205 Topic 7B

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Topic 7 (continued)

Price Discrimination
At times, different prices are charge at different market due to different price elasticity at different
market. For instance, when a monopolistic firm sells a single product in two or more separate
markets (e.g domestic and foreign) and therefore must decide upon the quantities (Q1, Q2 etc.) to
be supplied to the respective markets in order to maximise profit.
Let a monopoly sell it product in 3 different market such that
𝑇𝑅 = 𝑅1 (𝑄1 ) + 𝑅2 (𝑄2 ) + 𝑅3 (𝑄3 ) … … … … … … … … … … … . .1
𝐶 = 𝐶(𝑄) 𝑤ℎ𝑒𝑟𝑒 𝑄 = 𝑄1 + 𝑄2 + 𝑄3 … … … … … … … … … … … 2
Therefore, 𝜋 = 𝑅1 (𝑄1 ) + 𝑅2 (𝑄2 ) + 𝑅3 (𝑄3 ) − 𝐶(𝑄) … … … … … 3
𝜕𝜋1
= 𝑅1′ (𝑄1 ) − 𝐶 ′ (𝑄) ==> 𝑀𝑅1 = 𝑀𝐶 … … … … … … … … … 4
𝜕𝑄1

𝜕𝜋2
= 𝑅2′ (𝑄2 ) − 𝐶 ′ (𝑄) ==> 𝑀𝑅2 = 𝑀𝐶 … … … … … … … … … .5
𝜕𝑄2

𝜕𝜋3
= 𝑅3′ (𝑄3 ) − 𝐶 ′ (𝑄) ==> 𝑀𝑅3 = 𝑀𝐶 … … … … … … … … … . .6
𝜕𝑄3

Therefore, 𝑀𝐶 = 𝑀𝑅1 = 𝑀𝑅2 = 𝑀𝑅3


Thus, the level of Q1, Q2 and Q3 should be chosen such that the marginal revenue in each market
is equated to the marginal cost of the total output Q
Relationship Between Marginal Revenue (MR) and Price (P)
Recall that 𝑅𝑖 = 𝑃𝑖 𝑄𝑖
𝑑𝑅𝑖 𝑑𝑄𝑖 𝑑𝑃𝑖
𝑀𝑅𝑖 = = 𝑃𝑖 + 𝑄𝑖
𝑑𝑄𝑖 𝑑𝑄𝑖 𝑑𝑄𝑖
𝑑𝑃𝑖 𝑄𝑖 1
= 𝑃𝑖 (1 + ) = 𝑃𝑖 (1 + )
𝑑𝑄𝑖 𝑃𝑖 𝜀𝑑𝑖
Where 𝜀𝑑𝑖 , the point elasticity of demand in the ith market, is normally negative. Consequently,
the relationship between 𝑀𝑅𝑖 & 𝑃𝑖 can be expressed alternatively by the equation
1
𝑀𝑅𝑖 = 𝑃𝑖 (1 − )
|𝜀𝑑𝑖 |
If |𝜀𝑑𝑖 | < 1 (demand being inelastic at a point), then its reciprocal will exceed one, and the
parenthesized expression in the above equation will be negative, thereby implying a negative value
for 𝑀𝑅𝑖 .
Similarly, if |𝜀𝑑𝑖 | = 1 (unitary elasticity) then 𝑀𝑅𝑖 will take a zero value.
In as much as a firm’s MC is positive, the first order condition 𝑀𝐶 = 𝑀𝑅𝑖 requires the firm to
operate at a positive level of 𝑀𝑅𝑖 .
The first order condition 𝑀𝑅1 = 𝑀𝑅2 = 𝑀𝑅3 can now be translated into
1 1 1
𝑃1 (1 − ) = 𝑃2 (1 − ) = 𝑃3 (1 − )
|𝜀𝑑1 | |𝜀𝑑2 | |𝜀𝑑3 |
From above, it can be readily inferred that the smaller the value of |𝜀𝑑𝑖 |, the higher the price
charged in that market
Second Order Condition
To ensure maximization, let us examine the SOC from equations 4-6, the second order condition
