UNIT THREE

UNCONSTRAINED OPTIMIZATION
INTRODUCTION
Dear colleague! As you know economics is a science of choice. If we want to undertaken an
economic project, say producing a certain product, there may be several possible ways of doing
it. However, one or more of them will be more important than others from the point of view of
some criteria. Thus, the main duty of optimization problem is choosing the best alternative
according to the specified criteria.

In economics we usually use the objective of profit maximization or cost minimization as the
most common criteria to select the best alternative to carry out the project. In economics,
optimization problem is a general heading which represents both minimization and maximization
problem. Optimization means ' the quest for the best".
To solve optimization problem, first we should formulate the objective function which will be
maximized or minimized. This function includes dependent and independent variables. The
independent variables are referred to as choice variables because the economic unit chooses their
magnitude to optimize the objective function.

In general, the nature of optimization process is to get the values of the choice variables that will
optimize the objective function.

Dear colleague! This unit is emphasized on unconstrained optimization, i.e. minimization or

maximization of objective function without constraint.

Unit Objective
After completing this unit, your are expected to
- define the term optimization
- describe the conditions that should be satisfied for optimizing unconstrained
functions
- solve optimization of unconstrained functions with one independent variable
- solve optimization problem of function of two or more independent variables
- describe the unconstrained envelope theory

Section 3.1 Functions of One Independent Variable

Up on the completion of this section the student is expected to

- describe the first order condition that

should be satisfied for optimization
- explain the second order condition for
optimization
- solve economic models

Dear colleague! What is unconstrained function? You ought to refer your Quantitative
Method for economist I material to answer this question.
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
---?

66
Have you answered it? Good. Try to relate your answer with the following analysis.

Some objective functions involve constraints and others do [Link] which do not involve
constraints are referred to as unconstrained functions and the process of optimization is said to be
unconstrained or free optimization.

Given the function y = f(x) which is continuous and differentiable, it is said to have a maximum
value at a point where it changes from an increasing to decreasing function where as it is said to
have a minimum value at the point where it changes from decreasing to increasing functions. The
values of x at which the function is at its minimum or maximum point are known as critical
values. The given function should satisfy two conditions in order to decide about maximum and
minimum value at a particular point. These conditions are called order conditions.

a) Conditions for minimum value

1. First order condition f ( x)  0
(Necessary condition)
2. Second order condition f ( x)  0
(Sufficient condition)

b) Conditions for Maximum value

1. First order condition f ( x)  0
(Necessary condition)
2. Second order condition f ( x)  0
(Sufficient Condition)

However, the second derivative of the function may be equal to zero in some cases. When
f ( x)  0 , the second derivative test would be inconclusive. Thus, we should take the successive
derivative test to determine whether the function is at its extremum point or the point of
inflection. Evaluated at a critical point if the first non - zero value of a higher order derivative is
an odd numbered derivative, then the function is at the point of inflection. If the first non - zero
value of a higher order derivative is an even numbered derivative, the function is at it's relative
extremum with positive value the derivative shows the relative minimum and with negative value
the derivative indicates the relative maximum point.

Example
Find the minimum and maximum values of the function f ( x)  3x 4  10 x 3  6 x 2  5

Solution
The first order condition is f ( x )  0 .We can determine the critical values using this condition.
Thus, f ( x)  12 x 3  30 x 2  12 x  0
3 x( 4 x 2  10 x  4)  0
3 x[ 2 x(2 x  1)  4(2 x  1)]  0
3 x[(2 x  4)(2 x  1)]  0
3 x  0 or 2 x  4  0 or 2 x  1  0

1
Thus the critical values are x  0 or x  2 or x  .
2

67
We should test the second order condition at these points to know whether the function is at its
relative maximum or minimum point.
f ( x)  36 x 2  60 x  12
At x  0 , f ( x)  36(0) 2  60(0)  12  12  0 . Thus, the function is at its relative minimum
point at x = 0.
At x = 2, f ( x)  36(2) 2  60( 2)  12
=144-120 +12
f ( x)  36  0 . Thus, the function is at its relative minimum point at x  2 .
1 1
At x = ½, f ( x)  36( )  60( )  12
2 2
1
= 36( )  30  12
4
= 9  30  12  9  0
1
Therefore, the function is at its relative maximum point when x  .
2

3.1.1 Economic Applications

Revenue functions
Dear colleague! As you remember revenue represents the amount of money that the firm
generates either from the sale of the products or providing services. Therefore,

Total Revenue = Price x Quantity Sold

It can be written as
TR = P x Q
Where P is price and Q is quantity.
The firm can maximize its total revenue when
dTR
0 or MR  0 (First order condition)
dQ
d 2TR d ( MR )
and 0 or  0 ( Second order condition )
dQ 2 dQ

Example

1. A farmer wants to send his perishable product to a city market as soon as possible. He has
estimated that he can send now 1.5 tones of the product per day and can get a price of 2,500 birr
per tones. If he waits, he can get a price increase of 20 Birr per tones per day but the quantity of
the product to be supplied will be reduced by 0.01 tones per day. For how many days should he
wait so that his revenue becomes a maximum?

