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1. Graph Sketching
The rst step towards understanding an economic model is often to draw pictures: graphs
of supply and demand functions, utility functions, production functions, cost functions, and
so on. In previous chapters we have used a variety of methods, including dierentiation, to
work out the shape of a function. Here it is useful to summarise them, so that you can use
them in the economic applications in this chapter.
1.1. Guidelines for Sketching the Graph of a Function y(x)
Look at the function y(x) itself:
to nd where it crosses the x- and y-axes (if at all), and whether it is positive
or negative elsewhere;
to see what happens to y when x goes towards ;
to see whether there are any values of x for which y goes to .
Look at the rst derivative y
105
4
x 3.31 or x 1.81
So the function crosses the x-axis at 1.81, 0, and 3.31.
(iii) What happens to y(x) = 2x
3
3x
2
12x as x becomes innite?
For a polynomial, it is the term with the highest power of x that determines what
happens when x becomes innite it dominates all the other terms. In this case:
2x
3
as x , so y(x) as x
2x
3
as x , so y(x) as x
(iv) Are there any nite values of x that make y(x) innite?
No; we can evaluate y(x) for all nite values of x.
(v) The rst derivative of the function is:
y
(x) = 6x
2
6x 12
Stationary points occur where y
(x) = 0:
6x
2
6x 12 = 0
x
2
x 2 = 0
(x + 1)(x 2) = 0
x = 1 or x = 2
So there are stationary points at x = 1, y = 7 and x = 2, y = 20
(vi) The second derivative of the function is:
y
(x) = 12x 6
At (1, 7), y
(y) = 4y + 3
(iii) What is the average cost function?
AC(y) =
C(y)
y
= 2y + 3 +
8
y
(iv) Show that the marginal cost curve passes through the point of minimum average cost.
The derivative of the average cost function is:
dAC
dy
= 2
8
y
2
The average cost function has stationary point(s) where its derivative is zero:
2
8
y
2
= 0 y = 2 (ignoring negative values of y)
100 6. MORE DIFFERENTATION, AND OPTIMISATION
Look at the second derivative to see if this is a miminum:
d
2
AC
dy
2
=
16
y
3
Since this is positive when y = 2 we have found a minimum point. At this point:
y = 2, AC(y) = 11 and MC(y) = 11
So the marginal cost curve passes through the point of minimum average cost.
(v) Sketch the marginal and average cost functions.
We will sketch the functions for positive values of y only, since negative values are of no
economic interest. Sketching MC(y) is easy: it is a straight line, of gradient 4, crossing
the vertical axis at 3, and (from above) passing throught the point (2,11).
For the average cost function:
AC(y) =
C(y)
y
= 2y + 3 +
8
y
we already know that it has one stationary point, which is a minimum. Also, we have
found the second derivative, and it is positive for all positive values of y, so the gradient
is always increasing.
We can see by looking at AC(y) that as y 0, AC(y) , and that as y ,
AC(y) . The function does not cross either of the axes.
.
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Cost
y
10
20
6 4 2
MC(y)
AC(y)
Exercises 6.1: Sketching Graphs
(1) (1) Sketch the graphs of the functions:
(a) a(x) = (1 x)(x 2)(x 3) (b) b(x) = x
1
2
(x 6) for x 0.
(2) A rm has cost function C(y) = y
3
+ 54. Show that the marginal cost function
passes through the point of minimum average cost, and sketch the marginal and
average cost functions.
(3) A rm has cost function C(y) = 2y + 7. Sketch the marginal and average cost
functions.
6. MORE DIFFERENTATION, AND OPTIMISATION 101
2. Introduction to Optimisation
In economic applications we often want to nd the (global) maximum or minimum of a
function. For example, we may want to nd:
the level of output where a rms prot is maximised
the level of output where a rms average cost of production is minimised
the number of hours per week that an individual should work, if he wants to maximise
his utility.
