OPTIMIZATION FUNCTIONS

CHAPTER EIGHT: OPTIMIZATION FUNCTIONS

Chapter Objectives
After completing this chapter students should be able to:
Find the maximum or minimum point of a single variable function by differentiation and checking
first-order and second-order conditions.
Find the maximum or minimum value of more than single variable function by differentiation and
checking first-order and second-order conditions or by using Hessian determinant.
Use calculus to find a firm’s profit-maximizing output.
Solve constrained optimization problems by the substitution method.
Use the Lagrange method to set up and solve constrained maximization and constrained
minimization problems.
Use Boarder Hessian determinant to check optimum point of constrained optimization problems.

8.1. Unconstrained Optimization

The main duty of optimization problem is choosing the best alternative according to the specified criteria.
In economics optimization is a general heading which represents both minimization & maximization
problem. Optimization means "the quest for the best".
To solve optimization problem:
 Formulate objective function that will be maximize or minimize.
 Apply the conditions/specified criteria.
In general, the nature of optimization process is to get the values of the choice variables that will be
optimize the objective function.
When finding the relative extreme of an objective functions of more than one choice variables which are
independent of one another. The decision made regarding one variable does not affect the choice of the
other variable. Some functions involve constraints and others do not. Such functions which involve no
constraints are called unconstrained functions & the optimization process is called unconstrained or free
optimization.
In summary, as we study optimization, it is useful to understand the assumptions that are used for results
under each of the following categories:

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 OPTIMIZATION FUNCTIONS

Existence: Does the optimization problem have a solution?

Uniqueness: Does the optimization problem have multiple or exactly one solution?
Characterization: Are there conditions that solutions satisfy that are both necessary and
sufficient?
Regularity: Do the solutions depend continuously on the parameters of the problem?
Sensitivity: Does the optimal value (and the optimal choices) depend smoothly on the parameters
of the problem i.e. what if the effect of a marginal change in the parameters?

8.1.1. Optimization Function with one variable and its Economic Application
Given the function y = f(x) which is continuous and differentiable, it is said to have a minimum and a
maximum value at the critical value/at a particular point/. The given function should satisfy two
conditions in order to decide about maximum and minimum value at a particular point these conditions
are called order conditions.
A) Conditions for minimum value:
'
1. First order condition (necessary condition) f ( x )=0 )
2. Second order condition (sufficient condition) f (x)>
B) Conditions for maximum value:
'
1. First order condition (necessary condition) f ( x )=0 )
2. Second order condition (sufficient condition) f (x)<
F.O.C: The derivative version The differential version
dy '
=f ( x )=0 '
dx dy =f ( x ) dx=0 , dx≠0
d2 y ''
=f (CV ) ¿ 0→min
d 2 y =f ( CV ) dx 2 >→ min
2 ''
S.O.C : dx ¿ 0→ Max

Where CV- critical value. >àMax

= 0 test inconclusive
Example: Find the optimum value of the function f ( x )=−2 x 2 +8 x+ 25
Solution: 1st determine the critical value using first order condition. i.e. f ' ( x )=0
' −8
Thus, f ( x )=−4 x+ 8=0→−4 x=−8 → x= =2
−4

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 OPTIMIZATION FUNCTIONS

The critical value of f ' ( x ) is x=2.

Then test 2nd order condition at x=2 whether the function is maximum or minimum.
''
f ( x )=−4
At x=2 , f ' ' ( x )=−4< 0. therefore, the function is maximized at x=2.
The maximum value of f ( x )=−2 x 2 +8 x+ 25
2
¿−2(2) + 8(2)+ 25
¿−2(4 )+ 16+25
¿−8+16+25
¿−8+ 41
¿ 33

8.1.2. Economic Application

Example 1: For a non-linear demand function P=750−0.1 Q2 . what output will maximize the sales
revenue?
Solution:TR=PQ
¿ ( 750−0.1Q 2) Q=750Q−0.1 Q3
dTR
Then determine the critical values by using 1st order condition =0∨MR=0
dQ
dTR d ( 750Q−0.1 Q )
3
2
= =750−0.1 Q =0
dQ dQ
2
750−0.3 Q =0
2 −750
Q= =250
−0.3
Q=±50
Q=−50 orQ=50
But output can't be negative, so Q=50.
d TR d ( 750−0.3Q )
2 2

2
= =−0.6 Q
dQ dQ
2
d TR
At Q=50 , 2
=−0.6 ( 50 )=−3< 0
dQ

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 OPTIMIZATION FUNCTIONS

Therefore, the total revenue is maximized when Q=50.

The maximum value of TR=750Q−0.1 Q3=750 ( 50 )−0.1 ( 50 )3 =37,500−0.1 ( 125000 )
¿ 37,500−12,500
¿ 25,000
Example 2: Suppose the total cost of producing Q units of a certain product is described by the function
2
TC=100,000+1,500 Q+0.4 Q . Determine the amount of output which minimizes average cost.
2
T C 100,000+ 1,500Q+ 0.4 Q 100,000
Solution: AC= = = +1,500+0.4 Q
Q Q Q
dAC
Then determine the critical values by using 1st order condition =0
dQ

dAC
=
d ( 100,000
Q
+ 1,500+0.4 Q )
=
−100,000
+0.4=0
dQ dQ Q
2

−100,000
2
+ 0.4=0
Q
−100,000
2
=−0.4
Q
2
−100,000=−0.4 Q
2 −100,000
Q= =250,000
−0.4
Q=±500
Q=−500∨Q=500
But output can't be negative, so Q=500 .

