CHAPTER 2 "Basic Training oo and Managerial Economics ‘many of the decisions facing managers fal] into the category of optimization prob- ‘example, decisions relating to maximizing profit or minimizing cost clearly involye tion. Ofien such problems can be solved graphically or by using algebra. In other sever. the solution requires the use of calculus. More importantly, in many cases cal- bbe used to solve such problems more easily and with greater insight into the eco- underlying the solution. er a firm whose total revenues from sales are given by the function TR =200-@" shee O represents the rate of output. Assume that the total cost of producing any rate of out- S& sen by the equation TC = 50440 “Gren the firm's objective of maximizing profits (ie.,total revenue minus total cost), how 5 ouzpat should be produced? One approach would be to graph both the total revenue and ss functions. The vertical distance between the two functions is profit. By identifying ere this vertical distance is the largest, the profit-maximizing output is found. This ‘in Figure 2A.1, which shows profit is maximized by producing eight units of output o=%). "As alternative approach is to develop a table showing revenue, cost, and profit at each rate seiput. Such data are provided in Table 2.1. The tabular method has the advantage of be- more precise, That is, at an output rate of 8, total revenue is 96, total cost is 82, efit is 14, From the graph in Figure 2A.1, these values can only be approximated ‘Fhe problem is that neither method is very efficient. What if the profit-maximizing output $s £.000 or 80,00,000 instead of 8? The answer could be found using either approach, but that answer could take considerable time. What if there had been two outputs (Q; and Lj and three inputs (land, labor, and capital)? In this case, there would be no practical way to Sne profit-maximizing output rates for @, and Q, using these methods. 'A more powerful technique is needed so that the solution process can be both precise ss straightforward. Elementary calculus is easily adapted to optimization problems in eco- Indeed, a few basic principles can be used in many different kinds of problems. The ation problem just outlined could have been solved quickly using the most el- calculus. In the following pages, some basic principles of calculus are outlined and ‘application to economic problems is demonstrated.io PARTI Getting Started Total revenue Total cost Rs.) | 2 TR Tc GR -TO 9 0 50 -50 1 19 34 —35 2 36 58 —22 3 1 62 iL 4 64 66 2 s 75 70 $ 6 84 74 10 ze a B 13 8 96 82 14 9 99 86 13 10 100 ” 10 U 99 94 5Py CHAPTER 2 Basic Training a OF A FUNCTION cecall that for the function y = f(x), the slope of that function is the change in y tr Ay) divided by a change in x (i-e., x) The slope sometimes is referred to as the “henge in the variable measured on the vertical axis) over the rum (the change in the ‘on the horizontal axis).’The slope is positive if the curve slopes upward from ‘and negative if the function slopes downward from left to right. A horizontal line ‘slope, and a vertical line is said to have an infinite slope. For a positive change in = = b), a positive slope implies that Ay is positive, and a negative slope implies that Ay y = 10 + 27s graphed in Figure 2A.2, To determine the average slope of this ‘over the range x = 1 10.x = 2, first find the corresponding y values. Ifx, = 1, then ys = ‘<= 2,then y2 = 14, Then the slope is found by using the formula nie slope Tite =a 21 this method determines the slope of a straight line through the points @ and b in Fig Sa Thus itis only a rough approximation ofthe slope ofthe function y = 10 + 2, which -changesat every point on that function. By making the interval smaller, a better estimate a ‘slope is determined. For example, consider the slope over the interval x = Ltox = L1.If i then y; = 11,and x, = 1.1 implies that y2 = 11.21. Thus, the stope is ee ina tone Ag p10 ~~ “Bs using calculus, the exact slope at any point on the function can 3 be determined.PART I Genting Started “The first derivative of a function (denoted as dyédlx) is simply the slope of a function when the interval along the horizontal axis is infinitesimally shiall. Technieally the derivative is the limit of the ratio Ay/Ax as Ax approaches ero, that is, eee ee de aren Be The derivative of y = fle) iS sometimes written