LU 3 Applications of Linear

Functions

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Applications of Functions in Business and Economics: Objectives

 To formulate and evaluate total cost, total revenue, and

profit functions
 To find marginal cost, revenue, and profit, given linear
total cost, total revenue, and profit functions
 To write the equations of linear total cost, total
revenue, and profit functions by using information
given about the functions
 To find break-even points
 To evaluate and graph supply and demand functions
 To find market equilibrium

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Profit
The profit a firm makes on its product is the difference
between the amount it receives from sales (its revenue)
and its cost. If x units are produced and sold, we can write
P(x) = R(x) – C(x)
where
P(x) = profit from sale of x units
R(x) = total revenue from sale of x units
C(x) = total cost of production and sale of x units

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Revenue and Cost
 In general, revenue is found by using the equation
Revenue = (price per unit)(number of units)

 The cost is composed of two parts: fixed costs and variable costs.

 Fixed costs (FC), such as depreciation, rent, utilities, and so on,

remain constant regardless of the number of units produced.

 Variable costs (VC) are those directly related to the number of

units produced.

 Thus the cost is found by using the equation

Cost = variable costs + fixed costs

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Example 1 – Cost, Revenue, and Profit
Suppose that a firm manufactures MP3 players and
sells them for $50 each. The costs incurred in the
production and sale of the MP3 players are $200,000
plus $10 for each player produced and sold. Write the
profit function for the production and sale of x players.

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Marginals
 The slope of the profit function represents the rate of
change in profit with respect to the number of units
produced and sold. This is called the marginal profit
for the product.

 The marginal profit for the MP3 players in Example

21 is $40.

 The marginal cost for this product is $10 (the slope

of the cost function), and the marginal revenue
is $50 (the slope of the revenue function).

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Example 2 – Marginal Cost
Suppose that the cost (in dollars) for a product is
C = 21.75x + 4890.

What is the marginal cost for this product, and what does it
mean?

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Break-Even Analysis

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Example 3 – Break-Even Point
A manufacturer sells a product for $10 per unit. The
manufacturer’s fixed costs are $1200 per month, and the
variable costs are $2.50 per unit.

How many units must the manufacturer produce each

month to break even?

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Example 3 – Solution cont’d

Figure 1.42 shows that

for x < 160, R(x) < C(x), (resulting in a loss) and that
for x > 160, R(x) > C(x) (resulting in a profit).

Figure 1.42
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Example 3 – Solution cont’d

Using the fact that the profit function is found by subtracting the total
cost function from the total revenue function, we can form the profit
function for the previous example.

The profit function is given by

P(x) = 10x – (2.50x + 1200) Or P(x) = 7.50x – 1200

We can find the point where the profit is zero (the break-even point) by
setting P(x) = 0 and solving for x.

0 = 7.50x – 1200
1200 = 7.50x
x = 160

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Example 3 – Solution cont’d

Note that this is the same break-even point that we found

by solving the total revenue and total cost equations
simultaneously (see Figure 1.43).

Figure 1.43
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Supply, Demand, and Market Equilibrium
 Economists and managers also use points of intersection to
determine market equilibrium.

 Market equilibrium occurs when the quantity of a commodity

demanded is equal to the quantity supplied.

 Demand by consumers for a commodity is related to the price of

the commodity.

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Supply, Demand, and Market Equilibrium
The law of demand states that the The law of supply states that the
quantity demanded will increase as price quantity supplied for sale will increase
as the price of a product increases.
decreases and that the quantity demanded
Figure 1.45 shows the graph of a
will decrease as price increases.
typical linear supply function.
Figure 1.44 shows the graph of a typical
linear demand function.

Figure 1.45

Figure 1.44

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Example 4 – Market Equilibrium
Find the market equilibrium point for the following supply
and demand functions.

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Supply and Demand with Taxation
 Suppose a supplier is taxed $K per unit sold, and the tax is passed on to the
consumer by adding $K to the selling price of the product.

 If the original supply function p = f(q) gives the supply price per unit, then passing
the tax on gives a new supply function, p = f(q) + K.

 Because the value of the product is not changed by the tax, the demand function is
unchanged.

 Figure 1.48 shows the effect that this has on market equilibrium.

Figure 1.48

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Example 5 – Taxation
The supply and demand functions for dryers were given as
follows.

The equilibrium point was q = 40, p = $250. If the wholesaler

is taxed $14 per unit sold, what is the new equilibrium point?

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Example 5 – Solution
The $14 tax per unit is passed on by the wholesaler, so the new supply
function is p = 2q + 170 + 14 and the demand function is unchanged. Thus
we solve the system
p = 2q + 184
{ p = – 5q + 450

2q + 184 = – 5q + 450
7q = 266
q = 38
p = 2(38) + 184 = 260

The new equilibrium point is q = 38, p = $260

Checking, we see that

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 National Income
 The economy is divided into two sectors, households and firms. Firms
use resources such as land, capital and labour to produce goods and
services. These resources are known as factors of production and
are taken to belong to households.

 National income represents the flow of income from firms to

households given as payment for these factors. Households can then
spend this money on one of two ways. Income can be used for the
consumption of goods (C) produced by firms or it can be put into
savings (S). Therefore, C and S are functions of income, Y, that is
C = f(Y) and S = g(Y)
C and S are normally expected to increase as I rises.

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 Consumption
 C = f(Y)
C
C = aY + b (linear) where
a>0 and b>0.
 The intercept b is the level of
consumption when there is no
income (that is why Y=0) and
a C = aY + b is known as autonomous
consumption.