2
d AC
=
d
( −100,000
Q
2
+0.4
) = 200,000 Q = 200,000
2 4 3
dQ dQ Q Q
2
d AC 200,000 200,000
At Q=50 , 2
= 3
= =0.0016> 0
dQ (500) 125,000,000
Therefore, the average cost is minimized when Q=500.
100,000 100,000
The minimum value of AC= +1,500+0.4 Q= +1,500+ 0.4 ( 500 )
Q 500

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 OPTIMIZATION FUNCTIONS

¿ 200+1,500+200
¿ 1,900

Exercise: Suppose a monopolist has a demand curve Q=106−2 P& average cost
Q
AC=5+ . Determine the profit maximizing level of output and price of this monopolist.
50

8.1.2. Optimization Function with more than one /several/ independent Variables

Given z=f ( x , y ) : the objective function Z to be maximum or minimum. It satisfy both of the order
conditions.
Using the differential version of optimization, we have:

F.O.C:
dz=f x d x +f y d y =0 , . for . dx≠0. and . dy≠0

⇒ dz=0 , if fx and fy are zero

∂ z ∂ f (x , y ) ∂ z ∂ f (x , y)
Therefore, the [Link] be, fx=fy =0. That means f x = = =0∧f y = = =0
∂x ∂x ∂y ∂y

S.O.C Given
dz=f x d x +f y d y ,
∂ ( dz ) dx ∂ ( dz ) dy
d 2 z=d ( dz ) = +
∂x ∂y
∂ ( f x d x +f y d y ) d x ∂ ( f x d x +f y d y ) d y
= +
∂x ∂y
=( f xx d x + f yx d y ) d x + ( f xydx + f yydy ) d y

d 2 z=f xx dx 2 + 2 f xy dxdy+ f yy dy 2
For any dx and dy not both zero:

−d 2 z <0 →Max
−d 2 z >0 →Min
But for any values of dx and dy, not both zero:

→d 2 z <0 , iff . f xx <0 , f yy <0 ,. and . f xx f yy > ( f xy )2

→d 2 z >0 , iff . f xx >0 . f yy >0 , . and . f xx f yy > ( f xy )2

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Summary: Conditions for Optimization

Max Min

F.O.C.
f x =f y =0 f x =f y =0

S.O.C.
f xx < 0 , f yy < 0 f xx > 0 , f yy > 0

f xx f yy > ( f xy )2
And

Violation (failure) of the S.O.C

Saddle point inflection point
f xx f yy < ( f xy )2 f f <0 f f >o
i) if xx yy if xx yy
f xx f yy =( f xy ) 2
ii) Test inconclusive
in addition to the above condition, there is another method the function has maximum or minimum value
that is Hessian determinant.
f f
|H|=| xx xy |
f yx f yy
From this Hessian determinant (or simply a Hessian).

First principal minor of |H|, and is denoted by

|H 1|=f xx

The second principal minor of

|H 2|is:
f f xy
|H 2|=H =| xx |=f xx f yy −( f xy )2
f yx f yy
2
The sign definiteness of d z is determined by the sign of the two principle minors. Thus,
d 2 z >0 (positive definite or minimum value) if:
f f xy
|H 1|=f xx >0 , and .|H 2|=| xx |=f xx f yy−( f xy )2 >0
f yx f yy
d 2 z <0 (negative definite or maximum value) if:

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 OPTIMIZATION FUNCTIONS

f f xy
|H 1|=f xx<0 , and .|H 2|=| xx |=f xx f yy−( f xy )2 >0 .
f yx f yy
d 2 z is indefinite (inconclusive) if:
f f xy
|H 2|=| xx |<0 ,
f xy f yy
Example : Optimize the following function

z=f ( x , y )=6 x 2 −9 x−3 xy−7 y +5 y 2

Solution: F.O.C
f x =12 x−9−3 y =0

f y =−3 x−7+10 y=0

Solving simultaneously yields the critical values x =1 & y=1

S.O.C
f xx =12 , f yy =10 and f xy =f yx =−3

|H 1|=|12|>0,and .|H 2|=|12 −3|=111>0

Determinate Test −3 10
2
Thus, d z >0 (positive definite).i.e. the equation is minimized at the critical values.
Economic Application
Example 1: A firm produces two products that are sold in two markets with the demand schedule
P1=600−0.3 Q1∧P2=500−0.2 Q2 and the firm faces the total cost schedule
TC=16+1.2 Q1+ 1.5Q 2+ 0.2Q1 Q2
A) Determine the profit maximizing level of output & price in each market.
B) Determine the maximum profit of a firm.
Solution: TR=TR1+ TR2
¿ P1 Q 1+ P 2 Q 2
¿(600−0.3 Q¿¿ 1)Q1 +(500−0.2Q2 )Q2 ¿
2 2
¿ 600 Q1−0.3 Q1 +500 Q2−0.2 Q2
Profit (( π )=TR−TC
2 2
¿ 600 Q1−0.3 Q1 +500 Q2−0.2 Q2−(16+1.2 Q1+1.5 Q2 +0.2 Q1 Q 2)

