ECON 222: MATHEMATICS FOR BUSINESS

Tute # 10 (Week 12)

Topic # 23: Profit Maximization Revisited

Question 1

This question refers to a price-taking firm with production function

Q=f ( L , K ) =√ L+ √ K

The prevailing market price is ¿ $ 16 . Compute the value of the marginal physical product of each
input.

Answer

1
MPP L = and, by definition, Value of the MPP L =P × MPP L
2√L

1
∴ Value of the MPP L=16 ×
2√L

1
MPP K = and, by definition, Value of the MPP K =P× MPP K
2 √K

1
∴ Value of the MPP K =16 ×
2√K

Question 2

This question refers to a price-taking firm with production function

Q=f ( L , K ) =√ L+ √ K

The prevailing market price is ¿ $ 16 . Moreover, the wage rate and the rental cost of capital are
w=0.5∧r=1 , respectively.

Find the most profitable input combination and the corresponding value of the total profit
function.

Answer

Step 0: Construction of the objective function

The objective function is

Π=P × f ( L , K ) −(w × L+r × K )

In the present case:

1
P=16 , f ( L , K )=√ L+ √ K , w=0.5∧r=1

Therefore, the objective function is

Π=16 ( √ L+ √ K )−(0.5 × L+1 × K )

Step 1: first-order conditions

{
∂Π 1
=16 × −0.5=0
( FO )
∂L 2 √ L
∂Π 1
=16 × −1=0
∂K 2 √K

Step 2: Solve for x and y

Moving terms in the first equation of ( FO ) :

1 1 1 1 1
16 × −0.5=0  8× =  =
2 √L √L 2 √ L 16
16=√ L  L=256

From the second equation of ( FO )

1
16 × −1=0
2 √K

we find

K=64

Step 3: Compute the Hessian determinant of the profit function

The second partials of the profit function are

−1/ 2 −3 /2
Π L=8× L −0.5  Π ¿ =−4 × L

Π LK =0=Π KL
−1 /2 −3/ 2
Π K =8 × K −1  Π KK =−4 K

Therefore,

Hessian determinant : A=
|
Π ¿ Π LK
Π KL Π KK |

| |
−3 / 2 −3
−4 × L 0 2
A(L , K )= −3 /2 =16( LK )
0 −4 × K

2
Step 4: Evaluation of A ( x , y ) at the solution/s of (FO)

−6
A ( 256 , 64 )=7.63 ×10 > 0

Step 5: Locating maxima/minima

From step 4 we know that at the input combination ( L , K )=( 256.64)

A ( 256 , 64 )> 0

The value of Π ¿ at is

Π ¿ ( 256 , 64 )=−0.0001<0

Therefore, the profit-maximizing input combination is

( L , K )=( 256 ,64 )

Step 6: Optimum values

The most profitable output level Q is

Q=f ( L , K ) =√ 256+ √ 64=16+8=24

The total revenue when the firm is maximizing profits is

R ( Q )=P ×Q=16 ×24=384

The total cost when the firm is maximizing profits is

C=w × L+ r × K=0.5× 256+1 ×64=192

Finally, the maximum value of the total profit function is

Π=P × f ( L , K ) −( w × L+r × K )=16 ×24−(0.5 ×256 +1× 6)=192

Topic # 24: Constrained Optimization

Question 1

Optimize { z=f ( x , y )=x 2−3 xy +12 x } , subject ¿ : ∅ ( x , y )=2 x+ 3 y=6

Answer

Step 0: Lagrangian function

L=f ( x , y ) + λ [ C−∅ (x , y) ] =x −3 xy +12 x+ λ [ 6− ( 2 x +3 y ) ]

2

Step 1: First-order conditions

3
 {
L x =2 x−3 y +12+ λ (−2 )=0
(F 0) L y =−3 x + λ (−3 )=0
L λ=6−( 2 x+ 3 y )=0

