An economic problem involves tradeoffs and opportunity costs. An economic problem can be illustrated in the pricing decisions by Malaysia Airlines on whether to offer discounts for unsold business class seats, when it is unsure whether the seats will ever be sold. This topic provides selected basic tools often used in managerial economics. These include concepts of marginal analysis, net present value and the tradeoff between risk and returns.
In this topic, we will focus on learning the mathematical tools to find the best value. The tools are called optimisation techniques. Depending on the problem, the highest value or lowest value is the optimum. In golf, for instance, the lowest
TOPIC 2
FUNDAMENTAL ECONOMIS CONCEPT AND OPTIMISATION TECHNIQUES
13
number is the best but in bowling, the highest number is the best. Finding the least cost input combinations to produce a given output, the most profitable output, or the maximum net present value for a given investment; are all optimisation problems.
Marginal analysis is the most useful concept in economic decisionmaking. Since resources are scarce and we cannot have everything that we want, choices must be made. The concept of opportunity cost reminds us that every time we make a choice, something else must be given up. Economics provides us with a set of tools that can help us make better choices. Most of the time, the best decision is made by weighing the marginal benefits against the marginal costs. We will carry out the decision as long as the marginal benefit is greater than the marginal cost. The best is when marginal benefit equals marginal cost.
Marginal return (or marginal benefit or marginal revenue) is the change in total benefits derived from doing an activity and is also known as the additional benefits received when one more unit of the activity is produced. Benefits can be expressed in terms of units of utility or satisfaction, or they can be expressed in monetary values (for example, Ringgit Malaysia).
In microeconomics, Marginal Revenue (MR) is the extra revenue that an additional unit of product will bring to the firm. It can also be described as the change in total revenue/change in number of units sold.
More formally, marginal revenue is equal to the change in total revenue over the change in quantity when the change in quantity is equal to one unit (or the change in output in the bracket where the change in revenue has occurred).
In economics and finance, marginal cost is the change in total cost that arises when the quantity produced changes by one unit. Mathematically, the marginal cost (MC) function is expressed as the derivative of the total cost (TC) function with respect to quantity (Q). Note that the marginal cost may change with volume and so at each level of production, the marginal cost is the cost of the next unit produced.
14
TOPIC 2
FUNDAMENTAL ECONOMIS CONCEPT AND OPTIMISATION TECHNIQUES
MC
dTC
dQ
or
MC
/
TC
Q
In general terms, marginal cost at each level of production includes any additional costs required to produce the next unit. If producing additional vehicles requires, for example, building a new factory, the marginal cost of those extra vehicles includes the cost of the new factory. In practice, the analysis is segregated into short and longrun cases, and over the longest run, all costs are marginal. At each level of production and time period being considered, marginal costs include all costs which vary with the level of production and other costs are considered fixed costs (http://www.wikipedia.org).
In a nutshell, marginal cost is the change in total cost of doing an activity and is also known as the additional costs incurred when one more unit of the activity is produced.
The relationships among total profit, average profit and marginal profit are discussed below:
Total Profit, π(Q), is Total Revenue (TR) minus Total Cost (TC). Total profits are maximised at the output level (Q) where marginal revenue equals marginal cost. Another way to state the rule is that marginal revenue minus marginal cost must be zero for total profit to be a maximum.
Average profit is total profit divided by quantity: A _{π} (Q) = π(Q)/Q. Marginal profit is the profit attributable to the last unit of output:
M _{π} (Q) = Δπ(Q)/ΔQ.
TOPIC 2
FUNDAMENTAL ECONOMIS CONCEPT AND OPTIMISATION TECHNIQUES
15
Tables, graphs and/or algebraic expressions are usually used to show the relationships among total profit, average profit and marginal profit. The relationships are shown in Table 2.1 and Figure 2.1.
Table 2.1: Quantity (Q), profit (), average profit and marginal profit.
TR 
TC 
(Q) 
M _{} (Q) 
A _{} (Q) 
0 
_{}_{2}_{0} 
 
 