Solution
Let x be the number of days waiting
Total revenue (TR) = (2, 500 + 20x) (1.5-0.01x)
= 3,750 - 25x + 30x - 0.2x 2
TR = 3,750 + 5x - 0.2x2

68
Revenue is maximized when
dTR d 2TR
0 and < 0
dx dx 2

dTR
Thus,  5  0.4x = 0
dx
-0.4x = -5
x = 12.5
d 2TR
At x = 12.5,   0 .4  0
dx 2
Therefore, the farmer should wait for 12.5 days to maximize he's revenue.

2. Suppose a 200- room hotel in Addis Ababa will rent all its rooms when it charges 125 Birr per
night per room. However from past experience, the manager knows that for each 5 birr increase
in rate per night per room, 4 rooms remain unoccupied per night. What rent per room will
maximize total revenue per night?

Solution
Let x be increase in nightly rent per room.
TR = (200 – 4 x) (125+ 5x)
= 25,000 + 1,000 x – 500 x – 20 x2
TR = 25,000 + 500 x – 20 x2
dTR d 2TR
Total revenue is maximized when  MR  0 and <0
dx dx 2
MR = 500 - 40 x = 0
-40x = -500
x = 12.5
d 2TR
When x = 12.5,   40  0
dx 2
Thus, total revenue is maximized when x  12.5
The rent per room per night that should be charged to which maximizes revenue is
Rent = 125 + 5(12.5) = 125+ 6.5
= 187.5 Birr per room per night

Profit functions

Dear colleague! Do you remember the conditions that should be satisfied for profit
maximization? What are they? As we know that the main objective of every firm is profit
maximization; therefore, it wants to know the level of output which maximizes profit.
Total profit = Total revenue - Total cost
 = TR – TC
Where  represents total profit, TR is total revenue and TC is total cost.
We have discussed above that there are first orders and second order conditions for maximizing
profit. The first order condition that must be fulfilled for maximizing profit is that the slope of
total revenue (marginal revenue) has to be equal to the slope of total cost (marginal cost). That is
d dTR dTC
0  0
dQ dQ dQ

69
 MR - MC = 0

MR = MC

The second condition that has to be satisfied is that the slope of marginal revenue must be less
than the slope of marginal cost. In other words, the marginal cost curve has to cross the marginal
revenue curve from below. That is

d 2 d 2TR d 2TC
2 <0   <0
dQ dQ 2 dQ 2
d ( MR) d ( MC )

dQ dQ

Slope of < Slope of

MR MC

Dear colleague! Let us do the following examples to make it clear.

Example
1. Suppose a monopolist has a demand curve Q = 106 - 2 P and average cost curve
Q
AC = 5+ , where P is price per unit and Q is the number of units of output. Determine the
50
profit maximizing level of output and price of this monopolist.

Solution
Dear colleague! As we know, total profit (  ) = Total Revenue (TR) - Total Cost (TC) but TR
= PQ. Thus we should rewrite the demand function in the form of price expressed in terms of
quantity. That is
2P = 106 - Q
1
P = 53  Q
2
1
Thus, TR = (53 - Q) Q
2
1
TR = 53Q - Q2  MR = 53 - Q
2
And
TC = AC (Q)
Q
= (5+ )Q
50
1 1
TC = 5Q + 50 Q2  MC = 5 + 25 Q

70
 Dar colleague! I think you remember that profit is maximized when
MR = MC
1
53 - Q = 5 + Q
25
1
53 - 5 = Q + Q
25
26
48 = Q
25
48(25)
Q=
26
Q = 46.15
However, this information is not sufficient enough to conclude that it is the profit maximizing
level of output. Thus it must fulfill the following condition at this point.
d 2TR d 2TC 1
When Q = 46.15, 2 - 2 = -1 -
dQ dQ 25
 26
= <0
25
Now we are confident enough to conclude that Q = 46.15 is the profile maximizing level of
output of the monopolist as this level of output satisfies both of the above conditions.
The profit maximizing level of price is
1
P = 53 - (46.15)
2
= 53 = 23.075
P = 29.93
Cost Functions

Dear colleague! Do you remember the analysis of cost in your Microeconomics I study?
Please try to re-read that material so that you will have a good understanding for this of this
topic. As you remember costs represent the amount of expenditures that firm’s incurred in the
production process. It includes both implicit and explicit cost. Thus, firms want to minimize
these costs.

