MathimaticalUNIT Two
MathimaticalUNIT Two
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However, the second derivative of the function may be equal to zero in some cases.
When , the second derivative test would be inconclusive. Thus, we should take
the successive derivative test to determine whether the function is at its extremum point
or the point of inflection. Evaluated at a critical point if the first non - zero value of a
higher order derivative is an odd numbered derivative, then the function is at the point of
inflection. If the first non - zero value of a higher order derivative is an even numbered
derivative, the function is at it's relative extremum with positive value the derivative
shows the relative minimum and with negative value the derivative indicates the relative
maximum point.
Example
Find the minimum and maximum values of the function
Solution
The first order condition is .We can determine the critical values using this
condition. Thus,
or or
Thus the critical values are or or .
We should test the second order condition at these points to know whether the function is
at its relative maximum or minimum point.
=
=
Therefore, the function is at its relative maximum point when .
Revenue functions
As you remember revenue represents the amount of income that the firm generates either
from the sale of the products or providing services. Therefore,
Total Revenue =
2
It can be written as
TR = P x Q
Where P is price and Q is quantity.
The firm can maximize its total revenue when
or (First order condition)
Solution
Let x be the number of days waiting, total revenue of the firm is
Thus, -
At x = 12.5,
Therefore, the farmer should wait for 12.5 days to maximize he's revenue.
2. Suppose a 200- room hotel in Addis Ababa will rent all its rooms when it charges 125
Birr per night per room. However, from past experience the manager knows that for each
5 birr increase in rate per night per room, 4 rooms remain unoccupied per night. What
rent per room will maximize total revenue per night?
Solution
Let x be increase in nightly rent per room
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Total revenue is maximized when <0
Profit functions
Do you remember the conditions that should be satisfied for profit maximization? What
are they? As we know that the main objective of every firm is profit maximization.
Therefore, it wants to know the level of output which maximizes profit.
Total profit = Total revenue - Total cost
= TR – TC
Where represents total profit, TR is total revenue and TC is total cost. We have
discussed above that there are first orders and second order conditions for maximizing
profit. The first order condition that must be fulfilled for maximizing profit is that the
slope of total revenue (marginal revenue) has to be equal to the slope of total cost
(marginal cost). That is
The second order condition that has to be satisfied is that the slope of marginal revenue
must be less than the slope of marginal cost. In other words, the marginal cost curve has
to cross the marginal revenue curve from below. That is
<0 <0
Slope of <
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Let us do the following examples to make it clear.
Example
1. Suppose a monopolist has a demand curve and average cost curve
, where P is price per unit and Q is the number of units of output. Determine
the profit maximizing level of output and price of this monopolist.
Solution
It is clear that total profit ( ) = Total Revenue (TR) - Total Cost (TC) but TR = PQ.
Thus we should rewrite the demand function in the form of price expressed in terms of
quantity. That is
2P = 106 - Q
P = 53
Thus,
And
53 - 5 = Q + Q
48 = Q
Q=
Q = 46.15
However, this information is not sufficient enough to conclude that it is the profit
maximizing level of output. Thus it must fulfill the following condition at this point.
When Q = 46.15,
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Now we are confident enough to conclude that Q = 46.15 is the profile maximizing level
of output of the monopolist as this level of output satisfies both of the above conditions.
The profit maximizing level of price is
Cost Functions
Costs represent the amount of expenditures that firms incurred in the production process.
It includes both implicit and explicit cost. Thus, firms want to minimize these costs.
Given Total Cost (TC) = f (Q), where Q is output, Firms can minimize total cost if and
only if
i)
ii) >0
Example
1. Suppose the total cost of producing Q units of a certain product is described by the
function where TC is the total cost stated in Birr.
Determine the amount of output which minimizes average cost.
Solution
Average cost (AC) =
AC =
AC is minimized when
And
However, output should be positive. Therefore, Q = 500. We should check the second
order condition at this point to reach to our conclusion.
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When Q= 500, =
= = >0
Thus, the level of output which minimizes average cost is Q = 500 units.
Solution
Applying the same conditions
Therefore, AC is at its stationary point when Q = 5. The rate of change of the slope of AC
with respect to output is
When Q = 5,
=
= 0.4+0.2 = 0.6 > 0
Thus, the second order condition for a minimum value of AC is satisfied when Q = 5.
