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analysis.

BASIC TRAINING - ECONOMIC OPTIMISATION

This chapter introduces a number of fundamental principles of economic

In chapter one, we defined managerial economics and discussed the various objectives that managers aim to achieve. The definition specifically states the application of decision science tools in analysing and evaluating decision alternatives.

As managers we encounter problems daily. Be it minor or major in nature, each problem requires serious attention. Of utmost importance is selecting the optimal course of action in light of available options and objectives. Effective managers must be able to collect, organise and process these information.

Economists build models to better understand and portray the essential link in terms of appropriate decision variables, costs and benefits. For very complex scenario, models are used to breakdown and subdivide aspects of the problem where necessary. It is easy to build models, but to build a good model requires in depth knowledge of economic concepts and methodology, which means that managers must have prior knowledge of basic economics and mathematics.

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Chapter 2 Economic Optimisation

Even though solutions are easily arrived at via various means, economists place greater importance on number crunching and precision techniques which offer a realistic means in dealing with the complexities of goal-oriented managerial activities. Economists find calculus with specific reference to derivative or marginal analysis a vital tool.

This chapter places great emphasis on helping students understand marginal concepts and the rules of differentiation. To reinforce students’ understanding, chapter texts explicitly illustrate applications of marginal concept (be it unconstrained or constrained) in optimisation process.

Key terms for review:

Functions Total, average and marginal value Lagrangian multiplier

Aggregate Approach Marginal Approach Differentiation

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Chapter 2 Economic Optimisation

CHAPTER OVERVIEW

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Chapter 2 Economic Optimisation

Learning Objectives After reading this chapter, the students should be able to:

1. 2. 3.

Write functions to represent your economic problems. Build a model for the economic problem at hand. Relate the relationships that exist between total, average, and marginal concepts irrespective of whether it is revenue, cost or product.

4.

Perform optimisation analysis graphically via both aggregate and marginal approach.

5. 6. 7.

Conduct first- and second-order derivations. Apply marginal analysis in decision making Distinguish between maximum and minimum values in optimisation problems.

8. 9.

Perform optimisation analysis for multivariate functions. Solve constrained optimisation problems by the Lagrangian

technique. 10. Find an optimal solution to economic problems via the mathematical format.

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Chapter 2 Economic Optimisation

INTRODUCTION

Mathematics scares a lot of people. But we need it in many things we do. This section intends to show you the practical applications of economic theory because in your capacity as managers, you will resort to and rely on many concepts, graphs and simple numerical examples to assist you in your decision making. Moreover, explanations of economic term, concepts and methods of analysis rely primarily on verbal definitions, numerical tables, and graphs. Appropriate discussions will centre on the same material using both algebra and calculus. In addition, exercises and problems will be slotted in to give students ample opportunity to reinforce their understanding.

Many students have already learnt the mathematics employed in this text, however, some would have studied this material some time ago and may benefit from a review.

This chapter introduces a number of fundamental principles of economic analysis, basic economic relations, the tools and techniques of optimisation. First, we will examine the ways of presenting relationships. Subsequently, we will be examining the relationships between total, average, and marginal concepts. Then, we will move on to examine optimisation analysis. To find an optimal solution to complex problems and to facilitate the above and forth coming discussions, calculus with specific emphasis on rules of differentiation will be discussed. Finally, we will apply the rules of differentiation to unconstrained and constrained optimisation problems.

2.1

FUNCTIONAL RELATIONSHIP & ECONOMIC MODELS

Mathematics is an important instructional vehicle in managerial economics. Economists study variables such as price, output, revenue, cost, and profit. Economists try to understand how and why the values of these variables change and what conditions will lead to optimal values.

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.1a) y is said to be a function of x.Chapter 2 Economic Optimisation NOTES Optimal may refer to maximum value (as in the case of profit).1 below: y = f(x.2. y = f(x) (Eqn. For example.. • Multivariable But in most cases. x)..1a) has only one independent variable (i.e. f is the function and x is the independent variable.1b) NOTES Multivariate function will be discussed further under the partial derivative topic. functional relationship involves more than one independent variable (multivariate function) for example. The above function (Eqn. 34 .) FUNCTION • Single variable In mathematics.or it may refer to minimum value (as in the case of cost.2. z.1. equation 2.n) ( Eqn. the relationship of one variable’s value to the value of other variables is expressed in terms of function.2. where y is the dependent variable.

To illustrate the different ways of expressing a function.i. total revenue.next page) • Algebraic equation An equation is an expression of the functional relationships or connection among economic variables. and profit. As such.e.e.” It merely states some relation exist between output and total revenue but does not indicate the specific relation between them. 35 . Five key functions are used in this chapter.1b .1Q2 …(Eqn.Chapter 2 Economic Optimisation FUNCTIONAL FORMS Economic data are best presented in the forms of: 1) algebraic equations. the general functional relationship for total revenue is that it is dependent on the number of units sold. “Total revenue is a function of output. TR = f(Q).1a and 2. or 3) graphs (diagram 1. In economics. 2. a more precise expression would be: TR = PQ or TR = 7Q . TR = PQ This equation is read. we will try to use as many functions as possible. i. The value of the dependent variable (on the left hand side of the equal sign) depends on the size of the independent variable (on the right hand side of the equal sign). demand.0. total cost.1c) where P is the price at which each unit of Q is sold.2. RECALL Total revenue is defined as the unit price of a product (P) multiplied by the units sold (Q). 2) tables ( table 1 – next page ).

. The total revenue function (2.2) is depicted in table 1.1g) NOTES For the purpose of discussion in this chapter.2.1g (wherever applicable). which shows the relationship between total revenue and quantity over a selected range of output.(Eqn.1d) .3Q2+ 0.1Q TC = 10 + 8Q .0. Q = 2K + 3L + LK … (Eqn.0.1e) …(Eqn 2. * Table Table is the simplest and most direct form of presenting data.1c to 2.01Q3 π = -10 . the algebraic equations of price.. cost and profit are respectively presented as such: P = 7 .2Q .1f) Equation 2. 36 .2.01Q 2 3 …(Eqn.Q + 0.Chapter 2 Economic Optimisation Similarly.0.2. we will adhere consistently to equations 2.1g below is an example of an algebraic equation for a multivariate function where there are more than 1 independent variable.