34

8 
28 
8 

66 
32 
24 
16 

96 
52 
20 
17.33 

124 
68 
16 
17 

150

80 
12 
16 

174

88 
8 
14.67 

196 
92 
4 
13.14 

216 
92 
0 
11.5 

234 
88 
_{}_{4} 
9.78 

10 250 
170 
80 
_{}_{8} 
8 
In Table 2.1, total profit rises up to a maximum. Marginal profit is the slope of the total profit curve. The slope of total profit is zero at its maximum, because the slope of the horizontal line is zero. Hence, marginal profit is zero at maximum profit. The decision rule for maximising profits is to expand output until marginal profit is zero.
Figure 2.1: Total profit, average profit and marginal profit. Source: McGuigan, J. R., Moyer, R. C., & Harris, F. H. (2005) Managerial economics:
Applications, strategy and tactics (10th ed.). Mason, Ohio: SouthWestern.
In algebra, profit (called the dependent variable) depends on the level of output (the independent variable). The highest profits occur where ∆π(Q) = 0. You see that a quick method to find maximum profits uses calculus: marginal profit is the derivative of total profit. Therefore, local maximum profits occur at the quantity where the derivative of total profits with respect to output equals zero.
TOPIC 2
FUNDAMENTAL ECONOMIS CONCEPT AND OPTIMISATION TECHNIQUES
17
There are two types of optimisation techniques:
Unconstrained Optimisation is a relatively simple calculus problem that can be solved using differentiation, such as finding the quantity that maximises profit in the function π (Q) = 16Q  Q². [The answer is Q = 8.]
Constrained Optimisation involves one or more constraints. This happens when there are inequalities, for instance, when you must spend less than or equal to your budget allocation. Lagrangian multipliers are used to solve these problems.
We study differentiation and the rules for differentiating functions because these methods can be used to find optimal solutions to the various kinds of maximising and minimising problems in managerial economics.
The rules for differentiating functions are summarised below:
Name 
Function 
Derivative 
Example 
Constant 
Y = c 
dY/dX = 0 
Y = 5 
Functions 
dY/dX = 0 

A Line 
Y = cX 
dY/dX = c 
Y = 5X dY/dX = 5 
Power 
Y = cX ^{b} 
dY/dX = bcX ^{b}^{}^{1} 
Y = 5X ^{2} 
Functions 
dY/dX = 10X 

Sum of 
Y = G(X) + H(X) 
dY/dX = dG/dX + dH/dX 
Y = 5X + 5X ^{2} 
Functions 
dY/dX = 5 + 10X 

Product of 
Y = G(X) x H(X) 
dY/dX = (dG/dX)H + (dH/dX)G 
Y = (5X)(5X ^{2} ) 
Two Functions 
dY/dX = 5(5X ^{2} ) + (10X)(5X) = 75X ^{2} 
18
TOPIC 2
FUNDAMENTAL ECONOMIS CONCEPT AND OPTIMISATION TECHNIQUES
MAXIMISATION PROBLEM: Profit maximisation assumes that there is some output level that is the most profitable. A profit function might look like an arch, rising to a peak and then declining at even larger outputs. A firm might sell huge amounts at very low prices but discover that profits are low or negative.
MINIMISATION PROBLEM: Cost minimisation assumes that there is a least cost point to produce. An average cost curve might have a Ushape. At the least cost point, the slope of the cost function is zero.
The first order condition for an optimum is that the derivative at that point is zero. To determine whether that optimum is either maximum or minimum, you must find the second derivative, which is the derivative of the first derivative.
_{T}_{h}_{e} second order condition states that:

