Topic 0: Math for Managerial Economics

Introduction: Economic analysis is precise. It relies on fully specified assumptions embodied in economic models. Thus, we do some math, and we draw lots of graphs. In managerial economics we frequently examine optimization problems, either maximization or minimization problems. For example, well discuss different versions of profit maximization, corresponding to different environments but where the firm always wants to maximize profits. Solving optimization problems uses elementary calculus. So well develop the basics of this approach. I realize that this may be intimidating to some of you. I emphasize that what we will do is not difficult. We just need some very basics. This will also be helpful in many of the other courses you will take in this program. Before we start, one more comment: The ideas we develop will get clearer as we apply them in the course!

Outline: 1. 2. 3. 4. Functions. Tangents and slopes. Derivatives: Meaning and computation. Derivatives with multivariable functions.

1. Functions: Single variable: A single variable function gives the level of one variable (y) as determined by another variable (x). The defining feature of a function is that a value of x implies a unique value of y. Notation: Two standard notations: (i) y = f(x). (ii) f = f(x). In notation (i), the function value is given another label (y), beside f. In notation (ii), the function value is just called one thing (f). Examples: General form examples: Suppose that a firms profits () are determined by the quantity the firm sells (q). Then we have the functional relationship: = (q). (Im using notation (ii) that economists usually use.) Suppose that a firms total costs (C) are determined by the quantity (q) the firm produces. Then we have the functional relationship C = C(q), again using notation (ii).

Specific form examples: = 1000q q 2 C = 500 + 4q +q2 C = 300 + 2q (straight line example)

Graphing Functions: The determining value is usually measured on the horizontal axis, and the functional value is usually measured on the vertical axis. Other terminology for these two values is, respectively, the independent variable (determining value) and the dependent variable (functional value). Well focus on continuous (no jumps) and smooth (no kinks) functions. Examples are graphed on next page.

q C

q Figure 0.1: Functions Graphed

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Multivariable Functions: A multivariable function gives the level of one variable (y) as determined by more than one other variable (x1,x2,,xn). The defining feature of such a function is that a set of values of the xis implies a unique value of y. The xis are frequently referred to as the independent variables and the function value (y) as the dependent variable. Notation: Again, two standards: (i) y = f(x1,x2,,xn) (ii) f = f(x1,x2,,xn) General Form Examples: Total profits () in a market with two sellers might depend on the level of each of their outputs, q1 and q2. Thus: = (q1,q2). The price (P) at which a product can be sold might depend on the total quantity that is sold (q) and the average level of buyer incomes (I). Then: P = P(q,I). The quantity of a firms output (q) might depend on the level of labor employed (L) and the level of machine inputs employed (K). Then: q = q(L,K). Specific Form Examples:
2 (q 1 ,q 2 ) = 1000(q1 + q 2 ) q1 q2 2 2q1q 2

P(q,I) = 200I 2q2

Graphing Multivariable Functions: We wont much be concerned with this, except for one possibility discussed in a moment. But note these things: To graph a function, you need an axis for the functional value and each independent variable. If there are more than two independent variables, then it is impossible to graph the entire function since we only have three dimensions of space. If there are two independent variables, then, if youre talented, you can draw a three dimensional picture. We wont need to do this. Sometimes well have a multivariable function and well be interested in just the relationship between one of the independent variables and the function value. We can find this relationship if we fix the other independent variables. In effect, then, we have a single variable function that we can graph. Example: Suppose that price (P) depends on the quantity sold (q) and average consumer income as in the example above: P(q,I) = 200I 2q2 If we fix I at say I = 50,000, then we have a functional relationship between q and P: P = (200)(50,000) 2q2. We could obviously graph the latter. We could as well find the functional relationship between q and P for a different value of I, say I = 75,000. This would be given by: P = (200)(75,000) 2q2. Again, we could graph this.

