Optimization With More Than One Variable II

EC115 - Methods of Economic Analysis
Spring Term, Lecture 5

Optimization with more than one variable:
Economic applications
Renshaw - Chapter 15
University of Essex - Department of Economics
Week 20
Domenico Tabasso (University of Essex - Department of Economics) Lecture 5 - Spring Term Week 20 1 / 31
This weeks topics
Introduction: Review of a Single-Product Competitive
Firm;
Case of a Multi-Product Competitive Firm;
Duopoly: The Cournot Model;
Duopoly: The Stackelberg Model.
Introduction: Review of a Single-Product Competitive Firm
The concepts of maximum, minimum and saddle points
of a function have several applications in economics.
For example, consider the case of a group of
shareholders of a rm that would like to maximize the
prots of their rm:
= TR TC
Assume this rm produces a single product and
operates in a competitive market. This implies that it
takes the price of the good it produces, P, as given.
Hence the only instrument they can use to achieve their
goal is output, Q.
Translation into Maths
The problem of the shareholders can be described by
max
Q
(Q), where (Q) = TR(Q) TC(Q).
where TR(Q) = P Q is the total revenue of the rm
and TC(Q) is the total cost of the rm (both as
functions of output).
What is the level of Q that maximizes prots?
When an additional unit of output brings in more
revenue than it costs to produce then the rm will
increase production. At this point total prots are
increasing!
The rm will stop increasing production when the extra
revenue from producing one more unit of output equals
its cost of producing that extra unit.
Suppose we let Q
denote the level of output at which

the rm reaches this equality.
Why not produce more? If the rm did so, total prots
would start decreasing!
The rst order condition
This logic is summarized in the prot maximizing
condition:
MR(Q
) = MC(Q
)
Note that since:
MR(Q) =
dTR(Q)
dQ
and MC(Q) =
dTC(Q)
dQ
,
the prot maximizing condition can be re-written as:
d(Q)
dQ
=
dTR(Q
)
dQ

dTC(Q
)
dQ
= 0.
This expression is just the rst order condition for
maximizing (Q) with respect to Q.
The second order condition
To be sure that Q
is eectively a maximum and not a

minimum we have to verify that the prot function is
concave at Q
:
d
2
(Q
)
dQ
2
< 0.
That is, this condition guarantees that for output levels
Q < Q
the rms prots are increasing and for

Q > Q
the prots are decreasing.

