Quantitative Methods for MSEC

PART 1.2: Unconstrained Optimization

The One-Variable Case

Key Concepts

 Extremum of a function
 First-order conditions
 Second-order conditions
 Concavity and convexity

1. Optimization

 To find a set of values of the choice variables that will yield the desired
extremum of the objective function

1.1 Objective function

 The function to be maximized or minimized; y = f(x)

 The dependent variable, y, represents the object of maximization or
minimization

1.2 Choice variables

 The independent variables that can be chosen to achieve the desired

objective

2. Extremum

 An extreme value - a maximum or a minimum

2.1 Local (relative) vs Global (absolute) extremum

 Local extremum:
The maximum or minimum value of a function in the neighborhood of a
point
  Global extremum:
The maximum or minimum value of a function in the range of the function

3. First-order condition (FOC)

 Consider the function y = f(x).

 The necessary condition for a relative extremum (maximum or minimum) is
that the first-order derivative be zero, i.e.
f'(x) = 0.

3.1 Interpretation of the first order condition (FOC)

 At the highest and lowest points of a curve, the tangent to the curve at such
points is horizontal.
 The slope of the curve is zero.

3.2 Critical value

 Let f'(x) = 0 at x = x0.

o x0: Critical value of x
o f(x0): Stationary value of the function
o (x,f(x0)): Stationary point

3.3 Question

 Why is f'(x) = 0 not a sufficient condition for a local maximum or

minimum?
 Answer: Because f'(x) = 0 at some inflexion points.

Note: The first-order condition does not distinguish between a maximum and a
minimum.
4. Second-order condition (SOC)

If the first-order condition is satisfied at x = x0,

o f(x0) is a local maximum if f''(x0) < 0

o f(x0) is a local minimum if f''(x0) > 0

4.1 Interpretation of the SOC

Maximum:

o As you move up a curve from the left, leading to a maximum, the

curve gets increasingly flatter, i.e. the slope gets smaller and smaller.
o This means that f'' < 0.
o For example, if f' goes from 6 to 2, it means that f'' < 0.

Minimum:

o As you move down a curve from the left, leading to a minimum, the
curve gets increasingly flatter.
o However, since the slope is negative, a flattening of the curve implies
that f'' > 0.
o For example, if f' goes from -3 to -2, it means that f'' > 0.

5. Obtaining a local extremum

Consider the function y = f(x).

 Step 1: Obtain the first-order derivative of f(x).

 Step 2: Set f'(x) = 0.
o Solve for x.
o These are the critical values of x.
o But, at this point, you do not know if they yield a maximum or a
minimum.
 Step 3: Obtain the second-order derivative of f(x).
 Step 4: Determine the sign of f''(x) at the critical values of x.
o If f'' < 0, the critical value corresponds to a maximum.
o If f'' > 0, the critical value corresponds to a minimum.
5.1 Example

Consider the function y = f(x) = x2 - 5x + 8.

a. Obtain f'(x).
b. Set f'(x) = 0. Solve for x.
c. Obtain f''(x).
d. What is the sign of f''(x) at the critical value? Does the critical value yield a
maximum or a minimum?
e. Compute the stationary value of the function.

Exercises

Find the stationary points of the following functions and determine whether
they are max or min points

a. 3
y=2 x −9 x +12 x+5
b. 3
y=x −3 x +5
2

4 3 2
c. f ( x )=x −2 x −12 x −84 x+35
5 4 3
d. h ( t )=3 t −20 t + 40 t
4 3 2
e. g ( w )=w + 4 w −18 w −9
2 3
f. Q ( x )=10−30 x +2 x

6. Concavity and convexity

 Refers to the curvature of a graph

 Linked to the second-order derivative
6.1 Concave curve

 A line segment joining any two points on the curve lies on or below the
curve

6.2 Concave and strictly concave functions

 If f''(x) < 0 for all x, f(x) is strictly concave

6.3 Example

 f(x) = -3x2 + 5x - 2
 The function is strictly concave. Why?

6.4 Convex curve

 A line segment joining any two points on the curve lies on or above the
curve

6.5 Convex and strictly convex functions

 If f''(x) > 0 for all x, f(x) is strictly convex

6.6 Example

 f(x) = 3x2 + 5x - 2
 The function is strictly convex. Why?