Given Total Cost (TC) = f (Q), where Q is output, Firms can minimize total cost if and only if
dTC
i)  0  MC  0
dQ
2
d TC d ( MC )
ii) 0 >0
dQ 2 dQ

Example

[Link] the total cost of producing Q units of a certain product is described by the function TC
= 100,000 + 1, 500Q + 0.4 Q2 where TC is the total cost stated in Birr.
Determine the amount of output which minimizes average cost.

Solution

71
 TC
Average cost (AC) =
Q
100,000
AC = + 1, 500+ 0.4 Q
Q
AC is minimized when
dAC d 2 ( AC )
 0 And 0
dQ dQ 2

dAC  100,000
  0.4  0
dQ Q2
100,000
- = - 0 .4
Q2
100,000
 Q2
0.4
Q 2 = 250,000
Q =  500 but output should be positive.
Therefore, Q = 500. But we should check the second order condition at this point to reach to our
conclusion.
d 2 AC  2( 100,000)
When Q= 500, =
dQ 2
Q3
200,00 200,000
= = >0
Q3 (500)3
Thus, the level of output which minimizes average cost is Q = 500 units.

2. Find the minimum point of the average cost function

Ac = 25 Q 1 + 0.1Q 2

Solution
Applying the same conditions
dAC
= - 25 Q 2 + 0.2Q = 0
dQ
-25Q 2 + 0.2Q = 0
-25Q 2 = - 0.2Q
25
= 0.2Q
Q2
Q 3 = 125
Therefore, Ac is at its stationary point when Q = 5. The rate of change of the slope of AC with
d 2 AC
respect to output is  50 Q 3  0.2
dQ 2
d 2 AC 50
When Q = 5,  3  0.2
dQ 2 5
50
=  0.2
125

72
 = 0.4+0.2 = 0.6 > 0
Thus, the second order condition for a minimum value of AC is satisfied when Q = 5.
The actual value of AC at its minimum point will be
25
25 Q 1 + 0.1Q 2 = + 0.1 (25) = 5+2.5 = 7.5
5
Dear colleague! By now you have completed the first section of this unit. Therefore, try to do the
following self test questions to examine how you have understood this section.

Self - Test 3.1

Solve the following questions based on the information given above.

[Link] owner of the orange grove must decide when to pick one variety of oranges. She can sell
them for 8 birr a bushel if she sells them now, with each tree yielding an average of 5 bushels.
The yield increases by one - half bushel per week for the next five weeks but the price per bushel
decreases by 0.5 birr per bushel each week. When should the oranges be picked for maximum
return?
---------------------------------------------------------------------------------------------------------------------
---------------------------
[Link] a firm faces the demand schedule P = 90 - 0.3 Q how much does it has to sell to maximize
sales revenue?
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
---------------------
[Link] the non - linear demand function P = 750 - 0.1Q 2 what output will maximize the sales
revenue?
---------------------------------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------

4. What is the maximum profit a firm can make if it faces a demand function p =
660 - 3Q and the total cost function TC = 25+240 Q- 72Q2 + 6Q 3 ---------------------------
------------------------------------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------------------------------

[Link] Company is planning to market a new model of product X. The management collects
information from retailers that how many units of good X they would buy for various prices.
From this survey, it is determined that the unit demand function is
X = -1,500 p + 30,000

The fixed costs to the company for production of good X are found to be 28,000 birr and the cost
for material and labor to produce each unit of good X is estimated to be 8 birr per unit. Determine
the price that the company should charge to maximize its profit.
---------------------------------------------------------------------------------------------------------------------
-------------------------------------------------------------------------------------------------------------
6. Find the profit maximizing output for a firm with the total cost function
1
TC  Q 3  8.5Q 2  97Q  4 and total revenue TR  58Q  0.5Q 2 .
3

Dear colleague! Have you answered these questions? If your answer is no, please reread this
section and try to answer these questions. If your answer is yes, very good. Go to the next section.

Section 3.2 Functions of Several Independent Variables

73
 After completing this section, you should be able to

- describe conditions of optimization of these

functions
- solve optimization problem of multiproduct
firm
- explain optimal combination of various
different input

Dear colleague! Until now we have discussed about the problem of optimization of an objective
function with only one choice variable. Now let us turn our attention to develop away of finding
the extreme values of an objective function which includes two or more choice variables. Then
we will have the ability to solve problems such as determining the profit maximizing level of
outputs for several commodities and the optimal combinations of several different inputs.

