9 Unconstrained optimization

Learning objectives
After completing this chapter students should be able to:
• Find the maximum or minimum point of a single variable function by differenti-
ation and checking first-order and second-order conditions.
• Use calculus to help find a firm’s profit-maximizing output.
• Find the optimum order size for a firm wishing to minimize the cost of holding
inventories and purchasing costs.
• Deduce the comparative static effects of different forms of taxes on the output of
a profit-maximizing firm.

9.1 First-order conditions for a maximum

Consider the total revenue function

TR = 60q − 0.2q 2

This will take an inverted U-shape similar to that shown in Figure 9.1. If we ask the question
‘when is TR at its maximum?’ the answer is obviously at M, which is the highest point on
the curve. At this maximum position the TR schedule is flat. To the left of M, TR is rising
and has a positive slope, and to the right of M, the TR schedule is falling and has a negative
slope. At M itself the slope is zero.
We can therefore say that for a function of this shape the maximum point will be where its
slope is zero. This zero slope requirement is a necessary first-order condition for a maximum.
Zero slope will not guarantee that a function is at a maximum, as explained in the next
section where the necessary additional second-order conditions are explained. However, in
this particular example we know for certain that zero slope corresponds to the maximum
value of the function.
In Chapter 8, we learned that the slope of a function can be obtained by differentiation.
So, for the function

TR = 60q − 0.2q 2
dTR
slope = = 60 − 0.4q
dq

© 1993, 2003 Mike Rosser

 £
M
Y Z

TR

0 q

Figure 9.1

The slope is zero when

60 − 0.4q = 0
60 = 0.4q
150 = q

Therefore TR is maximized when quantity is 150.

Test Yourself, Exercise 9.1

1. What output will maximize total revenue if TR = 250q − 2q 2 ?
2. If a firm faces the demand schedule p = 90 − 0.3q how much does it have to sell
to maximize sales revenue?
3. A firm faces the total revenue schedule TR = 600q − 0.5q 2
(a) What is the marginal revenue when q is 100?
(b) When is the total revenue at its maximum?
(c) What price should the firm charge to achieve this maximum TR?
4. For the non-linear demand schedule p = 750 − 0.1q 2 what output will maximize
the sales revenue?

9.2 Second-order condition for a maximum

In the example in Section 9.1, it was obvious that the TR function was a maximum when its
slope was zero because we knew the function had an inverted U-shape. However, consider
the function in Figure 9.2(a). This has a slope of zero at N, but this is its minimum point not
its maximum. In the case of the function in Figure 9.2(b) the slope is zero at I, but this is
neither a maximum nor a minimum point.
The examples in Figure 9.2 clearly illustrate that although a zero slope is necessary for a
function to be at its maximum it is not a sufficient condition. A zero slope just means that
the function is at what is known as a ‘stationary point’, i.e. its slope is neither increasing nor
decreasing. Some stationary points will be turning points, i.e. the slope changes from positive

© 1993, 2003 Mike Rosser

 (a) y

S
T

0 x

(b) y

0 x

Figure 9.2

to negative (or vice versa) at these points, and will be maximum (or minimum) points of the
function.
In order to find out whether a function is at a maximum or a minimum or a point of inflexion
(as in Figure 9.2(b) ) when its slope is zero we have to consider what are known as the second-
order conditions. (The first-order condition for any of the three forms of stationary point is
that the slope of the function is zero.)
The second-order conditions tell us what is happening to the rate of change of the slope of
the function. If the rate of change of the slope is negative it means that the slope decreases as
the variable on the horizontal axis is increased. If the slope is decreasing and one is at a point
where the actual slope is zero this means that the slope of the function is positive slightly
to the left and negative slightly to the right of this point. This is the case in Figure 9.1. The
slope is positive at Y, zero at M and negative at Z. Thus, if the rate of change of the slope of
a function is negative at the point where the actual slope is zero then that point is a maximum.
This is the second-order condition for a maximum. Until now, we have just assumed that
a function is maximized when its slope is zero if a sketch graph suggests that it takes an
inverted U-shape. From now on we shall make this more rigorous check of the second-order
conditions to confirm whether a function is maximized at any stationary point.
It is a straightforward exercise to find the rate of change of the slope of a function. We
know that the slope of a function y = f(x) can be found by differentiation. Therefore if we
differentiate the function for the slope of the original function, i.e. dy/dx, we get the rate of
change of the slope. This is known as the second-order derivative and is written d2 y/dx 2 .

