INTERMEDIATE MICROECONOMICS

MATH REVIEW

August 31, 2008

OUTLINE

1. Functions

• Definition
• Inverse functions
• Convex and Concave functions

2. Derivative of Functions of One variable

• Definition
• Rules for finding a derivative
• Some applications to economics

3. Derivative of Multi-variable Functions

• Definition
• Partial Derivatives
• Total differentiation

• Some applications to economics

4. (Unconstrained) Optimization - Maximization and Minimization Problems

• First order conditions (FOC)- necessary

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 • Second order conditions(SOC)- sufficient
• Some applications to economics

5. Optimization with Linear Constraints

• Substitution Method
• Lagrange Multiplier Method
• Applications to economics

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1 Functions
Definition 1 A function f is a mapping from some set A (called the domain of
the function) to some set B (called the range of the function) which satisfies a
condition that to every element in A, f assigns a unique element from the set B.
In short we write: f : A → B

1.1 Inverse functions

We will see inverse functions when we talk about supply and demand functions.
We can express price as a function of quantity and quantity as a function of price.
Here is a formal definition.

Definition 2 Suppose that we are given a function f : X → Y . We say that f has

an inverse if there is a function g such that the domain of g is the range of f and
such that
f (x) = y if and only if g(y) = x
for every x ∈ X and for every y ∈ Y .

Example Demand function specifies what the quantity demanded will be for
a given price, e.g. Qd (p) = 100 − 5p.

Inverse demand function tells us what the price should be at a given quantity,
e.g. Pd (q) = 20 − 51 q.

NOTE: Make sure you know how to find the inverse of a given function!

1.2 Concave and convex functions

This section will be a about real-valued functions. (i.e. the range is the set real
numbers)

Definition 3 Assume we have a function f : A → R, where A is a convex set.

We say that the function f is convex if for all a1 ∈ A, for all a2 ∈ A and for all
λ ∈ (0, 1) we have:

f (λa1 + (1 − λ)a2 ) ≤ λf (a1 ) + (1 − λ)f (a2 )

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We say that the function f is concave if for all a1 ∈ A, for all a2 ∈ A and for all
λ ∈ (0, 1) we have:

f (λa1 + (1 − λ)a2 ) ≥ λf (a1 ) + (1 − λ)f (a2 )

Examples
1. Function f (x) = x2 is convex. To see this take for example x1 = 0, x2 = 2
and λ = 41 . Then check that the inequality holds. (NOTE: If you want to
completely prove that this function is convex, you need to show that the
inequality holds for any x1 , x2 ,and λ)
√
2. Function f (x) = x is concave. Try the same numbers as above. You can
also try different numbers.

2 Derivative of Functions of One variable

Let f : R → R be a real-valued function.
Definition 4 The derivative of f at point x∗ is defined as
f (x∗ + h) − f (x)
f 0 (x∗ ) ≡ lim
h→0 h
Definition 5 f is said to be differentiable at x∗ if the above limit exists.

Definition 6 f is said to be differentiable if it is differentiable at every point in

its domain.

• Intuitively, derivative of a real-valued function of one variable shows how

much the value of the function changes with respect to a very very small
change in its argument (x) at that point.

• Geometrically, derivative of a function at a point is equal to the slope of the

tangent line passing through that point.

• Sign of the derivative gives information about the behavior of the function.
If f 0 > 0, then f is strictly increasing; similarly, if f 0 < 0, then f is strictly
decreasing.

• Second derivative of f, denoted by f 00 , is the derivative of f 0 .

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2.1 Rules for finding derivatives
1. If k ∈ R, i.e. it is a constant, then
dk
=0
dx
2. Multiplication by a constant k,
d[kf (x)]
= kf 0 (x)
dx
3. If k is a constant, then
dxk
= k.xk−1
dx
d(lnx) 1
4. dx
= x

d(kx )
5. dx
= k x .lnk for any constant k ∈ R.
d(ex )
In particular, dx
= ex .lne = ex .
6. Derivative of sum-difference
d[f (x) ± g(x)]
= f 0 (x) ± g 0 (x)
dx
7. Derivative of multiplication of two functions (Product Rule)
d[f (x).g(x)]
= f 0 (x).g(x) + g 0 (x).f (x)
dx
8. Quotient Rule
d[f (x)/g(x)] f 0 (x).g(x) − f (x).g 0 (x)
=
dx [g(x)]2

9. Chain rule
d[f (g(x))]
= f 0 (g(x)).g 0 (x)
dx
or you can denote chain rule as,
if y = f (x) and x = g(z)
dy dy dx
= .
dz dx dz

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2.2 Second derivative
Definition 7 Second derivative of a function f at x∗ is defined as:

f 0 (x∗ + h) − f 0 (x∗ )
f 00 (x∗ ) ≡ lim
h→0 h
NOTE: second derivative is simply a derivative of the derivative.