The actual value of AC at its minimum point will be
Exercise
1. The owner of the orange grove must decide when to pick one variety of oranges.
She can sell them for 8 birr a bushel if she sells them now, with each tree yielding an
average of 5 bushels. The yield increases by one - half bushel per week for the next five
weeks but the price per bushel decreases by 0.5 birr per bushel each week. When should
the oranges be picked for maximum return?
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2. If a firm faces the demand schedule P = 90 - 0.3Q how much does it has to sell to
maximize sales revenue? -----------------------------------------------------------------------------
3. For the non - linear demand function P = 750 - 0.1Q what output will maximize
the sales revenue?
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4. What is the maximum profit a firm can make if it faces a demand function
and the total cost function
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The fixed costs to the company for production of good X are found to be 28,000 birr and
the cost for material and labor to produce each unit of good X is estimated to be 8 birr per
unit. Determine the price that the company should charge to maximize its profit.
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6. Find the profit maximizing level of output for a firm with the total cost function
and total revenue .
Given the function Z = f(x, y), the objective function z to be maximum or minimum, it
must satisfy both of the order conditions.
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--------------- (2)
It has n- number of principal minors. The necessary and sufficient condition for sign
definiteness is that all principal minors must be greater than zero for positive definiteness
and they have to alternate in sign as is negative for negative definiteness.
The total differential expressed in equation (3) above is in a quadratic form. As a result,
the discriminant is a determinant that contains the second order partial derivatives as its
elements. This determinant is referred to as Hessian determinant.
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And are the first and second principal minors
respectively.
By now we can express the sign defiantness of using the sign of these principal
minors and thereby we are able to identify the second order sufficient conditions for the
extremum of the function as
is positive definite iff And . In this case, the
function achieves its minimum.
is negative definite iff And . This indicates
that the function is at its maximum.
The first order condition for the extremum of the function is which
leads to the fact that
The second order sufficient conditions are identified using the Hessian determinant
The sufficient condition for the maximum of the function is satisfied when
.where as for the minimum of the function all
of the Hessian principal minors must be positive.
Example
1. Given the function , find the maximum
value of the function.
Solution
The first order conditions that should be satisfied for maximum are
And
--------------------------------------- (1)
-------------------------------------- (2)
Taking equation (1) and (2) simultaneously, multiplying (1) by 2 and subtracting
equation (2) from this gives us
6x +2y = 160
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12x +4y = 320
And
Alternatively, , and
Thus, the function is maximized when x = 20 and y = 20.
The maximum value of Z is
Example
1. A firm produces two products that are sold in two markets with the demand
schedules
P1 = 600 - 0.3Q1 and P2 = 500 - 0.2Q2. Production costs are related and the firm faces the
total cost schedule TC = 16+1.2Q1 + 1.5Q2 + 0.2 Q1Q2
Determine the profit maximizing level of output and price in each market.
Determine the maximum profit of the firm.
Solution
Total Revenue (TR) = TR + TR
=
=
TR = 600Q1 - 0.3Q + 500Q2 - 0.2Q
Profit ( ) = TR -TC
=
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------------------------------ (1)
And
------------------------------- (2)
Taking equation (1) and (2) simultaneously, multiplying equation (2) by 3 deducting it
from (1) gives us
-Q2 = - 896.7
Q2 = 896.7 units
So as to decide whether these output levels maximize the profit of the firm, we must
check the second order conditions at these levels of output. That is
, ,
Therefore, >
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= 600 - 209 .73 = 500 - 179.34
= 390.27 = 320.66
The maximum profit is
2. A multiplant monopoly operates two plants whose total cost functions are given by
TC1 = 8.5 + 0.03Q1 and TC2 = 5.2 + 0.04Q
If the demand function is given by , where Q= Q1 + Q , how much output
should the monopolist produce in each plant in order to maximize profit?
