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dessawitesfamariamMathematical Economics(Econ2051) 2019/20
CHAPTER ONE
1. Introduction
In this unit we shall revise what you have studied in Quantitative method for economists I
and II such as basic concepts from calculus which incorporates differential calculus,
integral calculus, differential and difference equations. In addition to these, we will revise
matrix algebra which includes matrix representation, determinants, inverse of a matrix,
solutions of simultaneous linear equation systems, Leontief input - output model and
linear programming. Therefore, you should read your module of the above two courses to
understand this unit properly.
1.1 Basic Concepts from Calculus
1.1.1 Differential Calculus - Differentiation
Given a function y = ƒ(x), where x and y are independent and dependent variables
respectively, if x is an increment in the value of x and y is an increment in the value
of y, then y is referred to as the average rate of change or the rate of change of y
x
with respect to the given change in x. This limiting value is also known as derivative
which is the instantaneous rate of change of y resulted from a very small change in x
represented by dy .
dx
f ( x x) f ( x)
Lim y x
This means
= Lim = dy dx
x
x 0 x 0
Thus, differentiation is the process of finding the rate of change of the dependent variable
(y) with respect to a given change in the independent variable (x). In other words, it is a
process of determining the slope of the function y= ƒ(x) at any point of x in the domain of
dy
the function. f (x)
dx
Rules OF Differentiation
.
Given the function y= ƒ(x) and other functions such as g(x) and h(x) which are
differentiable, the following are the rules of differentiation.
1.Constant function Rule
Given a function y = ƒ(x) = k, where k is constant
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dy dk
0, That is the derivative of the constant function is zero.
dx dx
dy
Example If ƒ (x) = 4 = 4x 0 , = 0 (4x 01 ) = 0
dx
2.Linear function Rule
Given a function y = ax + b, where a and b are constants
dy
a
dx
Example If ƒ (x) = 3x + 5, then ƒ' (x) = 3
If f(x) = 5x, then ƒ' (x) = 5
3.Power function rule
Given a function ƒ(x) =x n where x 0 and n is any real number
ƒ '(x) = n x n 1
Example If ƒ(x) = 2x 5 , ƒ ' (x) = 5 (2x 51 ) = 10x 4
If ƒ(x) = 1 3 x 3 , ƒ' (x) = -3 (x 31 ) = -3x 4
x
ƒ '(x) = 3 4
x
1 1
1 1 1
If ƒ (x) = x x ½, ƒ’ (x) = ½ x 2 = x 2
2 2 x
4.Sum and Difference Rule
When y = g(x) h(x), then ƒ' (x) = g' (x) h' (x)
Example If g (x) = 2x+3 and h (x) = 5x 2 + 2x, then
ƒ ' (x) =g'(x) h' (x)
= 2 (10x +2)
g' (x) + h' (x) = 10x +4
g' (x)- h' ( x) = 2 - (10x+2)
= -10x
5.Product rule
This rule enables us to differentiate two functions which are multiplied together.
If ƒ' (x) =g' (x) h(x) + h' (x) g(x)
(a) Example
dy
1. If ƒ(x) = ( 7.5+ 0.2 x 2 ) ( 4+8x 1 ) , What is ƒ' (x) = ?
dx
This function can be multiplied out and differentiated without using the product rule. But,
let us first use the product rule and then compare the answers obtained by the two
methods.
Let g (x) = 7.5 + 0.2x 2 and h(x) = 4+8x 1
Therefore, g' (x) = 0.4x and h' (x) = -1 (8x 2 ) = -8x 2
Using the product rule
ƒ' (x) = 0.4x ( 4+8x 1 ) + - 8x 2 ( 7.5 + 0.2x 2 )
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= 1.6x + 3.2 - 60x 2 - 1.6
f ( x) 60 x 2 1.6 x 1.6 --------------------------------- (1)
If we multiply the original function, we get
ƒ(x) = ( 7.5 + 0.2x 2 ) ( 4+8x 1 )
= 30+ 60x 1 + 0.8x 2 + 1.6 x
Therefore
f ( x) 60 x 2 1.6 x 1.6 ----------------------------------- (2)
These two derivatives, i.e. (1) and (2) are the same. But in some cases, it is not possible
to multiply out the different components of a function and then we must use the product
rule to differentiate.
Example
2.A firm faces a non - linear demand function P = ( 650 - 0.25q) 1.5
Determine the marginal revenue (MR) function of this firm. In this case first we should
determine the total revenue function and then differentiate it with respect to the level of
output using the product rule.
TR = p x q = q (650 - 0.25q) 1.5
To differentiate TR with respect to q using the product rule,
Let u = (650 - 0.25 q) 1.5 and v=q
du
Then = 1.5 (650 - 0.25q) 0.5
dq
dv
1
dq
dTR
Therefore, = 1 (650 - 0.25q) 1.5 + (q) (- 0.375) (650 - 0.25q) 0.5
dq
MR = (650 - 0.25q) 0.5 (650 - 0.625q)
6.Quotient rule
Dear colleague! This rule allows as differentiating two functions where one function is
divided by the other function.
If ƒ'(x) = h(x).g' (x) – g(x).h' (x)
( h (x) )2
1) Example
4x2
1.Determine ƒ' (x) if f ( x) =
8 0.2 x
2
Let g (x) = 4x and h(x) = 8+0.2x, g' (x) = 8x and h' ( x) = 0.2
According to the quotient rule,
ƒ'(x) = 8x(8+0.2x) – 0.2(4x2)
(8+0.2x) 2
= 64x + 1.6x2 – 0.8x2
(8+0.2x) 2
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64 x 0.8 x 2
ƒ' (x) =
(8 0.2 x) 2
2. If a monopoly faces a non- linear demand function
252
p=
(4 q)0.5
Derive the marginal revenue function (the rate of change of TR with respect to output).
As we know, TR = p x q,
252q
TR =
(4 q)0.5
If u = 252q and v = (4+q) 0.5 , then
du dv
252 And 0.5 (4+q)-0.5
dq dq
Now we can find the marginal revenue function using the quotient rule as follows.
dTR 252(4 q) 0.5 252q(0.5)(4 q) 0.5
MR = =
dq [(4 q) 0.5 ]2
= 252(4+q) 0.5 – 252q (0.5) (4+q) -0.5
(4+q)
(4 q)252 126q
=
(4 q)1.5
1,008 252q 126q
=
(4 q)1.5
1,008 126q
MR =
(4 q)1.5
7. Chain Rule
The chain rule enables us to differentiate' functions within functions ', for instance, given
a function y = ƒ (z) and z = g(x), then y= ƒ [g (x)].
To differentiate y with respect to x, we use chain rule which states that
dy dy dz
( )( )
dx dz dx
Example
1. Given a non- linear demand function, p = (150 -0.2q) 0.5 , find its slope.
Let z = 150 - 0.2q as a result p = z 0.5
dz dp dz
= = (0.5z 0.5 ) (-0.2)
dq dz dq
= -0.1(150-0.2q) 0.5
= - 0.1
(150 – 0.2q) 0.5
2. If the present value of a one birr due in 8 years time is given by the formula
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1
PV =
(1 r )8
Where r is the given interest rate, find the rate of change of PV with respect to r.
Let (1+r) = z, then PV= 1 8 = z 8
z
dPV 8 dz
This means 8 z 9 9 and =1
dz z dr
i) Thus, using the chain rule
dPV dPV dz
( ) 8(1 r ) 9 (1) 8(1 r ) 9
dr dz dr
dPV 8
dr (1 r ) 9
As you know in your microeconomics course the marginal revenge productivity theory of
demand for labor states that profit is maximized when MRP L = MC L .
Where MRP L = marginal revenue product of labor
MC L = Marginal cost of labor.
dTR dTC L
MRPL and MC L
dL dL
Where TR is total revenue and TC L is total cost of labor.
3. A firm is a monopoly seller of good q and faces the demand schedule P = 200 - 2q,
where p is price in birr and the short run production function is given as q = 4L0.5
Determine the marginal revenue productivity of labor (MRP L ) function.
dTR dq
MRP L = ,
dq dL
Thus, first we need TR, given P = 200 - 2q
TR = (200 - 2q) q = 200q - 2q 2
Therefore,
dTR dq
= 200 - 4 q, = 2L 0.5
dq dL
As a result, MRP L = (200 - 4q) (2L 0.5 )
= [200-4(4L0.5)] 2L 0.5
= (200- 16 L 0.5 ) 2 L 0.5
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MRPL = 400 – 32L 0.5
L 0.5
7.Implicit function Rule
Functions of the form y = ƒ(x) express the dependent variable y explicitly in terms of the
independent variable x and are called explicit functions. Where as functions of the form ƒ
(x, y) =0 do not express y in terms of x. These functions are referred to as implicit
functions. If the implicit function ƒ(x, y) = 0 exists, and the first order partial derivative
of the function with respect to y is different from zero (ƒ y 0), then the total differential
f x dx f y dy d 0
f x dx f y dy
Rearranging these terms,
dy fx ( f ( x, y )
= , where ƒx =
dx fy x
f ( x, y )
ƒy =
y
Example
dy
1. Given the function ƒ (x, y) = x 2 + y 2 - 9 = 0, find .
dx
To do this we should partially differentiate the function with respect to x and with respect
dy
to y, and then determine .
dx
f x 2 x and f y 2 y
dy 2x x
Thus, = =
dx 2y y
dy
2. Given the implicit function ƒ (x, y) = x 3 - 2x 2 y + 3xy 2 - 22 = 0, find .
dx
ƒ x = 3x 2 - 4xy + 3y 2 and ƒ y = - 2x 2 +6xy
dy (3x 2 4 xy 3 y 2 )
Therefore,
dx 2 xy 2 6 xy
9. Inverse function rule
Given the function y= ƒ(x), it has an inverse if and only if each value of y corresponds
with one and only one value of x. According to the inverse function rule, the derivative of
the inverse function is the reciprocal of the derivative of the original function. The
dy
derivative of the given original function is . Thus, the derivative of the inverse
dx
1
dy dx
function x = ƒ 1 (y) which is =
dx dy
Example If Q = P 3 + 2P 2 +7p, find the derivative of P with respect to Q
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dQ dp 1
= 3 P 2 + 4P + 7, Thus, =
dp dQ 3 p 2 4 P 7
10. Logarithm and Exponential Function Rules
a. Logarithmic function rule
If we have two numbers 8 and 64 that can be related with each other by the equation 8 2 =
64 the exponent 2 can be expressed as the logarithm of 64 to the base 8. This means.
Log648 = 2. In general, if y = a x , then log y a = x where a >0 and a 1
In logarithmic application two numbers are mainly selected as abase. These numbers are
10 and e. If the base is 10, then the logarithmic is referred to as common logarithm. But
if we use e as abase, then the logarithm is known as natural logarithm.
Natural logarithmic function rule
Given the function ƒ(x) = n 9( x ) = loge 9( x ) where ƒ(x) and g (x) are differentiable,
1
and g (x) 0, f (x) = [ g (x) ]
g ( x)
dy 6
Example If y = n 6 x 7 , then =
dx 6x 7
Logarithmic function of base a
Given the function f(x) = log ag ( x ) , when f(x) and g (x) are differentiable, and g(x) 0,
dy 1 1
= ƒ' (x) = [g' (x)] a
dx g ( x) n
ii) Example
1 1 1
1. If f(x) = x 3 log6 x , then ƒ' (x) = 3x 2 og6 x + x 3 = x 2 ( 3 og 6 + 6 )
x
6
x ln ln
2
x
ƒ' (x)= 3x 2 og 6 + 6
x
ln
(3 x 2 2 x )
2. If ƒ(x) =, Log 3 then ƒ' (x) = 6x+2
(3x2+2x) ln3
b) Exponential Function Rule
The function y = a x where a is constant and a > 0, a 1 is known as exponential
function to base a. If the base is e, the function is referred to as natural exponential
function.
y = e x , where e= 2.71828
In economics, natural exponential functions are particularly useful for analyzing the
growth rates of different variables.
Natural exponential function rule
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If ƒ(x) = e g ( x ) where ƒ (x) and g(x) are differentiable, then ƒ' (x) = e g ( x ) g' (x).
dy
Given the function y =ex, then = ex.
dx
a. Example
1. If ƒ(x) = 5e 1 x , then ƒ' (x) = -10x e 1 x
2 2
b.
e5 x 5e 5 x (e 5 x 1) 5e 5 x (e 5 x 1)
2. If ƒ (x) = 5 x , then ƒ' (x) =
e 1 (e 5 x 1) 2
10e 5 x
ƒ' (x) =
(e 5 x 1) 2
Exponential Function Rule for Base a
Given the function f(x) = a g(x) Where g(x) and ƒ(x) are differentiable, a>0, a 1,
ƒ' (x) = a g(x) n a
Example.1. ƒ(x) = a 3 x , then ƒ' (x) = a 3 x 3 n a
ƒ' (x) = 3a 3 x n a
i.
ii. 1.1.3 Differentials
Given the function y = ƒ(x) if we know the rate at which x changes, we can find the
y y dy
change in y, y ( )x . As x 0,
x x dx
Denoting dy as small change in y and dx as small change in x,
dy dy
dy = ( )dx, where f ( x)
dx dx
dy f ( x)dx It is the differential.
Example
Given y = (5x3 + 2x2+ x) dy = (15x2 + 4x+1) dx
Suppose x changes from 2 to 2.01 (i.e. dx = 0.01), by what value does the dependent
variable y changes?
dy = (15 x2 + 4x +1) (0.01)
= [15 (2 2 ) + 4 (2) + 1] (0.01)
= (60+ 8+1) (0.01)
dy = (69)0.01 = 0.69
From the original function, the actual change in y is
y = ƒ (2.01) - ƒ (2)
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ƒ (2) = 5(2 3 ) + 2(2 2 ) +2
= 5 (8) + 2(4) +2
ƒ (2) = 40+8+2 = 50
ƒ(2.01) = 5(2.01) 3 + 2(2.01) 2 + 2.01
= 40.606020+8.0802+2.01
=50.696220
y f (2.01) f (20 50.696220 50 0.696220
y dy 0.696220 0.69
= 0.006220
The value 0.006220 is the error term that is the error of calculation.
As x changes from 2 to 3, that is x = 1, what is the change in y?
dy = [15 (2) 2+ 4(2) + 1] 1
= 60+8 +1 = 69
y ƒ (3) - ƒ(2)
But we have determined that
ƒ (2) 50
ƒ (3) = 5 ( 33 ) + 2(32) + 3
= 5 (27) + 2(9) +3
ƒ (3) = 135 + 18 + 3 = 156
Thus, y = 156 - 50 = 116. The error term is 116-69 = 47
Note.
By now we have realized that the smaller the change in x the smaller error term and the
greater the change in x the larger will be the error term.
Total differentials
The concept of differential can be extended to a function of two or more independent
variables. Given the utility function U = U ( x1, x2)
Supposing U as continuous and differentiable
u
Ux1 = which is marginal utility of x1.
x1
u
Ux2 = which is marginal utility of x2.
x2
u
The change in total utility that results from small change in x 1 is given by dx1 and
x1
from small change in x2 is u dx 2
x 2
Then the total change in utility resulted from small change in x and small change in y is
represented by
u u
du dx1 dx2
x1 x2
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Example Find the total differential, given
1. z 3x 2 xy 2 y 3
z z
dz = dx dy
x y
dz = (6x + y) dx + (x- 6y2) dy
2. U = 2 x12 6 x1 x2 4 x22
dU (4 x1 6 x2 )dx1 (6 x1 8x2 )dx2
By now you have completed the first section of this unit. Therefore, try to do the
following self - test questions in order to examine how you have understood this
section.
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CHAPTER TWO
DERIVATIVE IN USE
2.1 Elasticity: Definition and as Logarithmic Derivative
Elasticity is a measure of a proportionate change in the dependent variable which results
from a proportionate change in the independent variable. Thus elasticity of demand is a
measure of the percentage change is quantity demanded due to a percentage change in the
factors which determine demand.
If there is change in quantity demanded from Q to (Q+ Q) resulting from a given
change in price from P to (P + P ), the price elasticity of demand is
E p = Proportionate change in quantity demanded
Proportionate change in price
Q
Q
=
p
p
Q p Q p
= x = ( )
Q p p Q
It gives us the average price elasticity of demand over the price range of P to (P+ p) . It
is possible to use the method of derivative to get the price elasticity of demand at a
particular point P, i.e., as p approaches to zero.
p Q P Q
E p = lim ( ) = lim
Q p Q P
p 0 p 0
P dQ
= ( )
Q dp
dQ p
Thus price elasticity of demand E p= ( )
dp Q
Example
1.Find the price elasticity of demand if the demand function for a product is
Q = P 2 - 6P + 36, where Q is quantity and P is price of a product. Using the above
formula
dQ p dQ
E p= ( ), but 2p 6
dp Q dp
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p
Therefore, E p = (2 p - 6)
P 6 P 36
2
2p 6p
2
Ep = 2
p 6 p 36
2 p2 6 p
Ep =
p 2 6 p 36
What is the elasticity of demand at P = 4?
2(42 ) 64)
Ep =
42 6(4) 36
32 24 8
= = < 1
16 24 36 28
As E p < 1, then demand is said to be price inelastic at P = 4.
2. Find the price elasticity of demand in terms of quantity sold.
10
P= = 10 (Q+1) 2
(Q 1) 2
dQ P 1 dp Q
Ep = ( ), Therefore, = ( )
dp Q Ep dQ P
Differentiating the demand function with respect to Q gives us
dp 20
-20 (Q+1) 3 =
dQ (Q 1)3
1 20 Q
Thus, =( )( )
Ep (Q 1) 3
10
(Q 1) 2
1 20 (Q 1) 2 (Q)
[ ][ ]
Ep (Q 1) 3 10
1 2Q
=
Ep (Q 1)
Q 1
This means Ep
2Q
3. If the demand function is given as Q= 10 p 2 , find the price elasticity of demand at
P = 2.
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dQ p dQ 1
Ep = ½ (10 - p 2 ) 2 (-2p)
dp Q dp
2p
= 1
2(10 P 2 ) 2
dQ p
dp 10 p 2
p p
Thus, E p = ( )( )
10 p 2 10 p 2
p2 22 4 2
Ep = . Thus, at P = 2, E p = =
10 p 2
10 2 2
6 3
This means, as the price of the product increases by one percent then the quantity
demanded for the product decreases by 2 percent at p = 2.
3
Elasticity as Logarithmic Derivative
In a function y = ƒ (t), when the dependent variable y is a function of time t, then the
instantaneous rate of growth is determined as
dy marg inalfuncti on
Rate of growth = dt =
y totalfunct ion
This ratio exactly represents the derivative of n ƒ (t). This means, the instantaneous rate
of growth of the function is the derivative of natural logarithm of the function with
respect to time. That is
d ln f (t )
Rate of growth =
dt
By now, given the function y = f(x), let us observe the result if we carry out
differentiation of ln y with respect to ( ln x). To start it, suppose u = ln y and v = ln x .
Then the chain of relationship relating u to y and v to x is that
u = n y , y = f(x), v = n x , x ev
Finding the derivative of ln y with respect to ln x gives us
d (n y ) du du dy dx
( ) ( )( )
d (n x ) dv dy dx dv
Using the method of substitution
d (n y ) d (n y ) dy d (e v )
[ ] [ ][ ]
d (n x ) dy dx dv
1 dy
= ( ) ( ) ev
y dx
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1 dy
= ( )( ) x as e v = x
y dx
d (n y ) dy x
( )
d (n x ) dx y
As you remember this expression is the point elasticity of the function. Hence, one can
generalize that for a function y = f(x), the point elasticity of y with respect to x is
d (n y )
E x y=
d (n x )
Example
1. Find the point elasticity of demand given Q = K/ P n where K and n are positive
constants
Q = K p n
ln Q ln K n ln P
d (ln Q )
Ep =-n
d (ln p)
d ln Q
Ep = n
d ln P
2. Find the point elasticity of demand provided that x = a p b where a and b are
positive constants, and x and p are quantity demanded and price of a product
respectively.
ln x = ln a + b ln P
d (ln x)
Thus, E p = =b
d (ln p)
Relationship between Marginal Revenue, Average Revenue and Elasticity of
Demand
Given the total revenue function TR= PQ where P is the price at which the product is sold
and Q is the quantity sold. Then marginal revenue that is the rate of change of total
revenue with respect output is
d ( PxQ )
MR =
dQ
Using the product rule of differentiation
dQ dp
MR p Q
dQ dQ
dp
MR = P + Q
dQ
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dQ p 1 dp Q
We know form the above analysis that E p which implies that ( )
dp Q Ep dQ p
p dp Q
multiplying both sides by p gives us ( )( ) p
Ep dQ p
p dp
Q
Ep dQ
Substituting it in the above marginal revenue function , we get
P
MR P
Ep
However, we also know that p is equal to average revenue (AR), thus
AR
MR AR
Ep
1 1
MR = AR (1+ ) = AR ( 1 )
Ep Ep
1
MR AR (1 )
Ep
From this equation we realize that
When demand is unitary elastic, i.e. E p = 1, MR = 0. This means, total revenue is
maximized.