2.2.1 Second derivative and concave/convex functions

Second derivative can be used to determine whether a real-valued function of one
variable is concave or convex.

Theorem 1 Suppose that f is a real-valued function of one variable and suppose

that f 00 exists. Then f is convex if and only if f 00 ≥ 0.

Theorem 2 Suppose that f is a real-valued function of one variable and suppose

that f 00 exists. Then f is concave if and only if f 00 ≤ 0.

2.3 Application to economics

In Econ1101, we defined marginal utility (MU) of a consumer as the increase in
utility by consuming an additional unit of a good; marginal cost (MC) of a firm as
the change in total cost if output increases by one unit; and marginal profit (MP)
of a firm as the change in profit if output increases by one unit.

Now, we are after how much the utility, cost or profit changes if we increase the
amount consumed or produced by a very very small amount. So, to find marginal
changes, we’ll find the derivatives of utility, cost or profit functions.

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3 Derivative of Multi-variable Functions
Economic problems usually involve functions of more than one variable. For
example, a consumer’s utility generally depends on more than one type of good.
Similarly, cost function of a firm depends on more than one type of input, i.e.
cost of labor, cost of physical capital and cost of land. Problems with multi-
variables are of interest since trade-offs must be made among these variables. The
dependence of one variable y on a series of other variables (x1 , x2 , ..., xi , ..., xn )
is denoted by y = f (x1 , x2 , ..., xi , ..., xn ).

3.1 Partial derivatives

Definition 8 Let y = f (x1 , x2 , ..., xi , ..., xn ). A partial derivative of f with re-
spect to xi at x̂ = (x̂1 , x̂2 , ..., x̂i , ..., x̂n ) 1 is:

∂f (x)  f (x̂1 , x̂2 , ..., x̂i + h, ..., x̂n ) − f (x̂1 , x̂2 , ..., x̂i , ..., x̂n )
≡ lim
∂xi x=x̂ h→0
 h
∂y
NOTE: equivalent notations are ∂xi
or fi (x).

It is easy to calculate partial derivatives. If you take partial derivative with re-
spect to xi , you have to treat other arguments as constants. The intuition is that
we keep the values of all other variables fixed.

Example

1. Suppose C(l, k) = 4l2 + 3k 2 .

∂C ∂C
= 8l = 6k
∂l ∂k

2. Suppose U (x, y) = 2lnx + lny.

∂U 2 ∂U 3
= =
∂x x ∂y y
1
The boldface letters denote vectors.

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3.2 Total differentiation
If all the x’s are varied by a small amount, the total effect on y will be the sum
of effects. In other words, total change in y can be decomposed into changes
resulting from changes of x1 , x2 , ..., xi , ..., xn .

Definition 9 Let y = f (x) = f (x1 , x2 , ..., xi , ..., xn ). A total differential of f is

defined as:
∂f (x) ∂f (x) ∂f (x)
df (x) = dx1 + dx2 + ... + dxn
∂x1 ∂x2 ∂xn
Examples
1. Suppose that, we have a daily income function of an individual given by:
I(h, w) = h · w. It’s a function of two variables: hours worked (h) and
hourly wage (w). We know that:
∂I ∂I
= w and =h
∂h ∂w
Hence the total differential will be:
∂I ∂I
dI = dh + dw = w · dh + h · dw
∂h ∂w
2. This example will use the chain rule. Suppose that, firm’s profit is a func-
tion of output and advertising. Let q denote output and a denote advertising
(it can be for example the amount of $ spent on it). The profit function is:
π(q, a) = 10q − q 2 + 2qa + 10a − a2 . We also know that firm’s output is
a function of world price p, i.e. q(p) = 50 + 2p. Initially q = 5, a = 5.
Calculate the change in profit if the world price falls by 0.1 and firm decides
to increase the money spent on advertising by 0.1.

