KWAME NKRUMAH UNIVERSITY OF SCIENCE AND

TECHNOLOGY, KUMASI

INSTITUTE OF DISTANCE LEARNING

MATH 473: MATHEMATICAL ECON0MICS 1

[Credits 3]

By
F.T. ODURO & C. SEBIL
DEPARTMENT OF MATHEMATICS, KNUST
OCTOBER, 2011
Contact Address

Dean
Institute of Distance Learning
New Library Building
Kwame Nkrumah University of Science and Technology
Kumasi, Ghana

Phone: +233-51-60013
+233-51-60014

Fax: +233-51-60023
+233-51-60014

E-mail: cdce@fdlknust.edu.gh
kvcit@fdlknust.edu.gh
kvcit@avu.org

Web: www.fdlknust.edu.gh

ii
About the Authors

F.T. ODURO is, currently, a senior lecturer at the Department of Mathematics of the Kwame
Nkrumah University of Science and Technology, Kumasi. Dr. F.T. Oduro has almost two
decades experience in the teaching of application oriented mathematical courses such as
engineering mathematics, classical fields, mathematical economics and graduate courses in
control theory and stochastic processes.
He has also supervised dozens of graduate research projects involving the mathematical
modeling and control of environmental, health and economic systems. He has held a number
of administrative positions at the university including Head of the Department of
Mathematics, Coordinator of the Actuarial Science programme and Head of the Kumasi
Virtual Center for Information Technology which is a department of the Faculty of Distance
Learning.
Dr. Oduro is a member of the Ghana Science Society, a member of the Mathematical
Association of Ghana and executive member of the Ghana Chapter of the International
Biometric Society

Email: francistoduro@yahoo.co.uk

C. SEBIL is currently a lecturer at the Department of mathematics of the Kwame Nkrumah

University of Science and Technology, Kumasi. Mr. C. SEBIL teaches Optimisation,
mathematical economics, Engineering mathematics, Algebra and statistical methods.
Mr. C. SEBIL is a member of the Ghana Science Society, a member of the Mathematical
Association of Ghana.

Email: sebicharles@yahoo.com
Course Introduction

This course is designed to present fourth year students of mathematics, actuarial science and
statistics students with the fundamental principles of mathematical economics. It focuses on
basic concepts and uncovers the simplicity and directness of a mathematical approach to
economics theory.
At the end of the course, students are expected to be able to appreciate the constrained
optimizing behaviour of consumers and producers as well as the key structures of the
marketplace.They should also be able to formulate and solve a lot of economic problems in a
mathematical context.

iv
Table of Content

Contact Address .........................................................................................................................ii

About the Author ..................................................................................................................... iii
Course Introduction .................................................................................................................. iv
Table of Content ........................................................................................................................ v
List of Figures ........................................................................................................................... vi

UNIT 1 ....................................................................................................................................... 1
GENERAL CONCEPTS ........................................................................................................... 1
Session 1-1: Introductory Remarks ........................................................................................ 1
Session 2-1: Special Processes............................................. Error! Bookmark not defined.

UNIT 2 ..................................................................................... Error! Bookmark not defined.

GENERAL CONCEPTS ......................................................... Error! Bookmark not defined.
Session 1-2: N-dimensional and Complex Processes .......... Error! Bookmark not defined.
Session 2-2: Stationary Processes ........................................ Error! Bookmark not defined.

UNIT 3 ..................................................................................... Error! Bookmark not defined.

CALCULUS OF STOCHASTIC PROCESSES ...................... Error! Bookmark not defined.
Session 1-3: Stochastic Continuity and Differentiability..... Error! Bookmark not defined.
Session 2-3: Stochastic Differential Equations .................... Error! Bookmark not defined.

UNIT 4 ..................................................................................... Error! Bookmark not defined.

CALCULUS OF STOCHASTIC PROCESSES ...................... Error! Bookmark not defined.
Session 1-4: Stochastic Integrals and Time Averages ......... Error! Bookmark not defined.
Session 2-4: Ergodicity ........................................................ Error! Bookmark not defined.

v
List of Figures

Figure 1-1 ................................................................................. Error! Bookmark not defined.

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Figure 1-5 ................................................................................. Error! Bookmark not defined.
Figure 1-6 ................................................................................. Error! Bookmark not defined.
Figure 1-7 ................................................................................. Error! Bookmark not defined.
Figure 1-8 ................................................................................. Error! Bookmark not defined.
Figure 1-9 ................................................................................. Error! Bookmark not defined.
Figure 1-10 ............................................................................... Error! Bookmark not defined.
Figure 1-11 ............................................................................... Error! Bookmark not defined.
Figure 1-12 ............................................................................... Error! Bookmark not defined.
Figure 1-13 ............................................................................... Error! Bookmark not defined.
Figure 2-1 ................................................................................. Error! Bookmark not defined.
Figure 2-2 ................................................................................. Error! Bookmark not defined.
Figure 2-3 ................................................................................. Error! Bookmark not defined.
Figure 2-4 ................................................................................. Error! Bookmark not defined.
Figure 3-1 ................................................................................. Error! Bookmark not defined.
Figure 3-2 ................................................................................. Error! Bookmark not defined.
Figure 3-3 ................................................................................. Error! Bookmark not defined.
Figure 4-1 ................................................................................. Error! Bookmark not defined.
Figure 4-2 ................................................................................. Error! Bookmark not defined.

vi
vii
 UNIT 1

PRELIMININARY MATHEMATICAL CONCEPTS

Introduction to Unit 1

In this introductory unit, we briefly review classical optimization which is the basis of
consumer optimizing behaviour. Next we deal with the basic concept of axioms of choice and
indifference curves. After the preliminary notions of probability theory, we present the main
ideas and fundamental properties. We continue with definitions and discussions on the
concepts of transformations, continuity, and differentiation. Finally we discuss simple
differential equations, as well as stochastic integrals, time averages, and ergodicity.

Session 1- 0: Review of Classical Optimization

1.1 Local Extrema of Functions on R

Consider a differentiable function f : . f is said to have a local maximum at a point

x * if for some 0 , f ( x * h) f ( x*) h . x * is then called a local maximum point

Similarly, f is said to have a local minimum at a point x * if for some 0 ,

f ( x * h) f ( x*) h . x * is then called a local minimum point.

A local extremum refers to either a local maximum or a local minimum.

Theorem (Necessary condition for a local extremum)

If f has a local extremum point at x * then f ' ( x*) 0

Note
The converse of the above theorem is not true

1
Example
Consider the function f ( x) x 3 , we note that although f ' (0) 0 , x 0 is neither a maximum
nor a minimum point; in fact, it is a point of inflection.

Theorem (Sufficient condition for a local extremum)

If f ' ( x*) 0 and f ' ' ( x*) 0 , then f has a local maximum point at x * .
If f ' ( x*) 0 and f ' ' ( x*) 0 , then f has a local minimum point at x * .

n
1.2 Local Extrema of Functions on R

Consider a differentiable function f : n . f is said to have a local maximum at a point

x* n if for some 0 , f ( x * h) f ( x*) h , x * is then called a local maximum

point
Similarly, f is said to have a local minimum at a point x* n , if, for some 0 ,

f ( x * h) f ( x*) h , x * is then called a local minimum point.

A local extremum refers to either a local maximum or a local minimum.

Theorem (Necessary condition for a local extremum)
If f has a local extremum point at x* n , then f ( x*) 0 ; i.e.
f ( x*) f ( x*) f ( x*)
... 0
x1 x2 xn
Note
The converse of the above theorem is not true

Theorem (Sufficient condition for a local extremum)

If x* n is a critical point of f and the Hessian H (x*) of f is negative definite, then f has a
local maximum point at x * .
If x* n is a critical point of f and the Hessian H (x*) of f is positive definite, then f has a
local minimum point at x * .
Note that the Hessian of f is the matrix of its second order derivatives and is given by

H hij , where, hij
2 f
xi x j

2
Positive/Negative definiteness of the Hessian
A Symmetric Matrix is positive definite if its principal minors are all positive. I.e.
h11 h12 h13
h11 h12
h11 0 , 0 , h21 h22 h23 0 ,
h21 h22
h31 h32 h33

A Symmetric Matrix is negative definite if its principal minors alternate in sign as follows:
h11 h12 h13
h11 h12
h11 0 , 0 , h21 h22 h23 0 ,
h21 h22
h31 h32 h33

Summary
Thus, for a multivariable function such as f : 2 with ( x, y) 2 ; for (x,y) to be a local
minimum or maximum three conditions must be met
1) The first order partial derivatives must equal zero simultaneously. This indicates that
at the given point (a, b) is a critical point at which the function is neither increasing
nor decreasing with respect to the principal axes but is at a relative plateau

2) The second-order direct partial derivatives when evaluated at the critical point must
both be positive for a minimum and negative for a maximum

3) The product of the second-order direct partials evaluated at the critical point should
exceed the product of the cross partials evaluated at the critical point.

Local Maximum Local Minimum

1. fx = 0 and fx = 0 1. fx = 0 and fx = 0
2. fxx < 0 and fyy < 0 2. fxx > 0 and fyy > 0
3. fxx fyy > (fxy)2 3. fxx fyy > (fxx)2

n
1.3 Constrained Optimization on R

Consider a differentiable function f : n . Subject to a constraint g ( x1 , x2 ,..., xn ) 0 is

said to A local extremum point x* n can be found if the function f to be optimized (the
objective function) is replaced by L : n1 called the Lagrangian and given by

3
L( x1 , x2 ,..., xn , ) f ( x1 , x2 ,..., xn ) g ( x1 , x2 ,..., xn )

is called a Lagrange multiplier. Similar necessary and sufficient conditions for local
extrema then apply
For a linear constraint on R2 the Hessian is said to be bordered and the sufficient (second
order) conditions are given by
h11 h12 p1
h11 h12
h11 0 , 0 , h21 h22 p 2 0 for a minimum
h21 h22
p1 p 2 0

and
h11 h12 p1
h11 h12
h11 0 , 0 , h21 h22 p 2 0 for a maximum
h21 h22
p1 p 2 0

Again note that here the Hessian of L is the matrix of its second order derivatives and is given
by

H hij , where, hij
2L
xi x j
for i, j 1,2 and pi
2L
xi

And the linear constraints are given by

g ( x1 , x2 ) p1 x1 p2 x2 C 0

Example
1) Optimize the function z = 4x2 + 3yx + 6y2 subject to the constraint x + y = 56
Solution
Set the constraint equal to zero: 56 + x y = 0
Multiply it by and add it to the objective to form the Lagrangian function Z
Z = 4x2 + 3xy + 16y2 + (56 x-y).
Take the first-order partials, set them equal to zero and solve simultaneously
Z
Zx 8 x 3 y '.............(1)
x
Z
Zx 3x 12 y 0.....'.............(2)
y
Z
Zx 56 x y 0

From 1) and 2) y = 20 and x = 36

4
Now from 1) 8x + 3y =
8(36) + 3(20) =
= 348
Substituting the critical value in Z:
Z = 4(36)2 + 3(36)(20) + 6(20)2 + 348(56 36 20) = 9744
Since Zxx > 0, Zyy > 0 the optimal value is a minimum

5
6
Session 1-1: Consumer Optimizing Behaviour.

