Econ 50: Modified Section Note 1

Fanqi Shi

September 29, 2017

These notes briefly go over single and two variable unconstrained optimization, rules
for logs, convexity and concavity, the chain rule, level curves, implicit differentiation and
optimization with equality constraints.

1 Warm Up?

1. Fanqi Shi (email: ericshi@stanford.edu); office hours: Wednesday 7:00-8:00 p.m. in

Lathrop 292.

2. Introduction.

2 Motivation

Why do we need mathematics in economics??

x2
increasing utility

(0,2)

(1,1)

0 (2,0) x1

3 Single-variable Unconstrained Optimization

Consider a differentiable function f (x).

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 In order to maximize or minimize it, we look at the “First-Order Condition” to find a
point of extremum.

• First-Order Condition
df (x)
f 0 (x) ≡ =0
dx

f (x)
(1,2)
(3,1.5)

(2,1)

0 (4,0) x

Common Derivatives and Basic Differentiation Rules

(xα )0 = αxα−1 (α real) (ax )0 = ax ln(a)
x 0
(e ) = e x (ln(|x|))0 = x1 (x 6= 0)
0 0
(cf ) = cf (c constant) (f ± 0 f 0 ± g0
  g) =
f f g−f g 0
0
(f g)0 = f 0 g + f g 0 (product rule) g = g2
(g 6= 0) (quotient rule)
g 0 (x)
f (g(x)) = f 0 (g(x))g 0 (x) (chain rule) (ln g(x))0 = g(x)

Let’s look at a simple application of this useful technique to an economics problem.

Suppose a firm’s output (denoted q) is√determined by the amount of labor (denoted l) it
hires, according to the function q(l) = 2 l. Further, assume that the firm can hire all the
labor it wants at a price (denoted pl ) of $1 per unit and sell its output at a price (denoted
pq ) of $5 per unit. How much labor should the firm optimally hire?
The objective of any firm is to maximize its profit (denoted π).

π = Revenue − Cost
= pq q − pl l
√
= 10 l − l (1)

So, this firm wants to maximize π, given in (1), as a function of l.

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 Revenue/Cost

Revenue

Cost

0 Labor

The first-order condition yields the optimal level of labor l∗ = 251 .

4 Two-Variable Unconstrained Optimization

The basic intuition from the single-variable case generalizes very well to the two-variable
case, with the differentials replaced by partial differentials.
Consider a function f (x, y) differentiable in both x and y.

• First-Order Condition
∂f (x, y)
f1 (x, y) ≡ =0 (2)
∂x
∂f (x, y)
f2 (x, y) ≡ =0 (3)
∂y

Equations (2) and (3) are two equations in two variables which can be solved to get x∗ and
y∗.

5 Rules for Logs

ln(xa y b ) = a ln x + b ln y
Very Important: logs are monotonic transformations and transform a multiplicative re-
lationship into an additive one.
Remember the differentiation rule for logs?
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It is a standard practice to denote the optimal quantities with a “*”.

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6 Convexity and Concavity

Consider two points x and y, a convex combination of x and y, z = αx + (1 − α)y for

some α ∈ [0, 1]. In other words, a convex combination is a weighted average.
x2

(0,3) (0.5,2.5)

(1.5,1.5)

(2.5,0.5)

0 (3,0) x1

A set S is convex if for any x, y ∈ S, any convex combination z ∈ S.

Consider a function f : R → R, f is said to be convex if for any α ∈ [0, 1]:
f (αx + (1 − α)y) ≤ αf (x) + (1 − α)f (y)

f (x)

convex set

1
f (x) = x

0 x

Similarly, a function f : R → R is said to be concave if for any α ∈ [0, 1]:

f (αx + (1 − α)y) ≥ αf (x) + (1 − α)f (y)

f (x)
√
f (x) = x

convex set

0 x

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7 The Chain Rule

The mathematical formulation of the chain rule is this: if h(x) = f (g(x)), then

h0 (x) = f 0 (g(x))g 0 (x)

For example, suppose we have the function h(x) = (3x + 2)2 . We can rewrite this as
f (g(x)) if

f (g) = g 2
g(x) = 3x + 2

Therefore

df
= 2g
dg
dg
=3
dx
so we have

dh df dg
= × = 2(3x + 2) × 3 = 18x + 12
dx dg dx

To choose an example that’s a harbinger of things to come, let’s assume that there’s
a ”utility function” u(x1 , x2 ) that assigns a total ”utility” to consuming x1 units of good
1 and x2 units of good 2. Furthermore, let’s assume that given the prices p1 and p2 and
income m, we’ve figured out ”demand equations” x∗1 (p1 , p2 , m) and x∗2 (p1 , p2 , m). We now
want to figure out how much your utility would change due to a change in income. Well,
we can write
V (p1 , p2 , m) = u(x∗1 (p1 , p2 , m), x∗2 (p1 , p2 , m))
for what we’ll call the indirect utility of p1 , p2 , and m: that is, the utility you would get
if you made the optimal purchase decision based on p1 , p2 , and m. The derivative of this
with respect to income is

∂V (p1 , p2 , m) ∂u(x∗1 , x∗2 ) ∂x∗1 (p1 , p2 , m) ∂u(x∗1 , x∗2 ) ∂x∗2 (p1 , p2 , m)

= × + ×
∂m ∂x∗1 ∂m ∂x∗2 ∂m
| {z } | {z }
∆V due to ∆x∗1 due to ∆m ∆V due to ∆x∗2 due to ∆m

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8 Level Curves

Definition 1. Given a constant c, the level curve for a function f (x, y) is the set of all
points (x, y) such that f (x, y) = c. Formally,

L(f ; c) = {(x, y) ∈ R2 |f (x, y) = c}

Example 2. Let f (x, y) = x + y and c = 1. Then L(f ; 1) is just the line x + y = 1.

Indifference curves are the level curves of the utility function.

9 Implicit Differentiation
dy
Go back to the motivation at the beginning, i.e. we want to know what dx is along f (x, y) =
c. To find this out, we take the partial derivative on both sides with respect to x:
d d
[f (x, y(x))] = [c]
dx dx

Applying the chain rule as we did in the previous section, we get

∂f (x, y) ∂f (x, y) dy
+ =0
∂x ∂y dx
In short, the rate at which  the left-hand side changes due to a change in x is the direct
∂f (x,y)
change that is, ∂x plus the change due to the change in y, due to the change in x
 
that is, ∂f∂y
(x,y) dy
dx .
dy
Solving for dx yields:
∂f (x,y)
dy f1
= − ∂f∂x
(x,y)
=−
dx f2
∂y

10 Optimization with Equality Constraints

Consider the following problem:

√
max xy − x2 s.t. y = 10
x,y

How would you solve this problem? A very simple way to do this is to substitute y = 10
into the objective function and maximize as a function of x only.

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 In general, suppose we want to maximize a function f (x, y) subject to the constraint
g(x, y) = 0. If lots of good conditions hold (and we’ll get into some of those in class),
the necessary ”first-order conditions” for an optimum are obtained by writing down the
function:
L(x, y, λ) = f (x, y) + λg(x, y)
and setting the partial derivatives of this function with respect to x, y, and λ to zero,
respectively.

∂L
= f1 + λg1 = 0 (1)
∂x
∂L
= f2 + λg2 = 0 (2)
∂y
∂L
=g=0 (3)
∂λ