 2   or -

Example:
Find the area between the x-axis and the curve f(x) = x2-9 from x=1to x = 4.
Solution
Sketch the graph and identify the region needed.

f(x)

A1

1
-3 3 4 x

A2
-9

Find A1 and A2.

A2 =

A1 =

Total area= A1 + A2
=

137
 Multivariable Calculus
1. Functions of several variables
A function such as y = f(x) = x 3 +3x2 +5x – 1000 has dependent variable y and
independent variable x. Since there is only one independent variable, f(x) is
called a function of one variable. If a function has two independent variables-
say x and y- it is called a function of two variables and is usually denoted by f(x,
y). If a function has three independent variables - say x, y and z- it is called a
function of three variables and is usually denoted by f(x, y, z). In general,
functions of more than one variable are called multivariate functions.

As a specific example, we consider a company producing metal tanks. It has been

determined that the daily production cost, z, is dependent on the daily number
of tanks produced, x, and the daily number of person hours used, y. these
quantities are related by the multivariate function
Z = f(x, y) = x2 – 8x + y2 – 12y + 1500
If during a given day, the company produced x = 2 tanks and used y = 5 person
hours of labor, then the daily production cost is
Z = f (2, 5) = 22 – 8(2) + 52 – 12(5) + 1500 = Birr 1,453.

Example
1. Revenue Function: Several Products
A watch manufacturing company produces two watches named Ovex and Rolex.
It has determined that the demand equations for the two types of watches it
produces are given by
p = 210 – 4x +y
q = 300 + x – 12y

Where p is the price of Ovex watch, q is the price of the Rolex watch, x is the
weekly demand for the Ovex watch, and y is the weekly demand for the Rolex
watch.
a) Find the weekly revenue function R(x, y) and evaluate R (20, 10).
b) If the weekly cost function is C(x, y) = 700 + 70x +100y, find the weekly
profit function P(x, y) and evaluate P(20, 10)
Solution:
a) Revenue = (Demand for the Ovex watch)* (Price of a Ovex watch) +
(Demand for the Rolex watch)* (price of a Rolex watch)
R(x, y) = (xp) + (yq)
= x (210 – 4x + y) + y (300 + x – 12y)
R(x, y) = 210x + 300y – 4x2 + 2xy – 12y2

138
 R (20, 10) = 210(10) + 300(10) – 4(20)2 + 2(20) (10) – 12(10)2
= Birr 4,800

c) Profit = Revenue – Cost

P(x, y) = R(x, y) – C(x, y)
= 210x + 300y – 4x2 + 2xy – 12y2 – 700 – 70x – 100y
= 140x + 200y – 4x2 + 2xy – 12y2 – 700
P (20, 10) = 140(20) + 200(10) – 4(20)2 + 2(20) (10) – 12(10)2 – 700
= Birr 1,700

2. Cobb- Douglas Production Function [f(x, y) = Cxay1-a where C and a are constants
with 0 < a < 1, x = number of units of labor, and y = number of units of capital]

For some company, the number of units of produced when using x units of labor
and y units of capital is given by the production function
f(x, y) = 80x1/4y3/4
Find the number of units produced when 625 units of labor and 81 units of
capital are used.
Solution:

f (625, 81) = 80(625)1/4(81)3/4

= 80 (5) (27) = 10, 800 units

3. Advertising and Sales

A company spends x thousands of dollars per week on newspaper advertising
and y thousand dollars per week on television advertising. Its weekly sales were
found to be given by
S(x, y) = 5x2y3
Find S (3, 2)
Solution:
S (3, 2) = 5(3)2(2)3 = Birr 360,000

2. Partial Derivatives
We know how to differentiate many kinds of functions of one independent
variable and how to interpret the results. What about functions with two or more
independent variables?

Recall the company producing metal tanks above. It has been determined that
the daily production cost, z, is dependent on the daily number of tanks

139
produced, x, and the daily number of person-hours used, y. These quantities are
related by the multivariate function

Z = f(x, y) = x2 – 8x + y2 – 12y + 1500.

