Chapter- two

Limits, continuity, Differentiation,

integration and their Applications in
economics and business
 Mathematics and Economics

▪ Mathematics is a very exact language that

is useful to express the relationships between
related variables.
▪ Economics is the study of the relationships
between resources and the alternative
outputs.
▪ Therefore, math is a useful tool to express
economic relationships
 What is Mathematical Economics?

▪ A approach to economic analysis in which the

economists make use of the mathematical symbols in
the statement of the problem and also draw upon known
mathematical theorems to aid in reasoning
▪ Refers to economic principles and analyses formulated
and developed through mathematical symbols and
methods.
▪ It is concerned with the empirical
determination of laws of economics, using the theory
and technique of mathematics and statistics.
Mathematical versus Non-mathematical Economics

Since mathematical economics is merely an

approach to economic analysis, it should not
differ from the nonmathematical approach to
economic analysis in any fundamental way.
The difference between these two
approaches is that in the former, the
assumptions and conclusions are stated in
mathematical symbols rather than words
and in equations rather than in sentences
 Economic Model
❑ This is a simple analytic frame which
shows the relationship between the main
factors, and explains the behavior of an
economic theory or phenomenon
❑ Economists use models to simplify reality
in order to improve our understanding of
the world
❑ When we use it as a mathematical
equation it is called a mathematical and
economic model.
 What makes a good model?

• Clearly and simply explains a principle without

extraneous detail

• In economics we generally use math (graphs)

• Equations linking complex factors to study the

effects of change
 Types of Economic Model

❑ Descriptive
– Like the Circular Flow
❑ Analytical
– Assumptions
– Mathematical model ( functions and
equations)
– Graphical analysis
 Function

▪ A relationship between the values of two or more

variables can be defined as a function when a
unique value of one of the variables is determined
by the value of the other variable or variables.
Examples of Function
R = f(X) – revenue function
Qd = f(P) – demand function
Qd = f (Price, Income, Tastes, Population, ect.)
Qs = f (P, Cost of Production, Technology, etc)
Q = f (K,L) – production function)
C = f(Y) – consumption function
 Variable and Constant

❑ Variable – A quantity that assumes different values in a

particular problem. It is a value that may change within the
scope of a given problem or set of operations.
❑ Constant – a quantity whose value remains unchanged
throughout a particular problem.
▪ Numerical Constant – has the same value in all problems
▪ Parametric Constant (Parameter) – has the same value
throughout the problem but may assume different values in
different problems
Ex.
R = 10x (Revenue function)
TC = a + bX (Cost)
C = a + bY (Consumption)
Qd = a – bY (Quantity Demanded)
 Dependent and Independent Variables
❑ A Function is a relationship between two or more
variables such that a unique value of one variable is
determined by the values taken by the other variables in
the function. These variables can be:
▪ Independent Variable – the variable representing the value
being manipulated or changed.
▪ Dependent Variable – observed result of the independent
variable being manipulated
❑ If every value of x is associated with exactly one value
of y, then y is said to be a function of x
❑ y = f (x). Where y is the dependent variable and x is the
independent variable
Inverse Function
Inverse Function
 Direct vs. Inverse Relationship

Direct Relationship
❑ a positive relationship between two variables in which change in one
variable is associated with a change in the other variable in the same
direction.
❑ In a direct relationship, as one variable, say x, increases, the other
variable, say y, also increases, and if one variable decreases, the other
variable decreases

Inverse Relationship
❑ a negative relationship between two variables in which change in one
variable is associated with a change in the other variable in the opposite
direction
❑ In a direct relationship, as one variable, say x, increases, the other
variable, say y, decreases, and if one variable decreases, the other
variable increases. For example, there is an inverse relationship between
education and unemployment — that is, as education increases, the rate of
unemployment decreases
 Inverse and Direct Relationship
Inverse Relationship has a downward sloping curve.
Direct relationship has an upward sloping curve.

Inverse Relationship Direct Relationship

Negative Linear Relationship

Y
Positive Linear Relationship

Y
 Direct vs. Inverse Relationship

Direct Relationship is a positive relationship between

two variables in which change in one variable is
associated with a change in the other variable in the
same direction.
Ex. Price and Quantity Supplied

Inverse Relationship is a negative relationship

between two variables in which change in one variable
is associated with a change in the other variable in the
opposite direction.
Ex. Price and Quantity Demanded
Slope
 Slope of a Line

▪ Slope is negative if the

line slopes downward
to the right
▪ Slope is positive if the
line slopes upward to
the right
▪ Slope of the x-axis or
horizontal line is zero
▪ The slope of the y-axis
or vertical line is
undefined.
 What is Calculus all about?

➢ Calculus is the study of changing quantities,

or more precisely, the rate of changes: e.g.
velocities, interest rate, return on an asset.
➢ The two key areas of Calculus are Differential
Calculus and Integral Calculus.
➢ The big surprise is that these two seemingly
unrelated areas are actually connected via the
Fundamental Theorem of Calculus.
 Introduction to Limits

Under this section the student will learn

about:
Functions and graphs
Limits: a graphical approach
Limits: an algebraic approach
Limits of difference quotients
 Functions and Graphs
A Brief Review

The graph of a function is the graph of the set of all

ordered pairs that satisfy the function. As an example, the
following graph and table represent the function
f (x) = 2x – 1.
x f (x)
-2 -5
We will use this
-1 -3 point on the
0 -1 next slide.
1 1
2 ?
3 ?
 Analyzing a Limit

We can examine what occurs at a particular point

Using the function f (x) = 2x – 1, let’s examine what
happens near x = 2 through the following chart:

x 1.5 1.9 1.99 1.999 2 2.001 2.01 2.1 2.5

f (x) 2 2.8 2.98 2.998 ? 3.002 3.02 3.2 4

We see that as x approaches 2, f (x) approaches 3.

 Limits
In limit notation we have
lim 2x − 1 = 3
3.
x→
2
Definition: We write
2
lim f (x) = L
x→c
or
as x → c, then f (x) → L,

if the functional value of f (x) is close to the single real

number L whenever x is close to, but not equal to, c (on
either side of c).
 One-Sided Limits
We write li f (x) K
x→c
−m =
and call K the limit from the left (or left-hand limit) if
f (x) is close to K whenever x is close to c, but to the left
of c on the real number line.
We write lim f (x) = L
x→c
+

and call L the limit from the right (or right-hand limit) if f
(x) is close to L whenever x is close to c, but to the right of c
on the real number line.
In order for a limit to exist, the limit from the left and the limit
from the right must exist and be equal.
 Example 1

4
2
2

lim− f (x) = 4
x→2

Since the limit from the left and the

lim f (x) = 2
x→2+ limit from the right both exist and but
are not equal, the limit at 2 does not
exist
 Limit Properties
Let f and g be two functions, and assume that the following
two limits exist and are finite:

lim f (x) = and lim g(x) =

x→
c L M
x→c
Then
• the limit of a constant is the constant.
• the limit of x as x approaches c is c.
• the limit of the sum of the functions is equal to the
sum of the limits.
• the limit of the difference of the functions is equal
to the difference of the limits.
 Limit Properties

• the limit of a constant times a function is

equal to the constant times the limit of the
function.
• the limit of the product of the functions is
the product of the limits of the functions.
• the limit of the quotient of the functions is
the quotient of the limits of the functions,
provided M  0.
• the limit of the nth root of a function is the
nth root of the limit of that function.
 Indeterminate Forms

It is important to note that there are restrictions on

some of the limit properties. In particular if
lim r( x) = 0
x→c

then finding lim f ( x) may present difficulties, since the

x→c r(x)
denominator is 0.
f (x)
If lim f (x) = 0and lim g(x) = ,0then lim
x→c g(x)
x→c x→c
is said to be indeterminate. Why ? 0/0 is indeterminate
The term “indeterminate” is used because the limit may or may
not exist.
 Example 4

This example illustrates some techniques that can

be useful for indeterminate forms.

x2 − (x 2)(x −
li 4 = + 2) = lim(x + 2)
m x − lim x− =4
x→ 2 x→ 2 x→2
2
Algebraic simplification
2 is often useful when
the numerator and denominator are both
approaching 0.
 Example 2

lim x2 – 3x = lim x2 - lim 3x = 4 – 6 = -2.

x→2 x→2 x→2

From this example we can see that for a

polynomial function
lim f (x) = f (c)
x→
c
 Indeterminate Form

f (x)
If limf
x→c
(x) = 0 and lim
x→c
g(x) = 0 , then lim
x→c
g (x)
is said to be indeterminate.

The term indeterminate is used because the limit may

or may not exist.
 Continuity

Under this sub section student will learn

about:

 Continuity and solving inequalities

using continuity properties
• The idea of continuity of a function is extremely
important in mathematics.
• Many convenient techniques of analysis can be used
if a function is continuous but not if it is discontinuous.
• In modeling economic problems, we often assume
that we can represent various economic concepts by
continuous functions (e.g., the relationship between
the quantity of some commodity produced by the firm
and its profit level).
• Thus it is important to know precisely what is the
content of this assumption, especially since in many
instances there is a natural reason to believe that the
function will not be continuous everywhere
 Continuity
Some graphs have holes in them, some
have breaks and some have other
irregularities. We wish to study each of
these oddities.
Then through a study of limits we will
examine the instantaneous rate of change.
• When we draw the graph of a function defined
on some interval, we usually do not have to lift
the pencil off the paper. The graph comes in
one piece, like a length of wire. There are no
gaps or jumps, although there may be sharp
corners.
• A function is said to be continuous if, when
considered on any interval in its domain, its
graph has no jumps – it can be traced without
lifting pencil off paper. (The domain of the
function may consist of several intervals).
 Definition

A function f is continuous at a point x = c if

1. lim f (x) exists
x →c

2. f (c) exists

3. lim f (x) = f (c)

x →c

THIS IS THE DEFINITION OF CONTINUITY

 Example 1

f (x) = x – 1 at x = 2.

a. xlim x − 1 = 1 The limit exist!

→2

b. f (2) = 1 AND !
1

c. lim x − 1 = 1 = f (2) 2
x→2

Therefore the function is continuous at x = 2.

