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Mathematical Economics

Hasin Yousaf

Week 5

Optimization
Overview of today’s lecture

Optimization

• Relative and absolute maximum and minimum

• FOC and how to interpret FOC

• SOC and how to interpret SOC

• n-th derivative

• Taylor expansion

• Concave/ convex functions


Optimum Values and Extreme Values

• The most common criterion for choice among alternatives in eco-


nomics is the goal of maximizing something or minimizing some-
thing.

• Utility maximizing
• Revenue maximizing
• Cost minimizing

• We can characterize such maximization and minimization problems


under the general heading of optimization.

• The elements of optimization are:

• Objective function to be optimized


• Dependent variable which represents the object of optimization
• Independent variable(s) which represent the choice variables to be
chosen
Optimum Values and Extreme Values

• For example, in a firm’s profit maximization problem


• Objective function: Π(Q) = R(Q) − C(Q)
• Dependent variable: Profit Π
• Independent variable: Quantity Q

• In a more general setting, we will consider the general function

y = f (x)

and attempt to find a procedure for finding the level of x that will
maximize or minimize the value of y.
Absolute Maximium/ Minimum

Definition: Absolute Extremum

Consider the function y = f (x). Then:

• A point x̄ is an absolute maximum of y if

f (x̄) ≥ f (x)

for all x.

• A point x is an absolute minimum of y if

f (x) ≤ f (x)

for all x.
Relative Maximium/ Minimum

Definition: Relative Extremum

Consider the function y = f (x). Then:

• A point x̄ is a relative maximum of y if there is a ball


Br (x̄) about x̄ such that

f (x̄) ≥ f (x)

for all x ∈ Br (x̄).

• A point x is a relative minimum of y on if there is a ball


Br (x) about x such that

f (x) ≤ f (x)

for all x ∈ Br (x).


Relative Versus Absolute Extremum

For example, in the following figure:

10
D

8
B

6
y

4
C

2
A

0 2 4 6 8 10
x

• A: Absolute Minimum
• B: Local Maximum
• C: Local Minimum
• D: Absolute Maximum
First-Derivative Test

• Given a smooth function y = f (x), the first derivative f 0 (x) will


play a major role in finding the extremum values.
• This is due to the fact that if a relative extremum of the function
occurs at x = x0 , then it is characterized by a zero slope, i.e.
f 0 (x0 ) = 0.
10
B

6
y

C
2

0 2 4 6 8 10
x
First-Derivative Test

Theorem: First-Derivative Test

Let y = f (x), if x = x0 is a relative extremum then f 0 (x0 ) = 0


(first-order condition: FOC) and
1. x0 is a relative maximum if f 0 (x) changes sign from + to −
from the immediate left of x0 to its immediate right,

2. x0 is a relative minimum if f 0 (x) changes sign from − to +


from the immediate left of x0 to its immediate right,

3. x0 is an infection point (neither a maximum nor a minimum)


if f 0 (x) maintains the same sign on both the immediate left
and immediate right of x0 .

We call x0 a critical value of x if f 0 (x0 ) = 0.


Note that f 0 (x0 ) = 0 is the necessary condition, and the change of
sign is the sufficient condition for existence of a relative extremum x0
(relative max or min).
First-Derivative Test

10
x0

6
(+) (−)
y

0 2 4 6 8 10
x
The point x0 is a critical point since f 0 (x0 ) = 0. It is also a relative
maximum since f 0 (x) changes sign from + to − from the immediate
left to the immediate right of x0 .
First-Derivative Test

10

6
y

(−) (+)
4

x0
2

0 2 4 6 8 10
x
The point x0 is a critical point since f 0 (x0 ) = 0. It is also a relative
minimum since f 0 (x) changes sign from − to + from the immediate left
to the immediate right of x0 .
First-Derivative Test

10

8
(+)

6
x0
y

(+)
2

0 2 4 6 8 10
x

The point x0 is a critical point since f 0 (x0 ) = 0. It is also an inflection


point since f 0 (x) maintains a constant sign on both the immediate left
and the immediate right of x0 .
Derivative of a Derivative

If the function f (x) is a differentiable function, then f 0 (x) is also a


function. If f 0 (x) is differentiable, we denote its derivative by f 00 (x),
and call it the second derivative of f . This generalizes to higher order
derivatives:

• f (x): original function


dy
• f 0 (x) = dx : first derivative
d2 y
• f 00 (x) = dx2 : second derivative
dn y
• f n (x) = dxn : nth derivative

Exercise
x
Find the first four derivatives of the function f (x) = 1+x .