We now consider finding the instantaneous rate of change of z with respect to x (i.e.,
the instantaneous rate of change of cost with respect to the number of tanks
produced). This is expressed by finding the derivative of z with respect to x.
however, since z = f(x, y)has two independent variables, the derivative of z with
respect to one of the independent variables is called a partial derivative, or
simply a partial. Specifically, the derivative of z with respect to x is called the
partial derivative of z with respect to x and is denoted by any of the following:
, fx (x, y), fx. It is defined by

provided that limit

exists. This is the ordinary derivative of z with respect to x. it is found by treating

x as a variable and the remaining independent variables (in this example, y) as
constants and applying the differentiation rules. Thus, if Z = f(x, y) = x 2 – 8x + y2 –
12y + 1500, then fx(x, y) = 2x – 8.

Similarly, the instantaneous rate of change of z with respect to y is expressed by

the partial derivative of z with respect to y and is denoted by any of the
following: , fy (x, y), fy. Similarly, it is defined by

provided that limit

exists.
The partial derivative of z with respect to y is found by treating y as a variable
and the remaining independent variables (in this example, x) as constants.
Hence, if Z = f(x, y) = x2 – 8x + y2 – 12y + 1500, then fy(x, y) = 2y – 12.
If we wish to evaluate at x = 6 and y = 10, this is denoted by any of the

following notations: , , or fx(6,10).

140
 Since is given by fx(x, y) = 2x – 8, then or fx (6, 10) is given by
fx(6,10) = 2(6) – 8
=4
Thus, when x = 6 tanks are being produced daily and y = 10 person hours are
being used daily, the instantaneous rate of change of cost with respect to the
number of tanks produced (i.e., the marginal cost is) is Birr 4. In other words,
assuming the number of person-hours used daily does not change, an additional
tank costs approximately Birr 4.
Analogously, if we wish to evaluate at x = 6 and y = 10, this is denoted by any

of the following notations: , , or fy(6,10).

Since is given by fy(x, y) = 2y – 12, then or fy (6, 10) is given by

fy(6,10) = 2(10) – 12 = 10
Thus, when x = 6 tanks are being produced daily and y = 10 person hours are
being used daily, an additional person hour costs approximately Birr 8. This
assumes the number of tanks produced daily remains fixed.

Example:
1. The revenue, z, derived from selling x units of calculators and y units of adding
machines is given by the function
Z = f(x, y) = -x2 + 8x - 2y2 + 6y + 2xy + 50
a) At a sales level of x= 4 calculators and y = 3 adding machines, find the marginal
revenue resulting from the sale of an additional calculator.
b) At a sales level of x= 4 calculators and y = 3 adding machines, find the marginal
revenue resulting from the sale of an additional adding machine.
Solution:
a) Since the marginal revenue resulting from the sale of an additional calculator is
defined as the instantaneous rate of change of z with respect to x, we calculate f x
by treating x as a variable and y as a constant. We thus obtain
fx (x, y) = -2x + 8 + 2y
fx (4, 3) = -2(4) + 8 + 2(3) = 6
Therefore, at x = 4 and y = 3, sales revenue is increasing at a rate of approximately
Birr 6 per calculator sold. Hence, the marginal revenue is Birr 6.

b) Since the marginal revenue resulting from the sale of an additional adding
machine is defined as the instantaneous rate of change of z with respect to y, we
calculate fy by treating y as a variable and x as a constant. We thus obtain

141
 fy (x, y) = -4y + 6 + 2x
fx (4, 3) = -4(3) + 6 + 2(4) = 2
Therefore, at x = 4 and y = 3, sales revenue is increasing at a rate of approximately
Birr 2 per adding machine sold. Hence, the marginal revenue is Birr 6.

2. For some firm the number of units of produced using x units of labor and y
units of capital is given by the production function f(x, y) = 80x1/4y3/4.

a) Find the equations for both marginal productivity of labor and

marginal productivity of capital.
b) Evaluate and interpret the results of part a when 625 units of labor
and 81 units of capital are used.
Solution:
a) Equations for marginal productivities:
Marginal productivity of labor = fx(x, y) = 80(1/4) x-3/4y3/4 = 20x-3/4y3/4.
Marginal productivity of capital = fy(x, y) = 80x1/4 (3/4) y-3/4 = 60x1/4y-1/4.
b) fx(625, 81) = 20(625)-3/4 (81)3/4 = 20(1/125)(27) = 4.32
Thus, when 625 units of labor and 81 units of capital are used, 1 more unit labor
results in approximately 4.32 more units of production.
fy(625, 81) = 60(625)1/4(81)-1/4 = 60(5)(1/3) = 100
Thus, when 625 units of labor and 81 units of capital are used, 1 more unit of
capital results in approximately 100more units of production.

