Exercise Session 8, November 17th , 2006

Mathematics for Economics and Finance

Prof: Norman Schürhoff
TAs: Zhihua Chen (Cissy), Natalia Guseva

Solutions

Exercise 1.
Consider a consumer who seeks to maximize her utility subject to budget
constraint. There are two goods x1 and x2 with prices p1 and p2 . Income of
consumer is I and utility function is u(x1 , x2 ) = x1 + ln x2 . Note that consumer
can not consume negative amount of goods.

Solution:
Formalization of consumer problem:

u(x1 , x2 ) = x1 + ln x2 → max
x1 ,x2
s.t. p1 x1 + p2 x2 ≤ I
x1 ≥ 0
x2 ≥ 0

Constraints are linear =⇒ Constraint Qualification is satisfied =⇒ Kuhn-

Tucker‘s Conditions are necessary for optimal solution.

Kuhn-Tucker‘s Conditions
L(x1 , x2 , λ, μ1 , μ2 ) = x1 + ln x2 + λ(I − p1 x1 − p2 x2 ) + μ1 x1 + μ2 x2

Lagrange conditions:
∂L
= 1 − λp1 + μ1 = 0 (1)
∂x1
∂L 1
= − λp2 + μ2 = 0 (2)
∂x2 x2
Complementary slackness conditions:

λ(I − p1 x1 − p2 x2 ) = 0
μ1 x1 = 0, μ2 x2 = 0
λ ≥ 0, μ1 ≥ 0, μ2 ≥ 0
x1 ≥ 0, x2 ≥ 0, p1 x1 + p2 x2 ≤ I

There are 23 possibilities.

1
 (a) λ = 0, μ1 = 0, μ2 = 0
(b) λ = 0, x1 = 0, μ2 = 0
(c) λ = 0, x1 = 0, x2 = 0
(d) λ = 0, μ1 = 0, x2 = 0
(e) I − p1 x1 − p2 x2 = 0, μ1 = 0, μ2 = 0
(f ) I − p1 x1 − p2 x2 = 0, x1 = 0, μ2 = 0
(g) I − p1 x1 − p2 x2 = 0, x1 = 0, x2 = 0
(h) I − p1 x1 − p2 x2 = 0, μ1 = 0, x2 = 0

Let‘s try to reduce amount of work.

(i) check if it it is possible that x2 = 0
(2)=⇒ 10 − λp + μ2 = 0 not possible,
=⇒ x2 6= 0
=⇒ cases (c) (d) (g) and (h) are not possible

(ii) check if λ = 0
(1) =⇒ 1 − 0 + μ1 = 0 =⇒ μ1 = −1 < 0 =⇒ not possible,
hence λ 6= 0, and cases (a) and (b) are not possible.
There are case (e) and (f) left.
(iii) case (e)
I − p1 x1 − p2 x2 = 0 =⇒ λ ≥ 0
μ1 = 0 =⇒ x1 ≥ 0
μ2 = 0 =⇒ x2 ≥ 0
(1) =⇒ 1 − λp1 = 0 =⇒ λ = p11 > 0
(2) =⇒ x12 − λp2 = 0 =⇒ x12 − pp21 = 0 =⇒
x2 = pp12 > 0
I − p1 x1 − p2 pp12 = 0
x1 = I−pp1 ≥ 0, if I ≥ p,
1

=⇒ if I ≥ p, x1 = I−p
p1 ≥ 0
1

p1
x2 = p2 > 0
λ = p11 ≥ 0
μ1 = 0
μ2 = 0
I − p1 x1 − p2 x2 = 0

(iv) case (f)

I − p1 x1 − p2 x2 = 0 =⇒ λ ≥ 0
x1 = 0 =⇒ μ1 ≥ 0
μ2 = 0 =⇒ x2 ≥ 0

2
 I
I − 0 − p2 x2 = 0 =⇒ x2 = p2 >0
(2) =⇒ x12 − λp2 = 0 =⇒ x2 = λp1 2 , x2 = pI2 =⇒ λ = 1
I
(1) =⇒ 1 − λp1 + μ1 = 0
1 − pI1 + μ1 = 0 =⇒ μ1 = p1I−I ≥ 0 if p1 ≥ I
if p1 ≥ I =⇒ x1 = 0
x2 = pI2 ≥ 0
μ1 = p1I−I ≥ 0
μ2 = 0
λ = I1 ≥ 0
I − p1 x1 − p2 x2 = 0

