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Subject Economics

Paper No and Title 1: Quantitative Methods –I (Mathematical methods for

Economics)
Module No and Title 8: Maxima and Minima: Applications

Module Tag ECO_P1_M8

ECONOMICS Paper 1: Quantitative Methods –I (Mathematical methods for Economics)

Module 8: Maxima and Minima: Applications
____________________________________________________________________________________________________

TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction

2.1 Definition of maxima and Minima

3. Necessary First order condition

4. Second Derivative test for function of two variables

5. Concave and Convex function

6. Second Derivative Tests for Concavity/Convexity: The Two Variable Case

7. Quasi-concave and Quasi-convex Functions

8. Economic applications

8.1 Maximization of Revenue

8.2 Maximization of Output

8.3 Minimization of Cost

8.4 Maximization of Utility

8.5 Maximization of Profit

9. Summary

ECONOMICS Paper 1: Quantitative Methods –I (Mathematical methods for Economics)

Module 8: Maxima and Minima: Applications
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1. Learning Outcomes
After studying this module, you would

Kn●w Know the concept of maxima and minima.

● Know the various applications of maxima and minima.

2. Introduction

This module talks about maxima and minima and their various applications.

Definition of maximum and minimum:

Let f be a function of n variable x1 , … , xn defined over a set S in Rn.

Suppose that c = (c1,...., cn ) belongs to S and gives a value to f that is larger than or equal
to the values attained by f at all other points x= (x1 , … , xn) of S. Thus in symbols,

f(x) f(c) for all x in S

Then c is called a (global) maximum point for f in S and f(c) is called the maximum
value.

Similarly, if c = (c1,...., cn ) belongs to S and gives a value to f that is larger than or equal
to the values attained by f at all other points x= (x1 , … , xn) of S. In symbols,

f(x) f(c) for all x in S

Then c is called a (global) minimum point for f in S and f(c) is called the minimum
value.

As collective names, we use extreme points and extreme values to indicate either
maxima or minima.

3. Necessary First-Order Conditions

For a function of n variables, vector c= (c1,....,cn) is called a stationary point of f(x1 , … ,
xn) if x=c is a solution ot the n equations
1 = 0, 2 = 0, ………. , n=0

ECONOMICS Paper 1: Quantitative Methods –I (Mathematical methods for Economics)

Module 8: Maxima and Minima: Applications
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THEOREM 1: Let f be defined in a set S in Rn and let c= (c1,....,cn) be an interior point

in S at which f is differentiable. A necessary condition for c to be a maximum or
minimum point for f is that c is a stationary point for f , that is,

f′(c) = 0 (i=1,......,n)

4. Second Derivative Test for Functions of Two Variables

The point c= (c1,....,cn) is said to be a local maximum point of f in S if f(x) f(c) for all
x in S sufficiently close to c. More precisely, the requirement is that there exist a positive
number r for which
f(x) f(c) for all x in S with x-c < r

Similarly, the point c= (c1,....,cn) is said to be a local minimum point of f in S if f(x)

f(c) for all x in S sufficiently close to c.
A stationary point c of f that is neither a local maximum nor a local minimum point is
called a saddle point of f.

THEOREM 2: Let f(x,y) be a function with continuous partial derivatives of the first
and second order in a domain S, and let (x0, y0) be an interior point of S that is a
stationary point for f. Write

A = f″11(x0, y0), B = f″12(x0, y0) and C = f″22(x0, y0)

Now:
(a) If A < 0 and AC-B2 >0, then (x0, y0) is a local maximum point.
(b) If A > 0 and AC-B2 >0, then (x0, y0) is a local minimum point.
(c) If AC-B2 < 0, then (x0, y0) is a saddle point.
(d) If AC-B2 < 0, then (x0, y0) could be a local minimum, a local maximum or a saddle
point.

5. Concave and Convex Function

The function f(x,y) is concave(convex) if its domain is convex and the line segment
joining any two points on the graph is never above (below) the graph.