When demand in elastic, i.e., E p > 1, MR > 0 which implies that total revenue is
increasing. However, as demand is inelastic, i.e., E p < 1, MR < 0 which implies that
total revenue in decreasing.
2.2 Higher Order Derivatives
Do you remember the concept of higher order derivatives from your earlier studies? So
far we have discussed the first order derivative f (x) of the function y = f(x). Now let us
turn our attention to the concept of second order derivative and higher order derivatives.
Having this knowledge enables us to have alternative criteria for determining the relative
maximum or minimum point of a function.
We know that the first order derivative f (x) of a function y = f (x) is a function of x. As
a result we can determine the rate of change of f (x) with respect to x if f (x) is
differentiable. The result of this differentiation is referred to as second order derivative of
the function y = f (x) . It is represented by f (x) where the double prime shows that the
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primitive function has been differentiated with respect to x twice. The expression (x) next
to the double prime indicates that the second order derivative in a function of x.
Alternatively this second order derivative can be represented by
d 2 y d dy
( )
dx 2 dx dx
The above expression indicates that the second derivative is a function of x . Thus, it is
possible to differentiate this function with respect to x in order to get the third order
derivative of the function f (x) or f 3 ( x) which in turn can be a source of fourth order
derivative and so on provided that the differentiable condition is satisfied.
Symbolically, these successive higher order derivatives are
f 3 (x), f 4 (x), f 5 (x) -----------, f n (x).
Or
d3y d4y d5y d n ( x)
, , , -----,
dx 3 dx 4 dx 5 dx n
Example
1. Find the first through the fourth derivative of the following function.
f (x) = 5x3 + 2x2 + 3x + 4
These derivatives are f (x) = 15x2 + 4x + 3
f (x) = 30x + 4
f (x) = 30
f 4 ( x) = 0
We have seen that each successive derivative gives us a simpler expression than it's
precedence until we get the fourth derivative. However, it is not always true. The fourth
order derivative is equal to zero does not imply that it does not exist.
2. Find the first four derivatives of the function given as
2x
f (x) = , x 1
1 x
2(1 x) (1)(2 x)
f (x) = , using the quotient rule
(1 x) 2
2(1 x) (1)(2 x) 2
f (x) = =
(1 x) 2
(1 x) 2
f (x) = 2(-2) (1-x)-3 (-1)
f (x) = - 4(-1) (1-x)-3 using the chain rule
= 4 (1-x) -3
f 3 ( x) (3)(4)(1 x) 4 (1)
f 3 ( x) = 12 (1-x)-4
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f 4 ( x) (4)(12)(1 x) 5 (1)
f 4 ( x) 48(1 x) 5
2.2.1 Convexity and Concavity of a Function
Given the function y = f(x), it is clear that the derivative of the function f (x) indicates
the rate of change of the primitive function with respect to x. Similarly, f (x) shows the
rate of change of f (x) with respect to x. Observing the sign of the first derivative of the
original function at any point of x, one can determine whether a function is increasing or
decreasing at that point. However, the sign of the second derivative indicates whether the
function is concave or convex at that particular point. In the original function is y = f(x),
f (a) > 0 implies that the function is increasing at x = a and
f (a) < 0 implies that the function is decreasing at x = a
f (a) = 0, implies that the function is at its optimum point at x = a
Similarly
If f (a) > 0, then the function is convex at x = a
If f (a) < 0, then the function is concave at x = a
If f (a) = 0, x = a is the point at which the curvature of the function is changed
In general, a positive first derivative coupled with a positive second derivative at x = a
shows that the function increases at an increasing rate at x = a . A positive first derivative
coupled with a negative second derivative at x = a , indicates that the original function is
increasing at a decreasing rate at this point. A negative first derivative with a positive
second derivative shows that the function is decreasing at an increasing rate where as a
negative first derivative with negative second derivative at x= a , implies that the function
decreases at a decreasing rate at x = a .
Example
If f (x) = x 3 - 12x 2 + 36x + 8,
a) Is it increasing or decreasing at x = 3?
b) Is it convex or concave at x = 3?
Solution
First we should find the first and second derivative of this function at x = 3 to answer
these questions.
f (x) = 3x2 - 24x + 36
f (x) = 6x - 24
Therefore, f (3) = 3(9) - 24(3) + 36
f (3) = 27 - 72+36 = 63- 72 = -9 <0
f (x) = 6(3) - 24 = 18 -24 = -6 <0
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This implies that the function is decreasing at decreasing rate at x= 3 and it is concave at
this point.
2.2.2. Linear Approximation
As we know there are complicated functions in economics. In order to avoid this
complexity, we sometimes try to find a simpler function which approximates the original
function. Given the function y = f(x), the equation of a straight line which passes through
point ( x1 , y1 ) and having a slope b is represented as
y y1
b =
x x1
b( x x1 ) = ( y y1 )
y b( x x1 ) y1
This means, the equation of the tangent line which passes through the graph of the
function y = f (x) at x = a provided that f(x) is continuous and smooth at x = a , is
expressed as
y f (a) f (a)( x a)
y f (a)( x a) f (a)
When we approximate the graph of f (x) by its tangent line at x = a . The resulting
approximation is referred to as linear approximation.
Example
1. Find the linear approximation of the function f ( x) 4 x , about x = 1.
First we should determine the value of f (x) and f (x) at x = 1 to answer this question.
Thus,
1 3
1 ( 4 1) = 1 ( 4 )
f (x) = x x
4 4
3
1
f (x) = 1 (1) 4 = 4
4
f (1) = 4 1 1
Therefore, the linear approximation of the function is
1
f (x) (x-1) + 1
4
1
If x = 1.02, f (x) (1.02 - 1) + 1
4
1
(0.02) +1
4
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1
f (x) +1 = 1.005
200
However, the actual value is f (1.02) = 4 1.02 =1.00496 which is very close to the
approximate value of the function, i.e., 1.005.
2. Determine the linear approximation of the function
1
3 1 2) 2
f (x) = (1+ x + x at x = 0
2 2
1 3 1 2 -½ 3
f (x) = (1+ x + x ) ( + x)
2 2 2 2
3
(1+ (0) + (0)]-½ ( 2 0)
1 3 1
This means f (0) =
2 2 2
1 1 3 1 3 3
f (0) = (1) 2 ( ) = ( ) =
2 2 2 2 4
1
3 1
And f (0) = [1+ (0) + (0)] 2
2 2
1
f (0) = (1) 2 = 1
Therefore, at x = 0 the linear approximation of the function is
f (x) f (0) (x- 0) + f (0)
3
f (x) (x - 0) + 1
4
3
f ( x) x 1
4
2.2.3. Polynomial Approximation
Approximation using linear functions is not as such accurate. Therefore, it is necessary to
use quadrate approximation or higher order approximation so as to minimize this
problem.
a) Quadratic Approximation
Given a function y = f(x), how can it be approximated by the second degree polynomial
of the form P( x) A B( x a) C ( x a) 2 as x is close to a ?
In this function we have seen three unknown coefficients such as A, B and C. Therefore,
we ought to put the following three conditions in order to determine these three
unknowns.
At x = a, it is assumed that
f (a) = P (a)
f ( a ) = P ( a )
f ( a ) = P ( a )
Given the polynomial function P( x) A B( x a) C ( x a) 2
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P(x) = B+ 2 C (x - a )
P(x) = 2C
When x = a , P ( a ) = A + B ( a - a ) + C ( a - a ) 2
= A = f (a)
P ( a ) = B+ 2C ( a - a )
P ( a ) = B = f ( a )
1
P ( a ) = 2C = f ( a ), C = f ( a )
2
Substituting these values in the given quadratic function gives us the quadratic
approximation of the function which is represented by
1
f (x) f ( a ) + f ( a ) (x- a ) + f ( a ) (x- a ) 2 as x is close to a .
2
Example
1. Determine the quadratic approximation to a function f(x) = 4 x about x= 1. In this
case, first we should find the value of f (x) , f (x) and f (x) at x = 1 . Thus,
1 1
4 4
f (x) = x , f (1) = 1 =1
3 3 1
f (x) = 1 x 4 , f (1) = 1 (1) 4
=
4 4 4
3 7 4 3
f (x) = 1 ( ) x , f (1) =
4 4 16
Thus,
1
f ( x) f (1) f (1)( x 1) f (1)( x 1) 2
2
1 1 3
f ( x) 1 ( x 1) ( )( x 1) 2
4 2 16
1 3
f ( x) 1 ( x 1) ( x 1) 2
4 32
Compare the actual value and the approximate value of this function when x 1.02 .
2. Find the quadrate approximation to a function f (x) = (5x +3) 2 about x = 0.
Solution
1
f (0) =
9
f (x) = -2 (5x+3)-3 (5) = -10(5x + 3)-3
f (0) = -10 [5(0) +3]-3 = -10 (3)-3 = 10
27
f ( x) 30(5x 3) (5) 150(5x 3) 4
4
150
f (0) = 150 (5(0) +3) 4 = 150 (3) 4
=
81
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Therefore, the quadratic approximation of the function is
1
f ( x) f (0) f (0)( x 0)
f (0)( x 0) 2
2
1 10 1 150
f ( x) ( )( x 0) ( )( x 0) 2
9 27 2 81
1 10 75 2
f ( x) x x
9 27 81
B. Higher Order Approximation
As it is indicated above quadratic approximation is more accurate than linear
approximation of a function. However quadratic approximation is not as such accurate.
Therefore, functions with higher order derivatives can be better approximated near one
point by using polynomial function of higher degree.
Given a function y = f (x) , how can we approximate it around x = a by an n th degree
polynomial of the form
P( x) A0 A1 ( x a) A2 ( x a) 2 A3 ( x a) 3 An x a) n
As we have seen this function has (n+1) unknown coefficients. Therefore, we should
impose (n+1) conditions on the polynomial to determine the value of the unknown
coefficients. These are, at x = a, it is assumed that
f (a) = P (a)
f ( a ) = P ( a )
f ( a ) = P ( a )
'
'
'
f ( a )= P n ( a )
n
Given the above polynomial function,
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P ( x) A1 2 A2 ( x a) 3 A3 ( x a) 2 4 A4 ( x a) 3 nAn ( x a) n 1
P ( x) 2 A2 6 A3 ( x a) 12 A4 ( x a) 2 20 A5 ( x a) 3 n(n 1) An ( x a) n 2
P 3 ( x) 6 A3 24 A4 ( x a) 60 A5 ( x a) 2 n(n 1)(n 2) An ( x a) n 3
.
.
.
P n ( x) n(n 1)(n 2)(n 3) (3)(2)(1) An
Therefore, when x is close to a ,
f (a)
P(a ) 0! A0 f (a ) A0
0!
f (a )
P (a ) 1! A1 f (a ) A1
1!
f (a)
P (a ) 2! A2 f (a) A2
2!
3
f (a)
P 3 (a ) 3! A3 f 3 (a) A3
3!
.
.
f n (a)
P n (a ) n! An f n (a ) An
n!
Substituting these values of the unknown coefficients in the polynomial function gives us
the polynomial approximation of the function as x is close to a , which is represented by
f (a ) f (a)
f (x) f ( a ) +
1!
(x- a ) +
2!
2
(x- a ) +---+
f n (a)
n!
x a) n
Example
Find the fourth order approximation of the function
f (x) = 1 x , about x = 0
f (0) f 3 (0) f 4 (0)
In this case f (x) f (0) + f (0) (x- 0) + 2
(x- 0) + 3
(x-0) + (x-0)4
2! 3! 4!
1
f (x) = 1 (1+x) 1 2 , f (0) = 1 (1+0) 2 = 1
2 2 2
1 3
f (x) = (1+x) 2 , f (0) = 1
4 4
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3 5 3
f 3 ( x) = 2
f 3 (0)
8 (1+x) , 8
15 7 15
f 4 (x) = (1+x) 2 , f 4 (0) =
16 16
Therefore,
1 1 1 3 1 15 1
1 x 1 ( x 0) ( )( )( x 0) 2 ( )( x 0) 3 ( )( )( x 0) 4
2 4 2 8 3! 16 4!
1 1 3 3 15 4
1 x 1 x x2 x x
2 8 48 384
2.2.4 Estimation of Functions (Maclaurin and Taylor Series)
A. Maclaurin Series (Expansion of a function around x = 0)
It is an expansion of a function y = f(x) that is differentiable, around x = 0. In other
words, it represents the polynomial approximation of the function around x= 0.
Therefore, given the function
f ( x) A0 A1 x A2 x 2 A3 x 3 .... An x n
Repeatedly differentiating this function gives us
f ( x) A1 2 A2 x 3 A3 x 2 4 A4 x 3 5 A5 x 4 6 A6 x 5 ... nAn x n 1
f ( x) 2 A2 6 A3 x 12 A4 x 2 20 A5 x 3 30 A6 x 4 .... n(n 1) An x n 2
3
f 3 ( x) 6 A3 24 A4 x 60 A5 x 2 120 A6 x . ....... n(n 1)(n 2) An x n 3
.
.
.
f n ( x) (n)(n 1)(n 2)(n 3).............................................(3)(2)(1) An
(Where n is Positive integer)
We have understood that the number of constant terms is decreased by one until the nth
derivative is reached. We can determine the value of each rate of change at various values
of x. In this case, let us evaluate these derivatives at x = 0. When we determine the value
of the derivatives at x = 0, then all terms containing x will be eliminated.
f (0) = A1, f (0) = 2A2, f 3 (0) = 3(2) A3, f 4
(0) = (4) (3) (2) A4 ---------, f n (0) = n (n-1)
(n-2) (n-3) ... (3) (2) (1) An
Using the symbol (n!) which can be read as n – factorial, where n! = n (n-1) (n-2) (n-3)---
- (3) (2) (1).
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f 3 (0) f n (0)
A1 = f (0) , A2 = f (0) , A3 = , ----------- An
1! 2! 3! n!
Now the primitive function f(x) can be expressed as a new polynomial function by
substituting these terms in it as follows
f (0) f (0) f (0) 2 f 3 (0) 3 f 4 (0) 4 f n (0) n
f ( x) x x x x ....... x
0! 1! 2! 3! 4! n!
In this case, the unknown coefficients of the primitive function are replaced by the
derivatives evaluated at x = 0. Zero factorial represents one (i.e., 0! =1). This power
series representation is known as Maclaurin series of the primitive function
f (x) around x = 0.
Example
1. Determine the Maclaurin series of the function
f ( x) 5 x 3 2 x 2 3 x 1
This function has the following derivatives
f ( x) 15 x 2 4 x 3
f ( x) 30 x 4
f 3 ( x) 30
f (0) 1
f (0) 15(0) 2 4(0) 3 3
So that
f (0) 30(0) 4 4
f 3 (0) 30
Therefore, the Maclaurin series of this function is
f (0) f (0) f 3 (0)
f ( x) f (0) ( x 0) ( x 0) 2 ( x 0) 3
1! 2! 3!
4 30
f ( x) 1 3( x 0) ( x 0) 2 ( x 0) 3
2 6
f ( x) 1 3 x 2 x 5 x
2 3
This result shows that the Maclaurin series really represents the given function f (x).
2. Find the Maclaurin series of the function
f ( x) 3 x 2 2 x 4
The derivatives from this function are
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f ( x) 6 x 2
f ( x) 6
So that f (0) = 4, f (0) = 2, f (0) = 6
Thus, the Maclaurin series of the function is
f (0) f (0)
f ( x) f (0) ( x 0) ( x 0) 2
1! 2!
6
f ( x) 4 2( x 0) ( x 0) 2 4 2 x 3x 2
2
B. Taylor's Series
It deals about the expansion of the primitive function f (x) provided that the function is
continuous and smooth, around any point x x0 . Thus given the function y = f(x), we
will explain it using a specific quadratic function for the sack of simplicity.
Let us consider the expansion of the function
f ( x) A0 A1 x A2 x 2 A3 x 3 A4 x 4 .... An x n at some point x = x0
First let us write this function in terms of the power of (x-x0)
f ( x) A0 A1 ( x x0 ) A2 ( x x0 ) 2 A3 ( x x0 ) 3 A4 ( x x0 ) 4 .... An ( x x0 ) n
This function has the following successive derivatives
f ( x) A1 2 A2 ( x x0 ) 3 A3 ( x x0 ) 2 4 A4 ( x x0 ) 3 5 A5 ( x x0 ) 4 ... nAn ( x x0 ) n 1
f ( x) 2(1) A2 3(2) A3 ( x x0 ) 4(3) A4 ( x x0 ) 2 .5(4) A5 ( x x0 ) 3 .... n(n 1) An ( x x0 ) n 2
f 3 ( x) 3(2)(1) A3 4(3)(2) A4 ( x x0 ) 5(4)(3) A5 ( x x0 ) 2 ........ n(n 1)(n 2) An ( x x0 ) n 3
.
.
.
f n ( x) (n)(n 1)(n 2)(n 3)......................................................................(3)(2)(1) An
So that
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f ( x0 )
f ( x0 ) 0! A0 A0
0!
f ( x0 )
f ( x0 ) 1! A1 A1
1!
f ( x0 )
f ( x0 ) 2! A2 A2
2!
.
.
f n ( x0 )
f n ( x0 ) n! An An
n!
Therefore
f ( x0 ) f ( x0 ) f ( x0 ) f 3 ( x0 ) f n ( x0 )
f ( x) ( x x0 ) ( x x0 ) 2 ( x x0 ) 3 ... ( x x0 ) n
0! 1! 2! 3! n!
This power series representation is referred to as Taylor's series.
If we consider 3 as a point of expansion, then
f 2 (3) f n (3)
f ( x) f (3) f (3)( x 3) ( x 3) 2 .......... ( x 3) n
2! n!
Example
Find the Taylor's series of the function f ( x) 3x 2 2 x 5 , around x x0
The successive derivatives of this function are
f (x) = 6x + 2
f (x) = 6
f ( x0 ) 3x02 2 x0 5
So that f ( x0 ) 6 x0 2
f ( x0 ) 6
Therefore,
6
f ( x) (3x02 2 x0 5) (6 x0 2)( x x0 ) ( x x0 ) 2
2
f ( x) (3x0 2 x0 5) (6 x0 x 6 x0 2 x 2 x0 ) 3( x 2 2 xx 0 x02 )
2 2
f ( x) 3x02 2 x0 5 6 x0 x 6 x02 2 x 2 x0 3x 2 6 x0 x 3x02
f ( x) 6 x02 5 6 x02 2 x 3x 2
f ( x) 5 2 x 3x 2 3x 2 2 x 5
This realizes that the Taylor's series correctly represents the given function.
2.2.5 Intermediate Value Theorem and Newton Method
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A. Intermediate Value Theorem
Suppose that there is a function f(x) that is continuous for all values of x in the close
interval [a, b], and assume that the values of the function at x = a and at x = b are not
equal to each other and each value has opposite sign, i.e., f (a) and f (b) have different
signs. The intermediate value theorem states that there is at least one value of x say c in
the interval [a, b] such that f (c) 0 .
Example
1. Prove that the equation x 6 3x 2 2 x 1 0 has at least one solution in between 0
and 1, i.e. [0, 1]
You ought to follow the steps below to solve this Problem.
First put the equation in a polynomial form of f ( x) x 6 3x 2 2 x 1
Second check whether the function is continuous in between 0 and 1 or not.
Third determine the value of the function at x = 0 and x = 1.
As we know the function f(x) is referred to as continuous in the interval (a, b) iff
i) f (x) is continuous at x = a [i.e., lim f(x) = f( a) ]
x a
ii) f(x) is continuous at x = b [ i.e. lim f(x) = f (b) ]
x b-
iii) f( x) is continuous at x = c[ i.e., a < c < b ]
As a given function in our example is a polynomial function, it is continuous in between
0 and 1.
f (0) = 06+ 3(0) 2 - 2 (0) - 1 = -1
f (1) = 16+ 3 (1)2 - 2(1) -1 = 1+3-2-1 = 4-3 =1
We have seen that f (0) and f (1) have different signs. Therefore, according to the
intermediate value theorem there is at least one number that is c [0, 1] so that f (c) = 0.