Chapter 2 Economic Optimisation Table 1 Total revenue schedule of a firm Quantity(Q) Price(P) Total revenue(TR)=P. total revenue.Q 0 10 20 30 40 50 60 70 • 7 6 5 4 3 2 1 0 0 60 100 120 120 100 60 0 Graphs The following diagrams show algebraic and graphical expressions for demand. π 37 . cost. and profit.

This is easily recognised by its parabolic shape. cost and profit functions (with 2 loops). • Type. ECONOMIC MODELS . and the corresponding relationship is called a cubic function e. the independent variable can be raised to a third power.symbolic model Models are defined as simplified representation of a complex situation. The total revenue is expressed as a quadratic. cost. They are used to model relationship that exists between and among variables and to facilitate your analysis and decisionmaking. • algebraic models that describe exactly the same Uses All models serve three main purposes: 1) pedagogical purpose . Diagrams and mathematical expressions similarly model a situation by means of lines or stating the relationship between and among variables.2) are economic models depicted graphically whilst equation (2. revenue. symbolic modes use jargons and symbols to represent reality. Where diagram (1.1c . profit) which are only verbal models of things and phenomenon. This is a result of a second power in the independent variable. 38 .to predict future behaviour.as a device to teach about the operation of a complex system . In addition. As a result we will derive a straight line to relate the relationship.Chapter 2 Economic Optimisation LINEAR. graphs and algebraic equations and you will keep on seeing and using them later. AND CUBIC FUNCTIONS The demand function in equation 2. For example.2.g. QUADRATIC. you have encounter jargon. 3) predictive purpose .TYPE AND USES In the above discussions.1g) are economic phenomenon.as a device to explain the relationship between and among events in a logical fashion. 2) explanatory purpose .1d is in linear form. Managerial economics are liberal with jargon words (for example.

1Q2. average and marginal functions are used. In optimisation analysis. A marginal relation is the change in the dependent variable caused by a one unit change in the independent variable.2 TOTAL. Here. Table 2 Total. AVERAGE AND MARGINAL RELATIONSHIP In the theory of demand. Table 2 shows the relationship between total. production and market structures specific functional relationships called total. average and marginal revenue of a firm Q PxQ 0 10 20 30 40 50 60 70 0 60 100 120 120 100 60 0 TR AR MR ∆TR÷∆Q 6 4 2 0 -2 -4 -6 Remember TR = 7Q-0. Column 3 and 4 is the derived average revenue and marginal revenue respectively.0. we assume the firm is in imperfect competition. cost. average and marginal revenue of a firm with TR = 7Q .Chapter 2 Economic Optimisation 2.1Q2 TR÷Q 6 5 4 3 2 1 0 39 . average and marginal is important I understanding the principle of managerial economics. the relationship between total. RECALL An average relation is the dependent variable divided by the independent variable. The first and second columns display the relationship between output and total revenue.

MARGINAL REVENUE In column 4.Chapter 2 Economic Optimisation AVERAGE REVENUE Column 3 depicts average revenue. thus a one unit change is equivalent to $6. This is the change from $0 when there is no output. when 10 units were sold. the marginal revenue earned from the tenth unit of output is $6. which is simply a division of total revenue with output. function. to $60 earned. Each subsequent row in the column is similarly derived. Diagram revenue Demand and maximising 2 Total function. the change in total revenue as a result of a change in output is called marginal revenue. thus. The average revenue of the tenth output is $6. Revenue price and quantity 40 . Each marginal revenue derived in subsequent rows is calculated on the same basis.

SUGGESTED SOLUTIONS When P=4.Chapter 2 Economic Optimisation SUMMARISING Let us summarise what we have discussed so far.2(4) = 8 ∴TR ∴TR = PQ = $24 = PQ = $24 41 .2P. average function is still positive but marginal function is negative 5) When total function is at its maximum. marginal function equals zero. Calculate total revenue when price is equal to 3 and when price is equal to 4. Example A firm’s demand function is defined as Q =14 . Q P=3. 2) The value of the marginal function at any point slope of a line drawn tangent to the total function at that point. 3) When total function increases. both average function and marginal function is positive 4) When total function is decreasing . average and marginal are: 1) The value of the average function at any point is the slope of a ray drawn from that point to the total function. What is marginal revenue equal to between P=3 and P=4? Explain your answer.2(3) = 6 = 14 . Q = 14 . The key relationships between total.

The slope of a function is critical to economic analysis because it is the essence of marginal analysis. the coefficient (-0.Chapter 2 Economic Optimisation There is no change in TR from P=4 to P=3.3. including purchasing additional equipment and hiring extra staff because of importance to you is the change in cost. we relate price to quantity in a linear fashion. whether or not to raise price would depend on the resulting change in revenue or profit. 42 . (i. We can use concepts of calculus to clarify the relationship between average. elementary calculus will be discussed in 2. In other words.8). thus MR is equal to 0..7 and 2. or profit associated with a change in your resource allocation. 2.6. productivity. ∆P/∆Q). 2. In a linear equation. Decisions made by managers involve some sort of change in one variable relative to a change in other variables. For example.e. Many other economic decisions rely on marginal analysis. NOTES In diagram 2b.1) is the change in the dependent variable (P) over the change in the independent variable (Q). marginal and total relations should be thoroughly understood as they are widely used in short-run optimisation problems (as shown in 2. and total. IMPORTANCE OF CONCEPTS The concepts of average. marginal. it represents the slope of the equation. Therefore.4. Thus this firm will maximise total revenue when output is between 6 units and 8 units. which measures its steepness.

0.8Q + 0. OPTIMISATION BY TOTAL REVENUE AND TOTAL COST APPROACH ( AGGREGATE APPROACH) The aggregate approach looks at aggregate.: π = TR . it can be illustrated graphically or calculated using calculus.10 .01Q 3 = 7Q . total profit is the difference between total revenue and total cost i.01Q 3 = . (In 2.0. optimisation generally means finding either the maximum or minimum value of a variable of a function.0. Thus. we will begin by showing graphically how optimal output is obtained by the aggregate approach followed by the marginal approach.0.6.Q + 0. for example. we will use calculus to ascertain that the outcome is the same as shown graphically). thus a firm determines the output level at which it maximises total profit or minimises cost.0. Likewise.01Q 3 43 .1Q2 and TC . π = 10 + 8Q .2Q2 .3 OPTIMISATION ANALYSIS In economic analysis.Chapter 2 Economic Optimisation 2.1Q2 .10 .3Q2 .3Q2 + 0. APPROACH FOR FINDING OPTIMAL VALUE We can use either the aggregate approach or the marginal approach.e.TC If given TR = 7Q .