Usually in economic applications the relevant function just has one stationary point, and this
is the maximum or minimum that we want. But, having found a stationary point it is always
wise to check that it is a maximum or minimum point (whichever is expected) and that it is
a global optimum.
2.1. Prot Maximisation
Suppose that a rm producing y units of output has cost function C(y), and faces inverse
demand function P(y). (In other words, if the rm makes y units, the total cost is C(y), and
each unit can be sold at a price P(y).)
The rms Revenue Function is: R(y) = yP(y)
The rms Prot Function is: (y) = R(y) C(y) = yP(y) C(y)
The rms optimal choice of output is the value of y that maximises its prot (y).
So we can nd the optimal output by nding the maximum point of the prot function.
Examples 2.1: A monopolist has inverse demand function P(y) = 162y and cost function
C(y) = 4y + 1.
(i) What is the optimal level of output?
The prot function is:
(y) = y(16 2y) (4y + 1)
= 12y 2y
2
1
Look for a maximum point where the derivative is zero:
d
dy
= 12 4y = 0 y = 3
To check that this is a maximum look at the second derivative:
d
2
dy
2
= 4 so it is a maximum
If you think about the shape of the function (or sketch it), you can see that this the
global maximum. So the optimal choice of output is y = 3.
(ii) How much prot does it make?
When y = 3:
(3) = 12 3 2 9 1 = 17
Prot is 17.
102 6. MORE DIFFERENTATION, AND OPTIMISATION
2.2. Marginal Cost, Marginal Revenue, and Prot Maximisation
We know that Marginal Cost is the cost of an additional unit of output, which is the derivative
of the cost function:
MC(y) =
dC
dy
Similarly Marginal Revenue is the revenue obtained when one more unit of output is sold,
and it is the derivative of the revenue function:
MR(y) =
dR
dy
To nd the optimal level of output, we look for the point where
d
dy
= 0.
But we can write the prot function as:
(y) = R(y) C(y)
d
dy
=
dR
dy
dC
dy
So the optimal level of output is where:
dR
dy
=
dC
dy
Marginal Revenue = Marginal Cost
The optimal level of output for a prot-maximising rm is
where
d
dy
= 0, or (equivalently) where MR = MC
If you want to nd the prot-maximising output you can either look for a stationary point
of the prot function, or solve the equation MR = MC.
Exercises 6.2: Introduction to Optimisation
(1) (1) A competitive rm has cost function C(q) = 3q
2
+ 1. The market price is p =
24. Write down the rms prot as a function of output, (q). Find the prot-
maximising level of output. How much prot does the rm make if it produces
the optimal amount of output?
(2) A monopolist faces demand curve Q
d
(P) = 10 0.5P. Find the inverse demand
function P
d
(Q), and hence the revenue function R(Q), and marginal revenue.
Suppose the monopoly wants to maximise its revenue. What level of output should
it choose?
(3) A competitive rm produces output using labour as its only input. It has no xed
costs. The production function is y = 6L
0.5
; the market price is p = 4, and the
wage (the cost of labour per unit) is w = 2. Write down the rms prot, as a
function of the number of units of labour it employs, (L). How many units of
labour should the rm employ if it wants to maximise its prot?
Further Reading and Exercises
Jacques 4.6.
Anthony & Biggs 8.1, 8.2.