If the second derivative is negative, then itÊs a maximum 

If the second derivative is positive, then itÊs a minimum 
Examples:
1. π = 100Q  Q ^{2}
First derivative: d π /dQ = 100 2Q To find the optimum point, set the first derivative as equals 0.
dπ /dQ = 100 2Q = 0
Therefore Q = 50 To determine whether Q = 50 is a maximum or minimum, find the second derivative. The second derivative is 2, thus implying that Q =50 is a MAXIMUM.
2. π = 50 + 5X ^{2} dπ/dX = 10X = 0 Therefore X = 0 The second derivative is 0, implying X = 0 is a MINIMUM.
TOPIC 2
FUNDAMENTAL ECONOMIS CONCEPT AND OPTIMISATION TECHNIQUES
19
Economic relationships usually involve several independent variables. For example: the production of shoes requires materials, machine and labour; while the demand for shoes depends on price and income. In this case, we use Partial Differentiation. A partial derivative is like a controlled experiment – it holds the „other‰ variables constant. Assume quantity, Q = f (P, I). If price is increased, holding the disposable income constant then the partial derivative of Q with respect to price is Q/P, holding income constant. Similarly, the partial derivative of Q with respect to income is Q/I, holding price constant.
Example:
Assume Sales is a function of advertising in newspapers and magazines (X, Y) and it is given in the following relationship:
Max S = 200X – 100Y – 10X ^{2} – 20Y ^{2} + 20XY
To find the optimum, differentiate the above with respect to X and Y and set them equal to zero:
S/X = 200 – 2 – 0X + 20Y= 0 S/Y = 100 – 40Y + 20X = 0
Then, solve for X & Y and Sales:
200 – 20X + 20Y= 0
100 – 40Y + 20X = 0
Adding them, the –20X and +20X cancel, so we get 300  20Y = 0, or Y =15
Plug into one of them: 200 – 20X + 300 = 0,
hence X = 25
To find Sales, plug into the equation: S = 200X + 100Y – 10X2 – 20Y2 + 20XY =
3,250
To find managerial decision rules that maximise shareholdersÊ wealth over a long period of time, you must consider the present value of the benefits as well as the present value of the costs. The net present value is the difference between the present values of all the benefits and costs. When the net present value is positive, then the decision improves shareholdersÊ wealth.
Present value recognises that a dollar received in the future is worth less than a dollar in hand today, because a dollar today could be invested to earn a return. To compare monies in the future with today, the future dollars must be discounted by a present value interest factor, PVIF = l/(l+i), where it is the interest compensation for postponing receiving cash by one period. For dollars received in n periods, the discount factor is PVIF _{n} = [l/(l+i)] ^{n}
.
What will be the present value of $500 to be received 10 years from today if the discount rate is 6%?
PV = 
$500 {1/(1+.06) ^{1}^{0} } 
= 
$500 (1/1.791) 
= 
$500 (.558) 
= 
$279 
TOPIC 2
FUNDAMENTAL ECONOMIS CONCEPT AND OPTIMISATION TECHNIQUES
21

Net Present Value, NPV = Present value of future returns minus initial outlay. This is for the simple example of a single cost today yielding a benefit or stream of benefits in the future. For the more general case, NPV = Present value of all cash flows (both positive and negative ones). 

Example: A project with an initial cash outlay of $40,000 with the following cash flows for five years. The firm has a 12% required rate of return. 

Year 
Inflows 
Outflows 
Net Cash flows (NCF) 

Initial outlay 
40,000 
40,000 


36,000 
14,000 


38,000 
13,000 


38,000 
13,000 


40,000 
12,000 


41,000 
11,000 

The present value of the NCFÊs is $47,678. Subtracting the initial cash outlay of $40,000 leaves an NPV of $7,678. NPV>0, therefore we accept. 