Given the function z = f(x, y), the objective function z to be maximum or minimum, it must
satisfy both of the order conditions.
The first order conditions are
z z
= 0 and =0
x y
This means, the first order total differential of the function is zero ( dz  f x dx  f y dy  0 ).
However, there are two sets of second order conditions
2z 2z
a) To be maximum  0 , and < 0 ----------------------------------- (1)
x 2 y 2
2 z 2 z
b) To be minimum >0, and >0 2
x 2 y
The other second order condition for both to be at maximum and minimum value is
2 z 2 z 2 z
( ) ( ) > ( )2
x 2 y 2
xy
Alternatively we can determine the second order sufficient condition using the concept of total
differential of the differential of the function which is denoted by
 ( f x dx  f y dy )  ( f x dx  f y dy )
d 2 Z  d (dZ )  dx  dy
x y
------------------------ (2)
d 2 Z  ( f xx dx  f xy dy ) dx  ( f yx dx  f yy dy ) dy
d 2 Z  f xx dx 2  f xy dydy  f yx dxdy  f yy dy 2
But we know that f xy  f yx (Young’s Theorem)
d 2 Z  f xx dx 2  2 f xy dxdy  f yy dy 2 --------------------------------------------- (3)
Then the second order condition for any value of dx and dy not both zero
d 2 Z  0 indicates that the function is at its maximum whereas d 2 Z  0 shows that the function
at it minimum point. However, for any value of dx and dy ,
d 2 Z  0 if and only if f xx  0, f yy  0 and f xx f yy  ( f xy )  0 .
2

74
 d 2 Z  0 if and only if f xx  0, f yy  0 and f xx f yy  ( f xy )  0 .
2

Dear colleague! Do you know the concept of discriminant of a quadratic function? Discuss
with your friends and try to answer this question.
---------------------------------------------------------------------------------------------------------------------
----------------------------------------------------------
Have you answered it? Good. Relate your answer with the following analysis.
Given the quadratic function U  ax12  bx1 x 2  cx22 , the discriminant, which is symmetric
determinant, is formed by putting the coefficient of the squared variable on the principal diagonal
and dividing the coefficient of the non squared term equally between the off-diagonal positions as
follows
b
a
D = 2
b
c
2
b2
Where D1  a the first principal minor of the discriminant and D2  ac  is the second
4
principal minor. The sign definiteness of the given function can be described in terms of sign
restriction on these principal minors.
U is positive definite iff D1  0 and D2  0 .
U is negative definite D1  0 and D2  0
For n-variable quadratic form of the function, the discriminant becomes

d 11 d 12. d 13 ...... d 1n
d 21 d 22 d 23 ..... d 2n
D 
d 31 d 32 d 33 ..... d 3n
d n1 d n2 d n 3 ...... d nn
It has n- number of principal minors. The necessary and sufficient condition for sign definiteness
is that all principal minors must be greater than zero for positive definiteness and they have to
alternate in sign as D1 is negative for negative definiteness.

Dear colleague! The total differential expressed in equation (3) above is in a quadratic form. As a
result, the discriminant is a determinant that contains the second order partial derivatives as it
elements. This determinant is referred to as Hessian determinant.
f xx f xy
H 
f yx f yy
H 1  f xx And H 2  f xx f yy  f yx f xy are the first and second principal minors respectively.
By now we can express the sign defiantness of d 2 Z using the sign of these principal minors
and there by we are able to identify the second order sufficient conditions for the extremum of the
function Z  f ( x, y ) as
d 2 Z is positive definite iff H 1  f xx  0 And H 2  f xx f yy  f yx f xy  0 . In this case, the
function achieves its minimum.
d 2 Z is negative definite iff H 1  f xx  0 And H 2  f xx f yy  f yx f xy  0 . This indicates
that the function is at its maximum.

75
Considering the function of n- choice variables
Z  f ( x1 , x 2 , x3 ,....x n )
The first order condition for the extremum of the function is f1  f 2  f 3  .........  0 which
leads to the fact that dZ  f1 dx1  f 2 dx 2  f 3 dx3  ......  f n dxn  0
The second order sufficient conditions are identified using the Hessian determinant
f 11 f 12. ........ f 1n
H  . f 21 f 22 .......... f 2 n
f n1 f n 2 .......... f nn
The sufficient condition for the maximum of the function is satisfied when
H 1  0; H 2  0; H 3  0,......(1) n H n  0 .where as for the minimum of the function all of
the Hessian principal minors must be positive.

Example
[Link] the function Z= 160x – 3x2 - 2xy - 2 y2 + 120 y - 18, find the maximum value of the
function.

Solution
The first order conditions that should be satisfied for maximum are
Z Z
Zx   0 And Zy  0
x y
z
Zx = = 160 - 6x - 2y = 0
x
6x + 2y = 160 -------------------------------- (1)

Z
Zy  = -2x - 4y + 120 = 0
y
2x + 4y = 120 -------------------------------------- (2)

Taking equation (1) and (2) simultaneously, multiplying (1) by 2 and subtracting equation (2)
from this gives us
6x +2y = 160
2 x  4 y  120
12x +4y = 320
2 x  4 y  120

10 x + 0 =200
10 x = 200
x= 20

Substituting 20 in place of x in either of the two equation we will get y = 20

Taking the second partial derivatives,
Z xx Z
= - 6 < 0, yy = - 4 < 0
And
Z
( Z xx ) ( yy ) > ( Z xy ) 2
(-6) (- 4) > (-2) 2
24 > 4

