Unit – 3

The Theory of Optimization

Introduction
The ability to make decisions that will lead to the best outcome under a given set of
circumstances is the distinguishing characteristic of a good manager. Finding the best
solution involves applying the fundamental principles of the theory of optimization. The
rules of optimizing behaviour are the underpinnings of managerial decision making. The
rules of optimization are pervasive in the study of economics; managers should know and
understand the basic principles because this knowledge will enable them to make better
decisions.

Concepts and terminology

Objective functions

Optimizing behaviour on the part of a decision maker involves trying to maximize

or minimize an objective function. For a manager of a firm, the objective function is
usually profit, which is to be maximized. For a consumer, the objective function is the
satisfaction derived from consumption of goods, which is to be maximized.

If the decision maker seeks to maximize an objective function, the optimization

problem is called a maximization problem. If the objective function is to be minimized,
the optimization problem is called a minimization problem. As a general rule, when the
objective function measures a benefit the decision maker seeks to maximize this benefit,
and is solving a maximization problem. When the objective function measures a cost, the
decision maker seeks to minimize this cost and is solving a minimization problem.

Activities or choice variables.

The value of the objective function is determined by the level of one or more
activities or choice variables. For example, the value of profit depends upon the number
of units of output produced and sold. The decision maker controls the value of the
objective function by choosing the level of the activities or choice variables.

Objective functions may be a function of more than one activity. If just two inputs
– labour and capital are used in production, the cost function (objective function) can be
expressed as

C = wL + rK
= f(L,K)

Where C = cost of production

w = Price of a unit of labour services
L = amount of labour services employed
r = price of a unit of capital services.

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 K = amount of capital services employed.

For any given level of output, a manager will choose L and K to minimize the
cost of production.

The choice variables in the optimization problems can be discrete or continuous

choice variable. A discrete choice variable can take on only specified integer values. A
continuous choice variable can take on any value between two end points.

Unconstrained and Constrained Optimization

Unconstrained optimization problems occur when a decision maker can choose

the level of activity from an unrestricted set of values in order to maximize the objective
function. In managerial decision making, the most important type of unconstrained
maximization problem arises when an activity generates both benefit and costs, and the
decision maker must maximize the net benefit of the activity. The profit maximization
problem is considered an unconstrained optimization problem because the manager can
choose any level of output in order to maximize net benefit.

Constrained optimization problems involve choosing the levels of two or more

activities that generate both benefits and costs to a decision maker. A constrained
maximization problem occurs when a decision maker chooses the levels of two or more
activities so as to maximize the total benefits, subject to the side constraint that the total
cost of these activities be held to a specific amount. An example of a constrained
maximization problem involves a corporate advertising director who can spend only $
10,000 per month, in total, on advertising in various media. The maximization problem is
a constrained problem because the combined cost of radio, newspaper, and bill board
advertising cannot exceed $ 10,000.

A constrained minimization problem occurs when a decision maker chooses the

levels of two or more activities so as to minimize the total costs from the activities,
subject to the side constraint that the total benefits of these activities are held to a specific
amount. An example of a constrained minimization problem involves a manager who
wishes to find the combination of inputs to hire in order to produce 300 units of output
per week at the lowest possible total cost.

Unconstrained maximization

An unconstrained maximization problem arises when a decision maker chooses

the level of an activity so as to obtain the maximum possible net benefit from the activity,
where net benefit (NB) is the difference between total benefit (TB) and total cost (TC).

NB = TB – TC.

The level of activity that maximizes net benefit is called the optimal level of the
activity. For finding the optimal level of an activity: increase the activity when another

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unit of the activity creates greater additional benefits than additional costs, and decrease
the level of the activity when one less unit of the activity creates a greater reduction in
costs than in benefits.

Maximization with a discrete choice variable

The following table shows schedule of total benefits and total costs for various
levels of some activity A, expressed in integers 0 to 8. Total benefit (Column 2) and total
cost (Column 3) increase as the activity is increased. The net benefit changes as the level
of the activity changes.

In this optimization problem, the activity level (A) is the choice variable because
it is the variable that determines the level of net benefit.