Answer:
p1 > I =⇒ x1 = 0
x2 = pI2
p1 ≤ I =⇒ x1 = I−pp1
1

p1
x2 = p2

Exercise 2.
Suppose a firm has its sales policies determined by a manager whose objective
function is to maximize revenue without letting profit drop below some fixed
level. There is an advertising cost a > 0 that affects positively the revenue. Let
√
R(a, y) = ay 2 be the firm’s revenue when production level is y, C(y) = y is
the cost of manufacturing y units of output. Solve maximization problem of the
firm.
Solution:
R(a, y) = ay 2 → max
a,y
s.t. a ≥ 0
2 √
ay − a − y ≥ L > 0

√
L(y, a, λ1, λ2 ) = ay 2 + λ1 a + λ2 (ay 2 − a − y − L)
Lagrange conditions:
∂L λ2
= 2ay + 2aλ2 y − √ = 0 (3)
∂y 2 y
∂L
= y 2 + λ1 + λ2 y 2 − 1 = 0 (4)
∂a
Complementary slackness conditions
λ1 a = 0, λ1 ≥ 0, a ≥ 0
√ √
λ2 (ay − a − y − L) = 0, λ2 ≥ 0, ay 2 − a − y − L ≥ 0
2

3
There are 4 cases:

(i) λ1 = 0, a≥0
√
λ2 = 0, ay 2 − a − y − L ≥ 0
(ii) λ1 ≥ 0, a=0
√
λ2 = 0, ay 2 − a − y − L ≥ 0
(iii) λ1 ≥ 0, a=0
√
λ2 ≥ 0, ay 2 − a − y − L = 0
(i) λ1 = 0, a≥0
√
λ2 ≥ 0, ay 2 − a − y − L = 0
√
(i) λ1 = λ2 = 0, a ≥ 0, ay 2 − a − y−L≥0
(3) =⇒ 2ay = 0 =⇒ a = 0
(4) =⇒ y 2 = 1 =⇒ y = 1 (positive output)
√
but ay 2 − a − y − L = −1 − L < 0 =⇒ not possible

(ii) a = λ2 = 0
(3) =⇒ 0 = 0
(4) =⇒ y 2 + λ1 − 1 = 0 (positive output)
√ √
ay 2 − a − y − L = − y − L < 0 =⇒ not possible
√
(iii) a = 0, ay 2 − a − y − L = 0
√ √
ay 2 − a − y − L = 0 =⇒ 0 − 0 − y − L = 0 =⇒ not possible
√
(iv) λ1 = 0, ay 2 − a − y−L=0
λ √ λ2
(3) =⇒ 2ay + 2aλ2 y − √2
2 y = 0 =⇒ a = 2 y2y(1+λ2 )
1
(4) =⇒ y 2 + λ2 y 2 − 1 = 0 =⇒ y 2 = 1+λ2 ≥0

a(λ2 , y) ≥ 0, if λ2 ≥ 0, y > 0
y(λ2 ) > 0, if λ2 ≥ 0 p
a(λ2 , y) ∗ y(λ2 )2 − a(λ2 , y) − y(λ2 ) − L = 0 =⇒ find λ2

if λ2 ≥ 0 =⇒ y(λ2 ) > 0
a(λ2 , y) ≥ 0
λ1 = 0
=⇒solution of optimization problem

4
 Exercise 3.
Consider a profit-maximizing firm with neoclassical production function f (l, k)
where l, k are the amount of labor and capital employed by the firm (in units
of output). The firm’s profit equals

Π(l, k) = pf (l, k) − wl − rk,

where p is the price of output, w is the real wage, and r is the real rental price of
capital. The firm takes p, w, and r as given. Assume that the Hessian matrix
of f is negative definite.
a) Show that if the wage increases by a small amount, the firm employs less
labor.
b) Show that if the wage increases by a small amount and the firm is con-
strained to maintain the same amount of capital k 0 , the firm will reduce labor
l by less than in a).

Solution:
a) FOC:
½ ∂Π ∂f
½
∂l = p ∂l − w = 0 =⇒ denote F1 (l, k, p, w, r) = p ∂f
∂l − w = 0
∂Π ∂f ∂f
∂k = p ∂k − r = 0 F2 (l, k, p, w, r) = p ∂k − r = 0

By Implicit Function Theorem, the sufficient condition is |J| 6= 0.In our case:
¯ ¯ ¯ ¯ ¯ ¯
¯ ∂F ¯ ¯¯ ∂F ∂l
1 ∂F1 ¯
∂k ¯
¯ pfll pflk ¯
¯ ¯ = p2 (fll fkk − f 2 ) > 0
¯ ∂(l,k) ¯ = ¯ ∂F2 ∂F2 ¯ = ¯
∂l ∂k
pflk pfkk ¯ lk

¯ ¯
¯ ∂F ¯
since f is negative definite =⇒ ¯ ∂(l,k) ¯ 6= 0, applly IFT
µ ∂l
¶ ¯ ¯ µ ∂F1
¶
∂w ¯ ∂F ¯−1 ∂w ∂l fkk
∂k = − ¯ ∂(l,k) ¯ ∂F2 =⇒ ∂w = 2 )
p(fll fkk −flk
<0
∂w ∂w
since f is negative definite =⇒ fkk < 0

b) If firm is constrained to keep capital on the same level k.