 Definition

A function f is continuous on the open

interval (a, b) if it is continuous at each
point on the interval.
If a function is not continuous it is
discontinuous.
 Example 2

f (x) = (x2 – 9)/(x + 3) at x = -3

x 2 −9
a. lim = -6 The limit exist!
x → −3 x + 3

b. f (-3) = 0/0 Is undefined! So

x 2 −9 -3
c. lim  f (−3)
x → −3 x + 3
-6
Therefore the function is not
continuous at x = -3.
 Example 3

f (x) = |x|/x at x = 0 and at x = 1

x
a. lim Does not exist!
x→0 x
Undefined!
b. f (0) = 0/0
0
x
c. lim  f (0)
x→0 x

Therefore the function is not continuous at x = 0.

Notice that the function is continuous at x = 1.
 Continuity Properties

If two functions are continuous on the

same interval, then their sum, difference,
product, and quotient are continuous on
the same interval except for values of x
that make the denominator 0.
Rules of Differentiation and Their Use
Rules of Differentiation and Their Use
Under this sub section students will be able to
know
• Rules of Differentiation for a Function of One
Variable
• Rules of Differentiation Involving Two or More
Functions of the Same Variable
• Rules of Differentiation Involving Functions of
Different Variables
• Partial Differentiation
 Differentiation and the Derivative
•The study of calculus usually begins with the
basic definition of a derivative.
•A derivative is obtained through the process of
differentiation, and the study of all forms of
differentiation is collectively referred to as
differential calculus.
•If we begin with a function and determine its
derivative, we arrive at a new function called the
first derivative. If we differentiate the first
derivative, we arrive at a new function called the
second derivative, and so on.
Differentiation is all about measuring RATE change!
Measuring change in a linear function:

y = a + bx
a = intercept
b = constant slope i.e. the impact of a unit change
in x on the level of y

b = y = y2 − y1
x x2 − x1
 If the function is non-linear:
40
e.g. if y = x2
30
y=x

20
2

10

0
0 1 2 3
X 4 5 6

y y 2 −y1
x
= x2 − x1
gives slope of the line
connecting 2 points (x1, y1) and (x2,y2) on a
curve
• (2,4) to (4,16): slope = (16-4)
/(4-2) =6
• (2,4) to (6,36): slope = (36-4)
/(6-2) =8
 The slope of a curve is equal to the slope of
the line (or tangent) that touches the curve at
that point
Total Cost Curve

40

35

30

25
y=x2

20

15

10

0
1 2 3 4 5 6 7

X
Example:A firms cost function is
Y = X2
X X Y Y
0 0
1 +1 1 +1
2 +1 4 +3
3 +1 9 +5
4 +1 16 +7

Y = X2
Y+Y = (X+X) 2
Y+Y =X2+2X.X+X2
Y = X2+2X.X+X2 – Y
since Y = X2  Y = 2X.X+X2
Y
X = 2X+X

The slope depends on X and X

 The slope of the graph of a function is
called the derivative of the function

dy y
f ' (x) = = lim
dx x→0 x
• The process of differentiation involves letting
the change in x become arbitrarily small, i.e.
letting  x → 0
e.g if = 2X+X and X →0
 = 2X in the limit as X →0
the slope of the non-linear function
Y = X2 is 2X
• the slope tells us the change in y that
results from a very small change in X
• We see the slope varies with X
e.g. the curve at X = 2 has a slope = 4
and the curve at X = 4 has a slope = 8
• In this example, the slope is steeper at
higher values of X
 Rules for Differentiation

1. The Constant Rule

If y = c where c is a constant,
dy
= 0
dx

dy
e.g. y = 10 then =0
dx
2. Th Linea Function
If y = a + bx Rule
dy
=b
dx
dy
=6
y = 10 +6x the dx
3. The Power Function Rule
n
If y = ax , where a and n are constants
dy
= n.a.x n −1
dx

dy
i) y = 4x => dx = 4 x 0
= 4

dy
ii) y = 4x 2
=> dx = 8x

dy −3
iii) y = 4x -2
=> dx = −8 x
4. The Sum-Difference Rule

If y = f(x)  g(x)
dy d [ f ( x )] d [ g( x )]
= 
dx dx dx

If y is the sum/difference of two or more

functions of x:
differentiate the 2 (or more) terms
separately, then add/subtract
dy
(i) y = 2x2 + 3x then = 4x + 3
dx
dy
(ii) y = 5x + 4 then dx = 5
 5. The Product Rule

If y = u.v where u and v are functions of x,

(u = f(x) and v = g(x) ) Then
dy dv du
= u +v
dx dx dx
 Examples

If y = u.v
dy dv du
=u +v
dx dx dx

i) y = (x+2)(ax2+bx)
dy = (x + 2)(2ax + b ) + (ax2 + bx)
dx

ii) y = (4x3-3x+2)(2x2+4x)
dy =  4x −3x +2 (4x +4)+ +4x 12x
3 2

dx     
2x2 −3
6. The Quotient Rule

• If y = u/v where u and v are functions

of x (u = f(x) and v = g(x) ) Then

du dv
v −u
dy dx dx
= 2
dx v
 du dv
v −u
u dy
If y = then = dx 2 dx
v dx v

Example 1

y=
(x + 2)
(x + 4)

dy ( x + 4 )( 1) − ( x + 2 )( 1) 2
= =
dx (x+ 4) 2
(x+ 4) 2
 7. The Chain Rule
(Implicit Function Rule)
• If y is a function of v, and v is a function of
x, then y is a function of x and

dy dy dv
= .
dx dv dx
 Explicit/Implicit

• Explicit functions:
y = 3x – 2
y = x2 + 5
• Implicit functions:
y2 + 2yx + 4x2 = 0
y5 - 3y2x2 + 2 = 0
 Why Implicit Differentiation?
• When an applied problem involves
an equation not in explicit form,
implicit differentiation is used to
locate extrema or to find rates of
change.
 Process for Implicit Differentiation
• To find dy/dx
– Differentiate both sides with respect to x
(y is assumed to be a function of x, so
d/dx)

– Collect like terms (all dy/dx on the same

side, everything else on the other side)

– Factor out the dy/dx and solve for dy/dx

 Example
• Find dy/dx if 3xy + 4y2 = 10
• Differentiate both sides with respect to x:
d
dx
(
3xy +4y2 ) d
= 10
dx
• Use the product rule for (3x)(y)
• (The derivative of y is dy/dx)

(3x) dy + y(3) = (3x) dy +3y

dx dx
 Example Con’t

d
dx
(
3xy+ 4y =
2 d
dx
)10

Since y is assumed to be some function

of x, use the chain rule for 4y2

d dy dy
dx
( )
4y2 = 4 )
dx
= 8y
dx
(
2y1
 Example Con’t

d d 10
dx
(
3xy+ 4y 2
= )
dx
dy dy
(3x) + 3y + 8y =0
dx dx

Combine like terms

dy dy
(3x) + 8y = −3y
dx dx
 Example Con’t

Factor and solve

dy
(3x + 8y) = −3y
dx
dy −3y
=
dx (3x + 8y)
 Tangent Lines
• Find the equation of the tangent line to
the curve below at the point (2,4)
 Tangent Example

• x3 + y3 = 9xy
Now what?
dy dy
3x2 + 3y2 = 9x + 9y
dx dx
dy dy
3y 2
− 9x = 9y − 3x2
dx dx
dy
(3y2 − 9x) = 9y − 3x2
dx
dy 9y −3x 2 2
3(3y −x ) 3y −x
2
= 2 = = 2
dx 3y − 9x 3(y − 3x) y − 3x
2
 Tangent Line Con’t

• The slope of the tangent line is found by plugging

(2,4) into the derivative

3y −x 2 3(4) −(2) 2 4
m= = =
y − 3x (4) − 3(2) 5
2 2

• Since we’re looking for the tangent line:

4
y= x+b
5 4 12
4=
4
(2) + b y= x+
5 5 5
12
=b
5
 dy dy dv
= .
Examples dx dv dx
i) y = (ax2 + bx)½
2
let v = (ax + bx) , so y = v½
( )
1
dy 1 −
2 .(2ax + b )
= ax + bx
2
dx 2

ii) y = + 3x – ) 4

37
3
(4x
let v = (4x + – 7 ), so y v4
dy
3x
dx
( = 3
)(
= 4 4x + 3x − 7 . 12x + 3
3 2
)
 8. The Inverse Function Rule

dy 1
=
If x = f(y) then dx dx dy

• Examples
i) x = 3y2 then
dx dy 1
dy
= 6y so dx = 6 y
ii) y = 4x3 then
dy =12 x 2 dx 1
dx so dy = 12 x 2
9. Differentiating Exponential Functions

If y = exp(x) = ex where e = 2.71828….

dy
then dx = e x

More generally,
rx
If y = Ae
dy
then dx = rAe rx
= ry
 Examples

2x
dy 2x
1) y = e then dx = 2e

dy
-7x -7x
2) y = e then dx = -7e
10. Differentiating Natural Logs
Recall if y = ex then x = loge y = ln y
x dy
• If y = e then dx
= ex = y

• From The Inverse Function Rule

dx 1
y = e  dy = y
x

• Now, if y = ex this is equivalent to writing

x = ln y
dx 1
• Thus, x = ln y =
 dy y
More generally,
dy 1
if y = ln x  dx = x

NOTE: the derivative of a natural log

function does not depend on the co-efficient
of x
Thus, if y = ln mx  dy
dx
=
1
x
 Proof