7. Profit maximization by firms

 Maximization problem:
Firm seeks to maximize profits by choosing optimal Q.
 Objective function:
The profit function
 Choice variable:
Output level, Q
 First-order condition:
o R'(Q) - C'(Q) = 0
o MR = MC (ah, yes, the familiar condition)
o The firm maximizes profits by producing the output level at which
marginal revenue equals marginal cost.
 But how do we know that profits are maximized, not minimized, at
this point?
 Second-order condition:
Sufficient conditions for maximum profits

8. Application: Profit maximization

Data for monopolist:

 Demand curve: P(Q) = a - bQ

 Cost function: C(Q) = cQ2 + eQ + F

Questions

a. What is the firm's fixed cost? Variable cost?

b. Obtain the firm's revenue R(Q) and marginal revenue (MR) functions.
c. Obtain the firm's marginal cost (MC) and average cost (AC) functions.
d. Write down the firm's profit function in terms of Q.
e. Obtain the first-order derivative of the profit function.
f. Obtain the second-order derivative of the profit function.
g. Under what conditions is the profit function strictly concave? Assume these
conditions hold.
h. Using the first-order condition, obtain the critical value of Q. Call this Q*.
i. Using the second-order condition, establish whether the critical value
corresponds to a maximum or minimum.
j. Obtain the firm's optimal price. Call this P*.
k. What is the relationship between MR and MC at Q*?
l. Sketch the demand, MR, MC and AC curves.
m. Indicate the firm's optimal output and price on the graph.
n. Use derivatives and graphs to show how the firm's price and output
combination is affected by:
i. A decrease in c.
ii. An increase in a.
iii. A decrease in F.
The Many-Variable Case

1. Functions of two variables

 Consider the function z = f(x, y)

1.1 Find the extremum of the function

a. Obtain the first-order and second-order partial derivatives of the function:

o f1, f2
o f11, f12, f21, f22
b. Write down the first-order conditions for an extremum.
o f1(x, y) = 0 (1)
o f2(x, y) = 0 (2)
c. Solve (1) and (2) for x and y. Denote them x0 and y0.
Note: There may be more than one set of (x, y) that satisfy equations (1) and
(2).
d. The function attains an extremum value at (x0,y0).
e. Evaluate the second-order partial derivatives at (x0,y0).
f. Check the second-order conditions to verify whether the extremum is a
maximum or a minimum:

Maximum if: f11 < 0, f22 < 0, f11f12 > f122

Minimum if: f11 > 0, f22 > 0, f11f12 > f122

1.2 The Hessian matrix, H

 The matrix whose elements are the second-order partial derivatives

evaluated at (x0, y0):

H=f f
21
|
22
|
f 11 f 12

Principal minors

 Obtained by deleting successive rows and columns of the Hessian

determinant (the "all-but" rule):
 o H1 = f11 (delete all but the first row and column)
2
o H2 = f11f22 - f12 (delete all but the first two rows and columns)
 Note: In the two-variable case, H2 = det(H), the Hessian itself.

1.3 Second-order conditions revisited

 For a maximum: H1 < 0, H2 > 0

 For a minimum: H1 > 0, H2 > 0

Note: The principal minors are evaluated at (x0,y0).

2. General case

2.1 Function of n variables

 Consider the function y = f(x1, x2,...,xn)

2.2 First-order conditions (FOC)

 f1 = 0, f2 = 0, ..., fn = 0

2.3 Second-order conditions (SOC)

Look at the signs of the principal minors.

 If they alternate in sign, the first being negative, the extremum is a

maximum:
H1 < 0, H2 > 0, H3 < 0,...
 If all the n principal minors are positive, the extremum is a minimum:
H1 > 0, H2 > 0, H3 > 0,..., Hn > 0

Examples
Find the extreme value(s) of the functions below and determine whether they are
maximum or, minimum.
a. z=x 2 + xy−2 y 2 +3
b. z=−2 x 2+ xy− y 2 +2 x + y
c. z=−x 2 + xy− y 2 + x +5 y
3. Application

Examples
Find the extreme value(s) of the functions below and determine whether they are
maximum or, minimum.
d. z=x 2 + xy−2 y 2 +3
e. z=−2 x 2+ xy− y 2 +2 x + y
f. z=−x 2 + xy− y 2 + x +5 y

Application
1. Find the optimum output of a firm whose total revenue and total cost functions are
given by R=40 q−q 2 and C=30+ 4 q , q being the output of the firm. Also find the
maximum profit.

A firm's demand and cost functions are given by (1) and (2) respectively:

P = 60 - 2Q, (1)
C = (1/3)Q3 -14Q2 + 140Q + 100, (2)
where Q is output, P is price, and C represents total cost.

