EC 2104 Quantitative Methods for Economic Analysis

Problem Set 7

Students will solve selected problems from the following questions during tutorial sessions the week
of March 18, 2019.

1. For each of the following functions, use the second derivative test to classify the stationary
points as local maxima, local minima, and saddle points.

(a) f (x, y) = x − 4xy 2 + y 2 − y

First-order conditions (FOCs):

f10 (x, y) = 1 − 4y 2 = 0

f20 (x, y) = −8xy + 2y − 1 = 0

1 1
The first condition implies that y = ± . When y = + , the second condition implies
2 2
1 1
that x = 0. When y = − , the second condition implies that x = . So, the station-
  2  2
1 1 1
ary points are 0, and , − . Now, we must examine the second-order partial
2 2 2
derivatives:
00
f11 (x, y) = 0
00 00
f12 (x, y) = f21 (x, y) = −8y
00
f22 (x, y) = −8x + 2
00 f 00 − (f 00 )2 at the two stationary points. f 00 f 00 − (f 00 )2 = −64y 2 < 0
Let’s examine f11 22 12 11 22 12
at both stationary points. Therefore, both stationary points are saddle points.

(b) g(x, y) = x2 y − xy 2

First-order conditions (FOCs):

g10 (x, y) = 2xy − y 2 = 0 ⇒ y(2x − y) = 0

g20 (x, y) = x2 − 2xy = 0 ⇒ x(x − 2y) = 0

These two conditions together imply that the only stationary point is (0, 0). Second-
order partial derivatives:
00
g11 (x, y) = 2y

1
 00 00
g12 (x, y) = g21 (x, y) = 2x − 2y
00
g22 (x, y) = −2x
00 g 00 − (g 00 )2 = 0 as well. This
At the stationary point, these are all equal to 0, so g11 22 12
means that the second derivative test fails and cannot classify the stationary point.
If we wished, we could check directly how the function changes as we move slightly
away from the stationary point. The function value is 0 at (0,0). If we move slightly
in positive x and negative y direction to the point (ε, −ε), the function value is −2ε3 ,
which is negative. If we move slightly in negative x and positive y direction to the point
(−ε, ε), the function value is 2ε3 , which is positive. The stationary point is therefore
a saddle point. Note that it is easy to prove that a stationary point is a saddle point,
as we just need to show that one point gives a larger function value and another point
gives a smaller function value. To show a maximum (or minimum), we need to show
that moving in any direction will not produce a larger (or smaller) function value than
at your stationary point.

(c) h(x, y) = 3x2 + y 2 − 12x + 2y − 7

First-order conditions (FOCs):

h01 (x, y) = 6x − 12 = 0

h02 (x, y) = 2y + 2 = 0

Clearly, the only stationary point occurs at (2,-1). Second-order partial derivatives:

h0011 (x, y) = 6

h0012 (x, y) = h0021 (x, y) = 0

h0022 (x, y) = 2

At all points, not just the stationary point, h0011 h0022 − (h0012 )2 = 12 > 0. Also, h0011 (x, y) =
6 > 0 and h0022 (x, y) = 2 > 0. Therefore, the stationary point (2,-1) is a local minimum
point for h. (2,-1) also happens to satisfy the sufficient conditions for a global minimum
point (since h0011 (x, y), h0012 (x, y), and h0022 (x, y) do not depend on x or y), so it is also the
global minimum point.

2
 (d) F (x, y) = xe2(x+y)

First-order conditions (FOCs):

F10 (x, y) = 2xe2(x+y) + e2(x+y) = 0

F20 (x, y) = 2xe2(x+y) = 0

For these two equations to hold simultaneously, it must be the case that e2(x+y) = 0.
However, the exponential function never has a value of 0. Therefore, there are no
stationary points of F for us to classify. F has no local maxima or minima, or saddle
points.

2. Find the minimum point and value of

1  x2 +y2 −2x 2 2

f (x, y) = e − e−(x +y −2x)
2
by first applying an increasing transformation to f .

