ECS1370

Solving edit Master subtitle style Click tomicroeconomics problems using algebra and calculus

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Aims and objectives

Up until now we have used graphical analysis to solve microeconomics problems. These problems can be solved using algebra and calculus. These slides show how to do so.

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Contents
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Solve profit maximisation problems Solve constrained maximisation problems. Each section contains worked examples, past exam questions, or questions form this years mid-tem-test.

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I. Supply and demand problems

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I. Profit maximisation problems

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What are these problems about?

Find quantity produced that maximises the firms profit. If the firm has market power then you also have to find the price that maximises profit. There are 2 tricky bits in these problems: you are never given the profit function itself, only the demand function and a cost function (total or marginal).

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you have to differentiate the profit 4/14/12

Tricky bit 1. Setting up a profit function

Step 1: use the definition of profit: Total revenue-total cost. (TR-TC) Step 2: If the demand function is given as Q(P), invert it to obtain P(Q). Step 3: calculate the total revenue using the inverted demand function, TR=P(Q)*Q.
Note: the reason for doing 2) and 3) is that TC is always a function of Q, never of P. If you dont invert Q(P), you will end up with a profit function with 2 unknown variables, P and Q, and only 1 equation to so

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Example of problems with noninverted demand functions

QD = 6500 100*P
C 2 + Q 2 ()7 =
2 Q 2 0 0

Market demand Total cost

Q 200

Profit function: TR-TC= P*Q-C(Q). But Q is a function of P. So you end up with: 2

(Q, P)= P *(6500 100* P) 722

You have to differentiate with respect to P and Q, equalise to 0 and solve for P and Q:

= (6500 200* (0) = P 32.5 P = 0 ) P Q = (0) = 0 =Q 0 Q 100

The result is complete non-sense: the firm produces 0 and charges 32.5. 4/14/12

Profit maximisation of perfectly competitive firms

In this case the price is given, and the profit maximising quantity is given by P=MC. If the MC is given in the exercise, you dont need to differentiate the cost function Example of this type of exercise: Mid-term test 1, part 2, question 2

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Tricky bit 1: practice exercises

Invert the demand functions, and set up the profit function: QD = 10 - 0.04*P, and C(Q)=250+Q^2/150 QD=500-5*P, and C(Q)=350+Q^3/50 QD=400-7*P, and C(Q)=50+Q^2/120 QD=200-4*P, and

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Tricky bit 1: answers to practice exercises

2 10 Q 10 *Q 2Q Q 1)P = and Q ) = ( 250 0.04 0.04 150 2 3 500 Q 500 *Q Q Q 2)P = and Q ) = ( 350 5 5 50 2 2 400 Q 10 *Q Q Q 3)P = and Q ) = ( 50 7 0.04 120 2 200 Q 200 *Q 2Q Q 4)P = and Q ) = ( 250 4 4 150

Note: 2) and 4) can be simplified further. 4/14/12

Tricky bit 2: differentiation of the profit function

The maximum (or minimum) of a function is the point where its first derivative is equal to 0. The maximum of a function is the point where its first derivative is 0 and its second derivative is negative. In practice, when the exercises involve profit maximisation, the demand and costs functions given will always produce a profit function that has a maximum. 4/14/12

Rules to calculate the derivative of a function.

Function f(x) df(x)/dx is the derivative of f(x)
n n n n n

n n n n n

f(x)=5 f(x)= 5*x f(x)=3*x16 f(x)= 5*x +5 f(x)= (5*x )*(3*x16 )

df(x)/dx=0 df (x)/dx=5 df (x)/dx=3*16*x16-1 df(x)/dx= 5+0 (SUM RULE) df (x)/dx= 5* (3*x16) + (3*16*x16-1)*(5*x) (PRODUCT RULE)

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Solving profit maximisation problems: summary

Step 1: invert the demand function if necessary Step 2: set up the profit function Step 3: differentiate the profit function with respect to Q, or take the derivative provided in the exercise Step 4: equalise the derivative of the profit function to 0 and solve for Q*. Q* is the profit maximising quantity.
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Warning: Step 2 has to be adapted to take into account specific profit maximising cases.

Example: A monopolist produces in 2 distinct markets, and faces 2 distinct demand functions.

In this case, the total revenue will be the sum of the revenues in both markets. The profit function will then be:
(Q1, Q2 ) = P (Q1)* Q1+ P2 (Q2 )* Q C (Q1, Q2 ) 1 2

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Example:Monopolist

A firm faces the following average revenue (demand) curve:

P = 120 0.02Q where Q is weekly production and P is price, measured in cents per unit. The firms cost function is given by C = 60Q + 25,000. Assume that the firm maximizes profits. What is the level of production, price, and total profit per week?
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The profit-maximizing output is found by setting marginal revenue equal to marginal cost.

Answer

Step 1 (invert demand function): Given a linear demand curve in inverse form, P = 120 0.02Q, we dont need to invert the demand function.

Step 2 (set-up profit function): TR=PxQ, this implies TR= (120-0.02Q)Q=120Q-0.02Q2. TC is given in the exercise. So the profit function is:

= 120Q-0.02Q2- (60Q + 25,000)

Step 3(differentiate the profit function):

d/dQ= 120-0.04Q-60=60-0.04Q.

Step 4 (equalise derivative of profit to 0):

This implies MC=MR because the derivative of the profit function is the sum of 2 derivatives MR and MC. Setting MR = MC to determine the profit-maximizing quantity: 120 0.04Q = 60, or Q = 1500.