SOME AXIOMS OF CONSUMER BEHAVIOUR

The ranking of goods by the consumer is called his preference function
1) The axiom of completeness or comparison. Given two commodities
X and Y the consumer should be able to state one and only one of the following
X Y : ( X is preferred to Y)
YX : ( Y is preferred to X)
X Y : ( X, Y equally satisfying, the consumer is indifferent between X and Y)
2) Axiom of Transitivity
X Y ,Y Z X Z
X Y ,Y Z X Z
3) Axiom of non-saturation or non-satiety
The consumer prefers more to less

Indifference Curves
An indifference curve is the locus of points or particular combination of goods each of which
gives the same satisfaction.

7
Utility, which is the measure of consumer satisfaction, is that function the level curves of
which are the indifference curves. Along a particular indifference curve, utility is constant.
Utility can thus be represented by a utility surface.

8
Properties of Indifference Curves
Indifference curves
1) are everywhere dense i.e. an indifference curve passes through any point on in the
commodity space

2) are negatively sloped

3) cannot intersect

4) are convex to the origin

Marginal Rate of Substitution (MRSyx )

The marginal rate of substitution of Y for X measures the number of units of Y that a
consumer is willing to sacrifice for a unit of X so as to maintain a constant level of utility or
satisfaction and it is given as the negative of the slope of an indifference curves

9
NB It is always defined along a particular indifference curves

The Constrained Maximization of Utility

The rational consumer desires to purchase a combination of X and Y from which he derives
the highest level of satisfaction. His problem is one of maximization. However, his income
is limited and he is not able to purchase unlimited amounts of the commodities. The
consumers budget constraint can thus be written as
XPX + YPY = I .. (1)
Where, I is his income and PX and PY are the respective prices of X and Y. The amount he
spends on commodity X (X PX) plus that spent on Y (Y PY) equals his income I.

The First Order and Second Order Conditions

The consumer desires to maximize his utility U = U(X,Y) subject to XPX + YPY = I
We form the Lagrangian
L (X,Y,) = f(X,Y) - (XPX + YPY - I)(2)
Where is the Lagrange multiplier
The first-order conditions are obtained by setting the first partial derivatives of L with respect
to X, Y and equal to zero. We obtain
L U
Px ()
X X
L U
Py () .(3)
Y Y
L
XPx YPy I 0

From the first two equations of (3) we have

L / X L / X

Px Px
Marginal utility divided by price must be the same for all commodities. The ratios give the
rate at which satisfaction would increase if an additional cedi were spent on a particular
commodity. If more satisfaction could be gained by spending an additional cedi on X rather
than Y, the consumer would not be maximizing utility. He could increase his satisfaction by
shifting some of his expenditure from Y to X.
The Lagrange multiplier is the marginal utility of income. The marginal utility of income is
positive.
Again, from (3), the first order condition for the optimization problem can also be written as

10
L / X Px

L / Y Py

Thus, the ratio of the marginal utilities must equal the ratio of prices for maximum.
Now U(X,Y) = constant along an indifference curve and hence
U U
dX dY 0
X Y
dX dY
MU x MU y 0
dX dY
dY
MU x MU y
dX
dY MU x dY MU x
MRS yx
dX MU y dX MU y

Graphical solution of the Consumers Optimization Problem

As one moves from A to D the MRSyx decreases. MRS tends to turn against the commodity
that is abundant and in favour of the commodity that is scarce. The budget line equation with
Px I
y as subject is given by Y X
Py Py

The consumer attains equilibrium on the budget line. At point F, the slope of I2 and the slope
of the budget line are the same i.e.

11
 PX
MRS YX
PY

MU X PX MU X MU X

MU Y PY PY PY
Linear Indifference Curves
Suppose I is an Indifference curve MRS is constant the commodities
are perfect substitutes. If the slope of budget is different from the indifferent curves then we
have specialization.

Income Consumption Curve (ICC)

Consider a consumer who receives a permanent rise in his income. If income rises and
prices remain constant, the budget line shifts line shifts parallel to the first one..
All ICC start at the origin. This is because at the origin the individuals income is zero and
hence cannot purchase any one of Y and X.
In most cases ICC are upward sloping if the commodities are normal or inferior. These are
defined in terms of income elasticities. If income elasticity is negative, the commodity is
inferior:

12
 = income elasticity
0 inferior goods
0 2 1 normal goods

Second Order Conditions

The second-order condition as well as the first-order condition must be satisfied to ensure that
a maximum is actually reached.
Denoting the second direct partial derivatives of the utility function by Uxx and Uyy and the
second cross partial derivatives by Uxy and Uyx , the second order condition for a constrained
maximum requires that the relevant bordered Hessian determinant be positive.
U xx U xy Px
U yx U yy Py 0
Px Py 0

Expanding, we get
U yx U yy U xx U xy
Px Py 0
Px Py Px Py

Px PyU yx PxU yy Py PyU xx PxU xy 0
Px PyU yx Px U yy Py U xx Py PxU xy 0
2 2

2Px PyU xy Px U yy Py U xx 0
2 2

U / X U / Y
Substituting Px and Py

we have

U / X U / Y U / X U / Y
2 2

2U xy U yy U xx 0

U U U U
2 2

2U xy U yy U xx 0
X Y X Y

13
Demand Function
Ordinary Demand Function
A Consumers ordinary function sometimes called a Marshallan demand function give the
quantity of a commodity that he will buy as a function of commodity prices and his income.
The demand function can be derived from the analysis of utility maximization. Using the
first-order conditions of maximization the demand functions can be obtained.
Example
Let us assume that the utility function is U = XY and the budget constraint.
I XPy YPx = 0. From the expression
L = XY + (I - XPy YPx) and its partial derivatives equal to zero
L
Y Py 0
X
L
X Px 0
Y
Solving for X and Y gives the demand functions
M M
X and Y
2 Px 2 Py

Properties of Demand Functions

1) The demand for a commodity is a single-valued function of prices and
income

2) Demand function is homogenous of degree zero in income. That is if all

prices and income change in the same proportion, the quantities demanded
remained unchanged. We now look at the proofs of these properties

1a) The first property follows from the strict quasi-concavity of the utility function, a
single maximum, and therefore a single commodity combination corresponds to a given set of
prices and income
NB
If the utility function were quasi-concave, the indifference curves would possess straight-line
portions and maxima would not need to be unique. In this case more than one value of the
quantity demanded may correspond to a given price, and the demand relationship is called a
correspondence rather than a demand function.
2b) To prove the second property, assume that all prices and income change in the
proportion K. The budget constraint becomes

14
KI KXPx - KYPy = 0 where K is the factor of proportionality and
L = U(X,Y) + (KI KXPx KYPy) and the first-order conditions are

L
U x KPy 0
X
L
U y KPx 0
Y
L
KI KXPY KYPY 0

KI - KXPX - KYPY can be written as K(I XPX - YPy) = 0 . Since K 0, I - XPx YPy = 0
Eliminating K from the first two equations of the first-order conditions for a maximum
we have
Uy KPx U P
x x
Ux KPy U y Py

U x Px
Hence we have I - XPx YPy = 0 and which are like the original equations
U y Py

Therefore the demand function for the price-income set (KPx,KPy, KI)) is derived from the
same equations as for the set (Px,Py, I)

Compensated Demand Function

Imagine a situation in which some public authority taxes or subsidies to a consumer in such a
way as to leave his utility unchanged after a price change. Assume that this is done by
providing a lump-sum payment that will give the consumers compensated demand function
the quantities of the commodities. They are obtained by minimizing the consumer
expenditure subject to the constraint that his utility is at the fixed level U (This is the dual
optimization problem)
Assume again that the utility function is U = XY. From the expression
Z = XPy + YPy + (U - XY) and setting its partial derivatives equal to zero, we get
Z
Px UY 0
X
Z
P2 UX 0
Y
Z
U XY 0

15
Now Px = UY , Py = UX
Px Y XPx
and Y =
Px X Py

XPx YPy

YPx
X
Px
Compensated demand for X

XP
U X x 0
Py

X 2 Py
U
Py

UPy UPy
X ..Y
Py Py

Demand Curves
In general the consumers ordinary demand function Qy is written as q1 = (P1, I) or
assuming that P2
Given parameters, p2 and I as fixed, q1 = D(P1) is the demand curve for commodity 1. It is
often assumed the function possesses an inverse such that price may be expressed as unique
function of quantity.
Generally demand curves are negatively sloped which implies that the lower the prices, the
greater the quantity demanded.
In exceptional cases the opposite may hold. An example is provided by ostentatious
consumption. If the consumer derives utility from a high price, the demand function may
have a positive slope.
Price Elasticity of Demand
The quantity demand of a commodity depends upon its price. It is of interest to measure the
relative change in quantity demanded as a result of given proportional change in price. This
measure is called the price elasticity of demand.