(1) (2) (3) (4) (5) (6)

Level of Total benefit Total cost Net benefit Marginal Marginal
Activity of activity of activity of activity benefit Cost
(A) (TB) (TC) (NB) (MB) (MC)
0 0 0 0 -- --
1 16 2 14 16 2
2 30 6 24 14 4
3 40 11 29 10 5
4 48 20 28 8 9
5 54 30 24 6 10
6 58 45 13 4 15
7 61 61 0 3 16
8 63 80 -17 2 19

The optimal level of the activity is three units, because the net benefit associated
with these units ($29) in column 4 is higher than that associated with any other levels.
Therefore, if the level of the activity is less than three, an increase in A increases the net
benefit. If the level of activity is greater than three, a decrease in A also increases the net
benefit. At the optimal level of the activity, the total benefit is not maximized nor is the
total cost minimized. The solution to an unconstrained maximization problem maximizes
the net benefit.

Using marginal analysis

The marginal analysis solution to optimization problems involves comparing the

marginal benefit (MB) of a change in an activity and the marginal cost (MC) of the
change. Marginal benefit is the addition to total benefit that occurs when the level of an
activity is increased by a small amount. Marginal cost is the increase in total cost that
occurs when the level of an activity is increased by a small amount.

Marginal benefit (MB) = Change in total benefit

Change in activity.

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 = ∆TB
∆A

Marginal cost (MC) = Change in total cost

Change in activity

= ∆TC
∆A
Thus, marginal benefit and marginal costs are the changes in benefits and costs
per unit change in the activity.

Columns 5 and 6 in table show the marginal benefit and marginal cost for each
change in the level of activity. The marginal benefit of the third unit of the activity is $10
because increasing A from two to three units increases total benefit from $30 to $40.
Reducing A from three to two units decreases total benefit by $10. Thus $10 is the
amount that the third unit adds to the total benefit and is also the amount by which the
total benefit falls when the third unit is given up.

If A increases by one unit two things occur;

1. Total benefit (TB) rises and total cost (TC) rises.

2. Marginal benefit exceeds marginal cost, total benefit must rise by more than
total cost rises; thus net benefit must rise.

In the table, the marginal benefit of the third unit of the activity is $10, and the
marginal cost is $5. Since the third unit adds $10 to total benefit and only $5 to total cost,
net benefit rises by $5 (from $24 to $29 as shown in the column 4). Suppose the decision
maker mistakenly decreases the activity when MB exceeds MC. In this case, total benefit
falls by more than total cost, and net benefit declines. For example, at three units of the
activity, reducing the activity level to two units causes total benefit to fall by $10 (MB)
and total cost to fall by $5 (MC). Net benefit falls by $5 (from $29 to $24) when A is
decreased from three to two units.

Suppose marginal benefit is less than marginal cost (MB<MC). Increasing A

causes total benefit to rise by less than total cost, and net benefit falls. In the table, the
marginal benefit from adding the fifth unit is $6 and the marginal cost is $10. Increasing
A from four to five units causes total benefit to rise by only $6, while total cost rises by
$10; net benefit must fall by $4 (from $28 to $24). Decreasing A from five to four units
will cause net benefit to rise. Total benefit falls by only $6, while total cost falls by $10,
causing net benefit to rise by $4 (from $24 to $28).

The relation between marginal benefit, marginal cost, and net benefit provides the
keys to finding the optimal level of an activity using marginal analysis. If the decision
maker mistakenly undertakes the fourth unit of activity, net benefit falls by $1. Thus, the

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optimal level of the activity is three units. Marginal analysis leads to the conclusion that
three units of activity maximize net benefit.

Constrained optimization
On many occasions a manager may face situations in which the choice of activity
levels is constrained by the circumstances surrounding the maximization or minimization
problem. These constrained optimization problems can be solved using the logic of
marginal analysis.

A crucial concept for solving constrained optimization problems is the concept of

marginal benefit per dollar spent on an activity.
Marginal benefit per dollar spent = Marginal benefit
Price
Example:
Suppose you shop around and find three brands of office copy machines (brands A,B, and
C) that have virtually identical features. The three brands do differ in price and in the
number of copies the machine will make before they wear out.