In other words, the above equation has at least one solution in between 0 and 1.
2. Prove that the equation 2 x 2 3x 2 has at least one solution in between 0 and 1,
i.e. [0, 1].
First make it in to polynomial function by squaring both sides of the equation as
( 2 x 2 3x ) 2 = 22
2x2 + 3x = 4
2x2 + 3x - 4 = 0, then f(x) = 2x2 + 3x - 4
As the function is polynomial it is continuous in between 0 and 1.
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f (0) = 2(0)2 + 3 (0) - 4 = -4, f (1) = 2+3 - 4 = 1
The value of this function has different signs at x= 0 and x = 1 which implies that there is
at least one solution for the equation in between 0 and 1.
3. Show that the equation x 2 1 3x has at least one solution in between 0 and 1.
Solution
Initially change the equation in to polynomial function by squaring both sides as
( x 2 1) 2 (3x) 2
x 2 1 9x 2
8x 2 1 0
Therefore, f ( x) 8x 1
2
As the function is a polynomial function, it is continuous in between 0 and 1.
f (0) = 1 and f (1) = - 8 (1)2 +1 = - 7
We have observed that f (0) and f (1) have different signs. As a result, the equation has
at least one solution in between 0 and 1.
B. Newton's Method
The intermediate value theorem does not provide information concerning the location at
which the solution resides. Rather it indicates the range in which the solution can be
found. Newton's method, however, leads to a better approximate solution of the equation
under consideration.
Given the function y = f(x) and assume f(x) = 0 at x = a, estimate a. To carry out this
activity, let us begin with an initial estimate x 0 of a. Constructing a tangent line which
passes through [ x0 , f ( x0 )] we get x1 near to a as shown in the following figure.
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Undertaking the same procedure we get the estimate x1 by drawing a tangent line
at [ x1 , f ( x1 )] . Continuing this process enables us to estimate the value of a. However, we
can also easily find the formula for x n derived by the Newton's method.
What is the equation of the tangent line which passes through [ x0 , f ( x0 )] and with slope
m? The slope of this line can be calculated as
y y0 f ( x) f ( x0 )
m= =
x x0 x x0
f ( x) f ( x0 )
m Using cross multiplication
( x x0 )
f ( x) f ( x0 ) = m ( x x0 ) , m represents the slope of the function at x x0
f ( x) f ( x0 ) = f ( x0 )( x x0 )
When x x1 , f ( x) 0 (for the tangent line passing through [ x0 , f ( x0 )]
Therefore, 0 f ( x0 ) = f ( x0 )( x1 x0 )
Rearranging this equation gives as
f ( x0 )
= ( x1 x0 )
f ( x0 )
f ( x0 )
This implies that x1 x0
f ( x0 )
f ( x1 ) f ( x2 )
Similarly x2 x1 , x3 x 2
f ( x1 ) f ( x2 )
In general the points generated by the Newton method are obtained by
f ( xn )
xn1 xn
f ( xn )
Example
1. Find the approximate values of the equation f ( x) x 6 3x 2 2 x 1 in the interval
[0, 1] using the Newton's method once.
Solution
In this case n = 0, and x 0 = 1
f ( x0 )
We know that x1 x0
f ( x0 )
f ( x0 ) = f (1) = 1+3 -2- 1 = 4-3 =1
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f ( x0 ) = 6x 5 + 6x - 2 f ( x0 ) = f (1) = 6+6 -2 = 10
1
Therefore, x1 1 0.9
10
If we check for f ( x1 ) = f (0.9)
6 2
= (0.9) + 3 (0.9) - 2(0.9) -1
= 0.53441 + 2.43 - 1.8 -1
f (0.9) = 0.161441
Applying Newton's method twice
f ( x1 )
x 2 = x1 -
f ( x1 )
f (0.9)
= 0.9 -
f (0.9)
0.161441
= 0.9 -
6.94294
x2 0.877
Thus, f (0.877) = (0.877)6+ 3(0.877) 2 - 2 (0.877) - 1
= 0.0084 which is more approximate to zero.
2. Determine the approximate value of the equation x 2 1 3x in the interval [0, 1]
using Newton's method once.
Solution
Squaring both sides of the equation gives us f (x) = - 8x2 + 1. In this case also n = 0,
x0 1
f ( x0 )
x1 x0
f ( x0 )
f ( x0 ) = (1) 2 (-8) + 1 = - 7
f ( x0 ) = f (1) = - 16 (1) = -16
Therefore
(7)
x1 1
(16)
= 1- 0.4375
x1 = 0.5625 0.56
If we check the original function at this value of x, we get f (0.56) 8(0.56)2 +1
= - 2.5088 +1
f (0.56) = - 1.5088
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Applying the Newton method twice gives us
f ( x1 )
x2 x1
f ( x1 )
f (0.56)
x2 0.56
f (0.56)
(1.5088)
x2 0.56 0.392
(8.96)
Then f (0.392) 8(0.392) 2 1 0.2293 which is more approximate to the solution
than the earlier value. This shows that we can determine the most approximate value of
the solution by applying this procedure continuously.
2.3 Multivariate Calculus
Some functions involve one dependent and more than one independent variable. These
functions are said to be multivariate functions. For example, the production function Q =
f (K, L) has one dependent and two independent variables, labor L and capital K.
2.3.1 Partial Derivatives
Partial differentiation is a technique of deriving the rate of change of the function with
respect to change in one of the independent variable when all other variables in the
function are held constant. Thus, if the production function Q = f (K, L) is differentiated
with respect to L, with K being constant, we obtain the rate of change of total product
with respect to labor, i.e., Marginal product of labor ( MPL ) .
Partial differentiation follows the normal rules of differentiation apart from the fact that
all variables other than the one the function is being differentiated with respect to are
assumed to be constant.
Given the function, y f ( x1 , x2 ) the usual notation for the partial derivative of the
function with respect to x1 is
y y
= f x1 and that of with respect to x 2 is = f x2
x1 x 2
Example
1. If the function is given by y 4 x12 x23 6 x12 x2 x14 7 x23 , find f x1 and f x2 .
f x1 8x1 x23 12 x1 x2 4 x13 ( x 2 is assumed to be constant)
f x 12 x12 x22 6 x12 21x22 ( x1 is assumed to be constant )
2
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Economic Applications
Partial differentiation is frequently applied in economic analysis as the economy is a
complex system to understand. Economists usually observe the effect of changes in one
variable supposing all other variables constant.
A. Elasticity
As we know quantity demanded for a product depends on various factors such as price of
the good , ( p) consumer's income ( y ) , price of related goods, and population ( n) .
Qdd f ( p, y, pc , ps , n) where p c is price of complement.
p s is price of substitutes.
And we also know that price elasticity of demand E p is
dQ p
Ep = ( )
dp Q
But with the existence of these determinants in the demand function
Q P
Ep ( )
P Q
Example
Given the demand function as Q 35 0.4P 0.15 y 0.25Pc 0.12P s 0.003n , what is
the price elasticity of demand when price is 24?
Q P Q
Ep ( ) , you are required to get .
P Q p
Q
- 0.4 (all factors other than the price of the product are constant)
P
(0.4)(24)
Ep
35 0.4(24) 0.15 y 0.25Pc 0.12 Ps 0.003n
(9.6)
Thus, Ep
25.4 0.15 y 0.25Pc 0.12 Ps 0.003n
The exact price elasticity of demand can be calculated if the values of the remaining
variables are given.
B. Utility Functions
According to the cardinality approach the consumer who consumes only two products A
and B will have the utility function
U U ( A, B)
We can determine the marginal utility of each good from this function using the
technique of partial differentiation.
Example
If the utility function of the consumer is given by U 2 A0.4 B 0.4 , where A and B
represent the quantity of the two goods consumed; find marginal utility of each good.
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MUA = 2(0.4)0.4
A-0.6 B0.4
0.8B
=
A0.6
MUB = 0.4(2)0.4A0.4 B- 0.6
0.8 A
=
B 0.6
As the consumption of good A increases, MUA decrease and as the consumption of B
increases MUB decreases. As a result the law of diminishing marginal utility holds for
both goods.
C) Production Function
When the firm produces a product using two or more variable inputs, then we can
determine the rate of change of total product with respect the change in each input using
the method of partial differentiation.
Example
If the production function for a product is given by Q = 20K 0.5 L 0.5 where K is capital
and L is labor, Find the marginal Product of each input.
Marginal product of labor (MPL) = 0.5 (20) K0.5 L-0.5
10 K 0.5
MPL
L0.5
Marginal Product of capital (MPK) = 0.5 (20) K 0.5 L 0.5
10 L0.5
MPK
K 0.5
Is the law of diminishing marginal productivity is satisfied for each input? Why
D) Revenue and Cost Functions
It is clear that in some cases firms may produce different products. If they use common
production facilities, the costs of each product will be related. Therefore, the marginal
cost function of the individual product can be determined by the method of partial
differentiation.
Example
A firm produces two products Q1 and Q2 and its total cost function is
C (Q1 , Q2 ) 20(Q1 Q2 ) , what are the relevant marginal cost functions?
C = 20Q1 + 20Q 2
C
Thus, Marginal cost of Q1 =
Q1
MC 1 = 20
Marginal cost of Q2 (MC2) = 20
In other cases, the firm may produce different products which are complementary with
each other. This means, the price of one good will affect the quantity demanded of the
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other good. Thus, the marginal revenue of one good is the partial derivative of total
revenue with respect to that good assuming the price of the other good constant.
Example
Suppose a firm produces two products A and B which are complements. The relevant
demand functions are
Q A 850 12.5PA 3.8PB
QB 936 4.8PA 24 PB
What are the marginal revenue functions of the two goods?
Marginal revenue is usually expressed in terms of quantity. Thus, we should initially
rewrite the demand functions in the form of price in terms of quantity.
For good A,
Q A 850 12.5PA 3.8PB
12.5PA 850 3.8PB Q A
850 3.8PB Q A
PA
12.5
PA 68 0.304 PB 0.08Q A
However, TRA PAQA 68QA 0.304PB QA 0.08QA2
Therefore, the marginal revenue of product A is
TRA
MR A
Q A
MR A 68 0.304 PB 0.16Q A
For good B,
QB 936 4.8PA 24 PB
24 PB 936 4.8PA QB
936 4.8PA QB
PB
24
Q
PB 39 0.2 PA B
24
Q B2
However, TR B = P B Q B = 39 Q B - 0.2 P A Q B -
24
TRB
MR B =
QB
1
MRB 39 0.2 PA QB
12
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The marginal revenue functions of the above two goods show that when the demand for
the two goods are interrelated, the marginal revenue function for one good will depend on
the price level of the other good.
E) Keynesian Multiplier
If we incorporate the government sector and foreign trade, the basic Keynesian
macroeconomic model will be
Y= C+ I + G+ (X -M)
and the functional relationship with consumption is
C = c Yd
Where c is the marginal Propensity to consume, and imports
M = m Yd
Where m is marginal propensity to import,
Y d = (1-t) Y
is the disposable income c, m and t are parameters and Investment I, Government
expenditure G and export X are exogenously determined.
Therefore Y = c Y d + I + G + [X- (m Y d )]
Y = c (1-t) Y + I+ G+ X- m (1-t) Y
Y - c ( 1-t) Y + m ( 1-t) Y = I+ G+X
Y [1-c (1-t) + m (1-t)] = I+ G+ X
I G X I G X
Y= =
1 c(1 t ) m(1 t ) 1 (c m)(1 t )
Dear colleague! If we are interested to determine the government expenditure multiplier,
we should partially different income with respect to G, holding Investment L and export
X constant as shown below.
Y 1
=
G 1 (c m)(1 t )
Y Y Y
However, = =
G X I
Example
In a Keynesian Macroeconomic model of an economy
Y = C+ I + G+(X-M) I = 820
C = 0.75 Y d G = 960
M = 0.25 Y d Y d = (1-t) Y
X = 650 t = 0.3
Determine the equilibrium level of national income. Using the export multiplier find out
what will happen to the balance of trade if export exogenously increases by 100.
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Initially, we should solve the relationship between income (Y) with consumption and
Import.
C= 0.75 Y d = 0.75 (1-t) Y = 0.75(1-0.3) Y
= 0.75 (0.7) Y
C = 0.525 Y
M = 0.25Y d = 0.25 (1- 0.3) Y
= 0.25 (0.7) Y
M = 0.175 Y
Therefore, the equilibrium level of national income is
Y = 0.525Y+ 820 + 960 + 650 - 0. 175Y
Y - 0.525Y + 0.175Y = 2430
0.65Y =2430
2430
Y= = 3,738.46
0.65
At this equilibrium level of income, import will be
M= 0.25 (0.7) (3,738.46)
M = 654.23
Thus, the balance of payment will be
X- M = 650 - 654.23
= -4.23 which is negative trade balance.
However, as export increases by 100, then the equilibrium level of income will be
increased by change in export times export multiplier, i.e.,
Y 1
Y X = 100 [ ]
X 1 (c m)(1 t )
1
=100[ ]
1 (0.75 0.25)(1 0.3)
1
=100 [ ]
1 (0.5)(0.7)
1
= 100 [ ]
0.65
Y 153.85
As a result, equilibrium level of income increases from 3,738.46 to 3,892.31 when export
increases from 650 to 750. At this new level of equilibrium income, import will be
M = 0.175 (3,892.31)
M = 681.15
And the new balance of trade will be
X - M = 750 - 681.15
= 68.85
Therefore, the balance of trade changes from 4.23 deficits to 68.85 surpluses when
export exogenously increases by 100.
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2.3.2 Second Partials and Young’s Theorem
As you know, if the first order partial derivatives of the function are continuous and
differentiable, differentiating these functions will result in second order partial
derivatives. Given the function Z=ƒ(x, y), if it is differentiable, it has two first order
Z Z
partial derivatives such as Zx= and Zy = . In addition to these, this function has
x y
four second order partial derivatives (direct and cross partial derivatives). These are
2Z
Z xx =
x 2
2Z
Z yy =
y 2
These two derivatives are referred to as direct second order partial derivatives where a as
z Z
Z xy = y and Z yx = x are said to be second order cross partial
x y
derivatives. According to the young's theorem, the mixed (cross) partial derivatives for a
given function are always equal if both cross partials exist and they are continuous. This
means
Z y Z x
Z xy Z yx =
x y
Example
1. Given the demand function for the two commodities Q1 and Q2
Q1 P11.7 P20.8 And Q2 P10.5 P20.2
Find the first and second order partial derivatives of the function and determine whether
the two goods are complementary or substitute. Show that whether young's theorem is
satisfied or not.
Q1 Q2
1.7 P1 2.7 P20.8 0.5 P1 0.5 P2 0.2
P1 p1
Q1 Q2
0.8 P11.7 P20.2 0.2 P10.5 P21.2
P2 p2
From these first order partial derivatives we have observed that an increase in the price
of commodity Q1 results in an increase in the quantity demanded of commodity Q2.
Therefore, Q1 and Q2 are substitute goods.
The second order direct partial derivatives are
2 Q1
(1.7)(2.7) P13.7 P20.8
P1 2
= 4.59 P13.7 P20.8
2Q2
= 0.24 P 10.5 P 22.2
P22
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The second cross partial derivatives are
(Q1 P1 )
= (0.8) (-1.7) P 12.7 P 20.2
P2
= 1.36P12.7 P20.2 ------------------------------- (a)
Q1
( )
P2
(1.7)(0.8) P12.7 P20.2
P1
= 1.36P12.7 P20.2 --------------------------------- (b)
(Q2 P 2 )
= (- 0.2) (0.5) P10.5 P21.2
P1
= - 0.1 P10.5 P21.2 ----------------------------------(c)
(Q2 p1 )
= (-0.2) (0.5) P 10.5 p 21.2
P2
= - 0.1 P10.5 P21.2 ----------------------------------- (d)
Equation a is equal to that of b and equation c is equal to equation d. It indicates that the
Young’s theorem is satisfied.
2. Given the production function Q= 6K+ 0.3 K2L + 1.2L2 derive the four second order
partial derivatives and interpret their meaning.
The two first order partial derivatives are
Q Q
= 6+ 0.6 KL and = 0.3 K2 + 2.4 L
K L
They represent the marginal product function of the two inputs.
The four second order partial derivatives are
2Q
i) 0.6 L
K 2
This represents the rate of change of marginal product of capital function with respect to
capital. It indicates that marginal productivity of capital increases as labor increases.
2Q
ii) 2.4
L2
It represents the slope of marginal product of labor function which is independent of
capital.
2Q
iii) 0.6 K
LK
This tells us that MP L increases if K is increased, for any given value of L.
2Q
iv) 0.6 K
LK
This tells us that MP K increases if L is increased, for any given value of L.
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2.3.3 Multivariate Chain Rule
As we know many economic models involve composite functions. Thus differentiation of
such functions requires the application of chain rule.
Chain rule for functions of one variable
dy dy dx
Given y = f(x) and x= g (t), then
dt dx dt
Chain rule for multivariate function
Suppose z= ƒ (x, y), x = ƒ (t) and y = ƒ (t), in this case we should use the total derivative.
dz z dx z dy
( ) ( )
dt x dt y dt
Given the function y = ƒ (x, w) and x g (w) to get this total derivative, let us initially
determine the total differential dy f x dx f w dw . If we divide both sides of this equation
by dw , we obtain
dy dx dw
fx fw
dw dw dw
dy dx
fx fw
dw dw
dx
fx Measures the indirect effect of w on y and, f w shows the direct effect of w on y.
dw
Example
1. Suppose that the relationship between revenue R, output Q produced and sold each
week is given by
R = 400Q - Q2
In addition, suppose that Q is a function of t, i.e. time period, Q = ƒ(t)
dR dR dQ
Thus dt dQ dt
dQ
(400 2Q)
dt
When Q = 30 and that the Management is considering to increase production by five
units per week,
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400 2(30)5
dR
dt
(400 60)5
dR
(340)5 1700
dt
Interpretation
The management decision to increase production by five units per week increases total
revenue by 1,700 units
2. Given the utility function U = x2+ x y + y2, x = t3 + 1 and y = t - t3
du u dx u dy
( ) ( )
dt x dt y dt
= (2x+y) (3t ) + (y+ 2y) (1-3 t2)
2
2.3.4 Homogenous Functions and Euler's Theorem
A function y f ( x1 , x2 ,....xn ) is referred to as homogenous of degree r if and
only if
f (tx1 , tx 2 ,....., tx n ) t r f ( x1 , x x ,..., xn ) , where t is any parameter.
Multiplying all the independent variables by a factor t will multiply the value of the
function by the factor t .
Example
1. If ƒ(x, y) = 3x 3 5x 2 y 2 y 3 , then
ƒ (t x, t y) = 3 (t3 x)3 3+ 52(t2x)2(t y3) + 2(t y )3
= 3t x 5t x y 2t y
3
3t 3 x 3 5t 3 x 2 y 2t 3 y 3
t 3 (3x3 5x 2 y 2 y3 )
Therefore, the function is homogenous of degree 3.
2. Consider the Cobb- Douglas production function
Q bL K 1
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f ( Lt, kt) b( Lt ) (kt)1
b t L k 1 t1
b t 1 L k 1
b t L k 1
t b L k 1
Thus, the production function is homogenous of degree 1.
Given the function f ( tx1 , tx 2, tx3, ... , tx n ) t f ( x1 x2 , x3, ....xn )
If r = 1, a function exhibits constant returns to scale
If r > 1, a function exhibits increasing returns to scale
If r < 1, a function exhibits decreasing rectums to scale
Euler's Theorem 1
If the function y = f ( x1 , x2 , x3 ) is homogenous of degree r, then according to the Euler's
theorem
f f f
x1 + x2 + x3 = rf ( x1 , x2 , x3 )
x1 x 2 x3
Example
Find the degree of homogeneity of the function
f ( x, y) x 4 x 2 y 2 Using Euler's theorem
f x x f y y r(x 4 x 2 y 2 )
(4 x 3 2 xy 2 ) x (2 x 2 y) y r ( x 4 x 2 y 2 )
= 4x 4 2x 2 y 2 2x 2 y 2
= 4x 4x y
4 2 2
= 4( x 4 x 2 y 2 )
Thus, the function is homogenous of degree 4.
Euler's Theorem 2
If a function y f ( x1 , x2 ,....xn ) is homogenous of degree r, then according to this
theorem the first partials f x1 , f x2 , f x3 are homogenous of degree (r 1) .