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 OPTIMIZATION FUNCTIONS

2 2
¿ 598.8 Q1−0.3 Q1 +498.5 Q2−0.2Q2−0.2Q1 Q2−16
The first order conditions for the profit function are:
∂π
=598.8−0.6 Q1−0.2 Q2=0→ 0.6 Q 1 +0.2 Q 2=598.8 Equation(1)
∂ Q1
∂π
=498.−0.4 Q2−0.2 Q1=0 → 0.4 Q2 +0.2Q 1=498.5 Equation(2)
∂ Q2
Expressing Q2 in terms of Q1 in Equation(1)
0.2 Q2=598.8−0.6 Q1
Q2=2994−3 Q1 Exquation ( 3 )
Substituting equation (3) into equation (2)
0.4 Q 2+0.2 Q1=498.5 where Q2=2994−3 Q1
0.4 (2994−3 Q1)+0.2 Q1=498.5
1197.6−1.2 Q1+ 0.2Q1 =498.5
−Q1=498.5−1179.6=−699.1
Q1=699 . 1units
Substitute the value of Q1 into equation (3)
Q2=2994−3 Q1
Q2=2994−3 ( 699.1 )
Q2=2994−2097.3
Q2=896 .7 units
We must check the second order conditions whether the profit is maximize at these levels of output. That
is:
∂ π ∂ ( 598.8−0.6 Q1−0.2 Q2 ) 0∧∂ π ∂ ( 498.−0.4 Q 2−0.2Q 1)
2 2

2
= =−0.6< 2
= =−0.4< 0
∂ Q1 ∂ Q1 ∂ Q2 ∂Q2
2
∂ π ∂ ( 598.8−0.6 Q1−0.2Q2 ) ∂ π
2 ∂ ( 498.−0.4 Q2−0.2 Q1 )
= = = =−0.2
∂ Q1 ∂ Q2 ∂Q 1 ∂ Q2 ∂Q1 ∂ Q2

( )
2 2
∂ π ∂ π
Therefore, 2
¿ 2
>¿
∂ Q1 ∂ Q2

(−0.6 )(−0.4 ) >¿

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0.24 >0.04
The corresponding Hessian determinant is
Π Π 12 −0 . 6 −0 . 2
|H|=| 11 |=| |
Π 21 Π 22 −0. 2 −0. 4
−0.6 −0.2
|H 1|=−0.6<0,and.|H 2|=| |=(−0.6)(−0.4)−(−0.2)2=0.24−0.04=0.2>0
−0.2 −0.4
Therefore, profit is maximized when Q1=699.1∧Q2=896.7 .
And the profit maximizing prices are:
P1=600−0.3 Q1 P2 =500−0.2 Q2
P1=600−0.3(699.1) P2=500−0.2(896.7)
P1=600−209.73 P2=500−179.34
P1=390 . 27 birr . P2=320 . 66 birr
The maximum profit is
2 2
π=598.8 Q1−0.3Q1 + 498.5Q 2−0.2 Q2−0.2 Q1 Q2−16
¿ 598.8(699.1)−0.3¿
¿ 418621.08−0.3 ( 488740.81 )+ 447004.95−0.2 ( 804070.89 )−125376.594−16
¿ 418621.08−146622.243+ 447004.95−160814.178−125376.594−16
¿ 418621.08+ 447004.95−146622.243−160814.178−125376.594−16
¿ 865626.03−432829.015
∴ π =432797 .015 birr
Exercise
For each of the following functions, find the critical values, and determine whether the function is at a
relative max, min, an inflection or saddle point?
2 2
1) z=f ( x , y )=3 x +2 y −5 y−4 x−7 y +12
x 2y
2) z=f ( x , y )=x +2 ey−e −e

3) z=e 2 x −2 x +2 y 2 +3
In the two variable case, the Hessian is

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 OPTIMIZATION FUNCTIONS

f f
|H|=| xx xy |
f yx f yy
The case of three variable, the Hessian is
f 11 f 12 f 13
|H|=|f 21 f 22 f 23|
Given f 31 f 32 f 33
2
the sign definiteness of d z depends on the signs of the first , second and third principal minors,
thus;
2 |H |>0 ,|H 2|>0 , and .|H|>0
i) d z >0 (positive define) if: 1
2
ii) d z <0 (negative definite) if:
|H 1|<0 ,|H 2|>0 , and .|H 3|<0 }the three principal minors alternate in
sign.