We can simplify this minimization problem by recognizing that this function is a strictly
increasing transformation of a simpler function. In particular, take

g(x, y) = x2 + y 2 − 2x
1 z
e − e−z


F (z) =
2
Then, f (x, y) = F (g(x, y)). To show that F (z) is strictly increasing, we examine its first
derivative:
1 z
F 0 (z) = e + e−z


2
z −z
Both e and e are always positive, so the first derivative of the function is always positive,
indicating that F is strictly increasing.
Now, we can solve the minimization problem just by solving for the minimum point of g(x, y).
The FOCs are that 2x − 2 = 0 and 2y = 0, so there is a stationary point at (x, y) = (1, 0).
00 = 2 > 0, g 00 = 2 > 0, and g 00 = 0, so this is
Taking the second derivatives, we find that g11 22 12
a minimum point.
To find the minimum value of f (x, y), we simply need to find f (1, 0). This turns out to be
1 −1
e − e1 ≈ −1.18


2

3
3. Consider 2 firms that sell an identical product to the same market. Instead of competing
with each other, the firms decide to join forces to maximize their total profits. Let us assume
that the inverse demand curve for the product is

P = c − aQ1 − bQ2

with the cost functions C1 (Q1 ) = hQ21 and C2 (Q2 ) = kQ22 , whereby Q1 and Q2 indicate the
output produce by Firm 1 and 2 respectively.
Assume that a, b, c, h and k are all greater than 0.

(a) Find the joint profit function.

Profit is equal to a firm’s revenue less its costs. So, the profit for firm i is πi (Qi ) =
P Qi − Ci (Qi ). Since we want to add the profits of the two firms, this gives us the joint
profit function:

π(Q1 , Q2 ) = P Q1 − C1 (Q1 ) + P Q2 − C2 (Q2 )

= (c − aQ1 − bQ2 )Q1 − hQ21 + (c − aQ1 − bQ2 )Q2 − kQ22
= c(Q1 + Q2 ) − (a + h)Q21 − (b + k)Q22 − (a + b)Q1 Q2

(b) Find the first order conditions and the stationary point(s) of the profit function.

FOCs:
π10 (Q1 , Q2 ) = c − 2(a + h)Q1 − (a + b)Q2 = 0
π20 (Q1 , Q2 ) = c − 2(b + k)Q2 − (a + b)Q1 = 0

We can solve these simultaneously to obtain:

c(a − b − 2k)
Q∗1 =
(a + b)2 − 4(a + h)(b + k)
c(b − a − 2h)
Q∗2 =
(a + b)2 − 4(a + h)(b + k)

(Q∗1 , Q∗2 ) is the only stationary point of the profit function.

(c) What further condition(s) must be placed on the parameters to guarantee that the sta-
tionary point(s) of the profit function maximize the profit?

4
 Second-order partials:

00
π11 (Q1 , Q2 ) = −2(a + h)
00
π12 (Q1 , Q2 ) = −(a + b)
00
π22 (Q1 , Q2 ) = −2(b + k)

Since we are looking for a global maximum, we should use the sufficient conditions for
a global maximum, which uses weak inequalities. We already have the conditions that
00 ≤ 0 and π 00 ≤ 0. Now, we
all of the parameters are positive. This guarantees that π11 22
must ensure that

00 00 00 2
π11 π22 − (π12 ) = 4(a + h)(b + k) − (a + b)2 ≥ 0

This is an extra condition that we must impose. I will leave it in this form.

(d) How would the value function (π ∗ (a, b, c, h, k)) change if the parameters were changed
(i.e. find all first-order partial derivatives of the value function)? Leave your answers in
terms of Q∗1 and Q∗2 .