Example
1. Given the function f ( x, y) x 4 x 2 y 2 ,
f 4 x 3 2 xy 2 , f y 2 x y
2
x
f x (tx, ty ) 4(tx ) 3 2(tx )(ty ) 2
= 4t 3 x 3 2t 3 xy 2
= t 3 (4 x 3 2 xy 2 )
Thus, the function f x is homogenous of degree 3.
f y (tx, ty ) 2(tx ) 2 (ty )
= 2t 2 x 2 ty
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= 2t 3 x 2 y t 3 (2 x 2 y)
This means, f y is homogenous of degree 3.
2. Given the Cobb - Douglas production function
3 1
f (L, K) = 60 L 4 K 4
Find the degree of homogeneity of f L and f k using Euler's theorem.
The first partial derivatives are
3 1 1 1 3 3
f L = 60 ( ) L 4 K 4 f k = (60) L 4 K 4
4 4
1
3
4 4
45 K 15 L
fL = 1
fK = 3
4 4
L K
1 1
Thus, f L (tL, tK ) 45(tL ) 4 (tK ) 4
1 1 1 1
4 4 4 4
= 45L t K t
1 1 1 1
( )
4 4
= 45(t ) L4 K 4
1 1
0 4 4
= t (45L K )
3 3
And f K (tL, tK ) 15(tL ) (tK ) 4 4
3 3 3 3
4 4 4 4
= 15L t K t
3 3 3 /3
( )
4 4
= 15(t ) L4 K 4
3 3
0 4 4
= t (15L K )
What we have seen from this is both of f L and f k is homogenous of degree 0. In other
words, the original Cobb-Douglas production is homogenous of degree 1.
2.3.5. Total Differential and Implicit Differentiation
Given the function y = f(x), the differential is dy f ( x)dx .The concept of differential
can be extended to functions with two or more independent variables.
Given the utility function, U f ( x1 , x2 ) , assuming that U is continuous and
differentiable
U
U x1 = Marginal utility of x1
x1
U
U x2 = Marginal utility of x 2
x 2
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U
Change in U which is resulted from small change in x1 is dx1 and from small change
x1
in x 2 is .
Thus the total change in utility is
If the two variables x and y are related by the implicit function
, the total differential of the function is
If we rearrange this equation, we get
As you remember in your microeconomic studies, the theory of
production states that the slope of the isoquant represents the marginal rate of technical
substitution (MRTS) between two inputs. In this case, the use of total differential can
help us to show the reality that MRTS between the two inputs is equal to the ratio of the
marginal products of the two inputs. If the producer use capital (K) and labor (L) in the
production process,
Given the production function , the total differential is
=
Once the isoquant is determined, there is no change in output along the same isoquant.
This means change in Q is zero. Therefore,
MRTS =
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3.1.1 Economic Applications
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 = Price x Quantity Sold
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
dTR
0 or MR 0 (First order condition)
dQ
d 2TR d( MR)
and 2
0 or 0 ( Second order condition )
dQ dQ
Example
1. A farmer wants to send his perishable product to a city market as soon as possible. He
has estimated that he can send now 1.5 tones of the product per day and can get a price of
2,500 birr per tones. If he waits, he can get a price increase of 20 Birr per tones per day
but the quantity of the product to be supplied will be reduced by 0.01 tones per day. For
how many days should he wait so that his revenue becomes a maximum?
Solution
Let x be the number of days waiting, total revenue of the firm is
TR (2,500 20 x)(1.5 0.01x)
TR 3,750 25 x 30 x 0.2 x 2
TR 3,750 5 x 0.2 x 2
Revenue is maximized when
dTR d 2TR
0 and < 0
dx dx 2
dTR
5 0.4 x 0
dx
Thus, 0.4 x 5 -
x 12.5
2
d TR
At x = 12.5, 0.4 0
dx 2
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
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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
TR (200 4 x)(125 5 x)
TR 25,000 1,000 x 500 x 20 x 2
TR 25,000 500 x 20 x 2
dTR d 2TR
Total revenue is maximized when MR 0 and <0
dx dx 2
MR 500 40 x 0
40 x 500
x 12.5
d 2TR
When x = 12.5, 40 0 Thus, total revenue is maximized when x 12.5 . The
dx 2
rent per room per night that should be charged to which maximizes revenue is
Rent = 125 + 5(12.5) = 125+ 6.5
= 187.5 Birr per room per night
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
d dTR dTC
0 0
dQ dQ dQ
MR MC 0
MR MC
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
d 2 d 2TR d 2TC
< 0 <0
dQ 2 dQ 2 dQ 2
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d ( MR) d ( MC )
dQ dQ
Slope of <
Slope of
MR
MC
Let us do the following examples to make it clear.
Example
1. Suppose a monopolist has a demand curve Q 106 2P and average cost curve
Q
AC 5 , where P is price per unit and Q is the number of units of output.
50
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
1
P = 53 Q
2
1
Thus, TR (53 Q)Q
2
1
TR 53Q Q 2 MR 53 Q
2
And
TC AC (Q)
Q
TC (5 )Q
50
1 1
TC 5Q Q 2 MC 5 Q
50 25
Profit is maximized when
MR = MC
1
53 - Q = 5 + Q
25
1
53 - 5 = Q + Q
25
26
48 = Q
25
48(25)
Q=
26
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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.
d 2TR d 2TC 1
2
2
1
dQ dQ 25
When Q = 46.15,
26
0
25
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
1
P 53 Q
2
1
P 53 (46.15)
2
P 53 23.075 29.93
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
dTC
i) 0 MC 0
dQ
2
d TC d ( MC )
ii) 2
0 >0
dQ dQ
Example
1.Suppose the total cost of producing Q units of a certain product is described by the
function TC 100,000 1,500Q 0.4Q 2 where TC is the total cost stated in Birr.
Determine the amount of output which minimizes average cost.
Solution
TC
Average cost (AC) =
Q
100,000
AC = 1,500 0.4Q
Q
AC is minimized when
dAC d 2 ( AC )
0 And 0
dQ dQ 2
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dAC 100,000
0.4 0
dQ Q2
100,000 100,000
2
0.4 Q 2
Q 0.4
Q 2 250,000
Q 500
However, output should be positive. Therefore, Q = 500. We should check the second
order condition at this point to reach to our conclusion.
d 2 AC 2(100,000)
When Q= 500, 2
=
dQ Q3
200,000 200,000
= = >0
Q 3
(500)3
Thus, the level of output which minimizes average cost is Q = 500 units.
2. Find the minimum point of the average cost function
AC 25Q 1 0.1Q 2
Solution
Applying the same conditions
dAC
25Q 2 0.2Q
dQ
25Q 2 0.2Q 0
25Q 2 0.2Q
25
0.2Q
Q2
Q 3 125 Q 5
Therefore, AC is at its stationary point when Q = 5. The rate of change of the slope of AC
d 2 AC
with respect to output is 2
50 Q 3 0.2
dQ
d 2 AC 50
When Q = 5, 3 0.2
dQ 2 5
50
= 0.2
125
= 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
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25
25Q 1 0.1Q 2 0.1(25) 5 2.5 7.5
5
Exercise
Solve the following questions based on the information given above.
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? -----------------------------------------------------------
----------------------------------------------------------------------------------------------------------
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 2 what output will maximize the
sales revenue? -----------------------------------------------------------------------------------------
4. What is the maximum profit a firm can make if it faces a demand function
P 660 3Q and the total cost function TC 25 240Q 72Q 2 6Q 3 ?------------------------------
------------------------------------------------------------------------------------------------------------------------------------------------------------------
5.ABC Company is planning to market a new model of product X. The management
collects information from retailers that how many units of good X they would buy for
various prices. From this survey, it is determined that the unit demand function is
X 1,500P 30,000
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. ----------
------------------------------------------------------------------------------------------------------------
6. Find the profit maximizing level of output for a firm with the total cost function
1
TC Q 3 8.5Q 2 97Q 4 and total revenue TR 58Q 0.5Q 2 .
3
3.2 Functions of Several Independent Variables
Given the function Z = f(x, y), the objective function z to be maximum or minimum, it
must satisfy both of the order conditions.
The first order conditions are
Z Z
= 0 and =0
x y
This means, the first order total differential of the function is zero
( dZ f x dx f y dy 0 ).
However, there are two sets of second order conditions
2Z 2Z
a) To be maximum 0 , and < 0 ------------------ (1)
x 2 y 2
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2Z 2Z
b) To be minimum >0, and >0
x 2 y
2
The other second order condition for both to be at maximum and minimum value is
2Z 2Z 2Z 2
( 2 )( ) > ( )
x y 2 xy
Alternatively, we can determine the second order sufficient condition using the concept
of total differential of the differential of the function which is denoted by
( f x dx f y dy ) ( f x dx f y dy )
d 2 Z d (dZ ) dx dy
x y
d 2 Z ( f xx dx f xy dy )dx ( f yx dx f yy dy )dy --------------- (2)
d 2 Z f xx dx 2 f xy dydx f yx dxdy f yy dy 2
But we know that f xy f yx (Young’s Theorem)
d 2 Z f xx dx 2 2 f xy dxdy f yy dy 2 -------------------------------------- (3)
Then the second order condition for any value of dx and dy not both zero
d 2 Z 0 indicates that the function is at its maximum whereas d 2 Z 0 shows that the
function at it minimum point. However, for any value of dx and dy ,
d 2 Z 0 if and only if f xx 0, f yy 0 and f xx f yy ( f xy ) 2 0 .
d 2 Z 0 if and only if f xx 0, f yy 0 and f xx f yy ( f xy ) 2 0 .
Given the quadratic function U ax12 bx1 x2 cx 22 , the discriminant, which is symmetric
determinant, is formed by putting the coefficient of the squared variable on the principal
diagonal and dividing the coefficient of the non squared term equally between the off-
diagonal positions as follows
b
a
D = 2
b
c
2
b2
Where D1 a the first principal minor of the discriminant and D2 ac is the
4
second principal minor. The sign definiteness of the given function can be described in
terms of sign restriction on these principal minors.
U is positive definite iff D1 0 and D2 0 .
U is negative definite D1 0 and D2 0
For n-variable quadratic form of the function, the discriminant becomes
d11 d12. d13 ...... d1n
d 21 d 22 d 23 ..... d 2n
D
d 31 d 32 d 33 ..... d 3n
d n1 d n2 d n 3 ...... d nn
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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 D1 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.
f xx f xy
H
f yx f yy
H 1 f xx And H 2 f xx f yy f yx f xy are the first and second principal minors
respectively.
By now we can express the sign defiantness of d 2 Z 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 Z f ( x, y) as
d 2 Z is positive definite iff H 1 f xx 0 And H 2 f xx f yy f yx f xy 0 . In this
case, the function achieves its minimum.
d 2 Z is negative definite iff H 1 f xx 0 And H 2 f xx f yy f yx f xy 0 . This
indicates that the function is at its maximum.
Considering the function of n- choice variables
Z f ( x1 , x2 , x3 ,....xn )
The first order condition for the extremum of the function is
f1 f 2 f 3 ..... f n 0 which leads to the fact that
dZ f1dx1 f 2 dx2 f 3 dx3 ...... f n dxn 0
The second order sufficient conditions are identified using the Hessian determinant
f11 f12. ........ f1n
H . f 21 f 22 .......... f 2n
f n1 f n 2 .......... f nn
The sufficient condition for the maximum of the function is satisfied when
H1 0; H 2 0; H 3 0,......(1) n H n 0 .where as for the minimum of the function all
of the Hessian principal minors must be positive.
Example
1.Given the function Z 160 x 3x 2 2 xy 2 y 2 120 y 18 , find the maximum value of
the function.
Solution
The first order conditions that should be satisfied for maximum are
Z Z
Zx 0 And Z y 0
x y
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Z
Zx 160 6 x 2 y 0
x
6 x 2 y 160 --------------------------------------- (1)
Z
Zy 2 x 4 y 120 0
y
2 x 4 y 120 -------------------------------------- (2)
Taking equation (1) and (2) simultaneously, multiplying (1) by 2 and subtracting
equation (2) from this gives us
6x +2y = 160
2 x 4 y 120
12x +4y = 320
2 x 4 y 120
10 x 4 y 200
10 x 200
x 20
Substituting 20 in place of x in either of the two equation we will get y = 20
Taking the second partial derivatives,
Z xx 6 0 & Z yy 4 0
And
( Z xx )( Z yy ) ( Z xy ) 2
(6)(4) (2) 2
24 4
6 2
Alternatively, H , H1 6 0 and H 2 24 4 20 0
2 4
Thus, the function Z is maximized when x = 20 and y = 20.
The maximum value of Z is
Z 160(20) 3(20) 2 2(20)(20) 2(20) 2 120(20) 18
Z 2,782
3.2.1 Economic Applications
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.
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Solution
Total Revenue (TR) = TR 1 + TR 2
= P1Q1 P2 Q2
= (600 0.3Q1 )Q1 (500 0.2Q2 )Q2
TR = 600Q1 - 0.3Q 12 + 500Q2 - 0.2Q 22
Profit ( ) = TR -TC
= 600Q1 0.3Q12 500Q2 0.2Q22 (16 1.2Q1 1.5Q2 0.2Q1Q2 )
598.8Q1 0.3Q12 498.5Q2 0.2Q22 0.2Q1Q2 16
The first order conditions for maximum profit are
598.8 0.6Q1 0.2Q2 0
Q1
0.6Q1 0.2Q2 598.8 ------------------------------ (1)
And
498.5 0.4Q2 0.2Q1 0
Q2
0.2Q1 0.4Q2 498.5 ------------------------------- (2)
Taking equation (1) and (2) simultaneously, multiplying equation (2) by 3 deducting it
from (1) gives us
0.6 Q1 + 0.2 Q2 = 598.8
Multiplying (2) by 3 0.2 Q1+ 0.4 Q2 = 498.5
0.6Q 1 + 0.2Q2 = 598.8
0.6Q1 1.2Q2 1,495.5
-Q2 = - 896.7
Q2 = 896.7 units
Substituting this value for Q 2 in (1), we get
598.8 0.6Q1 0.2(896.7) 0
598.8 179.34 0.6Q1
419.46 0.6Q1
Q1 699.1
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
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( 2 ) ( 2 ) ( 2 )
0.6 0 , 0.4 0 , 0.2
Q12 Q22 Q1Q2
2 2 ( 2 ) 2 2
Therefore, [ ][ ] > [ ]
Q12 Q22 Q1Q2
(0.6)(0.4) (0.2) 2
0.24 0.04
The corresponding Hessian determinant is
0.6 0.2
H , H1 0.6 0; H 2 (0.6)(0.4) (0.2) 2 0.2 0
0.2 0.4
Therefore, profit is maximized when Q 2 =896.7 and Q 1 =699.1 and the profit maximizing
prices are
P1 = 600 - 0.3 (699.1) P2 = 500 - 0.2 (896.7)
= 600 - 209 .73 = 500 - 179.34
P1 = 390.27 P2 = 320.66
The maximum profit is
(699.1,896.7) 16 598.8(699.1) 0.3(699.1) 2 498.5(896.7) 0.2(896.7) 2 0.2(699.1)(896.7)
(699.1,896.7) 432,797.02birr
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 22
If the demand function is given by P 60 0.04Q , where Q= Q1 + Q 2 , how much
output should the monopolist produce in each plant in order to maximize profit?
Solution
Total Revenue of the firm is
TR PQ (60 0.04Q)Q
TR 60Q 0.04Q 2
TR 60(Q1 Q2 ) 0.04(Q1 Q2 ) 2
TR 60Q1 60Q2 0.04Q12 0.08Q1Q2 0.04Q22
TR TC1 TC2
Total Profit
13.7 60Q1 60Q2 0.07Q12 0.08Q22 0.08Q1Q2
First order conditions for maximum profit are
= 60 - 0.14 Q 1 - 0.08 Q 2 = 0
Q1
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0.14Q 1 + 0.08Q 2 = 60 ------------------- (1)
And
= 60 - 0.16Q 2 - 0.08Q 1 = 0
Q2
0.08Q 1 + 0.16 Q 2 = 60 ----------------------- (2)
Taking equation (1) and (2) simultaneously, multiplying (1) by 2 and reducing (2) from
it
0.14Q 1 + 0.08 Q 2 = 60
0.08Q 1 + 0.16Q2 = 60
0.28Q1 + 0.16 Q2 = 120
0. 08Q1 + 0.16 Q2 = 60
0.2Q1 0 60
Q1 300
Substituting this value in place of Q 1 in equation (1), we get
0.14(300) 0.08Q2 60
0.08Q2 = 60 – 42
0.08Q2 = 18
Q2 225
When we check the second order conditions at these levels of output
2 2 2
= - 0.14 < 0, = - 0.16, < 0, = - 0.08
Q12 Q22 Q1Q2
Thus, (- 0.14) (- 0.16) > (-0.08)2
0.0224> 0.0064
This verifies that profit is maximized when Q1 = 300 and Q2 = 225
The total amount of output that the firm should produce to maximize profit is
Q = Q1 + Q2 = 525 units.
Therefore, P = 60 - 0.04 (525) = 60 - 21 = 39
3. Suppose a firm faces the production function Q 0.8K 0.4 L0.3 . It sells its output at a
fixed price of 450 Birr a unit and can buy K and L at 15 Birr per unit and 8 Birr per unit
respectively. What input mix will maximize profit?
Solution
TR PQ 450(0.8K 0.4 L0.3 )
Total revenue
TR 360 K 0.4 L0.3
Total cost (TC) = LPL + KP K
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TC = 8 L + 15 K
Thus total profit ( ) = TR - TC
= 360 K0.4 L 0.3 - 8 L - 15 K
The first order conditions for maximum output are
108K 0.4 L0.7 8 0
L
108K 0.4 L0.7 8
K 0.4 8
0.7
-------------------------- (1)
L 108
144 K 0.6 L0.3 15 0
K
144K 0.6 L0.3 15
L0.3 15
0.6
------------------------- (2)
K 144
Thus, we must have,
108 0.4
From (1) L0.7
K
8
10 4
(108) 7 7
L [ ] K ------------------------------- (3)
8
144 0.3
From (2) K 0.6 L --------------------------------------- (4)
15
Substituting equation (3) in place of L in (4), we get
10 4 3
144
K 0.6 7
[(13.5) K ] 7 10
15
3 6
144
K 0.6 = (13.5) 7 K 35
15
6 3
( 0.6 ) 144
K 35
(13.5) 7
15
3 3
K 7 (9.6)(13.5) 7
7
K = (9.6) 3 (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.
10 4
7 7
L = (13.5) (2, 644.25)
= (41.19) (90.282)
L = 3,718.72
Checking the second order conditions at these values,
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2
= -75.6 K 0.4 L 1.7 = - 75.6 (2,644.25) 0.4 (3,718.72) 1.7
L 2
= - 0.0015 < 0
2
86.4 K 1.6 L0.3 86.4(2,644.25) 1.6 (3,718.72) 0.3
K 2
2
0.0034 0
K 2
2
43.2 K 0.6 L0.7 43.2(2,644.25) 0.6 (3,718.72) 0.7
LK
2
0.00121 0
LK
2 2 2 2
( )( ) ( )
Therefore, L2 K 2 LK
(0.0015)(0.0034) (0.00121) 2
The corresponding Hessian determinant is
0.0015 0.00121
H , H1 0.0015 0; H 2 0 .
0.00121 0.0034
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
P1 63 4Q1
P2 105 5Q2
P3 75 6Q3
And the cost function is C 20 15Q; Q Q1 Q2 Q3
Determine the amount of output that should be sold to maximize profit. Identify the
prices charged in each market to maximize profit.