Brand Marginal benefit (number of copies) Price ($)

A 500,000 2500
B 600,000 4000
C 580,000 2600

Marginal benefit per dollar spent on copy machine A, MBA/ PA = 500,000/2500

= 200copies/dollar

Marginal benefit per dollar spent on copy machine B, MBB/ PB = 600,000/4000

= 150copies/dollar

Marginal benefit per dollar spent on copy machine C, MBC/ PC = 580,000/2600

= 223copies/dollar
Thus C is ranked first, machine A second, machine B third. While choosing among
different activities, a decision maker compares the marginal benefits per dollar spent on
each of the activities, not the marginal benefits of the activities.

Constrained maximization
A manager or a decision maker must choose the levels of two or more activities in order
to maximize a total benefit (objective) function subject to a constraint in the form of a
budget that restricts the amount that can be spent.

Example:
Consider a situation in which there are two activities, A and B. Each unit of the activity A
costs $4 to undertake, and each unit of activity B costs $2 to undertake. The manager
faces constraint that allows a total expenditure of only $100 on activities A and B
combined. The manager wishes to allocate the $100 between activities A and B so that
the total benefit from both activities combined is maximized. The manager is currently

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choosing to employ 20 units of activity A and 10 units of activity B. The constraint is met
for the combination 20A and 10B since ($4 x 20) + ($2 x 10) = $100. For this
combination of activities, suppose that the marginal benefit of the last unit of activity A is
40 units of additional benefit and the marginal benefit of the last unit of B is 10 units of
additional benefit. In this situation, the marginal benefit per dollar spent on activity A
exceeds the marginal benefit per dollar spent on activity B.

MBA/ PA = 40/4 = 10
MBB/ PB = 10/2 = 5

Spending an additional dollar on activity A increases total benefit by 10 units,

while spending an additional dollar on activity B increases total benefit by 5 units. Since
the marginal benefit per dollar spent is greater for activity A, it provides “more for the
money” or is a better deal at this combination of activities.

To take advantage of this fact, the manager can increase activity A by one unit
and decrease activity B by two units. (Now A = 21 and B = 8). This combination of
activities still costs $100 ($4 x 21) + ($2 x 8) = 100. Purchasing one more unit of activity
A causes total benefit to rise by 40 units, while purchasing two units less of activity B
causes total benefit to fall by 20 units. The combined total benefit from activities A and B
rises by 20 units (= 40-20) and the new combination of activities (A = 21 and B = 8) costs
the same amount, $100, as the old combination (A= 20 and B = 10).

The manager will continue to increase spending on activity A and reduce

spending on activity B as long as MB A/PA exceeds MBB/ PB. As the manager increases
activity A and decreases activity B, a point is eventually reached at which activity A is no
longer a better deal than activity B; that is MB A/PA equals MBB/ PB. At this point, the total
benefit is maximized subject to the constraint that only $100 is spent on the two
activities.

The optimal allocation of advertising expenditures: A constrained maximization

problem.

Suppose a manager of a small retail firm wants to maximize the effectiveness of

firm’s weekly advertising budget of $2000. The manager has the option of advertising on
the local television station or on the local AM radio station. Students of marketing in a
nearby college estimated the impact on the retailer’s sales of varying levels of advertising
in the two different media. The manager wants to maximize the number of units sold;
thus the total benefit is measured by the total number of units sold. The estimates of the
increases in weekly sales (the marginal benefits) from increasing the levels of advertising
on television and radio are as follows;

Number of Increase in units sold

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 advertisements MBTV MBRadio
1 400 360
2 300 270
3 280 240
4 260 225
5 240 150
6 200 120

Television advertisements are “more powerful” than radio advertisements in the sense
that the marginal benefits from additional TV advertisements tend to be larger than those
for more radio advertisements. However, since the manager is constrained by the limited
advertising budget, the relevant measure is not simply marginal benefit but, rather,
marginal benefit per dollar spent on advertising.

The price of television advertisements is $400 per ad, and the price of radio ads is
$300 per ad. Although the first TV ad dominates the first radio ad in terms of its marginal
benefit (increased sales), the marginal benefit per dollar’s worth of expenditure for the
first radio ad is greater than that for the first television ad.