∂f ∂f
FOC: ∂Π ∂l = p ∂l − w = 0 =⇒ F (l, k, p, w, r) = p ∂l − w = 0 =⇒
0
∂l F 1
∂w = − Fw0 = pfll <0
l

∂l fkk
in a) ∂w = 2 )
p(fll fkk −flk
∂l 1
in b) ∂w = pfll

Compare: ³ ´ ³ ´
2 2
fkk 1 1 fll fkk −fll fkk +flk 1 flk
2 )
p(fll fkk −flk
− pfll = p 2 )f
(fll fkk −flk ll
= p 2 )f
(fll fkk −flk ll
< 0,
2 2
since fll fkk − flk > 0, flk > 0. fll < 0
1 fkk
Hence pfll < 2 ).
p(fll fkk −flk

5
 Exercise 4.
A person can buy various brands of liquor at his home-town store, or at the
duty free stores of the various airports he travels through. The duty free stores
have cheaper prices, but the total quantity he can buy there is restricted by
his home country customs regulations. There are n brands. Let p be the row
vector of home-town prices and q that of duty free prices. The duty free prices
are uniformly lower: q ¿ p. The amount of income an individual has decided to
spend on liquor during the year is fixed at I. The number of bottles allowed in
the customs is K, y1 + ... + yn ≤ K. Solve the agent’s problem, assuming that
his utility U (c) depends only on total consumption c = x + y, and x and y are
restricted to be non negative.

Solution:
c = x1 + ... + xn + y1 + ... + yn → max , q << p
x1 ,..,xn ,y1 ,..,yn
s.t. xi ≥ 0
yj ≥ 0
p1 x1 + .. + pn xn + q1 y1 + .. + qn yn ≤ I
y1 + .. + yn ≤ k

1. Intuitive solution: an individual is indifferent between different types of

liquor, what he cares about is the total number of bottles. Without loss
of generality we can assume that p1 < p2 < ... < pn & q1 < q2 < ... < qn .
If a person buys something at home-store he would buy only the cheapest
brand, the same for duty-free shop. Since prices at duty-free are strictly
lower than at home store, a person will buy as much as he can at duty-free
and only if he still has some money left he will go to home-store.

If p1 < p2 < ... < pn & q1 < q2 < ... < qn & q << p ⇒
⎧
⎨ x1 = x2 = ... = xn = 0
y1 = qI1 , if qI1 ≤ K
⎩
y2 = ... = yn = 0
⎧
⎪
⎪ x1 = I−q 1k I
p1 , if q1 > K
⎨
x2 = ... = xn = 0
⎪
⎪ y =K
⎩ 1
y2 = ... = yn = 0

6
2. Solution by Kuhn-Tucker method

1) constraints are linear ⇒ qualification constraint is satisfied ⇒ K-T

conditions are necessary condition of optimal point.
2) K-T conditions
L (x1 , .., xn , λ1 , ..λn , μ1 , ..., μn , γ, α) =

x1 + .. + xn + y1 + ... + yn + λ1 x1 + .. + λn xn + μ1 y1 + ... + μn yn
+γ(I − p1 x1 − .. − pn xn − q1 y1 − .. − qn yn ) + α(k − y1 − .. − yn )
Lagrange conditions:
∂L(...)
∂xi = 1 + λi − γpi = 0, i = 1, 2, .., n (*)
∂L(...)
∂yj = 1 + μi − γqj − α = 0, j = 1, 2, .., n (**)
Complementary slackness conditions:
λi xi = 0, i = 1, 2, .., n
μj yj = 0, j = 1, 2, .., n
γ(I − p1 x1 − .. − pn xn − q1 y1 − .. − qn yn ) = 0
α(k − y1 − .. − yn ) = 0
xi ≥ 0
yj ≥ 0
k − y1 − .. − yn ≥ 0
I − p1 x1 − .. − pn xn − q1 y1 − .. − qn yn ≥ 0
λi ≥ 0, γ ≥ 0
μj ≥ 0, α ≥ 0
There are 2n + 2 complementary slackness conditions, it means that we have
to consider 22n+2 possibilities - too much.