2. Tangents and Slopes A straight line function has a slope. The general form of a straight line function is: y = a + bx, where a and b are constants. An example would be: y = 100 + 5x. The slope of a straight line function is the ratio of the change in y to a change in x. This ratio will be the same for any change in x. (This is generally written as y / x. ) For the general form y = a + bx, the slope will be given by b. (This is easy to prove.) For the example y = 100 +5x, the slope would be 5. The slope has a very useful interpretation. It tells you the rate at which the functional value (y) is changing as the independent variable (x) is changed. For example, if the slope is 5 and x rises by 1, then y would rise by 5 (i.e., the change in y equals the change in x times the slope). If x were to rise instead by 2, then y would rise by 10.

Now consider a non-linear function. Refer to the example in Figure 0.2 of a profit function. Again, we will be interested in how the functional variable changes as the independent variable changes. Well explain further why were interested in this in a few minutes. Consider this question: At what rate does profit change as quantity is changed? When the function is non-linear, the answer depends on where you are on the function. At q = q1, the rate at which profit changes as q changes is given by the slope of the tangent line at that point on the function. At q = q2, the rate at which profit changes is given by the slope of the tangent line at that point on the function. The tangent line at a point on a function is the straight line that just touches but doesnt cross the function. The rate at which a function value changes as the independent variable changes the slope of the tangent line is the derivative of the function. Sometimes the derivative is referred to as the instantaneous slope.

Tangent line at q=q1; its slope equals the rate changes as q changes when q=q1.

Tangent line at q=q2; its slope equals the rate changes as q changes when q=q2.

. .

q1

q2

Figure 0.2: Tangent lines and rates of change

3. Derivatives: Meaning and Computation: Suppose that I have a function, say profits as a function of quantity produced, and I can compute its derivative. What good does this do me?? There are two related applications: Application 1 of Derivatives: Solving optimization problems. Refer to the upper panel of Figure 0.3, which graphs the profit function. The firm wants to find the output where profits are at a maximum. We can see in the graph that the output that leads to profit maximization is q*. (Well typically use a * to indicate an optimal value.) How can we compute q* if we have the function? Note that the maximum has the property that the slope of the corresponding tangent line i.e., the derivative is equal to 0 at q*. This points to a method to find q*. If we compute the derivative of the function and set it equal to 0, this will give us an equation in q, the solution of which will be q*. Youll see this precisely in a bit when we do an example. Note, well, that this approach also works when our objective is to minimize a function. The lower panel of Figure 0.3 depicts an example of total cost (C) as a function of the ratio (R) of two types of labor inputs. The firm would want to hire the inputs in the ratio that minimizes total cost of producing. We can see in the graph that the cost minimizing ratio is R*. At R*, the slope of the tangent line is 0 the derivative is 0. If we can compute the derivative of the function, then we can set it equal to 0 and solve for R*.

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Figure 0.3: Derivative Equals 0 at Maximum and Minimum

(q)

derivative of (q) is 0 here

q* C(R)

derivative of C(R) is 0 here

.
R* R
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I should mention that there are some pitfalls associated with the basic technique to solve optimization problems, but well just deal with them when we need to do so. (Briefly discuss an example of this.) Almost without exception, well deal in environments where the pitfalls are a non-issue. Application 2 of Derivatives: Generally, the derivative provides useful information, this depending on the particular application. Well develop this kind of application throughout the course, but let me just mention a couple of examples to begin to clarify the idea. Take, again, the example of profits as a function of quantity. Suppose the firm is producing a particular quantity, say q1. Suppose that the derivative of profits at q = q1 is positive. This means that the rate of change of profits as q increases is positive. This means that the firm wants to produce more it would increase profits by doing so! Consider total cost of a firm and suppose that it is a function of quantity produced (which, of course, makes sense). Economists have a name for the derivative of this total cost function: Its called marginal cost. Marginal cost is the rate at which total cost changes as quantity changes. As we will see, marginal cost is a useful measure of cost. Why? If I can sell the next unit produced for $100 and thus increase revenues by $100 and if I know marginal cost equals $60 then I certainly want to produce the next unit and sell it. I would increase my profits by the difference, $40. (Well discuss this example much more thoroughly later.)