Step 2: Solve for x , y ,∧λ

Eliminate λ from the first two equations

{2 x−3−3yx+12=2
=3 λ { x=− λ
λ → 2 x−3 y +12=2 λ

2 x−3 y +12
=−2 → 2 x−3 y +12=−2 x
x

Express x as a function of y

4 x−3 y +12=0 → 4 x−3 y =−12→

3
x= y−3
4

Go to the constraint 6−( 2 x +3 y )=0

6−2 x −3 y=0

6−2
[ 3
4 ]
y−3 −3 y=0 →

3
6− y +6−3 y=0
2
 12−
[ ]
3
2
+3 y=0 
9
12− × y=0
2

Solve for y

9 24 8
12= × y  y=  y=
2 9 3

3
Go back to x= y−3 to find x
4

{
3
x= × y−3
4
8
¿ y=
3

4
 3 3 8 24
x= × y −3= × −3= −3
4 4 3 12

→ x=−1

8
At this stage, we know that x=−1 and y= .
3

Finally, to obtain λ we go back to the first (or the second) equation of (FO).

8
2 x−3 y +12+ λ (−2 )=0  2 × (−1 )−3× +12−2× λ=0  2−2× λ=0
3

It follows at once that

λ=1

Therefore, there is only one solution to the system (F 0):

8
( x ¿ , y ¿ , λ¿ )=(−1, , 1)
3

Step 3: Write the bordered Hessian determinant

| || |
Lxx L xy ϕ x 2 −3 2
H=H ( x , y , λ )= L yx L yy ϕ y = −3 0 3
ϕx ϕ y 0 2 3 0

Step 4: Expand H=H ( x , y , λ )

Expanding the third-order determinant H by the first row, we find:

| |
2 −3 2
H=H ( x , y , λ )= −3 0 3
2 3 0

H=2× |03 30|− (−3) ×|−32 30|+2 ×|−32 03|=2 × (−9) +3 × (−6 )+2 × (−9)=−18−18−18=−54=constant
Step 5: Locating constrained optima

We see that H is constant (note, however, that in many cases H ( x , y , λ ) is not constant).

This means that for any collection ( x , y , λ ) the determinant H has the same value (¿−54). It
must therefore be true that

H ( x ¿ , y¿ , λ ¿ ) =−54 ≠ 0

5
 ¿ ¿
The only solution of (F 0) is: ( x , y , λ )= −1 ,
¿
( 8
3 )
,1 . It is true that

H ( x ¿ , y¿ , λ ¿ ) =−54< 0

¿ ¿
(
Therefore, the point ( x , y ) = −1 ,
8
3 )
confers a constrained (local) minimum to the objective

function.

Step 6: Constrained optimum values

Evaluating the objective function z=f ( x , y )=x 2−3 xy +12 x at ( x , y ) = −1 ,

¿ ¿
( 8
3), yields

¿ ¿ 2 8
f ( x , y )=f (−1 , 8/3 ) =(−1 ) −3 × (−1 ) × +12× (−1 )=1+8−12=−3
3

Therefore,

f ( x ¿ , y ¿ )=−3

is the value of the constrained (local) minimum.

Question 2

Solve the following optimization problem:

Optimize { z=f ( x , y )=x × y } , subject ¿ : ∅ ( x , y ) =x + y =8

2 2

Answer

Step 0: Lagrangian function

L=f ( x , y ) + λ [ C−∅ (x , y) ] =xy + λ [ 8−( x + y ) ]