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Example: Cournot oligopolist (week 19 lecture)

Two firms produce luxury sheepskin auto seat covers, Western Where (WW) and B.B.B. Sheep (BBBS). Each firm has a cost function given by C (q) = 30q + 1.5q2 The market demand for these seat covers is represented by the inverse demand equation P = 300 3Q where Q = q1 + q2, total output. a) If each firm acts to maximize its profits, taking its rivals output as given (i.e., the firms behave as Cournot oligopolists), what will be the equilibrium quantities selected by each firm? What is total output, and what is the market price?

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Answer

Step 1: The demand is in inverted form, i.e., P(Q) and not Q(P). Step 2: set up the profit function for firm 1

TR= Pxq1= 300 3(q1+q2)q1=300-3q123q1q2 TC is given by C(q1)= 30q1+1.5q12. So your profit function is: =300-3q12-3q1q2-(30q1+1.5q12)
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answer

Step 3: differentiate the profit function with respect to q1 Step 4: equalise profit function to =, i.e., MC=MR

d/dq1= 300-6q1-3q2 -(30+3q1)

MC= 30+3q1 and MR= 300-6q1-3q2 300-6q1-3q2=30+3q1, 300-270-3q2=3q1+6q1

4/14/12 q1=(270-3q2)/9

(this is firm 1s reaction

answer
We know that both firms have the same cost function so we know that firm 2 has the same reaction function as firm 1: q2=(270-3q2)/9 In a Cournot problem, the equilibrium is found by equalising the 2 reaction functions which means you have to solve a system of 2 equations, for 2 unknowns (q1, and q2). If you do so you find that q1=q2=22.5. Step 5: replace equilibrium quantities in demand function to find the price.

P=300-3(22.5+22.5)=165
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II. Finding constrained maxima

1.Consumer choice 2.cost minimisation

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1. Consumer choice: graphical analysis

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Consumer problem
What are the quantities of goods X and Y that maximise utility and are affordable, given the consumers budget? Tricky bit 1: the budget constraint is not given. Tricky bit 2: the quantities found have to satisfy 2 conditions: 1. Maximise utility 2. Be affordable . Tricky bit 3: This maximisation involves 2 variables, i.e., X and Y. This means partial differentiation. It would be much easier to differentiate with respect to only 1 variable.
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Solve tricky bit 1: set up the budget constraint.

Px*X+py*Y=I Px is the price of good X and py is the price of good Y. Both prices are known. I is income.

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Solve tricky bit 2: Set up the consumer problem as a system of 2 equations

We know how to solve a system of 2 equations with 2 unknowns It would be easy to solve the consumer problem without graphs if it could be transformed into a system of 2 equations: Maximize U(X,Y) (equation 1) Px*X+py*Y=I (equation 2)
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U(X,Y) is the utility obtained from consuming goods X and Y. X and Y are quantities. The only unknowns in this system are X and Y, and since both appear in both equations, it should be possible to find a solution using algebra. Maximisation means finding the derivative and setting it to 0.

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Example of how to deal with tricky bit 3

Utility function: U(x,y)= x2+y Budget constraint: 10x+30y = 360 Step 1. Solve budget constraint for y: Step 2. Replace y in utility function: Note that the utility is a function of x only. Step 3. Find the F.O.C Step 4. Replace x* into y y=(360-10*(1/6))/30=11.95 y=(360-10x)/30 U(x)= x2+(360-10x)/30)

dU(x,y)/dx =2*x-(10/30)=0 x*=(1/6)

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2. Cost minimisation: graphical analysis

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Cost minimisation problem

Problem: Choose the number of workers and the number of capital units that minimise costs and allow the production of a chosen level of output. Tricky bit 1: the cost function is never given, only the price of capital and the wage. Tricky bit 2: the number of workers and the number of capital units must satisfy 2 conditions:
Result in the lowest possible cost of production Allow the firm to produce a chosen level of output

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Tricky bit 3: there are 2 variables, which means partial 4/14/12 differentiation

Tricky bit 1: set up the cost function

This is easy. Cost equals: price of capital * number of units of capital used in production+price of labour * number of workers employed. Total cost=pk*K+pw*L

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Tricky bit 2: Set up the problem as a system of 2 equations

Total cost=pk*K+pw*L Production function: Q (K,L)=K1/2*L1/2 Note: the bar above Q indicates that Q is constant.

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Tricky bit 3: reduce the 2 equations to 1 before differentiating TC

Total cost=pk*K+pw*L Production function: Q(K,L)=K1/2*L1/2 1. Rewrite Q(K,L) as K(Q,L):
KQL ) ( , Q = L
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2. Replace K(Q,L) in the total cost.

Q TC (L ) = K p *( ) p L L + * L 4/14/12
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Constrained maxima: summary

Step 1: set up the budget constraint or the cost function Step 2: rewrite the budget constraint or the production function so that you have only one variable and the constant in the right-hand side of the equation. Step 3: replace the variable found in step 2 in the function to be maximised (total cost or utility function). This function now has only one variable and constants on the right-hand side . Step 4: differentiate the function found in step 3, equalise to 0, and solve for the variable. Or use the derivative given. Step 5: replace the value of the variable found in step 4 into the budget constraint or production function.

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Example: P-R chapter 7, p. 269, exercise 2

The production function for a product is given by Q=100*K*L. If the price of capital is $120, and the price of labour is $30, what is the minimum cost of producing 1000 units of output?

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Example: P-R chapter 7, p. 269, exercise 2, answer.

The answer will be given during the lecture

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