The graphical representation shows that profit is maximised at Q2* =10 that is when the positive difference between TR and TC is the greatest (3a) or alternatively when the profit function is at its maximum (3b). 44 . by plotting the total revenue and total cost functions for a range of output. marginal cost and profit maximisation.Chapter 2 Economic Optimisation π π Diagram 3 Total revenue. Diagram 3a shows the plotted total revenue and total cost whilst 3b shows profit function. total cost. marginal revenue. We can show profit is maximised via graph. Q.

dQ dQ given that dTR /dQ is MR and dTC/dQ is MC it follows that M π = MR – MC 45 . MR = MC. profit is maximised when MR=MC. As long as marginal benefit exceed marginal cost. MR=MC occurs at Q2* = 10 as illustrated in 3a. The relevance of marginal revenue and marginal cost relations to profit maximisation can be demonstrated by considering the general expression π = TR – TC dπ dTR dTC -----dQ Marginal profit is M π = -----. Because the slopes of total revenue and total cost measures marginal revenue and marginal cost. hence when these slopes are equal. The maximum can also be located by finding the derivative or marginal of the function then determining the value of Q at which the derivative (Marginal Mπ ) is equal to 0. it pays for the firm to increase output and the firm will continue doing so till marginal revenue equals marginal cost (at this point the firm would be maximising profit).= -----. It stems from the fact that the distance between revenue and cost function is maximised at the point where their slopes are the same. For our hypothetical example.Chapter 2 Economic Optimisation OPTIMISATION BY MARGINAL APPROACH (MR=MC) RECALL According to the marginal analysis.

Differentiation is the process of determining the derivatives of a function.DEFINITION AND PURPOSE Even though tables and graphs are useful for explaining concepts.4 METHODS OF DIFFERENTIATION CALCULUS . we need to employ derivatives. 2. Consider the general function y = f(x). equations are more suitable for problem solving. To find the magnitude of the slope. As mentioned in earlier pages. at output Q =0 = 10. profit maximisation occurs where Mπ or where MR = MR – MC = MC. it is especially useful in constrained optimisation problems that often characterise managerial decision making. 46 .Chapter 2 Economic Optimisation Because maximization of any function requires that the first derivative equal zero. Calculus is a mathematical technique that enables you to find instantaneous rate of change of a continuous function. CONCEPT OF A DERIVATIVE A derivative is a precise specification of the marginal relation. the slope is a measure of the change in y relative to a infinitesimally small change in x. NOTES Differentiation means finding the change in y (∆y) for a change in x ( ∆ x) as the change of x approaches 0. Moreover. One reason being that the technique of differential calculus can be employed to locate maximum and minimum point more precisely.

” Mathematicians use d to represent very small changes in a variable.5 RULES OF DIFFERENTIATION Let us spend a few minutes reviewing basic differentiation. The ratio ∆y/∆x is a general specification of the marginal concept.Chapter 2 Economic Optimisation Expressed formally: ∆y ∆x→0 ∆x dy ----.= lim ---dx This notation is read: “The derivative of y with respect to x equals the limit of the change in y relative to the change in x as the change in x approaches zero.= nbxn-1 dx 47 . 2. refer to the MAT 153 (Business Calculus) module or any Calculus text FIRST AND SECOND DERIVATIVES OF FUNCTIONS Rule for finding derivative Take for example a function expressed in the general form of y = bxn The rule for finding derivative is dy --. If you need additional material.

(For a detailed summary of rules of differentiation. Let us try to use the rule. suppose we have the equation y = 5x2 The derivative of equation (2. 5x 2-1 = 10x dx meaning that if x=3. such as differentiating a logarithmic function or ‘function of a function’..Chapter 2 Economic Optimisation NOTES Derivative (or first derivative ) is denoted by dy/dx. In economic analysis. the instantaneous rate of change of y with respect to x is 10(3) or 30.= 2 . Thus.) 48 .7) according to this rule is dy --. there are several other rules for differentiating a function. which will be used extensively in this text. please refer to the table 3 that follows.

a. Function of a function y = f(u) where u = g(x) dy/dx = (dy/du) . y = (3x3 ) ( x2 + 2) dy/dx = (3x3)(2x) + (x2 + 2)(3.dv/dx dy/dx = u.u(dv/dx) dy/dx = ------------------------v2 3. actually Examples: 1. Can you identify and write down the functions U and V in the box provided? 3.(2.5 and 6 take into account the product of two functions 4. Quotient of two functions y=u.x2-1) dy/dx = (3. y = 3x3 dy/dx = 0 dy/dx = 3. Power function y=a y = axb y=u+v y=u-v dy/dx = 0 dy/dx = b. dv/dx + v.du/dx v(du/dx) .Chapter 2 Economic Optimisation Table 3 RULES FOR DIFFERENTIATING FUNCTIONS Function Derivative 1.3x3-1) 49 . (du/dx) Do not worry. Sums & differences function 4. y = 3 2. y = 3x3 + (x2 + 2) y = 3x3 .x2-1) = 9x2 + 2x = 9x2. The process of differentiating is rather simple.3x3-1) . do not let the mathematical symbols bother you. Product of two functions 5. Constant Function 2.xb-1 dy/dx = du/dx + dv/dx dy/dx = du/dx .(x2 + 2) dy/dx = (3.3 x3-1 = 9x2 The following examples comprise of more than one function.v y = u/v 6.2x Examples 4.3x3-1) +(2.