76
 6 2
Alternatively, H   2  4 , H 1  6  0 and H 2  20  0
Thus, the function Z is maximized when x = 20 and y = 20
The maximum value of Z is
Z= 160(20) - 3(20)2 - 2(20) (20) - 2(20)2 + 120 (20) - 18
Z = 2,782

3.2.1 Economic Applications

Example
1.A firm produces two products that are sold in two markets with the demand schedules
P1 = 600 - 0.3Q1 and P2 = 500 - 0.2Q2. Production costs are related and the firm faces the total cost
schedule TC = 16+1.2Q1 + 1.5Q2 + 0.2 Q1Q2
 Determine the profit maximizing level of output and price in each market.
 Determine the maximum profit of the firm

Solution

Total Revenue (TR) = TR 1 + TR 2

P1Q1  P2 Q2
=

=
(600  0.3Q1 )Q1  (500  0.2Q2 )Q2
TR = 600Q1 - 0.3Q 12 + 500Q2 - 0.2Q 22
Profit (  ) = TR -TC
= 600Q1  0.3Q12  500Q2  0.2Q22  (16  1.2Q1  1.5Q2  0.2Q1Q2 )
The first order conditions for maximum profit are


= 598.8 - 0.6 Q1 - 0.2Q 2 = 0
Q1
0.6Q1+ 0.2Q2 = 598.8------------------------------ (1)
And

= 498.5 - 0.4 Q2 - 0.2 Q1 = 0
Q2
0.2Q1  0.4Q2  498.5 ---------------------------------- (2)

Taking equation (1) and (2) simultaneously, multiplying equation (2) by 3 deducting it from (1)
gives us

0.6 Q1 + 0.2 Q2 = 598.8

Multiplying (2) by 3 0.2 Q1+ 0.4 Q2 = 498.5

0.6Q 1 + 0.2Q2 = 598.8

0.6Q1  1.2Q2  1,495.5
-Q2 = - 896.7
Q2 = 896.7 units

77
Substituting this value for Q 2 in (1), we get
598.8 - 0.6Q 1 - 0.2 (896.7) = 0
598.8 - 179.34 = 0.6Q1
419.46 = 0.6 Q1
Q1 = 699.1
Dear colleague! To decide whether these output levels maximize the profit of the firm,
We must check the second order conditions at these levels of output. That is
( 2  )
( 2 ) ( 2  )
( ) = -0.6 <0, = -04<0, = -0.2
Q12 Q22 Q1 Q2

 2  2 ( 2  ) 2 2
Therefore, [ ][ ] > [ ]
Q12 Q22 Q1Q2

(-0.6) (-0.4) > (-0.2) 2

0.24 > 0.04
The corresponding Hessian determinant is
 0.6  0.2
, H 1  0.6  0; H 2  (0.6)(0.4)  ( 0.2)  0.2  0
2
H 
 0.2  0.4
Therefore, profit is maximized when Q 2 = 896.7 and Q 1 =699.1 and the profit maximizing
prices are
P1 600 - 0.3 (699.1) P2 = 500 - 0.2 (896.7)
=
= 600 - 209 .73 = 500 - 179.34
P1 = 390.27 P2 = 320.66
The maximum profit is
 = 16 + 598.8 (699.1) - 0.3(699.1) 2 + 498.5(896.7) - 0.2(896.7) 2 - 0.2(699.1)
(896.7) = 432,797.02 Birr

2. A multiplant monopoly operates two plants whose total cost functions are given by
TC1 = 8.5 + 0.03 Q1 and TC2 = 5.2 + 0.04 Q 22
If the demand function is given by P = 60-0.04Q, where Q= Q 1 + Q 2 .How much output should
the monopolist produce in each plant in order to maximize profit?

Solution
Total Revenue (TR) = PX Q = (60 - 0.04Q) (Q)
TR= 60 Q - 0.04 Q2
TR  60(Q1  Q2 )  0.04(Q1  Q2 ) 2
TR = 60 (Q 1 + 60Q2 - 0.04 Q12 - 0.08Q1Q2 - 0.04Q22
Total Profit (  ) = TR - TC1 - TC1
 = -13.7 + 60 Q 1 + 60 Q2 - 0.07 Q12 - 0.08Q22 - 0.08Q1Q2
First order conditions for maximum profit are

= 60 - 0.14 Q 1 - 0.08 Q 2 = 0
Q1
0.14Q 1 + 0.08Q 2 = 60 ------------------- (1)
And

78
 
= 60 - 0.16Q 2 - 0.08Q 1 = 0
Q2
0.08Q 1 + 0.16 Q 2 = 60 ----------------------- (2)
Taking equation (1) and (2) simultaneously, multiplying (1) by 2 and reducing (2) from it