1. Optimal output and price

a. What is the firm's fixed cost?

b. What is the firm's variable cost?
c. Obtain the firms' revenue function R(Q).
d. Obtain the firm's MR and MC functions.
e. Obtain the firm's profit in terms of output.
f. Obtain the first-order derivative of the profit function.
g. Obtain the second-order derivative of the profit function.
h. Plot the profit function over Q = 0 to Q = 30.
i. Using the first-order condition, obtain the critical values of Q.
j. Using the second-order condition, establish the maximum and minimum.
k. Obtain the (local) maximum and minimum values of the profit function.
Indicate the values on the graph.
l. Is MR = MC at Q = 20? At Q = 4?
 m. Confirm the solution to the firm's problem: Optimal output = _____ units.
Optimal price = __________. Maximum profit = ____________.

2. Suppose the firm's fixed costs fall. Does the firm change its price and output?
Confirm using a new value for the fixed cost. Explain why the firm's optimal price-
output combination remains the same.

3. Suppose the demand for the firm's product rises. Using a new demand equation,
obtain the optimal price and output.

Optimal Input
Examples
1. The total output q as a function of input X, is given by the function

q=20 . 0+60 . 0 X +3 . 5 X −0 . 333 X .

2 3

Find the input for which the total output is maximum, and also the maximum
output.
2. A firm's production function is given by Q =3L0.6, where L is labor (number of
workers) and Q is output. The firm operates in a perfectly competitive market. It hires
workers at a wage w, and sells its output at a price of P.

a. Does labor exhibit diminishing returns? Explain.

b. Obtain the expression for MPL.
c. Noting that the firm's marginal revenue revenue product of labor is the
additional revenue obtained by adding 1 more worker, derive the expression
for MRPL.
d. Obtain the firm's profit function in terms of labor, π(L).
e. Is the profit function (strictly) concave or (strictly) convex?
f. Use the FOC to obtain the firm's optimal amount of labor in terms of w and P.
Call it L*(w,P).
g. Is the SOC for a maximum satisfied at L*?
h. At the optimal point, what is the relationship between MPL and real wage?
Between MRPL and nominal wage?
i. Use the partial derivatives of L*(w,P) to show the following:
i. An increase the the wage rate, ceteris paribus, will lead the firm to hire
fewer workers.
 ii. An increase the the price of the good, ceteris paribus, will lead the firm
to hire more workers.
j. Select suitable values for the wage rate and price.
i. Obtain the profit function.
ii. Calculate the optimal value of labor.
iii. Sketch the production function. Indicate L* on the graph.
iv. Show that the slope of the production function at L* equals the real wage
(w/P).
v. At the optimal point, what is the relationship between MPL and real
wage? Between MRPL and nominal wage?
vi. Provide an economic interpretation of your finding in (iv).

2. Consider the more general form of the problem in Q. 1. A firm's production

function is given by Q = AF(L), where L is labor (number of workers) and Q is
output. The firm operates in a perfectly competitive market. It hires workers at a
wage w, and sells its output at a price of P.

a. Obtain the firm's profit function in terms of labor, π(L).

b. Under what assumptions on the production function will the profit function be
strictly concave? Assume that these conditions hold.
c. Use the FOC to obtain PAF'(L) = w. Call this equation (1).
d. Check to see that the SOC for a maximum is satisfied.
e. Equation (1) can be used to solve for the optimal value of labor L* in terms of
the parameters P, A and w. Differentiate equation (1) totally and obtain the
signs for the following: dL*/dw, dL*/dP, dL*/dA. Interpret each of the signs.

Profit Maximization by a Multi-Product Firm

1. Consider a firm that produces two goods. The demand for each good, and the firm's
cost function are given:

Demand for Good 1: Q1 = 40 - 2P1 - P2

Demand for Good 2: Q2 = 35 - P1 - P2

Cost function: C(Q1,Q2) = Q12 + 2Q22 + 10

The firm wishes to maximize profits by choosing the optimal values of Q1 and Q2.

a. Rewrite the demand functions as P1 = f(Q1,Q2) and P2 = g(Q1,Q2).

 b. Obtain the revenue functions R1(Q1,Q2) and R2(Q1,Q2).
c. Obtain the profit function.
d. Obtain the first-order and second-order derivatives of the profit function.
e. Write down the FOCs.
f. Solve for the optimal values of the output levels.
g. Check the SOC. [Use the Hessian.]
h. Obtain the maximum value of the profit function.

2. Suppose, ceteris paribus, the demand for Good 1 changes to: Q1 = 50 - 2P1 - P2.

a. Obtain the firm's optimal values of output and price for each good.
b. What is the firm's maximum profit?