3x2(6x) = 36x3 But. y = u2 + 5 and u = 3x2 dy/dx = (2u) ( 6x) = 2.(3x3)(2. sum and differences.x2-1) -------------------------------------( x2 + 2)2 (x2 + 2) 9x2 . π dπ/dQ = .4Q . almost all of the mathematical examples and problems involving calculus only require the rules for constant.0. powers.0.Chapter 2 Economic Optimisation = (6x4) +(x2 +2)9x2 = 6x4 +9x4 +18x2 =15x4 +18x2 5.01Q3 = -1 + 0. Take this example that involves all the above.(3x3 )( 2x) = ------------------------------(x2 + 2)2 (x2 + 2) 9x2 .03Q2 50 . y = (3x3 )/( x2 + 2) dy/dx = (x2 + 2)(3.2Q2 .10 .3x3-1) .6x4 = -------------------(x2 + 2)2 3x4 + 18x2 = -------------(x2 + 2)2 6.Q + 0.

Chapter 2 Economic Optimisation Example Determine the derivative of this function: y = 2000 . As opposed to the above power function.400x + 9x2 FIRST DERIVATIVE As mentioned earlier.= 7 . the first derivative of a non-linear function is also called the marginal function.0.2Q = MR dQ the outcome is also known as the marginal revenue (MR) function.1Q2 When we take the first derivative of the above total function. take the case of a linear function such as the demand equation P = 7 .0. d(TR) -----. TR = 7Q . 51 .0.1Q. Turning now to the total revenue function.200x2 + 3x3 SUGGESTED SOLUTIONS dy/dx = .

DEFINITION Sometimes.= .0.1). PROCEDURE FOR FINDING SECOND DERIVATIVE The procedure for finding the second derivative is quite simple.0. Here. Generally. For example. Confusing? Not to worry.Chapter 2 Economic Optimisation The derivative is dP ----. . mathematical calculations require the use of second derivative.0. It simply means that the second derivative of a function is a measure of the rate of change of the first derivative. the slope of the linear function itself). we see that the first derivative of a linear function is simply the value of the b coefficient.1 dQ NOTES (dP/dQ is equal to a constant value . using the same TR function 52 . the second derivative is the derivative of its first derivative. All the rules for finding the first derivative also apply to obtaining the second derivative.1 (i. SUMMARISING First derivative of 1) a linear function is the slope and is a constant 2) a quadratic function is the marginal function SECOND DERIVATIVE.e.

order derivatives of this function: C = 2000 .and second.200x2 + 3x 3 Solution = .1Q2 d(TR) first derivative: --------.2 dQ2 NOTES Second derivative is denoted with a superscript 2.2Q dQ When we derive it for the second time d2 (TR) ------.0. (We will deal with this in more detail in 2.400 + 18X 53 .) Example Determine the first.0. Second order derivative is very important in optimisation problems.Chapter 2 Economic Optimisation TR = 7Q .400x +9x2 First derivative: dC/dx Second derivative: d2C/dx = .= 7 .6 .0.= .

AGGREGATE APPROACH A primary objective of managerial economics is finding optimal values of key variables.03Q 2 (-10 +Q)(10 . When a function is at a minimum or maximum. ii) setting it equal to zero.TC = 7Q .1Q2 . its slope or marginal value is equal to zero. Q2* coincides with the point shown in diagram 3a.1 + 0. d π/dQ = .Q + 0. =0 = 0 = 10 or Q1* =10/3 Alternatively. To illustrate we will discuss both aggregate and marginal approaches. For our hypothetical example.0. i) find the derivative of total revenue and total cost. We begin by i) finding the first derivative of the profit function.3Q2 . First.01Q 3 Let us now employ calculus to determine the point of profit maximisation.4Q . Beside being done graphically.3Q) Q2* MARGINAL APPROACH As expected.2Q2 .0. and iii) solving for the value of Q that satisfies this condition.8Q + 0.01Q 3 = -10 . you can use the marginal approach. thus the derivative must be equated to zero.6 OPTIMISATION BY CALCULUS MARGINAL ANALYSIS IN DECISION MAKING Managerial decision making requires one to find minimum or maximum value of a function.0. the optimisation analysis is conducted much more expediently with the use of calculus . then ii) set them equal to each other and finally 54 . the profit function is obtained as follows: π = TR .10 .0.Chapter 2 Economic Optimisation 2.using marginal analysis and derivative concepts.

Chapter 2 Economic Optimisation iii) solve for Q* MC = dTC/dQ = 8 . Since maximisation of any function requires that the first derivative = 0.2Q -1 + 0. MR and dTC/dQ is marginal cost.25Q2. MC.2Q and By equating MR = MC = Mπ = 0 7 . Form the firm’s profit function and then determine the level of output that yields the maximum profit.0.0.03Q2 =0 = 10 or Q1* =10/3 Mπ = dTR/dπ Mπ = dTR/dQ .6Q + 0.dTC/dQ .0. Marginal profit. the derivative of total profit is Given that dTR/dQ by definition is marginal revenue. it follows that Mπ = MR = MC.03Q2 MR = dTR/dQ = 7 . profit maximisation occurs at Mπ = MR = MC = 0 or where MR = MC = 0.0.03Q2 Q2* = 8 . Example A firm’s demand function is Q = 16-P and its total cost function is defined as TC = 3 + Q + 0.0.6Q + 0. What is the level of profit at the optimum? 55 .4Q .

Chapter 2 Economic Optimisation SUGGESTED SOLUTIONS TR given Q ∴P = PxQ = 16 .(see page 15 for second-order condition) Alternatively set hence MR MR MC 16 .3 .0.Q2 .25Q2 = 16Q .5Q Q = MC = 16 -2Q = 1 + 0.Q .Q2 and with TC = 3 + Q + 0.2Q 2.5Q = 1 + 0. which implies that Q = 6 is a maximum.25Q2 hence TR π Using calculus: first derivative: dπ/dQ = 15 .25 (36) = 42 56 . To find profit. substitute Q profit = 6 into the profit function.3 + 15(6) .5Q implies Q =0 =6 and the second derivative d2π/ dQ2 = .1.5Q = 15 = 6. hence = .5.25Q2 = .Q = 16Q .P = 16 .1.2.2.3 + 15Q .