Definition

16
The price elasticity of demand is the relative responsiveness of quantity demanded to change
in commodity price in other words price elasticity is the proportional change to quantity
demanded divided by the proportional change in price.
Let e be own price elasticity of demand for the commodity X, then e
Let the demand curve for commodity be q1 = f (P1, P2 ,..., Pn, I) where q is the quantity
demanded, pj the price of the jth commodity, I is the income and we assume there are n
commodities. By definition, the own price elasticity of demand is
qi pi (ln qi )
eii
pi qi (ln pi )
A numerically large value for an elasticity implies that the quantity is proportionately very
responsive to price changes. If e0 < -1, then the good is a luxury good. (A numerically high
value). If e0 > -1, then the good is a necessity. (A numerically small value)

Price Elasticity of Demand and Expenditure

The rate of change of consumer expenditure on q1 wrt p1 is given by
( p1q1 ) q p q
q1 p1 1 q1 1 1 1
p1 p1 q1 p1

= q1 (1 + e11)
( p1 q1 )
q1 (1 e11 )
p1
Thus the consumer expenditure on q1 will
i) Increase with p1 if e11 > -1 (necessity)

ii) Remain unchanged if e11 = -1

iii) Decrease if e11 < -1 (luxury)

Cross-Price Elasticity of Demand

DEFINITION The price cross-elasticity of demand measures the relative
responsiveness of quantity demanded of a given commodity to changes in the price of a
related commodity. In other words, it is the proportional change in the price of a good)
q1 p1 q1 P1
e11 ,
q1 P1 P1 q1
OR

17
 (ln q x ) q x p y
e xy
(ln p y ) p y q x

I) If exy > 0 then X and Y are substitutes

II) If exy < 0 then X and Y are complements

The Cournot Aggregation Condition

Taking the total differential of the budget constraint XPy + YPx= I and letting
Px NY
dI = dpy = 0 and multiplying through by
MXYdp
Px XY
pxdX + Xdpx + pydY = 0. Multiplying through by we get
IXYdp

Px XY P XY Py XY
p x dX x Xdp x p y dY 0
IXYdp x IXYdp x IXYdp x

dX p x XYp x dp x X 2 PxY dY Py Py Y
0
dp x X IY Px IXY dp x Y IX

Xp x Xp x PY
e xx e yx x x 0
I I I
XPx YPy
x exx y e yx x where x , y are the proportions of total expenditures
I I
for the two goods. Given e11 (own price elasticity of demand) for q1 the formula
1e11 2 e21 1 can be used to calculate the cross-elasticity of demand.
i) If e11 = -1, e21 = 0 i.e.
1 (1) 2 e21 1
2 e21 1 1
2 e21 0 e21 0
ii) If e11 < -1, e21 > 0
1e11 1, e21 0
Then - 1 + 1 e11 > 0 hence 2 e21 0 e21 0
Similarly,
iii) If e11 > -1, e21 < 0
1 e11 + 2 e21 1

18
 2 e21 1 1e11
(1 e11 ) 1
e21 1 (1 e11 )
2 1
e21 0
Income Elasticity of Demand
Income elasticity of demand for an ordinary demand function is defined as the proportionate
change in income with prices constant
( InX )
x
( InI )

Engels Aggregation Condition

Taking the total differential of the budget constraint, XPx + YPy I, we have
I
Px dX + Py dY = dI multiplying through by the first term on the left by
I
X Y
, the second by and dividing by dI, we get
X Y
I X IY I
Px dX Py dY dI
I X IY I
I X Px dX I Y Py dY dI I

I X dI I Y dI dI I
dX I XPx dY I YPy
1
dI X I dI Y I
XPx dX I YPy dY I
1
I dI X I dI Y
XPx YPy
11 2 2 1 where 1 , 2
M M
Is Engels aggregation condition

19
Price Elasticity and Marginal Revenue
By definition, Total Revenue (TR) is TR = pq where p is the price of the good q is the
commodity bought.
dTR
TR = pq and MR
dq

dTR dp q dp
MR pq P1
dq dq p dq
p dq q dp 1
But e
q dp p dq e
where e is the price elasticity of demand of the commodity.
1
MR P1
e

20
SOLVED PROBLEMS
Example 1
A consumer spends $360 per week on two goods and X and Y and Px = $3 and Py =$2.
His utility function is U = 2X2 Y. What quantities of X and Y does he buy each week in
equilibrium. Check whether the second-order condition of maximum is satisfied
Solution
We have: I = $360, U = 2X2Y, PX = $3, PY = $2
U U
Thus MU x 4 XY and MU y 2X 2
x y

U U
U xy 4 X U yx
x y y x

U U
U xx 4Y ,U yy 0
x x y y
At equilibrium
MU x 4 XY Px
2YPy XPx
MU y 2 X 2 Pv

And since YPy XPx I

We have 3YPy I

I
And therefore Y 60
3Px
1 1
Also YPy XPx XPx XPx I
2 2
2I
X 80
3Px
The second-order condition is given by

U U U U
2 2

2U xy U yy U xx 0
X Y X Y
Substituting values of the first and second order derivatives of U on the LHS, we get

2(4 X )4 XY 2 X 2 (0)4 XY (4Y ) 4 X 2
2

2

Which, simplifies to
64 X 2Y 16 X 2Y 0 0Y 0

21
Example 2
A consumer spends $450 per week on two goods X and Y, with PX = $5 and PY = $3.
His utility function is U = 0.5XY2.
i) Find his demand functions for X and Y

ii) Find the optimal values of X and Y

Solution
I = $450, PX = $3, PY = $2, U = 0.5XY2
U U
Thus, MU x 0.5Y 2 , MU y XY
x y
At equilibrium
MU x Px 0.5Y 2 Px
0.5YPy XPx
MU x Px XY Py

Thus, YPy XPx I becomes YPy 0.5YPy I

2I
i) Hence Y is his demand function for Y
3P y

Also, YPy XPx I becomes 2 XPx XPx I

I
Hence, X is his demand function for X
3P x

I 450 2 I 900
ii) Numerically, X 30 and Y 100
3Px 15 3Py 9

Example 3
A rational utility-maximizing individual lives in a world with only two goods: X and Y.
His utility function is given by U(X,Y) = XY . His money income is $256 per week and
PY = $8
a) Derive the equation for his demand curve for Y

b) Find the equilibrium quantity of Y

22
Solution
I $256 x Py $8,U XY

U 1 Y
MU x
X 2 X

U 1 X
MU y
Y 2 Y
At equilibrium
MU x Px Y P
x YPy XPx
MU y Py X Py

Thus, YPy XPx I becomes 2YPy I

I
And his demand curve for Y is given by Y
2 Py

I 256
The equilibrium quantity of Y: Y 16
2 Py 16

Example 3
Total Revenue from the sale of a commodity is given by the equation
TR 100Q 2Q 2
Calculate the point elasticity of demand when marginal revenue is 20.

Solution
Marginal revenue MR is given by

dQ P P
e
dP Q 2Q
Where Q 20 and P 100 2Q 100 2(20) 60
P 60
e 1.5 (demand is elastic)
2Q 40

Example 4
A rational utility-maximizing individual lives in a world with only two goods X and Y.

23
His utility function is U ( X , Y ) XY . His money income is $256 per week and Px = $8
a) Derive the equation for his demand curve for Y

b) If the price of Y is $2

i) Calculate his cross-elasticity of demand for Y w.r.t the price of X

ii) Calculate his income elasticity of demand for X

c) He is given the option of joining a club, for dues of $176 per week which would
give him one but only one, of the following rights concerning purchases for his
own consumption:

i) he would buy X at 50% of the normal price

ii) He could buy Y at 50% of the normal price

iii) He could buy both X and Y at 75% of the normal prices. The normal prices
are still Px = $8 and Py = $2 and his income before payment of dues is still at
$256 per week.

Will he join the club, and if so, will he choose option (i), (ii) or (iii)?
Solution
U 1 Y
MU x
X 2 X

U 1 X
MU y
Y 2 Y
At equilibrium
MU x Px Y P
x YPy XPx
MU y Py X Py

Thus, YPy XPx I becomes 2YPy I

I
And his demand curve for Y is given by Y
2 Py

I
b) i) From the demand equation Y the demand for Y is independent of the price
2 Py

of
X and hence the cross-elasticity is zero

24
Note also that YPy XPx implies 2 XPx I

I dX 1
Now X
2 Px dI 2 Px
Income elasticity for
dX I 1 I 1 I
Therefore, Income elasticity of demand eI = 1
dI X 2 Px X 2 Px I / 2 Px
Therefore, income elasticity of demand is unity
c) Using the demand equations derived above with given income and prices we know
that
if he does not join the club his position is
I 1 256
Y 64
2 Py 2 2

I 1 256
X 16
2 Px 2 8

U (16)(64) 32
i) If joins and buys X at 50% of the normal price his position is:
50
Px x8 $4
100
I = 256 176 = 180
I 1 180
X 22.5
2 Px 2 4
I 1 180
Y 45
2 Px 2 2

U (22.5)(45) = 22.5 2
iii) If he joins and buys Y at 50% of the normal price, his position

50
Py x 2 $1
100
I 1 180
Y 90
2 Py 2 1

I 1 180
X 11.25
2 Px 2 8

25
 U (11.25)(90) = 22.5 2
iii) If he joins and buys both X and Y at 75% of normal price his position is
75 75
Px x8 $6 and Py x 2 $3
100 100
I 1 180
X 15
2 Px 2 6
I 1 180
Y 30
2 Py 2 3

U (15)(30) = 15 2
Thus he will join and be indifferent to options (i) and (ii) because his utility in each case is
22.5 2 which is greater than the utility before joining the club which is 32 .
It is thus not worth joining in respect of option (iii).

Example 5
The relationship between a consumers income and the quantity of X he consumes is given
by the equation
I 1000Q 2
Calculate his point income elasticity of demand for X when his income is 64,000.
Solution

I 64000
Q2 Q 8
1000 1000
dQ 1 dQ I 1 64000 1
And
dI 2000Q dI Q (2000)(8) 8 2
His point income elasticity of demand for X is 0.5.

Example 6
A town of 2,000 households constitutes a market for eggs. Current sales are 2,400 dozen
eggs per week of $1.25 per dozen 1,200 households living on the west side of the river buy
1,600 dozen and their elasticity of demand is 1.5. The remaining households live on the east
of the river, buy the rest of the eggs, and have an elasticity of demand of -3 calculate the
elasticity of the market demand curve for the town as a whole.

Solution

26
If two-thirds of eggs are subject to an elasticity of 1.5 and-third to -3 the combined elasticity
is the weighted average.

2 1 2
1.5 x 3x
3 3 3
Therefore the elasticity of the market demand curve is -2.

Example 7
An individual spends his income on three goods. He buys 550 units of X at $1 per units,425
units of Y at $2 per month units, and 200 units of Z at $3 per unit. He now buys 440 units of
Y and 190 units of Z. Calculate his price elasticity of demand for X.

Solution
Old expenditure on Z = 200 x 3 = $600
Old expenditure on Y = 425 x 2 = $850
Total expenditure on Y and Z = $1450
New expenditure on Y = 440 x 2 = $880
New expenditure on Z = 190 x 3 = $570
Total expenditure of Y and Z = $1450
Expenditure on Y and Z remains unchanged hence expenditure on X remains unchanged.
Therefore the price elasticity of demand for X is -1.