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Computing the Derivative. To solve numerical problems, well need to compute derivatives in simple cases of functions. Well stick to cases that reduce to polynomial functions. Polynomial functions are of this form: f(x) = a0 + a1x + a2x2 + + anxn, where the ais are constants. Examples: f(x) = 10 + 2x 4x2 f(x) = 12x + x4 f(x) = 7 (this is a degenerate function of x as f doesnt vary with x) There are a few rules of differentiation that allow us to compute the derivative of any such example. Notation of Derivatives: (i) y = f ( x ) derivative isdenoted (ii) y = f ( x ) derivative isdenoted

dy dx df dx

(There is another standard notation that I wont use, but you might see it elsewhere. It is: y = f ( x ) derivative isdenoted f '(x) )

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Two basic rules of differentiation:

Rule 1. Differentiating a One-Term Polynomial:

y = axb , where a,b are cons tan ts dy = baxb1 dx

Two important special cases of the latter rule are: (i) y = ax or b = 1 (ii) y = a or b = 0
dy =a dx

dy =0 dx

Rule 2. Differentiating a Sum of Functions:

y = f1 (x) + f 2 (x) + ... + fn (x) df dy df1 df 2 + .... + n = + dx dx dx dx

In words, Rule 2 is that the derivative of a sum of functions is the sum of the derivatives of the individual functions. With the latter two rules we can differentiate any polynomial. Examples:
f(x) = 10 + 2x 4x2

df = 0 + 2 2 4 x 21 = 2 8x dx

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f(x) = 12x + x4 f(x) = 6x

df = 12 + 4x41 = 12 + 4x 3 dx

df = 6 (function is a straight line; rate of change dx is a constant, i.e., the same everywhere on the function) df = 0 (f is always 7, it doesnt really depend on x, dx so the rate of change of f as x changes is always 0)
Examples of Solving Optimization Problems:

f(x) = 7

Example 1: Recall the example of profits as a function of the quantity produced: (q) = 1000q q2 At what q are profits maximized? Compute the derivative and set it equal to 0, and then solve for q:
d = 1000 2q = set 0. dq

The solution is q* = 500. The corresponding profits are: (500) = 1000 500 5002 = 250,000. (You cant get profits any higher than 250,000!)

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Example 2: Suppose that total cost as a function of the output produced is: C(q) = 500 + 4q + q2 It is a silly problem to think about minimizing total cost with respect to the output produced, because then you would just produce nothing. But we might be interested in finding the output level where the cost per unit of output or average cost is at a minimum. Average cost (AC) is equal to total cost divided by q. Thus:
500 + 4q + q 2 500 AC(q) = + 4 + q = 500q 1 + 4 + q = q q

This is a polynomial so we can find the derivative:

dAC 500 = ( 1)(500)q 2 + 0 + 1 = 2 + 1 = set 0 dq q

Solving the latter equation gives:

q * = 500 = 10 5 22.36.

Computing average cost at this output gives: AC(22.36) = 500(22.36)-1 + 4 + 22.36 48.72 Thats as low as you can get average cost.

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The other type of application of using derivatives to provide useful information well see plenty of examples as the course unfolds. Three More Rules of Differentiation: You wont need these though they might at times allow a quicker derivation (obviously if you know them). I might use them a very few times in getting some results in class. Im not going to go through them, but theyre here is you want to learn them. Rule 3. Differentiating a Product of Functions:

f ( x ) = f1 (x) f 2 (x)

df df df = f1 (x) 2 + f 2 (x) 1 dx dx dx

Rule 4. Differentiating a Quotient of Functions:

f (x) =

f1 (x) df = f 2 (x) dx

f 2 (x)

df1 df f1 (x) 2 dx dx 2 f 2 (x)

Rule 5. Differentiating a Function of a Function of x (Chain Rule):

f (x) = f1 (f 2 (x))

df df1 df 2 = dx df 2 dx

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4. Derivatives with Multivariable Functions When we have a multivariable function, we are sometimes interested in how the function changes when just one of the variables changes. Recall the example we mentioned where the price (P) a firm can get depends on the quantity it sells (q) and average consumer income (I): P = P(q,I). We might be interested in how price changes when just the quantity changes. This only makes sense if we then fix the average consumer income. We can then calculate the derivative of P with respect to q in the usual way, where we treat I as a constant. This is called a partial derivative, but it is just the ordinary derivative where the other variable is held fixed. Notation: When you have a multivariable function: f = f(x1,x2,,xn) and you take the derivative with respect to one of the variables, say x2 (thus holding the other xis f constant), it is written: . x 2 The interpretation is analogous to the ordinary derivative: It is the rate of change of the function value as the x variable in question changes (holding other x variables fixed).