3. The annual profit of a certain hotel is given by

2 2
P(x, y) = 100x +4y +2x +5y + 100,000

Where x is the number of rooms available for rent and y is the monthly
advertising expenditures. Presently, the hotel has 90 rooms available and is
spending Birr 1000 per month on advertising.
a) If an additional room is constructed in an unfinished area, how will this affect
annual profits? Answer: Birr 18,002
b) If an additional Birr is spent on monthly advertising expenditures, how will this
affect profit? Answer: Birr 8,005
4. The cost of producing x washers and y dryers is given by
C(x, y) = 40x + 200y + 10xy + 300

Presently, 50 washers and 90 dryers are being produced. Find the marginal cost
of producing
a) 1 more washer. Answer: Birr 940

142
b) 1 more dryer. Answer: Birr 700

3. Second Order Partial Derivative

The partial derivative of a partial derivative is called a second partial derivative,
or simply a second partial. Specifically, if z = f(x, y), then there are four second
partials:
1. The partial derivative of with respect to x, or ( ). This is denoted by

any of the following: , fxx(x, y) or fxx. Take the first partial with respect to

x. Then take the partial of the result again with respect to x.

2. The partial derivative of with respect to y, or ( ). This is denoted by

any of the following: , fyy(x, y) or fyy. Take the first partial with respect to

y. Then take the partial of the result again with respect to y

3. The partial derivative of with respect to x, or ( ). This is denoted by

any of the following: , fyx(x, y) or fyx. Take the first partial with respect
to y. Then take the partial of the result again with respect to x.
4. The partial derivative of with respect to y, or ( ). This is denoted by

any of the following: , fxy(x, y) or fxy. Take the first partial with respect
to x. then take the partial of the result again with respect to y. NB: For all
continuous functions fyx = fxy.
Example:
1. For z = f(x, y) = x5 – y4 + 3x2y6 + 18, calculate each of the following.
a) fx b)fxx c) fxy d)fy e) fyy f) fyx

Solution:
a) 5x4 + 6xy6 b) 20x3 – 6y6 c) 36xy5 d) –4y3
+18x2y5
e) –12y2 + 90x2y4 f) 36xy5

2. For z = f(x, y) = 3x2 + 4y5 – 8x3y6 + 15, calculate each of the following.
a) fx b)fxx c) fxy d)fy e) fyy f) fyx

Solution:

143
 b) 6x - 24x2y6 b) 6 - 48xy6 c) -144x2y5 d)
4 3 5
20y -48x y
e) 80y3 - 240x3y4 f) -144x2y5

4. Relative Maxima and minima for functions of two variables

Relative maxima and minima of multivariate functions are defined in a manner

similar to that used for single variable functions. Specifically, a function z = f(x, y)
is said to have a relative maximum point at the point (x 0, y0) if f(x0, y0)> f(x, y) for
all points (x, y) neighboring to (x0, y0). A function z = f(x, y) is said to have a
relative minimum point at the point (x 0, y0) if f(x0, y0) < f(x, y) for all points (x, y)
neighboring to (x0, y0).
To determine the relative maxima and relative minima of functions involving
two variables, we use the first-derivative rule for functions of two variables.

This rule states that if a function z = f(x, y) has either a relative maximum or a
relative minimum at a point (x0, y0) and if both partial derivatives and
exist at (x0, y0), then it is necessary that both partial derivatives, when evaluated
at x = x0 and y = y0, to be equal to zero. This is because at a relative maximum or
minimum located at (x0, y0), the slope, fx(x0, y0), of the tangent line parallel to the
xz plane is zero and the slope fy(x0, y0), of the tangent line parallel to the yz plane
is zero. Such a point (x0, y0), at which both partial derivatives and equal
zero, is called a critical point of the function z= f(x, y). Thus to determine relative
maxima and relative minima of functions of two variables, we first search for
critical points. A point f(x0, y0) is called a critical point of z = f(x, y) if f x(x0, y0) = 0
and fy(x0, y0) = 0. Critical points yield candidates for relative maxima/minima.