as f(x). The ealeulus tetm dy/dx is analogous to Ay/Ax, but dy/dv is the precise slope at a point, whereas Ay/Ax is the average slope over an intesval of the function. The derivative can be thought of as the slope of a straight line drawn tangent to the function at that point. For example. the slope of the function y = 10 + x? al point a in Fugure 2A. is the slope of thee straight line drawn tangent to that function at a. What isthe signiticance of this concept for managerial economies? Recall from the discussion of total and marginal relationships that the marginal function is simply the slope of the total fune- ion, Calculus offers an easy way to find the marginal function by taking the first derivative of the total function. Calculus also offers 2 set of rules for using these derivatives to make optimizing de- ‘ons such as minimizing cost or maximizing profit. ‘Standard calculus texts present numerous formulas for the derivative of various functions In the hands of the skilled mathematician, these formulas allow the derivative of virtually any function to be found, However, only a few of these rules are necessary to-solve most of the rel- evant problems in managerial economics. In this section each of these basic rules is explained and its use demonstrated, The Derivative of a Constant “The derivative of any constant is zero, When plotted, the equation of a constant (such as y 5) is a horizontal line. For any Ax, the change in y is always zero, Thus for any equation y~ & where ais a constant, dy Sao » QA-t) dx ‘The Derivative of a Constant Times a Function “The derivative of a constant times a function is that constant times the derivative of the func- tion.’Thus the derivative of y = af(x), where a is constant, is ay = or note) (2-2) For example, if y = 3x, the derivative is dy ® _ 36x) = 30) = Be ah (x) = 30) =3 The Derivative of a Power Function For the general power function of the form y = ax”, the derivative ts bax? (2A-3)« CHAPTER 2 Basic Training s function y = x* isa specific ease of a power function where a= 1 and b = 2, Hence the de- _Swative of this function is Wi ygts ze OTS dy ‘Tbe interpretation of this derivative is that the slope of the function y = x2 at any point xis 2x. ‘For example, the slope at x = 4 would be found by substituting x = 4 into the derivative. That 5 (Z)..720=8 "Thus when x = 4, the change in y is 8 times a small change in x. ‘The function y = x7 is shown in Figure 2A.3.Note that the slope changes contintially, The Slope at.x = 4is 8. As x increases, the slope becomes steeper. For negative values of x, the slope S negative. For example, if x = —3, the slope is 6. ‘The Derivative of a Sum or Difference “The derivative of a function that is a sum or ‘ence) of the derivatives of each of the terms. difference of several terms is the sum (or differ- That is, ify = fix) + g(x), then ® = 70) +e) (A+)& PARTI Getting Started For example, the derivative of the function y= 104 Sx + 6x? is equal to the sum of the derivatives of each of the three terms on the right-hand side. Note that the rules for the derivative of a constant, a constant times a function, and a power func- tion must be used. Thus ® 04 (8 + Qo! =5 + 128 Consider another function: y = 2x3 - 6x? - 4x + 10 4 The derivative is 9° = (3)2x? ~ (-2)6x> 4-0 6x? +1209 = 4 The Derivative of the Product of Two Functions Given a function of the form y = f(x)g(x), the derivative dy/dv is given by d Fe oP ORG) + see) @A5) ‘Thatis, the derivative of the product of two functions is the derivative of the first function times the second function plus the first function times the derivative of the second. For example, the derivative of the function y=? - 4)? + 2x + 2) Sx* — 6x7 + 4 = 8 2 = (2x) QP + 2x + 2) + (2 = 4) Gx? + 2) The Derivative of a Quotient of Two Functions For a function of the form y = f(x)/g(x), the derivative is dy _ x)F'(%) — fix)g'(x) de EOP (2A-6) Given the function the derivative would be dy _ 2x -3)- 7-39 @x)_ 3 _ 3 dx @P a The Derivative of a Function of a Function The function ‘ ya@r+syCHAPTER 2 Basic Training & = ‘wo functions combined. That is, by writing w= fx) w=2et5 y= gu) ine ‘that pis a function of a function. That is, y= se) = aff] tive of y with respect to « and multiplied by the derivative of u with ye ae dx du dx ~ ‘the rule for the derivative of a power function yields ae = 2 du 3? = 3(2x + SY Ba oar + syy12=se2e+ 57 another example: i =—S— + Ox +6 y= +e +6?a PARTI Getting Started and due aN +2 Substituting x° + 2x + 6 for w and multiplying the two derivatives just given yields =, je + 2x + 6)-3(Sx* + 2) ‘These seven rules of differentiation are sufficient to determine the-derivatives of all the functions used in this book. However, sometimes two or more of the rules must be used at the same time. Example Finding the Marginal Function Given a total revenue function TR = 50Q - 0.59” and a total cost function TC = 2,000 + 200Q — 0.29? + 0.0019° find the marginal revenue and marginal cost functions. Solution Recall that a marginal function is simply the slope of the corresponding total fune- tion. For example, marginal revenue is the slope of total revenue. Thus, by finding the derivative of the total revenue function, the marginal revenue function will be obtained: a(TR) = ie = OS Shs) &: MR 9 (0.5) 0" =50-9 Similarly, the marginal cost function will be found by taking the first derivative of the to- tal cost function: MC = 0 + 200 — 2(0.2)9" ? + 3(0.001)07* = 200 ~ 0.40 + 0.00397 _ ATC) dQ 2 s cs endix, the derivative __ of most functions encountered in managerial economics can be found.a CHAPTER 2 Basic Training & gerivative of a function sometimes is called the first derivative to indicate that there are “derivatives The second derivative of a function is simply the first derivative of the Gerivatives it is wriiten d?y/dx? or f”. In the context of economies, the first derivative of a fonction is the marginal function. ‘The second derivative of the total function is the slope first derivative o: the rate at which the marginal function is changing. Higher-order derivatives are easy to find. One simply keeps taking the first Given the function IRDER DERIVATIVES derivative y = 100 + 3x7 - 5x +6 Hest derivative is 2 = 300 + 6x - 5 ‘the higher-order derivatives are dy second: “5 = 6ix +6 dy a ° “he second derivative has an important application in finding the maximum and/or mini- ‘of a function, This concept is explained in the following section. fourth: US AND OPTIMIZATION from the discussion of total and marginal relationships that if the marginal function is sve, the total function must be increasing; if the marginal function is negative, the total must be decreasing, It was shown that if the marginal function is zero, then the total must be at either a maximum or a minimum. In Figure 2A.4, a total function and its ‘marginal function are shown. At point a, which corresponds tox = x4,the total func at amaximum and the marginal function is zero. At point b, corresponding to.x = x2, the “function is minimized and the marginal function is again zero, Thus the marginal curve is ‘at both x, and r,. However, note the difference in the slope of the marginal function at see points. At x, the marginal curve has a negative slope, whereas atx the slope is positive. Because the total function is at a maximum or a minimum (je.,an extremum) when its “e zero, one way to find the value of x that results in a maximum or a minimum is to set S Sext derivative of the total function equal to zero and solve for x. This is a better approach ‘the trial-and-error method used earlier. In that example, a total revenue function, TR = 200 - 0% 7 ‘=e8 2 total cost function, TC =50+40= PARTI Getting Started y were given. The problem was to find the rate of output, Q, that maximized profit. The total profit function (=) is found by subtracting total cost from total revenue: a= TR-TC =200-@ -50- 40. =-@' +169 -50 ‘The profit function will have a slope of zero where that function is at a maximum and also at its minimum point. To find the profit-maximizing output, take the first derivative of the profit func- tion with respect to output, set that derivative equal tozero, and solve for output. That is, find the rate (or rates) of output where the slope of the profit function is zero. “Sometimes the result of this optimization process is a quadratic equation, thatis, ae + br tem ‘The solution (i, the value or values of x for which the equation is true) is given by the general equation yo DDE Shae Rk es For example, given the quadratic equation 2 — 6x + 510 =0 the solution is ——— gx = 6) = VE OF = AGO) es xD = 40 m=10* CHAPTER 2 Basic Training dz 20 + 16 = 20 = 16 Q=8 ‘will this output rate result in a profit maximum