A FIRM MAXIMIZING PROFIT

MATH 232

1. Two Products Assume a rm makes two products with output levels of Q1 and Q2 , prices P1 and P2 , and revenue is R = P1 Q1 + P2 Q2 . Assume the cost of production is C = Q2 + Q1 Q2 + Q2 , so the prot is 1 2 = R C = P1 Q1 + P2 Q2 Q2 Q1 Q2 Q2 . 1 2 We want to maximize the prot under two different assumptions. First Case: In this case, we assume there is pure competition and the prices are determined externally to the rm and are considered xed by the rm. Taking the partial derivatives with respect to Q1 and Q2 and setting them equal to zero, we get the two equations = P1 2Q1 Q2 Q1 0= = P2 Q1 2Q2 . Q2 0= Solving for Q1 and Q2 , we get the critical values Q = 1 The second partial derivatives are 2 = 2 Q2 1 2 = 1 Q1 Q2 so 2 = 2 < 0 Q2 1 2 2 Q2 Q2 1 1 and
2
1

and

2P1 P2 3

and Q = 2

2P2 P1 . 3 2 = 1 Q2 Q1 2 = 2, Q2 1

2 Q2 Q1

= (2)(2) (1)2 = 3 > 0,

and the quantities (Q , Q ) maximize prot. 1 2 Second Case: In this case, we assume that the rm has a monopoly and can set the prices of the two products. However, once the prices are xed, the quantities purchased of the two products is determined by
1

Based on the treatment in Fundamental Methods of Mathematical Economics by Alpha Chiang, McGraw Hill, Inc., 1984
1

MATH 232

a demand function set by the consumers. We assume that the products are interchangeable, and the demand of each product depends on the prices of both products by the rules Q1 = 40 2P1 + P2 Q2 = 15 + P1 P2 . Substituting in the quantity demanded for the prices, we get the expression for the revenue in terms of the prices, = P1 (40 2P1 + P2 ) + P2 (15 + P1 P2 ) (40 2P1 + P2 )2 (40 2P1 + P2 )(15 + P1 P2 ) (15 + P1 P2 )2 . We want to maximize the prot as a function of the prices. Taking the partial derivatives with respect to P1 and P2 , we get 0= P1 = (40 2P1 + P2 ) 2P1 + P2 + 4(40 2P1 + P2 )

+ 2(15 + P1 P2 ) (40 2P1 + P2 ) 2(15 + P1 P2 ) = 160 10P1 + 5P2 , and 0= P2 = P1 + (15 + P1 P2 ) P2 2(40 2P1 + P2 ) (15 + P1 P2 ) + (40 2P1 + P2 ) + 2(15 + P1 P2 ) = 10 + 5P1 4P2 . Thus, we have the two equations 0 = 160 10P1 + 5P2 0 = 10 + 5P1 4P2 .
Multiplying the second equation by 2 and adding, we get 0 = 140 3P2 or P2 = 140/3 = 462/3. Then 140/3) and P = 118/3 = 391/3. 10P1 = 160 + 5( 1 The second partial derivatives are

2 2 = 10 P1 2 =5 P1 P2 so 2 2 = 10 < 0 P1 2 2 2 2 P1 P1 and
2

2 =5 P2 P1 2 2 = 4, P1

2 P2 P1

= (10)(4) (5)2 = 15 > 0,

and the prices (P1 , P2 ) maximize prot.

A FIRM MAXIMIZING PROFIT

2. Multiple inputs and one product Assume a rm makes one product from n inputs. Let p be the price of the output, xj be the amount of the j th input used, and pj be the price of the j th input. Let G(x1 , . . . , xn ) be the production function, which gives the amount of output in terms of the inputs. The prots is = p G(x1 , . . . , xn ) p1 x1 pn xn . Assuming the prices are xed, the inputs which maximize prot satisfy G =p pi or 0= xi xi G pi = . xi p Thus, at the critical point, the marginal product of each input equals the price of the input relative to the price of the output. The matrix of second partial derivatives is 2 xi xj = p 2G xi xj . 2G < 0, but also that the x2 i

Thus, for the critical point to be a maximum it is necessary that not only p principal determinants have the correct signs, (1)k det p for each 1 k n. The requirement that p 2G xi xj >0
1i,jk

2G < 0 could be viewed as saying that a small change in x2 i the input xi makes more difference for small values of xi than for large input: diminishing returns. For two inputs, we need p p2 2G 2G p2 x2 x2 1 2 2G <0 x2 1 2G x1 x2 and > 0.

MATH 232

3. R ATE OF C HANGE OF M INIMAL C OST OF P RODUCTION Let Q = F (L, K) be the production function of a single output in terms of two inputs, labor L and capital K. Let w be the price of labor (wages) and r the price of capital (interest rate). Thus the cost function is C = wL + rK. Assume the output Q = Q0 is xed and the cost is minimized. Let L = L(w, r) be the amount of labor and K = K(w, r) be the amount of capital which realizes this minimum. Dene C(w, r) = w L(w, r) + r K(w, r) be the minimal cost at these values. Shepherds Lemma says that C (w0 , r0 ) = L(w0 , r0 ) and w C (w0 , r0 ) = K(w0 , r0 ). r This says that the rate of change of cost with respect to change in wages is equal to the size of the labor force, and does not depend on the change of the size of the labor force or amount of capital. See [2] for a discussion of the economic interpretation. The derivation is not too difcult but does involve the introduction of a new function. Let L0 = L(w0 , r0 ) 0 , r0 ) be the size of labor and capital at this minimum for wages s0 and interest rate r0 . We and K0 = K(w form the function g(w, r) = C(w, r) w L0 r K0 . The terms subtracted involve the changing cost of labor and capital while holding the amounts xed. The value g(w0 , r0 ) = C(w0 , r0 ) w0 L0 r0 K0 = 0 by the denitions. For (w, r) = (w0 , r0 ), C(w, r) w L0 + r K0 because (L0 , K0 ) satises the production constraint and the new values L(w, r) and K(w, r) minimize the cost. Therefore, g(w, r) 0 and g attains its maximum at (w0 , r0 ), so C g (w0 , r0 ) = (w0 , r0 ) L0 and 0= w w g C 0= (w0 , r0 ) = (w0 , r0 ) K0 , r r so C (w0 , r0 ) = L0 = L(w0 , r0 ) and w C (w0 , r0 ) = K0 = K(w0 , r0 ) r as claimed. R EFERENCES
[1] C. Simon and L. Blume, Mathematics for Economists, W. W. Norton & Company, New York, 1994 [2] D. Besanko and R. Braeutigam, Microeconomics: An Integrated Approach, John Wiley & Sons, Inc., New York, 2002.