• if y = ln mx m>0
• Rules of Logs  y = ln m+ ln x
• Differentiating (Sum-Difference rule)
dy 1 1
= 0+ =
dx x x
 Applications of Single-Variable Calculus
In economics, derivatives are used in
various ways:
➢ Marginal amounts (slope)
➢ Maximization
➢ Minimization
➢ Elasticity and
 Instantaneous Slope
To calculate an instantaneous slope/find
a derivative (using calculus), you
need:
1) A function
2) A continuous function
3) A smooth continuous function
 A Function
-A function is any rule that assigns a maximum
and minimum of one value to a range of another
value
- i.e y=f(x) assigns one value (y) to each x
-note that the same y can apply to many x’s, but
each x has only one y
-ie: y=x1/2 is not a function
x = argument of the function (domain of
function)
f(x) or y = range of function
 Higher Order Derivatives
-First order derivate (y’), show us the
slope of a graph
-Second order derivatives measure the
instantaneous change in y’’, or the
slope of the slope or the change in the
slope:
-(Higher-order derivate are also possible)
 Second Derivatives
x=15-10t+t*t
Here the slope
increases as t
10
increases, 5
transitioning 0
from a negative 1 2 3 4 5 6 7 8 x

x
-5

slope to a positive -10

slope. -15
t

A second derivative would be positive, and

confirm a minimum point on the graph.
 Second Derivatives
Here, the slope x=15+10t-t*t

moves from
positive to 50

40
negative, 30
x
decreasing
x
20

over time. 10

0
1 2 3 4 5 6 7 8
t

A second derivative would be negative and

indicate a maximum point on the graph.
 Second Order Derivatives
To take a second order derivative:
1) Apply derivative rules to a function
2) Simplify if possible
3) Apply derivative rules to the answer to (1)
Second order differentiation can be shown
a variety of ways:
a)d2y/dx2 b) d2f(x)/dx2
c)f ’’(x) d) fxx(x)
e) y’’
Second Derivative Examples

3
y=12x +2x+11
y’=36x +2
2

y’’=72x
 Derivative Applications - Graphs
Maxima/minima can aid in drawing graphs
Maximum Point:
If 1) f(a)’=0, and
2) f(a)’’<0,
-graph has a maximum point (peak) at x=a
Minimum Point:
If 1) f(a)’=0, and
2) f(a)’’>0,
-graph has a minimum point (valley) at x=a
x’’= 2, slope is increasing; graph is convex

x=15-10t+t*t
x’=-10+2t=0
t=5
10

0
1 2 3 4 5 6 7 8 x
x

-5

-10

-15
t
x’’=-2, slope is decreasing; graph is concave

x=15+10t-t*t
x’=10-2t=0
t=5

50

40

30
x
x

20

10

0
1 2 3 4 5 6 7 8
t
 Derivative Applications - Graphs
Inflection Points:
If 1) f(a)’’=0, and
2) the graph is not a straight line
-then an inflection point occurs
-(where the graph switches between
convex and concave)
Graphing Steps:
i) Evaluate f(x) at extreme points (x=0, ∞,
- ∞, or a variety of values)
ii) Determine where f(x)=0
iii) Calculate slope: f ’(x) - and determine
where it is positive and negative
iv) Identify possible maximum and
minimum co-ordinates where f ‘(x)=0.
(Don’t just find the x values)
Graphing Steps:
v) Calculate the second derivative – f ‘’(x)
and use it to determine max/min in iv
vi) Using the second derivative, determine
the curvature (concave or convex) at
other points
vii) Check for inflection points where f
‘’(x)=0
Example : y=(x-5)2-3
i) f(0)=(0-5)2 - 3 = 22, f(∞)= ∞, f(-∞)=∞
ii) y=0 when
(x-5)2=3
(x-5) = ± 31/2
x = ± 31/2+5
x = 6.7, 3.3 (x-intercepts)
iii) y’=2(x-5)
y’>0 when x>5
y’<0 when x<5
 y=(x-5)2-3
iv) y’=0 when x=5
f(5)=(5-5)2-3=-3
(5,-3) is a potential max/min
v) y’’=2, (5,-3) is a minimum
vi) Function is always positive, it is
always convex
vii) y’’ never equals zero
 Graphing Example 1

y=(x-5)(x-5)-
3

25 (0,22)

20

15
y

10

5 (3.3,0 (6.7,0
0 ) )
-5 1 2 3 (5,-3)
4 5 6 7 8 9 10

x
 Graphing Example 2

y=(x+1)(x-3)=x2-2x-3
i) f(0)=-3, f(∞)= ∞, f(-∞)=∞
ii) y=0 when
(x+1)(x-3) =0
x = 3,-1 (x-intercepts)
iii) y’=2x-2
y’>0 when x>1
y’<0 when x<1
y=(x+1)(x-3)=x2-2x-3
iv) y’=0 when x=1
f(1)=12-2(1)-3=-4
(1,-4) is a potential max/min
v) y’’=2, x=1 is a minimum
vi) Function is always positive, it is
always convex
vii) y’’ never equals zero
 Graphing Example 2
y=(x+1)(x-
3)

70

60
9, 60

50
8, 45
40

30 -5, 32
7, 32

20 -4, 21 6,
21
-5 -4 -3 -2 -1 0 0, -13 1, -24 2, -3 4 5 6
10 7 8 9 -3, 12 5, 12
-2, 5
4, 5
0 -1, 0 3, 0

-10
OPTIMIZATION
• This section reviews basic results
about functions of one variable,
including the notions of derivative,
extremum and convexity

• It also describes a numerical method

for finding x such that f(x)= 0, known
as \binary search".
 Learning objectives
After completing this chapter students should be able
to:
• Find the maximum or minimum point of a single
variable function by differentiation and checking
first-order and second-order conditions.
• Use calculus to help find a firm’s profit-maximizing
output.
• Find the optimum order size for a firm wishing to
minimize the cost of holding inventories and
purchasing costs.
• Deduce the comparative static effects of different
forms of taxes on the output of a profit-maximizing
firm.
 Optimization
Some claim economists have 3 jobs:
1) Analyze what has happened (past)
2) Describe the current economy (present)
3) Advise on future decisions (future)

For #3, an economist must first calculate

the best possible result.
Optimization falls into two
categories:
1) Maximization (ie: production, profits,
utility, happiness, grades, health,
employment, etc.)

2) Minimization (ie: costs, pollution,

disutility, unemployment, sickness,
homework, etc.)
 Optimizing in 3 Steps
There are three steps for
optimization:
1) FIRST ORDER CONDITION (FOC)
Find where f’(x)=0. These are potential
maxima/minima.
2) SECOND ORDER CONDITION (SOC) Evaluate
f’’(x) at your potential maxima/minima. This
determines if (1)’s solutions are
maxima/minima/inflection points
3) Co-Ordinates Obtain the co-ordinates of your
maxima/minima
 Optimizing Example 1
Cooking is tricky – too long spent cooking,
and it burns, too little time spent cooking
– and some of it is raw and inedible.

Production of oat meal is expressed as:

Let x=15+10t-t2
x = bowls of oatmeal
t = minute intervals of time( 5 minutes)
Maximize Oat meal Production
Optimum of Oat meal
Let x=15+10t-t2
FOC:
x’ = 10-2t = 0
10 = 2t
5 =t
SOC:
x’’ = -2
x’’ < 0, concave, maximum
Let x=15+10t-t2
Co-ordinates:
x(5) = 15+10(5)-52
x(5) = 15+50-25
= 40
Gourmet oatmeal production is maximized at 40
bowls when 25 minutes (5X5) are spent
cooking (All else held equal).
Production is maximized at (5,40).

x=15+10t-t*t

50

40

30
x
x

20

10

0
1 2 3 4 5 6 7 8
t
 Necessary and Sufficient
The FOC provides a NECESSARY
condition for a maximum or
minimum.
The FOC is not a SUFFICIENT
condition for a maximum or
minimum.
The FOC and SOC together are
NECESSARY AND SUFFICIENT
conditions for a max. or min.
 Marginal Concepts in economics
Marginal Profit = Change in profit from the
sale/production of one extra unit.
M =dp/dq
If Marginal Profit >0, quantity should
increase; as the next unit will increase
profit.
If Marginal Profit <0, quantity should
decrease, as the last unit decreased
profit
Quantity is therefore optimized
when Marginal Profit=0; when
dπ/dq=0.
Second Order Condition still
confirms that this is a maximum
(ie: that the previous unit
increased profit and the next unit
will decrease profit.)
 Marginal Concepts
Alternately, remember that
Profit = Total Revenue – Total Costs
Or π = TR-TC
therefore
Mπ=MR-MC (dπ/dq=dTR/dq-dTC/dq)
So Mπ = 0 is equivalent to saying that
MR-MC =0
MR=MC
 Constrained Optimization
so far we have considered
UNCONSTRAINED optimization. (No
budget constraint, time constraint, savings
constraint, etc.)
We can also deal with CONSTRAINED
optimization.
Maximize utility with respect to a set income.
Maximize income with respect to a 24 hour day.
Maximize lie effectiveness while keeping a
straight face.
• Unconstrained: simply means that the choice variable can
take on any value—there are no restrictions.
• Constrained: means that the choice variable can only take
on certain values within a larger range.
• In a sense, nearly all economic problems are constrained
because we are interested almost exclusively in non-negative
numbers for variables like output and prices.
• However, this constraint is so common that we tend to ignore
it and think of constrained problems as those with constraints
in addition to non-negativity.
• For example, the budget constraint in the simple consumer
problem (remember this? Income must be greater than or
equal to Expenditure) restricts the number of goods that you
can buy given income and prices.
• So, we don’t want you to think of problems that only restrict
values of the choice variable to non-negative numbers as
constrained problems.
 First-derivative test
• The first-order condition or necessary
condition for extrema is that f '(x*) = 0 and
the value of f(x*) is:
• A relative maximum if the derivative f '(x)
changes its sign from positive to negative
from the immediate left of the point x* to its
immediate right. (first derivative test for a
max.)
y
A f '(x*) = 0

x*
• The first-order condition or necessary
condition for extrema is that f '(x*) = 0
and the value of f(x*) is a relative
minimum if f '(x*) changes its sign
from negative to positive from the
immediate left of x0 to its immediate
right. (first derivative test of min.)
y

B
f '(x*)=0
'(x

x
x*
• The first-order condition or necessary
condition for extrema is that f '(x*) = 0 and
the value of f(x*) is neither a relative maxima
nor a relative minima if
f '(x) has the same sign on both the immediate
left and right of point x0. (firstderivative test
for point of inflection)