Example:
1. Find the critical points for the function z = f(x, y) = x2 – 8x + y2 – 12y + 1500
Solution
We must compute fx and fy, set them equal to zero, and solve for x and y.
computing fx and fy gives
fx = 2x – 8 and fy = 2y - 12

Setting fx and fy equal to zero and solving for x and y yields

0 = 2x – 8 0 = 2y - 12
x=4 y=6

144
 Thus, the point (x0, y0) = (4, 6) is the only critical point of the function z = (x, y)

2. Find the critical point of the function z = f(x, y) = x3 + x2y + 2x – 4y + 8

Solution
We must compute fx and fy, set them equal to zero, and solve for x and y.
computing fx and fy gives
fx = 3x2 +2xy + 2 and fy = x2 - 4

Setting fx and fy equal to zero gives the equations

3x2 +2xy + 2 = 0 and x2 – 4 = 0
Since this set of equations does not constitute a linear system, we attempt to
solve one of the equations for one of its unknowns and substitute the result(s) in
to the other equation to solve for the remaining unknown.

Solving the second equation, x 2 – 4 = 0, gives x = ±2. Solving the first equation, 3x 2
+2xy + 2 = 0, for y gives . Substituting x = 2 in to this equation gives

. Thus, (2, -7/2) is a critical point. Substituting x = -2

in to the equation for y yields . Thus, (-2, 7/2) is

another critical point.

As previously stated in this section, we first search for the critical points when
attempting to determine relative maxima and relative minima of functions of two
variables. However, a critical point may or may not yield either a relative
maximum or relative minimum. Recall that this is also the case with functions of
one variable. Just as we have a second derivative test for functions of one
variable, we also have a similar test to identify the relative minima and maxima
of functions of two variables. This test is stated as follows.

Second derivative test for functions of two variables

Let (x0, y0) be a critical point of z = f(x, y) such that f x, fy, fxx, fyy, and fxy are
continuous at (x0, y0). Also, let

A = fxx(x0, y0)
B = fyy(x0, y0)
C = fxy(x0, y0)
Then
1. f(x0, y0) is a relative maximum if AB – C2 > 0 and A < 0.

145
 2. f(x0, y0) is a relative minimum if AB – C2 > 0 and A > 0.
3. f(x0, y0) is a saddle point if AB – C2 < 0 and A < 0.
4. The test fails and no information is given about the point (x0, y0) if AB =
C2 > 0 and A < 0.

Example
1. Find any relative maxima and minima of the function
z = f(x, y) = x2 – 8x + y2 – 12y + 1500
Solution
First, we find the critical points. Computing fx and fy gives
fx = 2x – 8 and fy = 2y - 12
Setting fx and fy equal to zero and solving for x and y gives x = 4 and y = 6. Hence,
(4, 6)is the only critical point. We now apply the second derivative test for
functions of two variables. Computing fxx, fyy, and fxy gives
fxx(x, y)= 2, fyy(x, y)= 2 and fxy(x, y)= 0.

Evaluating each of these at the critical point (x, y) gives

A = fxx(x, y) = 2
B = fyy(x, y) = 2
C = fxy(4, 6) = 0
AB – C2= 2(2)-02 = 4
Since AB – C2> 0 and A > 0, then, according to the second derivative test, a
relative minimum occurs at (4, 6). Thus, the relative minimum value of z is z (4,
6) = (4)2 – 8(4) + (6)2 – 12(6) + 1500 = 1448.

To find relative extrema for functions of two variables

1. Search for critical points
· Find the first order partials fx and fy
· Set the first order partials equal to zero and solve for x and y
· Determine all possible ordered pairs (x, y) that satisfy both
equations fx(x, y) = 0 and fy(x, y) = 0. These are the critical points.

2. Apply the second derivative test for functions of two variables

· Compute the second order partials fxx, fyy and fxy.
· Evaluate the second order partials at each critical point.
· Apply the second derivative test to each critical point.

Example
1. The revenue, z, derived from selling x units of calculators and y units of adding
machines is given by the function

146
 Z = f(x, y) = -x2 + 8x - 2y2 + 6y + 2xy + 50
a) How many calculators and adding machines should be sold in order to
maximize sales revenue?
b) What is the maximum sales revenue?

Solution
Critical points
a) we first calculate fx and fy, as follows:
fx = -2x + 8 + 2y
fy = -4y + 6 + 2x

Setting fx and fy equal to 0, we have

0 = -2x + 8 + 2y
0 = -4y + 6 + 2x
Solving for this linear system for x and y, we obtain x = 11 and y = 7. Thus, the
only critical point is (11, 7).
Second derivative test
We calculate fxx = -2, fyy = -4, and fxy = 2.