Answer: Compute the total differential of the profit function. It is given

by:
∂π ∂π ∂π ∂q ∂π
dπ = dq + da = dp + da =
∂q ∂a ∂q ∂p ∂a
= (10 − 2q + 2a)2dp + (2q + 10 − 2a)da
Since dp = −0.1 and da = 0.1 we get:
dπ = (10−2·5+2·5)·2·(−0.1)+(2·5+10−2·5)·0.1 = −20·0.1+10·0.1 = −1

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3.3 Application to economics
• Again, partial derivatives are used to analyze the trade-off among differ-
ent variables. We’ll see the concepts such as marginal rate of substitution
among two different goods; marginal rate of technical substitution among
factors of production.

• It is used to calculate elasticity. For instance, price elasticity of demand and

supply; or income elasticity of demand.

4 (Unconstrained) Optimization
We are interested in problems such as consumer maximizing utility, consumer
minimizing expenditure, firm maximizing profit or firm minimizing cost. We can
find solutions to maximization and minimization problems by applying simple
calculus techniques.

Definition 10 Function f has a local maximum at x∗ if there exists some open

interval I that contains x∗ and f (x∗ ) ≥ f (x) for all x ∈ I.

Definition 11 Function f has a global maximum at x∗ if f (x∗ ) ≥ f (x) for all x

in the domain of f .

Definition 12 If a function f has a local (global) maximum at x∗ then x∗ is called

a local (global) maximizer of f .

Next theorem says that if a differentiable function has a local maximum/minimum

at a point, then the derivative at this point has so be zero.

Theorem 3 First Order Necessary Condition for maximum/minimum

Let f be a real-valued function of one variable. Suppose that f has a local maxi-
mum/minimum at some point x∗ and suppose that f 0 (x∗ ) exists. Then f 0 (x∗ ) = 0.

Remark: This theorem does not say that if f 0 (x∗ ) = 0 then f has a maxi-
mum/minimum at the point. In particular, we are not able to distinguish between
maximum and minimum. It can also happen that neither one occurs.

The next two theorems help us determine whether the function attains a maxi-
mum or a minimum.

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Theorem 4 Sufficient Condition for maximum (SOC)
Let f be a real-valued function of one variable. Suppose that f 00 (x∗ ) exists and
suppose that f 0 (x∗ ) = 0 and f 00 (x∗ ) < 0. Then f has a local maximum at x∗ .

Theorem 5 Sufficient Condition for minimum(SOC)

Let f be a real-valued function of one variable. Suppose that f 00 (x∗ ) exists and
suppose that f 0 (x∗ ) = 0 and f 00 (x∗ ) > 0. Then f has a local minimum at x∗ .

Examples

1. Suppose that the relationship between profits π and quantity produced q is

given by π(q) = 1000q − 5q 2 . We can verify that q ∗ = 100 maximizes
profits. FOC (necessary)
dπ
= 1000 − 10q = 0
dq
implies that at q ∗ = 100 profit function attains either a maximum or a min-
imum. We need to see q ∗ = 100 is indeed a local maximum by checking
SOC, i.e. π 00 = −10 < 0.

2. Consider a function f (x) = 16x − 2x2 . We can verify that the function
 has
∗ 0
a local maximum at a point x = 4. We have that f (4) = 16 − 4xx=4 =
16 − 4 · 4 = 0. FOC is satisfied. We can calculate f 00 (4) = −4 < 0, hence
the sufficient condition is satisfied. Function f has a local maximum at 4.

3. This example will highlight the difference between a local and a global
maximum/minimum. Suppose that we have a function f : R+ → R, i.e.
f is a real-valued function defined on the set of non-negative real numbers.
Assume f (x) = 13 x3 − 23 x2 + 2x + 10. We want to find local and global
maximuma/minima. FOC for maximum/minimum is: f 0 (x) = x2 −3x+2 =
0, which can be solved for x to give x = 1 or x = 2. Now we notice that
f 00 (x) = 2x − 3, hence f 00 (1) = −1 < 0 and f 00 (2) = 1 > 0, so there is a
local maximum at x = 1 and a local minimum at x = 2. We can evaluate
the function at x = 1 and at x = 2: f (1) = 10 56 and f (2) = 10 64 . However,
f (0) = 10 < 10 46 = f (2), so global minimum is not at x = 2 (it’s actually
at x=0). We also have that limx→∞ f (x) = ∞, so the function doesn’t have
global maximum.