First we should construct the total revenues for each market. These are
TR1 63Q1 4Q12
TR2 105Q2 5Q22
TR3 75Q3 6Q32
Therefore, the total profit function is TR1 TR2 TR3 C
63Q1 4Q12 105Q2 5Q22 75Q3 6Q32 (20 15Q1 15Q2 15Q3 )
48Q1 4Q12 90Q2 5Q22 60Q3 6Q32 20 -------------------------(1)
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First order conditions
1 48 8Q1 0 Q1 6
Q1
2 90 10Q2 0 Q2 9
3 60 12Q3 0 Q3 5
P1 57, P2 60, P3 45
We can check the second order condition using the sign of the principal minors of the
Hessian determinant. The corresponding Hessian determinant is
11 8, 12 0, 13 0
21 0, 22 10, 23 0
31 0, 32 0, 33 12
11 12 13 8 0 0
H 21 22 23 0 10 0
31 32 33 0 0 12
Evaluating the successive principal minors,
8 0
H 1 8 0, H 2 80 0, H 3 H 960 0
0 10
It indicates that d 2 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
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
1. What are the conditions for the optimization of a function Y = f(x, z)? ------------
---------------------------------------------------------------------------------------------------
----------------
2. A firm produces two products which are sold in separate market with demand
functions
P1 180 15Q1
and the cost function is TC 150 120Q where Q Q1 Q2
P2 380 20Q2
How much should the firm charge in each market to maximize profit? --------------
---------------------------------------------------------------------------------------------------
-----------------
3. A Multi-plant monopoly operates two plants whose cost functions are
TC1 2.4 0.015Q12 & TC2 3.5 0.012Q22 And its demand function
is P 32 0.02Q , Q Q1 Q2 .How much should it produce in each plant to
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maximize its profit? ------------------------------------------------------------------------------
----------------------------------------------------------
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 0.4 L 0.2 , what is the maximum profit
?
3.3 Unconstrained Envelope Theorems
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.
Although these parameters are assumed to be constant during the process of
optimization, they may vary according to the economic situation. Therefore, what
happens to the optimal value of the objective function when these parameters change?
Considering the firm which produces an output Q using L units of labor as input, and its
production function is given by Q f (L) . Suppose the price of the product is p and that
of labor is w , the theory of the firm states that the firm chooses the amount of labor L
which maximizes profit. The profit function is
[ L, (w, p)] pf ( L) wL pQ wL
Considering L ( w, p) as the optimal amount of labor when the prices are w and p , then
the maximal profit of the firm is represented by
(w, p) pf [ L (w, p)] wL (w, p)
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 p is the partial
derivative of the direct profit function with respect to p , evaluated at L L (w, p)
namely f [ L (w, p)] .
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 w is L (w, p) . 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.
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Fig.3.1 Envelop Curve
Each of the inverted U-shaped curves is the graph of direct profit function ( L, (w, p)) as
a function of w for a given value of L and p . Each of these graphs show how changes
due to change in w for a given value of L and p . To get the solution of the maximization
problem for any given value of w , we should find the highest function for that value of w .
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 w in our case.
Example
1. Suppose a firm is producing a certain product Q and wants to maximize its profit.
Suppose a tax rate t is imposed on a production of Q. What is the effect of change in the
tax rate on total profit?
Total Profit ( ) =TR-TC
TR R(Q)
TC C (Q) tQ
Thus, (Q, t ) R(Q) C(Q) tQ
The first order condition for maximum profit is
(Q, t ) R(Q) C (Q) t 0
MR MC t 0
MR MC t -------------------------------- (1)
From equation (1) we can determine the critical value of the profit function and let’s
say Q Q .
Second order condition for maximum profit is
(Q, t ) R(Q) C (Q) 0
Given the optimal output Q Q (t ) , the maximal profit is
(Q (t )) R(Q (t )) C (Q (t )) tQ (t )
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
d dQ dQ dQ
R(Q (t ). C (Q (t )). Q t
dt dt dt dt
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dQ dQ
= [ R (Q (t )) C (Q (t ))] Q t
dt dt
However, R(Q (t )) C (Q (t )) t
d dQ dQ
Therefore, [C (Q (t )) t C (Q (t ))] Q t
dt dt dt
dQ dQ
=t Q t
dt dt
d
Q
dt
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.
1.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 (24 3x) x ( x 2 8x 4 x)
24 x 3x 2 x 2 12 x
4 x 2 12 x
Determining the critical value applying the first order condition
8x 12 0
8x 12
x 1.5units
Second order condition is
8 0
Therefore, x x 1.5 is the optimal amount of output.
Then (t ) 4 x 2 16 x 1.5t 4(1.5) 2 16(1.5) 1.5t
= 9 24 1.5t 15 1.5t
d
1.5 x
dt
Exercise
1. A firm has the demand function P = 100 - 0.01Q and the cost function TC = 50Q
+ 30,000 and a tax of 10 Birr per unit is imposed.
a. What will be the profit maximizing price and quantity before and after tax.
b. Determine the rate of change of total profit ( ) with respect to the tax
rate (t)
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Chapter Four: Constrained Optimization
In the previous chapter we have studied the optimization of functions without the
existence of constraints. In business and economics studies, however, there are many
situations in which complete freedom of action is impossible. For example, a firm can
maximize output subject to the constraint of a given budget for expenditures on inputs, or
it may need to minimize cost subject to a certain minimum output being produced. Such
functions which involve constraints are called constrained functions and the process of
optimization is referred as constrained optimization. This chapter explains the ways of
solving constrained optimization problems with equality and inequality constraints.
4.1 One Variable Constrained Optimization with Non - Negative
Constraint
i) With equality constraint
Maximize y = f(x), subject to x x . In this case y f (x )
It simply involves determining the value of the objective function at the given point in
the domain.
ii) With non - negativity constraints
Maximize the function y f (x) subject to x 0
(a)
At x 0, f ( x) 0
For the above function the unconstrained maximum attained when x < 0 at point b as
shown in the above figure where as the function attains its constrained optimum at point a
where x 0 . y f (0)
(b)
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In this case the constrained and unconstrained maximum value of the function lie at the
same point, i.e., they coincide at point a as shown above. y f (x) . At x 0, f ( x) 0
(c)
In this case, similar to that of b, the constrained and unconstrained maximum value of the
function reside on the same point,
y f (0)
f ( x) 0
Please try to minimize y f (x) , subject to x 0 in a similar way.
Given the function y f (x) subject to the x 0
For maximization,
f ( x) 0 if f ( x) 0, x 0
if f ( x) 0, x 0
For minimization
f ( x) 0 if f ( x) 0, x 0
if f ( x) 0, x 0
Example
Maximize the objective function y = - 3x2 - 7 x + 2 subject to x 0.
First order condition for maximization
f ( x) 6 x 7 = 0
6x= - 7
7
x
6
Second order condition for maximization
f ( x) 6 0
7
Thus, the unconstrained maximum value of the function locates at x
, i.e., x < 0
6
but the constrained maximum lies at x 0, f (0) 7 0 . Thus the constrained
maximum is the function is y 2 .
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2. Minimize y = x2 + 2x+ 5, subject to x 0
First order condition
f ( x) 2 x 2 0
x 1 0
Second order condition
f ( x) 2 0
Thus the function actives it’s unconstrained minimum at x = -1, i.e., y = 4. However,
at x 0, f ( x) 2 0 . Therefore, the minimum value of the constrained function
is y f (0) 5 .
Exercise
Solve the following questions based on the information in the above section.
1. Maximize y = -x 2 + 5x + 6, subject to x 2 ,
2. Maximize y = - 2 x2 + 3 x + 4, subject to x 0
3. Find the maximum value of the function y = -3x 2 + x + 7, subject to x 0
4. Minimize the function y = x2 + 3 x + 4, subject to x 0 5. Find the minimum value of
the function y = 2x2 + x + 7 , subject to x 0
4.2 Two Variable Problems with Equality Constraints
This section is emphasized on the two methods of constrained optimization. These are.
Constrained optimization by substitution
Lagrange multiplier method
A. Constrained Optimization by Substitution
This method is mainly applicable for problems where the objective function with only
two variables is maximized or minimized subject to one constraint.
Consider a firm that wants to maximize output given the production function
Q f ( K , L) and suppose PK and PL prices of K and L respectively and a fixed budget B.
Then, we can determine the amount of K and L that optimize the output Q using the
method of substitution.
Example
1. A firm faces the production function Q= 12K0.4 L0.4 and assume it can purchase K and
L at price per unit of 40 birr and 5 Birr respectively and it has a budget of 800 Birr.
Determine the amount of K and L which maximizes output.
Solution
The problem is Maximize Q= 12K0.4 L0.4
Subject to 40K+5L = 800
According to the theory of production, the optimization condition is written in such away
that the ratio of marginal product of every input to its price must be the same. That is
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MPK MPL
PK PL
The marginal products can be obtained using the method of partial differentiation as
follows.
MPK 4.8K 0.6 L0.4 -------------------------------- (1)
MPL 4.8K 0.4 L0.6 --------------------------------- (2)
Substituting these marginal products and the given prices in the constraint function gives
us
4.8K 0.6 L0.4 4.8K 0.4 L0.6
40 5
K 0.6 L0.4 8K 0.4 L0.6
Multiplying both sides by K 0.6 L0.6 results in
L = 8K------------------------------------------------------ (3)
Substituting (3) in the budget constraint we get
40K + 5(8K) =800
40K+ 40K = 800
80k =800
K=10
Thus, L= 8(10) =80
Therefore, this firm should employ 10 units of capital and 80 units of labor in the
production process to optimize its output.
2. Suppose the utility function of the consumer is given by U 4 xy y 2 and the budget
constraint is 2x+y = 6. Determine the amount of x and y which will optimize total utility
of the consumer.
Solution
MU X MU y
Utility is maximized when
Px Py
In our example, MU X 4 y & MU Y 4 x 2 y .Therefore, at the point of equilibrium
4 y 4x 2 y
2 1
4 y 8x 4 y
4 y 4 y 8x
8 y 8x
x y ---------------------------------------- (4)
Substituting (4) above in the budget constraint gives us
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2x x 6
3x 6
x2 y
Therefore, this consumer can optimize his utility when it consumes 2 units of good x and
2 units of good y.
B. Lagrange Multiplier Method
What is Lagrange Multiplier Method? What are the steps to use this method? How do
you interpret the Lagrange multiplier?
The essence of this method is to change a constrained optimization problem in to a form
such that the first order condition of the unconstrained optimization problem can still be
applicable. This method can be used for most type of constrained optimization problems.
Given the function Z f ( x, y) subject to g ( x, y) PX x PY y M , to determine the
amount of x and y which maximize the objective function using the Lagrange
Multiplier Method, we should involve the following steps.
Step 1 Rewrite the constraint function in its implicit form as
M xPx yPy 0
Step 2 Multiply the constraint function by the Lagrange multiplier
(M xPx yPy )
Step 3 Add the above constraint to the objective function and thereby formulate the
Lagrange function that is a modified form of the objective function which includes the
constraints as follows:
L( x, y, ) Z ( x, y) (M xPx yPy ) ------------------- (5)
Necessary condition, i.e. the first orders condition for maximization is that the first order
partial derivatives of the Lagrange function should be equal to zero.
Differentiating L with respect to x , y and and equating it with zero gives us.
L Z
Px 0 --------------------------- (6)
x x
L Z
Py 0 ----------------------------- (7)
y y
L
M xPx yPy 0 ------------------------- (8)
From equation (6) and (7) we get
Z Zy
= x and =
Px Py
Zx Zy Z x Px
This means, or
Px Py Z y Py
Sufficient condition -To get the second order condition, we should partially differentiate
equations (6), (7) and (8). Representing the second direct partial derivatives by Z xx and
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Z yy , and the second cross partial derivatives by Z xy and Z yx , the border Hessian
determinant bordered with 0, g x and g y is
0 gx gy 0 Px Py
H gx Lxx Lxy Px Z xx Z xy o
gy L yx L yy Py Z yx Z yy
d 2 Z is referred to as positive definite subject to dg = 0 iff H <0,
d 2 Z is referred to as negative definite subject to dg = 0 iff H > 0 .
2
Negative definiteness of d Z implies that the function achieves its relative maximum
point where as a positive definite is a sufficient condition to satisfy the relative minimum
of the objective function.
i) Maximization
Example
Given the utility function of the consumer who consumes two goods x and y as
U (x, y) = (x+ 2) (y+1)
If the price of good x is Px 4 birr, that of good y is Py 6 Birr and the consumer has a
fixed budget of 130 birr. Determine the optimum values of x and y using the Lagrange
multiplier method,
Solution
Maximize U (x, y) = x y + x+ 2y + 2
Subject to 4x + 6y = 130
Now we should formulate the Lagrange function to solve this problem. That is
L( x, y, ) = x y + x+ 2y + 2 + (130 - 4x - 6y) --------------------------------- (9)
L L L
Necessary conditions for utility maximization are 0, 0, 0
x y
L
( y 1) 4 = 0
x
y = -1 + 4 ------------------------------------- (10)
L
( x 2) 6 0
y
x 2 6 ---------------------------------- (11)
L
4 x 6 y 130 0
4x+6y= 130----------------------------------- (12)
Substituting the value of x and y explained in equation (10) and (11) in to (12) enables us
to determine
4 (-2+ 6 ) + 6 (-1 +4 ) = 130
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- 8 + 24 - 6 + 24 = 130
48 = 144
=3
Therefore, x = -2+6(3)
x = -2 + 18 = 16
y = -1 + 4 (3)
y = 11
Second order sufficient condition for utility maximization is
0 gx gy
H gx Lxx Lxy
gy L yx L yy
The second partial derivatives of the objective function and the first partial derivatives of
the constraint function are
2L
L xx = = 0, L yy = 0, L xy = L yx = 1
x 2
g g
gx = 4, and g y 6
x y
Therefore, the bordered Hessian determinant of this function is
0 4 6
H 4 0 1 = - 4(0-6) + 6 (4- 0) = 48 > 0
6 1 0
The second order condition, i.e., H > 0 which is negative definite, is satisfied for
maximization. Thus, the consumer maximizes utility when he consumes 11 units of good
y and 16 units of good x. The maximum utility is U = (16+2) (11+1) = (18) (12) = 216
units which is similar to the value of the Lagrange function at these values of x, y and .
The value of the Lagrange multiplier is 3. It indicates that a one unites increase
(decrease) in the budget of the consumer increases (decreases) his total utility by 3 units.
2. Suppose the monopolist sells two products x and y and their respective demand is
P x = 100 - 2 x and P y = 80 - y
The total cost function is given as TC = 20x + 20y, when the maximum joint product of
the two outputs 60 unit. Determine the profit maximizing level of each output and their
respective price.
Solution
As it is known profit ( ) = TR - TC, where TR represents total revenue and TC
represents total cost.
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TR= x P x + y P y = (100x - 2x2) + (80y - y2)
Thus = 100x - 2x2 + 80 y - y2 - 20x - 20 y
= 80 x + 60 y – 2x2- y2
But this monopolist can maximize its profit subject to the production quota. Thus,
Maximize = 80x + 60 y- 2x2- y 2
Subject to x+ y = 60
To solve this problem, we should formulate the Lagrange function,
L (x, y, ) = 80x + 60y - 2x2 - y 2 + (x+ y - 60) --------------- (13)
First order conditions for maximum profit are
L x = 80 - 4x + = 0
- 4x = - 80 -
1
= 20 + ------------------------------------------------ ------- (14)
4
L y = 60 - 2y + = 0
- 2y = - 60 -
1
y = 30 + ----------------------------------------------------------- (15)
2
L = x + y -60 = 0
x + y = 60------------------------------------------------------------ (16)
Substituting equation (14) and (15) in equation (16), we get
1 1
20 + + 30 + = 60
4 2
3
50 + = 60
4
3
= 10
4
40
3
1 40 1 (40)
Thus, x = 20 + ( ) y = 30 +
4 3 2 3
= 20+ 3.33 = 30+6.67
x = 23.33 y = 36.67
Second order condition for maximum profit is
L XX 4, LYY 2, L XY LYX 0
g X 1 & gY 1
Therefore, the bordered Hessian determinant of the given function is
0 1 1
H 1 4 0 = 1(2 0) 1(0 4) 6 0
1 0 2
The second order condition is satisfied for maximization of functions.
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Px 100 2(23.33) Py 80 36.67
Px 53.34 Py 43.33
Therefore, the monopolist maximizes its profit when it sells 23.33 of good x at a price of
53.34 birr per unit and 36.67 units of good y at a price of 43.33 birr per unit.
40
= shows that a one unit increase in total expenditure on inputs increases total profit
3
40
of the monopolist by units. In other words, if the constant of the constraint relaxes by
3
one unit that is x y 61 , then the value of the objective function increases by the value
the Lagrange multiplier.
ii) Minimization
The firm can determine the least cost combination of inputs for the production of a
certain level of output Q. Given the production function Q= f (L, K) and the cost function
of the firm is C = LPL + KP k Where L = labor, K = capital, Q = output. Suppose the price
of both input to be exogenous, we can formulate the problem of minimizing the cost as
Minimizes C = PL L + P k k
Subject to Q = f (L, K)
To determine the amount of labor and capital that should be employed initially we should
formulate the Lagrange function. It is
L LPL KPK (Q f ( L, K ) --------------------------- ---- (17)
First order conditions for a minimum cost are
LL PL QL 0
P P
L L ---------------------------------------------- (18)
QL MPL
LK PK Qk 0
PK P
K ------------------------------------------- (19)
QK MPK
L Q f ( K , L) 0 --------------------------------------------- (20)
Where QL and Qk represents marginal product of labor and capital respectively.
From equation (17) and (18), we get
P P
L K -------------------------------------------------- (21)
MPL MPK
Equation (21) indicates that, at the point of optimal input combination the input - price
ratio and the marginal product ratio have to be the same for each input. This ratio shows
the amount of expenditure per unit of the marginal product of the input under
consideration. Thus, the interpretation the Lagrange multiplier is the marginal cost of
product at the optimal condition. In other words, it indicates the effect of change in
output on the total costs of production, i.e., it measures the comparative static - effect of
the constraint constant on the optimal value of the objective function.
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The first order condition indicated in equation (21) can be analyzed in terms of isoquants
and isocosts as
P MPL
= L = --------------------------------------------- (22)
Pk MPk
MPL
The represents the negative of the slope of the isoquant, which measures the
MPK
marginal rate of technical substitution of labor to capital (MRTS Lk ).
PL
The ratio shows the negative of the slope of the isocost. An isocost is a line which
PK
indicates the locus of input combinations which entail the same total cost. It is shown by
the equation
C PL
C= PL L + P k K or K = - L
PL Pk
PL MPL
= indicates the fact that the isocost and isoquant lines are tangent to each other
Pk MPk
at the point of optimal input combination.
Second order condition for minimization of cost.
A negative bordered Hessian determinant is sufficient to say the cost is at its minimum
value. That is
0 QL QK
H QL LLL LLK 0
QK LKL LKK
Example
Suppose a firm produces an output Q using labor L and capital K with production
function Q 10K 0.5 L0.5 . If the output is restricted to 200 units, the price of labor is 10
birr per unit and Price of capital is 40Birr per unit. Determine the amount of L and K that
should be employed at minimum cost. Find the minimum cost.
The problem is Minimize C = 10 L + 40K
Subject to 200 10K 0.5 L0.5
Formulating the Lagrange function
L( L, K , ) 10L 40K (200 10K 0.5 L0.5 ) ---------------------- (23)
First order conditions
LL 10 5K 0.5 L0.5 0
2 L0.5
0.5 ----------------------------------------------------------- (24)
K
LK 40 5K 0.5 L0.5 0
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8K 0.5
---------------------------------------------------------- (25)
L0.5
L 200 10K 0.5 L0.5 0
10K 0.5 L0.5 200 --------------------------------------------------- (26)
From equation (24) and (25), we get
2 L0.5 8 K 0.5
=
K 0.5 L0.5
2L = 8K
L= 4K ------------------------------------------------------- (27)
Substituting equation (27) in to (26) gives us
K 0.5 (4K ) 0.5 20 ---------------------------------------------- (28)
2K = 20
K = 10 and L = 4(10) = 40, = 4
Second order condition
Now we should check the second order condition to verify that cost of production is least
at K = 10 and L = 40.
For cost minimization the determinant of the bordered Hessian matrix must be less than
zero.
0 QL QK
H QL LLL LLK 0
QK LKL LKK
At L = 40 and K = 10
QL = Q
K 10
= (5) (5) 2.5
L L 40
Q k = Q = (5)
L 40
(5) 10
k K 10
LLL = 2.5 K 0.5 L1.5 = 2.5(4)(10) 0.5 (40) 1.5
= 0.125
L kk = 2.5 K 1.5 L0.5 = 2.5(4)(10) 1.5 (40) 0.5
=2
LKL LLK 2.5K 0.5 L0.5 2.5(4)(10) 0.5 (40) 0.5
0.5
Therefore, the determinant of the bordered Hessian matrix is
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0 2.5 10
H 2.5 0.125 0.5
10 0.5 2
= - 2.5 (5+5) +10(-1.25 -1.25)
= - 2.5 (10) + 10 (-2.5)
H 50 0
Thus, the firm can minimize its cost when it employs 10 units of capital and 40 units of
labor in the production process and the minimum cost is
C = 10 (40) + 40 (10)
Min. C = 400 + 400 = 800 birr
In this problem K, L and are endogenous. The Lagrange multiplier measures the
responsiveness of the objective function to a change in the constant of the constraint
function.