there are instances when the function has both a maximum and a minimum value. The rule is that if the second derivative is positive. the maximum value is the focus. As mentioned in our earlier discussions. depending on the type of function discussed. that means.REVISITED However. First order condition Second order condition d2 /dx 2 < 0 d2 /dx2 > 0 Maximum value Minimum value dy/dx = 0 dy/dx = 0 57 . (diagram1d . whilst the minimum value would be the main concern if the total cost function is analysed −. we have a minimum. when a profit or total revenue function is analysed. finding optimum values generally means finding the maximum or minimum value of a variable. which is. requires the use of second derivative. A formal mathematical procedure to distinguish between maximum or minimum value. Since marginal value equals zero for both maximum and minimum values of a function. the method described previously cannot tell us whether the optimum is a maximum or minimum. SECOND DERIVATIVE. RULES Using mathematical notation. differentiation of the first derivative.when a function is in cubic form). and if the second derivative is negative. Hence further analysis is required. rules for finding first derivative also apply to obtaining the second derivative.Chapter 2 Economic Optimisation DISTINGUISHING MAXIMUM AND MINIMUM VALUES IN THE OPTIMISATION PROBLEMS In economic analysis. we have a maximum. we can then state that the first-and second-order conditions for determining maximum and minimum values of a function are as follows. For example.

0.0.01Q3 Let us now employ calculus along with the first.10 . Suppose the firm has the following revenue and cost function (note: we use a cubic function) TR = 7Q .and second.order conditions to determine the point at which the firm maximises its profit. only one satisfies the secondorder condition.4Q .4 . let us find the second derivative of the function by taking the derivative of the marginal profit function or second derivative of the profit function: d2π ---dQ2 58 = 0.06Q .0.01Q3 Based on these equations. the firm’s total profit function is π = .0.03Q2 = marginal profit Q1* = 10/3 Q*2 = 10 Although both Q1 * and Q2 * fulfil the first-order condition.2Q2 . To find out which one. dπ --dQ = (-10 + Q) (10-3Q) = 0 = -1 + 0.1Q2 TC = 10 + 8Q .Chapter 2 Economic Optimisation USE OF MARGINALS TO MAXIMISE THE DIFFERENCE BETWEEN TWO FUNCTIONS Now to illustrate.3Q2 + 0.Q + 0.0.

0.0.2 Thus. the value of the second derivative is a positive number: d2π/ dQ2 = 0.Chapter 2 Economic Optimisation By substitution. it must satisfy both the F. Profit is not necessarily maximised at any point where MR=MC (for example Q2*.O. we see that only Q2* enables us to adhere to the second-order condition of d2π /dQ2 < 0.=10/3) NOTES Optimal output is derived when total profit function reaches a maximum.2 On the other hand.0.06(10/3) = 0. we see that when Q= 10/3. To be the optimal output.C. the value of the second derivative is a negative number: d2π/ dQ2 = 0. As shown by graph (3a.C that is dπ/dQ = 0 and d2π/ dQ2 < 0. Our example also shows that MR=MC at profit maximising output level.O.06(10) = . only Q2* is THE optimal output. the converse does not hold true. and S. This corresponds to the point when Mπ = 0 at Q2*. 59 . 3b) and calculus above.4 .4 . when Q=10.

= MR = 25 .05 < 0 dQ2 60 .0. determine the quantity that results in maximum total revenue.025Q ∴ and TR = PQ = 25Q . d(TR) -----. d2(TR) ------. SUGGESTED SOLUTIONS Given Q P = 1000 . and solve for Q.Chapter 2 Economic Optimisation Example Given the demand function Q = 1000 . set it equal to zero. where Q is quantity and P is price. that is.40P = 25 .= .05Q = 0 dQ Q = 500 That Q=500 is a maximum is clear because the second derivative is negative. take the first derivative.0.0.40P.0.025Q2 To determine the quantity that maximises TR.

Perform optimisation analysis. Apply marginal analysis in decision making Distinguish between maximum and minimum values in optimisation problems. Conduct first. we introduce the concept of partial derivative and then use it to examine the maximisation process of a multivariate function PARTIAL DERIVATIVE The functions discussed so far involve only one variable. First. and marginal concepts irrespective of whether it is revenue. average. for example y = f(x. Relate the relationships that exist between total. Build a model for the economic problem at hand. we determine maximum and minimum values of a function with more than one variable. the concept of partial derivative is employed.and second-order derivations. graphically via both aggregate and marginal approach.z).Chapter 2 Economic Optimisation CHECKLIST Take a few minutes to check if you are now able to: Write functions to represent your economic problems. 2. For a multivariate function. cost or product. Many functional relationships which you will encounter later involve more than one independent variable.7 MULTIVARIATE OPTIMISATION In this section. 61 .

∂y/∂z means a small change in z is associated with y changing at the rate of (2z .x The partial derivative ∂y/∂x means that a small change in x is associated with y changing at the rate of (6x . that is {TR= f(Q. If z =2. it is important to determine the marginal effect of each independent variable separately.z) when z is held constant. given y = f (x. ∂y/∂x = 6x . z) y = 3x2 -xz + z2 When analysing multivariate function. ∂y/∂x.A. and taste factors (T).…)}. we first take the partial of y with respect to x. Similarly. total revenue (TR) depends on output (Q). Similarly. and taking the first derivative of y with respect to z. for example.2). 62 . demand of a product (Qdx) is influenced by the price of the product itself (Px ). to be constant. I. To do so.T)} and output (Q)is a function of labour (L) and capital inputs(K).z and ∂y/∂z = 2z . For example.Chapter 2 Economic Optimisation SOME EXAMPLES OF MULTIVARIATE FUNCTIONS Most economic relationship involves more than one variable. when x is held constant. the slope associated with y and x is (6x . taste(T) and others. that is {Qdx = f(Px.T. Py. i. price of a related product (Py.e. income (I). NOTES Partial derivative is denoted by ∂y/∂x.x). where y could be a substitute or complement). advertisement (A). This indicates the slope relationship between y and x when z is held constant. we use partial derivative. Hence. the partial derivative of y with respect to z (∂y/∂z) is derived by assuming x Thus.

to maximise total profit function π = xz -3x2 . we get z = 1 and substituting these values into the profit function . set it equal to 0 and solve for x and z. For example.z2 + 11x we find partial derivative. we have to set each partial derivative equal to zero and solve simultaneously for the optimal value of the independent variable.2z =0 =0 ------------------------------------------11x x ∴z = 22 =2 =1 Substituting x = 2 into ( i ).6x + 11 = 0 ∂ π/ ∂z = x . we get 2z-12z + 22 x .(1)2 + 11(2) = 11 Thus when this firm maximises its profit amounting to $11 when it sells 2 units of x with 1 unit of y.Chapter 2 Economic Optimisation MAXIMISING A MULTIVARIATE FUNCTION To maximise or minimise a multivariate function.2z =0 …( i ) …( ii ) Multiplying ( i ) by 2 and add to ( ii ). ∂ π/∂ x = z . 63 . we get total profit: π = (2)(1)-3 (2)2 .

