Problem Set 3.

Profit Maximization and Profit Functions

EconS 526

1. The production function for good z is 𝑓𝑓(𝑥𝑥) = 100x − x 2 where x is an input. The price of
good z is p and the input price for x is w.
a. Set up the problem for a profit maximizing firm and solve for the demand function for x.
Do not forget to show the first order condition and show if the second order condition
satisfies the condition for a maximum.
b. What condition is required for x>0? When will the firm opt to produce x=0?
c. Derive the profit function. What is the derivative of the profit function with respect to w?
Show the expression and interpret it.

a.

max 𝑝𝑝(100x − x 2 ) − 𝑤𝑤𝑤𝑤

𝑥𝑥

First order condition,

𝑝𝑝(100 − 2𝑥𝑥) − 𝑤𝑤 = 0
𝑤𝑤
Therefore, 𝑥𝑥 ∗ = 50 − .
2𝑝𝑝

The SOC is -2p<0.

b.

We need 100p>w for x>0. If 100p<=w then x=0.

c.

𝑤𝑤 𝑤𝑤 𝑤𝑤 𝑤𝑤 𝑤𝑤
𝜋𝜋(𝑤𝑤, 𝑝𝑝) = 𝑝𝑝 �100 − 50 + � �50 − � − 𝑤𝑤 �50 − � = �50p − � �50 − �
2𝑝𝑝 2𝑝𝑝 2𝑝𝑝 2 2𝑝𝑝
𝑑𝑑𝑑𝑑(𝑤𝑤,𝑝𝑝) 𝑤𝑤
From envelope theorem, we know this will equal –x* so we would find, 𝑑𝑑𝑑𝑑
= −(50 − ) which can
2𝑝𝑝
be verified by taking the derivative of the above function.

2. A firm employs a Cobb-Douglas production function of the form 𝑦𝑦 = 𝐾𝐾 0.4 𝐿𝐿0.4. The output
price is p and the input prices are r and w for K and L, respectively. Set up the problem for a
profit maximizing firm and solve for the demand function for both inputs. Do not forget to
show the first order condition and interpret each condition. Also show if the second order
condition satisfies the condition for a maximum. Finally, derive the profit function.

max 𝜋𝜋 = 𝑝𝑝𝐾𝐾 0.4 𝐿𝐿0.4 − 𝑟𝑟𝑟𝑟 − 𝑤𝑤𝑤𝑤

𝐾𝐾𝐾𝐾

FOCs
𝜕𝜕𝜕𝜕
= 𝑝𝑝0.4𝐾𝐾 −0.6 𝐿𝐿0.4 − 𝑟𝑟 = 0 which means the value of marginal product of capital is equal to the input
𝜕𝜕𝜕𝜕
price of capital.

𝜕𝜕𝜕𝜕
= 𝑝𝑝0.4𝐾𝐾 0.4 𝐿𝐿−0.6 − 𝑤𝑤 = 0 which means the value of marginal product of capital is equal to the input
𝜕𝜕𝜕𝜕
price of labor.

𝑟𝑟 1/0.4 0.6/0.4
From the first FOC we get 𝐿𝐿 = � � 𝐾𝐾 . Substitute this into the second FOC and solve for K,
𝑝𝑝0.4

𝑟𝑟 −0.6/0.4 −0.36/0.4
𝑝𝑝0.4𝐾𝐾 0.4 � � 𝐾𝐾 − 𝑤𝑤 = 0
𝑝𝑝0.4

1
𝐾𝐾 = � 2 3 � (𝑝𝑝0.4)5
𝑤𝑤 𝑟𝑟

So, we have

1
𝐿𝐿 = � 3 2 � (𝑝𝑝0.4)5
𝑤𝑤 𝑟𝑟

SOC,

𝜕𝜕2 𝜋𝜋
= −𝑝𝑝0.24𝐾𝐾 −1.6 𝐿𝐿0.4 < 0;
𝜕𝜕𝐾𝐾2
𝜕𝜕2 𝜋𝜋
= −𝑝𝑝0.24𝐿𝐿−1.6 𝐾𝐾 0.4 < 0;
𝜕𝜕𝐿𝐿2
𝜕𝜕2 𝜋𝜋 𝜕𝜕2 𝜋𝜋
= = 0.16𝑝𝑝𝐾𝐾 −0.6 𝐿𝐿−0.6 > 0.
𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕 𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕

𝜕𝜕2 𝜋𝜋 𝜕𝜕2 𝜋𝜋 𝜕𝜕2 𝜋𝜋 𝜕𝜕2 𝜋𝜋

The determinant of the Hessian is − = 𝑝𝑝0.24𝐾𝐾 −1.6 𝐿𝐿0.4 𝑝𝑝0.24𝐿𝐿−1.6 𝐾𝐾 0.4 −
𝜕𝜕𝐾𝐾2 𝜕𝜕𝐿𝐿2 𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕 𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕
(0.16𝑝𝑝𝐾𝐾 −0.6 𝐿𝐿−0.6 )2 > 0

This is a max.