D
• f '(x*)
' =0

x* x
 Example

y = f ( x )= x3 −12x 2 +36 x +8 primative function

f '( x ) = 3x − 24x + 36 = 0
2
1st derivative
f '( x ) = 3 ( x − 8 x + 12 ) =
2

0 ( x − 2 )( x − 6 ) = x *
1
= 2; x =6
*
2
extrema
0left y = f (x )
* *
i
right
f ( 1.5 ) = 38.375 f ( 2 ) = 40 f 2.5 = 38.625 max
f '( 1.5 ) = 6.75 f '( 2 ) = 0 f '( 2.5 ) = −5.25 ( +,1)
f ( 5.5 ) = 9.375 f ( 6 ) = 8 f ( 6.5 ) = 9.625 min
f '( 5.5 ) = −5.25 f '( 6 ) = 0 f '( 6.5 ) = 6.75 ( −,+)
 primitive function and 1st & 2nd
derivatives
1) f ( x ) = (x 3 − 12 x 2 + 36 x + 8 )

2) f  ( x ) = ( 3 x 2 − 24 x + 36 )
f  ( x ) = (x 2 − 8 x + 12 ) = 0
( x − 2 )(x − 6 ) = 0

3) f  ( x ) = ( 6 x − 24 ) = 0
x=4
 Example 2

AC =Q2 − 5Q + 8 primativ functio

e n
f ( Q = 2Q − 5 =
/
1st derivativ
) Q0* = 5 / 2 = 2.5 e
extrem
( )
a
left AC = f Q right
f ( 2.4 ) = f ( 2.5 ) = f ( 2.6 =
*
relativ min
f '() 2.6 ) =
1.75 1.76 e
f 1.76 /

'( 2.4 ) = f ( 2.5 ) = 0 0.2 ( −,+ )

−0.2
plots: primitive convex function, as well as

1st & 2nd derivatives

1) AC = Q 2 − 5Q + 8

2) MC = 2Q − 5
MC = 2Q − 5 = 0
Q=5 2

3) MC  = 2
Example on Re venue function
1 ) R = 1200Q − 2Q 2
primative function
Revenue function
dR
2) = 1200 − 4Q = 0 1st derivative
dQ
3 ) 4Q = 1200; Q = 300
*
extrema
d R 2

4) = −4 2nd derivative
dQ 2

if f ( x  0, then relative maximum

//
Primitive function and 1st &
2nd derivatives

1) R = 1200Q − 2Q 2

2 ) MR = 1200 − 4Q
1200 − 4Q = 0
Q = 300
3 ) MR = −4
 More on necessary and sufficient conditions
• The zero slope condition is a necessary
condition and since it is found with the first
derivative, we refer to it as a 1st order
condition.
• The sign of the second derivative is sufficient
to establish the stationary value in question as
a relative minimum if f "(x0) >0, relative
maximum if f "(x0)<0.
 Profit maximization

1) TR = 1200Q − 2Q 2 revenue function

2) TC = Q 3 −61.25Q 2 +1528.5Q + 2000 cost function
3) π = TR - TC = 1200Q − 2Q 2 − ( Q 3 − 61.25Q 2 + 1528.5Q + 2000 ) profit
= −Q 3 + 59.25Q 2 − 328.5Q − 2000
function simplified
5)   = −3Q 2 + 118.5Q − 328.5 = 0 1st derivative
6) Q1* = 3 Q2* = 36.5 quadratic eq. → extrema
7)   = −6Q + 118.5 2nd derivative
8)  ( 3 ) = 100.5  ( 36.5 ) = −100.5 solving 2nd der. w/ extrema
9)   (Q1* )  0 →   (Q2* )  0 → applying the smile test
min max
 Profit function: example 3

revenue and cost

functions
1) TR = 1200Q − 2Q 2
2) TC = Q 3 − 61.25Q 2 + 1528.5Q +
profit 2000
function
3) π = TR - TC = − Q 3 + 59.25Q 2 − 328.5Q −
2000 of profit
1st derivative
function
4)   = −3Q 2 + 118.5Q − 328.5
5) =
Q*0= 3 Q* =
1 2

2nd derivative of36.5 profit

6function
)  = −6Q +
7)  (118.5
3 ) = 100.5  ( 36.5 ) =
−100.5
applying the smile
( ) ( )
test
8)  Q 1
*
 0 → min  2 Q*  0
→ max
 Imperfect Competition, Example 4
Total revenue function
1) TR  AR*Q =  8000 − 23Q
 +1.1Q2 −0.018Q3  

 
Average and total revenue functions
1) AR = f ( Q ) = 8000 − 23Q + 1.1Q 2 −
2) 0.018Q3
Marginal = f (Q )and
TR revenue Q the product rule
3) MR = f ( Q )Q + Qf ( Q )
4) MR = ( 8000 − 23Q + 1.1Q2 − 0.018Q3 ) (1)
+Q ( −23 + 2.2Q − .054Q 2 )
= 8000 − 46Q + 3.3Q 2 − 0.0.72Q 3
2nd derivative
5) MR = f  ( MR )
6) MR = −46 + 6.6Q − 0.216Q 2 = 0
7) Q1* = 10.76 Q2* = 19.79
3rd derivitive
8) MR  = f  ( MR )
9) MR( Q ) = 6.6 − 0.432Q
10 ) MR( 10.76 ) = 1.95 MR"( 19.79 ) = −1.94
smile test
11 ) MR( Q1* )  0 → min. MR"( Q2* )  0 → max.
 Lagrange form of the
remainder
Y = (7 - x)4 primitive function
Y / = - 4( 7 - x)3 1st deriative
Y / = 0 at x* = 7 the critical value
Y (7 ) = 12( 7 - x) = 0
// 2 2 nd deriviative
Y ( 3 ) (7 ) = -24( 7 - x) = 0 3rd derivative
Y (4)
(7 ) = 24 4th derivative
(n )
Because first nonzero derivative Y is even (4)
and Y (4)  0 (24), critical value is a minimum.
Lagrange form of the remainder

Y = ( 7-x)4 primitive
 function

Y ( 4) = 24 4th derivative
decisionrule :
n is even (4) and  0
thereforea
minimum
CONSTRAINED OPTIMIZATION
• In constrained optimisation we distinguish
between the thing we’re trying to maximize –
the objective function and the thing that
places constraints – the constraints or the
constraint functions.
 The Lagrangean technique

.
 The constrained optima problem can be stated as finding the
So Lagrange (a mathematician) formed the augmented
function.

extreme value of

subject to
denotes augmented function
will behave like the function if the constraint is followed.
 Lagrange Multipliers

• Given the augmented function, the first order condition

for optimization (where the independent variables are
, and λ) is as follows:
 Lagrange Multipliers
 Suppose utility function : U =5X1X2
 Budget constraint :
 Then, find optimal level of x1 and x2

note:
to be on the budget
line
• Solving these 3 equations simultaneously:
Lagrange Multipliers

• Solving these 3 equations simultaneously (cont’d):

 Lagrange Multipliers

• If , then

• This solution yields the same answer as the

substitution method, i.e., and .
 Lagrange Multipliers
• Economists prefer using the Lagrange technique
over the substitution method, because:

(i) easier to handle for most cases and

(ii) provides additional information.


Namely for (ii), the value of λ has an economic
interpretation. (There is no counterpart to this
variable in the substitution method).
 Lagrange Multipliers
 Given,

where C is the level of expenditures

(budget = $100 in this example).

here the Lagrange multiplier measures the

sensitivity of
to changes in the constraint (C
 Lagrange Multipliers
 2nd order conditions

Given

 1st order conditions for extremum:

 Lagrange Multipliers
• 2nd order conditions involve second order
partial derivatives expressed in the form of a
determinant.
• In the constraint case, we will utilize the
bordered Hessian – which is the Hessian of the
free optima case surrounded by the partial
derivatives with respect to the Lagrange
multiplier λ.
 Lagrange Multipliers

 2nd order partials:

 Lagrange Multipliers

 2nd order partials:

 Lagrange Multipliers

Note: partials with respect to Lagrange

multiplier (λ) form the border
 Lagrange Multipliers

 So the 2nd order condition is:

 Let’s now return to our previous example:

◦ Recall the critical values of ,

and .
 Lagrange Multipliers

• What about the 2nd order conditions?

 Lagrange Multipliers

Find
 Lagrange Multipliers

Expand by 1st row:

 Lagrange Multipliers

represents a relative maxima

The essence of the technique is that it turns an
optimisation with constraints (which we don’t know
how to solve) into an unconstrained optimisation
(which we can solve).
1. Identify the objective, f(x,y) and the constraint(s),
g(x,y) = 0.
2. Set up the “Lagrangean”:
L = f(x,y) + λg(x,y)
3. Maximize this function with respect to x, y, and λ
(lambda – called the “lagrangean multiplier”).

Example: f = -x2 + 10x-6, g = 4-x, so

L = -x2 + 10x-6 + λ(4-x)
Maximization consists of:
1. Partially differentiating to obtain the first-order
conditions.
2. Solving the resulting system of equations
3. Checking second order conditions.

Example: L = -x2 + 10x-6 + λ(4-x)

L
=−2x+10− =0
x
L
=4− x=0

2. X = 4
3. You do it.
 Utility maximisation example
Suppose that utility is derived from two goods, x and y,
according to the utility function u = lnX + lnY . The
consumer has the income I to spend; the prices of the two
goods are Px and Py.

The Lagrangian for the utility-maximization problem is

thus
The interpretation of equation – is that the marginal
rate of substitution between x and y equals their
price ratio.

Since there are only two choice variables (not

counting λ), the second-order condition for this

problem is that the determinant of the bordered

Hessian be positive:
The solution for the first-order conditions given by
equation --- are thus true maximum. The first-order
conditions are three equations with three unknowns x, y
and , but they are non-linear equations. The solutions
λ
can be derived by successive substitutions, however. For
example, to derive the demand for x, we first use the last
two first-order conditions to solve for as a function of x
λ
and then substitute that function into the first of the first-
order conditions:
• The economic interpretation of the
above solution is that the amount
demanded of x is a function of income (I)
and its own price (Px) and similarly, the
amount of y is a function of income (I) its
own price (Py).
More on utility maximization: use the same approach.

