205 Topic 7B
205 Topic 7B
205 Topic 7B
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
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.
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
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