2 2

Step 1: First-order conditions

{
Lx = y+ λ (−2 x ) =0
(F 0) L y =x+ λ (−2 y )=0
L λ=8−( x + y )=0
2 2

Step 2: Solve for x , y ,∧λ

{ y=2 λx → y = x → y 2=x 2
x=2 λy x y

6
Therefore, the system (F 0) has four (4) solutions:

¿ ¿ ¿ 1
x =2 y =2 λ =
2
−1
¿ ∗¿ = ¿
2
¿∗¿=−2 λ ¿
¿∗¿=2 y ¿
x

¿∗¿ ¿∗¿ ¿∗¿ 1

x =−2 y =−2 λ =
2
−1
¿∗ ¿∗¿ = ¿
2
¿∗¿∗¿=2 λ ¿
¿∗¿∗¿=2 y ¿
x

Step 3: Write the bordered Hessian determinant

| || |
Lxx L xy ϕ x −2 λ 1 2x
H=H ( x , y , λ )= L yx L yy ϕ y = 1 −2 λ 2 y
ϕx ϕ y 0 2x 2y 0

Step 4: Expand H=H ( x , y , λ )

Expanding the third-order determinant H by the first row, we find:

H=−2 λ × |−22 yλ 20y|−1 ×|21x 20y|+2 x ×|21x −2 λ

2y |
H=−2 λ × (−4 y 2 )−1 × (−4 xy ) +2 x × ( 2 y +4 x λ )
2 2
H=8 λ y + 4 xy + 4 xy +8 λ x
2 2
H=8 λ y + 8 xy + 8 λ x

H=H ( x , y , λ )=8 λ ( x 2 + y 2 ) +8 xy

Because the constraint x 2+ y 2=8, H can be slightly rewritten as

H ( x , y , λ )=64 λ+ 8 xy

Step 5: Locating constrained optima

We must evaluate H ( x , y , λ ) at each solution of (F 0):

H ( x ¿ , y¿ , λ ¿ ) =64> 0→ ( 2 , 2 ) confers a constrained ( local ) maximum

H¿

H ( x ¿∗¿ , y ¿∗¿ , λ¿∗¿ ) =64> 0→ (−2 ,−2 ) confers a constrained ( local ) maximum

7
H¿

Step 6: Constrained optimum values

Evaluating the objective function,

f ( 2 , 2 )=4 ← value of the constrained local maximum

f ( 2 ,−2 )=−4 ← value of the constrained local minimum

f (−2 ,−2 )=4 ← value of the constrained local maximum

f (−2 , 2 )=−4 ← value of the constrained local minimum

Critical Thinking (Topic # 24)

Question 3

What is false in the following reasoning?

“Economists make much use of the method of Lagrange multipliers. This method is
named after his discoverer, the French mathematician Joseph Louis Lagrange (1736
– 1813). Unfortunately, Lagrange was unable to realize that before applying his
method it is convenient to verify that the objective function

z=f ( x , y )

has an unconstrained optimum. Otherwise, the constrained optimization problem

Optimize { z=f ( x , y ) } , subject ¿ : ∅ ( x , y )=C

cannot possibly have a solution. It is a good thing to recognize the creators of

original contributions but we have to realize that intellectual innovators tend to be
unable to do lateral thinking.”

Answer

The existence of an unconstrained optimum of the objective function it is not a necessary

condition for the problem

Optimize { z=f ( x , y ) } , subject ¿ : ∅ ( x , y )=C

to have a solution. For example, the unconstrained problem

Optimize { z=f ( x , y )=xy }

8
has no solution (Check that the Hessian determinant A=A ( x , y ) is always negative and equal
to −1). However, the constraint optimization problem

Optimize { z=f ( x , y )=xy } , subject ¿: 2 x + y=4

¿ ¿
has a constrained maximum at ( x , y ) =(1 , 2) and the value of the objective function is z=2. It
is a good exercise to work out for yourself this example.

Topic # 25: Constrained Cost Minimization

Question 1

The technology of the firm is described by the production function

Q=f ( L , K ) =2 LK

The firm in question faces (constant) input prices are w=3∧r=4 . Find the minimum total cost
¿
of producing Q =337.5 units of output.

Answer

The constraint optimization problem is

¿
Minimize { TC=wL+ rK } subject ¿ : f ( L , K )=Q ,
¿ ¿
where Q is a prescribed output level and f ( L , K )=Q is called the output constraint.