Example:A firm produces three products Q1, Q2and Q3. The profit function is given by:
Π ( Q 1 , Q2 Q 3 )=180 Q 1 +200 Q 2 +150 Q 3−3Q1 Q 2−2 Q 2 Q3 −2 Q1 Q 3 −4 Q 21 −5 Q22 −4 Q32 , then optimize the

profit function?
Solution:

F.O.C: Π 1 =0
Π 2 =0

Π 3 =0
¿ ¿ ¿
Critical values:
Q1 =14 . 53 ,Q2 =13 . 27 , and . Q3 =11.79

−8 −3 −2
|H|=−3 −10 −2
S.O.C: −2 −2 −8
|H 1|=|−8|=−3<0

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 OPTIMIZATION FUNCTIONS

−8 −3 Therefore, the profit function is maximized at

|H 2|=| |=71>0
−3 −10 Critical values.

|H 3|=|H|=−520<0
the case of n- variable, the Hessian is
z=f ( x 1 , x 2 ⋯ x n )
Given

F.O.C.
f 1=f 2 =⋯⋯f n =0

f 11 f 12⋯ f 1 n
|H 1|=| f 21 f 22⋯ f 2 n |
S.O.C. f n 1 f n 2 ⋯ f nn
i) Positive Definite (minimum)
|H 1|=> 0 ,|H 2|>0 ,⋯⋯|H n|>0
ii) Negative definite (Maximum)

|H 1|<0 ,|H 2|>0 ,|H 3|<0 ,⋯⋯ (−1 )n|H n|>0 → All odd numbered principal minors are negative, and all
even numbered ones are positive.

Exercises
1.A firm produces two products x & y. the cost of producing the products is :
c ( x , y )=0 . 04 x 2 +0 . 01 xy+0. 01 y 2 +4 x +2 y+500 . Suppose that the firm sells all its output at a per unit
price of birr 15 for X, and birr 9 for y. optimize the profit function of the firm?
3
[Link] production function for product Q is given by: Q=f ( L , K ) =6 √ K √ L . Let the price per unit of
output be birr 0.5. the cost per unit of capital is birr 0.1 and the price per unit of labor be birr 1.
Optimize the profit function of the firm?
[Link] a profit maximizing firm that sales its output Q at a constant unit price, P and purchases two
inputs X1& X2 at constant unit factor prices w1&w2 respectively. The firm faces competitive input

& output market and the production function is given by: Q ( X 1 , X 2 ) . then optimize the profit
function of the firm and provide economic interpretation of the first & second order conditions?

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 OPTIMIZATION FUNCTIONS

[Link] a monopolist firm that produces two products Q 1& Q2. Suppose that the demands facing the
firm are as follows:
P1 =55−Q1 −Q2
P2 =70−Q1 −2 Q2

The total cost function is given by: c ( Q1 , Q2 ) =Q1 +Q 1 Q 2 +Q2 , then optimize the profit function of
2 2

the firm and determine the optimal levels of output, price and profit?
[Link] a monopolist firm sales a certain product Q in three separate markets. The demand facing
the firm are as follows.
P1 =63−4 Q1
P2 =105−5 Q2
P3 =75−6 Q3

The total cost function is : C ( Q ) =20+15 Q

Where
Q=Q 1 +Q2 +Q3
Then optimize the profit function in of the firm, i.e. determine the prices charged, the quantities sold as
well as the optimal profit?
[Link] a monopolist is practicing price discrimination in the sale of product Q by charging different
prices in two separate markets. The demand functions in the two markets are given by:
P1 =100−Q1
P2 =80−Q2

Suppose the cost function is: C=6 Q

Where Q=Q 1 +Q 2
a) How much would be sold in the two markets to maximize profit?
b) What are the prices charged?
c) How much is the maximum profit?

8.2. Constrained Optimization

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Functions which involve constraints are called constraint functions and the process of optimization is
referred to as constrained optimization. In economic optimization problems, the variables involved are
often required to satisfy certain constraints.
Examples:
Prices & quantities are non – negative
Production quotas
Budget limitations, etc.
Constraints narrow the domain and hence the range of the objective function.

8.2.1. Two variable problems with equality constraint

Max / Min : y=f ( x 1 , x2 ) , S .t : g ( x 1 , x 2 ) =c
x1 , x2

Example : Max u ( x 1 , x 2 ) , s . t . p1 x 1 + p2 x 2 =M
There are two methods of constrained optimization. These are:
1. Constrained optimization by direct substitution
2. Lagrange multiplier method.