6. MORE DIFFERENTATION, AND OPTIMISATION 103
(x) = u(x)v
(x) + u
(x)v(x)
or equivalently
dy
dx
= u
dv
dx
+ v
du
dx
Examples 3.1: Product Rule
(i) Dierentiate y(x) = (5x + 3)(x
2
x + 1)
Put u(x) = 5x + 3, and v(x) = x
2
x + 1:
dy
dx
= (5x + 3)(2x 1) + 5(x
2
x + 1)
= 15x
2
4x + 2
(ii) Dierentiate 2x
3
2
(x
3
2)
f(x) = 2x
3
2
(x
3
2)
Put u(x) = 2x
3
2
and v(x) = x
3
2:
f
(x) = 2x
3
2
3x
2
+ 3x
1
2
(x
3
2)
= 9x
7
2
6x
1
2
3.2. Quotient Rule
So far we have no method for dierentiating a function such as:
y(x) =
3x 2
2x + 1
but there is a rule for dierentiating the quotient of two functions:
The Quotient Rule: If y(x) =
u(x)
v(x)
then
y
(x) =
u
(x)v(x) u(x)v
(x)
v(x)
2
or equivalently:
dy
dx
=
v
du
dx
u
dv
dx
v
2
104 6. MORE DIFFERENTATION, AND OPTIMISATION
Examples 3.2: Quotient Rule
(i) Dierentiate g(x) =
3x 2
2x + 1
Putting u = 3x 2 and v = 2x + 1:
dg
dx
=
(2x + 1) 3 (3x 2) 2
(2x + 1)
2
=
6x + 3 6x + 4
(2x + 1)
2
=
7
(2x + 1)
2
(ii) Dierentiate h(x) =
3x
x
2
+ 2
h
(x) =
(x
2
+ 2) 3 3x 2x
(x
2
+ 2)
2
=
3x
2
+ 6 6x
2
(x
2
+ 2)
2
=
6 3x
2
(x
2
+ 2)
2
3.3. Chain Rule
To dierentiate the function:
y(x) = 4(2x
3
1)
7
we could multiply out the brackets to obtain a very long polynomial (of degree 21) and then
dierentiate. But this would take a very long time. Instead we can do it by writing y as a
function of a function:
y = 4u
7
where u = 2x
3
1
and then using the Chain Rule:
The Chain Rule
If y is a function of u, and u is a function of x:
dy
dx
=
dy
du
du
dx
Applying this to the example above:
dy
dx
= 28u
6
6x
2
= 28(2x
3
1)
6
6x
2
= 168x
2
(2x
3
1)
6
The Chain Rule is the rule for dierentiating a composite function (see Chapter 4). Another
way of writing it is:
Alternative Form of the Chain Rule
If y(x) = v(u(x))
y
(x) = v
(u(x))u
(x)
6. MORE DIFFERENTATION, AND OPTIMISATION 105
Examples 3.3: Dierentiate the following functions using the Chain Rule:
(i) y(x) = (1 8x)
5
y = u
5
where u = 1 8x
dy
dx
= 5u
4
(8) = 5(1 8x)
4
(8) = 40(1 8x)
4
(ii) f(x) =
_
(2x 3)
First write this as: f(x) = (2x 3)
1
2
. Then:
f = u
1
2
where u = 2x 3
f
(x) =
1
2
u
1
2
2
=
1
2
(2x 3)
1
2
2
=
1
2x 3
(iii) g(x) =
1
1 + x
2
g =
1
u
where u = 1 + x
2
g
(x) =
1
u
2
2x
=
2x
(1 + x
2
)
2
(Note that we could have done this example using the quotient rule.)
3.4. Dierentiating the Inverse Function
x
y
.
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x
y
Remember from Chapter 5 that the derivative of a function is
approximately equal to the ratio of the change in y to the change
in x as you move along the function:
dy
dx
y
x
If a function has an inverse:
y = f(x) and x = f
1
(y)
then the gradients of these two functions are:
dy
dx
y
x
and
dx
dy
x
y
So the gradient of the inverse function f
1
=
1
the gradient of the function f
dx
dy
=
1
dy
dx
We will use this rule in later sections of this chapter.
106 6. MORE DIFFERENTATION, AND OPTIMISATION
Exercises 6.3: More Rules for Dierentiation
(1) (1) Use the product rule to dierentiate:
(a) y(x) = (x
2
+ 3x + 2)(x 1) (b) f(z) = z(1
z)
(2) Use the quotient rule to dierentiate: k(x) =
x + 1
2x
3
+ 1
(3) Use the chain rule to dierentiate: (a) a(x) = 2(2x 7)
9
(b) b(y) =
_
y
2
+ 5
(4) For a rm facing inverse demand function P(y) =
1
2y + 3
, nd the revenue function
R(y), and the marginal revenue.