ECONOMICS Paper 1: Quantitative Methods –I (Mathematical methods for Economics)

Module 8: Maxima and Minima: Applications
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Definition of a concave function :

A function f(x) = f(x1 , … , xn) defined on a convex set S is concave in S if

f((1- )x0 + x ) (1- )f(x0) + f(x)

for all x0, x S and all (0,1).

The function f is convex in S if -f is concave.

THEOREM 3: Suppose that f(x) has continuous partial derivatives in a convex set S in
Rn, and let x0 be an interior point in S. Now:
(a) If f is concave , then x0 is a (global) maximum point of f in S iff x0 is a stationary
point of f.
(b) If f is convex , then x0 is a (global) minimum point of f in S iff x0 is a stationary
point of f.

6. Second Derivative Tests for Concavity/Convexity: The two Variable

Case

For functions of two variables, the following theorem reveals whether a function is
convex or concave.

THEOREM 4: Let z = f(x,y) be a function with continuous partial derivatives of the

first and second order, defined over an open convex set S in the plane. Then:

(a) f is concave f″11 0 , f″11 0 and 0

(b) f is convex f″11 0 , f″11 0 and 0

where all the inequalities should hold throughout S.

ECONOMICS Paper 1: Quantitative Methods –I (Mathematical methods for Economics)

Module 8: Maxima and Minima: Applications
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A variant of the above theorem gives us sufficient

conditions for strict concavity/convexity.

THEOREM 5: Let z = f(x,y) be a function with continuous partial derivatives of the

first and second order, defined over an open convex set S in the plane. Then:

(a) f″11 < 0 and >0 f is strictly concave.

(b) f″11 > 0 and >0 f is strictly convex

where all the inequalities should hold throughout S.

The above mentioned results have various interesting implications in optimization

theory.
Combining theorems 3 and 4 gives the following useful result.

THEOREM 6: Sufficient conditions for global extreme points.

Let z = f(x,y) be a function with continuous partial derivatives of the first and second
order in a convex domain S, and let (x0, y0) be an interior point of S at which f is
stationary.

(a) If, for all (x, y) in S, one has f″11(x, y) 0, f″22(x, y) 0 and
f″11(x, y) f″22(x, y) - [ f″12(x, y)] 2 , then (x0, y0) is a maximum point for f(x,y) in S.

(b) If, for all (x, y) in S, one has f″11(x, y) 0, f″22(x, y) 0 and
f″11(x, y) f″22(x, y) - [ f″12(x, y)] 2 , then (x0, y0) is a minimum point for f(x,y) in S.

7. Quasi-concave and Quasi-convex Functions

Let f(x) be a function, defined over a convex set S in Rn. For each real number a, we
define the set Pa by
Pa = { x S : f(x) a }
Then Pa is a subset of S that is called an upper level set for f.

ECONOMICS Paper 1: Quantitative Methods –I (Mathematical methods for Economics)

Module 8: Maxima and Minima: Applications
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Quasi-concave: The function f, defined over a convex set

S Rn, is quasi-concave if the upper level set Pa = { x S :
f(x) a } is convex for each number a.

Quasi-convex: We say that f is quasi-convex if -f is quasi-concave. So if f is quasi-

convex iff the lower level set Pa = { x S : f(x) a } is convex for each number a.

If f(x) is concave, then f(x) is quasi-concave.

If f(x) is convex, then f(x) is quasi-convex.

The following simple characterization of quasi-concave function is useful.

THEOREM 7 : Let f be a function of n variables defined over a convex set S in Rn.

Then f is quasi concave iff, for all x , x0 S, and all [0,1], one has
f(x) f(x0) f( (1- )x + x0 ) f(x0)

Strictly quasi-concave: A function f(x) is strictly quasi-concave if

f(x) f(x0) , x x0, and 0 < <1 f( (1- )x + x0 ) f(x0)

8. Economic Applications

8.1 Maximization of Revenue

Let total revenue, TR = p.x, where p is price and x is quantity.

Total Revenue will be maximum at level of output where d(TR)/dx = 0 (or MR = 0) and
d2(TR)/dx2 < 0. The first order condition implies that d(TR)/dx = p + x(dp/dx) 0 or
(p/x)(dx/dp) = -1 i.e. = 1.
Thus maxima of total revenue occurs where elasticity of demand is unity.