0.14Q 1 + 0.08 Q 2 = 60
0.08Q 1 + 0.16Q2 = 60

0.28Q1 + 0.16 Q2 = 120

0. 08Q1 + 0.16 Q2 = 60
0.2Q1  0  60
Q1  300

Substituting this value in place of Q 1 in equation (1), we get

0.14(300)  0.08Q2  60
0.08Q2 = 60 – 42
0.08Q2 = 18
Q2  225
When we check the second order conditions at these levels of output
 2  2  2
= - 0.14 < 0, = - 0.16, < 0, = - 0.08
Q12 Q22 Q1 Q2

Thus, (- 0.14) (- 0.16) > (-0.08)2

0.0224> 0.0064

This verifies that profit is maximized when Q1 = 300 and Q2 = 225

The total amount of output that the firm should produce to maximize profit is
Q = Q1 + Q2 = 525 units.
Therefore, P = 60 - 0.04 (525) = 60 - 21 = 39

[Link] a firm faces the production function Q = 0.8 K 0.4 L 0.3. It sells its output at a fixed price
of 450 Birr a unit and can buy K and L at 15 Birr per unit and 8 Birr per unit respectively. What
input mix will maximize profit?

Solution
Total revenue (TR) = PQ = 450 (0.8K 0.4 L)
TR = 360 K0.4 L0.3
Total cost (TC) = LPL + KP K
TC = 8 L + 15 K
Thus total profit (  ) = TR - TC
 = 360 K0.4 L 0.3 - 8 L - 15 K
The first order conditions for maximum output are

 108K 0.4 L 0.7  8  0
L
108 K 0.4 L0.7  8

79
 K 0.4 8
 0.7
 -------------------------- (1)
L 108
  0.6 0.3
 144 K L  15  0
K
144 K 0.6 L0.3  15
L0.3 15
0.6
 ------------------------- (2)
K 144

Thus, we must have,

108 0.4
K
From (1) L0.7 = 8
10 4
(108) 7 7
L= [ ] K ------------------------------- (3)
8
144
From (2) K 0.6 = L 0.3 --------------------------------------- (4)
15
Substituting equation (3) in place of L in ( 4) , we get
10 4 3
144
K 0 .6  [(13.5) 7 K 7 ]10
15
3 6
144
K 0.6 = (13.5) K
7 35
15
6 3
( 0.6  ) 144
K 35
 (13.5) 7
15
3 3
K 7  (9.6)(13.5) 7
7
K = (9.6) 3 (13.5)
= (195.87) (13.5)
K = 2,644.25
Substituting the value of K in equation (3) enables us to determine the amount of labor that
should be employed in the production process.
10 4
L = (13.5) 7 (2, 644.25) 7

= (41.19) (90.282)
L = 3,718.72
Dear colleague! As you know it is necessary to check the second order conditions at these values.
Therefore,
 2
= -75.6 K 0.4 L 1.7 = - 75.6 (2,644.25) 0.4 (3,718.72) 1.7
L2
= - 0.0015 < 0
 2
= - 86.4 k 1.6 L 0.3 = - 86.4 (2644.25) 0.6
(3781.72) 0.7
K 2
= 0.00121
   
2 2
  2 2
( )( )( )
L K
2 2
LK

80
 Therefore, (- 0.0015) (- 0.0034) > (0.00121) 2
The corresponding Hessian determinant is
 0.0015 0.00121
H  , H 1  0.0015  0; H 2  0 .
0.00121  0.0034

Now we are confident enough to conclude that the firm will maximize its profit when it employs
2, 644.25 units of capital and 3, 718.72 units of labor in the production process.

4. suppose the monopolist sells a certain product in three separate markets and the demand
functions facing the firm are
P1  63  Q1
P2  105  5Q2 And the cost function is C  20  15Q; Q  Q1  Q2  Q3
P3  75  6Q3
Determine the amount of output that should be sold to maximize profit .Identify the prices
charged in each market to maximize profit.
First we should construct the total revenues for each market. These are
TR1  63Q1  Q12
TR2  105Q2  5Q22
TR3  75Q3  6Q32
Therefore, the total profit function is   TR2  TR2  TR3  C
  63Q1  Q12  15Q2  5Q22  75Q3  6Q32  (20  15Q1  15Q2  15Q3 )
  48Q1  4Q12  90Q2  5Q22  60Q3  6Q32  20 ---------------------------(1)
First order conditions


1   48  8Q1  0  Q1  6
Q1
 2  90  10Q2  0  Q2  9
 3  60  12Q3  0  Q3  5
P1  57, P2  60, P3  45
We can check the second order condition using the sign of the principal minors of the Hessian
determinant. The corresponding Hessian determinate is
 11  8,  12  0,  13  0
 21  0,  22  10,  23  0
 31  0,  32  0,  33  12

 11  12  13 8 0 0
H   21  22  23  0  10 0
 31  32  33 0 0  12

Evaluating the successive principal minors,

8 0
H 1  8  0, H 2   80  0, H 3  H  960  0
0  10

81
 It indicates that d 2 is negative definite. Thus, the monopolist can maximize its profit when it
sells 20 units of out put out of which 6 units at a price of 57 birr per unit in market 1, 9 units at a
price of 60 birr per unit in market 2 and 5 units at a price of 45 birr per unit in market 3.