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Example Computation: Recall the example earlier of demand where the price (P) depends on the quantity sold (q) and average consumer income (I): P(I,q) = 200I 2q2 Suppose that we want to find how price changes as quantity changes, thus necessarily holding income (I) fixed. Compute the derivative of the equation with respect to q, treating I as a constant value (which means treating I as if it were a number). We get:

P = 0 4q = 4q (the 0 because the first term, 200I, is q treated as a constant value and thus doesnt vary with q)
Suppose we want to find how price varies with average consume income, then treating q as a constant. We get:

P = 200 + 0 = 200 (the 0 by the same logic as in the previous I example).

Note that most of the problems we encounter will not be multivariable, but some important problems are multivariable.

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Practice Problems (answers on the next page). Compute the derivative: 1. y = 4 + 7x + 2x-2
6 2. y = + 17x 4 (Hint: First rewrite as a polynomial.1) x 3. y = (2 + x) + 12 + 2x 2 (Hint: First rewrite as a polynomial.2) x2 (Hint: First rewrite as a polynomial.3)

4. y = (4+x)(2+x)2 Find the maximum:

5. Let q denote quantity and P denote price. Because demand is downward sloping, the price a firm can get declines with the quanitity; specifically: P = 100-2q. The firms total cost is q2. (i) Profits equal revenues (Pq) minus total cost, but the price needs to be consistent with the quantity sold through the demand curve. Exploiting this consistency requirement, write out profits as just a function of q. Lets denote this function (q). (ii) Find the quantity that maximizes profits. Then calculate the corresponding price that is being charged and the level of maximized profits. 6. Do the same problem but with demand P = 400-q and total cost 2q2.

1 2

If you know all the rules of differentiation, then you need not first rewrite as a polynomial. If you know all the rules of differentiation, then you need not first rewrite as a polynomial. 3 If you know all the rules of differentiation, then you need not first rewrite as a polynomial.

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Answers to Practice Problems: 1. dy = 7 4x 3 dx

2. Rewrite first as: y = 6x 1 + 17x 4 Then: dy = 6x 2 + 68x 3 dx

3. Rewrite: y = (2 + x)x 2 + 12 + 2x 2 = 2x 2 + x 1 + 12 + 2x 2 Then: dy = 4x 3 x 2 + 4x dx

4. Rewrite: y = (4 + x)(2 + x)(2 + x) = (4 + x)(4 + 4x + x 2 ) = 16 + 16x + 4x 2 + 4x + 4x 2 + x 3 = 16 + 20x + 8x 2 + x 3 Then: dy = 20 + 16x + 3x 2 dx

5. (i) (q) = P(q) q q 2 = (100 2q)q q 2 = 100q 3q 2 (ii) Find d/dq and set equal to 0. We have: d = 100 6q =set 0 Solving : q* = 50 / 3. dq Find P using the demand equation: P* = 100 2(50/3) = 200/3. Compute profits at the maximum: * = P *q * (q*) 2 = (200 / 3)(50 / 3) (50 / 3) 2 = ... = 2500 / 3. 6. (i) (q) = P(q) q 2q 2 = (400 q)q 2q 2 = 400q 3q 2 (ii) Find d/dq and set equal to 0. We have: d = 400 6q =set 0 Solving : q * = 200 / 3 dq Find P using the demand function: P* = 400 200/3 = 1000/3. Compute profits:

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 * = P *q * 2(q*)2 = (1000 / 3)(200 / 3) 2(200 / 3) 2 = ... = 40, 000 / 3.

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