A. Direct substitution Method:

This method is mainly applicable for problems where the objective function with two variables is
maximized or minimized subject to one constraint, but it is also applicable to more than two variable
problems.
⇒ Max , u=u ( x 1 , x 2 ( x1 ) ) or ⇒ Max , u=u( x 1, x 2 ) subject . tog ( x 1, x 2 )=c ⇒ p1 x 1 + p2 x 2 =m ; wherem=income

du ∂u ∂u ∂ x 2
= + . =0
dx 1 ∂ x 1 ∂ x 2 ∂ x 1

E.g.u=x1 , x 2 , s .to . x 1 + 4 x 2 =120

4 x 2=120−x 1
1
x 2 =30− x1
4

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 OPTIMIZATION FUNCTIONS

(
⇒ u= x 1 30−
1
4 )
x 1 =30 x 1 −
1
4
x 21

du 1
=30− x 1 =0
dx
F.O.C. 1
2

⇒ x 1 =60 , and , x 2 =15

Example: a firm faces the production function Q=12 K 0.4 L0.4 and assume it can purchase K & L at prices
per unit of 40 birr and 5 birr respectively and it has a budget of 800 birr. Determine the amount of K & L
which maximizes output.
Solution: the problem is maximize Q=12 K 0.4 L0.4
S ubject ¿ 40 K +5 L=800
According to the theory of production, the optimization condition is written in such a way that the ratio of
marginal product of every input to its price must be the same. That is
MP K MP L
= → Optimalinputcombinationatagivenlevelofoutput .
PK PL
The marginal products can be obtained by the method of partial differentiation as follows.
0.4 0.4
∂ Q ∂(12 K L )
MP K = = =12 ( 0.4 ) K 0.4 −1 L0.4 =4.8 K −0.6 L0.4 Equation(1)
∂K ∂K
0.4 0.4
∂Q ∂(12 K L )
MP L = = =12 ( 0.4 ) K 0.4 L0.4 −1=4.8 K 0.4 L−0.6 Equation(2)
∂L ∂L
These implies that:
MP K MP L
=
PK PL
−0.6 0.4 0.4 −0.6
4.8 K L 4.8 K L
=
40 5
−0.6 0.4 0.4 −0.6
4.8 K L 8 × 4.8 K L
=
4.8 4.8
−0.6 0.4 0.4 −0.6
K L =8 K L
−0.6 0.4 0.4 −0.6
K L 8K L
0.4 −0.6
= 0.4 −0.6
K L K L
−0.6−0.4 0.4 +0.6
K L =8

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 OPTIMIZATION FUNCTIONS

−1
K L=8
L
=8 → L=8 KE quation ( 3 )
K
Substituting equation (3) into the budget constraint we get:
40 K +5 L=800
40 K +5 ( 8 K ) =800
40 K + 40 K=800
80 K=800
K=10 thus , L=8 K =8 ×10=80
Therefore, this firm should employ 10 units of capital and 80 units of labor in the production process to
optimize its output.
Example: suppose the utility function of the consumer is given by U =4 xy − y 2 and the budget constraint
is 2 x+ y=6. Determine the amount of x & y which will optimize total utility of the consumer.
MU x MU y
Solution: utility is maximized when =
Px Py
The marginal utilities can be obtained by the method of partial differentiation as follows.
2 2
∂ U ∂(4 xy− y ) ∂U ∂ (4 xy − y )
MU x = = =4 y MU y = = =4 x−2 y
∂x ∂x ∂y ∂y
MU x MU y
Therefore, at a point of equilibrium =
Px Py
4 y 4 x −2 y
= → 4 y=2 ( 4 x−2 y ) → 4 y=8 x−4 y
2 1
4 y +4 y=8 x → 8 y=8 x → y= xequation (1 )
Substituting equation (1) in to the budget constraint gives as
2 x+ y=6
2 x+ x =6
3 x=6
∴ x= y=2
Therefore, the consumer can optimize his/her utility when they consumes 2 units of good x & 2 units of
good y.

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 OPTIMIZATION FUNCTIONS

B. Lagrange Multiplier Method

When the constraint is a complicated function or when there are several constraints, we resort to the
method of Lagrange.
To find the solutions of the problem max ( min ) Z=f ( x , y ) subject ¿ g ( x , y )=c ¿ by using this method
proceed as follows:
[Link] down the Lagrange function
L ( x , y , λ )=f ( x , y )−λ ( g ( x , y )−c ) or
L ( x , y , λ )=f ( x , y ) + λ ( c −g ( x , y ) )
[Link] L with respect to x, y & λ and equating the partials to zero.
∂L
=f x ( x , y ) −λ g x ( x , y )=0first order conditions
∂x
∂L
=f y ( x , y ) −λ g y ( x , y )=0 (necessary conditions) for
∂y
∂L
=g ( x , y )−c=0 max. or min.
∂λ
[Link] three equations in step 2 yields the following three equations:
f x (x, y)
f x ( x , y )=λ g x ( x , y ) → λ=
gx ( x , y )
f y( x , y)
f y ( x , y )=λ g y ( x , y ) → λ=
gy ( x , y )
g ( x , y )=c
[Link] these three equations for the three unknowns x, y & λ
[Link] the second order sufficient condition for the problem is max (min) by using border Hessian
determinant. The second order partial derivatives are L xx , L yy , L xy ∧L yx the border Hessian
determinant bordered with 0 , g x ∧g y is
L λλ =0 , L λx = g x , L λ =g y
S.O.C: y

L xx =f xx + λg xx ,
L xy =f xy + λg xy =L yx =f yx + λg yx
L yy =f yy +λg yy

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 OPTIMIZATION FUNCTIONS

In matrix form:

( )( )
Lλλ Lλx L λy 0 gx gy
Lxλ Lxx L xy = g x L xx Lxy
L yλ L yx L yy gy L yx L yy

