Economics Dr.

Sauer

Chapter 7 Lecture Handout 7.1 Partial Derivatives (a) z = 2x2 + 3xy + 5 (b) Q = 10L0.7K0.3 (c) U = x2y5

Notice that the mixed second-order partial derivatives are equal. 7.2 Applications 1. Production Functions The Cobb-Douglas production function is widely used in economic analysis. It takes the form: Q = ALK A. Marginal and Average Functions The partial derivatives of the production function are the marginal functions.

Notice that the marginal functions are positive, meaning the production function is increasing as the input is increasing. Notice that the straight second derivative is negative, meaning the law of diminishing returns applies. Ex: Q = 10L0.4K0.6

Average functions for a Cobb-Douglas production function:

In general, firms follow these conditions when deciding how much output to produce: QL = MPL > 0 QLL < 0 MPL < APL

B. Isoquants Productions functions are often represented graphically as isoquants. Various combinations of labor and capital can be used to produce a particular level of output.

The slope of an isoquant is called the Marginal Rate of Technical Substitution.

The slope of an isoquant is the ratio of the marginal products.

Example: Q = 10L0.5K0.5

C. Returns to Scale If you change both inputs by the same proportion, you can determine the proportionate change in output.

Ex: Q = 5L0.2K0.5

______________________________________________________________________ 2. Utility Functions Cobb-Douglas is also widely used for utility functions. Utility functions are often graphically represented as indifference curves.

The slope of an indifference curve is called the Marginal Rate of Substitution.

The slop of an indifference curve is the ratio of the marginal products.

Ex: U = 8x0.3y0.7

3. Partial Elasticities For a general demand function QA = f(PA, Y, PB) we can use partial derivatives to find the price, income, and cross-price elasticities of demand. Ex: QA = 100 2PA + 0.2Y + 0.3PB PA = 6, Y = 500, PB = 10

Similarly, we can find the partial elasticity with respect to Labor or Capital. Ex: Q = 2L0.9K0.1

Optimization 7.3 Unconstrained Optimization Find the 1st and 2nd partial derivatives. Set the 1st derivatives equal to zero and solve for the turning points. Use the 2nd derivative test to determine the nature of the turning points. The point is a maximum if the second derivatives are negative and >0. The point is a minimum if the second derivatives are positive and >0. The point is an inflection point if both second derivatives have the same sign and <0. The point is a saddle point if the second derivatives have different signs and <0. ( )( ) ( )

Example: A monopoly firm produces 2 goods, X and Y. The demand for each is given by: Px = 36 3x Py = 56 - 4y

Example: A competitive firm produces 2 goods, X and Y. The prices are $54 and $52 respectively. The firms total cost function is given by: TC = 3x2 + 3xy + 2y2 100

7.4 Constrained Optimization In the real world, there are limitations on things like our current incomes or the amount of labor a firm can hire. - You want to maximize your utility, subject to your budget constraint. - A firm wants to minimize its costs, subject to producing a given level of output. Example: Your utility function is given by U = 5xy. You have $30 to spend and the prices of goods X and Y are $5 and $1 respectively. Find the quantity of X and Y that will maximize your utility, given your budget.

Example: A firm has the following production function: Q = L0.3K0.7. The firm has to keep its costs at $150 or less. The price of labor is $3 and the price of capital is $15. Find the values of K and L that maximize output, given the firms constraint.

Example: A firm has the following production function: Q = L0.5K0.5. The firm must produce 240 units of output. The wage is $25 per worker and the rental rate of capital is $50 per unit. Find the values of K and L that minimize this firms costs, while producing the target level of output.