In the present case, the problem is

Minimize { TC=3 L+ 4 K } subject ¿ : 2 LK=337.5

Step 0: Lagrangian function

¿
M =wL+rK + μ[Q −f ( L , K ) ],

M =3 L+4 K + μ [ 337.5−2 LK ] ( μ=Lagrange multiplier)

Step 1: First-order conditions

∂M
=3+ μ [ −2 K ] =0
∂L

9
 ∂M
=4+ μ [ −2 L ] =0
∂K

∂M
=337.5−2 LK=0
∂μ

Step 2: Solving for L , K ,∧μ

3=μ [ 2 K ]

3 K 3
 = →K= × L
4 L 4

4=μ [ 2 L ]

3
337.5−2 LK =0 →337.5−2× L× ×L
4
2 2
1.5 × L =337.5 → L =225 → L=15

3
Because K= × L we find
4

K=0.75× 15=11.25

Using the first equation of the system of first order conditions, we find

3
3+ μ [ −2 K ] =0 →3=μ 2 K → 3=μ ×2 ×11.25 → μ=
22.5

μ ≈ 0.133

Step 3: Bordered Hessian Determinant

f ( L , K )=2 LK →
{
f L =2 K
f K =2 L

| || |
M ¿ M LK f L 0 −2 μ 2 K
D= M KL M KK f K ¿ −2 μ 0 2L
fL fK 0 2K 2l 0

Step 4: Expand D=D ( L , K , μ )

| |
0 −2 μ 2 K
D=¿ −2 μ 0 2 L =−16 × L× K × μ
2K 2L 0

Expansion of D:

10
 D=0× |20L 20L|−(−2 μ) ×|−22 Kμ 20L|+2 K ×|−22 Kμ 20L|
D=0+2 μ (−4 LK ) +2 K (−4 Lμ )=−8 LKμ−8 LKμ=−16 LKμ

Step 5: Locating constrained optima

Evaluating D at the solution of the first order conditions ( L , K , μ )=(15 , 11.25, 0.133) we
find:

D ( L , K , μ )=−16 × 15× 11.25×0.133 <0

Therefore, the least-cost input combination is

( L¿ , K ¿ ) =( 15 ,11.25 )

Step 6: Constrained optimum values

The minimum total cost of producing Q¿ =337.5 is

¿ ¿ ¿
TC =w L +r K =3 ×15+ 4 ×11.25=$ 90.00

Critical thinking (Topic # 25)

Question 2

What is false in the following reasoning?

“The constraint-cost minimization problem answers a fundamental problem for all

firms: how to select inputs to produce a given output at minimum cost. The main
message conveyed by the solution to this problem is that to minimize the total cost
¿
of producing a prescribed output level Q we need to know the least cost-input
¿ ¿
combination (L , K ). The value of L¿ represents the quantity demanded of labour
and K ¿is the quantity demanded of capital. The point of tangency of the strictly
¿
convex isoquant for Q=Q and an isocost line determines this input combination.
Furthermore, at the point of tangency there is a precise relationship between the
marginal rate of technical substitution and the input prices. With unchanging
technology, this means that if you are a cost-minimizing decision maker, you
should be concerned with inflation. In fact, increases in the nominal prices such as,
for example, wage rate w and rental cost of capital r will shift the least-cost input
¿ ¿
combination (L , K ), that is, will change the quantities demanded of both inputs.“

Answer

The sentence “In fact, increases in the nominal prices such as, for example, wage rate w
¿ ¿
and rental cost of capital r will shift the least-cost input combination (L , K ), that is, will
change the quantities demanded of both inputs.“ is false.

11
If all input prices increased in the same proportion, the relative input price remains
unchanged. We saw this in Question 10, Topic # 19. Therefore, the quantities demanded
of labour and capital remain constant.