Example: A wholesaler of pencils charges Rs 24 per dozen on order of 50 dozen or less.

For order in excess of 50 dozen , the price is reduced by 20 paise per dozen in excess of
50 dozen. Find the size of the order that maximises his total revenue.
Solution: Let x be the number of dozens in an order.
When x 50, TR = 24x
When x > 50, the price charged per dozen is given by
p = 24 - 0.20(x-50) = 34 - 0.20x
Thus , TR = p.x = (34 - 0.20x)x = 34x - 0.20x2
We note that Tr will have a maxima only when x > 50 because, when x 50,
TR is
a straight line and hence has no maxima.
For maximum TR, we have

ECONOMICS Paper 1: Quantitative Methods –I (Mathematical methods for Economics)

Module 8: Maxima and Minima: Applications
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d(TR)/dx = 34 - 0.4x = 0 or x = 34/0.4 = 84

dozens

Since d2(TR)/dx2 = -4 < 0 , the second order condition is satisfied.

8.2 Maximization of Output

Assuming that labour is the only variable factor , we can write the production function of
a firm as x = f(L), where x denotes total product of labour which will be denoted as TPL.

The Average product of labour is APL = TPL/L = f(L)/L.

The Marginal product of labour is MPL = dx/dL = f′(L).
The Necessary condition for maximum output is d(TPL)/dL = dx/dL = MPL = 0
Often we are interested in finding the level of employment of labour at which its average
product is maximum.
For maxima of APL, we have
d(APL)/dL =[ L.f′(L) - f(L) ]/L2 = 0
L.f′(L) = f(L) or f′(L) = f(L)/L or MPL = APL.
Thus the marginal product and average product of a factor are equal at the maxima of
the later.

Example : The short run production function of a manufacturer is given as x = 11L +

16L2 - L3
(i) Find the average product functio, APL, the marginal product function ,
MPL, and
show that MPL = APL where APL is maximum.
(ii) Find the value of L for which output is maximum.
Solution:
(i) APL = x/L = 11 + 16L - L2 . MPL = dx/dL = 11 + 32L + L2

We have d(APL)/dL = 16 - 2L =0. Thus, APL is maximum at L = 8.

Since d2(APL)/dL2 = -2 < 0, the second order condition is satisfied.

The maximum APL = 11 + 16 8 - 82 = 75

Further, MPL when L = 8, is 11 + 32 8 - 3 82 = 75.
Thus, APL = MPL when APL is maximum.

(ii) For maximum output:

dx/dL = 11 + 32L - 3L2 = 0

or (11 - L)(1 +3L) = 0 , therefore L =11. The other value being negative is
dropped.

ECONOMICS Paper 1: Quantitative Methods –I (Mathematical methods for Economics)

Module 8: Maxima and Minima: Applications
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Since d2x/dL2 = 32 -6L = -34 < 0, the

second order condition for maxima is
satisfied.

8.3 Minimization of Cost

If total cost C = F(x) , then we can define AC = C/x = F(x)/x, and

MC = dC/dx = F′(x)
Very often we're interested in finding the level of output that gives minimum Ac. For
minima of AC we have:
dAC/dx =[ x.F′(x) - F(x)]/x2 = 0
x.F′(x) = F(x) or F′(x) = F(x)/x or MC = AC
Thus, marginal cost is equal to the average at the minima of the later.

Example: The cost of fuel consumed per hour in running a train is proportional to the
square of its speed (in kms per hour), and it costs Rs 3200 per hour at a speed of 40 kms
per hour. What is the most economical speed, if the fixed charges are 12,800 per hour ?

Solution: Let F be the cost of fuel and x be the speed of the train per hour.
We are given that F is directly related to x2 or F = kx2, where k is a constant of
proportionality.
When x = 40, F is given to be 3200, therefore k = 3200/1600 = 2.

Thus we can write F = 2x2 , as the cost of fuel per hour of running the train when its
speed is x kms per hour.Now the total cost of running the train when its speed is x kms
per hour is TC = 12800 + 2x2
Average cost AC = 12800/x + 2x
The most economical speed will be that value of x which minimises AC.
AC/dx = -12800/x2 + 2 = 0, for minima
or x2 = 12800/2 = 6400 or x = 80 kms/hour.

