LESSON 2.

OPTIMIZATION PROCESS

ULO. Compute optimization process of a firm using the concept of derivatives and
the rules of differentiation.

Essential Knowledge
In the previous ULO, we defined managerial economics as a tool that helps
managers in decision making by applying economic theory and the tools of decision
sciences in achieving the firm’s objectives most efficiently. In the case of a for-profit firm,
its objective is to maximize the value of the firm. This ULO introduces you to the
techniques of optimization: the methods for maximizing or minimizing the objective
function of a firm. Please note that you are not limited to exclusively refer to these
resources. Thus, you are expected to utilize other books, research articles and other
resources that are available in the university’s library e.g. ebrary, search.proquest.com
etc., and even online tutorial websites.
1. Optimization: Methods for maximizing or minimizing an objective function.
The market is filled with optimization problems. Some of the real-world problems
of optimization are as follows:
Consumers make buying decisions to maximize utility (or satisfaction).
Consumers make labor decisions to maximize utility (in terms of earnings).
Businesses make capital investment decisions to minimize costs.
Businesses make pricing decisions to maximize revenues.
Government makes procurement decisions to maximize government efficiency.
All these are some optimization problems which require tools to analyse them and
provide a best solution.
The first step in presenting optimization techniques is to examine ways to express
economic relationships. Economic relationship can be expressed in the form of
equation, tables, or graphs. When the relationship is simple, a table and/ or graph
may be sufficient. However, if the relationship is complex, expressing the relationship
in equational form may be necessary. Expressing an economic relationship in
equational form is also useful because it allows us to use the powerful techniques of
differential calculus in determining the optimal solution of the problem. The process
by which a firm determines the output level at which it maximizes its wealth or value
(theory of the firm model) is called optimization analysis.
2. Profit maximization by total-revenue and total-cost approach
Total profit (π) is the difference between total revenue (TR) and total cost (TC).
Mathematically, π = TR – TC. When TR exceeds TC, the firm earns a profit.
Otherwise, the firm losses. A breakeven is achieved when TR = TC. This means the
firm is neither profiting nor losing.
3. Optimization by marginal analysis
According to marginal analysis, the firm maximizes profits when marginal revenue
equals marginal cost. Marginal revenue (MR) is the change in total revenue over a
change in output or sales. Geometrically, this is given by the slope of the TR curve.
Marginal cost (MC) is the change in total cost per unit change in output or sales and
is given by the slope of the TC curve.
According to marginal analysis, as long as the slope of the TR curve or MR
 exceeds the slope of the TC curve or MC, the firm has to continue to produce more
output and generate sales. As long as MR exceeds MC, the firm would be increasing
its total revenue than its total cost, and so its total profit would increase.
The total profit is maximized when the marginal revenue equals the marginal cost.
4. The derivative and rules of differentiation
Optimization analysis can be examined more efficiently using the concept of
derivative. The concept of derivate is closely related to the concept of margin
discussed earlier.
In general, if we let TR=Y and Q=X, the derivative of Y with respect to X is given
by the change in Y with respect to X, as the change in X approaches zero. So we
define this concept in the following expression:

This is read as: “the derivative of Y with respect to X is equal to the limit of the ratio
∆Y/∆X as ∆X approaches zero”. This concept as the limit of a ratio is equivalent to the
slope of a curve at a point.

dY
Rules of differentiation
a. Constant function rule. The derivative of a constant, Y = f(X) = a, is zero for all values of a
(the constant).
Y = f (X ) = a
dY
=0
dX
For example, Y=5
dY/dX = 0, the slope of the line Y is zero.

b. Power function rule. The derivative of a power function, where a and b are constants, is
defined as follows:
Y = f (X ) = aX b
dY
= b  a X b −1
dX
For example, Y=5x
dY/dX=5

c. Sum-and-Differences Rule. The derivative of the sum or difference of two functions U and
V, is defined as follows.
Y = U V
dY dU dV
= 
dX dX dX For example, Y=U+V=4x+ x3
dY/dX=4+3x2
d. Product rule. The derivative of the product of two functions U and V, is defined as follows
Y = U V
dY dV dU
=U +V
dX dX dX