0 gx g y
|H̄|=|g x L xx Lxy |
g y L yx L yy

Second order sufficient condition |H̄|>0 for maximum value.

|H̄|<0 for minimum value.
An interpretation of the Lagrange Multiplier
the Lagrange multiplier λ , measures the effect on the objective function of a one unit change in the
constant of the constraint function (stock of a resource) . To show this; given the Lagrangian function;
Max : f ( x 1 , x 2 )
subject to g ( x 1 , x 2 )= c
L= f ( x 1 , x 2 ) + λ ( c− g ( x 1 , x 2 ) )

F.O.C.
L1 =f 1 ( x1 x 2 )−λg 1 ( x 1 , x 2 )=0
L2 =f 2 ( x 1 x 2 )−λg 2 ( x 1 , x 2 )=0
L λ=c−g ( x 1 , x 2 ) =0
¿ ¿ ¿
We can express the optimal choice of variables λ , x 1 and . y 2 as implicit functions of the parameter c:
¿ ¿
x 1=x 1 ( c )
x ¿2 =x¿2 ( c )
λ ¿= λ¿ ( c )
Now since the optimal value

( ) + λ [ c− g ( x ) ] , differentiating L* with respect to c, we have:

( c) (c ) ( c) ( c) ( c)
¿ ¿ ¿ ¿ ¿
L∗¿ f x1 , x 2 1 , x2

[ ]
¿ ¿ ¿ ¿
dL¿ dx dx dλ¿ ¿ dx dx
=f x 1 + f x 2 + [ c−g ( x ¿1 , x ¿2 ) ] + λ 1−gx 1 1 −g x 2 2
dc 1 dc 2 dc dc dc dc

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 OPTIMIZATION FUNCTIONS

¿ ¿ ¿
dx dx dλ
=( f x 1−gx 1 λ g x ) 1 + ( f x 2− λ¿ g x2 ) 2 + [ c−g ( x¿1 , x¿2 ) ]
¿
+ λ¿
dc
1
dc dc
¿
dL ¿
=λ
dc
Note :- If λ> 0 , it means that for every one unit increase ( decrease ) in the constant of the constraining
function, the objective function will decrease ( increase by a value approximately equal to λ .

If λ> 0 , a unit increase (decrease( in the constant of the constraint will lead to an increase ( decrease ) in
the value objective function by approximately equal to λ .
Example 1: Given the utility function of the consumer who consume two goods x & y as
U ( x , y ) =( x+2 )( y +1 )=xy +2 y + x +2. If the price of good x & y is 4 and 6 birr respectively and the
consumers has a fixed budget of 130 birr. Determine the optimum values of x & y using the Lagrange
multiplier method.
Solution: Max U ( x , y )=xy +2 y + x +2 subject ¿ 4 x+ 6 y
 Formulate the Lagrange function to solve the this problem. i.e.
L ( x , y , λ )=xy +2 y + x +2+ λ ( 130−4 x−6 y )
 Necessary conditions for utility maximization are:
∂ L ∂(xy + 2 y + x +2+ λ ( 130−4 x −6 y ))
= = y +1−4 λ=0 → y=4 λ−1 eq(1)
∂x ∂x
∂ L ∂ ( xy +2 y + x +2+ λ ( 130−4 x−6 y ) )
= =x+2−6 λ=0 → x=6 λ−2 eq ( 2 )
∂y ∂y
∂L
=130−4 x−6 y=0 → 4 x +6 y =130 eq ( 3 )
∂λ
substitutingthe values of x∧ y explained ∈equation ( 1 ) ∧( 2 ) into ( 3 ) gives as :
4 x+ 6 y=130
4 ( 6 λ−2 ) +6 ( 4 λ−1 ) =130
24 λ−8+ 24 λ−6=130
48 λ−14=130
48 λ=130+14
48 λ=144

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 OPTIMIZATION FUNCTIONS

λ=3
Therefore , x=6 λ−2=6 × 3−2=18−2=16
y=4 λ−1=4 ×3−1=12−1=11
 Second order sufficient condition for utility optimization is:
0 gx g y
|H̄|=|g x L xx Lxy |
g y L yx L yy
The second partial derivatives of the Lagrange function and the first partial derivatives of the
constraint function are:
∂ L ∂ ( y+ 1−4 λ )
2
L xx = 2
= =0
∂x ∂x
∂ L ∂ ( x +2−6 λ )
2
L yy = 2 = =0
∂y ∂y
2
∂ L ∂ ( y +1−4 λ ) ∂ L
2
∂ ( x+ 2−6 λ )
L xy = = =L yx = = =1
∂x ∂ y ∂y ∂ y ∂x ∂x
∂ g ( x , y ) ∂ ( 4 x +6 y −130 )
g x= = =4
∂x ∂x
∂ g ( x , y ) ∂ ( 4 x +6 y−130 )
g y= = =6
∂y ∂y
Therefore, the Border Hessian determinant of this function is
0 4 6
|H̄|=|4 0 1 |=0−4(4×0−6×1)+6( 4×1−6×0)=0+24+24=48>0
6 1 0
The second order condition. i.e. |H̄|>0 is satisfied for maximization.
The maximum utility of the consumer is U =xy+ 2 y + x +2
¿ 16 ×11+ 2× 11+16+2
¿ 176+22+16+ 2
¿ 216 utils
The value of Lagrange multiplier λ is 3. It indicates that a one unit increase in the budget of the
consumer , then the total utility of the consumer is increases by 3 units.