Example 8
An individual lives in a world where there are only two goods X and Y. His utility function
per period is:
U = 50X 0.5X2 + 100Y Y
The price of X is 4 and his income per period is 672.

b) derive his demand function for Y

c) If the price of Y is 14, how much X does he buy?

d) At equilibrium. Calculate his income point elasticity of demand for X

27
 e) The individual is given the opportunity to join a society whose members can buy
Y at z price of 5, this would be individuals only benefit from membership. What
is the maximum amount that he would just be prepared to pay in membership dues
each period to join the society?

f) Suppose the membership dues are 222 per period. Will he join? What then would
be the marginal utility of money to him?

Solution

MU x Px
a) the equilibrium condition are ,..and .. XPx YPx I
MU x Px

MU x Px
,..and .. XPx YPy I
MU y Py

U = 50X 0.5 X2 + 100Y Y2

U U
MU x 50 X , MU y 100 2Y
X X
Py (50 X) = Px (100 2Y)
(50Py X) =Py (100Px 2YPx)
50Py XPy = 100Px 2YPx
-XPx = 100Px 2YPx 50Px
100 Px 2YPx 50 Py
X=
Py

50 Py 2YPx 50 Py
X=
Py

50 Py 2YPx 100 Px
But XPx + YPy = I so Px YPy I
Py
50PxPy + 2YPx 100Px = Py I
Py I 100 Px2 50 Px Py
Y
2 Px2 Py2

b) Given that Py = 14 Px = 4

28
 Py I 100 Px2 50 Px Py
Y
2 Px2 Py2

14 x672 100 x 4 2 50 x4 x 4

2 x 4 2 x14 2
9408 1600 2800
Y 36
32 196
Now from MPx + YPy = I, we have
X(4) + 36 x 14 = 672
4X + 504 672
4X = 672 594 = 168
X = 42
There equilibrium quantity of X bought is 42

e) We find the demand function for x

MU x Px 50 X P
..so... x
MU y Py 100 2Y Py

Hence
50Py - XPy = 100Px 2YPx
2YPx = 100Px 50Py + XPy
100 Px 50 Py XPy
Y
2 Px
Substituting into the budget constraint we get
100 Px 50 Py
XP Py I
2 Px
2XPx + 100Px 50Px 2Px I
2 Px I 100 Py Px 50 Py
X
2 Px2 Px2
Hence the demand function for X is
2 Px I 100 Py Px 50 Py
X
2 Px2 Px2

dX I dX 2 Px
Income elasticity But
dI X dI 2 Px2 Py2

29
 2 Px I
Therefore income elasticity = substituting the values of
2 Px Py X
2 2

Px, Py and X we have income elasticity

2 x4 672 8 672
, x 0.56103508 5614(4d . p)
2 x4 14 2 42 32 196 42
2

Income elasticity of demand for X=0.5614

d) If joins he would not like his utility to fall at least he would want t0 maintain his
original utility. When X = 42 and Y = 36 his

U = 50(42) 0.5(42)2 + 100(36) 362 = 3522

The new equilibrium will be
MU x Px 50 X 4

MU y Py 100 2Y 5

i.e. Px = 4, Py = 5
250 5X = 400 8Y
8Y = 400 + 5X 250
150 + 5X
But U = 3522
150 5 X 150 5 X
U 3522 50 X 0.5 X 2 100
8 8

15000 500 X 150 2(150) 2 )(5 X ) 25 X 2

50 X 0.5 X
2
3522
8 8 64
64(50X) (0.5)(64)X-2 + (15000)(8) + 500X(8) + 22500 1500X 252 3522(64)
57.X2 - 5700X + 127908 = 0
X-2 100X + 2244 = 0
(X-34)(X-66)=0
X = 34 or 66
From (b) X = 42, hence X = 34
150 5 X 150 34(5)
But = 40
8 8
Therefore his new expenditure is
XPx + YPy = 34(4) + 40(5) = 336
To remain at the same level of utility he spends $336. Therefore he will be prepared to use
the balance to pay his dues. Hence maximum membership dues = $672 - $336 = $3

30
 e) Since 222 is less than 336 he will join. His new remaining income is $672-$222 =
$450

MU y MU y
The marginal utility of money is
Px Py

THEORY OF PRODUCTION
The two fundamental concepts behind supplies decision are:

31
 i) Production ii) Cost
All economic goods come to existence through the process of production. This includes
production. This includes production of goods and services e.g. Legal service, medical etc.
In the theory of the firm, the theory of consumer behaviour consumer maximize satisfaction
and firms maximizing profits. In production we have Marginal rate of Technical Production
between inputs. In the theory of consumer behaviour consumers maximize ordinal utility. In
the theory of the firm, the firms maximize cardinal variables. The production process utilizes
the production of inputs e.g. Capital goods i.e. intermediate products, all capital goods come
into existence through an act of production.
Assumption
1) We have one variable input, one fixed input and they may be combined in
various proportions. Fixed-an input whose quantity cant be readily
changed when market conditions indicates immediate change in output. In
actual fact, no input is fixed. The cost of varying might be too high.

Short Run is one in which one or more input is fixed. In the Short Run, change in product
cant be accomplished by varying the variable inputs.
In the Long Run all inputs are variable.
Fixed proportion production: There is only one ratio of input that can be used to produce an
input.
Production Function If a schedule showing the maximum output that can be produced from
any specified set of inputs.

Example
Q= f(K,L),
K is fixed capital; L, labour is assumed variable
The figure below depicts total output at alternative units of variable inputs. At L=0, Q = 0
since capital alone cant produce an output: we need L to combine.
The Average product of L:
APP = Q/L
The Marginal product of L:
MPP = dQ/d/L
As the variable input remaining is increased a point is reached where maximum product is
achieved and after that point it reduces or diminishes. As we increase the input from the

32
origin, MP rises to a maximum at L0 and then it begins to fall. L0 is called a point of
inflexion: a point where the curve changes its concavity. At L2, MP is zero. The Average
product is increasing from the origin and MP remains greater than AP before the point of
intersection L1 where AP achieves a maximum.

Stage I : APPL is rising (L is between 0 and L0 )

Stage II: MPPL is falling but it is positive (L is between L0 and L2 )
Stage III: MPPL is falling and it is negative (L is greater than L2 )
No rational producer produces in stage III because MPPL is negative. Also no rational
producer produces in stage I because in stage I we have too few labourers on a large plant
(and in stage III we have too many labourers the plant).

ISOQUANTS

33
Isoquants are curves input space showing all positive combinations (bundles) of inputs that
are capable of producing a given output. Isoquants are downward sloping. They dont
intersect. Isoquants are convex to the origin. A higher isoquant is preferred to a lower one.
The downward slope implies that if one increases one input one has to reduce the other and if
one decreases the one, one should increase the other. The further away from the origin an
isoquant is, the higher the associated level of output. MR of Technical
Substitution
dK
KL, MRTSKL = measures the number of units of K that replaces a unit of L at a point
dL
so as to produce a given level of output. Along an isoquant the level of output is constant and
therefore
Q = F(K,L)
dQ = Fkdk + FdL
Along the isoquant Q = constant
dQ = 0
0 = Fk dK F1dL
dK FL
MRTS k1
dL Fk
As L is substituted for K along an isoqunt the MRTSKL declines law of diminishing
MRTSKL

ISOCOST CURVE:
R rental rate of capital
W wage rate of labour
Optimal way in which the firm combines various input is given below
We assume that the firm purchases from a P.C input market (prices are given) The T.C of
purchasing K and L is C = PkK + PLL i.e C = rK + wL
C = rK + wL
w C
K L isocost curve (or equation
r r

It is a line showing all

34
 w
Slope combination of the various
r
inputs that the firm can
isocost curve purchase at the given costs

The totality of all the isocost curves is the isocost map. We first consider profit maximization
- Profit = Revenue-Cost

- = PQ (rK + wL)

If firm is a Perfect Competitor in the input market and in the output markets and in this
case P is given, then when C is minimum would be maximum output for given cost or
minimum cost for a given output. Implies we are moving along a given isoquant. An
isocost curve further away form the origin corresponds to a higher TC. It is not possible
to produce at C. The cost minimization point is E where the isocost curve is tangential to
the isoquant. At E therefore
MPPL w
MRTS
MPPK r
If the above question is not satisfied, the producer will substitute one of the inputs for the
other. From the equation
r MPL MPL
, marginal cost of labour per unit of output
MPK MPL MPL
W is the unit cost of labour. MPL is how much output increases if we increase the number of
labour by 1.
r
marginal cost of capital per unit of output
MPL
r w
MC of output is the increase in output due to an increase K
MPx MP
We substitute L for K because MC of output due to L is cheaper and this is same as
MPL w

MPL r

MPL MPK MPL

output per units of labour
w r w
MPK
output per unit of K
r

35
Instead of minimizing cost we can maximize output in the dual optimization problem. Now
output varies and cost is
Qx is not attainable Q1 is attainable but not the right equilibrium position
At E, MRTS = ratio of prices. Equilibrium is the same in both cases.
DEFINITION OF SOME CONCEPTS
Isocline is the locus of points along which MRTS is constant. It connects points along which
MRTS is the same.

K
Expansion path

Suppose inputs prices are given and the firm wants to expand output. When all the
equilibrium points are joined together we have Expansion Path. An Expansion
Path is an isocline along which output will expand if factor prices remain constant. An
Expansion Path has a positive slope so that if we want to increase output then employment of
both inputs should be increased.
RETURNS TO SCALE refers to a relationship between the proportionate change in all
inputs and the resultant proportionate change in output. If output changes by the same
proportion we have constant return to scale (CRS). If output changes by more than the
proportionate change in input, we have increasing Returns to scale (IRS). If output changes
by less than proportionate change in inputs we have decreasing Returns to Scale (DRS)
There is a presumption that production functions exhibit CRS
Reasons
1) The production process can be duplicated

2) IRS implies indivisibility (efficiency)

3) Division of labour (efficiency)

Reasons for DRS

36
 1 There are certain cases where inputs can be doubled example extractive
industries-mining

2 Difficult in supervision e.g as scale of operations increase management becomes

less efficient

THEORY OF COST

37
Social cost of production, when resources are used to produce a commodity it implies the
society in curs a loss of production of another commodity
Opportunity cost the opportunity cost of producing one units of X is the amount Y that must
be sacrificed for producing X
Explicit Cost. Are payments made by firms for purchase or hired factors of production
Implicit Cost: Are the imputed cost of self-owned factors of production
Total Cost Explicit: Implicit Costs
Implicit and Explicit costs are private costs of production.
In economics, cost means opportunity cost unless otherwise stated.