However, this is just the second order condition to
examine if the function (Q) = TR(Q) TC(Q)
reaches a maximum at Q = Q
.
Multi-product competitive rm
Now suppose that the rm is able to produce two
dierent goods, Q
1
and Q
2
, each of which is sold in a
competitive market at per unit prices of P
1
and P
2
respectively. Again, the shareholders seek to maximize
prots.
The prot function is given by:
(Q
1
, Q
2
) = TR
1
(Q
1
) +TR
2
(Q
2
) TC(Q
1
, Q
2
).
Now assume that the total cost is given by:
TC(Q) = 2Q
2
1
+2Q
1
Q
2
+Q
2
2
.
Hence the prots of this rm can be written as:
(Q
1
, Q
2
) = P
1
Q
1
+P
2
Q
2
2Q
2
1
2Q
1
Q
2
Q
2
2
where P
1
and P
2
are positive constants.
What the shareholders would like to know are the values
of Q
1
and Q
2
the rm has to produce to maximize
prots max
Q
1
,Q
2
(Q
1
, Q
2
). Thus they need to solve:
max
Q
1
,Q
2
(Q
1
, Q
2
) = (P
1
Q
1
+P
2
Q
2
2Q
2
1
2Q
1
Q
2
Q
2
2
)
Partial dierentiation
Because this is a function of two independent variables,
we need to apply the technique learned in the last
lecture!
The rst order conditions are that at
(Q
1
= Q
1
, Q
2
= Q
2
):
(Q
1
, Q
2
)
Q
1
= 0
(Q
1
, Q
2
)
Q
2
= 0.
The second order conditions are that at
(Q
1
= Q
1
, Q
2
= Q
2
):
2
(Q
1
, Q
2
)
Q
2
1
< 0
2
(Q
1
, Q
2
)
Q
2
2
< 0
2
(Q
1
, Q
2
)
Q
2
1
2
(Q
1
, Q
2
)
Q
2
2
>
2
(Q
1
, Q
2
)
Q
1
Q
2
2
[Recall that the last term follows from Youngs
Theorem.]
Lets solve it
For simplicity assume that P
1
= 10 and P
2
= 8 such
that
(Q
1
, Q
2
) = 10Q
1
+8Q
2
2Q
2
1
2Q
1
Q
2
Q
2
2
What are the values of Q
1
and Q
2
which make
(Q
1
, Q
2
) as big as possible?
We start by solving the following rst order conditions:
(Q
1
, Q
2
)
Q
1
= 0 10 4Q
1
2Q
2
= 0
(Q
1
, Q
2
)
Q
2
= 0 8 2Q
2
2Q
1
= 0
This is a system of two linear equations!
The solution is:
Q
1
= 1 and Q
2
= 3.
To verify this:
10 4Q
1
2Q
2
= 10 4 6 = 0
8 2Q
2
2Q
1
= 8 2 6 = 0.
These are the candidate points for a maximum.
The next step is to obtain the second partial and cross
partial derivatives and use them to check the second
order conditions.
The second order conditions
Here:
2
(Q
1
, Q
2
)
Q
2
1
= 4 < 0 for any value of Q
1
and Q
2
2
(Q
1
, Q
2
)
Q
2
2
= 2 < 0 for any value of Q
1
and Q
2
and:
2
(Q
1
, Q
2
)
Q
1
Q
2
= 2 for any value of Q
1
and Q
2
.
Since 8 > 4 the cross partial derivative condition is also
satised.
We can conclude that the shareholders want the rm to
produce one unit of good 1 and three units of good 2
at the going prices.
The maximum prot the rm can make is then:
(Q
1
, Q
2
) = 10 1 +8 3 2 1
2
2 1 3 3
2
= 10 +24 2 6 9 = 34 17 = 17.
Duopoly: An Introduction
We dene as a duopoly a situation in which only two
rms are present in a certain market and sell the same
good;
The rms have two options: they can compete or they
can collude;
We will only focus on the competitive case.
In this respect we will focus on two dierent models:
1
Duopoly la Cournot;
2
Duopoly la Stackelberg.
NOTE:These models are not explained in the book from
Renshaw. In the CMR you will nd some extra material on
duopoly. This material is 100% part of the course!
Duopoly: The Cournot Model
In the Cournot model two identical rms (A and B)
compete choosing the quantity so that they can both
maximize their prots.
It is important to note that A and B choose their quantities
simultaneously. So basically rm A observes what rm B
produces and chosees its optimal answer (in terms of
quantity).
At the same time rm B does the same: observes the
quantity chosen by A and optimally reacts to this quantity.
The Cournot Model - The reaction curve, 1
Imagine the market demand is given by Q = f (p).
Imagine that for some reasons A decides to produce
q
A
= 100. Hence B now faces a residual demand
Q = f (p) 100.
But now B can act as a monopolist and choose the
quantity q
B
such such that MR = MC.
Of course this quantity depends on q
A
: Had A chosen
q
A
= 200, the residual demand for B would have been
dierent and so the optimal quantity q
B
P
MR1 MR2 MR3
MC
q1
q2
q1 q1 q1
q2
q2
q2
q1
q1 q1 q1
q2=0
So for each quantity chosen by A, theres a best
response q
B
which depends on (it is a function of) q
A
.
The same is true for A, which observes the behaviour of
rm B and chooses its optimal q
A
as a reaction to Bs
choice.
We can then graph two dierent reaction curves: One
for the reactions of A with respect to Bs choices and
one for Bs reactions to As choices.
The equilibrium is found when both rms choose their
optimal quantity as a reaction to the other rm choice.
qB
Reaction
Equilibrium
Function of
Firm A
Equilibrium
q*B
Reaction
Function of
Firm B
q