Dear colleague! By now you have completed the second section of this unit. Therefore, try to do
the following self - test questions to evaluate whether you understand the section or not.

Self - Test 3.2

Do the following questions based on the above examples.
[Link] are the conditions for the optimization of a function Y = f(x, z)?
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------
2. A firm produces two products which are sold in separate market with demand functions
P1  180  15Q1
and the cost function is TC  150  120Q where Q  Q1  Q2
P2  380  20Q2
How much should the firm charge in each market to maximize profit?
---------------------------------------------------------------------------------------------------------------------
----------------------------
3. A multipant monopoly operates two plants whose cost functions are
2 2
TC1 = 2.4 + 0.015 Q1 and TC2 = 3.5 + 0.012 Q2 and its demand function is
P = 32- 0.02 Q,
How much should it produce in each plant to maximize its profit?
---------------------------------------------------------------------------------------------------------------------
------------------------------------
4.A firm selling in a perfectly competitive market where the ruling price is 40 birr can buy inputs
K and L at prices per unit of 20 birr and 6 Birr respectively and operates with production function
0 .4
Q = 21 K L 0 .2 , what is the maximum profit ?
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
----------------------------------------------------------.
Have you answered these questions? If your answer is no, please reread this section and try to do
them. If your answer is yes, very good, go to the next section.

Section 3.3 Unconstrained Envelope Theorems

Up on the completion of this section, the student is expected to

- describe the envelope theorem

- explain the difference between direct and indirect objective
function
- describe what the envelope theorem states for unconstrained
optimization problem

82
 Dear colleague! Have you ever heard about envelope theorem? What does it state? Try to
discuss with your friends and answer this question. And write your answer on a rough
paper.--------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------

Have you answered it? Good. Try to relate your answer with the following analysis. Until now
we have discussed about the way how the maximum or minimum value of the function depends
on the value of the independent variables under consideration. However, in economic theory we
are usually interested in how the optimal value of a function depends on some parameters such as
tax rates etc.

Although these parameters are assumed to be constant during the process of optimization, they
may vary according to the economic situation. Therefore, what happens to the optimal value of
the objective function when these parameters change?

Considering the firm which produces an output Q using L units of labor as input, and it's
production function is given by Q= f( L). Suppose the price of the product is p and that of labor
is w , the theory of the firm states that the firm chooses the amount of labor L which maximizes
profit. The profit function is

 [ L, ( w, p )]  pf ( L)  wL

Considering L ( w, P ) as the optimal amount of labor when the prices are w and P , then the
maximal profit of the firm is represented by
  ( w, p )  pf [ L ( w, p )]  wL ( w, p )
This function is known as the firms indirect profit function. According to the envelope theory,
the partial derivative of the profit function with respect to P , evaluated at L  L ( w, P ) is
 ( L ( w, p ))
In this case the derivative is positive which indicates that as the price of the product increases,
the profit of the firm increases.

Similarly, the envelope theorem states that the derivative of the firms profit function with respect
to w is  L ( w, p ) .But in this case the derivative is negative which shows that an increase in
the price of an input decreases the maximal profit of the firm.
Dean Colleague! The following graph shows how the indirect objective function envelopes the
direct objective function.

83
 Fig.3.1 Envelop Curve.
Each of the inverted U-shaped curves is the graph of direct profit function  ( L, ( w, p )) as a
function of w for a given value of L and p .Each of these graphs show how  changes due to
change in w for a given value of L and p .To get the solution of the maximization problem for
any given value of w , we should find the highest function for that value of w . Thus the graph
of the indirect profit function is the locus of these highest points. Thus, the indirect objective
function is the envelop curve of the direct objective function at various values of w in our case.