3.5. More Complicated Examples
Examples 3.4: Sometimes we need more than one of the product, quotient and chain rules:
(i) Dierentiate the function y(x) = x
3
(x
2
+ 1)
4
.
By the Product Rule:
dy
dx
= x
3
d
dx
_
(x
2
+ 1)
4
_
+ 3x
2
(x
2
+ 1)
4
Then use the Chain Rule to dierentiate the term in curly brackets:
dy
dx
= x
3
4(x
2
+ 1)
3
2x + 3x
2
(x
2
+ 1)
4
= 8x
4
(x
2
+ 1)
3
+ 3x
2
(x
2
+ 1)
4
Factorising:
dy
dx
= x
2
(x
2
+ 1)
3
(11x
2
+ 3)
(ii) Dierentiate: f(x) =
_
x
x +
_
(x) =
_
x
x +
_
1
d
dx
_
x
x +
_
Then use the Quotient Rule to dierentiate the term in curly brackets:
f
(x) =
_
x
x +
_
1
_
(x + )
2
_
=
x
1
(x + )
+1
Exercises 6.4:
(1) (1) Find the derivative of y(x) =
_
x
1 x
(2) Dierentiate z(t) =
t
a
(2t + 1)
b
where a and b are parameters.
(3) If f(q) = q
5
(1 q)
3
, for what values of q is f(q) increasing?
(4) (Harder) Using the chain rule and the product rule, derive the quotient rule.
Further Reading and Exercises
Jacques 4.4.
Anthony & Biggs 6.2, 6.4 and 6.5.
6. MORE DIFFERENTATION, AND OPTIMISATION 107
4. Economic Applications
4.1. Minimum Average Cost
If a rm has total cost function C(q), where q is its output, its average cost function is:
AC(q) =
C(q)
q
The derivative of the average cost function can be found using the Quotient Rule:
dAC
dq
=
qC
(q) C(q)
q
2
At a point where average cost is minimised,
dAC
dq
= 0, so:
qC
(q) C(q) = 0
C
(q) =
C(q)
q
MC = AC
We have proved that for any cost function, MC = AC when AC is minimised: the marginal
cost function passes through the minimum point of the average cost function.
4.2. The Marginal Revenue Product of Labour
If a rm uses labour to produces its output y, with production function f(L), revenue is a
function of output, and output is a function of labour:
Revenue = R(y) where y = f(L)
The marginal revenue product of labour is the additional revenue generated by employing one
more unit of labour:
MRPL =
dR
dL
Using the chain rule:
dR
dL
=
dR
dy
dy
dL
= MR MPL
The marginal revenue product of labour is the marginal revenue multiplied by the marginal
product of labour.
Exercises 6.5:
(1) (1) A rm has cost function C(q) = (q +2)
_
= p
_
1
1
||
_
From this expression we can see that revenue is increasing with quantity if and only if || > 1:
that is, if and only if demand is elastic.
5.4. Other Elasticities
We can dene other elasticities in just the same way as the price elasticity of demand. For
example:
If q
s
(p) is a supply function, the elasticity of supply is
p
q
s
dq
s
dp
If Y (L) is a production function,
L
Y
dY
dL
is the elasticity of output with respect to
labour.
Exercises 6.6: Elasticity
(1) (1) Find the price elasticity of demand for the demand function Q
d
(P) = 100 5P,
as a function of the price. What is the elasticity when P = 4?
(2) If the inverse demand function is p
d
(q) = 10+
20
q
, nd the price elasticity of demand
when q = 4.
(3) Find the elasticity of supply, as a function of price, when the supply function is:
q
s
(p) =
3p + 4.