LONG-RUN COST CURVES

The least cost of producing a given a quantity of output is summarized in the long-run total
cost curve. And it shows how total cost varies as the level of output varies. It is cost-output
equivalent of the expansion path.
L
TC is concave to the origin at low levels of output and becomes convex. It starts from the
origin. The shape of the curve reflects the characteristics of the production function. It
reflects return to scale.
1st TRS, 2nd CRS 3rd DRS

SHORT-RUN TOTAL COST CURVE

In the long-run the firm operates along the expansion path but in the short-run some of the
factors are fixed. Once the tangency condition is violated in the short-run, it implies that it
costs more to produce a given quantity of output in the short-run than in the long-run
In the long-run all costs are variable
SRTC = SRFC + SRVC

38
Corresponding to TCs we have Average costs and marginal costs
SAC = AFC + AVC
d ( STC ) d (dQ TFC
SMC ' , AFC
dQ dQ Q

39
The AFC is U-shaped Assume labour is the only variable factor
TFC = w,L where w is the wage rate
TVC w.L L
AVC w.
Q Q Q
d (TVC ) dL d (TVC dQ w
SMC ,
dL dQ dL dL MPPL
dQ
Marginal product of labour
dL
dQ
SRMC and the are inversely related
dL
Both the SRVC , STC start from the origin is asymptotic to the cost axis. The gradient of the
ray from the origin to the STC gives the ATC at that point
LONG-RUN COST CURVES
In the long run, all inputs are variable. It is the planning of the firm. The long-run cost
curves are always below the short-run cost curves. If a firm wants to take a decision it
happens in the long-run. LCRC SRC>
All production take place in the short-run. As we move towards the LR, the fixed factor
becomes variable. We have a series of SRC curves. The LTC is the envelope of the possible
short-run TC curves. The long-run LTC is also the envelope of all the possible short-run, AC
curves.

40
FUNCTION COEFFICENT
It shows the proportionate change in output when all inputs are changed by the same
proportion. If is the change in input then function coefficient
Q

Q
If > 1 implies increasing return to scale. IRS or economics of scale
< 1, constant returns to scale (CRS)
= 1 , decrease returns to scale or diseconomies of scale (DRS)
LAC C Q C
,
LMC C Q C
Q C Q LAC
, LAC
Q C C LMC

41
 C LAC
Average cost
Q LMC
1 LAC LMC
1 LAC LMC
1 LAC LMC
If the production function exhibits CRS then the expression path is linear i.e. through origin.
If the production function is linear, it implies CRS
If expansion path is linear then it belongs to homothetic production functions.

42
THEORY OF THE FIRM MARKET STRUCTURES
How do we classify market structure? We consider two criteria:
1) Number of firms in the industry

2) The nature of the product produced by the firms in the industry:

1. The basis of the first criteria

We classify industry whether there are many firms, few or one firm in the industry
2. We categorize the industries by whether the products of the firms are homogeneous or
different

Number 0f Firms
Number of product Many Few One
Homogeneous PC Pure Oligopoly
Differentiated MC Differentiated Monopoly
Oligopoly

PC Perfect competition
MC Monopolistic competition
We use the world competition to imply many firms in the industry
Oligopoly implies few firms in the industry.
Perfect and Pure implies homogeneity of product
Competition does not mean competition in the real sense of the word. Here rivalry is absent.
All other market structures other than perfect are classified as imperfect competition. We are
talking about the sellers side of the product. We have the counterpart of this that is those who
do the buying.
If the buyers are many implies perfective competitive buyer
If there is one buyer, then the market is monopsonistic
If a monopolist faces a single buyer, we have a bilateral monopoly

43
PERFECT COMPETITION
Economists use four conditions to characterize perfect competition
1) suppliers and demanders are both price takers

2) The product is homogeneous

3) Free mobility of resources, i.e. are perfectly mobile. There are no special skills
that one needs

4) Perfect knowledge producers and owners of factors production and buyers have
knowledge about the economy. Market participants have knowledge about the
future

The model of PC contains certain properties of economic efficiency. Because PC firm is

price taker output is proportional to revenue.

Firms are free to enter or leave the industry

THE VERY SHORT-MARKET PERIOD

P1
B D1
D2

The market period only supply determines the equilibrium output and demand determines the
price.

SHORT-RUN EQUILIBRIUM OF THE FIRM

STC
=TR-TC TC

Fixed
Cost =0

44
 =0

At A and B, the tangents to the STC is parallel to TR,BT<B Corresponds to profit

minimization
Profit Maximization
1) MR = MC

2) MC must be increasing

d d (TR) d (TC )
0
dQ dQ dQ
MR - MC = 0
MR MC
d 2
Second order condition 0
dQ 2

d 2 (TR) d 2 (TC )
0
dQ 2 dQ 2
d ( MR) d ( MC )
0, MR = constant PC
dQ dQ
d ( MC )
0
dQ
MC is an increasing function
MC is increasing

45
At the min point of the SAC the firm is indifferent about production i.e. it can continue to
produce or shut down. That is at this point the firms covers its variables costs.

SUPPLY CURVE OF THE FIRM

The industry supply curve can be the summation of the individual supply curves of the firms
of the expansion does not affect the cost curves of the firms.
If resource prices do not change the supply curve of the industry will be the horizontal
summation of the supply curves of the individual firm. But if the prices changes then this
cannot be done.

LONG-RUN EQUILIBRIUM OF PC
The long-run adjustment of a single firm
In the long-run the firm will operate at point E. At q, the firm will be making profits hence
new firms will enter into the industry.
LONG-RUN EQUILIBRIUM THE INDUSTRY
At qi, the firm will be making profits hence new firms will enter hence the curve will shifts to
right that is S1 S 2 .

46
At q, firm will be making losses firms will be leaving the industry. At q, supply to S 1. As
firms leave the industry the long-run supply will be S2 .

MONOPOLY
If there is only one producer in the market then we have monopoly. Monopoly and PC are
extreme cases.
1} PC has many rivals. We have competition in technical sense
2} In the case of monopoly rivalry does not exist. There is only firm in the in the market.
However there are indirect forms of competition that the monopolist faces.

i) That is competition for the consumer income. That is he has to secure a

market for his products.

ii) The existence of substitutes for his products. His power depends on the
exact goods. Reasons why monopolists exist

1) Control of the basic input. That is the Aluminum Company of USA owns the Bauxite
in the production of A1 in USA.
2) A firm can obtain the property right to produce a commodity. They cannot prevent
other firms from producing close substitute example Pata and Club, IBM and the rest
3. The Average Cost of producing a product reaches its minimum at an output rate that
is ideal for one firm
If more than one firm does the production they produce a higher AC. There will be a price
warfare and some of them will be driven out of production, hence leaving only one firm in
the market, this termed as natural monopoly which means the emergence of one firm as the
sole producer of a commodity due to the price warfare
4) Demand curve facing the monopoly. The dd curve facing the monopolist is the same
as the market dd curve.
5) Under monopoly the firm chooses the price. The MR is not the supply curve as is the
case.
SHORT-RUN EQUILIBRIUM OF THE MONOPOLIST
A firm may be a monopolist in the product market and may be a PC in the input market. If it
is a PC in the input market then the cost curves will be the same as the PC.

47
Let us consider a monopolist who owns two plants. Each of the plants has its own cost
curves. He decides on output and price. The allocation of optimal output in each plant are as
follows:
Total Market

MC MC1 MC2 MC

P
P MC = MR
D
Q

At the optimal level MC1 = MC2,

When MC1 < MC2 then there will be a shift of production from MC1 to MC2,
p FR (Q)
P F (q1 q 2 )
Q q1 q 2
R pq qF (q1 q2 )
R(Q) f (q1 )
C=fq1),C2=g(q2)
R(q1 q2 ) C1 (q1 )
= R(q1 + q1) g(q2)
Q Q
R(q1 q 2 ) f ' (q1 )i.e. 1
q1 q1 q2
R Q
, P(q1 ) R' f ' 0 R' f ' MR Mc
Q q1
Q
R' (q1 q 2 ) g' 0
q 2 q1

R' R' 0, MR MC

MC1 MC2 MC3

These are first order conditions. The second order conditions

48
 2 2
q1 2 q1q 2

Second order conditions
2
2

q 2q1 q 2

11 12 12
, 11 0. 11 0
21 22 21 22
The second order condition implies MC must be rising.

LONG-RUN EQUILIBRIUM
Since entry is blocked in the LR profit is not reduced to zero. If the monopolist incurs a SR
loss and there is a revenue for expanding output then in the LR it will close down. If the
monopolist makes profits in the SR, he can expand output. The maximum-maximum plant is
the plant which gives the maximum of the maxima profit.
That is LMC = MR
SAC is the optimal plant of the LR. The maximum-mximum plant is the plant which gives
the maximum of all profits. In the LR, monopolist need not operate at the minimum point of
the LAC, so reso@ e perfectly utilized in PC. To the monopolist. P < MC price
or dd represents the marginal social evaluation of a product LM MC shows the marginal
social cost i.e. society wants more of product but the monopolist will not increase output. PC
promotes social welfare more than monopoly. That is P = MC in PC and P > MC in
monopoly.

LONG-RUN EQUILIBRIUM OF A TWO PLANT MONOPOLIST

In the long-run, the monopolist can alter the plant size.
Cost curve for one plant

49
LONG-RUN EQUILIBRIUM OF A MULTIPLANT MONOPOLIST

P C
P

P LMC = LAC
A B
D

Qp
Number of firms in a PC market will be
q
Q
Number of firms in a monopoly market will be
q
Qp Q
. And the monopolist will change a higher price.
q q

50
QUESTIONS
Construct a short-run supply function for an entrepreneur whose short-run cost function
is TC = 0.04q3 0.8q2 + 5 + 10q
1) Solution

TC = 0.04q3 0.8q2 + 5 + 10q

TVC = 0.04q3 0.8q2 + 10q
TVC
AVC 0.06q 2 0.8q 10
q
dAVC
For Min AVC set 0
dq
dAVC
0.08q 0.8 0
dq
80
q 10
8
When q = 10, AVC = 0.04 x 100 0.8(10) + 10 = 6
MC = 0.12q2 1.6q + 10
0.12q 3 1.6q 10 p
Multiply through by 12.5
5q2 20 + 125 12.5p = 0

20 400 6(125 12.5 p

q
3

20 5 3 p 14
q
3
The positive branch gives output at which MC is increasing, hence dS/dp >0 and
20 5 3 p 14
S= .if..p 6
3
I,e. minimum AVC = 6, below 6, S = 0) min P = 6

2) The long-run cost function for each firm that supplies Q is C = q3 4q + 5q.