For example, Y=4x2(3-2x)

dY/dX =4x2(dV/dX)+(3-2x)(dU/dX)
=4x2(-2) + (3-2x)(8x)
=-8x2+ 24x-16x2
= -24x2+24x
= -24x(x-1)

e. Quotient rule. The derivative of the ratio of two functions U and V, is defined as follows.
U
Y=
V
dY
=
(
V dU
dX ) − U ( dV dX )
2
dX V

3−2𝑥
For example, 𝑌= 4𝑥 2
𝑑𝑦 4𝑥 2 (−2)−(3−2𝑥)8𝑥
=
𝑑𝑥 (4𝑥 2 )2
−8𝑥 2 −24𝑥+ 16𝑥 2
= 4𝑥 4
8𝑥 2 −24𝑥 8𝑥 (𝑥−3) 𝑥−3
= = =
16𝑥 4 8𝑥(2𝑥 3 ) 2𝑥 3

5. Optimization with calculus

We now apply the rules of differentiation to the process of optimization. First, we
determine the point at which a function is maximum or minimum. Then, we distinguish
between a maximum and a minimum.

Determining a maximum or a minimum

Optimization seeks to find the maximum or the minimum value of a function. For
example, a firm may seek to maximize its sales, minimize the total cost, and
eventually, maximize its profits. For a function to be at its maximum or minimum, the
derivative of the function (that is, the objective function) must be zero. This is
equivalent to the point where the curve has zero slope.

Suppose, the total-revenue function is given by,

TR = 200Q – 20Q2
𝑑(𝑇𝑅)
= 200 − 40𝑄
𝑑𝑄
 𝑑(𝑇𝑅)
Setting 𝑑𝑄
= 0, 𝑤𝑒 𝑔𝑒𝑡, 200 – 40Q = 0
Therefore, Q=5

This means that for the total-revenue function given above, the TR function has zero
slope at 5 units of output produce.
Distinguishing between a maximum and a minimum
When the derivative (slope) of a function is zero, we find its maximum or minimum
point. This is the first order derivative. To distinguish between a maximum and a
minimum point, finding the second derivative is necessary.
𝑑2𝑦
For the general function Y = f(x), the second derivative is written as 𝑑𝑥 2 and is found
by taking the derivative of the first derivative using the rules of differentiation
presented above.
The rule is if the second derivative is positive (d2Y/dX2 > 0), then we have a minimum,
and if the second derivative is a negative (d2Y/dX2 < 0), then we have a maximum.
Suppose, TR = 200Q – 20Q2
𝑑(𝑇𝑅)
= 200 − 40𝑄
𝑑𝑄
and
𝑑 2(𝑇𝑅)
= −40
𝑑𝑄2

This means that TR function has zero slope at 5 units of output. Since d2(TR)/dQ2= -20, this
TR function reaches a maximum at Q=5.

Optimization involving multivariable functions

To maximize or minimize of multivariable functions, first we find the partial derivatives
(denoted by the symbol 𝜕) of the dependent variable (say, profit 𝜋) with respect to
each of the independent variables (say, price and advertising), then we set all first-
order partial derivatives equal to zero, and then solve the resulting set equations
simultaneously for the optimal value.
Rules for determining the partial derivatives are the same as those discussed in the
previous section. Note that the partial derivatives measure the marginal effects of
each of the independent variables to the dependent variable.
Suppose that the firm has the following profit function
 = 100X-2X2-XY-3Y2+100Y
We set 𝜕/ 𝜕X and 𝜕/𝜕Y equal to zero and solve for X and Y
𝜕/ 𝜕X = 100-4X-Y=0
𝜕/𝜕Y = -X-6Y+100=0
 Then solve simultaneously by multiplying the first of the above expressions by – 6,
rearranging the second and adding, we get
-600+24X+ 6Y = 0
100 – X –6Y= 0
-500 +23X =0

Thus, X = 500/23 = 21.74. Substituting the value of X into any of the partial equations
set equal to zero, and solving for Y, we get Y = 13.04.

Therefore, the firm maximizes  when it sells 21.74 units of commodity X and 13.04
units of commodity Y. By substituting these values into the profit function above, the
total profit would then be $2,249.25.

Reference:

Reginio, N. & Ranalan, R L. (2020). Project WRITE XI: managerial economics. CHED XI,
Course Pack Making.