What happens to the value of the Lagrange function and the constrained function when
total output increases from 200 to 201? What about the amount of L and K? Compare the
value of the constrained function and that of the Lagrange function at this point. Interpret
the value of .
Optimization of n - variable case
Given the objective function
Optimize Z f ( x1 , x2 , x3 ...., xn )
Subject to g ( x1 , x2 , x3 ,...., xn ) c
Similar to our earlier discussion we ought to first formulate the Lagrange function. That
is
L f ( x1 , x2 , x3 ...., xn ) (c g ( x1 , x2 , x3 ,..., xn ))
The necessary condition for optimization of this function is that
L L1 L2 L3 L4 Ln = 0
The second order condition for optimization of this function depends on the sign of d 2L
subject to dg g1dx1 g 2 dx2 g 3 dx3 ..... g n dxn 0 similar to our earlier discussion.
The positive or negative definiteness of d 2 L involves the Bordered Hessian Determinate
test. However, in this case the conditions have to be expressed in terms of the bordered
principal minor of the Hessian. Given the bordered Hessian as
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0 g1 g2 g3 . . gn
g1 L11 L12 L13 . . L1n
g2 L21 L22 L23 . . L2 n
H g3 L31 L32 L33 . . L3n
. . . . . . .
. . . . . . .
gn Ln1 Ln 2 Ln 3 . . Lnn
The successive bordered principal minors are
0 g1 g2 g3
0 g1 g2
g1 L11 L12 L13
H 2 g1 L11 L12 , H3 etc
g2 L21 L22 L23
g2 L21 L22
g3 L31 L32 L33
However, H H n .
H 2 Shows the second principal minor of the Hessian bordered with 0, g 1 and g 2 .
d 2 L is positive definite subject to dg 0 if and only if H 2 , H 3 ,-----, H n 0 .
d 2 L is negative definite subject to dg 0 if and only if H 2 0, H 3 0, H 4 0 ,---.
A positive definite d 2 L is a sufficient condition for minimum value and negative definite
d 2 L is sufficient condition for maximization of the objective function.
In our analysis above H 2 is the one which contains L22 as the last element of its
principal diagonal. H 3 is the one which includes L33 as the last element of its principal
diagonal etc.
Optimization when there is more than one equality constraint
Let us consider the optimization problem involves three variables and two constraints.
Optimize Z f ( x1 , x2 , x3 )
Subject to g 1 ( x1 , x2 , x3 ) c1
g 2 ( x1 , x2 , x3 ) c 2
As usual we should construct the Lagrange function by using the Lagrange
multiplier .Since we have two constraint functions, we are required to incorporate two
s, i.e., 1and2 in our analysis.
The Lagrange function is
L f ( x1 , x2 , x3 ) 1 (c1 g 1 ( x1 , x2 , x3 )) 2 (c 2 g 2 ( x1 , x2 , x3 ))
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First order conditions for optimization
L1 f1 1 g11 2 g12 0
L2 f 2 1 g 12 2 g 22 0
L3 f 3 1 g 31 2 g 32 0
L1 c1 g 1 ( x1 , x2 , x3 ) 0
L 2 c 2 g 2 ( x1 , x2 , x3 ) 0
When there are n - variables and m - constraints, the Lagrange function becomes
m
L f ( x1 , x2 , x3 ,....., xn ) j [c j g i ( x1 , x2 , x3 ,..., xn )]
j 1
In this case we will have m+ n variables in the Lagrange function and we will have also
m+ n simultaneous equations.
First order conditions are
Li f i j g ij , (i = 1, 2, 3, ---, n) and (j= 1, 2, 3, --- m)
Li c j g i ( x1 , x2 , x3 ,..., xn ) 0
Second order conditions for optimization of three variables and two constraints problem
are
0 0 g11 g 12 g 31
0 0 g12 g 22 g 32
H g11 g12 L11 L12 L13
1 2
g 2 g 2 L21 L22 L23
1 2
g 3 g 3 L31 L32 L33
In this case, H 3 = H . Thus for a maximum value,
H 2 > 0, H 3 < 0.
For a minimum,
H 2 < 0, H 3 < 0.
With the existence of n - variables and m - constraints, the second order condition is
explained as
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0 0 0 . . 0 g11 g 12 g 31 . . g 1n
0 0 0 . . 0 g12 g 22 g 32 . . g n2
0 0 0 . . 0 g13 g 23 g 33 . . g n3
. . . . . . . . . . . .
. . . . . . . . . . . .
0 0 0 . . 0 g m
1 g m
2 g m
3 . . g nm
H . .
g11 g 12 g 31 . . g 1n L11 L12 L13 . . L1n
g 2
1 g 2
2 g 2
3 . . g 2
n L21 L22 L23 . . L2 n
g 3
1 g 3
2 g 3
3 . . g 3
n L31 L32 L33 . . L3n
. . . . . . . . . . . .
. . . . . . . . . . . .
g m
1 g m
2 g m
3 . . g m
n Ln1 Ln 2 Ln 3 . . Lnn
Now we have divided the Bordered Hessian Determinant in to four parts. The upper left
area includes zeros only and the lower right area is simply a plain Hessian. The
remaining two areas include the g ij derivatives. These derivatives have a mirror image
relationship to each other considering the principal diagonal of the Bordered Hessian as
a reference.
We can create several bordered principal minors from H . It is possible to check the
second order sufficient condition for optimization using the sing of the following
bordered principal minors:
H m1 , H m 2 ,----------, H n
The objective function can sufficiently achieve its maximum value when the successive
bordered principal minors alternate in sign. However, the sign of H m1 is (-1) m+1 where
as for minimum value the sufficient condition is that all bordered principal minors have
the same sign, i.e., (-1) m. This indicates that if we have an odd number of constraints,
then sign of all bordered principal minors will be negative and positive with even number
of constraints.
Exercise
1. Suppose a firm faces the production function Q = 120 L + 200K - L2 - 2K 2 for
positive values of Q. If it can buy L at 5 birr per unit, K at 8 birr per unit and has a
budget of 70 Birr, determine the maximum output that it can produce using
substitution method.
2. Suppose the prices of inputs K and L are 12 birr and 3 birr per unit respectively
and the production function of the firm is Q= 25K0.5 L 0.5 . Determine the
minimum costs of producing 1,250 units of output using Lagrange multiplier
method
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3. 6. Suppose a consumer has a utility function of U = 40x 0.5 y0.5. If the price of x is
20 birr per unit, price of y is 5 birr unit and the consumer has a budget of 600 birr.
Determine the amount of x and y which maximize utility using the Lagrange
multiplier method.
4.3 Inequality Constraints and Kuhn-Tucker Theorems, and Mixed
Constraints
Nonlinear Programming
The problem of optimization of an objective function subject to certain restrictions or
constraints is a usual phenomenon in economics. Mostly, the method of maximizing or
minimizing a function includes equality constraints. For instance, utility may be
maximized subject to a fixed income that the consumer has and the budget constraint is
given in the form of equation. Such type of optimization is referred to as classical
optimization. But objective function subject to inequality constraints can be optimized
using the method of mathematical programming. If the objective function as well as the
inequality constraints is linear, we will use a method of linear programming. However, if
the objective function and the inequality constraints are nonlinear, we will apply the
technique of nonlinear programming to optimize the function.
Maximization problem
Maximize = f ( x1 , x2 , x3 ,....., xn )
Subject to g 1 ( x1 , x2 , x3 ,..., xn ) k1
g 2 ( x1 , x2 , x3 ,..., xn ) k 2
g 3 ( x1 , x2 , x3 ,..., xn ) k3
: : :
g ( x1 , x2 , x3 ,..., xn ) k m
m
and xj 0 , ( j 1,2,3....., n)
Minimization Problem
It can be expressed in the form of
Minimize C = f ( x1 , x2 , x3 ,....., xn ) )
Subject to g 1 ( x1 , x2 , x3 ,..., xn ) k1
g 2 ( x1 , x2 , x3 ,..., xn ) k 2
g 3 ( x1 , x2 , x3 ,..., xn ) k 3
: : : :
g ( x1 , x2 , x3 ,..., xn ) k m , x j 0
m
( j 1,2,3....., n)
Where C- represents total cost which is the objective function.
x j - is the amount of output produced
k i - is the constant of the constraint function
-
gi is the constraint function.
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We have observed from the above expression that the nonlinear programming also
includes three ingredients. These are
the objective function
a set of constraints ( inequality )
non - negativity restrictions on the choice variable
The objective function as well as the inequality constraints is assumed to be differentiable
with respect to each of the choice variables. Like linear programming we apply the
constraints for maximization and minimization problem involves only constraints.
Example1
1. Find the values of x and y of the following function graphically.
a) Minimize C x 2 y 2
Subject to x y 25
x, y 0
First we should convert the inequality constraint in to equality as xy 25 and draw the
graph of this constraint function on the xy plane.
x 1 2 3 4 5 6 7 ...............................25
y 25 12.5 8.3 8.3 5 4.6 3.57 ..........................1
Fig. (a)
The shaded region in the above figure represents the feasible region. Let us evaluate the
objective function C at points A, B, C, D and E on the graph.
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At point a (1, 25), C=12+ 252 = 1+ 625 = 626
At point B (4, 6.3), C = 42 + (6.3) 2 - 16+ 39.69 = 55.69
At point c (5, 5), C = 52 + 52 = 25 + 25 = 50
At point d (6, 4.6) C = 62 + (4.6) 2 = 36 + 21.16 = 57.16
At point E (25, 1) , C = ( 25) 2 + 12 = 625 + 1 = 626
Therefore, the value of x and y which minimizes the objective function are 5 and 5
respectively. The minimum value is C = 50.
b) Maximize = x2 + (y - 2) 2
Subject to 5x + 3y 15
And x, y 0
Solution
Similar to that of problem a, we should convert the inequality constraint in to equality
constraint and draw its graph in the x y plane. It is 5x + 3y = 15
X 0 1 2 3
Y 5 3.3 1.67 0
Fig.(b)
The shaded region of the above figure represents the feasible region as every point in this
feasible region satisfies the inequality constraint 5 x + 3y 15.
Evaluating the objective function at points A, B, C and D of the above graph (fig. b),
At point A (0, 5), = 02 + (5 - 2)2 = 0 + 9 = 9
At point B (1, 3.3), = 12+ (3.3 - 2) 2 = 1+1.69 = 2.69
At point C (2, 1.67), = 22 + (1.67 - 2)2 = 4 + 0.1089 = 4.1089
At Point D (3, 0), = 32 + 9 (0 - 2)2 = 9+4 = 13
Therefore, the objective function is maximized when x = 3 and
y = 0. The maximum profit is = 13
In general, we can distinguish the nonlinear programming from that of linear one based
on the following points.
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In nonlinear programming the field of choice not necessarily locates at its extreme
points.
The number of constraints may not be the same with the choice variables.
Following the same direction in a movement may not lead to a continually
increasing or (decreasing) value of the objective function.
The feasible region may not be a convex set.
A local optimum may not be a global optimum.
Kuhn - Tucker Conditions
In the previous section of this chapter, we have discussed about optimization problems of
the objective function with equality constraints and without explicitly restricting the sing
of the choice variables. In this case, the first order condition is satisfied provided that the
first order partial derivative of the Lagrange function with respect of each choice variable
and with respect to the Lagrange multiplier is zero. For instance, in the problem
Maximize = f ( x, y)
Subject to g ( x, y) k
The Lagrange function is
L f ( x, y) (k g ( x, y))
The first order condition states that
Lx L y L 0
In non-linear programming, there is a similar first order condition which is referred to
as Kuhn-Tucker conditions. As we discussed previously, in classical optimization
process, the first order condition is a necessary condition. However, a certain condition
should be fulfilled for the Kuhn - Tucker conditions to be necessary conditions.
Now let us discuss Kuhn-Tucker conditions in two steps for the purpose of making the
explanation easy to understand.
Step 1
In the first step, let us take a problem of optimizing the objective function with non
negativity restrictions and with no other constraints. In economics, the most common
inequality constraint is non negativity constraint.
Maximize = f(x)
Subject to x 0
provided that the function is supposed to be continuous and smooth. Based on the
restriction x 0, we may have three possible results. As shown in the following figures.
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When the local maximum resides in side the shaded feasible region as shown above at
point B of diagram (i), then we have an interior solution. In this case, the first order
d
condition is similar to that of the classical optimization process, i.e. 0.
dx
Diagram (ii) shows that the local maximum is located on the vertical axis indicated by
point C. At this point, the choice variable is 0 and the first order derivative is zero, i.e.
d
= 0, at point C we have a boundary solution.
dx
Diagram (iii) indicates that the local maximum may locate at point D or point E with in
the feasible region. In this case, the maximum point is characterized by the inequality
d
< 0 because the curves are at their decreasing portion at these points.
dx
From the above discussion it is clear that the following three conditions have to be met so
as to determine the value of the choice variable which gives the local maximum of the
objective function.
f ( x) 0 , and x > 0 (point B)
f ( x) 0 , and x = 0 (point C)
f ( x) 0 , and x = 0 (point D and E)
Combining these three condition in to one statement given us
f ( x) 0 x 0 and xf ( x) 0
d
The first inequality indicates the information concerning . The second inequality
dx
shows the non negativity restriction of the problem. The third part indicates the product
of the two quantities x and f (x) . The above statement which is a combination of the
three conditions represents the first order necessary condition for the objective function
to achieve its local maximum provided that the choice variable has to be non negative.
If the problem involves n - choice variables like
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Maximize f ( x1 , x2 , x3 ,...xn )
Subject to xi 0
The first order condition in classical optimization process is
f 1 = f 2 = f 3 = -------= f n = 0
The first order condition that should be satisfied to determine the value of the choice
variable which maximizes the objective function is
fi 0 xi 0 and xi f i = 0 (i =1, 2, 3, -------, n)
Where f i is the partial derivative of the objective function with respect to xi , i.e.,
fi .
xi
Step 2
Now we continue to the second step. To do this, let us attempt to incorporate inequality
constraints in the problem. In order to simplify our analysis, let us first discuss about
maximization problem with three choice variables and two constraints as shown below.
Maximize = f ( x1 , x2 , x3 )
Subject to g 1 ( x1 , x2 , x3 ) k1
g 2 ( x1 , x2 , x3 ) k2
And x1, x2, x3 0
Using the dummy variables s1 and s2 we can change the above problem in to
Maximize = f ( x1 , x2 , x3 )
Subject to g 1 ( x1 , x2 , x3 ) s1 k1
g 2 ( x1 , x2 , x3 ) s2 k 2
x1 , x2 , x3 0 & s1 , s2 0
We can formulate the Lagrange function using the classical method provided that the non
negativity constraints of the choice variables are not existed as
L f ( x1 , x2 , x3 ) 1[k1 g 1 ( x1 , x2 , x3 ) s1 ] 2 [k 2 g 2 ( x1 , x2 , x3 ) s2 ]
It is possible to derive the Kuhn- Tucker conditions directly from the Lagrange function.
Considering the above 3-variable 2-constraints problem
The first order condition is
L L L L L L L
= = = = = = =0
x1 x 2 x3 s1 s 2 2 1
However, x j and s i variable are restricted to be non negative. As a result, the first order
conditions on these variables ought to be modified as follows.
L L
0 xj 0 and x j =0
x j x j
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L
0 si 0 and s i L = 0
s i s i
L = 0 Where (i = 1, 2 and j= 1, 2, 3)
i
However, we can combine the last two lines and thereby avoid the dummy variables in
L
the above first order condition as shown below. As i , the second line shows that
si
i 0, , si 0 and – s i i = 0
or
i 0, si 0 and s i i =0
But, we know that si k i g i ( x1 , x2 , x3 ) . By substituting it in place of s i , we can get
k i g i ( x1 , x2 , x3 ) 0 , i 0 and i [ k i g i ( x1 , x2 , x3 ) ] =0
Therefore, the first order condition without dummy variables in expressed as
L L
0 xj 0 and x j =0
x j x j
L
= k i g i ( x1 , x2 , x3 ) 0 i 0 and i [ k i g i ( x1 , x2 , x3 ) ] =0
i
These are the Kuhn - tucker conditions for the given maximization problem.
How can we solve minimization problem?
One of the methods to solve this problem is changing it in to maximization problem and
then applies the same procedure with maximization. Minimizing C is similar to
maximizing ( C ). However, keep in mined the fact that we have to multiply each
constraint inequalities by ( 1 ). We can directly apply the Lagrange multiplier method
and determine the minimization version of Kuhn - Tucker condition instead of
converting the inequality constraints into equality constraints using dummy variables as
L L
0 x j 0 and x j =0
x j x j
L L
0 i 0 and i = 0 (minimization)
i i
Example
2. Let us check whether the solutions of our example 1 satisfy the Kuhn - Tucker
conditions or not
a) Minimize C= x2+ y2
Subject to x y 25
x, y 0
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The Lagrange function for this problem is
L x 2 y 2 (25 xy )
It is a minimization problem. Therefore, the appropriate conditions are
L L
2 x y 0 , x 0 and x =0
x x
L L
2 y x 0 , y 0 and y =0
y y
L L
25 xy 0 , 0 and 0
Can we determine the non negative value which will satisfy all the above conditions
together with the optimal solution x and y? The optimal solutions in our earlier discussion
L
are x=5 and y=5, which are nonzero. Thus, the complementary slackness ( x = 0,
x
L L L
y = 0) shows that 0 and = 0.
y x y
Thus, we can determine the value of by substituting the optimal values of the choice
variables in either of these marginal conditions as
L
= 2x - y = 0
x
2(5) - (5) = 0
10 - 5 = 0
=2>0
L L L
This value = 2, x = 5 & y = 5 imply that = 0, = 0, = 0 which fulfils the
x y
marginal conditions and the complementary slackness conditions. In other words, all the
Kuhn - Tucker conditions are satisfied.
3. Maximize Z 10 x x 2 180 y y 2
x y 80
Subject to
x, y 0
Solution
First we should formulate the Lagrange function assuming the equality constraint and
ignoring the non negativity constraints.
L 10 x x 2 180 y y 2 (80 x y)
The first order conditions are
L
10 2 x 0 10 2 x (1)
x
L
180 2 y 0 180 2 y (2)
y
L
80 x y 0 x y 80 (3)
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Taking equation (1) and (2) simultaneously
10 2 x 180 2 y
2 y 2 x 170
2 y 170 2 x
y 85 x (4)
If we substitute equation (4) in to (3), we get
x 85 x 80
2 x 5 x 2.5
However, the value of the choice variables is restricted to be non negative.
Thus x 2.5 is infeasible. We must set x= 0 since it has to be non negative. Now we
can determine the value of y by substituting zero in place of x in equation (3).
0 y 80
y 80
Therefore, 180 2(80) 20
The possible solutions are x 0, y 80, 20
However, we must check the inequality constraints and the complementary slackness
conditions to decide whether these values are solutions or not.
1) Inequality constraints
i) The non negativity restrictions are satisfied since x 0, y 80, 20 0
ii) Inequality constraints
x y 80
0 80 80
2) Complementary Slackness conditions
L L
i) x 0, x 0 0 as the problem is maximization.
x x
L
10 0
x
L L
ii) y 0, y 80 0 0
y y
L
180 2(80) 20 0
y
L L
0, 20 0 0
iii)
L
80 0 80 0
All the Kuhn Tucker conditions are satisfied. Thus, the objective function is maximized
when x 0, y 80, 20 .
Economic Application
Example
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4. Given the revenue and cost conditions of a firm as R 32 x x 2 and C x 2 8x 4 ,
where x is output. Suppose the minimum profit is 0 18 . Determine the amount of the
output which maximizes revenue with the given minimum profit. In this case, the revenue
function is concave and the cost function is convex.
The Problem is
Maximize R 32 x x 2
Subject to x 2 8x 4 32 x x 2 18
And x 0
Under these situations the Kuhn-Tucker conditions are necessary and sufficient
conditions as all of the above three conditions, i.e., (1), (2), 4(3), are satisfied.