In symbols, if the firm is minimizing costs

w
MRTS=
r

With unchanging technology, MRTS cannot change. But if w and r are increased in the
same proportionm , meaning

w → m× w∧r → m×r ,

the relative price of labour in terms of capital remains intact

m× w w
=
m× r r
¿ ¿
and therefore, the least-cost input combination (L , K ), cannot change.

With a given technology, the quantities demanded of labour and capital will change only if
the input price ratio changes. Increases in nominal input prices in the same proportion
and direction do not alter the point of tangency.

Topic # 26: Constrained Utility Maximization

Question 1

Suppose that the prices of the products X and Y are, respectively,

P x =2 , P y =4

(a) Find the best affordable bundle for a consumer whose utility function and income
are
U =U ( x , y )=xy + y and I =18,
respectively.

(b) What is the maximum level of satisfaction attainable for this consumer?

Answer

Step 0: Lagrangian function

L=U ( x , y )=xy + y + λ [18−(2 x +4 y)] (λ=Lagrange multiplier)

Step 1: First-order conditions

∂L
= y+ λ [−2 ] =0
∂x

12
 ∂L
=x+1+ λ [−4 ] =0
∂y

∂L
=18−(2 x +4 y)=0
∂λ

Step 2: Solving for L , K ,∧λ

Eliminating λ from the first two equations,

y + λ [ −2 ]=0 → y=2 λ

y 2
 x+1 = 4 → y=1/2( x +1)

x +1+ λ [ −4 ] =0 → x+1=4 λ

18−(2 x+ 4 y )=0 → 18−2 x−4 ×1 /2( x+1)=0 → 18−4 x−2=0

∴ x=4 → y=2.5 → λ=1.25

Step 3: Bordered Hessian Determinant

| || || |
L xx L xy ∅ x U xx U xy P x 0 1 2
H= L yx L yy ∅ y ¿ U yx U yy P y ¿ 1 0 4
∅x ∅ y 0 Px P y 0 2 4 0

Step 4: Expand H

| |
0 1 2
H=¿ 1 0 4 =16 >0 for all x >0∧ y> 0
2 4 0

Step 5: Locating constrained optima

Evaluating H at the solution of the first order conditions

( x , y , λ )=(4 , 2.5 , 1.25)

we find:

H=H ( x , y , λ )=H (4 , 2.5 ,1.25)=16 >0

Therefore, the best affordable bundle is

( x ¿ , y ¿ ) =(4 , 2.5)

Step 6: Constrained optimum values

The maximum attainable level of satisfaction for this consumer is

13
 U ( x ¿ , y ¿ )=x ¿ × y ¿ + y ¿ =4 × 2.5+2.5=12.5

Question 2

Solve the following consumer’s optimization problem:

Maximize {U =U ( x , y) } subject ¿: P x × x + P y × y=I ,

where

U =U ( x , y )=2 xy , P x =3 , P y =4 ,∧I =90

Answer

Step 0: Lagrangian function

L=U ( x , y )=2 xy + λ[90−(3 x +4 y)] (λ=Lagrange multiplier)

Step 1: First-order conditions

∂L
=2 y + λ [−3 ] =0
∂x

∂L
=2 x + λ [ −4 ] =0
∂y

∂L
=90−(3 x+ 4 y )=0
∂λ

Step 2: Solving for x , y ,∧λ

Eliminating λ from the first two equations,

y 3 3
= → y= × x
x 4 4

Substituting this into the third equation, we obtain one equation for one unknown
yielding x=15 :

3
90−( 3 x+ 4 y )=90−[3 x + 4 × × x ]=0
4

90−[ 6 x ] =0 → x=15

3
Because y= × x, it follows that
4

y=11.25

14
We can use either the first of the second equation of the first order conditions to find λ :

2 y + λ [ −3 ] =0 → 2× 11.25=3 λ

22.5=3 λ → λ=7.5

Therefore the solution of the first-order conditions is

( x , y , λ )=(15 , 11.25, 7.5)