4z = 0 190 .2z2 + 190z.(30)(30) .xz .8x .x2 . at that combination.2(40)(40) = $5300 64 . Find partial derivative of π with respect to x and z.z) = 100x .4z + 190 …( i ) …( ii ) To solve.4z = 0 --------------------210 .z = -x . Find the combined output of x and z that maximises profit and profit.Chapter 2 Economic Optimisation Example Given a firm’s total profit depends on the sale of product x and product z is π = f(x.(ii) 400 .2x . SUGGESTED SOLUTIONS ∂π/∂x and ∂π/∂z = 100 .x . (i)x4 ( iii) .30(40) .7x x ∴ z =0 = 30 = 40 …( iii ) Substituting x =30 and z = 40 into the profit function gives profit amounting to $5300 π = 100(30) .

x(10-x) = 3x2 + 100 . One way to solve a constrained optimisation problem is the substitution method. Minimise subject to TC x+z Solving the constraint for z and substituting this value into the objective function results in z and TC = 10 . And solve for value of x: 65 . This would limit their options. we find the first derivative. subject to the constraint that total output of both products is 10 units. a firm operates with this total cost function: TC = 3x2 + z2 .Chapter 2 Economic Optimisation 2. the constrained optimisation problem is: = 3x2 + z2 . managers face constrains. = 3x2 + (10-x)2 .30x + 100 Now.8 CONSTRAINED OPTIMISATION All the above discussions are illustrations of unconstrained optimisation. Suppose.xz where x and z represent two products to be produced.x.10x + x2 = 5x2 . it is possible to treat the above equation as an unconstrained minimisation problem. but that is not a realistic scenario. hence the maximisation or minimisation of an objective function is subjected to constrain. The manager is requested to determine the least-cost combination of x and z. SOLVING BY SUBSTITUTION METHOD In chapter 1. we mentioned that in attempting to achieve goals. set it equal to zero. = 10. Therefore.20x + x2 . To solve.xz.

When we substitute x = 3 into the constraint equation. the substitution technique discussed in the preceding section is not always feasible. To overcome this. Some decision problems involve numerous and complex constraint conditions.= 10 dx2 Since the second derivative is positive. 66 .Chapter 2 Economic Optimisation dTC -----. The total cost of this combination is TC = 3(9) . SOLVING BY LAGRANGIAN MULTIPLIER TECHNIQUE Fallacy of the substitution technique Unfortunately.= 10x -30 = 0 dx 10x x = 30 =3 A check of the sign of the second derivative at that point has to be made to ensure a minimum: d2TC ----. x = 3 is indeed a minimum. we can determine the optimal output for z. x + z = 10 z = 10 -3 =7 Thus a production of 3 units of x and 7 units of z is the least-cost combination for producing 10 units. we have to resort to the Lagrangian multiplier technique.(3)(7) + 49 = $55.

denoting the Lagragian multiplier ) times the constraint function and set equal to zero−. 67 . This combined equation called the Lagragian function is created in such a way that when it is maximised or minimised. (either maximises or minimises) plus λ (lambda . the original objective function is also maximised or minimised and all constraints are satisfied.Chapter 2 Economic Optimisation LAGRANGIAN TECHNIQUE This method optimises a function which incorporates the original objective function and the constraint function. (Objective function) z TC subject to total output (Constraint function) Thus L TC = 3x2 + z2 .z + λ . Min. The partial derivative of the above functions with respect to the three unknown. Lagrangian function The first step in this method is to form a Lagrangian function. This is simply done by writing the objective function that the firm wishes to seek.10) L TC is defined as the Lagrangian function for the constrained optimisation under consideration. z. λ and are as follows: ∂LTC ----∂x = 6x .x. x.xz + λ( x + z . For our hypothetical example.

2z + x . 6x . Setting these partial derivatives equal to zero.x + λ At a minimum point on a multivariate function.30 7x . gives three equations and three unknown.x + λ = 0 x + z .3z =0 … ( iv ) Next. all partial derivatives are equal to zero.3z =0 =0 --------------------------------------10x . ( λ ) by subtracting ( ii ) from ( i ) 6x .Chapter 2 Economic Optimisation ∂LTC -----∂z ∂LTC and -----∂λ = x + z .30 10x x = 0 = 30 =3 Substituting x = 3 into equation ( iii ) yields z = 7.z + λ = 0 2z . to get rid of z.λ gives 7x .z + λ . multiply ( iii) by 3 and add to ( iv ) to give the solution for x: 3 x + 3z . First we get rid of one unknown.20 = 2z . 68 .10 = 0 … (i) … (ii) …(Iii) The above can be solved simultaneously.

SUMMARISING Steps to follow: 1. gives the λ value: 6(3) . Find partial derivate (L ( ) ) with respect to λ. the Lagrangian technique for constrained optimisation is used to develop the optimal input proportion rule. 4. solve simultaneously to get values of the first and second variable and λ. 5. meaning that if the firm reduces output from 10 to 9 units. total cost will fall by approximately $11.Thus. Form the Lagrangian function. Find partial derivative (L ( ) ) with respect to the second variable. The marginal relation described by the multiplier provides managers with economic data to evaluate the potential benefits or costs of relaxing constraints. Find partial derivative (L ( ) ) with respect to the first variable. 69 .7 +λ λ =0 = -11 Here. λ = -11 is interpreted as the marginal cost of producing 10 units. 3. Again. (L ( ) ) 2. Finally. λ is the marginal effect on the objective function associated with per unit change (increase or decrease) in the constraint.Chapter 2 Economic Optimisation 3+z z = 10 = 7 and substituting x = 3 and z = 7 into equation ( i ). in chapter 5. NOTES The use of Lagrangian multiplier method is further examined in chapter 4 to find consumer’s maximum satisfaction from consumption.