© 1993, 2003 Mike Rosser

 Example 9.1

Show that the function y = 60x − 0.2x 2 satisfies the second-order condition for a maximum
when x = 150.

Solution
The slope of this function will be zero at a stationary point. Therefore
dy
= 60 − 0.4x = 0 (1)
dx
x = 150
Therefore the first-order condition for a maximum is met when x is 150.
To get the rate of change of the slope we differentiate (1) with respect to x again, giving
d2 y
= −0.4
dx 2
This second-order derivative will always be negative, whatever the value of x. Therefore, the
second-order condition for a maximum is met and so y must be a maximum when x is 150.

In the example above, the second-order derivative did not depend on the value of x at the
function’s stationary point, but for other functions the value of the second-order derivative
may depend on the value of the independent variable.

Example 9.2

Show that TR is a maximum when q is 18 for the non-linear demand schedule.

p = 194.4 − 0.2q 2

Solution
TR = pq = (194.4 − 0.2q 2 )q = 194.4q − 0.2q 3
For a stationary point on this cubic function the slope must be zero and so
dTR
= 194.4 − 0.6q 2 = 0
dq
194.4 = 0.6q 2
324 = q 2
18 = q
When q is 18 then the second-order derivative is
d2 TR
= −1.2q = −1.2(18) = −21.6 < 0
dq 2

© 1993, 2003 Mike Rosser

Therefore, second-order condition for a maximum is satisfied and TR is a maximum when
q is 18. (Note that in this example the second-order derivative −1.2q < 0 for any positive
value of q.)

Test Yourself, Exercise 9.2

Find stationary points for the following functions and say whether or not they are at
their maximum at these points.
1. TR = 720q − 0.3q 2
2. TR = 225q − 0.12q 3
3. TR = 96q − q 1.5
4. AC = 51.2q −1 + 0.4q 2

9.3 Second-order condition for a minimum

By the same reasoning as that set out in Section 9.2 above, if the rate of change of the slope
of a function is positive at the point when the slope is zero then the function is at a minimum.
This is illustrated in Figure 9.2(a). The slope of the function is negative at S, zero at N and
positive at T. As the slope changes from negative to positive, the rate of change of this slope
must be positive at the stationary point N.

Example 9.3

Find the minimum point of the average cost function AC = 25q −1 + 0.1q 2

Solution
The slope of the AC function will be zero when
dAC
= −25q −2 + 0.2q = 0 (1)
dq
0.2q = 25q −2
q 3 = 125
q=5
The rate of change of the slope at this point is found by differentiating (1), giving the
second-order derivative
d2 AC
2
= 50q −3 + 0.2
dq
50
= + 0.2 when q = 5
125
= 0.4 + 0.2 = 0.6 > 0

© 1993, 2003 Mike Rosser

Therefore the second-order condition for a minimum value of AC is satisfied when q is 5.
The actual value of AC at its minimum point is found by substituting this value for q into
the original AC function. Thus

AC = 25q −1 + 0.1q 2 = 25
5 + 0.1 × 25 = 5 + 2.5 = 7.5

Test Yourself, Exercise 9.3

Find whether any stationary points exist for the following functions for positive
values of q, and say whether or not the stationary points are at the minimum values of
the function.
1. AC = 345.6q −1 + 0.8q 2
2. AC = 600q −1 + 0.5q 1.5
3. MC = 30 + 0.4q 2
4. TC = 15 + 27q − 9q 2 + q 3
5. MC = 8.25q

9.4 Summary of second-order conditions

dy
If y = f(x) and there is a stationary point where = 0, then
dx
d2 y
(i) this point is a maximum if <0
dx 2
d2 y
(ii) this point is a minimum if 2 > 0
dx
Strictly speaking, (i) and (ii) are conditions for local maximums and minimums. It is possible,
for example, that a function may take a shape such as that shown in Figure 9.3. This has no
true global maximum or minimum, as values of y continue towards plus and minus infinity
as shown by the arrows. Points M and N, which satisfy the above second-order conditions
for maximum and minimum, respectively, are therefore just local maximum and minimum
points. However, for most of the examples that you are likely to encounter in economics any
local maximum (or minimum) points will also be global maximum (or minimum) points and
so you need not worry about this distinction. If you are uncertain then you can always plot a
function using Excel to see the pattern of turning points.
If d2 y/dx 2 = 0 there may be an inflexion point that is neither a maximum nor a minimum,
such as I in Figure 9.2(b). To check if this is so one really needs to investigate further, looking at
the third, fourth and possibly higher order derivatives for more complex polynomial functions.
However, we will not go into these conditions here. In all the economic applications given
in this text, it will be obvious whether or not a function is at a maximum or minimum at any
stationary points.
Some functions do not have maximum or minimum points. Linear functions are obvi-
ous examples as they cannot satisfy the first-order conditions for a turning point, i.e. that
dy/dx = 0, except when they are horizontal lines. Also, the slope of a straight line is always