51
Firms will enter the industry if profits are positive and leave the industry if profits are
negative. Describe the industrys long-run supply function. Assume that the corresponding
demand function is D = 2000 100p.
Determine equilibrium price of industry and number of firms

OTHER QUESTIONS
1) A firm has the following long-run production function
X = A0.5 B 0.5C 0.25 where X is weakly output,
is positive constant A, B and C are the weekly outputs of the three factors used.
The price of A is $1, the price of B is $ and the price of C is $8
a) Derive the following:
i) the firms long-run total cost function
ii) the firms short-run average cost function
iii) the firms short-run average variable cost function
b) if the short-run factor C is fixed, while factors A and B are variable, derive the
following
i) the firms short-run average function

ii) the firms short-run average cost function

iii) the firms short-run average cost function

iv) the short-run average marginal cost function

c) Derive an equilibrium in the form C = f(x) showing the optimum quantity of the fixed
factor
C for the firm to acquire as a function of the intended output of X

Solution
The equilibrium or cost-minimum conditions are
MPPa Pa MPPa Pa
,
MPPb Pb MPPb Pb
From th given data

52
MPPa = o.5 A-0.5 B0.3 C0.25
MPPb = 0.5 A-0.5 B0.3 C0.25
MPP = o.25 A0.5 B0.5 C0.25

MPPa Pa 0.5A0.5 B 0.5 C 0.25 1

=
MPPb Pb 0.25A0.5 B 0.5 C 0.25 9

2e 1 A
So C .............(ii )
A 8 16
Substituting (i) and (ii) into production function we get
0.5 0.25
A A
X A0.5
9 16
( A) 0.5 ( A) 0.25
A0.5
3 2

.0.8
6
X A0.25 A X 0. x .................(iii )
6
LTC APa BPb CP c

A A
= AS1) ($9) ($8)
9 16
A 5A
A A
2 2
0.8
6
But A X 0.8

0.8
5 6
Hence LTC = X 0.8
2
0.8
5 6
(i) LTC = X 0.8
2
0.8
LTC 5 6
(ii) LAC = X 0.81
X 2

0.8
5 6
= X 0.8
2

53
 0.8 0.8 0.8
dTC 5 6 4 6 6
(iii) LMC = (0.8) X 0.2 X 0.2 2 X 0.2
dX 2 2

A
b) From a) we have X = C 0.25 B 0.5 A0.5 ..and ...B
3

0.5
A A
X C 0.25
A0.5 C 0.25
9 3

AC 0.25 3X
X A
3 C 0.25
SFC = AP + BP + CP

A
But (i) STC = d($1) + ($9) $8) A A 8C
9
STC = 2A + 8C
3X
But A
C 0.25
3X 6X
Hence STC = 2 0.25 8C 8C
C C 0.25
STC 6X 8C
(ii) SAC
X C 0.25
X
6 8C
=
C 0.25
X
TVC 6X
(iii) SAVC = , but...TVC
X C 0.25

6X 6
Hence SAVC 0.25
/X
C C 0.25
dSTC d 6X 6
v) SMC = 8C
dX dX C 0.25
C
0.25

6
SMC =
C 0.25
16
b) From part A 16C , B C
9
X = A0.5 B 0.5C 0.25 substituting A and B we have

54
 0.5
16
X (16C ) C C 0.25
9

4 0.5 0.25 16 1.25

X AC 0.5 C C C
3 3
0.8
3
C X 0.8
16
2) A firm uses a number of factors to produce a single product. X. In the short-run plant
is fixed, while all other factors are variable. We are concerned with two of the possible
plants. In the long long-run of course all factors are variable. The cost functions are
LTC = 0.005 X3 1.4X3 + 280X
Plant 1 : STC1 = 0.006X2 -1.33X2 + 6860
Plant II STC2 = 0.0057 X2 -1.424 X-2 + 205.6X + 10240
a) Derive equation for the following LAC, LMC, SAC, SATC,..SMC,,SMC

b) At what output does the firm achieve minimum LAC?

c) Does either plant permit achievement of minimum LAC?

d) At what output is SAC, minimized?

e) What is the level of SAR at 160?

f) What is the level of SAC at X = 160?

g) At what is the SAC minimized?

h) Which of these two plants will the firm use if it intends to produce the
output in (g)

i) For what output would plant 2 be the best of all possible plants

j) Would plant 1 operate in the short- run if the product price were 120?

k) Would plant 2 operate in the short-run if the product price were 120?

l) Which plant would be more profitable if product price were 120?

m) At what product price would the firm produce the same positive output in
the short-run which ever of these two plants it had?

55
Solution
LTC = 0.005X3 -1.4X2 + 280X

LTC
a) LAC = 0.005 X 2 1.4 X 280
X

LAC = 0.005X2 1.4X + 280

LTC
LAC = 0.15 X 2 28 X 280
X
STC1 = 0.006X3 -1.33X2 + 201.6X + 6860
STC1
SAC
X
SAC1 = 0.006X2 1.33X + 201.6 + 6860X-1
STC1
SAVC =
X
SAC = 0.006X3 1.33X2 + 201.6X
SAC = 0.006X2 1.33X + 201.6
STC1
SAFC1 = but SFC = 6860
X
SAFC1 = 6860X-1
dSTC1
SMFC1 = 0.018 x 2 2.66 x 201.6
dX
SMC = 0.018.X2 2.66x + 201.6
STC1
SAC = = 0.0057X -1.424X + 205.6 + 10240X-1
X
SAC = 0.0057X2 -1.424X + 205.6 + 10240X-1
dSTC
SALC2 = 0.0171x 2 2.848 x 205.6
dX
Either set the derivative of LAC - or set LAC = LAFC
LAC = 0.005X2 - 1.4X + 280
dLAC dLAC
0.01X 1.4 Set 0 0.01X 1.4, X 140
dX dX
d 2 LAC
For min 0
dX 2
d 2 LAC
0.01 minimum, hence X = 140
dX 2

56
 or
LAC = LMC
LAC = 0.005X2 1.4 + 280
LMC = 0.015X2 2.8X + 280
0.005X2 1.4X + 280 = 0.015X2 2.8X + 280
(0.005 0.015) X2 1.4X + 2.8X = 0
-0.01X2 + 1.4X = 0
X(-0.01X + 1.4) = 0
X = 0 or X = 140
X = 140
C) SAC1 at X = 140 is
6860
SAC1 = 0.003(140)2 - 1.33(140) + 201 + 182
140
SAC at X = 140 is
10240
SAC = 0.0057(140)2 1.424(140) + 205.6 + 191.1
140
LAC at X = 140 is
LAC = 0.005 (1402) 1.4 (140) + 28 = 182
Hence plant 1 achieves minimum LAC
d) Find the minimum of SAC. Thus we find the derivative of SAC , and set it equal to zero
and check whether it is a minimum

SAC1 = 0.006X2 -1.33X + 201.6 + 6860X-1

dSAC1 dSAC1 6860
0.912 x,1.33 6860 x 2 ..Set. 0 0.012 x 1.33 0
dX dX X2
0.012 X3 1.33X2 6860 = 0
Solving we get
X1 = 140,X2, = -14.58 + 62.21, X, = -14.58 62.21
d 2 SAC1
For minimum, 0
dX 12

d 2 SAC1 2(6860) 13750

0.012 3
0.012
dX 12
X X 3

57
 d 2 SAC1
0.012 0.005 0
dX x 140

X = 140 gives a minimum

d 2 SAC1
0 I .E (14.58 62.21) 3 0
dX 12 X X 2 , X1

X = 140 minimizes SAC1

SMC2 = 0.0171X2 2.848X + 205.6
= 0.0171 (1602) 2.848 (160)
= 437.76 455.68 + 205.6
= 187.68
SMC2 = 187.68 at = 160

g) From theory SMC cuts SAC at its minimum point. But at

X = 160, SAC2 = SAC2 = 187.68 hence SAC2 is minimized at the
output level of X = 160
SMC2 = 0.0171X2 -2.848.X + 205.6
dSMC 2
0
dX
dSMC 2
0.0342 X 2.848
dX
dSMC2
0.0342(160) 2.848 5.472 2.848 2.624
dX x 160

Hence SMC2 is rising

X = 160 is the output level at which SAC is minimised
h) That SAC2 is minimized at X = 160 does not mean that SAC < SAC1 at X = 160
At X = 160
SAC = 0.006X2 = 1.33X + 201.6 + 6860X-1
6860
i.e. SAC1 = 0.006 (1602) 1.33 (160) + 201.6 +
160
SAC1 = 185.275 and SAC2 = 187.68
Thus plant 1 has a lower average cost than 2 therefore plant 1 will be used to produce the
output of X = 160

58
 i) It is necessary that SAC1 = LAC at tangency and therefore SMC2 = LMC setting
the average cost equal yields a cubic equation i.e.