Finally, the profit function is,

(𝑝𝑝0.4)4 (𝑝𝑝0.4)5
𝜋𝜋� = 𝑝𝑝 � 𝑤𝑤 2 𝑟𝑟 2
� −2 𝑤𝑤 2 𝑟𝑟 2
.

3. The following production function characterizes production of good y, 𝑓𝑓(𝑥𝑥, 𝑧𝑧) = x 𝑎𝑎 + z 𝑏𝑏

where 0< 𝑎𝑎 <1 and 0<b<1. The output price is p, the input prices for x and z are wx and wz,
respectively.
a. Calculate the input demand functions, the supply function and the profit function.
b. Use the profit function and envelope theorem to derive the effect wz on input demand for
z and x. Are x and z complements or substitutes? Prove your answer.
 a.

max 𝜋𝜋 = 𝑝𝑝(x 𝑎𝑎 + z 𝑏𝑏 ) − 𝑤𝑤𝑥𝑥 𝑥𝑥 − 𝑤𝑤𝑧𝑧 𝑧𝑧

𝑥𝑥,𝑧𝑧

FOCs

𝑝𝑝𝑝𝑝𝑥𝑥 𝑎𝑎−1 − 𝑤𝑤𝑥𝑥 = 0

𝑝𝑝𝑝𝑝𝑧𝑧 𝑏𝑏−1 − 𝑤𝑤𝑧𝑧 = 0

Thus,

𝑤𝑤 1/(𝑎𝑎−1) 𝑤𝑤 1/(𝑏𝑏−1)
𝑥𝑥 = �𝑝𝑝𝑝𝑝𝑥𝑥 � and 𝑧𝑧 = �𝑝𝑝𝑝𝑝𝑧𝑧�

𝑤𝑤 𝑎𝑎/(𝑎𝑎−1) 𝑤𝑤 𝑏𝑏/(𝑏𝑏−1)
The supply function is therefore 𝑓𝑓 = �𝑝𝑝𝑝𝑝𝑥𝑥 � + �𝑝𝑝𝑝𝑝𝑧𝑧� .

1
𝑤𝑤 𝑎𝑎/(𝑎𝑎−1) 𝑤𝑤 𝑏𝑏/(𝑏𝑏−1) 𝑤𝑤 𝑎𝑎−1 𝑤𝑤 1/(𝑏𝑏−1)
The profit function is 𝑝𝑝 ��𝑝𝑝𝑝𝑝𝑥𝑥 � + �𝑝𝑝𝑝𝑝𝑧𝑧� �− 𝑤𝑤𝑥𝑥 �𝑝𝑝𝑝𝑝𝑥𝑥 � − 𝑤𝑤𝑧𝑧 �𝑝𝑝𝑏𝑏𝑧𝑧�

b.

From envelope theorem, we know 𝜋𝜋�𝑤𝑤𝑧𝑧 = −𝑧𝑧 ∗ .

𝜕𝜕𝜕𝜕
X and z are not related because 𝜋𝜋�𝑤𝑤𝑧𝑧𝑤𝑤𝑥𝑥 = − = 0.
𝜕𝜕𝑤𝑤𝑥𝑥

4. A competitive profit maximizing firm has the following profit function: 𝜋𝜋(𝑝𝑝, 𝑤𝑤1 , 𝑤𝑤2 ) =
𝑝𝑝(𝑔𝑔(𝑤𝑤1 ) + ℎ(𝑤𝑤2 )).
a. Characterize the functions 𝑔𝑔(𝑤𝑤1 ) and ℎ(𝑤𝑤2 ). (Describe their first and second order
conditions for the profit function to be well behaved).
b. How does the price of input 2, 𝑤𝑤2 , affect factor demand for input 1? Prove your answer.

a.

Since the profit function is convex and decreasing in input prices, we would need 𝑔𝑔′ < 0, 𝑔𝑔′′ >
0, ℎ′ < 0, and ℎ′′ > 0.

b.

It has no effect. First, we can get factor demand for input 1 using envelope theorem,
𝜕𝜕𝜕𝜕
− = −𝑝𝑝𝑔𝑔′ (𝑤𝑤1 ) ≡ 𝑥𝑥1
𝜕𝜕𝑤𝑤1
Take the cross derivative with respect to w2,

𝜕𝜕 2 𝜋𝜋 𝜕𝜕𝜕𝜕
− = =0
𝜕𝜕𝑤𝑤1 𝜕𝜕𝑤𝑤2 𝜕𝜕𝑤𝑤2

Deadline: October 5, 2016 beginning of class. See syllabus for penalty due to late submissions.