© 1993, 2003 Mike Rosser

 y

–x x

–y

Figure 9.3

a constant and so the second-order derivative, which represents the rate of change of the
slope, will always be zero.

Example 9.4

In Chapter 5 we considered an example of a break-even chart where a firm was assumed to

have the total cost function TC = 18q and the total revenue function TR = 240 + 14q. Show
that the profit-maximizing output cannot be determined for this firm.

Solution
The profit function will be
π = TR − TC
= 240 + 14q − 18q
= 240 − 4q
Its rate of change with respect to q will be
dπ
= −4 (1)
dq
There is obviously no output level at which the first-order condition that dπ/dq = 0 can
be met and so no stationary point exists. Therefore the profit-maximizing output cannot be
determined.

End-point solutions
There are some possible exceptions to these first- and second-order conditions for maximum
and minimum values of functions. If the domain of a function is restricted, then a maximum or

© 1993, 2003 Mike Rosser

minimum point may be determined by this restriction, giving what is known as an ‘end-point’
or ‘corner’ solution. In such cases, the usual rules for optimization set out in this chapter will
not apply. For example, suppose a firm faces the total cost function (in £)

TC = 45 + 18q − 5q 2 + q 3

For a stationary point its slope will be

dTC
= 18 − 10q + 3q 2 = 0 (1)
dq
However, if we try using the quadratic equation formula to find a value of q for which (1)
holds we see that
√ √ √
−b ± b2 − 4ac −(−10) ± 102 − 4 × 18 × 3 10 ± −116
q= = =
2a 2×3 6
We cannot find the square root of a negative number and so no solution exists. There is no
turning point as no value of q corresponds to a zero slope for this function.
However, if the domain of q is restricted to non-negative values then TC will be at its
minimum value of £45 when q = 0. Mathematically the conditions for minimization are not
met at this point but, from a practical viewpoint, the minimum cost that this firm can ever
face is the £45 it must pay even if nothing is produced. This is an example of an end-point
solution.
Therefore, when tackling problems concerned with the minimization or maximization of
economic variables, you need to ask whether or not there are restrictions on the domain of
the variable in question which may give an end-point solution.

Test Yourself, Exercise 9.4

1. A firm faces the demand schedule p = 200 − 2q and the total cost function

TC = 23 q 3 − 14q 2 + 222q + 50

Derive expressions for the following functions and find out whether they have
maximum or minimum points. If they do, say what value of q this occurs at and
calculate the actual value of the function at this output.
(a) Marginal cost
(b) Average variable cost
(c) Average fixed cost
(d) Total revenue
(e) Marginal revenue
(f) Profit
2. Construct your own example of a function that has a turning point. Check the
second-order conditions to confirm whether this turning point is a maximum or a
minimum.
3. A firm attempting to expand output in the short-run faces the total product of
labour schedule TP L = 24L2 − L3 . At what levels of L will (a) TPL , (b) MP L ,
and (c) APL be at their maximum levels?
© 1993, 2003 Mike Rosser
 4. Using your knowledge of economics to apply appropriate restrictions on their
domain, say whether or not the following functions have maximum or minimum
points.
(a) TC = 12 + 62q − 10q 2 + 1.2q 3
(b) TC = 6 + 2.5q
(c) p = 285 − 0.4q

9.5 Profit maximization

We have already encountered some problems involving the maximization of a profit function.
As profit maximization is one of the most common optimization problems that you will
encounter in economics, in this section we shall carefully work through the second-order
condition for profit maximization and see how it relates to the different intersection points of
a firm’s MC and MR schedules.
Consider the firm whose marginal cost and marginal revenue schedules are shown by MC
and MR in Figure 9.4. At what output will profit be maximized?
The first rule for profit maximization is that profits are at a maximum when MC = MR.
However, there are two points, X and Y, where MC = MR. Only X satisfies the second rule
for profit maximization, which is that MC cuts MR from below at the point of intersection.
This corresponds to the second-order condition for a maximum required by the differential
calculus, as illustrated in the following example.