Click for Detailed Solution


Interpretation of the Second Derivative

• The derivative function f 0 (x) measures the slope (rate of change)


of the function f (x).

• By the same token, the second derivative function f 00 (x) measures


the rate of change of the first derivative, i.e. the slope of f (x).
( (
f 0 (x0 ) > 0 increase
• ⇒ the value of the function, f (x), tends to
f 0 (x0 ) < 0 decrease

( (
f 00 (x0 ) > 0 0 increase
• ⇒ the slope of the curve, f (x), tends to
f 00 (x0 ) < 0 decrease
Interpretation of the Second Derivative

Thus for positive first derivatives:

• f 0 (x) > 0 and f 00 (x) > 0 ⇒ the slope of the curve is positive and
increasing, so f (x) is increasing at an increasing rate.
• f 0 (x) > 0 and f 00 (x) < 0 ⇒ the slope of the curve is positive but
decreasing, f (x) is increasing at a decreasing rate.

The case of a negative first derivative can be interpreted analogously,


but we must be a little more careful:

• f 0 (x) < 0 and f 00 (x) > 0 ⇒ the slope of the curve is negative and
increasing, but this means the slope is changing to a larger number.
In other words, the negative slope becomes less steep as x increases.
• f 0 (x) < 0 and f 00 (x) < 0 ⇒ the slope of the curve is negative
and decreasing, and so the negative slope becomes steeper as x
increases.
Second-Derivative Test

Theorem: Second-Derivative Test

If the value of the first derivative of a function f at x = x0 is


f 0 (x0 ) = 0, the value of the function at x0 , f (x0 ), will be

• A relative maximum if the second-derivative value at x0 is


f 00 (x0 ) < 0.

• A relative minimum if the second-derivative value at x0 is


f 00 (x0 ) > 0.

Note that one drawback of the second-derivative test is that no un-


equivocal conclusion can be drawn in the event that f 00 (x0 ) = 0. For
then, the value f (x0 ) can be either a relative maximum, or a relative
minimum, or even an inflection value. Then, we must either revert to
the first-derivative test, or another test which we will develop later.
Second-Derivative Test

Example 1: Given f (x) = 4x2 − x, find the critical points


and classify them.
1
f 0 (x) = 8x − 1 = 0 ⇒ x0 = is a critical point
8
1
f 00 (x) = 8 > 0 ⇒ x0 = is a relative minimum
8

Example 2: Given g(x) = x3 − 3x2 + 2, find the critical


points and classify them.

g 0 (x) = 3x2 − 6x = 0 ⇒ x1 = 2 and x2 = 0 are critical points

g 00 (x) = 6x − 6 ⇒ g 00 (2) = 6 > 0 =⇒ x1 = 2 is a relative minimum


00
g (0) = −6 < 0 =⇒ x2 = 0 is a relative maximum
N th Derivative Test

Theorem: N th Derivative Test

Given a function y = f (x) and f 0 (x0 ) = 0; if the first nonzero


derivative in x0 encountered in successive derivations is that of
the nth derivative; the stationary value f (x0 ) will be
1. relative maximum if n is an even number and f (n) (x0 ) < 0;
2. relative minimum if n is an even number and f (n) (x0 ) > 0;
3. inflection point if n is an odd number.

Exercise

Examine the function y = (7 − x)4 for its relative extremum.

Click for Detailed Solution


Concavity and Convexity of Functions

Definition: Concave and Convex Functions

• A function f (x) is convex if the line segment formed by


joining any pair of points x1 and x2 on the curve f (x) lies
above or coincides with the curve. The function f (x) is
strictly convex if the line segment lies entirely above the
curve.