Since the partial critical point is (11, 7), then

A = f (11, 7) = -2
B = f (11, 7) = -4
C= f (11, 7) = 2.
AB – C2 = -2(-4) - 22 = 4
Since AB – C2 > 0 and A < 0, then, according to the second derivative test, a
relative maximum occurs at (11, 7). Thus, in order to maximize revenue, x = 11
calculators and y = 7 adding machines must be sold.
b) The maximum sales revenue is
Z = f (11, 7) = - (11)2 + 8(11) – 2(7)2 + 6(7) + 2(11) (7) + 50 = Birr 115.

2. Meditech, Inc. produces two products used in the dental industry. Each thousand
units of product 1 sells for Birr 100, and each thousand units of product 2 sells for
Birr 80. Meditech’s analysts have determined that if x thousand units of product
1 and y thousand units of product 2 are produced, the total production cost is
given by
C(x, y) = 10x2 + 5y2 – 10xy – 20x +5y +12

a) Determine the equation for total sales revenue, R(x, y).

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 b) Determine the equation for total profit, P(x, y).
c) Determine the number of units of each product that should be produced
in order to maximize total profit.

Solution
a) The total sales revenue is given by R(x, y) = 100x + 80y
b) The total profit function is given by
P(x, y) = R(x, y) – C(x, y)
= 100x +80y – (10x2 + 5y2 – 10xy – 20x +5y +12)
= -10x2 - 5y2 + 10xy + 120x + 75y – 12

c) computing Px and Py, we have

Px = -20x + 10y + 120
Py = -10y + 10y + 75
Setting Px and Py equal to zero and solving for x and y yields the critical point,
(19.5, 27). Computing Pxx, Pyy, and Pxy and applying the second derivative test for
functions of two variables gives
Pxx(x, y) = -20
Pyy(x, y) = -10
Pxy(x, y) = 10
Hence,
A = Pxx(19.5, 27) = -20
B = Pyy(19.5, 27) = -10
C = Pxy(x, y) = 10
AB – C = (-20) (-10) – 102 = 100
2

Since AB – C2 > 0 and A<0, then, by the second derivative test, a relative
maximum occurs at (19.5, 27). Thus 19.5 thousand units of product 1 and 27
thousand units of product 2 should be produced in order to maximize total
profit. The maximum profit is
P (19.5, 27) = -10(19.5)2 – 5(27)2 + 10(19.5) (27) + 120(19.5) + 75(27) – 12
= Birr 2,170.50.

3. A firm manufactures two competing brands of a given

product. Let p1 and p2 be the case selling prices (in Birr) of brands 1 and 2
respectively. If x1 cases of brand 1 and x2 cases of brand 2 are demanded by the
market, then the relationship between the unit (case) prices and the demands for
the competing brands are given by equations
X1 = 80 – 2p1 + p2
X2 = 30 + p1 – p2

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 a) Determine the equation for the total sales revenue, R (p1, p2).
b) If Birr 40 and Birr 30 are the unit case costs of brand 1 and brand 2,
respectively, determine the total cost, C (p1, p2).
c) Determine the equation for total profit, P (p1, p2).
d) Determine the case selling prices, p1 and p2, that maximize total
profit, P (p1, p2).
Solution
a) Since sales revenue for each brand is price * quantity, then the total sales
revenue is R = p1x1 + p2x2.
Since we want R (p1, p2), we substitute 80 – 2p1 + p2 for x1 and 30 + p1 – p2 for
x2 to obtain R (p1, p2) = p1 (80 – 2p1 + p2) + p2 (30 + p1 – p2)
= -2p21 – p22 + 2p1p2 + 80p1 + 30p2
b) Multiplying each case cost by the respective demand gives the total cost
C = 40x1 + 30x2

Since we want C (p1, p2), we substitute 80 – 2p1 + p2 for x1 and 30 + p1 – p2 for x2 to

obtain C (p1, p2) = 40(80 – 2p1 + p2) + 30(30 + p1 – p2)
= -50p1 + 10p2 + 4100

c) The total profit is given by

P (p1, p2) = R (p1, p2) – C (p1, p2)
= (-2p21 – p22 + 2p1p2 + 80p1 + 30p2) – (-50p1 + 10p2 + 4100)
= -2p21 – p22 + 2p1p2 + 130p1 + 20p2 - 4100

d) Computing the partial derivatives Pp1 and Pp2 gives

Pp1 = -4p1 + 2p2 +130
Pp2 = -2p2 + 2p1 + 20

Setting the above partial derivatives equal to zero and solving for p1 and p2 yields
the approximate critical point, (75, 85). Computing the second partials and
applying the second derivative test for functions of two variables gives
Pp1p1 (p1, p2) = -16
Pp2p2 (p1, p2) -2
Pp1p2 (p1, p2) = 2
Hence,
A = Pp1p1 (75, 85) = -16
B = Pp2p2 (75, 85) -2
C = Pp1p2 (75, 85) = 2