The Lagrange function of this problem is
L 32 x x 2 (22 2 x 2 24 x) (1)
Thus,
L
32 2 x 4x 24 0 (2)
x
L
22 2 x 2 24 x 0 (3)
22 2 x 2 24 x 0
From equation (3)
2 x 2 24 x 22 0 (4)
3 1
Solving (4) we get, x 1 or x 11. 0r
2 2
However, we must check the inequality constraints and the complementary slackness
conditions to decide whether these values are the solutions or not
L L
0, x0 and x 0, -----------------------------(5)
x x
L L
0, 0 and 0, -----------------------------(6)
At X=1
L L 3
At this point x 0 this implies that 0 . Thus, 30 20 0 . It does
x x 2
not satisfy equation (6).
L L 1
At X=11, x 0 this implies that 0, Thus 10 20 0 . It satisfies
x x 2
both equation (5) and (6). This means, the Kuhn-Tucker conditions are fulfilled
at x 11. Therefore, revenue is maximized when the firm sells x 11 units of output.
Mixed Constraints
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An optimization problem with mixed constraints can be reformulated either as
maximization or minimization problem. This procedure incorporates the following
conditions.
i) Maximizing the objective function Z (x) is equivalent to the problem of Minimizing
Z (x) or vice versa-
ii) The constraint g ( x) c can be presented as g ( x) c .
iii) The constraint g ( x) c is equivalent to the double constraint g ( x) c
iv) The non negativity constraint x 0 can be denoted by a new constraint g ( x) x 0 .
Exercise
Solve the following questions based on the information given above.
1. Describe non linear programming
2. Explain the difference between linear programming and nonlinear programming
3. What are the ingredients of non linear programming problems?
4. Write the Kuhn - Tucker condition of the problem
Maximize U U ( x1 , x2 , x3 ,...., xn )
Subject to p1 x1 p2 x2 p3 x3 ..... pn x B
x1 , x2 , x3 ,.....xn 0
When xi represents goods consumed and p i represent the respective price of these goods.
------------------------------------------------------------------------------------------------------------
5. Check whether the Kuhn - Tucker conditions are satisfied or not for the problem given
in example 1 (b) at the optimal values of x and y. ------------------------------------------------
-----------------------------------------------------------------------------------------------------------
6. Minimize C = x2 + y2
Subject to x + y 2
x, y 0
Write out the Kuhn - Tucker conditions and use them to find the optimal solution by trial
and error, what are the values of x and y? ---------------------------------------------------------
7. Given the demand function of the firm is given as
1
P 12 x And the cost function is C x 2 when the minimum profit is 24 ,
2
then
Maximize R f (x)
Subject to C ( x) R( x) 24
x 0
Is the Kuhn - Tucker condition satisfied or not?
Determine the value of x using trial and error.
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UNIT FIVE
DYNAMIC EQUILIBRIUM ANALYSIS
Introduction
So far we have discussed about comparative static analysis which is emphasized on
comparison of different equilibrium situations. For instance, in the theory of supply and
demand analysis, an increase in demand for a product increases equilibrium price and
quantity, other things being equal. However, nothing is said about the process by which
price and quantity are being adjusted to the new equilibrium values. The study of the
process of adjustment over time is the concern of dynamic analysis. In this unit you will
deal about discrete time and continuous time dynamic analysis and their economic
application. In the former case there will be a change in variable only once with in a
period of time where as in the later case there may be a change in variables at each point
of time.
5.1 Continuous Time Dynamic Analysis
Differential equation is an equation that shows an implicit or explicit relationship
between the function y f (t ) and one or more of its derivatives. For instance,
dy
= 6t + 10, where t represents time
dt
dy d2y dy
= 15 y, 2
-2 + 19 = 0
dt dt dt
The highest power attained by the derivative in the equation is known as degree of the
differential equation where as the order of a differential equation is the order of the
highest derivative in the equation.
Example
dy
a) = 3x + 7 (first degree, first order)
dt
d3y dy
b) 3
+ ( ) 4 + 2x2 = 0 (third order, first degree)
dt dt
5.1.1. First -Order Linear Differential Equations
dy
In this case, if the derivative, and y have to be in first degree and if no product of
dt
dy
y ( ) exist, then the equation is referred to as first order linear differential equation.
dt
This equation will generally take a form
dy dy
+ vy = z or + v(t) y = z(t) ---------------- (1)
dt dt
Where v and z are constants or functions of time, t, like y. When v and z are constants
and z is zero, then equation (1) will be
dy
y = 0 ------------------------------------ (2)
dt
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Where is constant which represents v. Such type of differential equation is referred to
dy
as homogenous as each term in the equation is in first degree in terms of y and .
dt
Rearranging equation (2), we get
1 dy
---------------------------------------- (3)
y dt
Now we can obtain the solution of equation (3) by integrating both sides of the equation
with respect to t. By substitution rule and log rule, the left side of the equation gives us
1 dy dy
y dt dt y ln y c1 , (y 0 )
The right side gives us
dt t c2 , (as - is constant)
By equating the above two integrals and combining the two constants, we get
n y t + C
Using the method of antilogarithm
( t C )
n y
e = e
y = e ( t e c
y(t ) Ae t , where A e c ----------------------- (4)
There is an arbitrary constant A in equation (4). Therefore, it is a general solution.
If we substitute a particular value for A , then it will be a definite solution. We have seen
two situations in the solution of differential equation. These are.
The solution is given in function form, not in number.
The solution is free of any derivative. As result, we can determine the value of y if
a specific value is assigned for t.
When we put a nonzero constant in equation (2) in place of z, we get the equation,
dy
+ y = , where is constant ---------------------------- (5)
dt
Such type of equation is known as non-homogenous linear differential equation. Here,
the problem is how can we determine the solution? The solution of this equation will
contain two different terms. One is complementary function represented by y c and the
other is particular integral represented by y p as we will see it later.
Let us observe the solution of the homogenous equation even if we are dealing about the
way to solve non homogenous equation. For its convenient let us consider the
homogenous equation as reduced equation and the non homogenous one as complete
equation. Thus, the solution of the reduced equation represents y c and y p represents
particular solution of the complete equation. This means,
yc Ae t , from equation (4)
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We have said that y p denotes a particular solution of the complete function. Thus, let us
dy
first try to obtain the simplest type of solution taking y as some constant k . Then, 0
dt
when y is constant. As a result equation (5)
0 y
yp , 0
Then the general solution of the complete function is
y(t ) yc y p Ae t , ( 0) (6)
y (0) Ae ( 0)
When t = 0, y (0) A
A y (0)
t
Thus, y(t ) [ y(0) ]e , ( definite solution, 0 ) ------------ ( 7)
Example
dy
1. Find the definite solution of the equation +4y=12, y(0)=0. In this
dt
case, 4, 12 , thus
y (t ) [0 3]e 4t 3
y (t ) 3e 4t 3
dy
2. Determine the general solution of the equation 3 + 6y = 5
dt
Dividing both sides by 3, we get the equation
dy 5
+ 2y =
dt 3
5
y(t ) Ae 2t
6
5.1.2 Economic Applications
Differential equations are beneficial to determine the dynamic stability condition of the
market equilibrium. When the rate of growth of a function is given, differential equation
enables us to get the function whose growth is explained.
Example
1. Assume that the demand and supply functions of a particular product are given as
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Qd a bP, (a, b, 0) (8)
Qs c dP, (c, d 0)
As we remember from comparative static analysis, equilibrium Price, P is
ac
P = ------------------------------------------------------------- (9)
bd
dP
Assuming that the rate of change of price in the market, is a positive linear function
dt
of excess demand, Qd QS 0 ,
dP
k (Qd Qs ) , k is constant, k > 0 ------------- (10)
dt
Given sufficient time for adjustment process, under what condition P(t ) converges to the
equilibrium price P as t ---------------------------------------------------------------------
----------------------------------------------------------------------?
dp
We know that = 0 if and only if Qd QS
dt
Substituting the given parameters for Qd and Qs in equation (10)
dP
k[(a bP) (c dP)] k (a c) k (b d ) P
dt
dP
k (b d ) P k (a c) (11)
dt
We have seen that equation (11) is expressed in the form of differential equation. As the
coefficient P is different form zero, it is possible to apply the solution formula and
present the solution as
( a c ) k ( b d ) t ( a b)
P(t ) [ P(0) ]e
(b d ) (b d )
P(t ) [ P(0) P ]e k (b d )t P (12)
As P (0) and P are constants whether P (t) P as t or not depends on the
exponential expression e k (b d )t . If k (b+ d) > 0, the exponential expression approaches to
zero as t approaches to infinity. As a result, the time path will really direct the price
towards equilibrium position on the assumption of our model. In this case, the
equilibrium is refereed to as dynamically stable.
2. If Cˆ , IˆandYˆ are deviations of consumption, investment and income from their
respective equilibrium values C , I and Y , determine the dynamic stability conditions for
the two sector income determination model.
Cˆ C (t ) C , Yˆ Y (t ) Y and Iˆ I (t ) I
Income changes at a rate proportional to excess demand
dYˆ (t )
(C I Y ) and Cˆ gYˆ (t ) , Iˆ(t ) bYˆ (t ) , a(Cˆ Iˆ Yˆ ) , 0 a, b, g 1
dt
dYˆ
Using substitution, a( gYˆ bYˆ Yˆ ) a( g b 1)Yˆ
dt
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dYˆ
a( g b 1)dt (13)
Yˆ
When we integrate this function, we get
ln Yˆ a( g b 1)t C (14)
Using the method of antilogarithma ( g b 1) t c
e n ŷ =
Yˆ e c e a ( g b 1)t
Yˆ kea ( g b1)t , if , k e c
As t = 0, ŷ = y (0) - ŷ = k
As a result, Yˆ [Y (0) Y )]e a ( g b1)t . However, Yˆ Y (t ) Y , Y (t ) Yˆ Y
Thus, Y (t ) [Y (0) Y ]e a ( g b1)t Y (15)
This solution shows that as t , Y (t ) Y if and only if g b 1 .
3. It is clear that a change in the rate of investment will affect both aggregate demand and
productive capacity of the economy. The Domar model wants to determine the time path
along which an economy can grow while maintaining full utilization of its productive
capacity. Given the marginal propensity to save s and the marginal capital- output ratio
k as constant, determine the desired investment function for the growth to be needed.
As we know change in aggregate demand is equal to change in investment multiplied by
1
the multiplier .
s
dy dI 1
= ( ) ------------------------------------- (16)
dt dt s
Change in productive capacity is equal to the change in capital stock multiplied by the
reciprocal of marginal capital- output ratio,
dQ 1 dK 1 dK
= = I, as = I ---------------------- (17)
dt k dt k dt
Equating equation (16) and (17), gives us
1 dI 1
( )= I
s dt k
1 1
dI Idt --------------------------------------------------- (18)
s k
Rearranging this equation, we get
dI s
dt 0 -------------------------------------------------- (19)
I k
Applying the method of integration on equation (19), it becomes
s
ln I t C
k
s
ln I t C
k
Using antilogarithm
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s
[( ) t c ]
e ln I
e k
s
( )t
I (t ) e e c k
s
( )t
I (t ) Ae k
, if , A e c (20)
Equation (20) is the desired investment function for the growth to be needed which
s
indicates that investment has to grow at a constant rate determined by (saving rate
k
divided by capital output ratio).
5.1.3 Second - Order Linear Differential Equations
d2y dy
Functions of the form 2
+ a1 a2 y b where a a1 , a 2 , and b are constants is
dt dt
referred to as second-order linear differential equations. ------------------------- (21)
If the tem b is zero, the given function is homogenous. However, if b is different from
zero, the equation is known as non homogenous equation.
The solution of the given equation has two components. These are complementary
function ( y c ) and particular integral ( y p ).
y(t ) yc y p
Similar to the previous analysis y c represents the deviation of y (t) from equilibrium for
every point of time path where as y p denotes the equilibrium value of the variable y in
intertemporal sense.
Particular integral ( y p )
Let us try the simplest possible way, i.e., setting y = a, constant, to find the particular
integral y p .
If y a which is constant, then the above second order linear differential equation
dy d 2y d2y dy
becomes 2
0, As a result, the equation 2
+ a1 a2 y b will be
dt dt dt dt
b
reduced to a2 y b which gives us y .
a2
b
Thus, the particular integral is y p , (a2 0) (22)
a2
If a2 0, we have to find some non constant form of a solution. Setting y kt
which is the simplest possibility, the second order differential equation (21) is
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b
reduced to a1k b .This gives us the value of k which is the particular
a1
integral .Then the particular integral is
b
y p t , a1 0, a 2 0 , ---------------------------------- (23)
a1
If a1 0 , the solution with a form y kt fails since it is undefined.
consequently, we have to find other solution of the form
y kt 2 when a1 a2 0 , then equation ( 21) is reduced to
d2y
b (24)
dt 2
dy d2y
y kt Implies that,
2
2kt, 2 2k . Then the differential equation indicated in (24)
dt dt
b
can be presented as 2k = b which implies that k and then the particular integral is
2
b 2
y p t , (a1 a2 0) (25)
2
Example
Find the particular integral of the equation
d2y dy
2
- 2 + 5y = 2
dt dt
2
Solution: y p
5
2 2
If a2 0 , y p t t (using equation (23)). But, if a1 0, y p t 2 t 2 .
2 2
The complementary function ( y c )
The complementary function of equation (21) denotes the general solution of the equation
d2y
2
+ a1 dy a 2 y 0 ---------------------------------------- (26)
dt dt
dy
As we have discussed in equation (4), y e rt . Adopting this solution, rAe rt and
dt
2
d y
r 2 Ae rt
dt 2
Substituting these terms in equation (26), we get
r 2 Ae rt a1rAe rt a 2 Ae rt 0
Ae rt (r 2 a1r a 2 ) 0 (27)
Equation (27) shows that A e rt = 0 or (r 2 a1r a2 ) 0
We know that the value of A is determined by the use of the initial condition of the
problem. Consequently, we cannot set A e rt = 0. Thus, it is necessary to observe the value
of r which satisfies the equation (r 2 a1r a2 ) 0 . This equation is referred to as
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characteristic equation of the homogenous function expressed in equation (26). This
characteristic equation has a form of quadratic equation which will result in two solutions
(roots). These roots are known as characteristic roots. Using quadratic formula,
a1 a1 4a 2
2
r1 , r2 (28)
2
r1 and r2 are the only values we can put for r in the solution y = A e rt . Since there are
two roots r1 and r2 , then we will have two solutions. These are,
y1 A1e r1t and y 2 A2 e r2t , where A1 and A2 are constants and r1 and r2 are
characteristic roots. The general solution is the summation of the above two solutions.
This means,
yc y1 y2 (29)
The characteristic equation may have three different types of roots, namely distinct real
roots, reaped real roots and complex roots.
Case 1 When a12 4a2 , the square root in equation (28) will be a real number and the two
roots r1 and r2 will be distinct real numbers. In this case
yc y1 y 2 A1e r1t + A2 e r2t , ( r1 r2 ) ------------------------------- (30)
Case 2 When a12 4a2 , the term in the square root of equation (28) becomes zero. As a
result the two roots will be equal. The complementary function will be
yc ( A1 A2 )e rt
Case 3 When a12 4a2 the term in the square root of equation (28) becomes negative
number which is referred to as imaginary number. For the time being let us ignored this
case.
For the first two cases it is possible to determine the dynamic stability of equilibrium
condition based on the sign of the characteristic roots. The condition (i.e., yc 0 as t
) is fulfilled iff both r1 and r2 have negative sign.
Example
Find y c , y p , the general solution and the definite solution of the equation
y(t ) 9 y(t ) 14 y 7 (32)
1
Since the value of a 2 is different from zero, y p
2
To determine the complementary function y c , we should first find the value of r1 and r2
9 81 56 95
r1 , r2 = , r1 = 2 , r2 = 7
2 2
We know that yc y1 y 2 A1e r1t + A2 e r2t ------------------------------ (33)
Subsisting the value of r1 and r2 in equation (33) gives us
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yc A1e 2t A2 e 7t
Therefore, the general solution of the equation is
1
y(t ) A1e 2t A2 e 7t (34)
2
5
When y (0) = and y (0) = 6, then the definite solution becomes,
2
1 5
y (0) A1 A2
When t = 0, 2 2
A1 A2 2 (35)
y (0) 2 A1e 2t 7 A2 e 7t 2 A1 7 A2
y (0) 2 A1 7 A2 6
2 A1 7 A2 6 (36)
Taking equation (35) and (36) simultaneously, multiplying (35) by 2 and deduct it from
equation (36) gives A2 2 . Substituting the value of A2 in equation (35), we get
A1 2 2
A1 4
1 5
Therefore, y(t ) 4e 2t (2)e 7t is the definite solution when y (0)= and y (0)
2 2
=6
5.1.4 Economic Applications
It is clear that future price expectation affects supply and demand decisions. The price
dP d 2P
trend existing at the moment in continuous time context can be found in and .
dt dt 2
Therefore, we ought to incorporate these two derivatives in the demand and supply
functions as additional components to consider the price trend in our analysis.
Example
1.Suppose the demand and supply functions of a product are given as
dP d 2 P
Qd 42 4 P 4 2
dt dt
Qs 6 8P (37)
With initial condition P(0) 6 and P(0) 4 . Assuming market clearance at every point
of time, find the time path P(t ).
As we know market equilibrium is achieved when Qd Qs . Thus, at the point of
equilibrium
dP d 2 P
42 4 P 4 2 6 8P (38)
dt dt
Rearranging this equation, we get
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d 2P dP
2
-4 -12P = -48 which is second order differential equation in form.
dt dt
Thus, P(t ) Pp Pc where Pp represents the particular integral and Pc denotes the
complementary function. Thus, to determine the general solution P(t ), we should find
Pp and Pc .In this equation, a1 4, a2 12, b 48 , since a2 0, then
48
Pp 4.
12
To determine, we should find r1 and r2 . Using the formula presented in equation (28 ),
4 16 48 48
r1 , r2 = =
2 2
r1 , r2 = 6,2 , i.e., r1 = 6 and r2 = - 2
This means Pc A1e 6t A2 e 2t
Therefore, the general solution is
P(t ) A1e 6t A2 e 2t 4 (39)
Considering the initial conditions p (0) = 6 and P (0) = 4,
P(0) A1 A2 4 6
A1 A2 2 (40)
P (0) 6 A1e 0 (2) A2 e 0 4
6 A1 2 A2 4 (41)
Taking equation (40) and (41) simultaneously, multiplying equation (40) by 2 and adding
it on (41), we get A1 1 and A2 1 . Therefore, the definite solution is
P(t ) e 6t e 2t 4
Since r1 6 , P(t ) cannot converge to the intertemporal equilibrium. It is dynamically
unstable.
By now you have completed the first section of this unit. Therefore, try to do the
following self - test questions to examine how you understand this section.
Exercise
Do the following questions based on the information given above.
1. Describe dynamic equilibrium analysis----------------------------------------------------------
---------------------------------------------------------------------------------------------------
2. What is differential equation explain it briefly. -----------------------------------------------
---------------------------------------------------------------------------------------------------
3. Describe the difference between homogenous and non homogenous differential
equation. ------------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------------
4. Explain the difference between general solution and definite solution of an equation ---
-------------------------------------------------------------------------------------------------
5. Given demand and supply functions of a product as
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Qd 125 2 P
Qs 45 8P
Determine whether the equilibrium price , P is dynamically stable over time or not as
there is sufficient time for adjustment using the formula presented in equation ( 12) ------
---------------------------------------------------------------------------------------------------
6. Suppose the demand and supply functions of a product are given as:
d 2P dP
Qd 2 3 2 P 10
dt dt
Qs 2 P 30
With P (0) = 4 and P(0) 9 , determine the price path, assuming market clearance at
every point of time. Is the time path convergent? ------------------------------------------------
------------------------------------------------------------------------------------------------------------
------------------
Dear colleague! Have you answered these questions? If your answer is no, please reread
this section and answer them. If your answer is yes, go to the next section.
5.2 Discrete Time Dynamic Analysis
In the previous section we have discussed the continuous time dynamic analysis. In that
case, the magnitude of change in time is very small. As result, the change in y which is
emanated from this change in time is expressed in the form of derivative. However, this
section is emphasized on discrete time dynamic analysis. In this case, time is considered
as discrete variable and the dynamic adjustment process between equilibriums is
observed as a step-by-step process rather than that of continual adjustment. Thus the
change in y has to be explained by "differences" rather than derivatives or differentials.
Accordingly, we can calculate the different values of the variables which are adjusting to
new equilibrium levels using
The mathematical concept of difference equation and
Spreadsheet
.Difference equation is an equation which expresses the relationship between the
dependent variable and a lagged independent variable that changes at discrete intervals of
time. The largest number of periods lagged represents the order of difference equation.