or a profit minimum? _ setting the first derivative equal to zero and solving results in an extremum, but be 2 maximum or a minimum. But Figure 2A.4 shows that if the total function is ed_the marginal function has a negative slope. Conversely. a minimum point on a tion is associated with a positive slope of the marginal function. use the slope of the marginal function is the first derivative of that marginal function, fest to determine if a point is 2 maximum or minimum is suggested. Find the second ‘of the total function and evaluate it at the point where the slope of the total func~ sero If the second derivative is negative (i.e., the marginal function is decreasing), the at a maximum. If the second derivative is positive at that point (Le.. the mar- is increasing), the total function is at a minimum point. She profit-maximization problem just discussed, the second derivative of the profit fune- —2 which is negative. Therefore, profit is maximized at Q = 8 finding the extremum of any function, setting, the first derivative equal to zero is first-order condition, meaning that this condition is necessary for an extremum but stent to determine if the function is at a maximum or a minimum. The tes! for a max- ‘a minimum using the second derivative is called the second-order condition. The first O de some problems there will be two or possibly more points where the first derivative Therefore, all these points will haye to be evaluated using the second-order condi- test for a minimum or a maximum. As shown in Figure 2A.5, a function could have ‘points, such as a, b, ¢ and d, where the slope is zero. Points a and care relative max- ‘6 and d are relative minima. The term re/ative means that the point js an extremum part of the function. Point a is a maximum relative to other points on the function 4“ Itis not the maximum point for the entire function because the value of y at point ‘that at point a. To find the absolute maximum, the value of the equation must be for all relative maxima within the range that the function is defined and also at ae ‘economic phenomena are described by multivariate functions (.¢., equations that have pendent variables). Given a general multivariate function such asow PARTI Getting Started y Y= fz) the first partial derivative of y with respect to x, denoted as 6y/6x of f,, indicates the slope relationship between y and x when z is held constant. This partial derivative is found by con- sidering z to be fixed and taking the derivative of y with respect to x in the usual way. Simi- larly, the partial derivative of y with respect to z (i., 8y/6z or f.) is found by considering x to be a constant and taking the first derivative of y with respect to z. For example, consider the function yeetazt? ‘To find the partial derivative ay/ax or f,, consider z as a fixed and take the derivative, Thus f= 27! + Gz) + 0= 2x4 32 ‘This partial derivative means that a small change in x is associated with y changing at the rate 2x + 32 when z is held constant at a specified level. For example, if z = 2, the slope associated with y and x is 2x + 3(2) or 2x + 6.1f z = 5, the slope associated with y and x would be 2x + 3(5), or 2x + 15. Similarly, the partial derivative of y with respect to z would be f,= 04 3x +227) = 342 This means that a nal change in zis associated with y changing at the rate 3x + 2z when xis a constant.* CHAPTER 2 Basie Training oa ATION AND MULTIVARIATE FUNCTIONS roach to finding the maximum or minimum value of a multivariate function involves ‘steps First, find the partial derivative of the function with respect to each independent » Second, set all the partial derivatives equal to zero. Finally. solve the system of equa {determined in the second step for the values of each of the independent variables. That yadn— xt - 2g + xr + 22? she partial derivatives are ay De 4+ oe +z a Me 24x42 az sng these derivatives equal to zero - -w+z=0 : -2+x4+42=0 ; sed solving these two equations simultaneously for x and z yields “These values of x and z minimize the value of the function. The approach to testing the optimizing solution results in a maximum or minimum for a multivariate func- Ss complex and beyond the scope of this book. In this text, the context of the problem ‘ndicate whether a maximum or minimum has been determined.Problems 2A-1. 