can be found.
𝜋11 = 𝑅1′′ (𝑄1 ) − 𝐶 ′′ (𝑄)
𝜋22 = 𝑅2′′ (𝑄2 ) − 𝐶 ′′ (𝑄)
𝜋33 = 𝑅3′′ (𝑄3 ) − 𝐶 ′′ (𝑄)
And 𝜋12 = 𝜋21 = 𝜋31 = 𝜋13 = 𝜋23 = 𝜋32 = −𝐶 ′′ (𝑄)
By arranging the partial second derivatives into Hessian determinant, we have
𝑅1′′ − 𝐶 ′′ −𝐶 ′′ −𝐶 ′′
|𝐻| = | −𝐶 ′′ 𝑅2′′ − 𝐶 ′′ −𝐶 ′′ |
−𝐶 ′′ −𝐶 ′′ 𝑅3′′ − 𝐶 ′′
The second order sufficient condition will thus be duly satisfied, provided we have
1. |𝐻1 | = 𝑅1′′ − 𝐶 ′′ < 0 that is the slope of 𝑀𝑅1 is less than the slope of MC of the entire
output
2. |𝐻2 | = (𝑅1′′ − 𝐶 ′′ )(𝑅2′′ − 𝐶 ′′ ) − (−𝐶 ′′ )2 > 0
3. |𝐻3 | = (𝑅1′′ 𝑅2′′ 𝑅3′′ ) − (𝑅1′′ 𝑅2′′ + 𝑅1′′ 𝑅3′′ + 𝑅2′′ 𝑅3′′ )−𝐶 ′′ < 0
Example 1
A monopolist’s firm faces a two distinct demand function
Q1 = 24 − 0.2P1 Q2 = 10 − 0.05P2 and a cost function C = 35 + 40Q where
Q =Q1+Q2. Find
i. Output in each market
ii. Price level in each market
iii. Is output optimized in the market?
iv. Profit of the monopoly
v. The point elasticity of demand in each market
vi. Comment on your answer in v
Solution
i.
From equation 1,
𝑄1 = 24 − 0.2𝑃1
𝑃1 = 120 − 5𝑄1 … … … … … … … . .3
From equation 2,
𝑄2 = 10 − 0.05𝑃2
𝑃2 = 200 − 20𝑄2 … … … … … … … . .4
Therefore, 𝑇𝑅1 = 𝑃1 𝑄1 = (120 − 5𝑄1 )𝑄1
= 120𝑄1 − 5𝑄12
𝑑𝑇𝑅1
= 𝑀𝑅1 = 120 − 10𝑄1 … … … … … … . .5
𝑑𝑄1
For second market
𝑇𝑅2 = 𝑃2 𝑄2 = (200 − 20𝑄2 )𝑄2
= 200𝑄2 − 20𝑄22
𝑑𝑇𝑅2
= 𝑀𝑅2 = 200 − 40𝑄2 … … … … … … . .6
𝑑𝑄2
Cost
𝐶 = 35 + 40(𝑄1 + 𝑄2 )
𝑑𝐶
= 40 … … … … … … … … … … … … … 7
𝑑𝑄
Therefore, 𝑀𝑅1 = 𝑀𝐶
120 − 10𝑄1 = 40
̅̅̅1 = 8
𝑄
Also, 𝑀𝑅2 = 𝑀𝐶
200 − 40𝑄2 = 40
̅̅̅
𝑄2 = 4
ii. 𝑃̅1 = 120 − 5𝑄1 = 120 − 5(8) = 80
̅̅̅
𝑃2 = 200 − 20𝑄2 = 200 − 20(4) = 120
iii. Is output optimized in the market?
We use Hessian boarder determinant to test
𝑓 𝑓
|𝐻| = | 11 12 | = |−10 0
| = 400 > 0
𝑓21 𝑓22 0 −40
The function is negative definite; therefore, output is maximised when 𝑄̅̅̅1 = 8 and ̅̅̅
𝑄2 = 4 i.e
|𝐻1 | = 𝑓11 = −10 < 0
|𝐻| = 400 > 0
iv. Profit of the firm
𝜋 = 𝑇𝑅 − 𝐶
𝜋 = 𝑇𝑅1 + 𝑇𝑅2 − 𝐶
𝑇𝑅1 = 𝑃1 𝑄1 = 8 × 80 = 640
𝑇𝑅2 = 𝑃2 𝑄2 = 120 × 4 = 480
𝐶 = 35 + 40(𝑄1 + 𝑄2 ) = 35 + 40(8 + 4) = 515
Therefore, 𝜋 = 640 + 480 − 515 = 605
v. Elasticity
𝑑𝑄 𝑃
𝜀𝑑 = ×𝑄
𝑑𝑃
For first market,
𝑑𝑄1 𝑃
𝜀𝑑1 = × 𝑄1
𝑑𝑃1 1
Recall equation 1 𝑄1 = 24 − 0.2𝑃1
𝑑𝑄1
= −0.2
𝑑𝑃1
Thus,
𝑑𝑄1 𝑃 80
𝜀𝑑1 = × 𝑄1 = −0.2 × = −2
𝑑𝑃1 1 8