.λ (1000 .75 y0.25 y0.O.Chapter 2 Economic Optimisation The exercise below provides another perspective of the usefulness of the Lagrangian method.C.75 .y 0.75(2x -0.4y) b) F. Example Given the utility function as follows u = 2x 0. SUGGESTED SOLUTIONS a) L( U*) = 2x0.25 ) + 2 λ = 0 ∂x ∂ U* ---. Just follow the steps above 1000 = 2x + 4y a) Formulate a Lagrangian function b) What are the values of x and y that will maximise utility? c) Find the value of λ and interpret it.75) + 4λ = 0 ∂y 70 …(1) …(2) .2x .75 y -0.25(2x0.= 0.= 0. ∂ U* ---.25 It would be great if you attempt the question before looking at the and the constraint function answer.25 .

25 (62.5x -0.25 y0.5)0.Chapter 2 Economic Optimisation ∂ U* -----.25 + 2 λ λ =0 = .0.5x0.5 x = 6(62.5 into equation (1) 5(375)-0.0.5 will maximises utility.479 when the income falls by one unit.25 0.1000 + 2x + 4y ∂λ =0 …(3) Divide equation (1) by (2) 1. 71 .75 y -0. c) Substitute x = 375 and y = 62.479 λ is the marginal effect of the objective function associated with the per unit change in the constraint function. A λ of .5) = 375 A combination of x = 375 and y = 62.75 .= ----- 3y ---x 2x x 2 = ---4 = 12y = 6y …(4) Substitute equation (4) into (3) 2 (6y) + 4y = 1000 y = 62.2λ .479 means that total utility will fall by 0.= .4λ ---------------.

a) What is the optimal input combination for x and y in this production if the firm is operating with a $1000 budget constraint? (use the Lagrangian multiplier method) b) What is the increase in output that could be obtained from an additional expenditure of $1? Q2. Q = 2x + 3y + 6xy Px = $4. b) What should be the combination of K and L that will maximise output Q? c) How much is the maximum output? 72 . A firm’s production function is given by Q = L2 + 5LK + 4K2 The price of a unit of labour service and a unit of capital is $5 and $10 respectively.Chapter 2 Economic Optimisation QUESTIONS Q1. and Px and Py are prices of x and y respectively. Assume a firm produces its product in a market described with the following production function and price data. Py = $6 where x and y are two variable input factors in the production of output Q. The firm has a cost limitation of $1000 per time period. a) Formulate the Lagrangian function.

L is number of workers employed per month. Einstein invented a new alarm system for which he receives royalty of 20% of total revenue from the sales of the alarm system.0.25K2 + 100E . Q3. If the total cost and demand function is given by TC Q = 200 000 + 30Q + 0. A. machine and electricity per month? c) What is the profit maximising level of output? 73 . A company produces according to the following production function: Q = 500L . machines cost $9000.10 per kilowatt/hour. electricity costs $0.002Q = 12 500 .0.Chapter 2 Economic Optimisation d) Interpret the meaning of the Lagrangian multiplier.1E2 where Q is output per month.50P a) Calculate the total revenue maximising price and output. b) What is the profit maximising level of labour. K is machines used per month and E is electricity used per month. All output is sold at $10 per unit. What is the amount of royalty Einstein would receive? b) Calculate the profit maximising output and price. a) Formulate the profit function. What is the amount of royalty Einstein would receive at this output? Q4. L costs $2000 per month.5L2 + 1000K -0.

8Q 2 + 57Q + 2 a) derive the equation of the total profit function b) determine the output level that maximises total profit c) calculate the maximum total profit Q6.Chapter 2 Economic Optimisation d) What is total profit per month? Q5. Given Q = 1500 –50P a) determine the TR function b) determine the rate of output that maximise TR c) calculate maximum TR 74 .5Q where Q represents output and p represents price Its total cost is given by the equation TC = Q 3. The demand function faced by john associate is P = 45 – 0.

(5) ⇒ 18y -12x y =0 =0 =0 = 2x /3 …(4) …(5) Substitute into (3) 4x + 6 (2/3)x 4x + 4x x y = 1000 = 1000 = 125 = 125(2/3) = 83. Objective function ⇒ Q = 2x + 3y + 6xy Constraint function ⇒ 4x + 6y = 1000 LQ = 2x + 3y + 6xy + λ (4x + 6y .Chapter 2 Economic Optimisation SUGGESTED SOLUTIONS Q1 Steps to follow: 1 ) Form the Lagrangian function.1000) ∂LQ/ ∂x = 2 + 6y + 4λ ∂LQ/ ∂y = 3 + 6x + 6λ ∂LQ/ ∂λ = 4x + 6y . solve simultaneously to get values of x.1000 a) =0 =0 =0 …(1) …(2) …(3) (1) x 3 ⇒ 6 + 18y + 12λ (2) x 2 ⇒ 6 + 12x + 12λ (3) . 5 ) Finally. y. and λ. 3 ) Partial derivate (L ( ) ) with respect to y. 4 ) Partial derivate (L ( ) ) with respect to λ.33 75 . (L ( ) ) 2 ) Partial derivate (L ( ) ) with respect to x.

a) Objective function ⇒ Q = L2 + 5LK + 4K2 Constraint function ⇒ 5L + 10K = 1000 ∴ LQ = L2 + 5LK + 4K2 + λ (5L +10K -1000) b) ∂LQ / ∂L = 2L + 5K + 5λ ∂LQ/ ∂K ∂LQ/ ∂λ = 5L + 8K + 10λ = 5L + 10K .33 units b) Substitute x = 125 and y =83.33 into (1) 2 + 6(83.5 units. See Q1 for steps to follow.33) λ = 4λ = 502/4 = 125.(2) ⇒ -L + 2K L From (5) ⇒ =0 =0 = 2K …(6) …(4) …(5) Substitute (6) into (3) ⇒ 5(2K) + 10K 20K K ∴L = 1000 = 1000 = 50 = 100 Output is maximised when K=50 and L =100 . 76 . Q2.5 When expenditures increase by $1. output will increase by 125.1000 =0 =0 =0 …(1) …(2) …(3) (1) x 2 ⇒ 4L + 10K + 10λ (4).Chapter 2 Economic Optimisation Therefore optimal combination is x = 125 and y = 83.