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4.1 Unconstrained optimization with more than one variable
Now assume that we have a real-valued function y = f (x1 , ..., xn ), where all
x0 s ∈ R.

Theorem 6 First Order Necessary Condition for maximum/minimum

Suppose that f has a local maximum/minimum at some point x∗ = (x∗1 , ..., x∗n ).
∗ ∗ ∗ ∗ ∗
Suppose that ∂f∂x(x1 ) ,... ∂f∂x(xn ) exist. Then ∂f∂x(x1 ) = ∂f∂x(x2 ) = ... = ∂f∂x(xn ) = 0.

Intuitively, if one of the partials were greater or less than 0, then y could be
increased by increasing or decreasing xi .

5 Constrained Optimization
Consider the following problem: There is a consumer who gets utility by consum-
ing pizza and beer. Suppose this consumer has 24 dollars to spend on these goods.
The price of one slice of pizza is 2 dollars, the price of one beer is 3 dollar. The
utility function of the consumer is given by:

U (p, b) = 2ln(p) + ln(b)

This consumer’s problem can be written as:

max U (p, b) = 2ln(p) + ln(b)

x,y

subject to
2p + 3b = 24 (BudgetConstraint)

U is called the objective function, p and b are called choice variables.

There are two ways to solve this problem.

5.1 Substitution method

We can rewrite the budget constraint as b = 8 − 32 p and plug this into objective
function. Then, the consumer’s problem becomes simply maximizing
2
U (p) = 2ln(p) + ln(8 − p)
3

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FOC (necessary) implies

dU 2 2/3
= − =0
dp p (8 − 23 p)

We can verify p∗ = 8 satisfies the above equation. We have to check second

derivative is negative to show that this is indeed a maximum. (It is left as an
exercise.)
Now, we can find maximum b∗ from the constraint.
2 8
b∗ = 8 − .8 =
3 3

5.2 Lagrange multiplier method

One method for solving constraint maximization problems is the Lagrangian mul-
tiplier method.
The formal problem:
Suppose you want to find the values x1 , ..., xn that maximize

y = f (x1 , ..., xn )

subject to
g(x1 , ..., xn ) = c
First, we set up Lagrangian

L = f (x1 , ..., xn ) + λ[c − g(x1 , ..., xn )] (1)

where λ is the additional variable called the Lagrange multiplier. (We’ll treat
λ as a variable in addition to x’s.) Note that when the constraint holds L and
f have the same value. So, if we restrict attention only to x’s that satisfy the
constraint, finding the constraint maximum value of f is equivalent to finding
optimal(critical) values of L. The following are conditions for a critical point for
the function L. Note that there are n + 1 equations with n + 1 unknowns.

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 From Equation 1, the FOCs for an optimum (critical) point are:
∂L ∂f ∂g
= +λ =0
∂x1 ∂x1 ∂x1
∂L ∂f ∂g
= +λ =0
∂x2 ∂x2 ∂x2
.
.
∂L ∂f ∂g
= +λ =0
∂xn ∂xn ∂xn
∂L
= [c − g(x1 , ..., xn )] = 0.
∂λ

Let’s apply this method to the consumer’s problem. The objective function is
U (p, b) = 2ln(p) + ln(b) and the constraint function is g(p, b) = 2p + 3b and
c = 24. The Lagrangian function is:
L = 2ln(p) + ln(b) + λ[24 − (2p + 3b)]
FOCs of the Lagrangian are:
∂L 2
= ∗ − 2λ∗ = 0
∂p p
∂L 1
= ∗ − 3λ∗ = 0
∂b b
∂L
= [24 − (2p + 3b)] = 0
∂λ
.
Note that the last equation simply says that the budget constraint in the maxi-
mization problem has to hold. The above system has 3 equations and 3 unknowns
(p∗ ,b∗ and λ∗ ) and easy to solve. You’ll see λ∗ = 1/8, p∗ = 8 and b∗ = 8/3. (Do
it!)

Remark:The variable λ has an important economic interpretation. It tells us how

much will the value of our maximized objective function increase if we relax our
constraint. Suppose we will increase consumer’s income from 24 to 25. λ∗ = 1/8
says that maximum possible utility obtained by these goods will increase by ap-
proximately 1/8.

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