Example 9.5

Find the profit-maximizing output for a firm with the total cost function
TC = 4 + 97q − 8.5q 2 + 1/3q 3
and the total revenue function
TR = 58q − 0.5q 2 .

Y MC

D
X
MR

0 q

Figure 9.4
© 1993, 2003 Mike Rosser
Solution
First let us derive the MC and MR functions and see where they intersect.
dTC
MC = = 97 − 17q + q 2 (1)
dq
dTR
MR = = 58 − q (2)
dq
Therefore, when MC = MR

97 − 17q + q 2 = 58 − q
39 − 16q + q 2 = 0 (3)
(3 − q)(13 − q) = 0

Thus q = 3 or q = 13

These are the two outputs at which the MC and MR schedules intersect, but which one
satisfies the second rule for profit maximization? To answer this question, the problem can
be reformulated by deriving a function for profit and then trying to find its maximum. Thus,
profit will be

π = TR − TC = 58q − 0.5q 2 − (4 + 97q − 8.5q 2 + 1/3q 3 )

= 58q − 0.5q 2 − 4 − 97q + 8.5q 2 − 1/3q 3
= −39q + 8q 2 − 4 − 1/3q 3

Differentiating and setting equal to zero

dπ
= −39 + 16q − q 2 = 0 (4)
dq
0 = 39 − 16q + q 2 (5)

Equation (5) is the same as (3) above and therefore has the same two solutions, i.e. q = 3 or
q = 13. However, using this method we can also explore the second-order conditions. From
(4) we can derive the second-order derivative

d2 π
= 16 − 2q
dq 2
When q = 3 then d 2 π/dq 2 = 16 − 6 = 10 and so π is a minimum.
When q = 13 then d 2 π/dq 2 = 16 − 26 = −10 and so π is a maximum.

Thus only one of the intersection points of MR and MC satisfies the second-order conditions
for a maximum and corresponds to the profit-maximizing output. This will be where MC
cuts MR from below. We can prove that this must be so as follows:
By differentiating (1) we get
dMC
slope of MC = = −17 + 2q
dq

© 1993, 2003 Mike Rosser

By differentiating (2) we get
dMR
slope of MR = = −1
dq
When q = 3, then the slope of MC is
−17 + 2(3) = −17 + 6 = −11 < −1 (i.e. steeper negative slope than MR)
When q = 13, then the slope of MC is
−17 + 2(13) = 9 (i.e. positive slope, greater slope than MR)
Thus, when q = 3, the MC schedule has a steeper negative slope than MR and so must cut
it from above. When q = 13, MC has a positive slope and so must cut MR from below.

Test Yourself, Exercise 9.5

1. A monopoly faces the total revenue schedule TR = 300q − 2q 2
and the total cost schedule TC = 12q 3 − 44q 2 + 60q + 30
Are there two output levels at which MC = MR? Which is the profit-maximizing
output?
2. If a firm faces the demand schedule p = 120 − 3q
and the total cost schedule TC = 120 + 36q + 1.2q 2
what output levels, if any, will (a) maximize profit, and (b) minimize profit?
3. Explain why a firm which is a monopoly seller in a market with the demand
schedule p = 66.8 − 0.4q and which faces the total cost schedule

TC = 220 + 120q − 12q 2 + 0.5q

can never make a positive profit.

4. What is the maximum profit a firm can make if it faces the demand schedule
p = 660 − 3q and the total cost schedule TC = 25 + 240q − 72q 2 + 6q 3 ?
5. If a firm faces the demand schedule p = 53.5 − 0.7q, what price will maximize
profits if its total cost schedule is TC = 400 + 35q − 6q 2 + 0.1q 3 ?

9.6 Inventory control

In Chapter 8, we considered a few applications of differentiation, such as tax yield maximiza-
tion, without taking second-order conditions into account. We can now look at an application
where it is not obvious that a function is maximized or minimized when its slope is zero and
where second-order conditions must be fully investigated. This application analyses how the
optimum order size can be calculated for a firm wishing to minimize ordering and storage
costs.
A manufacturing company has to take into account costs other than the actual purchase
price of the components that it uses. These include:
(a) Reorder costs: each order for a consignment of components will involve administration
work, delivery, unloading etc.

© 1993, 2003 Mike Rosser