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LESSON TWO : ECONOMIC OPTIMIZATION/BASIC TRAINING

A. Methods of Differentiation

The slope of a function y = f(x) is the change in y divided by the corresponding

change in x. In order to find the value of slope, there is a need to use derivatives.
For a function y=f(x), the derivative, written as dy/dx is the slope of the function at
a particular point on the function.

Rules of differentiation:

Example:
y = 10
dy/dx = 0

If y = axn then, dy/dx = n*ax (n – 1)

Example:
y = 10x2
dy/dx = (2)10x(2-1) = 20x

If y = a*f(x), where x is constant, dy/dx is a.

Example:
y = 10 x(1-1)
dy/dx = (1)10X(0) = 10

If y = f(x) + g(x), then dy/dx = f’(x) + g’(x).

Example:
y = 20x + 10
dy/dx = (1)20x(1-1) + 0 = 20

Where f’(x) = df/dx and g’(x) =dg/dx

Example:
y = (x2 – 3)(x3 + 4x + 2)

f’(x) = df/dx = 2x and g’(x) =dg/dx =(3x2 + 4)

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so to find dy/dx , we use the following formula:

If the value of x is given (x=1) then

dy/dx = 5(1)4 + 3(1)2 + 4(1) + 12
= 24

6. The derivative of a quotient function.

If y = f(x)/g(x), then

[g(x)]2

Example:
y = x2 -4x
x2

(x2)2

(x4)

(x4)

= 4x2

x4

dy/dx = 4/x2

Exercise 1A:

Determine the derivatives of each of the following functions.

a) Y = 20

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b) Y = 6X2 + 8X + 50

c) Y = (X2 - 2)(X2 + 4X +10)

d) Y = X2 + 3X + 4
X2 – 4

e) Q = 120 – 0.2P2

i) The maximum or minimum point of a function, y = f(x) can be found by setting

the first derivative of the function to zero and solving the equation for the
value(s) of x.

Example 1B:

If y = 200x – 0.4x2, find the optimum value of x.

Find dy/dx = 0 allows you to find the optimum value of x.

dy/dx = 200 – 0.8x = 0

0.8x = 200
X = 200/0.8
x = 25

ii) When the first derivative of a function is zero, the function is at a maximum if
the second derivative is negative, or at a minimum if the second derivative
is positive.

From example 1B, the first derivative of y = 200x – 0.4x2

is dy/dx = 200 – 0.8x.
Setting it to zero, the optimum value of x is 25. To determine whether this
value of x is minimum or maximum, you have to find the second derivative of
the function.

d2y/dx2 = -0.8

since d2y/dx2 is less than zero, then x = 25 is the maximum

value.

Example 2B:

If total revenue, TR = 200Q – 2Q2 , what is the output level that can maximize
TR?

Maximize TR = dTR = MR = 0

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dQ
= 200 – 4Q =0
4Q = 200
Q = 50

To determine whether Q = 50 is indeed the maximum value, you have

to find the second derivative of the TR function.
dTR/dQ = 200 – 4Q
d2TR/dQ2 = -4 (less than zero)

This shows that Q = 50 is indeed a maximum value.

iii. Sometimes, setting the first derivatives to zero will give two extremum values.
In order to identify which one is the optimum value, one has to substitute the
two values into the second derivative.

Example 3B:

TR = 7Q – 0.1Q2
TC = 10 + 8Q – 0.3Q2 + 0.01Q3

Find the value of Q that will maximize profit.

Profit = TR – TC
= -10 – Q + 0.2Q2 – 0.01Q3

d(Profit) = -1 + 0.4Q – 0.03Q2 = 0

dQ
= (3Q – 10) (Q – 10) = 0

Thus, 3Q – 10 = 0 OR Q – 10 = 0
Q = 10/3 Q = 10

There should be only one optimum value. Therefore, substitute these

values into the second derivative.

dQ2

dQ2

dQ2

The value of Q that will maximize profit is Q = 10.

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iv. To be an optimal value, the value must fulfill both first order condition
(setting first derivative equals zero) and second order condition
(finding the second derivative.)