MBTV/ PTV = 400/400 = 1 unit/ dollar

MB Radio/ P Radio = 360/300 = 1.2 unit/ dollar

This indicates that sales rise by 1 unit per dollar spent on the first television ad
and 1.2 units on the first radio ad. Therefore, when the manager is allocating the budget,
the first ad she selects will be a radio ad- the activity with the larger marginal benefit per
dollar spent. Following the same rule, the $2000 advertising budget would be allocated as
follows:
Decision MB/P Ranking of MB/P Cumulative expenditures
Buy radio ad 1 360/300 = 1.20 1 $300
Buy TV ad 1 400/400 = 1.00 2 700
Buy radio ad 2 270/300 = 0.90 3 1000
Buy radio ad 3 240/300 = 0.80 4 1300
Buy TV ad 2 300/400 = 0.75 1700
Buy radio ad 4 225/300 = 0.75 5 (tie) 2000

By selecting two television advertisements and four radio ads, the manager of the
firm has maximized sales subject to the constraint that only $2000 can be spent on
advertising activity. Note that the optimal levels of television and radio ads (two TV and
four radio):
MBTV/ PTV = MB Radio/ P Radio = 0.75

Constrained minimization

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 Constrained minimization problems involve minimizing a total cost function (the
objective function) subject to a constraint that the levels of activities be chosen such that
a given level of total benefit is achieved.

Consider a manager who must minimize the total cost of two activities, A and B,
subject to the constraint that 3000 units of benefit are to be generated by those activities.
The price of activity A is $5 per unit and the price of activity B is $20 per unit. Suppose
the manager is currently using 100 units of activity A and 60 units of activity B and this
combination of activity generates total benefit equal to 3000. At this combination of
activities, the marginal benefit of the last unit of activity A is 30 and the marginal benefit
of the last unit of activity B is 60.
MBA/ PA = 30/5 = 6
MBB/ PB = 60/20 = 3

In this situation, the marginal benefit per dollar spent on activity A exceeds the marginal
benefit per dollar spent on activity B. Activity A gives “more for the money”. The
manager will continue to increase activity A and decrease activity B at the rate that holds
total benefit constant until;
MBA/ PA = MBB/ PB

The optimal combination of inputs: A constrained minimization problem

Cyber Corporation is currently producing 10,000 units of output using two inputs:
capital and labour. At the existing input usage level, the marginal product of capital is
300 (the last unit of capital increased output by 300 units) and the marginal product of
labour is 150 (the last worker hired increased output by 150 units per year). Cyber wishes
to produce 10,000 units at the lowest possible total cost.

The current wage rate (w) is $30,000 per year, and the annual cost of using a unit
of capital (r) is $80,000 per year. Comparing the marginal benefits per dollar spent on
labour and capital reveals that Cyber Corporation is currently using too much of capital
and too little labour.
MPK /r = 300 / 80,000 < 150 / 30,000 = MPL / w

If Cyber reduces capital usage by one unit, output would fall by 300 units per
year, and annual cost would decline by $80,000. Then, to hold output at 10,000 units per
year, the 300 units per year lost from the reduction in capital could be produced by
employing two more workers, at a cost of only $60,000, because the marginal product of
each worker is approximately 150 units of output and each of the two additional workers
costs the firm $30,000. The following table summarizes the transaction:

Action Cost Output

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 Reduce capital by one unit -$ 80,000 -300
Employ two additional 60,000 300
workers
Net change -$20,000 0

As this example indicates, the firm can save $20,000 while continuing to produce
10,000 units per year by replacing some of its capital with labour. Cyber would continue
reducing its capital and adding labour, holding output constant, as long as the above
inequality held. As capital is reduced, MP K rises; as labour increases, MPL falls.
Eventually a point is reached where MP L/ w equal MPK / r, and no further reallocations
will lower cost.

Practical applications of marginal analysis

Managers make use of marginal analysis in their practical life for optimal decision
making. Common applications are to maximize profits or revenue, or to identify the
average cost minimizing level of output.