(4) Show that demand function q
d
(p) = p
dy
dx
= 2 3e
3x
= 6e
3x
(ii) Y (t) = ae
bt
Y
(t) = a (b) e
bt
= abe
bt
(iii) k(x) = 5e
x
4
+2x
Using the chain rule: k
(x) = 5e
x
4
+2x
(4x
3
+ 2)
= 5(4x
3
+ 2)e
x
4
+2x
6.2. The Derivative of the Logarithmic Function
The logarithmic function lnx is the inverse of the exponential function, and we can use this
to nd its derivative:
y = lnx x = e
y
dx
dy
= e
y
= x
dy
dx
=
1
dx
dy
=
1
x
So we have obtained a rule for dierentiating lnx:
If y = lnx then
dy
dx
=
1
x
1
You could try to verify this by dierentiating e
x
= lim
n
1 +
x
n
n
.
112 6. MORE DIFFERENTATION, AND OPTIMISATION
Examples 6.2: Dierentiate the following functions:
(i) f(x) = ln(5x)
Again we can use the chain rule: f
(x) =
1
5x
5 =
1
x
(ii) p(q) = 3 ln(q
2
5q)
p
(q) = 3
1
q
2
5q
(2q 5) =
3(2q 5)
q
2
5q
Exercises 6.7: Dierentiation of Exponential and Logarithmic Functions
(1) (1) Dierentiate the function: f(x) =
1
2
e
8x
.
(2) What is the derivative of 4 ln(3x + 1)?
(3) Find the derivative of C(q) = 3qe
q
2
+ 4e
2q
.
(4) Dierentiate the function: g(y) = y
2
ln(2y)+2. For what values of y is g increasing?
(5) Find and classify the stationary points of the function: F(t) = e
t
(t
2
+ 2t 2).
(6) If f(x) is any function, nd the derivative of (a) y(x) = e
f(x)
(b) z(x) = lnf(x).
6.3. Economic Application: Growth
In Chapter 4, we modelled the GDP of a country as depending on time, according to the
equation:
Y (t) = Y
0
e
0.03t
(Remember that the parameter Y
0
represents GDP at time t = 0.)
Dierentiating this equation we get:
Y
(t) = 0.03Y
0
e
0.03t
= 0.03Y (t)
So we can now see that the rate of increase of GDP, Y
(t), is a constant proportion, 0.03, of
GDP. In other words, GDP is growing at a rate of 3%.
6.4. Economic Application: The Optimum Time to Sell an Asset
F(t)
t .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Suppose that, as a forest grows over time,
the value of the timber is given by F(t),
where F is an increasing, concave, func-
tion of time. Then, if the interest rate is
r, the present value of the forest at time t
is:
V (t) = F(t)e
rt
(See Chapter 3.)
6. MORE DIFFERENTATION, AND OPTIMISATION 113
The best time to cut down the forest and sell the timber is when the present value is max-
imised. Dierentiating (using the product rule):
dV
dt
= F
(t)e
rt
rF(t)e
rt
= (F
(t) rF(t))e
rt
The optimum moment is when
dV
dt
= 0:
F
(t) = rF(t)
F
(t)
F(t)
= r
This means that the optimum time to sell is when the proportional growth rate of the forest
is equal to the interest rate. (You can verify, by dierentiating again, that this is a maximum
point.)
To see why, call the optimum moment t
. After t
, the forest grows fast: it oers a better rate of return than the bank.
Exercises 6.8:
(1) (1) A painting is bought as an investment for 3000. The artist is increasing in
popularity, so the market price is rising by 300 each year: P(t) = 3000 + 300t.
If the interest rate is 4%, when should the painting be sold?
(2) The output Y of a country is growing at a proportional rate g and the population
N is growing at a proportional rate n:
Y (t) = Y
0
e
gt
and N(t) = N
0
e
nt
Output per person is y(t) =
Y (t)
N(t)
. Using the quotient rule, show that the propor-
tional rate of growth of output per person is g n.
Further Reading and Exercises
Jacques 4.8.
Anthony & Biggs 7.2 and 7.4.