• A function f (x) is concave if the line segment formed by


joining any pair of points x1 and x2 on the curve f (x) lies
below or coincides with the curve. The function f (x) is
strictly convex if the line segment lies entirely below the
curve.
Concavity and Convexity of Functions

10

6
y

0 2 4 6 8 10
x
The function y = f (x) is strictly convex since the line segment joining
any pair of points on f (x) lies entirely above the curve.
Concavity and Convexity of Functions

10

6
y

0 2 4 6 8 10
x
The function y = f (x) is strictly concave since the line segment joining
any pair of points on f (x) lies entirely below the curve.
Testing for the Concavity and Convexity of Functions

Theorem: Concave and Convex Functions

Consider a function f (x), then

• if f 00 (x) < 0 for all x, then f (x) must be a strictly concave


function.

• if f 00 (x) > 0 for all x, then f (x) must be a strictly convex


function.

For example, the functionf (x) = 4x2 + 5 is strictly convex since f 00 (x) =
8 > 0.

For example, the function f (x) = x is strictly concave on its domain
[0, +∞) since f 00 (x) = − 14 x−3/2 < 0.
Maclaurin Series of a Polynomial Function

Consider the polynomial function of nth degree

f (x) = a0 + a1 x + a2 x2 + a3 x3 + a4 x4 + · · · + an xn

Successive differentiation yields:

f 0 (x) = a1 + 2a2 x + 3a3 x2 + 4a4 x3 + · · · + nan xn−1


f 00 (x) = 2a2 + 3(2)a3 x + 4(3)a4 x2 + · · · + n(n − 1)an xn−2
f 000 (x) = 3(2)a3 + 4(3)(2)a4 x + · · · + n(n − 1)(n − 2)an xn−3
f (4) (x) = 4(3)(2)a4 + 5(4)(3)(2)a5 x + · · · + n(n − 1)(n − 2)(n − 3)an xn−4
..
.
f (n) (x) = n(n − 1)(n − 2)(n − 3)...(3)(2)(1)an
Maclaurin Series of a Polynomial Function

The Maclaurin Series is evaluated at x = 0. Hence, the derivatives


become:
f 0 (0)
f 0 (0) = a1 = 1!a1 ⇒ a1 =
1!
00 f 00 (0)
f (0) = 2a2 = 2!a2 ⇒ a2 =
2!
f 000 (0)
f 000 (0) = 3(2)a3 = 3!a3 ⇒ a3 =
3!
f (4) (0)
f (4) (0) = 4(3)(2)a4 = 4!a4 ⇒ a4 =
4!
..
.
f (n) (0)
f (n) (0) = n(n − 1)(n − 2)(n − 3)...(3)(2)(1)an = n!an ⇒ an =
n!
Maclaurin Series of a Polynomial Function

Using factorials we can express the given function f (x) as a new, equiv-
alent, same-degree polynomial - the coefficients are expressed in terms
of derivatives evaluated at x = 0. This series is called the Maclaurin
series:

f (0) f 0 (0) f 00 (0) 2 f 000 (0) 3 f (4) (0) 4 f (n) (0) n


f (x) = + x+ x + x + x +· · ·+ x
0! 1! 2! 3! 4! n!

Exercise

Find the Maclaurin series for the function

f (x) = 2 + 4x + 3x2

Click for Detailed Solution


Taylor Series of a Polynomial Function

Consider the polynomial function of nth degree

f (x) = a0 + a1 x + a2 x2 + a3 x3 + a4 x4 + · · · + an xn

Successive differentiation yields:

f 0 (x) = a1 + 2a2 x + 3a3 x2 + 4a4 x3 + · · · + nan xn−1


f 00 (x) = 2a2 + 3(2)a3 x + 4(3)a4 x2 + · · · + n(n − 1)an xn−2
f 000 (x) = 3(2)a3 + 4(3)(2)a4 x + · · · + n(n − 1)(n − 2)an xn−3
f (4) (x) = 4(3)(2)a4 + 5(4)(3)(2)a5 x + · · · + n(n − 1)(n − 2)(n − 3)an xn−4
..
.
f (n) (x) = n(n − 1)(n − 2)(n − 3)...(3)(2)(1)an
Taylor Series of a Polynomial Function

Using factorials we can express the given function f (x) as a new, equiva-
lent, same-degree polynomial - the coefficients are expressed in terms of
derivatives evaluated at x = x0 . This series is called the Taylor series:

f (x0 ) f 0 (x0 ) f 00 (x0 ) f (n) (x0 )


f (x) = + (x−x0 )+ (x−x0 )2 +· · ·+ (x−x0 )n
0! 1! 2! n!