qA q*A
The Cournot Model: Translation into Math, 1
Suppose the market demand for the good is: Q = 100 p,
so the inverse demand will be p = 100 Q, where
Q = q
A
+q
B
.
Each rm has identical production costs:
TC
i
(q
i
) = c q
i
, i = A, B
If we focus on rm A, we know it can only provide the
market with the quantity not already provided by B, so the
prot function for A will be:
A
= q
A
p c q
A
A
= q
A
(100 q
A
q
B
) c q
A
The same situation holds for B, so the two rms have to
simultaneously solve the following problems:
max
q
A
A
= q
A
(100 q
A
q
B
) c q
A
max
q
B
B
= q
B
(100 q
A
q
B
) c q
B
where rm i can only maximize with respect to quantity i ,
taking the quantity produced by the rival rm as given (as
a constant).
The rst order conditions are:
For rm A:
A
q
A
= 0 100 2q
A
q
B
c = 0
For rm B:
B
q
B
= 0 100 2q
B
q
A
c = 0
which imply:
q
A
=
100 q
B
c
2
(1)
and
q
B
=
100 q
A
c
2
(2)
Equations (1) and (2) above are exactly the equations that
dene the reaction curves: We simultaneously observe
q
A
= F(q
B
) and q
B
= F(q
A
).
Solving (1) and (2) simultaneously means solving a system
of 2 linear equations in 2 unknowns, q
A
and q
B
.
The solutions are:
q
A
= q
B
=
100 c
3
(3)
A
=
B
=
(100 c)
2
9
(4)
The Cournot Model: Some additional notes
We just found q
A
= q
B
and
A
=
B
. This is not by chance!
Since the two rms are identical, they face the same demand and
they have the same cost function, in equilibrium they MUST
produce the same quantities and have the same prots.
Of course this result would not be true if we had assumed some
kind of asymmetries between the two rms (dierent cost
functions, production boundaries, dierent demands and so on).
Note that the prots for the two rms would be higher if they
could collude, i.e. act as a monopolist and equally share the
resulting monopolist prot.
All the results hold on the base of simultaneous competition on
the quantity. Competition on price would have led us toward a
duopoly la Bertrand (that we dont study), while by relaxing
the assumption of simultaneity we end up in a framework la
Stackelberg.
Duopoly: The Stackelberg Model
As already said, in the Stackelberg model the rms do not
choose their quantity simultaneously but sequentially
First one rm (say A) chooses its quantity, then the other
(say B) tries to maximize its prots taking into
consideration the residual demand. The fact that rm A
can choose its quantity rst gives to A the so-called
rst-mover advantage. This means that A will be able to
make more prots than B.
The Stackelberg Model: Translation into Math, 1
Timing:
A market demand is observed;
1
Firm A chooses quantity q
A
so as to maximize its
prots;
2
Firm B observes the residual demand and chooses q
B
so
as to maximize its prots, taking q
A
as given.
The standard way to solve a sequential game is by
backward induction, i.e. we start from period 2 and go
back in the time line.
Assume the same inverse demand function as before:
p = 100 Q.
In the last period rm B problem is:
max
q
B
B
= q
B
p c q
B
(5)
max
q
B
B
= q
B
(100 q
A
q
B
) c q
B
(6)
where q
A
is the quantity chosen by A in the previous
period. FOC:
B
q
B
= 0 100 q
A
2q
B
c = 0 (7)
Solving eq. 7 we obtain:
q
s
B
=
100 q
A
c
2
But note that when rm A chooses its quantity already
knows that B will try to maximize its prots, so A already
knows that q
s
B
will be the outcome of the max. process we
just outlined. Hence we can now show that in period 1,
rm A problem is:
max
q
A
A
= q
A
p c q
A
= q
A
(100 q
A
q
s
B
) c q
A
= q
A
100 q
A
100 q
A
c
2
c q
A
max
q
A
A
= q
A
100 qA +c
2
c q
A
FOC:
A
q
A
= 0 50 +q
A
c
2
= 0
which implies that the optimal quantity for A is now:
q
s
A
= 50
c
2
which can be substituted into the previous expression for
q
s
B
in order to obtain:
q
s
b
= 25
c
4
The Stackelberg Model: Conclusions
Note that, as long as c < 100, i.e. as long as producing is
protable, in the Stackelberg framework
q
s
A
> q
s
B
and that
s
A
>
s
B
(check this last result holds). These outcomes are due to
the rst mover advantage: as A moves rst it is able to
exploit this advantage in terms of quantity produced and
hence prots.

Optimization With More Than One Variable II

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Optimization With More Than One Variable II

Cargado por

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EC115 - Methods of Economic Analysis

Spring Term, Lecture 5

denote the level of output at which

is eectively a maximum and not a

the rms prots are increasing and for

the prots are decreasing.

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