10240
SAC2 = 0.0057X2 -1.424X + 205.6 +
X
LAC = 0.005X2 1.4X + 280
0.0057X2 1.424X + 205.6 + 10240X-1= 0.005X 1.4X + 280
0.0007X - 0.024X2 74.4 + 10240X-1 = 0
= 0.0007X3 0.024X2 74.4 + 10240 = 0
Solving we get X1 = 365.71, X2 = 200.00, X3 = 199.99 = 200
Hence X = 200 i.e. X cannot be negative
Setting the marginal equal we have
0.01XX2 -2.8X + 280 = 0.017X2 2.848X + 205.6
0.0021X2 0.048X + 74.4 = 0
Solving we get
X1 = 200, X2 = -177.14
Hence X = 200 as output cannot be negative
j) To continue operation it is necessary that SAC = p and SAVC P
Set SMC1 = p
0.018X2 -2.66X = 201.6 = 120
0.018X2 2.66X = 8X.6 = 0
Solving gives
X1 = 104.32.X, 43.15
dSMC1
0.036 X 2.66
dX

dSAMC1
0.036(104.32)2.66,1.1 0
dX X 104

Hence SMC1 is rising

dSMC1
0.036(104.32) 2.66 1.112
dX X ,1115

59
Hence SMC is falling. Thus X 104.32
At X = 104.32
SAVC1 = 0.006 X2 -1.33X + 201.6
= 0.006 (104.32)2 -1.33 (104.32) + 201.6 = 128.15
Now p = 120 hence SAVC1 > p
Hence plant 1 would not operate
k) Set SAR2 = p

0.9171X2 -2.848X + 205.6 = 120

0.0171X2 2.848X + 85.6 = 0

Solving we get
X = 127.2, X2 = 39.36
dSMC 2
0.0342 X 2.848
dX
dSMC1
00342(39.36) 2.848 1501
dX X , 3936

Thus SMC2 is falling. Thus X = 127.2

STC2 = O.00557X3 1.424X2 + 10240
STVC
SAVC 2
X
SAVC = 0.0057X-3 -1.424X2 + 205.6X
SAVC2 = 0.0057X-2 -1.424X + 205.6
At X = 127.2
SAVC2 = 0.0057 (127.2) -1.424 (127.2) + 205.6 = 116.7
Hence SAVC2 < 120 i.e. p> SAVC2
Thus plant 2 would operate
1) Plant 1 would not operate and hence it will incur a loss equal to the LFC 6860

Plant 2 TR = 127.2 x 120 = 15264

STC at X = 127.2
STC 2= 0.0057X2 -1.424X2 + 205.6 (127.2) + 10240
= 0.0057 (127.2)2 1.424 (127.2)2 + 205.6 (127.2) + 10240
= 11731.03 2040.09 + 10240 = 25.083.26

60
 STR1 = 15264, STC2 = 25083.26
Loss STR, STC2 15264 25083.26 = 9819.26
Pure loss = 9819.26
Thus plant 1 is the more profitable since its loss when closed down is smaller than the
loss in plant 2.

m) The necessary condition would be

(i) SMC1 = SMC2 (ii) SAVC1 (iii) SAVC2 SMC2
SMC = 0.018X2 -2.66X + 205.6
SMC =0.0171X2 -2.848X + 205.6
0.018X2 2.66X + 201.6 0.0171X2 2.848X 295.6
0.0009X2 + 0.188X 4.0
Solving gives
X1 = -228.35, X2 = 19.46
Hence X = 19.46
ii) SAVC1 = O.006X2 -1.33X + 201.6

SAVC at X = 19.5 is
SAVC1 = 177.94
SMC1 = 156.57
SAVC1 < SMC1 and hence violates SAVC1 SMC1
III) SAVC2 SMC1
SAVC = 0.0057X2 -1.424 X + 205.6
SAVC at X = 19.5 is SAVC = 179.999
SAVC = 180
SMC2 = 0.0171X2 -2.848X + 205.6
SMC at X = 19.5 is
SMC2 = 6.50 55.536 + 205.6 156.564
Again SAVC2 > SMC2 i.e 180 > 156.564
Since (ii) and (iii) are violated, there is no such price.

1) A firm uses capital and labour to produce widgets . In the short run capital is fixed,
while labour is variable the short run production function is X=-1 + 24 + 240L where

61
 X is the number of widgets produced per week, and L is the number of workers
employers employed. Each works a 40 hour week. The wage rate is $12 per hour.

a) Calculate the range of values for L over which the the firm in (i) Stage I (ii) Stage II
(iii)
b) What iis the minimum product price at which the firm will operate in the short6
run?

The product price over which the firm has no control, in such such that the firms maximum
possible pure profit is $1096 per week. In order to achieve that level of profit must employ
16 workers. How much is the firms total first cost?

Solution
a) Locate the input values at at which APP1 = 0. From the production
X
APP1 24 L 24O
L
dAPP1
2 L 24 0 L 12
dL
d 2 APP1
2 MAX POINT
dL
dX
MPP 3L 240
dL
Set MPP1 = 0 and solve
3L2 48L 240 0
L = -4 and L = 20
Hence L = 20
Now we look at MPP1 at L > 20
MPP = -3L2 + 48L + 240
MPP at L = 21, MPP1 =-26535
MPP1 is negative for all values of L > 20
Thus
i) Stage 1 is over the range L < 12

ii) Stage II is over the range 12 > L 20

iii) Stage III is over the range L > 20

62
 b) The shut-down point is when P = minimum SAVC, WHICH coincides with ma
APP

Thus from a) L = 12 . At L = 12,X = 4608

The weekly wage , w=$MVP = MPP1 is the unit price of commodity X w = MPP, PX
w AtL
MPP1 = 16, w 480
Px P
MPP1 = 3L2 + 48L + 240
3(162) + 48(16) + 240 = 240
w 480
Px $2.
MPP1 240
when L = 16
Thus total revenue = XPx = 5888 ($2) - $11776
X = (1) + 24(16) + 240(16) = 5888
TVC = $480 X 16
$7680
But profit total revenue total cost
= 11776 (7680 + TFC) = 1096
TFC = $3000
4) A firms only variable factor is labour and it produces a single product. X. It also has
fixed costs. The short run production function is X = -0.1L2 + 6L2 + 12L where X is the
output per per week in tons and L is the number of persons employed.
a) How many persons are employed if the average physical product of labour is minimized?
b) How many persons are employed if the marginal product of labour is maximized
c) what quantity of X is produced when average variable cost is minimized?
d) If the weekly wage is $360 and the price of X is $30 per ton, how much X should be
produced to maximize profit?

Solution
a) The production function is X 0AL2 + 12L
dPPL
2 L 6 0
dL
L = 30

63
 dPPL
0.2 max
dL
c) From the production function, MPP

dX
2 L2 12 L 12
dL
dMPP d 2 X
0.6 L 12 L 20
dL dL
d 2 MPPL
0.6 max
dL
MPP is maximizes when L = 20
c) Average variable cost is minimized when APPL is maximized and from a) APPL
is maximized

when L=30. From the production function when L 30

X = -0.1 (30) = 12 (30) = 3060
d) The profit maximizing condition is
AVP = pMPPL = w
MPPL = -3L2 + 12L + 12
W = $360, p = $30
360
0.3L2 12 L 12 12
30
--0.3L2 + 12 = 0
Solving gives L = 0 or L = 40
Since L > 30 it is worth producing i.e. it is in stage II
When L = 40
X = -01 (40)2 + 6(40)2 + 12(40)
X = 3680
5) A typical firm in a perfectly competitive industry has the following long-run total function
LTC =q2 60q2 + 1500q where cost is measured in dollars and q is output per month:
a) Derive corresponding equations for
i) Long-run average cost
ii) Long-run marginal cost
b) If the firm can sell its output at a price of p = $975, how much will it produce
to maximize profit?

64
c) Is the equilibrium of the firm in b) compatible with equilibrium
d) If the industry is one of the constant costs, derive the equation for the long-run
supply curve of the industry7
e) If the market demand curve is p = 9000 3Q, howe many firms will there be in the
industry in long-run equilibrium?

Solution
LTC
a) (i) LAC q 2 60q 1500
q
dLTC
(ii) LMC 3q 2 120q 1500
dq
Set LMC = p
3q2 120q + 1500 = 975
3q2 120q + 525 = 0
q1 = 5,q2 = 35
But at equilibrium. LMC must be rising
dLMC
6q 120
dq

dLMC
6(5) 120 90
DQ q 5

dLMC
(35) 120 90
dq q 35

Hence q=35 is the equilibrium output

Or
TR TC
But TR = 975q, TC = q3 60q2 + 1500
975q q 3 60q 2 1500q
d
975 3q 2 120q 1500 3q 2 120q 525 0
dq
q = 5 or q = 35
d 2
For 0
dq 2

65
 d 2
6q 12
dq 2

dLMC dLMC
90, -90
DQ q 5 DQ q 35

Hence q = 35 is the equilibrium output

c) The industry equilibrium occurs at the min of LMC, hence we find the output of the
LTC
LAC q 2 60q 1500
q

dLAC
2q 60 0 q 30
dq

d 2 LAC
2 a minimum
dq 2
Hence the industry equilibrium is q=30. Thus the firms equilibrium of q=35 is not
compatible with the industrys equilibrium
d) Finding LAC at q = 30
LAC q3 60q + 1500
LAC q 30 = 600 Industry supply is p = 600

c) p = 9,600 -2Q
If there are n-firms in the industry with each producing q units then
Q = nq and q = 30, p = 600
600 9600 2nq
600 = 9600 2n(30)
60n = 9000
N = 1500
There are 150 firms in the industry
6) A firm uses and labour to produce commodity A. In the short run the amount capital
is fixed while labour is variable. The firm buys capital at a price beyond its control and
calculates the daily cost to allow for depreciation, maintenance ETC. At the current interest
rate the cost capital is $30 per unit per day. The wage rate is $3.9 man-hour.
On the basis of those factor prices the plans and builds its plant so as to maximize profits at
expected selling price of commodity A over which it has no control firms daily cost curves
are as follows, where costs are in dollars and q is the daily of commodity A.

66
 2 3
Long run total cost q 16q 2 180q
3
Short run total cost = q3 24q2 + 195q = 450
a) What did the firm expect the price of commodity A to be?

b) How much profit did the firm expect to make per day

c) What is the lowest price of commodity, A at which the firm will still operate in
short run if there is no change in factor prices?

d) If the prices of commodity A is $124 and the firm expects that price to continue
indefinitely with no change in factor prices, how many commodity A per day will
firm plan to produce in the long-run?

e) If the price of commodity A is what the firm initially expected to be, but
during initial short run the wage rate rises to $7.50 per man-hour, while the cost of
capital to $28 per unit per day, $28 per unit per day, how many commodity will
the firm produce per day in the short-run?