Example
1. Suppose a firm is producing a certain product Q and wants to maximize its profit. Suppose a
tax rate t is imposed on a production of Q. What is the effect of change in the tax rate on total
profit?
Total Profit (  ) =TR-TC
TR  R (Q )
TC  C (Q)  tQ
Thus,  (Q, t )  R (Q)  C (Q)  tQ
The first order condition for maximum profit is
 (Q, t )  R (Q)  C (Q)  t  0
MR  MC  t  0
MR  MC  t -------------------------------- (1)
From equation (1) we can determine the critical value of the profit function and let’s say Q  Q 
.
Second order condition for maximum profit is
 (Q, t )  R (Q)  C (Q)  0
Given the optimal output Q  Q  (t ) , the maximal profit is
 (Q  (t ))  R (Q  (t ))  C (Q  (t ))  tQ  (t )
The effect of change in the tax rate on total profit is determined by differentiating the
Profit function with respect to the tax rate. It is given as
d dQ  dQ  dQ 
 R (Q  (t ).  C (Q  (t )).  Q  t
dt dt dt dt
 
dQ dQ
= [ R (Q  (t ))  C (Q  (t ))]  Q  t
dt dt
However, R (Q 
(t ))  C (Q 
(t ))  t
d dQ  dQ 
Therefore,  [C (Q  (t ))  t  C (Q  (t ))]  Q  t
dt dt dt

84
 dQ  dQ 
=t  Q  t
dt dt
d
 Q 
dt
Dear colleague! As you have seen the rate of change of total profit with respect to tax rate is
negative. It indicates that an increase in tax decreases the total profit of the firm.
[Link] that the demand and the total cost functions of the monopolist are P=24-3x and C=
x2+8x respectively. Determine the rate of change of the profit function with respect to the tax rate
when a tax rate of 4 Birr per unit of production is imposed.
Total profit   (24  3x) x  ( x 2  8 x  4 x)
 24 x  3 x 2  x 2  12 x
  4 x 2  12 x
Dear colleague! Now let us determine the critical value applying the first order condition.
   8x  12 
 8 x  12
x   1.5units
Second order condition is
   8  0
Therefore, x  x   1.5 is the optimal amount of output.
Then  (t )  4 x 2  16 x  1.5t  4(1.5) 2  16(1.5)  1.5t
=  9  24  1.5t  15  1.5t
d
 1.5   x 
dt

Dear colleague! By now you have completed the third section of thin unit. Thus, to do the
following self - test questions

Self - Test 3.3

Do the following questions based on the information above.

1. What does the envelope theorem states?

---------------------------------------------------------------------------------------------------------------------
-----------------------------------------------
2. What is the difference between direct objective function and indirect object function?
---------------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------
3. What happen to total profit of the firm when there is an increase in wage rate given other
factors?
---------------------------------------------------------------------------------------------------------------------
-------------------------------------------------------------------------------
4. A firm has the demand function P = 100 - 0.01Q and the cost function TC = 50Q + 30,000 and
a tax of 10 Birr per unit is imposed. What will be the profit maximizing price and quantity before
and after tax?
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------

85
 Determine the rate of change of total profit (  ) with respect to the tax rate (t)
--------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------

Check List

Write √ inside the box which corresponds to the question which is easy for you
1 Describe the first order condition for the function y = f ( x) to achieve it's
optimum value -----------------------------------------------------------
2 Describe the second order condition for optimization of the above function
-------------------------------------------------------------------------
3 What is unconstrained function? ---------------------------------------------
4 What is free optimization----------------------------------------------------
5 Describe the order conditions for optimization of several independent
variables function ---------------------------------------------
6 What is Multiplant monopolist -------------------------------------------
7 How the Multiplant monopolist maximizes it's profit? ------------------
8. Explain discriminatory monopolist------------------------------------------
9. Explain envelope theorem for unconstraint optimization

Dear colleague! Is there any box in which you didn't tick? If yes, please reread this unit and
try to do it. If no, very good Go to then next unit.

Unit Summary

In economics we usually use profit maximization or cost Minimization as the most common
criteria to select the best alternative to under take a project. Optimization problem is a general
heading which represents both maximization and maximization problems.

To solve the optimization problem first we should formulate the objective function.
Objective functions which do not involve constraints are called unconstrained functions and their
process of optimization is referred to as free optimization or unconstrained optimization.

In the optimization process, the parameters are assumed to be constant even if they vary
according to the economic situation.

Envelope theorems are theorems that describe conditions under which the value of a
parameterized optimization problem is a differentiable function of the parameter.

The indirect objective function is the envelope curve of the direct objective function at various
values of the parameter.

Important Points

Optimization
Unconstrained function
Choice variables
Minimization
Maximization

86
 Order conditions
Hessian determinant
Critical points
Unconstrained Envelop theorem
Direct objective function
Indirect objective function
Parameters
Free optimization

Answers for Self Test Questions

Self test 3.1

1) The orange must be picked at the 3rd week to maximize return. (Hint.
TR  (8  0.5 x )(5  0.5 x ), where X represents number of weeks.)
2) Q = 150 units
3) Q = 50units
4) Max.  5,075 , when Q= 10.
5) P  14 & Q  9,000units
6) Q= 13

Self Test 3.2

2) P1  150 & P2  250
3) Q1  266.67 & Q2  333.33units
4)   29,69.47, when, K  1,493.47 & L  2,489.12
Self Test 3.3
4) Before tax P  75 & Q  2500
After tax P  80 & Q  2000
d
 2500
dt

87