Example. Lense has preferences described by the

utility function, U = x0.5y0.5. She has an income of
1000 and the price of x is 10, while the price of y is
20. What is her optimal level consumption?

1. The objective is: x0.5y0.5

The constraint is: 1000 = 10x + 20y or 1000-10x-20y = 0

2. The lagrangean: x0.5y0.5 + λ(1000-10x-20y)

 Utility maximisation.

2. The lagrangean: x0.5y0.5 + λ(1000-10x-20y)

3. First order conditions.

L
=0.5x −0.5 y 0.5 −10 =0
x
L
=0.5x 0.5 y −0.5 −20 =0
y
L
=1000−10x−20 y=0

 Solving...
We are not usually interested in λ. The standard way to solve is:
1. Eliminate λ. (e.g. by making λ the subject of equations 1 and 2.)
2. Make either x or y the subject of the resulting equation.
3. Use equation 3 to eliminate either x or y. This gives the demand for one
good.
4. Then reinsert the result to find the demand for the other good.
E.g.
L
=0.5x −0.5 y 0.5 −10 =0
x
L
=0.5x 0.5 y −0.5 −20 =0
y
Yields, 0.5x −0.5 y 0.5 =10
0.5x 0.5 y −0.5 =20
Divide:
0.5x −0.5 y 0.5 10
=
0.5x 0.5 y −0.5 20
 Solving...

0.5x −0.5 y 0.5 10

=
0.5x 0.5 y −0.5 20
Or, x −0.5 y 0.5 1
=
x 0.5 y −0.5 2
Or,
x−1y =0.5
Or
y =0.5x
Now use the third equation: 1000 = 10x + 20y = 10x +20.0.5x = 20x

So x = 50
Use y = 0.5x to get y = 25.
Concavity, convexity and
second derivatives
 Objective

➢ To determine the convexity and

concavity of functions
 Concavity and Convexity

• Frequently, we need to know more about the shape (or the convexity and
concavity nature) of the curve than where it is increasing and where it is
decreasing. Moreover, in economic analysis, function is often referred to as
concave or convex. For example, production possibility frontiers are usually
assumed to be concave, whereas indifference curves are assumed to be
convex. The convexity and concavity nature of a function can be determined
either graphically or algebraically. However, determining whether a function
is concave or convex either graphically or algebraically is a difficult task and
thus we need to have another method to know the concavity and convexity
nature of a function.
• A function is said to be strictly convex on interval
if the tangent line at every point on lies below its
curve.

• Moreover, a function is strictly convex if the

tangent line lies below its curve throughout its
domain.

• Note that a strictly convex function can be either

monotonic increasing or monotonic decreasing.
• A function is said to be strictly concave on
interval if the tangent line at every point on lies
above its curve. Moreover, a function is strictly
concave if the tangent line lies above its curve
through its domain.

• Note that a strictly concave function can be

either strictly increasing or strictly decreasing.
Solu~o
ns

il.~~S~. = 2and = 0 for all values of x, this function is neither strictly

: ~; convex nor strictly
conca
ve.
b) f'(x) = 2xand !' (x) = 2 > 0 fuall values of x. Thus, the function
is strictly convex.
c) (x)=6 .
J'(x)=3x2and x
f
Now, f is strictly f •(x) > 0 which tha 6x > 0.1.1!ll also >
convex if implies t implies that x 0.
Thus, f is strictly (-<0
convex~ 0) .
Similarly, is conca if f •(x) < 0 implies 6x < 0. turn
f strictly ve which that Thi.~. in implies
that x < 0. Thus, f is convex (0
strictly f..o..r...x...<...0....o oo) .
 Example
Consider the FF example for a function of two variables. Locate the stationary
points of and find out if the function is convex, concave or neither at the
points of optima based on the testing rules discussed above.

f (x) = − 45x + 40x + 5

4 3

12x 5
Since the 2nd
derivative is non-zero x = x * = 0 is neither a point of or minimum
but it is a point maximum
of inflection. Hence the function is neither convex nor concave at this
point.

Consider x = x* = 1
j "(x"') = 240(x"')3 - 540(x"')2 + 240x*= -60 at x"' = 1
Since the second derivative is negative, the point x = x* = 1 is a point of local maxima a
with
maximum value = 12 - 45 + 4 O+ 5 = 12. Al this the function concave sinc
ofj(x) point is e
u3 j I ox2< 0.

Consider x = x* = 2

f "(x"') = 240(x")3 - 540(.r}2 + 240x*= 240 = 2

at x*
Sinee the second derivative is positive, the point x = x* = 2 a point of minima with a
local
is
minimum value ofj(x) = -11. At this point the function is since a2 j I ih-2>
convex
0.
220
Linear programming problems
 What is LP?
 The word linear means the relationship which can be
represented by a straight line .i.e the relation is of the
form ax +by=c.

 In other words it is used to describe the relationship

between two or more variables which are
proportional to each other.

The word “programming” is concerned with the optimal

allocation of limited resources.
 Definitions of LP
• LP is a mathematical modeling technique useful
for the allocation of “scarce or limited “
resources, such as labor, material, machine ,time
,warehouse space ,etc…,to several competing
activities such as product ,service ,job, new
equipments, projects, etc...on the basis of a
given criteria of optimality.
• The phrase scare resource means resource that
are not available in infinite quantity during the
planning period.
• The criteria of optimality ,generally is either
performance ,return on investment ,profit ,cost
,utility ,distance etc.
 Definitions of LPP
• A mathematical technique used to obtain
an optimum solution in resource
allocation problems, such as production
planning.
• It is a mathematical model or technique
for efficient and effective utilization of
limited recourses to achieve organization
objectives (Maximize profits or Minimize
cost).
 Linear Programming - LP
• The maximization or minimization of some quantity is
the objective in LP problems.
• All LP problems have constraints that limit the degree
to which the objective can be pursued.
• A feasible solution satisfies all the constraints.
• An optimal solution is a feasible solution that results
in the largest possible objective function value when
maximizing (or smallest when minimizing).
• A graphical solution method can be used to solve a
linear program with two variables.
• Decision variables: We need to evaluate various
alternatives (course of action) for arriving at the optimal
value of objective function. The evaluation of these
alternatives is guided by the nature of objective function
and availability of resource. For this we presume certain
activities (decision variables) usually denoted by
x1,x2….xn.
– The value of these activities represents the extent to
which each of these is performed.
• The constraints: There are always certain limitations
(or constraints ) on the use of resources e.g. labour, m/c,
raw material, money etc.. That limit the degree to which
an objective can be achieved. Such constraints must be
expressed as linear equalities or inequalities in terms of
decision variables.
– The soln of LP model must satisfy these constrai2n27ts.
 LP Assumptions
• When we use LP as an approximate representation
of a real-life situation, the following assumptions are
inherent:
1. Proportionality. - The contribution of each decision variable
to the objective or constraint is directly proportional to the
value of the decision variable.
2. Additivity. - The contribution to the objective function or
constraint for any variable is independent of the values of the
other decision variables, and the terms can be added
together sensibly.
3. Divisibility. - The decision variables are continuous and thus
can take on fractional values.
4. Deterministic. - All the parameters (objective function
coefficients, right-hand side coefficients, left-hand side, or
technology, coefficients) are known with certainty.
 Optimization & Problem Solving
• Optimization attempts to express the goal of solving a
problem in the best way.
– Running business to maximize profit, minimize loss and
risk
– Design a bridge to maximize strength
– Selecting a flight plan to minimize time and fuel use
• To solve a problem:
– Define and formulate the problem
– Build a mathematical model of the problem
– Verify the model
– Identify and evaluate suitable feasible alternatives
– Select the best alternative
– Interpret and present your decision
 Advantages of LPP
• LP helps in attaining the optimum use of productive
resources.
• LP improves the quality of decisions .
• The decision-making approach of the user of the
technique becomes more objective and less subjective.
• It also helps in providing better tools for adjustments to
meet changing conditions.
• Most business problems involve constraints like raw
material availability, etc which must be taken into
consideration. Just coz we can produce so many units
does not mean that they can be sold. LP can handle
such situation also since it allows modification of its
mathematical solutions.
• Highlighting the bottle neck in the production process is
the most significant advtg of this process.
 Limitations of LPP
• LP treats all relationships among decision variables as linear.
However ,generally, neither the OF nor the constraints in real
life situations concerning business and industrial problems are
linearly related to the variables .It may yield fractional valued
ans for decision variables, round the same values may not yield
an optimal solu.
•
LP model does not take into consideration the effect of time and
• uncertainty.
Parameters appearing in the model are assumed to be constant
but in real life situations, they are frequently neither known nor
• constant.
It deals only with single objectives, whereas in real-life
situations we may come across conflicting multi-objective
• problems.
For large problems having many limitations and constraints, the
computational difficulties are enormous, even when the
assistance of computer is available. For it, the main problem
can
eachbe fragmented
one separately.into several small problems and solving231
 Problem Formulation
• Problem formulation or modeling is the process of
translating a verbal statement of a problem into a
mathematical statement.
guideline for LPP formulation
• Understand the problem thoroughly.
• Describe the objective.
• Describe each constraint.
• Define the decision variables.
• Write the objective in terms of the decision
variables.
• Write the constraints in terms of the decision
variables.
 Example. A Nutrition Aid Problem
• A Nutrition Aid Program is considering two food
supplements S1 and S2 for distribution among a
population deficient in nutrients N1, N2, and N3. The
nutritional content and prices of the food supplements
and the minimum daily nutritional requirements per
person are given in Table 3.1
• For example, each unit of S1 provides 4 units of N1, 8
units of N2, 5 units of N3, and costs 6 pesos.
• The problem is to determine the daily quantities of the
food supplements for each person that meet the
minimum daily requirements and entail the least cost.
To formulate this problem mathematically, let x i (i = 1,2)
denote the quantity of Si (i = 1,2) needed per person per day.
The cost C (assuming no discounts) is given by
C = 6x1 + 4x 2 .
To satisfy the.minimum.daily requirements, we must have
4x1 + 12x 2 > 96
8x1 + 4x 2 > 112
5x1 + 5x 2 > 100.
Finally, the quantities x must not be negative, i.e.,
i

x1 >0, x2  0.
The problem is expressed formally as follows:
Minimize 6x1 + 4x 2
subject to 4x1 + 12x 2 > 96
8x1 + 4x 2 > 112
5x1 + 5x 2 > 100
and x1 >0, x2  0.
 Example. A Product Mix Problem
• A firm produces two different products P1 and
P2. Every unit of P1 uses 3 units of resource 1
(R1) and 1 unit of resource 2 (R2) and earns a
profit of 5 pesos. The firm wants to determine
how many of the two products must be
manufactured each week in order to maximize
profit subjectProduct1
only to P
resource availability.
Product 2 P Available
1 2
(per unit) (per unit) Resource
R1 3 2 60
R2 1 2 40
Unit Profit P5 P4
 P1 P2 Available
(per unit) (per unit) Resource