Solution
a) The firm chose its plant so that LMC = SMC = p
2 1
LTC q 16q 2 180q
3
dLTC
LMC 2q 2 16q 180
dq
STC = q 2 24q2 + 195q + 450
dSTC
SMC 3q 2 48q 195
dq
Set LMC = SMC
2q2 32q + 180 = 3q2 48q + 195
q2 + 16q 15 = 0
q2 16q + 15 = 0
q 16q 15 = 0
But LMC or SMC must be rising
dLMC
4q 32
dq

67
 dLMC
4q 32 28 LMC is falling
dq q 1

dLMC
32 28 LMC is rising hence q=15
dq q 15

At q = 15
LAMC = SMC = 2(15)2 32(15)+180 = 150
The expected price was $150
b) Profit TR TC

Expected Revenue = 15(150) $2,250

2
Mq 15, expected LPC = SPC = 15) 180(15) $1350
3
TR = $2250
TC = $1350
= 2250 1350
= $900 = Expected Profit
c) Lowest price will equal min SAVC
STC = q3 24q2 + 195q + 450
STVC = q3 24q2 + 195q
STVC
SAVC q 2 24q 195
q
SMC = 3q2 48q = 195

Set SMC = SAVC

3q2 48q + 195 = q2 24q + 195
2q2 24q = 0
Q = 0, or q = 132
At q = 12, SAVC = (12)2 24(12) = 195 = 51
Therefore price is $51
c) Set p LMC = 124

q2 32q + 180 = 124

q2 16q + 28 = 0
Q = 2 or q = 14

68
 dLMC
4q 32
dq

dLMC
4(2) 32 24
dq q 5

dLMC
4(14) 32 24
dq q 14

Hence q= 14
2
At q = 14, LAC = (14) 16(14) 180
3
= $86.67
Hence p = 124 > LAC
Therefore the firm will price 14 units of commodity A.
c) LMC = SMC = p in above SMC = $150
SMC = 3q2 48q + 195
7 .5
The new marginal cost will increase by the ratio , hence the new
3 .9

SMC
7.5 2
3.9

3q 48q 195
Also in the short-run capital is fixed, hence the marginal cost does not depend on capital but
rather labour. To find the units of commodity A that will be produced set the new SMC
equal to $150.

SMC
7.5 2
3.9

3q 48q 195 = 150
22.5q2 360q + 877.5 = 0
q2 16q + 39 = 0
q2 = 3 or q = 13
dSMC 7.5
(6q 48)
dq 3.9

dSMC 7.5
(6(3) 48) 0
dq q 3
3.9

dSMC 7.5
(6(13) 48) 0
dq q 13
3.9

Hence q = 13

69
At q = 13 SAVC=
3.9

7.5 2

q 24q 195
7.5 2
3.9

13 24(13) 195 $100

But p = 150 hence p > SAVC

There firm will produce 13 per day.

7) A perfect competitive firm operates in the short-run with labour as its only variable
factor. Its production function is X= -L3 = 10L2 +88L where X is output per week,
measured in tone, and L is the number of workers employed.

a) The weekly wage is $324 and the product sells for $3.24 per ton. How many
workers should the firm employ to maximize profit?

b) Calculate the firms point elasticity of demand for labour at equilibrium in a)

c) The price of the product now rises $4 per ton with no change in the wage rate. By
how much does the firms maximum pure profit increase?

d) Calculate the firms are elasticity of supply of the product over the range of price
from $3.24 to $4.00.

e) If the price of the product remains at $4.00, but the weekly wage increase to
$480.00, how much output should the firm product to maximize profit?

Solution
w
a) The profit maximizing MPP , where..MPP1 APP 1
p
From the production function
MPP1 = -3L2 + 20L + 88
W = $324,p = $3.24
3.24
3L 20 L 88
3.24
3L2 20L + 12 = 0
2
OR L = 6
3
L=6
AL = 6, MPP1 = 3(6) + 20(6) 2+ 88 = 100
APP = -L2 + 10L + 88

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 APP at L, = -(6)2 + 10(6) + 88 = 112
Thus APP1 < APP1, hence stage II of production. The firm employs 6 workers
dL w w
b) Point elasticity of dd for labour is , but from a) MPP1 w pMPP1
dw L p
Also p = $3.24
w3.24(3L2 20L 88)
dw
19.44 L 64.8
dL
dL 1

dw 1944 L 64.8
elasticity of demand for labour is -1.04167
c) MPP = 3L 2 + 20L + 88 $324.p = $4.00
w
MPP
L
324
3L 20 L 88 81
4
-3L + 20L + 7 = 0
1
L OR L = 7
3
In a) L = 6X = -(6) + 10(6) + 88(6) = 672
TR = X.p = 672 X 3.2 = $2177.28
TVC = Lxw = 6X324 = $1944.00
Profit T 6R TC
= 2177.28 TVC - TFC
2177.28 1944 TFC
= 4233.28 TFC
In c) L = 7,X = -(7)3 + 10(7)2 + 88(7)=763
Price = $4
TR = 763 x 4 = $3052
TVC = 7 x 324 = $2268
Profit = 3052 2268 TFC = $784 TRC
Thus the increasing profit is 784 TFC 9233.28 TFC) = 784 233.28 = $550.72
Q2 Q1 P1 P2
d) Are elasticity = ,
P2 P1 Q1 Q2

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 Q2 = 763, Q1 = 672, P1 = 3.24, P2 = 400
(763 672) (3.24 4)
Are elasticity = , 0.6041
(4 3.24) (672 763)
Are elasticity = 0.6041
w
c) MPP1 , w $480, p $4
l
MPP1 = -3L2 + 20L + 88
480
3L2 20 L 88 120
4
3L 20L + 32 = 0
8
L ..OR..L 4 L 4
3
At L = 4, MPP1 = 120
APP1 = -L + 10L + 88 = - (4) + 88 = 112
MPP1 . APP1 , thus stage 1
Hence the firm closes down and its output is zero.
A production function is said to be homogeneous if when each input factor is
multiplied by a positive real constant K, the constant can be completely factored out.
Mathematically, a function Z =f(x,v) is homogeneous of degree n if for all positive
real values of k. f(kx,kv) = K f(x,v) i.e
1) 8v, 9v is homogeneous of degree 1 because f(kx,kv) =8kx = 9kv = k(8x+9y)

2) Z = x2 + xy + y is homogeneous of degree 2 because

f(kx,ky) = (kx)2 + (kx)(ky)2 = k 3 x 2 xy y 2
3) z=x y is homogeneous of degree less than 1 because
= k0.3+0.7 x0.3 y0.4
= k0.2 x0.3 y0.4
2x
4) z= is homogeneous of degree o because
y

2kx 2x 2x
f (kx, ky) k 0
ky y y
5 z = x3 + 2xy + + y2 is not homogeneous because k cannot be completely
f(kx,ky) = (kx)3 + 2(kx)(ky)3

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 = k3 x3 + 2k2 xy = k3 y3

= k 2 kx3 2 xy ky3

Question 7
Given the profit function = 160x 3x2 2xy 2y2 + + 120 - 18
For a firm producing to goods x and y,
a) Maximize profits

b) Test the second-order condition and

c) Evaluate the function at the critical values x and y

Solution
= 160x -3x2 2xy 2y2 + 120y - 18
d
x 160 6 x 2 y
dx
d
y 2 x 4 y 120
dy
Set and m equal to zero and solve simultaneously for x and v
160 6x 2y = 0
3x + y = 80 (1)
-2x 4y + 20 = 0
X + 2y = 60 . (2)
From 1) and 2)
X = 20 y = 20
d 2
b) xx 6
d 2
d 2
yy 4
d 2
d 2 d d
xx 2
dxdy dx dy
With both xx yy negative and xx yy > ( xx)2
i.e. -6x -4 > (-2)2 , 24 > 4
is maximized at x = 20 and y = 20
c) = 160x -3x2 -2xy 2y2 + 120y 18

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 when x = 20 and y = 20
= 160 (20) -3 (20)2 -2(20)(20) -2(20)2 + 120(20) 18 = 2782

TUTORIAL SHEET
1) A monopolist sells two goods x and y for which the demand functions are

X = 25 = 0.5 Px, y = 30 Py and the combined cost function is C = x2 + 2xy + y2 20

Find a) the profit-maximizing price for each good
c) the profit maximizing price for each good

d) the maximum profit

2) Find the profit-maximizing level of a) output b) profit for a

monopoiist with the demand function x = 50 0.5Px, y=76 - Py
and the total cost function c = 3x2 + 2xy + 2y2 + 55

3) a) Maximize utility U = Q1Q2 when Px = 1, Py = 4 ones budget B = 120

b) Estimate the effect of a 1=unit increase in the budget (Marginal utility
of money)

4) Use the properties of homogeneity to show that a strict Cobb-Douglas production

Function q = AK L , where + = 1, exhibits constant returns to scale
5) Given the utility function U Q1Q2 + Q1 + 2Q2, maximize U subject to
P1 = 2 P2 = 5 and B = 100

6) Determine the level of homogeneity and returns to scale for each of

The following functions:

i) Q = x2 + 6xy + 7y2

ii) Q = x2 xy2 + 3y3 + x2y

3x 2
iii) Q
5y2

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Note
7) A monopolists production function and the factor prices that he must pay are such
that he can produce any output at a constant level of average cost $5 per unit. He
sells his product in two distict markets between which price discrimination is
possible. The demand curves in the two markets are given by the equations:

Q1 = 55 = P1,Q2 = 70 2P2
The monopolist maximizes his total pure profit. Calculate
a) The total output

b) The quantity sold in each market

c) The price in each market

d) The monopolists total profit

8) A monopolist sells his output in two distinct markets between which price
discrimination is possible. His total costs and the demand curves are given by the follwing
equations: TC = 8Q + 100,Q1 = 10 0.5P1,Q2 = 40 P2

a) Calculate from-maximizing values for P! P2 ,Q1 and Q2

b) Prove that the higher price is charged in the market with the lower elasticity of
demand.

9) A firm produces a single product X, from two factors, A and B. The factor prices are
constants Pa and Pb. The production function is
X = Aa B1-a where and are constants and ) < < l

a) Derive the firm;s long-run total cost cost function

b) If = 1 and = 0.5, derive equations for long-run average cost and long-run
marginal cost;

c) If = 1 and o.5, derive the short-run total cost function when B is fixed, B

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 d) = 1 and = o.5 and B = 20, derive equations for short-run variable cost, and short
run average variable cost, and short run marginal cost:

If 1 and = 0.5 B = 20, Pa=4 and Pb

e) = 9 at what output of X is the firm in possible long-run equilibrium?

10) Find the equilibrium price and quantity for the following markets:
a) Qx = -20 = = 3p and Qd = 220 5P
b) Qx = -45 + 8P and Qd = 125 2P
c) Qx + 32 7P = 0 and Qd 128 + 9P = 0
d) 13P Qx = 27 and Qd + 4P 24 = 0

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