6.2.1 First Order Linear Difference Equations
First order difference equation represents a time lag of one period. The change in y
which is resulted from change in time t from t to t 1 is referred to as the first
difference of y which is represented by
y t y yt 1 yt ..............................(1)
This equation is first-order linear difference equation. Given the first-order linear
difference equation
y 3 yt 1 yt
yt 1 yt 3.............................................(2)
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Let us find the solution of this equation by using iterative method first and then the
general method.
A. Iterative Method
Given equation (2), it is not difficult to find the value of y1 provided that the initial value
of y, i, e, y0 is given. We can also find the value of y 2 once we have determined the value
of y1
EXAMPLE
1. Find the solution of the difference equation yt 1 yt 3 provided that y 0 20 using
iteration method.
y1 y o 3
y 2 y1 3 y o 3 3 Y0 23
y 3 y 2 3 y1 3 3 y o 33 3 y 0 3(3)
y 4 y 3 3 y 0 4(3)
y t y 0 t (3)
For any period t, the solution of equation (2) with y 0 20 is
(3)
yt 20 3t
2. Find the solution of the difference equation yt 1 2 y1 0 . In this case, the initial value
is unspecified simply represented by y 0 . using the method of iteration,
y1 2 y 0
y 2 2 y1 22 y 0 2 y 0
2
y 3 2 y 2 2 y 0
3
y t 2 y 0
t
The solution of yt 1 2 y0 0 at any period t is
(4)
yt (2) t y0
B) General method
Given the first order linear difference equation
yt 1 byt a......................................................................(5)
Where a and b are constants, the general solution s a combination of the particular
integral y p and the complementary function y c . y p denotes the intertemporal equilibrium
level of y where as y c represents the deviation of the time path from this equilibrium.
Incorporating the initial condition we can determine the definite solution.
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Let us first determine the complementary function which is the solution of the reduced
equation yt 1 byt 0 . Based on equation (4) above,
yt (b) t y0 ..............................................................................(6)
Putting the constant A in place of y 0 , we get
yt A(b) t
Thus, the complementary function is
yc A(b) t .............................................................................(7)
Now let us find the particular integral y p
Taking the simplest form yt k where k is constant, we have to have yt 1 k. If we
substitute these n to equation (5), we will get k+ b k= a
k 1 b a k
a
, b 1
1 b
Then the particular integral becomes,
, b 1....................................................(8)
a
yp k
1 b
Therefore, the general solution of the equation is
yt y c y p
a
yt A(b) t , b 1..........................................................(9)
1 b
If b=-1 the general solution will be
yt A at
Setting the initial condition that yt y0 when t =0,
a a
y 0 A(b) 0 A , b 1,
1 b 1 b
a
A y0
1 b
Are a result, the definite solution is
a a b 1.............................................(10)
yt y0 (b)
t
1 b 1 b,
Example
Solve the first order difference equation
yt 1 3 yt 8 0 yt 1 3 yt 8, when y0 16
yt 1 3 yt 8
Using the formula in equation (10) , a =-8 , b 3, y 0 16
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8
3
8
yt 16
t
1 3 1 3
yt 16 2 3 2 18 3 2
t t
The given equation s referred to as dynamically stable or convergent provided that the
complementary function approaches to zero as t approaches to infinity. The convergence
of the term b t depend the absolute value of b. If b 1 , the time path will move away
from equilibrium. If b 1 , the time path will move towards to equilibrium, i.e.,
convergent. In our example above, b=-3, b 3 1. Therefore, the equilibrium is
dynamically unstable. In other words, the time path is divergent.
5.2.2 Second Order Linear Difference Equations
Given the second order difference equation
yt 2 a1 yt 1 a2 yt C.............................................................(11) , the general
solution is composed of that of particular integral and complementary function. We know
that the particular integral is any solution of the complete equation. Thus, setting the
simplest solution
yt k , Equation (11) becomes
, a1 a 2 1
c
k
1 a1 a 2
c
Therefore, yp k , a1 a2 1............................(13)
1 a1 a 2
If a1 a2 1, equation (13) will be undefined. Thus, we have to set another value for
y t . .Let yt kt, then equation (11) becomes,
k t 2 a1k 1 t a2 kt c................................(14)
Rearranging this equation,
k t a1t a 2 a1 2 c,
k t 1 a1 a 2 a1 2 c, as a1 a 2 1
This equation becomes
k a1 2 c k
c
, a1 2
a1 2
Thus, yp
c
t , a1 a2 1, a1 2....................(15)
a1 2
When a1 a2 1 and a1 2 then equation (15) will be undefined. Therefore, we
should set another value for y t . Let yt kt 2 , then equation (11) becomes,
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k t 2 a1 k t 1 a 2 k t c...........................(16)
2 2 2
k t 2 4t 4 a1 t 2 2t 1 a 2 t 2 c
k t 2
1 a1 a2 t 4 2a 4 a c, as
1 1 a1 a 2 1 and a1 2
This equation becomes,
k t 2 0 t o 4 2 c
.
k 2 c k
c
, a1 a 2 1 and a1 2
2
Therefore, yp
c 2
t , a1 a2 1 and a1 2......................(17)
2
As complementary function is the solution of the reduced equation, we should emphasize
on the equation
y 2t a1 yt 1 a2 yt 0...................(18) to determine the complementary
function of the given equation we know that yt Ab t . Thus the above reduced equation
becomes
Ab 2t a1 Ab t 1 a 2 Ab t 0...................................(19)
Ab t b 2 a1b a 2 0
Ignoring the nonzero common factory gives us,
b 2 a1b a2 0..................................................(20)
This equation is referred to as characteristic equation of equation (18)
The solution of this equation using the quadratic formula
a1 a12 4a 2
b1 , b2 ....................................(21)
2
We face three possible phenomenon based on the term in the square root of equation (21).
Case1, When a, 2 4a2, the characteristic equation will have two distinct roots,
b1 and b2, In this case, the complementary solution will be
yc A1b1t A2 b2t ................................................(22)
Case 2, When a, 2 4a2, the characteristic equation will have only one root, this means,
a1
b1 b2 b
2
The complementary function becomes
y c A1b t A2 b t A1 A2 b t A3b t
y c A3b t A4 tb t .................................................(23)
Case 3, When a12 4a2, the term in the square root will be negative which an imaginary
number is. There is no characteristic root for the equation provided that we restrict our
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domain to the real number system. Thus, we are forced to include numbers outside the
real number system. Ideally, we can define i 1 which a square root of negative one
is. It is not real number rather it is known as imaginary number. Therefore, we can write
25 25 1 5i, 10 10 1 10i
Given the diagrams
Imaginary
Axis
R v
h Real axis
v h
sin , cos
R R
v R sin , h R cos R h2 v2
Then the conjugate complex number
h vi R cos RiSin
According to De Moivers theorem h vi R n cos n Ri sin n......(24)
n
If a, 2 4a2 0 in equation (21), then the roots will tae the form
a a12 4a 2
b1 , b2 h vi, where h 1 , v ,i 1
2 2
2
a 4a 2 a1
2 2
R= 1 a2
4
The complementary function becomes
y c A1b1t A2 b2t
A1 h vi A2 h vi
t t
A1 R t cos t i sin t A2 R t cos t i sin t
y c R t A1 A2 cos t A1 A2 i sin t
IfA1 A2 A5 and A1 A2 i A6 , then
yc R t A5 cos t A6 sin t ..............................................(25)
In al of the above three cases, the equilibrium will be dynamically stable provided that
the absolute value of every root is less than one whatever the initial condition may be
Table 6 1. Values of sin and cos
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1 3 3
0 2 6 4 3 4
2 2
sin 0 1 0 1 0 1 1 3 1
cos 1 0 1 0 1 2 2 2 2
32 1 2 1 1 2
2
Example
Given the equation yt 2 4 yt 15, y0 12, y1 11,
a. Determine the general and definite solution of the equation
b. Is the time path convergent or not?
Solution
15
a1 0, a 2 4, C 15 yp 3
5
a1 o
R 4 2, cos 0
2 a 2 22
a12
sin 1
4a 2
0
1 1
16
sin 1
Sin 1 and cos 0 .Thus, as it is shown in table 1, when we substitute this
2
value in equation (25), the complementary function will be
y c 2 t A5 cos t A6 sin t
2 2
Then the general solution becomes
y t 2 t A 5 cos t A 6 sin t 3.....................................(26)
2 2
When t 0, y0 2 0 A5 cos 0 A6 sin 0 3 12
A5 (1) A6 (0) 3 12
A5 3 12
A5 12 3 9
When t=1, 1
y1 2 A5 cos A6 sin 3 11
2 2
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2A5 (0) A6 (1) 3 11
2 A6 3 11
2 A6 8
A6 4
Therefore, the definite solution be comes
yt 2 t 9 cos t 4 sin t 3......................................................(27)
2 2
5.2.3 Economic Applications
In this sub topic you will learn about the application of first order and second order linear
difference equations on economic models.
A. Application of First Order Linear Difference Equation
Cobweb Model
In certain markets particularly agricultural markets, if demand for a product increase,
supply cannot immediately increase to satisfy the prevailing demand. Crops must be
planted and growth and livestock takes time to raise. Some manufactured products may
also take certain time when customers order that products suddenly. The Cobweb model
considers this lagged in supply side of the market by supposing that the present quantity
supplied is based on the ruling price in the previous time period. That is,
Qts f Pt 1
But the consumers demand for the same product depends on the prevailing price that is
Qtd f Pt
This is a logical situation of several agricultural markets. The quantity supplied this year
is based on the price of that product in last year. The Cobweb model assume that
The market is perfectly competitive.
The demand and supply functions are linear.
Given these assumptions, the Cobweb model can still give a fair idea of how price and
quantity adjust in many markets with a lagged supply. Based on the above assumptions,
the demand and supply functions of a product can be expressed in the form
Qtd a b Pt (demand function )...........
Qts c d Pt 1 (sup ly function )
As you know, the market achieves its equilibrium when quantity demanded is equal to
quantity supplied.
In other words, Qtd Qts
a bPt c dPt 1
bPt c a dPt 1
.................................................................(28)
ca d
Pt Pt 1
b b
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This equation is the Cobweb difference equation. Thus, solving the Cobweb difference
equation means setting it in the format Pt f (t ). As a result; we can calculate the value
of Pt at any time period. The solution of the Cobweb difference equation includes two
parts. There are:
a) Long run equilibrium price
b) a complementary function which indicates how much price diverges from this
equilibrium level at different points in time.
c)
Now let us first find the long run equilibrium price P . In the log run, Pt Pt 1 P .
Therefore
ca d
Pt Pt 1
b b
cb d ac
P PP , b d .............................................(29)
b b d b
To determine the complementary function, we can rewrite equation (28) as
d ca
Pt 1 Pt ..............................................................................(30)
b b
Using the method of determining the complementary function described in equation (7)
above,
Pc P0 d
b
t
If we substitute, A, a Constance in place of P0 , we get
t
d
Pc A ......................................................................................(31)
b
In this case the value of A can be determined if a certain value of Pt is known for specific
value of t.
The complete solution of the Cobweb difference equation, therefore, becomes
ac
t
d
Pt A
d b b
t ........................................................(32)
d
Pt P A
b
From this equation
t
d
1. If d 1, approaches to zero when t approach to infinity. In this case the
b b
market is stable. Price converges to the long run equilibrium price P .
t
d d
2. If 1, then when t . In this case the market is unstable. Price
b b
diverges from the equilibrium level.
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t
d d
3. If 1, then 1, as t . In this case, price neither return to its
b b
equilibrium nor 'explode'.
Example
1. Given the demand and supply for the Cobweb model as
Qtd 400 20 Pt ................................................................(33)
Qts 50 10 Pt 1
Determine the long run (intertemporal) equilibrium price P , the complementary
function and the complete solution.
Determine whether the equilibrium is stable or not.
Solution
a =400, b =-20, c =-50, d=10
a c 400 50 450
P
d b 10 20 30
P 15 (Inter temporal equilibrium).
The complementary function is
t
10
Pc A
20
Therefore, the complete solution is
Pt A 0.5 15.........................................................(34)
t
d
Since 1 1 1, the equilibrium is dynamically stable.
b 2 2
What happens to the market if quantity supplied suddenly changes to 160?
______________________________________________________________
__________________________________________________________________
The initial stock output level is Q0 160 so that price will adjust until all output is
sold. Then P0 can be calculated from the demand function by substituting Q0 160.
Therefore, 160 400 20P0 .
P0 12
By now we can determine the value of A.
P0 A0.5 15 12
0
A 15 12
A 3
Thus, the definite solution is
Pt 3 0.5 15........................................35
t
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Using this equation we can calculate the price of the product at any time period and there
by we can check whether the price converges to the equilibrium level or not.
2. In a market where the assumptions of the cobweb model hold,
Qtd 200 8Pt
Qts 43 8.2 Pt 1 .......................................................36
The long run equilibrium is disturbed when quantity suddenly changes to 90.
What happens to price in the following time period?
Solution
In the long run equilibrium, Q Qtd Qts & p pt pt 1 thus,
200 8P 43 8.2 P
16.2 P 243
P 15
t
8.2
The complementary function is pc A A 1.025 ..................................(37)
t
8
Thus, the general solution is
Pt A 1.025 15............................................38
t
Q0 90,
90 200 8 P0
When
8P0 110
Po 13.75
If Po 13.75, the value of A will be,
13.75 A 1.025 15
0
13.75 A 15
A 1.25
Thus, the definite solution is
pt 1.25 1.025 15.......................................(39)
t
The Keynesian Macroeconomic Model
In the Keynesian model of national income determination, if foreign trade and
government expenditure and tax are not included, the model becomes,
Y C I ...................................(40)
And
C a bY ..................................(41)
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Where Y is national income, C is consumption, I is investments a is autonomous
consumption and b is marginal propensity to consume. Then equilibrium level of
national income is
Y a bY I
Y bY a I
Y 1 b a I
aI
Y , b 1..................................(42)
1 b
, Y Y at equilibrim
This equation shows that this national equilibrium income Y can be evaluated for a
given values of a, b and I . When there is a disturbance from this equilibrium, there will
not be an immediate adjustment to the new equilibrium. As the consumer expenditure
may not adjust immediately to the new level of income, a lagged effect may be
introduced in the consumption function, as follows,
Ct a bYt 1 ..............................................(43)
This means, consumer's expenditure at present depends on the income of the previous
year. But national income is still determined by the sum of all current expenditure
Thus, Yt Ct I t ........................................(44)
Substituting (43) in to (44) gives us
Yt a bYt 1 I t
Yt bYt 1 a I t .............................................(45)
Equation (45) is a first order linear difference equation,
The general solution of this equation includes two parts, namely intertemporal
equilibrium and complementary function Yc . At the point of equilibrium,
Y Yt Yt 1
Thus,
Y bY a I t
Y bY a I t
a It
Y (int ertemporal equilibriu m)...........(46)
1 b
The complementary function as referred to equation ()7
Yc Ab t ..........................................................(47)
Thus, the general solution becomes
a It
Yt Ab t ........................................................(48)
1 b
b 1.
This equation shows that the equilibrium will be dynamically stable provided that
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Example
Given the Keynesian model
yt Ct I t
Ct 650 0.5Yt 1
And I t 300
Then it suddenly increases to 420
What will be the actual level of Y six time periods after this change?-------------------------
------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------
Solution
a 650, b 0.5, I t 300
The initial equilibrium level of income is
650 300
Y 1,900
1 0.5
Thus, consumption C o is
C0 650 0.51.900 1,600
Thus, the value of Y immediately after the shock is
Yo C0 I 0
Yo 1600 420 2,020
The new equilibrium level is
650 420
Yˆ 2,140
1 0.5
Substituting this value in general solution above, we will get
Yt Yˆ Yo Yˆ b t
Yt 2,140 2,020 2,140 0.5
t
2,140 1200.5
t
Y6 2,140 1200.5
6
2,140 1.875
Y6 2,138.125
How much time period will it take y to reach 2,130? --------------------------------------------
------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------
2,130 2,140 1200.5
t
10 1200.5
t
0.5
10 t
120
Putting this equation in it's logarithm form
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10
log 0.5t
log
120
10
log t log 0.5t
120
10
log
t 120 3.585
log 0.5
t 3.585
The equilibrium national income will reach 2,130 units after 3.585 time period.
Samuel Son's Multiplier-Acceleration Interaction Model
To observe the application of second order difference equations in economies, let us
consider Samuel son's classic interaction model. This model examines the dynamic
process of income determination if the acceleration principle works with the Keynesian
multiplier. The model describes the situation that the interaction of the multiplier and the
accelerator results in cyclical fluctuation endogenously.
Suppose the national income Yt is a combination of consumption C t , investment I t and
government expenditure G t . It is also assumed that current consumption is a function of
last year’s income Yt 1 , Investment I t is function of difference in consumption
Ct 1 C t Ct 1 . suppose I t is s fixed proportion of Ct 1 . Gt is assumed to be
exogenous. Thus, the model becomes
Yt Ct I t G0
Ct bYt 1 , 0 b 1................................(49)
I t aCt Ct 1 , a 0
, Where b is marginal propensity to consume and a is accelerator coefficient. Now we
can express I t in terms of income as
I t abYt 1 bYt 2
I t abYt 1 Yt 2 .................................(50)
If we substitute (50) and C t in equation (49), we get
Yt bYt 1 abYt 1 Yt 2 G0
I t b1 a Yt 1 abYt 2 G0
This means
Yt 2 b1 a Yt 1 abYt G 0 .................................(51)
This equation is a second order linear difference equation. As a result, we can solve it
using the method discussed in equation (11).
Solution
The general solution will include the particular integral Y p and the complementary
function y c . The particular integral Y p is
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G0 G
Yp 0
1 b1 a ab 1 b
Complementary function
As far as the complementary function is concerned, we are faced with three possible
phenomena
Case 1 If b 2 1 a 4ab
4a
or b
2
,
1 a 2
Equation (51) with characteristic equation r 2 b1 a r ab 0 will have two roots,
b1 a b 2 1 a 4ab
2
r1 , r2 .................................(52)
2
As we know whether the equilibrium is dynamically stable or not depends on r1 and
r2 which in turn are based on the value of a and b, we can express the dynamic stability in
terms of a and b.
Case 2 If b 2 1 a =4ab, we will have only one root,
2
b1 a
r
2
Case 3 If b 1 a 4ab, then we should use the method explained in equation (25)
2 2
b1 a b 2 1 a 4ab
2
r1 , r2 h vi, Where h ,v
2 2
i 1 , R ab
Then the complementary function becomes
Yc A1 r1t A2 r2t
A1 h vi A2 h vi
t t
Yc R t A1 A2 cos t A1 A2 i sin t
IfA1 A2 5 and A1 A2 i A6 ,
Yc R t A5 Cost A6 sin t ..........................................................(53)
Then the general solution in case 3 becomes,
G
Yt R t A5 Cost A6 sin t o ..........................................(54)
1 b
Now try to determine the general solution of the equation in case 1 and case 2.
In all of the three cases, the equilibrium will be dynamically stable iff a b < 1, that is, the
product of the accelerator and marginal propensity to consume must be less than one.
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By now you have completed the second section of this limit. Thus, try to do the following
question to evaluate how you understand this section.
Exercise
Solve the following questions based on the information above.
1. What is difference equation? -----------------------------------------------------------------
2. What is the difference between discrete and continuous variable----------------------------
---------------------------------------------------------------------------------------------------
3. Solve the difference equation 5 yt 1 2 yt 140, y0 30 -------------------------------------
---------------------------------------------------------------------------------------------------
4. Given the second order linear difference equation yt 2 7 yt 1 6 yt 42 Find the
general solution. ----------------------------------------------------------------------------------
5. assuming the usual Cobweb assumption, derive the difference equation which will
calculate price in the time periods following the unexpected decrease in equilibrium
quantity to 75 given
Qtd 160 20 Pt
Qts 80 40 Pt 1
6. A Keynesian macroeconomic model with a single time period lag on the consumption
function described below is initially in equilibrium with the level of I t 500.
Yt Ct I t
Ct 750 0.5Yt 1
If it is increased to 650, find the value of y in the fourth time period after this
disturbance.
7. If the accelerator is 0.5 and the marginal propensity to consume is 0.6, what will
happen to the time path? Answer this question using equation (51).
Have you answered these questions? If your answer is no, re read this section and try to
do them. If your answer is yes, good. Go to the following check list.
HU| Department of Economics Page 115
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