Solution
Total Revenue of the firm is
Total Profit
First order conditions for maximum profit are
= 60 - 0.14 Q - 0.08 Q = 0
0.14Q + 0.08Q = 60 ------------------- (1)
And
= 60 - 0.16Q - 0.08Q = 0
0.08Q + 0.16 Q = 60 ----------------------- (2)
Taking equation (1) and (2) simultaneously, multiplying (1) by 2 and reducing (2) from
it
0.14Q + 0.08 Q = 60
0.08Q + 0.16Q2 = 60
0.08Q2 = 60 – 42
0.08Q2 = 18
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When we check the second order conditions at these levels of output
Solution
Total revenue
-------------------------- (1)
------------------------- (2)
From (1)
------------------------------- (3)
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From (2) --------------------------------------- (4)
Substituting equation (3) in place of L in (4), we get
K =
K = (9.6) (13.5)
= (195.87) (13.5)
K = 2,644.25
Substituting the value of K in equation (3) enables us to determine the amount of labor
that should be employed in the production process.
L = (13.5) (2, 644.25)
= (41.19) (90.282)
L = 3,718.72
Checking the second order conditions at these values,
= -75.6 K L = - 75.6 (2,644.25) (3,718.72)
= - 0.0015 < 0
Therefore,
, .
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Now we are confident enough to conclude that the firm will maximize its profit when it
employs 2,644.25 units of capital and 3,718.72 units of labor in the production process.
4. Suppose the monopolist sells a certain product in three separate markets and the
demand functions facing the firm are
-------------------------(1)
We can check the second order condition using the sign of the principal minors of the
Hessian determinant. The corresponding Hessian determinant is
It indicates that is negative definite. Thus, the monopolist can maximize its profit
when it sells 20 units of out put out of which 6 units at a price of 57 birr per unit in
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market 1, 9 units at a price of 60 birr per unit in market 2 and 5 units at a price of 45 birr
per unit in market 3.
Exercise
2. A firm produces two products which are sold in separate market with demand
functions
and the cost function is where
How much should the firm charge in each market to maximize profit?
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3. A Multipant monopoly operates two plants whose cost functions are
And its demand function is
,
How much should it produce in each plant to maximize its profit?
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4.A firm selling in a perfectly competitive market where the ruling price is 40 birr can
buy inputs K and L at prices per unit of 20 birr and 6 Birr respectively and operates with
production function Q = 21 K L , what is the maximum profit ?
The previous section deals with the way how the maximum or minimum value of the
function depends on the value of the independent variables under consideration.
However, in economic theory economists are usually interested in how the optimal value
of a function depends on some parameters such as tax rates etc.
Considering the firm which produces an output Q using L units of labor as input, and its
production function is given by . Suppose the price of the product is and that
of labor is , the theory of the firm states that the firm chooses the amount of labor L
which maximizes profit. The profit function is
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Considering as the optimal amount of labor when the prices are and , then
the maximal profit of the firm is represented by
This function is known as the firms indirect profit function. According to the envelope
theorem, the derivative of the indirect profit function with respect to is the partial
derivative of the direct profit function with respect to , evaluated at namely
.
In this case the derivative will be positive which indicates that as the price of the
product increases, the profit of the firm increases.
Similarly, the envelope theorem states that the derivative of the firm’s profit function
with respect to is . In this case the derivative is negative which shows that
an increase in the price of an input that is wage rate decreases the maximal profit of the
firm.
The following graph shows how the indirect objective function envelopes the direct
objective function.
Each of the inverted U-shaped curves is the graph of direct profit function
as a function of for a given value of and . Each of these graphs show how changes
due to change in for a given value of and . To get the solution of the maximization
problem for any given value of , we should find the highest function for that value of .
Thus the graph of the indirect profit function is the locus of these highest points. Thus,
the indirect objective function is the envelop curve of the direct objective function at
various values of in our case.
Example
1. Suppose a firm is producing a certain product Q and wants to maximize its profit.
Suppose a tax rate is imposed on a production of Q. What is the effect of change in the
tax rate on total profit?
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Total Profit ( ) =TR-TC
Thus,
The first order condition for maximum profit is
-------------------------------- (1)
From equation (1) we can determine the critical value of the profit function and let’s say
.
Second order condition for maximum profit is
The effect of change in the tax rate on total profit is determined by differentiating the
Profit function with respect to the tax rate. It is given as
=
However,
Therefore,
This result indicates that the rate of change of total profit with respect to tax rate is
negative. It implies that an increase in tax decreases the total profit of the firm.
2. Assume that the demand and the total cost functions of the monopolist are P=24-
3x and C= x2+8x respectively. Determine the rate of change of the profit function with
respect to the tax rate when a tax rate of 4 Birr per unit of production is imposed.
Total profit
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=
Exercise
Do the following questions based on the information above.
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