a) Let us assume there exist i & j such that

xi > 0 & xj > 0 ⇒ λi = 0, λj = 0

½
1 + 0 − γpi = 0
(∗) ⇒ ⇒ pi = pj
1 + 0 − γpj = 0
Two brands may be chosen in positive quantities only if they have the same
prices. We assumed that p1 < p2 < ... < pn , so that there are no two brands
with equal prices. It means that there can not be two brands bought in home-
store in positive quantities ⇒ a person buys maximum one brand of x

b) So, if xi > 0 ⇒ xj = 0, j 6= i, ⇒ λi = 0, λj ≥ 0
½
1 − γpi = 0
(*) ⇒
1 + λj − γpj = 0 ∀j 6= i
⇒ λj = γ(pj − pi ) since λj ≥ 0, γ ≥ 0, pj ≥ pi ∀j 6= i
⇒ pi ≤ pj ∀j 6= i since we assumed p1 < p2 < ... < pn only a brand
x1 can come in a positive quantity (the brand with the lowest price)

7
c) By the same line of reasoning we can establish that if a person buys bottles
at duty-free he will only buy bottles of one brand that is the cheapest.
This implies that

if q1 < q2 < ... < qn ⇒ y1 ≥ 0, y2 = ... = yn = 0

d) We can have x1 ≥ 0, y1 ≥ 0, x2 = ... = xn = y2 = ... = yn = 0

It means four cases:

(i) x1 > 0, y1 = 0
(ii) x1 = 0, y1 > 0
(iii) x1 > 0, y1 > 0
(iv) x1 = 0, y1 = 0

(i) x1 > 0, y1 = 0 ⇒ λ1 = 0, μ1 ≥ 0
(*) ⇒ 1 − γp1 = 0 ⇒ γ = p11
(**) ⇒ 1 + μ1 − γq1 − α = 0 ⇒ 1 + μ1 − pq11 − α = 0
y1 = y2 = ... = yn = 0 ⇒ y1 + .. + yn < k ⇒ not binding ⇒ α = 0
1 + μ1 − pq11 = 0
q1 < p1
μ1 = pq11 − 1 < 0
But we have that μ1 ≥ 0 ⇒ not possible
(ii) x1 = 0, y1 > 0 ⇒ λ1 ≥ 0, μ1 = 0
(**) ⇒ 1 + 0 − γq1 − α = 0
(*) ⇒ 1 + λ1 − γp1 = 0 ⇒ γ = 1+λ
p1 > 0
1

q1
1 − (1 + λ1 ) −α = 0
p1
q1
α = 1− (1 + λ1 )
p1
γ > 0 ⇒ p1 x1 + q1 y1 = I is binding
I
x1 = 0, y1 =
q1
y1 + .. + yn < k
I I
y1 = , y2 = ... = yn = 0, ≤k
q1 q1
I
If < k ⇒ not binding ⇒ α = 0 ⇒
q1
q1 p1
1− (1 + λ1 ) = 0 ⇒ λ1 = −1>0
p1 q1

So

8
 p1
x1 = 0, λ1 = −1>0
q1
I
y1 > 0, y1 = , μ1 = 0
q1
1 + λ1
p1 x1 + q1 y1 = I, γ = >0
p1
y1 < k, α = 0
So x1 = ... = xn = 0
y1 = qI1 , y2 = ... = yn = 0 is a solution as long as I
q1 <k

(iii) x1 > 0, y1 > 0 ⇒ λ1 = 0, μ1 = 0

1
(∗) ⇒ 1 − γp1 = 0 ⇒ γ = >0
p1
(∗∗) ⇒ 1 − γq1 − α = 0
q1
1− = α>0
p1
γ > 0 ⇒ p1 x1 + q1 y1 ≤ I is binding
α > 0 ⇒ y1 ≤ k is binding
I−q1 k
So y1 = k, p1 x1 + q1 y1 = I ⇒ x1 = p1
So, x1 = I−q 1k
p1 , x2 = ... = xn = 0
y1 = k, y2 = ... = yn = 0 is a solution as long as x1 ≥ 0 ⇒
I−q1 k
p1 ≥ 0 ⇒ I ≥ q1 k

(iv) x1 = 0, y1 = 0 ⇒ y1 ≤ k is not binding ⇒ γ = 0 ⇒ 1 + λ1 = 0

p1 x1 + q1 y1 ≤ I is not binding ⇒ α = 0 ⇒ 1 + μ1 = 0
but λ1 ≥ 0, μ1 ≥ 0 ⇒ not possible

Answer:

I x1 = I−qp1
1k
k≤ q1 ⇒
y1 = k
x2 = ... = xn = 0
y2 = ... = yn = 0
I
k> q1 ⇒ x1 = x2 = ... = xn = 0
y2 = ... = yn = 0
y1 = qI1

As you see, K-T method gives the same results as intuitive solution. Intuitive
solution is much simpler, however, if you are able to apply K-T method it will
give you a sure answer in less intuitive problems as well.