Exercise

Find the Taylor series at x = x0 for the function

f (x) = 2 + 4x + 3x2

Click for Detailed Solution


Expansion of an Arbitrary Function

It is possible to express any arbitrary function - not necessarily a


polynomial - in a polynomial form, provided that the function has finite
and continuous derivatives up to the desired order at the expansion x0 .

Theorem: Taylor’s Theorem

Consider a function φ(x) with finite and continuous derivatives


at the point x = x0 . Then, the nth order Taylor polynomial at
the point x = x0 is given by

φ(x0 ) φ0 (x0 ) φ(n) (x0 )


 
n
φ(x) = + (x − x0 ) + · · · + (x − x0 ) + Rn
0! 1! n!
φ(x) = Pn + Rn

where Pn represents the nth order Taylor polynomial, and Rn


denotes the remainder.
Expansion of an Arbitrary Function

Example 1: Find the second order Taylor Polynomial for the


1
function φ(x) = 1+x at x0 = 1.
−1
φ0 (x) = −(1 + x)−2 ⇒ φ0 (1) =
4
00 −3 00 1
φ (x) = 2(1 + x) ⇒ φ (1) =
4
Hence, the second order Taylor Polynomial is given as
φ(1) φ0 (1) φ00 (1)
P2 = + (x − 1) + (x − 1)2
0! 1! 2!
1 1 1
= − (x − 1) + (x − 1)2
2 4 8
7 1 1 2
= − x+ x
8 2 8
Then the functionφ(x) is given as
φ(x) = P2 + R2
7 1 1
= − x + x2 + R2
8 2 8
Detailed Solutions
• The first derivative:

f 0 (x) = (1 + x)−2

• The second derivative:

f 00 (x) = −2(1 + x)−3

• The third derivative:

f 000 (x) = 6(1 + x)−4

• The fourth derivative:

f (4) (x) = −24(1 + x)−5

Go Back
The derivatives of the function f (x) = 2 + 4x + 3x2 are:

f 0 (x) = 4 + 6x ⇒ f 0 (0) = 4
00 00
f (x) = 6 ⇒ f (0) = 6

Thus, the Maclaurin series is

f (0) f 0 (0) f 00 (0) 2


f (x) = + x+ x
0! 1! 2!
2
f (x) = 2 + 4x + 3x

Go Back
The derivatives of the function f (x) = 2 + 4x + 3x2 are:

f 0 (x) = 4 + 6x ⇒ f 0 (x0 ) = 4 + 6x0


00 00
f (x) = 6 ⇒ f (x0 ) = 6

Thus, the Taylor series is

f (x0 ) f 0 (x0 ) f 00 (x0 )


f (x) = + (x − x0 ) + (x − x0 )2
0! 1! 2!
6
= 2 + 4x0 + 3x20 + (4 + 6x0 )(x − x0 ) + (x − x0 )2
2
= 2 + 4x0 + 3x20 + 4x − 4x0 + 6xx0 − 6x20 + 3x2 + 3x20 − 6xx0
= 2 + 4x + 3x2

Go Back
Find the extremum:

f 0 (x) = −4(7 − x)3 = 0 ⇒ x0 = 7

nth derivative test:

f 00 (x) = 12(7 − x)2 ⇒ f 00 (7) = 0


f 000 (x) = −24(7 − x) ⇒ f 000 (7) = 0
f (4) (x) = 24 ⇒ f (4) (7) = 24 > 0

Since n = 4 is an even number and f (4) (x0 ) > 0, then f (x0 = 7) is a


relative minimum.

Go Back