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AB – C2 > 0 and A < 0, then by the second derivative test, a relative maximum
occurs at (75, 85). Thus, brand 1 should be priced at Birr 75 per case and brand 2
should be priced at Birr 85 per case in order to maximize total profit.
The maximum profit is
P (75, 85) = -2(75)2 – (85)2 + 2(75) (85) + 130(75) + 20(85) - 4100
= Birr 1625.

Lagrange Multipliers
Some times we must optimize a function z= f(x, y), where x and y are
constrained. As an example, consider a factory that burs two types of fuel: BF108
and BF109. The number of tons of pollutant exhausted by the factory in a year is
given by
Z = f(x, y) = x2 +2y2 – xy – 279,990.
Where x is the amount (in thousands of gallons) of BF108 fuel used annually and
y is the amount (in thousands of gallons) of BF109 fuel used annually. The
factory uses a combined amount of 800 thousand gallons of fuel annually. We
seek to determine how many thousands of gallons of each type of fuel should be
burned annually in order to minimize the amount of pollutant exhausted.

Since the factory uses a combined amount of 800 thousand gallons of fuel
annually, then
x + y = 800
Mathematically, our problem is to
Minimize f(x, y) = x2 +2y2 – xy – 279,990.
Subject to the constraint g(x, y) = x + y =800
Such a problem may be solved by the method of Lagrange multipliers. In
general, the method of Lagrange multipliers is used to solve the following type
of problem.

Maximize (or minimize) z = f(x, y)

Subject to g(x, y) = C, where c is constant.

To use the method of Lagrange multipliers, we define a new function

F(x, y, λ) = f(x, y) + λ(c – g(x, y))
Where λ is called the Lagrange multiplier and the function F is called the
lagrangian function. Studying the lagrangian function, F, note that since g(x, y) =
C, then C – g(x, y) = 0, and the value of F will equal that of the original function,
f. Thus, by finding the values of x, y, and λ that maximize (or minimize) F, we

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also find the values of x and y that maximize (or minimize) f(x, y) subject to the
constraint equation g(x, y) = C.

Returning to our problem, we find

F(x, y, λ) = f(x, y) + λ(c –g(x, y))
= x2 + 2y2 – xy – 279,990 + λ (800 – x – y)

We now find the critical values of F.

Calculating FX, FY, Fλ, we have
FX = 2x – y – λ
FY = 4y – x – λ
Fλ = 800 – x – y
Setting these equal to zero yields
2x – y – λ = 0
4y – x – λ = 0
800 – x – y = 0
Solving the first equation for λ, we have
λ = 2x – y
λ = 4y - x
Equating these two expressions for λ yields
2x – y = 4y - x
-5y = -3x
y=

Substituting for y in to the third equation 800 – x – y yields

800 – x – = 0. Solving for x, we obtain x = 500.

Substituting x = 500 in to y = , we have y =

We now substitute x = 500 and y = 300 in to either of the equations for λ.
Arbitrarily choosing the equation λ = 2x – y we obtain λ = 2(500) – 300 = 700.
Thus, the function F has a critical point x= 500, y = 300, and λ = 700.

Then we test the critical points for maxima and minima. The function F has only
one critical point at (500, 300, 700), we conclude that (500, 300) produces a
minimum for f. Hence,
Min f(x, y) = f (500, 300)
= (500)2 + 2(300)2 – (500) (300) – 279,990.
= 10 – is the minimum number of tons of exhausted pollutant.

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 Interpretation of Lambda, Λ

If x = x0, y = y0 and λ = λ0 are the optimal solution values to the constrained

optimization problem
Maximize (or minimize) z = f(x, y) subject to g(x, y) = C then it can
be shown that where is evaluated at the optimal solution values.

In other words, λ0 is the rate of change of z with respect to c and thus measures
the sensitivity of the optimal value of f to a change in c. returning to our original
example, recall that λ0 = 700. Since = λ0 = 700, then each unit increase in c (i.e.,
each additional thousand gallons of fuel used) increases the optimal amount of
pollutant exhausted by approximately 700 tons.

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