R1 3 2 60
R2 1 2 40
Unit Profit P5 P4
 Methods of Solving Linear
Programming Problems (LPP)
There are Two important methods of solving L.P.P. They
are:

(1) Graphical method

(2) Simplex method
 Example 1: A Maximization Problem

• LP Formulation

Max 5x1 + 7x2

s.t. x1 < 6
2x1 + 3x2 < 19
x1 + x2 < 8
x 1, x 2 > 0
 Example 1: Graphical Solution

• Constraint #1 Graphed
x2

6
x1 < 6
5

2
(6, 0)
1

1 2 3 4 5 6 7 8 9 10
x1
• Constraint #2 Graphed
x2

8
(0, 6 1/3)
7

4 2x1 + 3x2 < 19

3

2 (9 1/2, 0)
1

1 2 3 4 5 6 7 8 9 10
x1
 Example 1: Graphical Solution

• Constraint #3 Graphed
x2
(0, 8)
8

7
x1 + x2 < 8
6

1
(8, 0)

1 2 3 4 5 6 7 8 9 10
x1
 Example 1: Graphical Solution

• Combined-Constraint Graph
x2
x1 + x2 < 8
8

6
x1 < 6
5

3
2x1 + 3x2 < 19
2

1 2 3 4 5 6 7 8 9 10
x1
 Example 1: Graphical Solution
• Feasible Solution Region
x2

3
Feasible
2
Region
1

1 2 3 4 5 6 7 8 9 10
x1
 Example 1: Graphical Solution
• Objective Function Line
x2

7
(0, 5)
6 Objective Function
5 5x1 + 7x2 = 35
4

2
(7, 0)
1

1 2 3 4 5 6 7 8 9 10
x1
 Example 1: Graphical Solution
• Optimal Solution
x2
Objective Function
5x1 + 7x2 = 46
8

6
Optimal Solution
(x1 = 5, x2 = 3)
5

1 2 3 4 5 6 7 8 9 10
x1
 Extreme Points and the Optimal Solution

• The corners or vertices of the feasible region

are referred to as the extreme points.
• An optimal solution to an LP problem can be
found at an extreme point of the feasible
region.
• When looking for the optimal solution, you do
not have to evaluate all feasible solution
points.
• You have to consider only the extreme points
of the feasible region.
 Summary of the Graphical Solution Procedure
for Maximization Problems

• Prepare a graph of the feasible solutions for

each of the constraints.
• Determine the feasible region that satisfies all
the constraints simultaneously.
• Draw an objective function line.
• Move parallel objective function lines toward
larger objective function values without entirely
leaving the feasible region.
• Any feasible solution on the objective function
line with the largest value is an optimal solution.
 Slack and Surplus Variables

• A linear program in which all the variables are non-

negative and all the constraints are equalities is said to be
in standard form.
• Standard form is attained by adding slack variables to
"less than or equal to" constraints, and by subtracting
surplus variables from "greater than or equal to"
constraints.
• Slack and surplus variables represent the difference
between the left and right sides of the constraints.
• Slack and surplus variables have objective function
coefficients equal to 0.
 Example 1: Graphical Solution
• The Five Extreme Points
Point Z
x2
(0,0) 0
8
(6,0) 30
7
5 (6,2) 44
6
(5,3) 46
5
(0,19/3) 44.33
4

3 4
2 Feasible 3
1 Region
1 2
1 2 3 4 5 6 7 8 9 10 x1
 A Maximization Problem
• Optimal Solution
Point Z
x82
(0,0) 0
(6,0) 30
7
(6,2) 44
6
Optimal Solution (5,3) 46
5
(0,19/3) 44.33
4

x1
1 2 3 4 5 6 7 8 9 10
 Extreme Points and the Optimal Solution
• The corners or vertices of the feasible region are
referred to as the extreme points.
• An optimal solution to an LP problem can be found
at an extreme point of the feasible region.
• When looking for the optimal solution, you do not
have to evaluate all feasible solution points.
• You have to consider only the extreme points of the
feasible region.
 Feasible Region
• The feasible region for a two-variable linear programming
problem can be nonexistent, a single point, a line, a
polygon, or an unbounded area.
• Any linear program falls in one of three categories:
– is infeasible
– has a unique optimal solution or alternate optimal
solutions
– has an objective function that can be increased without
bound
• A feasible region may be unbounded and yet there may be
optimal solutions. This is common in minimization problems
and is possible in maximization problems.
 Special Cases

• Alternative Optimal Solutions

In the graphical method, if the objective function line is
parallel to a boundary constraint in the direction of
optimization, there are alternate optimal solutions, with all
points on this line segment being optimal.
• Infeasibility
A linear program which is overconstrained so that no point
satisfies all the constraints is said to be infeasible.
• Unbounded
For a max (min) problem, an unbounded LP occurs in it is
possible to find points in the feasible region with arbitrarily
large (small) Z
 Example with Multiple Optimal
Solutions
x2
z1 z2 z3
Maximize z = 3x1 – x2
4

3 subject to 15x1 – 5x2  30

2
10x1 + 30x2  120
1
x1  0, x2  0
0
0 1 2 3 4 x1
 Example: Unbounded Problem
• Solve graphically for the optimal solution:

Max z = 3x1 + 4x2

s.t. x1 + x2 > 5
3x1 + x2 > 8
x 1, x2 > 0
 Example: Unbounded Problem
• The feasible region is unbounded and the objective function line can be moved
parallel to itself without bound so that z can be increased infinitely.

x2

3x1 + x2 > 8
8

5
x1 + x2 > 5

x1
2.67 5
Solve the following LP graphically

A
B
C
D
E
F

Where x1 is the quantity produced from

product Q, and x2 is the quantity of Are the LP assumptions
product P valid for this problem?
 The graphical solution
P
Assignment:
240 Max Q Complete the problem to find
the optimal solution
E
200
D
160

120 Max P
F
80
A
(
40 1
B ) C
0
0 40 80 120 160 200 240 280 320 360 Q
 Graphical solution of a Minimization Problem
• LP Formulation

Min 5x1 + 2x2

s.t. 2x1 + 5x2 > 10

4x1 - x2 > 12
x1 + x2 > 4

x 1, x 2 > 0
 Example 2: Graphical Solution
• Graph the Constraints
Constraint 1: When x1 = 0, then x2 = 2; when x2 =
0, then x1 = 5. Connect (5,0) and (0,2). The ">"
side is above this line.
Constraint 2: When x2 = 0, then x1 = 3. But
setting x1 to 0 will yield x2 = -12, which is not on
the graph. Thus, to get a second point on this
line, set x1 to any number larger than 3 and
solve for x2: when x1 = 5, then x2 = 8. Connect
(3,0) and (5,8). The ">" side is to the right.
Constraint 3: When x1 = 0, then x2 = 4; when x2 =
0, then x1 = 4. Connect (4,0) and (0,4). The ">"
side is above this line.
 Example 2: Graphical Solution
• Constraints Graphed

x2 Feasible Region

4x1 - x2 > 12
5

4 x1 + x2 > 4

3
2x1 + 5x2 > 10
2

1
x1
1 2 3 4 5 6
 Example 2: Graphical Solution

• Graph the Objective Function

Set the objective function equal to an arbitrary
constant (say 20) and graph it. For 5x1 + 2x2 = 20,
when x1 = 0, then x2 = 10; when x2= 0, then x1 = 4.
Connect (4,0) and (0,10).
• Move the Objective Function Line Toward
Optimality
Move it in the direction which lowers its value
(down), since we are minimizing, until it touches the
last point of the feasible region, determined by the
last two constraints.
 Example 2: Graphical Solution
• Objective Function Graphed

x2 Min z = 5x1 + 2x2

4x1 - x2 > 12
5

4 x1 + x2 > 4

3
2x1 + 5x2 > 10
2

1
x1
1 2 3 4 5 6
 Example 2: Graphical Solution

• Solve for the Extreme Point at the Intersection of

the Two Binding Constraints
4x1 - x2 = 12
x 1+ x 2 = 4
Adding these two equations gives:
5x1 = 16 or x1 = 16/5.
Substituting this into x1 + x2 = 4 gives: x2 = 4/5
 Example 2: Graphical Solution
• Solve for the Optimal Value of the
Objective Function
Solve for z = 5x1 + 2x2 = 5(16/5) +
2(4/5) = 88/5.
Thus the optimal solution is
x1 = 16/5; x2 = 4/5; z = 88/5
 Example 2: Graphical Solution

◼ Optimal Solution
x2 Min z = 5x1 + 2x2

4x1 - x2 > 12
5

4 x1 + x2 > 4

3 2x1 + 5x2 > 10

2
Optimal: x1 = 16/5
1 x2 = 4/5
x1
1 2 3 4 5 6
Simplex Method for solving linear
programming problems

270
 Feasible Region
• The feasible region for a two-variable linear programming
problem can be nonexistent, a single point, a line, a
polygon, or an unbounded area.
• Any linear program falls in one of three categories:
– is infeasible
– has a unique optimal solution or alternate optimal
solutions
– has an objective function that can be increased without
bound
• A feasible region may be unbounded and yet there may be
optimal solutions. This is common in minimization
problems and is possible in maximization problems.