For second market,


𝑑𝑄2 𝑃
𝜀𝑑2 = × 𝑄2
𝑑𝑃2 2
Recall from equation 2, 𝑄2 = 10 − 0.05𝑃2
𝑑𝑄2
= −0.005
𝑑𝑃2
Thus,
𝑑𝑄2 𝑃 120
𝜀𝑑2 = × 𝑄2 = −0.005 × = −0.15
𝑑𝑃2 2 4
vi. The result shows that the market with higher price (market 2) has a lower degree of
elasticity while the market with lower price has a higher degree of elasticity. This
means that it is advisable for the monopoly to charge higher price in the second market.

Constraint Optimization
Economic problem often involves maximization and minimization of some objectives but usually
they are constraint which limit our alternatives for which the maximum or minimum is chosen.
Example 2
A consumer aims at maximizing utility subject to the level of income Y. if he’s faced with two
commodity X1 and X2 whose price are P1 and P2 respectively, and his total income to maximise
is Y. Therefore, he must maximise his utility which is a function of X1 and X2 subject to price
equal Y.
The above statement can be written as
𝑀𝑎𝑥: 𝑈 = 𝑓(𝑥1 , 𝑥2 )
𝑆 𝑇: 𝑌 = 𝑃1 𝑋1 + 𝑃2 𝑋2

Example 3
A producer will want to maximise it output Q but he’s limited by the cost of its input such that he
will have to maximise 𝑄 = 𝑓(𝐿, 𝐾)
𝑆𝑇: 𝐶 = 𝑃𝐿 𝐿 + 𝑃𝐾 𝐾
Example 4
Let the utility function of a consumer
𝑈 = 𝑓(𝑥1 , 𝑥2 ) = 𝑥1 𝑥2 + 2𝑥1
Assuming the consumer income (Y) is 60 and price of X1 is N4 and price of X2 is N2.
Solution
𝑀𝑎𝑥: 𝑈 = 𝑓(𝑥1 , 𝑥2 ) = 𝑥1 𝑥2 + 2𝑥1 … … … … … … .1
𝑆 𝑇: 4𝑥1 + 2𝑥2 = 60 … … … … … … … … 2
From equation 2, 𝑥2 = 30 − 2𝑥1 … … … … … … … .3
Using substitution method, substitute equation 3 in 1
𝑈 = 𝑥1 (30 − 2𝑥1 ) + 2𝑥1 ==> 32𝑥1 − 2𝑥12
𝑑𝑈
= 32 − 4𝑥1 = 0
𝑑𝑥1
𝑥1 = 8………………4
Substitute equation 4 in 3,
𝑥2 = 30 − 2𝑥1 = 30 − 2(8) = 14
SOC
𝑑2 𝑈
= −4 < 0
𝑑𝑥12
Therefore, U is maximized when X1 = 8 and X2 =14
When the constraint is itself a complicated function, or when there are several constraints to
consider, however, the technique of substitution and elimination of variables could be a
burdensome task. In such case, we resort to a method known as the method of Lagrange.
Lagrangian Multiplier Method
The essence of the Largragian multiplier approach is to convert a constrained extremum problem
into a form such that the first order condition of the free extremum problem can still be applied.
Example 5: let reconsider example 4
𝑀𝑎𝑥: 𝑈 = 𝑓(𝑥1 , 𝑥2 ) = 𝑥1 𝑥2 + 2𝑥1 … … … … … … .1
𝑆 𝑇: 4𝑥1 + 2𝑥2 = 60 … … … … … … … … 2
Solution
𝐿(𝑥1 , 𝑥2 , 𝜆) = 𝑥1 𝑥2 + 2𝑥1 + 𝜆(60 − 4𝑥1 − 2𝑥2 ) … … … … . .3
𝜕𝐿
= 𝑥2 + 2 − 4𝜆 = 0 … … … … … 4
𝜕𝑥1
𝜕𝐿
= 𝑥1 − 2𝜆 = 0 … … … … … 5
𝜕𝑥2
𝜕𝐿
= 60 − 4𝑥1 − 2𝑥2 = 0 … … … … … 6
𝜕𝜆
From equation 4 and 5
𝑥2 +2
𝜆= 4
𝑥1
𝜆= 2
𝑥2 +2 𝑥1
Therefore, =
4 2
𝑥2 = 2𝑥1 − 2 … … … … … … … 7
Sub. Equation 7 in 6
60 − 4𝑥1 − 2(2𝑥1 − 2) = 0
𝑥1 = 8 … … … … … . .8
Sub. Equation 8 in 7
𝑥2 = 2𝑥1 − 2 = 2(8) − 2 = 14
𝑥2 +2 𝑥1
𝜆= = =4
4 2
The Lagrange multiplier (λ) approximates the marginal impact on the objective function caused
by a small change in the constant of the constraint. Lagrange multipliers are often reffered to as
shadow prices. In utility maximization subject to a budget constraint, λ shows the marginal utility
of an extra naira of income.
SOC
𝑓11 𝑓12 𝑓13 𝑓11 𝑓12 𝑃𝑥
|𝐻| = |𝑓21 𝑓22 𝑓23 | = | 21 𝑓22 𝑃𝑦 |
𝑓
𝑓31 𝑓32 𝑓33 𝑃𝑥 𝑃𝑦 0
If the bordered Hessian determinant |𝐻 ̅ | is less than zero, that means that the bordered Hessian is
positive definite. Hence, a positive definite hessian always satisfied the sufficient condition for a
relative minimum.
If the bordered Hessian determinant |𝐻 ̅ | is greater than zero, the bordered Hessian is negative
definite and a negative Hessian always meet the sufficient condition for a relative maximum.