L=100 into equation (1) 2(100) + 5(50) + 5λ λ =0 = -90 When production budget falls by a unit. Steps to follow: 1) Find TR 2) Conduct F.02Q2 = 250 .0.02(6250) = $ 125 therefore TR = 125 x 6250 = $ 781 250 therefore the amount of royalty = 20%( 781 250) = $ 156 250 77 . = L2 + 5LK + 4K2 = 100(100) + 5(100)(50) + 4(50)(50) = 45 000 Q d) Substitute K =50.C.04Q = 0 = 6250 Substitute Q*=6250 into P function: P* = 250 . the output falls by 90 units. Q3.O.0.O.50P = 250 . = 12500 .0. a) TR = PxQ given Q ∴P and F. to reaffirm maximising.C on TR to get Q* and P* 3) Calculate 20% of TR 4) Conduct S.02Q TR dTR/ dQ Q* = 250Q .0.C.Chapter 2 Economic Optimisation c) Substitute K=50 and L =100 into the output function.O.

0.02Q2 .044Q Q* P* =0 = 5 000 = 250 .O. to reaffirm maximising 4) Find TR by substitute Q* and P* into TR 5) Calculate 20% of royalty π = TR .O.5L2 + 1000K -0. K.0. to reaffirm maximising 5) Find π by substituting into answer a) a) π = TR .{ 200 000 + 30Q + 0.0.C.25K2 + 100E .0.0002Q2 } = .0. K.200 000 + 230Q .1E2 78 .E 4) Conduct S.C on π function to get Q* and P* 3) Conduct S.TC = 250Q .02(5000) = $150 TR = PxQ = 150(5 000) = $ 750 000 Royalty = 20%(750 000) = $ 150 000 Q4.Chapter 2 Economic Optimisation b) Steps to follow: 1) Find profit 2) Conduct F.TC TR = PxQ given P = $10 and Q = 500L . E 3) Solve for Q* for respective L.O. Steps to follow: 1) Find profit by subtracting TC from TR 2) Partial derivate π with respect to L.0.C.022Q2 ∂ π/∂Q = 230 .

25K2 + 100E .1E = 10(500L .0.0.1E2) . you have reached the end of the chapter.Chapter 2 Economic Optimisation ∴ TR given PL ∴ ∴ TC π = 10(500L .5(300)2 + 1000(200) .0.25(200)2 +100(499.95 = 500(300) . It has also been a long chapter.2000 in π =0 L* = 300 Machines: ∂π/∂K = 10( 1000 .5K) .1E b)To maximise π .25K2 + 100E .95) – 0. Please make sure you have understood the steps used in the calculation.9000 = 0 K* = 200 Electricity: ∂π/∂E = 10( 100 . Labour : ∂π/∂L = 10( 500 .0.1(499.L) .1E2) = 2000.0.1(499. if you find difficulties in understanding 79 .1 = 2000L + 9000K + 0.0.0.95)2 = 320 000 units π = TR .2000L + 9000K + 0.0.2E) .5L2 + 1000K -0.1 =0 E* = 499.0.5L2 + 1000K -0.95) = 1 800 000 = 50 2 400 050 --------------Total profit $799 950 --------------- Well. The math in this chapter has been carefully explained step by step. and PE = 0. PK = 9000. input is employed to the point where the change associated with hiring one additional unit of input is equal to zero.TC TR ⇒ 10( 320 000) TC ⇒ Labour : 2000(300) = 600 000 3 200 000 c) Q d) Machines: 9000(200) Electricity: 0.

average function is still positive but marginal function is negative. Economic models are used to illustrate an economic principle. When total function is at its maximum. When total function increases. Functional relationships can be expressed in algebraic equations. explain an economic phenomenon. quadratic or cubic. marginal function equals zero. Optimisation means finding either the maximum or minimum value of a variable of a function. average. both average function and marginal function is positive. When total function decreases. The key relationships between total. or to predict implications as a result of changes that affect the functional relationship. please go through the sections again carefully and note down questions that you need to discuss with your lecturer or “classmates” SUMMARY The functional relationship y = f(x) means there is a systematic relationship between the dependent variable y and the independent variable x.Chapter 2 Economic Optimisation the material. Functions can be linear. and marginal are: ⎩ ⎩ ⎩ ⎩ ⎩ The value of the average function at any point is the slope of a ray drawn from that point to the total function. tables or graphs. 80 . The value of the marginal function at any point is the slope of a line drawn tangent to the total function at that point.

Chapter 2 Economic Optimisation The slope of a function y = f(x) is the change in y (∆y) divided by the corresponding change in x (∆x). the concept of partial derivative ( ∂y /∂x) has to be employed. Revenue is maximised when MR = 0 Average cost is minimised when MC = AC and average cost is increasing as output expands. The derivative of this function dy/dx or f ’(x) is the slope of a straight line drawn tangent to the function at that point. for example. second derivative is the derivative of the first derivative. Conversely. 81 . Higher order derivatives are found by taking the first derivative of each resultant derivative. When we partial derivate y with respect to x. Profit is maximised when MR=MC or Mπ = 0 and dMπ /dQ< 0 (or alternatively dπ/dQ = 0 and d2π/dQ2 < 0). For multivariate function (function with more than one independent variable y = f (x z) ). A function is at a maximum if dy/dx = 0 and d2y/dx2 < 0. The maximum or minimum value of a function y = f(x) can be found by setting the first derivative equal to zero (dy/dx = 0 ) and solving for the value of x. To maximise or minimise a multivariate function. we set each partial derivative equal to zero and solve the resulting set of simultaneous equations for the optimal value of the independent variables. we hold z constant meaning that we isolate the marginal effect on y from changes in x only. A function is at a minimum if dy/dx = 0 and d2y/dx2 > 0. The rules of differentiation contained in page will help you find derivatives of functions encountered in managerial economics.

λ.Chapter 2 Economic Optimisation For constrained optimisation problems. The Lagrangian function incorporates the objective function and the constraint conditions. STUDY NOTES 82 . The Lagrangian multiplier. the Lagrangian technique has to be adopted. indicates the marginal effect on the objective function as a result of a unit increase or decrease in the constraint function.

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