Second order condition

d2(Ac)/dx2 = 25600/x3 > 0, when x = 80.
Thus, the second order condition for minima is satisfied.

8.4 Maximization of Utility

Let u = (x) be the utility function of a consumer, where u denotes utility and x denotes
the level of consumption of commodity. The utility is maximum at a value of x such that
du/dx = 0 and d2u/dx2 < 0.

Example : The utility function of a consumer of two goods is u = x.y. price of x is Rs 10

per unit and that of y is Rs 15 per unit . If the consumer has only Rs 90 to spend on the
two goods, determine his optimum purchases.

ECONOMICS Paper 1: Quantitative Methods –I (Mathematical methods for Economics)

Module 8: Maxima and Minima: Applications
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Solution: The budget constraint can be written as 10x +

15y = 90
Solving this equation for y, we get u = [90x - 10x]/ 15

Substituting this value in the utility function we get u = [90x - 10x2]/15

We want to find x such that u becomes maximum

du/dx = [90x - 20x]/ 15 = 0 x = 4.5.
Further, y = (90 - 45)/15 = 3

Since d2u/dx2 = -20/15 < 0, the second order condition is also satisfied.

8.5 Maximization of Profit

Profit is the difference between total revenue and total cost of a producer or a firm. We
now know that the total revenue as well as total costs are often expressed as functions of
level of output, x.
If we write TR = R(x) and TC = C(x), then the profit can be written as (x)= R(x) - C(x).
We want to find that value of x so that (x) becomes maximum. The conditons for
maxima of (x) are:
First order condition
(x) = R′(x) - C′(x) = 0, or R′(x) = C′(x) or MR(x) = MC(x)

Let xe satisfy this equation. then, we can write R′(xe) < C′(xe)
Here xe is termed as the profit maximising or equilibrium output. Note that the first order
condition is also termed as the equilibrium condition.

Second order condition

In order that profit (x) is maximum at xe , we should have (xe) < 0.
This condition implies that R″(xe) < C″(xe) or MR′(xe) < MC′(xe), i.e. the slope of
marginal revenue curve must be less than the slope of marginal cost curve at equilibrium.

9. Summary

If f is a function of n variable x1 , … , xn defined over a set S in Rn and f(x) f(c) for

all
x in S, then c is called a (global) maximum point for f in S and f(c) is called the
maximum
value. Similarly, if f(x) f(c) for all x in S, Then c is called a (global) minimum
point
for f in S and f(c) is called the minimum value.

● If f is a function defined in a set S in Rn and c= (c1,....,cn) is an interior point in S at

ECONOMICS Paper 1: Quantitative Methods –I (Mathematical methods for Economics)

Module 8: Maxima and Minima: Applications
____________________________________________________________________________________________________

which f is differentiable. A necessary condition for c to be

a maximum or minimum point for f is that c is a stationary
point for f , that is, f′(c) = 0 (i=1,......,n)

●The point c= (c1,....,cn) is said to be a local maximum point of f in S if f(x) f(c) for all
x in S sufficiently close to c. Similarly, the point c= (c1,....,cn) is said to be a local
minimum point of f in S if f(x) f(c) for all x in S sufficiently close to c.

● A function f(x) = f(x1 , … , xn) defined on a convex set S is concave in S if

f((1- )x0 + x ) (1- )f(x0) + f(x)

for all x0, x S and all (0,1).

● Quasi-concave: The function f, defined over a convex set S Rn, is quasi-concave if

the upper level set Pa = { x S : f(x) a } is convex for each number a.
Quasi-convex: We say that f is quasi-convex if -f is quasi-concave. So if f is quasi-
convex iff the lower level set Pa = { x S : f(x) a } is convex for each number a.

● There are various economic applications of optimization theory such as Revenue

maximization, profit maximization, Cost minimization, etc.

ECONOMICS Paper 1: Quantitative Methods –I (Mathematical methods for Economics)

Module 8: Maxima and Minima: Applications