Profit maximization
Storrs manufacturing Company has developed and test marketed “The Golden Bear Golf
Cart”, a new and highly energy-efficient golf cart. The product is unique and Storrs can
obtain a substantial market share if it acts quickly to expand production from its current
level of 400 units per month. Data from independent marketing consultants retained by
Storrs indicate the following monthly demand, total revenue and marginal revenue
relations;
P = 7500- 3.75Q (Demand)
TR = 7500 Q – 3.75Q2 (Total revenue)
MR = ∆TR/∆Q = 7500- 7.5Q (Marginal revenue)
In addition, Storrs Accounting Department has estimated monthly total cost and marginal
cost relations of
TC = 1012500 + 1500 Q + 1.25 Q2 (Total cost)
MC = ∆TC/∆Q = 1500 + 2.5Q (Marginal cost)
To determine the optimal level for the firm,
Profit can be maximized where MR = MC

MR = MC
Therefore,
7500- 7.5Q = 1500 + 2.5Q
7500 – 1500 = 2.5Q + 7.5Q
6000= 10Q
Q = 600 units
At this optimal activity, price TR and maximum profit can be calculated as;
P = 7500- 3.75Q
= 7500- 3.75 (600)
= $5250 per unit
TR = 7500 Q – 3.75(Q2)

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= 7500 x 600 – 3.75 (6002)
= 3,150,000
Profit, ∏ = TR – TC
= 3,150,000 – 1012500- 1500 Q – 1.25Q2
= 3,150,000 – 1012500- 1500 x 600 – 1.25(6002)
= $787,500
Conclusion:
To maximize short run profits, Storrs should expand from its current level of 400 units to
600 units per month. Any deviation from an output of 600 units and price of $5250 per
unit would lower Storrs short run profits.

Revenue maximization
Consider Storrs might wish to deviate from the short run profit maximizing activity level
in order to achieve certain long run objectives. Suppose Storrs fears that short run profits
as high as $787,500 per month (or 25% of sales) would provide a powerful enticement
for new competitors.
To limit an increase in the current and future competition, Storrs may decide to lower
prices to rapidly penetrate the market and preclude entry by new rivals. For example,
Storrs might wish to adopt a short run operating philosophy of revenue maximization as
a part of a long run value maximization strategy

For Revenue Maximization strategy set MR =0

7500- 7.5Q = 0
7500 = 7.5Q
Q = 7500/7.5 = 1000 units

P = 7500 – 3.75 (Q)

= 7500 – 3.75 x 1000
= 7500- 3750
= 3750
TR = 7500 Q – 3.75(Q2)
= 7500 (1000) – 3.75 (1000)2
= 3750,000
Profit, ∏ = TR – TC
= - 5 (10002) + 6000 (1000) – 1012500
= -12500 (Loss)
Note:
Revenue maximization involves a consideration of revenue or “demand-side” influences
only. In this example, the revenue maximizing activity occurs when a loss of $12500 per
month is occurred. In other instances, the profits may be high or low at the point of
revenue maximization. Unlike profit maximization, cost relations are not considered at
all. Relative to profit maximization, revenue maximization increases both unit sales and
total revenue but substantially decreases short run profitability. These effects are typical
and a direct result of the lower prices that accompany a revenue maximization strategy.
Average Cost Minimization

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Suppose Storrs manufacturing company decides on an intermediate strategy of expanding
sales beyond the short run profit maximizing activity level but to a lesser extent than that
suggested by revenue maximization. This might be appropriate when Storrs is unable to
finance the very high rate of growth necessary for short run revenue maximization. Given
the specific nature of Storrs’ total cost and profit relations, the company might decide on
a short run operating strategy of average cost minimization. The average cost is falling
when MC < AC; rising when MC > AC, and at a minimum when MC =AC.

Activity level that generates the lowest average cost,

MC = AC

Therefore, the average cost minimizing activity for Storrs is;

MC = AC = TC/Q
1500 + 2.5Q = 10112500 + 1500 Q + 1.25Q2
Q
1500 + 2.5 Q = 1012500 + 1500 + 1.25Q
Q
2.5Q – 1.25Q = 1012500
Q
1.25Q = 1012500
Q
2
1.25Q = 1012500
Q2 = 1012500
1.25
= 810000
Q = 900 units
P = 7500 – 3.75Q
= 7500 – 3.75 x 900
= $4125 per unit
TR = 7500 (900) – 3.75 (9002)
= 3712500
Profit, ∏ = TR – TC
= -5(900)2 + 6000 (900) – 1012500
= 337,500

Conclusion:
For Storrs average cost minimization involves operation at an activity level that lies
between those indicated by profit maximization and revenue maximization strategies.
Because average cost minimization reflects a consideration of the cost relations or
“supply-side” influences only, however, either greater or lesser activity levels than those
indicated by profit maximization or revenue maximization strategies might result. In
Storrs case, average cost minimization leads to some of the market penetration
advantages of revenue maximization but achieves some of the greater profits associated
with lower activity levels. It might be an attractive short run strategy for the company.