SOC for example 5


𝑓11 = 0 𝑓12 = 1 𝑓13 = −4
𝑓21 = 1 𝑓22 = 0 𝑓23 = −2
𝑓31 = −4 𝑓32 = −2 𝑓33 = 0
𝑓11 𝑓12 𝑓13 0 1 −4
|𝐻| = |𝑓21 𝑓22 𝑓23 | = | 1 0 −2|
𝑓31 𝑓32 𝑓33 −4 −2 0
|𝐻| = 16 > 0
Therefore, U is maximized at X1 =8 and X2 =4
Example 6
A firm has the opportunity of producing two goods namely rice (x) and sugar (y). The joint
cost function of producing these goods is C = 6 x + 10 y − xy + 30 and firm has a production
2 2

quota of x + y = 34 .
i. Set up the optimization problem of the firm
ii. What combination of rice and sugar should the firm produce?
iii. Estimate the effect on costs if the production quota is reduced by 1unit
iv. Is the production of the two goods in b(ii) optimize?
Solution
𝑀𝑖𝑛: 𝐶 = 6𝑥 2 + 10𝑦 2 − 𝑥𝑦 + 30
𝑆𝑡: 𝑥 + 𝑦 = 34
i. 𝐿(𝑥, 𝑦, 𝜆) = 6𝑥 2 + 10𝑦 2 − 𝑥𝑦 + 30 + 𝜆(34 − 𝑥 − 𝑦) … … … … … . .1
ii.
FOC from equation 1
𝜕𝐿
= 12𝑥 − 𝑦 − 𝜆 = 0 … … … … … … .2
𝜕𝑥
𝜕𝐿
= 20𝑦 − 𝑥 − 𝜆 = 0 … … … … … … .3
𝜕𝑦
𝜕𝐿
= 34 − 𝑥 − 𝑦 = 0 … … … … … … .4
𝜕𝜆
From equation 2 and 3
𝜆 = 12𝑥 − 𝑦
𝜆 = 20𝑦 − 𝑥
Therefore, 12𝑥 − 𝑦 = 20𝑦 − 𝑥
21
𝑥 = 13 𝑦 … … … … … … … 5
Sub. Equation 5 in 4
21
34 − 13 𝑦 − 𝑦 = 0
𝑦 = 13 … … … … … … … … … … … 6
Sub. Equation 6 in 5
21
𝑥 = 13 (13) = 21
iii. Effect on costs if the production quota is reduced by 1 unit
Recall 𝜆 = 12𝑥 − 𝑦 = 12(21) − 13 = 239
Therefore, if production is reduced by 1 unit, production quota will reduce by 239
iv. SOC from equation 2, 3 and 4

𝑓11 = 12 𝑓12 = −1 𝑓13 = −1


𝑓21 = −1 𝑓22 = 20 𝑓23 = −1
𝑓31 = −1 𝑓32 = −1 𝑓33 = 0
𝑓11 𝑓12 𝑓13 12 −1 −1
|𝐻| = |𝑓21 𝑓22 𝑓23 | = |−1 20 −1|
𝑓31 𝑓32 𝑓33 −1 −1 0

|𝐻| = −32 < 0


Therefore, costs of production is minimized at x =21 and y =13

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