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 OPTIMIZATION FUNCTIONS

Example 2: Suppose a firm produces an output Q using labor L and capital K with production function
0.5 0.5
Q=10 K L . If the output is restricted to 200 units, price of labor and capital are 10 & 40 birr
respectively.
[Link] the amount of L & K that should be employed at minimum cost.
B. Find the minimum cost.
C. Interpret the Lagrange multiplier.
Solution: minimize cost TC=10 L+ 40 K
Subject to 200=10 K 0.5 L0.5
Formulate the Lagrange function
L ( L, K , λ )=10 L+ 40 K −λ ( 200−10 K 0.5 L0.5 )

∂ L ∂(10 L+ 40 K −λ ( 200−10 K L0.5 ) )

0.5 0.5
0.5 −0.5 2L
FOCs:- = =10−5 λ K L =0 → λ= 0.5
eq (1)
∂L ∂L K

∂ L ∂ ( 10 L+ 40 K −λ ( 200−10 K L ))
0.5 0.5 0.5
−0.5 0.5 8K
= =40−5 λ K L =0 → λ= 0.5 eq ( 2 )
∂K ∂K L
∂L 0.5 0.5 0.5 0.5
=200−10 K L =0 → 10 K L =200 eq (3 )
∂λ
From equation (1) & (2) we get
0.5 0.5
2L 8K
0.5
= 0.5
K L
0.5 0.5 0.5 0.5
2 L L =K 8 K
2 L=8 K
L=4 K eq (4)
Substituting equation (4) into (3) gives as
0.5 0.5
10 K L =200
0.5 0.5
10 K ( 4 K ) =200
0.5 0.5
10 K 2 K =200
20 K=200
K=10 → L=4 K=4 ×10=40

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 OPTIMIZATION FUNCTIONS

0.5 0.5 0.5

2L L 40 0.5
λ= 0.5 =2( ) =2( ) =2( 4) =2× 2=4
K K 10
SOCs:- at L=40 & K=10
∂ Q ∂ ( 10 K L )
0.5 0.5
0.5 −0.5 0.5 −0.5
Q L= = =10 ( 0.5 ) K L =5 K L =5 ¿
∂L ∂L
¿5¿
¿5¿

∂Q ∂ ( 10 K L )
0.5 0.5
−0.5 0.5 −0.5 0.5
Q K= = =10 ( 0.5 ) K L =5 K L =5 ¿
∂K ∂K
¿5¿
¿5¿

∂ L ∂ ( 10−5 λ K L−0.5 )
2 0.5 0.5
0.5 −1.5 K
L¿ = 2
= =−5 (−0.5 ) λ K L =2.5 λ 1.5
∂L ∂L L =2.5 × 4 ¿ ¿ ¿
=10 ¿ ¿
∂ L ∂ ( 40−5 λ K L0.5 )
2 −0.5
−1.5 0.5
L KK= 2
= =−5 (−0.5 ) λ K L
∂K ∂K
0.5
L
¿ 2.5 λ 1.5
K =2.5 × 4 ¿ ¿ ¿
¿ 10 ¿ ¿
2
∂ L ∂ ( 10−5 λ K 0.5
L−0.5 ) 2
∂ L ∂ ( 40−5 λ K −0.5
L0.5 ) −0.5 −0.5
L LK= = =L KL= = =−5(0.5)λK L
∂ L∂K ∂K ∂K ∂ L ∂L
−2.5 ( 4 ) −10 −10 −10 −10 −1
¿ = = = = = =−0.5
K L
0.5 0.5
( KL ) 0.5
( 10× 40 )0.5
( 400 ) 0.5
20 2
Therefore, the determinant of border Hessian matrix is
0 Q L Q K 0 2.5 10
|H̄|=|Q L L LL L LK |=|2.5 0.125 −0.5 |
Q K L KL L KK 10 −0.5 2
¿0−2.5(2.5×2−(10×−0.5))+10(2.5×−0.5−10×0.125)

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 OPTIMIZATION FUNCTIONS

=−2.5(5+5)+10(−1.25−1.25)
=−2.5(10)+10 (−2.5)
=−25−25=−50<0
Thus the firm can minimize its cost when it employs 10 units of capital and 40 units of labor in the
production process and the minimum cost is
C=10 L+40 K
¿ 10 × 40+40 ×10
¿ 400+ 400
¿ 800 birr .
Interpretation of λ : it indicates that one unit increase in output of the firm, then the cost of the firm is
changed by 4 units.
NB: The Lagrange multiplier λ measures the responsiveness of the objective function to a change in the
constant of the constraint function.
Lambda ( λ ¿ is the shadow price which shows the sensitivity of the Lagrange function to changes in the
dL
right hand side of the constraint. i.e. =λ.
dC