271
Simplex Method for solving linear programming problems
Simplex:
•
a linear-programming algorithm that can
solve problems having more than two decision
variables.
• The simplex technique involves generating a
series of solutions in tabular form, called tableaus.
By inspecting the bottom row of each tableau, one
can immediately tell if it represents the optimal
solution. Each tableau corresponds to a corner
point of the feasible solution space. The first
tableau corresponds to the origin. Subsequent
tableaus are developed by shifting to an adjacent
corner point in the direction that yields the highest
(smallest) rate of profit (cost). This process
continues as long as a positive (negative) rate of
profit (cost) exists.
 Simplex Algorithm

The key solution concepts

• Solution Concept 1: the simplex method focuses

on CPF solutions.

• Solution concept 2: the simplex method is an

iterative algorithm (a systematic solution
procedure that keeps repeating a fixed series of
steps, called, an iteration, until a desired result
has been obtained) with the following structure:
 Simplex algorithm
Initialization: setup to start iterations, including
finding an initial CPF solution

Optimality test: is the current CPF solution

optimal?
op

if no if yes stop

Iteration:
It Perform an iteration to find a better CFP solution
 Simplex algorithm

• Solution concept 3: whenever possible, the

initialization of the simplex method chooses the
origin point (all decision variables equal zero) to
be the initial CPF solution.
• Solution concept 4: given a CPF solution, it is
much quicker computationally to gather
information about its adjacent CPF solutions than
about other CPF solutions. Therefore, each time
the simplex method performs an iteration to move
from the current CPF solution to a better one, it
always chooses a CPF solution that is adjacent to
the current one.
 Simplex algorithm
• Solution concept 5: After the current CPF solution is
identified, the simplex method examines each of the
edges of the feasible region that emanate from this
CPF solution. Each of these edges leads to an
adjacent CPF solution at the other end, but the
simplex method doesn’t even take the time to solve
for the adjacent CPF solution. Instead it simply
identifies the rate of improvement in Z that would be
obtained by moving along the edge. And then
chooses to move along the one with largest positive
rate of improvement.
 Simplex algorithm

• Solution concept 6: A positive rate of

improvement in Z implies that the
adjacent CPF solution is better than the
current one, whereas a negative rate of
improvement in Z implies that the
adjacent CPF solution is worse.
Therefore, the optimality test consists
simply of checking whether any of the
edges give a positive rate of
improvement in Z. if none do, then the
current CPF solution is optimal.
 The simplex method in tabular form
• Steps:
1. Initialization:
a. transform all the constraints to equality by
introducing slack, surplus, and artificial variables
as follows:

Constraint type Variable to be added

≥ + slack (s)

≤ - Surplus (s) + artificial (A)

= + Artificial (A)
 Simplex method in tabular form

b. Construct the initial simplex tableau

Basic X1 … Xn S1 …... Sn A1 …. An RHS

variable
S b1
Coefficient of the constraints

A bm
Z Objective function coefficient Z
In different signs value
 Simplex method in tabular form
2. Test for optimality:
Case 1: Maximization problem
the current BF solution is optimal if
every coefficient in the objective
function row is nonnegative
Case 2: Minimization problem
the current BF solution is optimal if
every coefficient in the objective
function row is nonpositive
 Simplex method in tabular form
3. Iteration
Step 1: determine the entering basic variable
by selecting the variable (automatically a
nonbasic variable) with the most negative
value (in case of maximization) or with the
most positive (in case of minimization) in
the last row (Z-row). Put a box around the
column below this variable, and call it the
“pivot column”
 Simplex method in tabular form

• Step 2: Determine the leaving basic variable by

applying the minimum ratio test as
following:
1. Pick out each coefficient in the pivot column that is
strictly positive (>0)
2. Divide each of these coefficients into the right hand
side entry for the same row
3. Identify the row that has the smallest of these
ratios
4. The basic variable for that row is the leaving
variable, so replace that variable by the entering
variable in the basic variable column of the next
simplex tableau. Put a box around this row and call
it the “pivot row”
 Simplex method in tabular form
• Step 3: Solve for the new BF solution by using elementary
row operations (multiply or divide a row by a nonzero
constant; add or subtract a multiple of one row to another
row) to construct a new simplex tableau, and then return to
the optimality test. The specific elementary row operations
are:
1. Divide the pivot row by the “pivot number” (the number in
the intersection of the pivot row and pivot column)
2. For each other row that has a negative coefficient in the
pivot column, add to this row the product of the absolute
value of this coefficient and the new pivot row.
3. For each other row that has a positive coefficient in the pivot
column, subtract from this row the product of the absolute
value of this coefficient and the new pivot row.
 Simplex method
• Example (All constraints are )
Solve the following problem using the simplex method
• Maximize
Z = 3X1+ 5X2
Subject to
X1  4
2 X2  12
3X1 +2X2  18
X1 , X2  0
 Simplex method
• Solution
• Initialization
1. Standard form
Maximize Z,
Subject to Sometimes it is called
the augmented form of
Z - 3X1- 5X2 =0 the problem because
the original form has
X1 + S1 = 4 been augmented by
some supplementary
2 X2 + S2 = 12
variables needed to
3X1 +2X2 + S3 = 18 apply the simplex
X1 , X2, S1, S2, S3  0 method
 Definitions
• A basic solution is an augmented corner point solution.
• A basic solution has the following properties:
1. Each variable is designated as either a nonbasic
variable or a basic variable.
2. The number of basic variables equals the number of
functional constraints. Therefore, the number of
nonbasic variables equals the total number of variables
minus the number of functional constraints.
3.
The nonbasic variables are set equal to zero.
4.
The values of the basic variables are obtained as
simultaneous solution of the system of equations
(functional constraints in augmented form). The set of
5. basic variables are called “basis”
If the basic variables satisfy the nonnegativity
constraints, the basic solution is a Basic Feasible (BF)
solution.
 Initial tableau
Entering variable
2. Initial tableau
Basic X1 X2 S1 S2 S3 RHS
variable
S1 1 0 1 0 0 4
S2 0 2 0 1 0 12
S3 3 2 0 0 1 18
Z -3 -5 0 0 0 0

Leaving Pivot
Pivot
variable Pivot row
column number
 Simplex tableau
Notes:
• The basic feasible solution at the initial
tableau is (0, 0, 4, 12, 18) where:
X1 = 0, X2 = 0, S1 = 4, S2 = 12, S3 = 18, and
Z=0
Where S1, S2, and S3 are basic variables
X1 and X2 are nonbasic variables
• The solution at the initial tableau is
associated to the origin point at which all
the decision variables are zero.
 Optimality test
• By investigating the last row of the
initial tableau, we find that there are
some negative numbers.
• Therefore, the current solution is
not optimal
 Iteration
• Step 1: Determine the entering variable by
selecting the variable with the most
negative in the last row.
• From the initial tableau, in the last row (Z
row), the coefficient of X1 is -3 and the
coefficient of X2 is -5; therefore, the most
negative is -5. consequently, X2 is the
entering variable.
• X2 is surrounded by a box and it is called
the pivot column
 Iteration
• Step 2: Determining the leaving variable by using
the minimum ratio test as following:

Basic Entering RHS Ratio

variable variable X2
(1) (2) (2)(1)
S1 0 4 None
S2 2 12 6
Leaving Smallest ratio
S3 2 18 9
 Iteration
• Step 3: solving for the new BF solution by using
the eliminatory row operations as following:
1. New pivot row = old pivot row  pivot number
Basic X1 X2 S1 S2 S3 RHS
variable
S1
X2 0 1 0 1/2 0 6
S3
Z

Note that X2 becomes in the basic

variables list instead of S2
 iteration
2. For the other row apply this rule:
New row = old row – the coefficient of this row in the pivot column (new pivot row).
For S1

1 0 1 0 0 4
-
0 (0 1 0 1/2 0 6)
1 0 1 0 0 4
For S3

3 2 0 0 1 18
-
2 (0 1 0 1/2 0 6)
3 0 0 -1 1 6
for Z
-3 -5 0 0 0 0 Substitute this
- values in the
-5(0 1 0 1/2 0 6)
-3 0 0 5/2 0 30
table
 Iteration

This solution is not optimal, since there is a negative

numbers in the last row
Basic X1 X2 S1 S2 S3 RHS
variable
S1 1 0 1 0 0 4
X2 0 1 0 1/2 0 6
S3 3 0 0 -1 1 6
Z -3 0 0 5/2 0 30

The smallest ratio is

The most negative
6/3 =2; therefore, S3 is
value; therefore, X1 is
the entering variable the leaving variable
 Iteration
• Apply the same rules we will obtain this solution:

Basic X1 X2 S1 S2 S3 RHS
variable
S1 0 0 1 1/3 -1/3 2
X2 0 1 0 1/2 0 6
X1 1 0 0 -1/3 1/3 2
Z 0 0 0 3/2 1 36

This solution is optimal; since there is no negative solution in

the last row: basic variables are X1 = 2, X2 = 6 and S1 = 2; the
nonbasic variables are S2 = S3 = 0
Z = 36
Revision of Linear Economic
Models
Simultaneous Equations
Market Equilibrium
Solving Simultaneous Equations
Example

• 4x + 3y = 11 (eq.1)
• 2x + y = 5 (eq.2)

Express both equations in terms of the same value of x (or y)

• 4x = 11 - 3y (eq.1’)
• 4x = 10 - 2y (eq.2’)

Hence
• 11 - 3y = 10 - 2y

Collect terms
• 11 – 10 = -2y + 3y
• y=1

Compute x
• 4x = 10 - 2y
• 4x = 10 – 2 = 8
• x=2
 15 4x+3y-11
2x+y=5

10

5
Y

0
-3 -2 -1 0 1 2 3 4 5 6 7

-5

-10
X
 Note that if the two functions do not
intersect, then cannot solve equations
simultaneously…..
• x – 2y = 1 (eq.1)
• 2x – 4y = -3 (eq.2)
Step 1
• 2x = 2 + 4y (eq.1*)
• 2x = -3 + 4y (eq.2*)
Step 2
• 2 + 4y = -3 + 4y BUT =>
2+3 = 0…………
• No Solution to the System of Equations
 Solving Linear Economic Models
e.g market equilibrium
• Quantity Supplied: amount of a good that sellers
are willing and able to sell
• Supply curve: upward sloping line relating price to
quantity supplied
• Quantity Demanded: amount of a good that buyers
are willing and able to buy
• Demand curve: downward sloping line relating
price to quantity demanded
• Market Equilibrium: quantity demand =
quantity supply
 Price of
Ice-Cream
Cone