Step 3: Bordered Hessian Determinant

| || || |
L xx L xy ∅ x U xx U xy P x 0 2 3
H= L yx L yy ∅ y ¿ U yx U yy P y ¿ 2 0 4
∅x ∅ y 0 Px P y 0 3 4 0

Step 4: Expand H

| |
0 2 3
H= 2 0 4 =48>0 for all x >0∧ y >0
3 4 0

Step 5: Locating constrained optima

Evaluating H at the solution of the first order conditions ( x , y , λ )=(15 , 11.25, 7.5)

we find:

H=H ( x , y , λ )=H (15 , 11.25, 7.5)=48> 0

Therefore, the best affordable bundle is

( x ¿ , y ¿ ) =(15 , 11.25)

Step 6: Constrained optimum values

The maximum attainable level of satisfaction for this consumer is

U ( x ¿ , y ¿ )=2 × x ¿ × y ¿=2 ×15 × 11.25=337.5

Topic # 26: Appendix

Geometrical Aspects of the Consumer’s Optimization Problem

Question 1

If the prices of products X and Y are P x ∧P y , respectively, and the consumer’s income is
denoted by I, what is the formula defining the budget line?

15
Answer
P x × x + P y × y=I

Question 2

Is there any relationship between the relative price of product X with respect to product
Y, defined as

Px
Py

and the slope of the budget line?

Answer

Yes, the slope of the budget line is the negative of the relative price. More precisely,

I Px
P x × x + P y × y=I → y= − ×x
Py Py

Therefore,

dy −P x
=Slope of budget line=
dx Py

Question 3

The budget line has an important property: if the price of product X falls and P y ∧I remain
constant, the original budget line rotates outward. This is true but not intuitively evident.
To see the rotation, consider two situations and represent graphically the corresponding
budget lines.

 Situation 1

The prices of the products X (coffee) and Y (tea) are, respectively,

P x =2.00 , P y =4.00

and the consumer’s income is I =18 , so that the budget line is

2 × x +4 × y=18 ← Budget line L1

 Situation 2

The price of coffee falls from $ 2.00 to $ 1.00, but everything else remains as in situation 1.

1 × x +4 × y=18 ← Budget line L2

16
Answer

When the price of coffee falls from $ 2.00 to $ 1.00, the budget line rotates outward from
L1to L2 . The vertical intercept ( x , y ) =( 0 , 4.5 ) does not change.

Diagram not available.

Question 4

Consider a function U = U(x, y) that assigns to each product bundle (x, y) one and only one
real number U, called ‘utility’. Let A, B, and C be three product bundles such that

U(A) = 100, U(B) = 100, and U(C) = 200

Utility is said to be ordinal if

a. The consumer is able to say by how much A is preferred to B.

b. The gain in the quantity of happiness in moving from A to C equals the gain in
moving from B to C.
c. The consumer need not know precisely the quantity of satisfaction, but she
must be able to compare levels of satisfaction.
d. The assignment of real numbers to the consumption bundles is wholly
arbitrary.
e. The utility function describing the consumer’s preferences is unique.

Answer

c. is the correct option

------------------------------------------------------------------------------------------------------------------------

Questions 5 and 6 refer to Diagrams A, B, and C.

17
 y y y

x x x
0 0 0
(A) (B) (C)

Question 5

Which, if any, of these diagrams tells us that tangency is not a sufficient condition for
optimality?

a. Diagrams (A) and (B)

b. Diagram (B) only
c. Diagram (C) only
d. Diagrams (B) and (C)
e. None of the above

Answer

b. is the correct option.

Question 6

Which, if any, of these diagrams illustrates the case of a “corner solution”?

a. Diagrams (A) and (B)

b. Diagram (B) only
c. Diagram (C) only
d. Diagrams (B) and (C)
e. None of the above

Answer

18
c. is the correct option.

19