Exercise1B:

1. Optimize the following functions and find the value of x at the optimum
point. Then determine whether x is a minimum or maximum point.
a) y = 3x2 – 4x + 25

b) y = (3x – 2 )2

2. Given the following total revenue and total cost functions of a firm:

TR = 22Q – 0.5Q2
TC = 1/3Q3 – 8.5Q2 + 50Q + 90

determine,

a) the level of output at which the firm maximizes its total profit
b) the maximum profit that the firm could earn.

C. Partial Derivative

In the previous section, the exercises given involve differentiation of simple function
i.e. one dependent and one independent variables. However, functions are normally
in the form of multivariate functions i.e. one dependent but many independent
variables. In order to find the derivative of the multivariate function, we have to find
the partial derivative of the function.

Example:

i) Find the partial derivatives of the function with respect to each

independent variable x and z and set these derivatives
equal to zero.

From (1), Substitute z = 16x in (2) gives

-130 + x + 4(16x) = 0
-130 + x + 64x =0
-130 + 65x =0
65x = 130
x = 130/65
x = 2

Substitute x = 2 in z = 16x

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z = 16x
= 16 (2)
z = 32

Exercise 1C:

1. Find the partial derivative for the following functions.

a) y = 4 – x2 – 2z + xz + 2z2

determine;

i) the level of output of each commodity at which the firm

maximizes its total profit,

ii) the value of the maximum amount of the total profit of the firm

Y = 50 + 18X + 10Z – 5XZ – 2X2

find the value of X and Z that will maximize the function. What is the
maximum value of Y?

D. Lagrangian : Solving a constrained optimization problem

In many decision problems, there are constraints imposed that limit the options of choices
available to the decision makers.

Example:

TC = 3x2 + 6y2 – xy

x = output produced by line 1

y = output produced by line 2

Objective function : TC = 3x2 + 6y2 – xy

Constraint function : x + y = 20

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Methods:

1. normal/substitution method
2. lagrangian method

TC = 3x2 + 6y2 – xy ------ (1)

x+y = 20 ------ (2)
X = 20 – y

Substitute (2) into (1):

TC = 3(20 – y)2 + 6y2 – (20 – y)y
TC = 1200 – 140y + 10y2 ---------- (3)

d(TC)/dy = -140 + 20y = 0

y = 7 -------- (4)

Thus, at x = 13 and y = 7, total cost is minimized at 710.

Method 2 : lagrangian

Lagrangian is a process to combine the objective function and the constraint function
with a multiplier (lambda).

Steps:
(i) Objective function : TC = 3x2 + 6y2 – xy
(ii) Constraint function : x + y = 20
(iii) Rewrite the constraint function as follows:
x + y – 20 = 0
OR
20 – x – y = 0

LTC = 3x2 + 6y2 – xy - λ(x + y – 20)

OR
LTC = 3x2 + 6y2 – xy + λ(20 – x - y)

(vi) Solve simultaneous equation

(v) Interpret lambda

Solution:

LTC = 3x2 + 6y2 – xy – λ(x + y – 20)

LTC = 3x2 + 6y2 – xy – xλ – yλ + 20λ

dLTC /dx = 6x – y – λ =0 ------ (1)

dLTC /dy = 12y – x – λ =0 ------ (2)

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dLTC /dλ = – x – y + 20 =0 ------ (3)

(1) – (2) : 7x – 13y = 0 ------ (4)

(4) : x = 13y/7 ------ (5)
Sub.(5) into (3) : –(13y/7) – y + 20 =0
[–13y – 7y + 140] = 0
-------------------------
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[–13y – 7y + 140] = 0 ×7

– 20y – 140 = 0

Y =7 ------ (6)

Substitute (6) into (4):

7x – 13y = 0
7x – 13(7) = 0
7x – 91 =0
X = 91/7

x = 13 ------ (7)

Substitute (6) and (7) into (1):

6(13) – 7 – λ = 0
78 – 7 – λ =0
71 – λ = 0
λ = 71

Substitute (6) and (7) into TC function; TC = RM710

λ = 71 means if output (constraint) were to increase by one unit from 20 to 21, then
the TC (obj. function) will increase by 71.

Exercise 1D:

It faces the constraint that the output of commodity x plus output of

commodity y must be 12.

a. Use the Lagrangian Multiplier method to find profit maximization.

b. Interpret the value of lambda.