Supply

2.00
equilibrium

Demand

0 7 Quantity of
Ice-Cream Cones
 Finding the equilibrium price and
quantity levels…..
• In general,

Demand: QD = a + bP (with b<0)

Supply: QS = c + dP (with d>0)
• Set QD = QS and solve simultaneously for
Pe = (a - c)/(d - b)
• Knowing Pe, find Qe given the demand/supply
functions
Qe = (ad - bc)/(d - b)
 Example 1

Demand QD = 50 – P (i)
Supply QS = – 10 + 2P (ii)

Set QD = QS find market

equilibrium P and Q P

• 50 – P = – 10 + 2P
50

• 3P = 60
S

• P = 20 20

Knowing P, find Q 5

• Q = 50 – P D

• = 50 – 20 = 30
-10 0 30 50 Q

Check the solution

• i) 30 = 50 – 20 and (ii) 30 = – 10
+ 40
In both equations if P=20 then
Q=30
 Example 2
Demand QD = 84 – 3P (i)
Supply QS = – 60 + 6P (ii)

Set QD = QS to find market

equilibrium
84 – 3P = – 60 + 6P
P
144 = 9P 28
S

P = 16 16

Knowing P, find Q
10
D

Q = –60 + 6P -60 0 36 84 Q

= – 60 + 96 = 36
Check the solution
36 = 84 – (3*16) and
36= –60 + (6*16)
In both equations if P=16
then Q=36
Market Equilibrium + Excise Tax
Impose a tax t on suppliers per unit sold……
Shifts the supply curve to the left
QD = a – bP
QS = d + eP with no tax
QS = d + e(P – t) with tax t on suppliers
So from example 1….
QD = 50 – P,
QS = – 10 + 2P becomes
QS = – 10 + 2(P-t) = – 10 + 2P – 2t
cont…..
 Continued…..

Write Equilibrium P and Q as functions of t

Set QD = QS
50 – P = – 10 + 2P – 2t
60 = 3P - 2t
3P = 60 + 2t
P = 20 + 2/3t
Knowing P, find Q
Q = 50 – P
Q = 50 – (20+2/3t)
Q = 30 – 2/3t
 Comparative Statics: effect on P
and Q of t
As  t, then  P paid by consumers by 2/3t
(i)
 remaining tax (1/3) is paid by suppliers
total tax t = 2/3t + 1/3t

Consumers pay Suppliers pay

Price consumers pay – price suppliers receive = total
tax t

(ii) and  Q by 2/3t , reflecting a shift to the left of the

supply curve
For Example let t = 3
P
• QD = 50 – P 50

• QS = – 10 + 2(P-t) S with tax

S no tax
= – 16 + 2P 22
Tax = 3

19

• New equilibrium Q = 28 8
5 D
(Q = 30 - 2/3t)
• New equilibrium P = 22 -16 -10 0 28 30 50 Q
( P = 20 + 2/3t )

Supplier Price = 19
Tax Revenue = P*Q = 3*28 = 84
 Another Tax Problem….

QD = 132 – 8P
QS = – 6 + 4P
• Find the equilibrium P and Q.
• How does a per unit tax t affect outcomes?
• What is the equilibrium P and Q if unit tax t = 4.5?
 Solution…..
(i) Market Equilibrium
values of P and Q
• Set QD = QS
132 – 8P = – 6 +4P S
12P = 138 P

P = 11.5 16.5

• Knowing P, find Q 11.5

Q = – 6 +4P 1.5 D

• = – 6 + 4(11.5) = 40 -6
0 40 132 Q

• Equilibrium values:
P = 11.5 and Q= 40
(ii) The Comparative Statics of
adding a tax……
QD = 132 – 8P
QS = – 6 + 4(P – t) = – 6 + 4P – 4t
Set QD = QS
132 – 8P = – 6 +4P – 4t
12P = 138 + 4t

P = 11.5 +1/3 t = 13 if t = 4.5

Imposing t =>  consumer P by 1/3t, supplier pays

2/ t
3

Knowing P, find Q
Q = 132 –8(13) = 28
 (iii) If per unit t = 4.5

S with tax
Tax = 0 S no tax
P
Consumer Price = 11.5 16.5

13
Supplier Price = 11.5 Tax = 4.5
8.5
6
Tax = 4.5
1.5 D
Consumer Price = 13 -24 -6
0 132
28 40 Q
Supplier Price = 8.5

Tax Revenue = P*Q = 4.5*28 =126

 Market Equilibrium and Income
• Let QD = a + bP + cY

Example: the following facts were observed

for a good,
• Demand = 110 when P = 50 and Y = 20
• When Y increased to 30, at P = 50 the
demand = 115
• When P increased to 60, at Y = 30 the
demand = 95
 (i) Find the Linear Demand Function QD?
Rewriting the facts into equations:
• 110 = a + 50b + 20c eq.1
• 115 = a + 50b + 30c eq.2
• 95 = a + 60b + 30c eq.3

To find the demand function

QD = a + bP + cY
we need to solve these three equations
simultaneously for a, b, and c
Rewriting 1 and 2
a = 110 - 50b - 20c (eq.1*)
a = 115 - 50b - 30c (eq.2*)
=>
110 – 50b – 20c = 115 – 50b – 30c
10c = 5
c=½
Rewriting 1 & 3 given c = ½
110 = a + 50b + 10 (eq.1*)
95 = a + 60b + 15 (eq.3*)
a = 100 – 50b (eq.1*)
a = 80 – 60b (eq.3*)
100 – 50b = 80 – 60b
10b = -20
b = -2
Given b= -2 and c = ½ , solve for a
• a = 110 – 50b – 20c eq.1’
• a = 110 + 100 – 10 = 200
•  QD = 200 -2P + ½Y
Now, let QS = 3P – 100

Describe fully the comparative static’s of the

model using QD and QS equations?

Set QD = QS for equilibrium values of P and Q

• 200 -2P + ½Y = 3P – 100
• 5P = 300 + ½Y
• P = 60 + 1/10Y

Knowing P, find Q
• Q = 3(60 + 1/10Y) -100
• = 80 + 3/10Y
What is equilibrium P and Q when
Y = 20
• P = 60 + 1/10Y
• P = 60 + 1/10 (20) = 62

i.e  P by 1/10 of 20 = 2

• Q = 80 + 3/10Y
• Q = 80 + 3/10 (20) = 86

i.e  Q by 3/10 of 20 = 6
 Qd = 200 – 2P + ½ Y
Qs = 3P – 100

• Finding Intercept :
S(Q,P): (-100, 0)
and (0, 331/3 )
Y=0:
D1(Q,P): (200, 0)
and (0, 100)
Y=20:
D2(Q,P): (210, 0)
and (0, 105)
The Cobb-Douglas Production
Function
Y = AK L( 1− )
 The General Problem
• An increase in a nation’s capital
stock or labor force means more
output.
• Is there a mathematical formula
that relates capital, labor and
output?
 The General Form

 1−
Yt = At Kt Lt
Increasing Capital

Yo = AK o L 1−
o

Y = A(2K o ) L  1−
o
 Increasing Capital

Yo = AK o L  1−
o

Y = A(2K o ) L  1−
o
=

2 AK o L 1−
o
= 2 Yo
 Increasing Capital

Yo = AK o L  1−
o

Y = A(2K o ) L  1−
o
=

2 AK o L  1−
o
= 2 Yo

Diminishing returns to proportion

 Increasing Labor

Yo = AK L 
o
1−
o

Y = AK o (2Lo ) 1−
 Increasing Labor

Yo = AK o L  1−
o

Y = AK o (2Lo ) 1−
=
21− 
AK o L 1−
o
=2 1−
Yo
 Increasing Labor

Yo = AK o L  1−
o

Y = AK o (2Lo ) 1−
=
2 1− 
AK o L 1−
o
=2 1−
Yo
Diminishing returns to proportion
 Increasing Both

Yo = AK L
o
1−
o

Y = A(2K o ) (2Lo )
 1−
 Increasing Both

Yo = AK o L  1−
o

Y = A(2K o ) (2Lo )
 1−
=

2 AK o L 1−
o
= 2 Yo
 Increasing Both

Yo = AK o L  1−
o

Y = A(2K o ) (2Lo )
 1−
=
2 AK o L  1−
o
= 2 Yo
Constant returns to scale
 Substitution

Yo = AK o L  1−
o

Y = A(2K o ) ( xLo )
 1−
= Yo

Capital and Labor Can be Substituted

 An Illustration

Yt = At K L 1/ 2
t
1/ 2
t
 An Illustration

Y = AK 1/ 2
L1 /2
 An Illustration

Y = A KL
 An Illustration
A =3 L =10

Y = A KL
K =10
 An Illustration

Y = 3 (10)(10) = 3 100 = 30
 Doubling Capital

Y = 3 (20)(10) = 3 200 =
30 2  42
 Constant Returns to Scale

Y = 3 (20)(20) = 3 400 = 60
 Substitution

Y = 3 (20)(x) = 30
x=5
Homogeneous Function

A function y = f(x1 ,x2 , ,xn ) is homogeneou of degree k if,

for any numbers where s  0 s
s kY = f ( sx1 ,sx2 , ,sxn )
Cobb-Douglas Function

We have the Cobb - Douglas ProductionFunction

Y = K  L
Increase the inputs by a factor s
Y1 = δ (sK ) (sL) =α+ β δK α Lβ = s α+ βY
α β

Our sCobb - Douglas function is homogeneous of degree  +  .

If  +   1, we have decreasingreturns to scale.
If  +  = 1, we have constant returns to scale.
If  +   1, we have increasing returns to scale.