Work out problems

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1. You are interviewing three people for one sales job. On the basis of your experience
and insight you believe Jane can sell 600 units a day, Joe can sell 450 units a day, and
Joan can sell 400 units a day. The daily salary each person is asking is as follows:
Jane, $200; Joe, $150; and Joan, $100. How would you rank the three applicants?
2. A decision maker is choosing the levels of two activities, A and B, so as to maximize
total benefits under a given budget. The prices and marginal benefits of the last units
of A and B are denoted PA, PB, MBA, MBB.
(a) If PA = $20, PB = $15, MBA = 400 and MBB = 600, what should the decision maker do?
(b) If PA = $20, PB = $15, MBA = 200 and MBB = 300, what should the decision maker
do?
(c) If PA = $20, PB = $40, MBA = 300 and MBB = 400, how many units of A can be
obtained if B is reduced by one unit? How much will benefits increase if this exchange is
made?
3. A decision maker wishes to maximize the total benefit associated with
three activities, X, Z and Y. The price per unit of activities X, Y,
and Z are $1, $2 and $3 respectively. The following table gives the
ratio of marginal benefit to the price of the activities for various
levels of each activity.
Level of activity MBX/ PX MBY/ PY MBZ/ PZ
1 10 22 14
2 9 18 12
3 8 12 10
4 7 10 9
5 6 6 8
6 5 4 6
7 4 2 4
8 3 1 2

a) If the decision maker chooses to use one unit of X, one unit of Y, and one unit of
Y, the total benefit that results is $ ____________.
b) For the fourth unit of activity Y, each dollar spent increases total benefit by
$______. The fourth unit of activity Y increases total benefit by $________.
c) Suppose the decision maker can spend a total of only $18 on three activities.
What is the optimal level of X, Y and Z? Why is this combination optimal? Why
is the combination 2X, 2Y and 4Z not optimal?
d) Now suppose the decision maker has $33 to spend on the three activities. What is
the optimal level of X, Y, and Z? If the decision maker has $35 to spend, what is
the optimal combination? Explain
4. Janice Waller, the manager of the customer service department at First Bank of
Jefferson country, can hire employees with a high school diploma for $20,000 annual
and employees with a bachelor’s degree for $30,000. She wants to maximize the
number of customers served, given a fixed payroll. The table below shows how the
total number of customers served varies with the number of employees:

Number Total number of customers served

of High school diploma Bachelor’s

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 employees degree
1 120 100
2 220 190
3 300 270
4 370 330
5 430 370
6 470 410
a) If Ms. Waller has a payroll of $160,000, how should she allocate this budget in
order to maximize the number of customers served?
b) If she has a budget of $150,000 and currently hires three people with high school
diplomas and three with bachelor’s degrees, is she making the correct decision?
Why or why not? If not, what should she do? (Assume she can hire part-time
workers.)
c) If her budget is increased to $240,000, how should she allocate this budget?

5. Twenty first century electronics has discovered a theft problem at its warehouse and
has decided to hire security guards. The firm wants to hire the optimal number of
security guards. The following table shows how the number of security guards affects
the number of radios stolen per week.

Number of security Number of radios

guards stolen per week
0 50
1 30
2 20
3 14
4 8
5 6
a) If each security guard is paid $200 a week and the cost of a stolen radio is $25,
how many security guards should the firm hire?
b) If the cost of a stolen radio is $25, what is the most the firm would be willing to
pay to hire the first security guard?
c) If each security guard is paid $200 a week and the cost of a stolen radio is $50,
how many security guards should the firm hire?

6. Giant Screen TV, Inc., is a San Diego based importer and distributor of 60-inch
screen, high-resolution televisions for individual and commercial customers. Revenue
and cost relations are as follows:
TR = 1800Q – 0.006Q2
MR = = 1800- 0.012Q
TC = 12,100,000 + 800Q + 0.004Q2
MC = = 800 + 0.008Q
a) Calculate output, marginal cost, average cost, price, and profit at the average cost-
minimization activity level.

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 b) Calculate these values at the profit maximizing activity level.

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