Y
0

 The slope a, is the change in C brought about by a one-unit increase in Y and is

known as the marginal propensity to consume (MPC).
 Income is used up in C and S, so that Y = C + S. Only a proportion of the one-unit
increase in income is consumed; the rest goes into savings. Hence the slope, a, is
generally smaller than 1, that is a<1. That is 0 < a <1.

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 Saving
Given that Y = C + S and C = aY + b,
S=Y–C
= Y – (aY + b)
= Y – aY – b
= (1 – a)Y – b

The slope of the saving function, (1- a) is called the marginal propensity to save
(MPS), that is MPS = 1 – a = 1 – MPC.


S

S = (1 – a)Y - b
Y
0

-b

The autonomous savings (that is, the value of S when Y = 0) are equal to –b, which
is negative because b > 0. This is to expected because whenever consumption
exceeds income, households must finance the excess expenditure by withdrawing
savings.
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 Model of National Economy
Injections; investment
I

C Firms Y

Expenditure: Income: payments for

consumption of factors of production
domestically produced
goods

Households
C Y
S
Withdrawals: savings

 Households: the flow of money entering this box is Y and the flow leaving it is C + S.
Hence we have, Y = C + S.
 Firms: the flow entering it is C + I, and the flow leaving it is Y, so Y = C + I.
• Suppose that the level of investment that firms plan to inject into the economy is known
to be some fixed value, I*. If the economy is in equilibrium the flow of income and
expenditure balance, so that Y = C + I*.

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 Continued…
 To make the model more realistic, let include government
expenditure (G) and taxation (T) in the model.
 The injection box now includes G in addition to I, so
Y=C+I+G
 Assuming that planned G and planned I are autonomous with fixed
values G* and I* respectively, so that in equilibrium
Y = C + I* + G*
 The withdrawals box now includes taxation. This means that the
income that household have to spend on consumer goods is no
longer Y but rather Y – T (income less tax) which is called disposable
income Yd. Hence,
C = aYd + b with Yd = Y – T

 The tax will either be

1. autonomous (T = T* for some lump sum T*)
2. a proportion of national income (T = tY for some proportion t)
3. a combination of both (T = tY +T*)
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Example 6
Given that G = 20 I = 35
C = 0.9Yd + 70 … (1)
T = 0.2Y + 25 … (2)

Calculate the equilibrium level of national income.

Answer:
From theory: Y = C + I + G … (3)
Substitute G and I into (3):
Y = C + 20 + 35
Y = C + 55 … (4)

From theory: Yd = Y – T … (5)

Substitute (2) into (5):
Yd = Y – 0.2Y – 25
Yd = 0.8Y – 25 … (6)

Substitute (6) into (1):

C = 0.9(0.8Y – 25) + 70
C = 0.72Y – 22.5 + 70
C = 0.72Y + 47.5 … (7)

Substitute (7) into (4):

Y = 0.72Y + 47.5 + 55
Y = 0.72Y + 102.5
0.28Y = 102.5
Y = 366
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 IS
 Return to the two-sector model, Y = C + I
C = aY + b
 Investment, I was taken to be constant. It is more realistic to
assume that planned investment depends on the rate of interest,
r. As the r rises so investment falls, so the relationship is
I = cr + d where c < 0 and d > 0.
  Example
C = 0.8Y + 100 I = -20r + 1000
  Commodity market is in equilibrium when Y = C + I.
Substitution for C and I into the equation gives
Y = (0.8Y + 100) + (-20r + 1000)
= 0.8Y – 20r + 1100
0.2Y + 20r = 1100
 This equation relating national income, Y and interest rate, r, is
called the IS schedule.

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 LM
 The money market is said to be in equilibrium when the supply of money, Ms,
matches the demand for money, MD that is when MS = MD.
 The level of MS ia assumed to be controlled by the central bank and is taken to
be autonomous, so that MS = M*S for some fixed value M*S.
 The demand for money comes from three sources,
1. transactions demand: used for daily exchange of goods and services.
2. precautionary demand: used to fund any emergencies requiring unforeseen
expenditure.
(1)  and (2) are assumed to be proportional to national income, L1 = k1Y.
3. Speculative demand: used as a reserved fund in case individuals or firms
decide to invest in alternative assets such as government bonds. As interest
rates rise, speculative demand falls, L2 = k2r + k3. (k2= negative constant, k3 =
positive constant).
 So, total demand, MD = L1 + L2 = k1Y + k2r + k3
 If the money market is in equilibrium then
M*s = k1Y + k2r + k3
 This equation relating Y, and r is called LM schedule.
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Example 7
Determine the equilibrium income and interest rate given
the following information about the commodity market
C = 0.8Y + 100 I = -20r + 1000
 
And the money market
Ms = 2375 L1 = 0.1Y L2 = -25r + 2000

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 Example 7-Solution
Commodity market is in equilibrium when Y = C + I.
Substitution for C and I into the equation gives
Y = (0.8Y + 100) + (-20r + 1000)
= 0.8Y – 20r + 1100
0.2Y + 20r = 1100 (IS schedule) … (1)

For the money market, the money supply is M s = 2375

The total demand for money is MD = L1 + L2 = 0.1Y – 25r + 2000
The money market is in equilibrium when M S = MD, that is
2375 = 0.1Y – 25r + 2000
0.1Y – 25r = 375 (LM schedule) … (2)

Double (2) and subtract from (1): 0.2Y + 20r = 1100

- 0.2Y – 50r = 750
70r = 350
r=5

 Substitute r = 5 into (1): 0.2Y + 20(5) = 1100

0.2Y + 100 = 1100
0.2Y = 1000
Y = 5000
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