The value function, π ∗ , can be obtained by plugging the maximum point (Q∗1 , Q∗2 ) into
the profit function:
π ∗ (a, b, c, h, k) = π(Q∗1 , Q∗2 )

Then, to find the first-order partials of the value function, we would simply need to
differentiate it with respect to each parameter separately. This is quite messy since the
expressions for Q∗1 and Q∗2 are messy. Instead, we can use the envelope theorem. For
our case, this says that
∂π ∗ ∂π
=
∂r ∂r (Q1 ,Q2 )=(Q∗ ,Q∗ )
1 2

where r is one of the parameters. We can therefore begin with our profit function:

π = c(Q1 + Q2 ) − (a + h)Q21 − (b + k)Q22 − (a + b)Q1 Q2

5
 We now take the partial derivatives with respect to the parameters:
∂π
= −Q∗2 ∗ ∗
1 − Q1 Q2
∂a (Q1 ,Q2 )=(Q∗1 ,Q∗2 )
∂π
= −Q∗2 ∗ ∗
2 − Q1 Q2
∂b (Q1 ,Q2 )=(Q∗1 ,Q∗2 )
∂π
= Q∗1 + Q∗2
∂c (Q1 ,Q2 )=(Q∗1 ,Q∗2 )
∂π
= −Q∗2
1
∂h (Q1 ,Q2 )=(Q∗1 ,Q∗2 )
∂π
= −Q∗2
2
∂k (Q1 ,Q2 )=(Q∗1 ,Q∗2 )

4. Sample Final Question: Take the function

f (x, y) = 400(x + y) − 2(x2 + y 2 ) − 196xy

dy
(a) Find along a level curve of this function in terms of x and y using implicit differen-
dx
tiation.

The level curves of this function are defined by:

400(x + y) − 2(x2 + y 2 ) − 196xy = c

We will differentiate with respect to x:

     
dy dy dy
400 1 + − 2 2x + 2y − 196 x +y = 0
dx dx dx
dy
(400 − 4y − 196x) + 400 − 4x − 196y = 0
dx
dy 400 − 4x − 196y
= −
dx 400 − 4y − 196x

(b) Find the marginal rate of substitution of f (x, y).

The marginal rate of substitution is given by:

f10 (x, y)
MRS =
f20 (x, y)
400 − 4x − 196y
=
400 − 4y − 196x
dy
This can also be found by recognizing that MRS = − .
dx

6
(c) Determine if f (x, y) is homogeneous and/or homothetic.

First, we find f (tx, ty):

f (tx, ty) = 400t(x + y) − 2t2 (x2 + y 2 ) − 196t2 xy

= t(400(x + y) − 2t(x2 + y 2 ) − 196txy)
6= tk f (x, y)

So, f (x, y) is not homogeneous. To check homotheticity, first assume f (x1 , y1 ) =

f (x2 , y2 ):

400(x1 + y1 ) − 2(x21 + y12 ) − 196x1 y1 = 400(x2 + y2 ) − 2(x22 + y22 ) − 196x2 y2

400(x1 + y1 − x2 − y2 ) = 2(x21 + y12 + 98x1 y1 − x22 − y22 − 98x2 y2 )
200(x1 + y1 − x2 − y2 ) = (x21 + y12 + 98x1 y1 − x22 − y22 − 98x2 y2 )

Next check if f (tx1 , ty1 ) = f (tx2 , ty2 ):

?
400t(x1 + y1 ) − 2t2 (x21 + y12 ) − 196t2 x1 y1 = 400t(x2 + y2 ) − 2t2 (x22 + y22 ) − 196t2 x2 y2
?
400t(x1 + y1 − x2 − y2 ) = 2t2 (x21 + y12 + 98x1 y1 − x22 − y22 − 98x2 y2 )
?
200(x1 + y1 − x2 − y2 ) = t(x21 + y12 + 98x1 y1 − x22 − y22 − 98x2 y2 )

Given our assumption, this is only true if t = 1. Since this is not true for all t > 0, this
function is not homothetic.

(d) Find the stationary points of this function and classify those points (local maxima, local
minima, saddle point, or undetermined) using the second derivative test.

To find the stationary points, we have to satisfy the first-order conditions:

f10 (x, y) = 400 − 4x − 196y = 0
f20 (x, y) = 400 − 4y − 196x = 0
Solving these equations simultaneously, we find that x = y = 2. The only stationary
point is (2,2). To classify this stationary point, we need to examine the second derivatives
of f (x, y):
00
f11 (x, y) = −4
00
f12 (x, y) = −196
00
f22 (x, y) = −4
00 f 00 − (f 00 )2 = −38400. The second derivative test tells us that this
This implies that f11 22 12
point is a saddle point.