8.2.2. Optimization of n- variable case

Z=f ( x 1 , x 2 ⋯⋯x n )
Given
g ( x 1 , x 2 ⋯⋯ x n ) =c
s. to
first formulate the Lagrange function. i.e.
Z=f ( x 1 , x 2 ⋯⋯x n ) −λ ( c−g ( x 1 , x2 ⋯⋯ x n ) )

 First order condition for optimization:

L λ=L1 =L2 ⋯⋯ Ln =0
 The second order condition for min & max involves the border Hessian determinant test. Given the
border Hessian determinant of the above function as:
0 g1 g2 ⋯⋯ g n
g L11 L12 L1n
|H̄|=| 1 |
⋮
gn Ln 1 Ln 2 Lnn Its bordered leading principal minors can be defined as:

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 OPTIMIZATION FUNCTIONS

0 g1 g2 g3
0 g1 g2
g L11 L12 L13
|H̄ 2|=|g 1 L11 L12|,|H̄ 3|=| 1 |
g2 L21 L22 L23
g2 L21 L22
g3 L31 L3
2
L33
etc. However, |H̄|= |H̄ n|
Conditions Max Min

F.O.C.
L λ=L1 =L2 ⋯⋯ Ln =0 The same

S.O.C.
|H̄ 2|>0,|H̄ 3 <0,||H̄ 2|,|H̄ 3|,............|H̄ n|<0
|H̄ 4|>0 ,⋯⋯ (−1 )n|H̄ n|>0

Example: MAx : z ( x , y ) =2 xy . subjectto 3 x+4 y=90

L=2 xy +λ ( 90−3 x−4 y )
L λ=90−3 x−4 y=0 x ¿ −15
L x =2 y −3 λ=0 | y ¿=11. 25
L y =2 x−4 λ=0 λ¿ =7 .5
F.O.C:-

( )
0 g1 g2 0 3 4
g1 L xx L xy ⇒|H̄|=|3 0 2|
g2 L yx L yy 4 2 0
S.O.C:

|H̄|=|H̄ 2|=48>0→ Max

[Link] with More than one Equality constraint

Let us consider the optimization problem involves three variables and two constraints.
Max/ Min :f ( x 1 , x 2 , x 3 ) s . t g ( x 1 , x2 , x 3 , ) =c 1 and
'

g2 ( x 1 , x 2 , x 3 ) =c 2
The Lagrange function is:
L=f ( x 1 , x 2 , x 3 ) + λ1 ( c 1 −g 1 ( x 1 , x 2 x 3 ) )+ λ2 ( C2 −g2 ( x1 , x 2 x 3 ) )
1 2
F.O.C.: L1 =f 1 −λ 1 g 1− λ2 g1 =0

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 OPTIMIZATION FUNCTIONS

L2 =f 2 −λ 1 g 12− λ2 g22 =0

L3 =f 3− λ1 g13 −λ 2 g 23=0
L λ =C 1 −g 1 ( x 1 , x2 , x 3 )=0
1

L λ =C 2 − g2 ( x 1 , x 2 , x 3 )= 0
2

S.O.C. For optimization of three variables & two constraints are:

0 0 g11 g12 g 13
0 0 g21 g22 g 23
H̄=| g11 g 21 L11 L12 L13 |
g12 g 22 L21 L22 L23
g 13 g32 L31 L32 L33

For this border Hessian determinant are symbolized by

|H̄ m+1|,|H̄ m+2|.......|H̄ m+n|=|H̄|

 For maximum value:

(−1)m+1|H̄ m+1|; where m= number of constraints.

 For minimum value:

(−1)m|H̄ m+1|

|H̄ 2|= is one that contains L as the last element of its principal diagonal
22

|H̄ 3=|is one that contains L as the last element of its principal [Link].
33

Exercise:
1. A monopolistic firm produced two related goods. The demand and total cost functions are:
Q 1 =100−2 p1 +2 p2
Q 2 =75+0 . 5 p1 − p2

TC=Q21 +2 Q1 Q2 + Q22

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 OPTIMIZATION FUNCTIONS

Optimize the firms profit function by:

a)Finding the inverse demand functions?
b)Using Cramer's rule for the f.o.c?
c)Using the Hessian for the s.o.c?
2. Minimize a firm’s total cost:

c=45 x 2 +90 xy +90 y 2 , when the firm has to meet a production quota: 2 x+3 y =60 , by:
a)Using Cramer's rule for the f.o.c?
b)Using the Hessian for the s.o.c?
3. A monopolist firm produces two substitute goods and faces the following demand functions.
X =80−P x +2 p y
y=110+2 p x −6 p y

Its total cost function is : TC=0 .5 x 2 +xy+ y 2 what is the profit maximizing level of output if the firm
has to meet a production quota of 3 x+4 y=350 ?
0 . 25 0 . 4
4. Maximize utility: u ( x, y )= x y , s. t . 2 x+8 y=104 (use any method).

Mathematics for Economists Lecture NotePage 25