NPV Rule: Carry out all projects that have a positive net present value. By doing this, the manager will maximise shareholder wealth. 
Some investments may increase NPV, but at the same time, they may increase risk. Whether the extra risk is acceptable depends on what is the acceptable rate of return for that risk.
Uncertainty about a situation can often indicate risk, which is the possibility of loss, damage or any other undesirable event. Most people desire low risk, which would translate to a high probability of success, profit or some form of gain.
22
TOPIC 2
FUNDAMENTAL ECONOMIS CONCEPT AND OPTIMISATION TECHNIQUES
Risk
event.
is the possibility of loss, damage or any other undesirable
For example, if sale for next month is above a certain level (a desirable event), then these orders will reduce inventory and if there is a delay in shipping orders (an undesirable event) which means losing orders, then that possibility of delay is a risk to the firm.
An investment decision is riskfree when the expected dollar returns and initial investment are certain. But most managerial decisions involve uncertainties. There is always a possibility that cash flows will fall below the expected level and sometimes there is also the possibility that the cash flows will be negative (a loss).
Variability in the outcomes of an investment is a measure of risk. The bigger the variability of the possible outcomes, the higher is the risk of the investment. Variability can be described using probability distributions.
n
In any distributions, the sum of the probabilities, p _{j} , must equal one ∑ p _{j} = 1.
j=1
This assures that all possible outcomes, r _{j} , have been exhausted and each outcome is discrete. Probabilities can be thought of as the percentage likelihood that each outcome, or state of nature, occuring:
(a) Expected Value is the weighted average of the possible outcomes:
^ 
n 

r 

j=1 

____________ σ = √ Σ (r j  
= ∑ p _{j} r _{j} = 1.
j=1
(b) Standard Deviation, σ measures the dispersion of outcomes around its expected value.
r^) ^{2} p _{j}
The expected values and standard deviations of two projects, with differing cash flows and differing probability distributions, can be compared. If two projects have the same expected value, you may wish to select the one with the lower standard deviation. Or if two projects have the same standard deviations, you may wish to select the one with the higher expected value. If one project has a higher expected value and a higher standard deviation, then the choice depends on a tradeoff between risk and return.
TOPIC 2
FUNDAMENTAL ECONOMIS CONCEPT AND OPTIMISATION TECHNIQUES
23
We face risk every day. Driving a car or riding a motorcycle, crossing a busy street, even eating your favourite meals, involves some form of risk. With investment decisions, balancing risk and return can be very tricky. Investors want to maximize their return, while at the same time want to minimize risk. Unfortunately, for most investments, the higher the return, the higher is the risk associated with it.
Some investments are certainly more "risky" than others but no investment is riskfree. Avoiding risk by not investing at all can be the riskiest move of all. Try to keep your money under your pillow! You will not earn anything from it; you will definitely lose due to inflation or worse, somebody might steal it from you. Trying to avoid risk is like standing at the curb, never setting your foot into the street to get to the other side. You will neve r be able to get to your destination if you do not accept some risk. In investing, just like crossing that street, you carefully consider the situation, accept a comfortable level of risk and proceed to where you are going. Risk can never be eliminated but it can be managed.
In an investment decision, we can divide the required return into two parts, the risk free return and a risk premium.
Required Return = Riskfree Return + Risk Premium
The greater the risk, the greater must be the risk premium as a reward for accepting that risk.
Two mutually exclusive projects with different risks can be compared using the NPV rule. You can discount the riskier project with a higher required return (because of its higher risk premium). The different discount rates adjust for risk. The project with a higher riskadjusted NPV should be selected.
24
TOPIC 2
FUNDAMENTAL ECONOMIS CONCEPT AND OPTIMISATION TECHNIQUES

The marginal analysis concept requires that a decisionmaker determine the additional (marginal) costs and additional (marginal) benefits associated with a proposed action. If the marginal benefits exceed the marginal costs (that is, if the net marginal benefits are positive), the action should be taken. 

Marginal analysis is useful in making decisions about the expansion or contraction of an economic activity. 

Differential calculus, which bears a close relationship to marginal analysis, can be applied whenever an algebraic relationship can be specified between the decision variables and the objective or criterion variable. 

The net present value of an investment is equal to the present value of expected future returns (cash flows) minus the initial outlay. 

Risk refers to the potential variability of outcomes from a decision alternative. It can be measured by the standard deviation. 
A positive relationship exists between risk and required rates of return on securities and physical assets investment. Investments involving greater risks must offer higher expected returns.
Average profit Differential calculus Marginal analysis Marginal cost Marginal profit
Marginal revenue Net present value Risk and return Total profit
Much more than documents.
Discover everything Scribd has to offer, including books and audiobooks from major publishers.
Cancel anytime.