2A. 2A- be 2A4. PARTI Getéing Started Determine the first and second derivatives of each of the following functions. a Y=10 b. Y=347 +4x +25 c. Y= (2 = ax? 42x + 5) re © O=100- 02 £ R= S00Q(1 — SQ) g Y=aX*+bX+e h. (00 = 200.7 + 3.x° =(x-2) je Y=3x7@x? +2) 2. Determine all the first-order partial derivatives for each of the following functions. a, y=3X°+2XZ4+Z2? b. 0 = 10K%#1°% c. @= Wop, Py"? d. C = 20) + 10X} + 2X,.X3 + 343 . Given the multivariate function ¥ =S50 + 18X + 10% —SXZ—2x" determine the values of X and Z that maximize the function. The total revenue (TR) function for a firm is given by TR = 1,0000 ~ 100? where @ is the rate of output per period. Determine the rate of output that results in maximum total revenue. (Be sure that you have maximized, not minimized, total rev- enue.) Samarth and Rajnayak haye written a new managerial economics book for which they receive royalty payments of 15 percent of total revenue from sales of the book. Because their royalty income is tied to revenue, not profit, they want the publisher to set the price so that total revenue is maximized. However. the publisher's objective is maximum profit. If the total revenue function is TR = 1,00,000Q — 10Q? and the total cost function is TC 10,000 + 209 + @ determine a. The output rate that will maximize total royalty revenue and the amount of royalty income that Samarth and Rajnayak would receive. b. The output rate that would maximize profit to the publisher. Based on this rate of output, what is the amount of royalty income that Samarth and Rajnayak would re- ceive? Compare the royalty income of Samarth and Rajnayak to that determined in part (a), (Hinz: First determine a function for total profit by subtracting the cost func- tion from the total revenue function.) A study indicated that the average cost function for a high school is AC = 10.3 — 0.49 + 0.000120? Where 0 is the number of students in the school* CHAPTER 2 Basic Training a in terms of number of students) results in minimum average equations for total and marginal cost. ‘has determined that its annual profits depend on the number of salespeople it and the amount spent on advertising. Specifically, the relationship between = (in lakhs), salespeople, S (in thousands), and advertising expenditures, A (in m= 10 +605 + 104 — 28? ~ A? the number of salespeople and the amount of advertising expenditures that ‘maximize the firm's profits. produces two products, milk and cheese. Q, and Q) represent the output rates nd cheese, respectively. The profit function is T= —100 + 200; + 600; ~ 100," — 20,?- 20,0, ine the output rate for each product that will maximize profit.nh Sy Mahajan’s Preowned CD Players Akhil Mahajan, a recent business school graduate, is thinking about starting his own business, and he has determined that he can procure and market recycled compact disk changers at Rs. 2,000 per piece. An expert in the field has offered the opinion that unit sales in any year will be 800, 1,000, or 1,200 with probabilities 0.2, 0.4, and 0.4, respectively. Given the nature of this industry, investors expect to earn a rate of return of about 12 percent per year. As the market for this product has matured, no growth is expected. This expert also thinks that realistically, Akhil probably could maintain this business for about 15 years. After that, he probably would have to develop a new business. ‘ The direct cost of purchasing each unit and refurbishing it is Rs. 1,000. In addition, Akhil has the following annual fixed costs: Rent (Rs) 2,00,000 Utilities (Rs) 1,50,000 Property tax(Rs) 50,000 Insurance (Rs.) 50,000 Akhil would pay himself a salary of Rs. 20,000 per month, which is lower than the Rs. 4 lakhs per year offer that he is regularly offered by several large firms, including National Elec- tronics. This salary offer is the same as that being offered to others with Akhil’s training and experience. Requirements: , 1. Develop accounting and economic income statements for each possible level of unit sales. 2. Based on expected profit, what is the value of this firm? 3. After Akhil completed his business plan, but before he actually started the operation, Na- tional Electronics increased its salary offer to Akhil to Rs. 6 lakhs per year. Again, this is now the salary being offered to others with skills similar to Akhil’s. Under this condition, repeat requirements 1 and 2 as indicated above. ll : ese