For more discussion of When to cut a forest see Varian, Intermediate Microeco-
nomics, Chapter 11 and its Appendix.
114 6. MORE DIFFERENTATION, AND OPTIMISATION
Solutions to Exercises in Chapter 6
Exercises 6.1:
(1) (a) Graph crosses y-axis
at y = 6 and x-axis
at 1,2 and 3. Max
at x = 2.577; min at
x = 1.423. a
as x and a
as x .
(b) Graph passes
through (0,0) and
crosses x-axis at
x = 6. Min at
x = 2, b = 5.66.
Convex: b
(x) > 0
for all x. b as
x .
(2) MC = 3y
2
; AC = y
2
+
54
y
. AC is minimised
when y = 3. At this point
MC = AC = 27.
(3) MC is a horizontal
line MC = 2. AC is
downward-sloping and
convex. As y 0,
AC , and as y ,
AC 2.
Exercises 6.2:
(1) (q) = 24q 3q
2
1.
Prot is maximised when
q = 4. (4) = 47.
(2) P
d
(Q) = 20 2Q
R(Q) = (20 2Q)Q
MR = 20 4Q
Revenue is maximised
when Q = 5.
(3) (L) = 24L
0.5
2L.
Prot is maximised when
L = 36.
Exercises 6.3:
(1) (a) y
(x) = 3x
2
+ 4x 1
(b) f
(z) = 1
3
2
z
(2) k
(x) =
14x
3
6x
2
(2x
3
+1)
2
(3) (a) a
(x) = 36(2x 7)
8
(b) b
(y) =
y
y
2
+5
(4) R(y) =
y
2y+3
MR =
3
(2y+3)
2
Exercises 6.4:
(1) y
(x) =
1
2x
1
2 (1x)
3
2
(2) z
(t) =
t
a1
(a+2at2bt)
(2t+1)
b+1
(3) f
(q)
= 5q
4
(1q)
3
3q
5
(1q)
2
= q
4
(1 q)
2
(5 8q)
So f is increasing when
q <
5
8
.
(4) Let y(x) =
u(x)
v(x)
. Write it
as:
y(x) = u(x) (v(x))
1
dy
dx
=
du
dx
v
1
+ u
d
dx
{v
1
}
=
du
dx
v
1
uv
2 dv
dx
= v
2
_
v
du
dx
u
dv
dx
_
=
v
du
dx
u
dv
dx
v
2
Exercises 6.5:
(1) q =
2
1
(2) (a) R(Q) =
54Q
Q+9
(b) (i) Q = 9
(ii) MPL =
1
9
(iii) P = 3
(iv) MR =
3
2
(v) MRPL =
1
6
Exercises 6.6:
(1) =
5P
1005P
; =
1
4
(2) 3
(3)
3p
2(3p+4)
(4) = p
1
p
q
= p
1
q
=
Exercises 6.7:
(1) f
(x) = 4e
8x
(2)
12
3x+1
(3) 3(1 + 2q
2
)e
q
2
8e
2q
(4) g
(x) = f
(x)e
f(x)
(b) z
(x) =
f
(x)
f(x)
Exercises 6.8:
(1) The present value is
(3000 + 300t)e
0.04t
.
This is maximised when
t = 15.
(2) y
(t) =
N(t)Y
(t)Y (t)N
(t)
N
2
But:
Y
= gY and N
= nN
so:
y
=
gNY nNY
N
2
= (g n)
Y
N
= (g n)y
2
This Version of Workbook Chapter 6: August 22, 2003
6. MORE DIFFERENTATION, AND OPTIMISATION 115
_
t
(b) Explain why the present value of the revenue received if the wine is sold in t
years is given by:
V (t) = Aexp
_
t
1
2
rt
_
(c) Dierentiate V , and hence determine the optimum time to sell the wine.
(d) Explain intuitively why the wine should be kept longer if the interest rate is
low.
(e) If the interest rate is 10%, should the Governing Body support the Bursar or
the economist?