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Web Chapter A

Optimization Techniques
Overview
• Unconstrained & Constrained Optimization
• Calculus of one variable
• Partial Differentiation in Economics
• Appendix to Web Chapter A:
» Lagrangians and Constrained Optimization

2002 South-Western Publishing Slide 1

Optimum Can Be Highest or Lowest

• Finding the maximum flying range for
the Stealth Bomber is an optimization
problem.
• Calculus teaches that when the first
derivative is zero, the solution is at an optimum.
• The original Stealth Bomber study showed that a
controversial flying V­wing design optimized the
bomber's range, but the original researchers failed to
find that their solution in fact minimized the range.
• It is critical that managers make decision that
maximize,  not minimize, profit potential!
Slide 2
Unconstrained Optimization
• Unconstrained Optimization is a relatively
simple calculus problem that can be
solved using differentiation, such as
finding the quantity that maximizes profit
in the function:
π (Q) = 16∙Q ­ Q2.
• The answer is Q = 8 as we will see.
Where  dπ/dQ = 0.
Slide 3
Constrained Optimization
• Constrained Optimization involves one or more
constraints of money, time, capacity, or energy.
• When there are inequality constraints (as when
you must spend less than or equal to your total
income), linear programming can be used.
• Most often, managers know that some
constraints are binding, which means that they
are equality constraints.
» Lagrangian multipliers are used to solve these problems
(which appears in the Appendix to Web Chapter A).
Slide 4
Optimization Format
• Economic problems require tradeoffs forced on
us by the limits of our money, time, and energy.
• Optimization involves an objective function
and one or more constraints , b.
Maximize    y = f(x1 , x2 , ..., xn )
Subject to g(x1 , x2 , ..., xn ) < b

or:    Minimize      y = f(x1 , x2 , ..., xn )
Subject to g(x1 , x2 , ..., xn ) > b
Slide 5
Using Equations
• profit = f(quantity) or Π = f(Q)
» dependent variable & independent variable(s)
» average profit = Π/Q
» marginal profit = ∆Π / ∆Q
• Calculus uses derivatives
» dΠ/dQ = lim ∆Π / ∆Q
∆Q 0

» SLOPE = MARGINAL = DERIVATIVE

» NEW DECISION RULE: To maximize profits,
find where dΠ/dQ = 0 -- first order condition
Slide 6
Quick Differentiation Review
Name Function Derivative Example
• Constant Y = c dY/dX = 0 Y=5
dY/dX = 0

dY/dX = 5

• Power Y = cXb dY/dX = b•c•X b-1 Y = 5•X2

dY/dX = 10•X

Slide 7
Quick Differentiation Review
• Sum Rule Y = G(X) + H(X) dY/dX = dG/dX + dH/dX

• Product Rule Y = G(X)•H(X)

dY/dX = (dG/dX)H + (dH/dX)G
example Y = (5•X)(5•X2 )
dY/dX = 5(5•X2 ) + (10•X)(5•X) = 75•X2

Slide 8
Quick Differentiation Review
• Quotient Rule Y = G(X) / H(X)
dY/dX = (dG/dX)•H - (dH/dX)•G
H2
Y = (5•X) / (5•X2) dY/dX = 5(5•X2) -(10•X)(5•X)
(5•X2)2
= -25X2 / 25•X4 = - X-2

• Chain Rule Y = G [ H(X) ]

dY/dX = (dG/dH)•(dH/dX) Y = (5 + 5•X)2
dY/dX = 2(5 + 5•X)1(5) = 50 + 50•X
Slide 9
Applications of Calculus in
Managerial Economics
• max imizati on probl em :    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.
• At the maximum, the slope of the profit function is zero.  The
first order condition for a maximum is that the derivative at
that point is zero.
• If  π =  50∙Q  ­  Q2,  then  dπ/dQ  =  50  ­  2∙Q,  using  the  rules  of
differentiation.
• Hence, Q = 25 will maximize profits where 50 ­ 2•Q = 0.
Slide 10
More Applications of Calculus
• minimization problem: Cost minimization
supposes 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 a minimum is that
the derivative at that point is zero.
• If C = 5∙Q2 ­ 60∙Q, then dC/dQ = 10∙Q ­ 60.
• Hence, Q = 6 will minimize cost where
10•Q ­ 60 = 0.
Slide 11
More Examples
• Competitive Firm: Maximize Profits
» where Π = TR - TC = P•Q - TC(Q)
» Use our first order condition: dΠ
/dQ = P - dTC/dQ = 0. a function of Q
» Decision Rule: P = MC.
Problem 1 Problem 2
● Max Π = 100•Q - Q2 ● Max Π = 50 + 5•X2
100 -2•Q = 0 implies So, 10•X = 0 implies
Q = 50 and Π = 2,500 Q = 0 and Π = 50

Slide 12
Second Order Condition:
One Variable
• If the second derivative is negative, then
it’s a maximum
• If the second derivative is positive, then it’s
a minimum

Problem 1 Problem 2
●Max Π = 100•Q - Q 2 ●Max Π = 50 + 5•X2
100 -2•Q = 0 10•X = 0
second derivative is: -2 second derivative is: 10
implies Q =50 is a MAX implies Q = 0 is a MIN
Slide 13
Partial Differentiation
• Economic relationships usually involve
several independent variables.
• A partial derivative is like a controlled
experiment -- it holds the “other” variables
constant
• Suppose price is increased, holding the
disposable income of the economy constant
as in Q = f (P, I ), then ∂Q/∂P holds income
constant.
Slide 14
Problem:
• Sales are a function of advertising in
newspapers and magazines ( X, Y)
• Max S = 200X + 100Y -10X2 -20Y2 +20XY
• Differentiate with respect to X and Y and set
equal to zero.
∂S/∂X = 200 - 20X + 20Y= 0
∂S/∂Y = 100 - 40Y + 20X = 0
• solve for X & Y and Sales
Slide 15
Solution: 2 equations & 2 unknowns
• 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 equation:
S = 200X + 100Y -10X2 -20Y2 +20XY =
3,250
Slide 16
International Import Restraints

• Import quotas of Japanese automobiles are
inequality constraints. The added constraint will
affect decisions.
• A Japanese manufacturer will shift more
production to U.S. assembly facilities and
increase the price of cars exported to the U.S.
• We may also expect that the exported cars will be
"top of the line" models, and we expect U.S.
manufacturers to raise domestic car prices.
Slide 17
Web Chapter A -- Appendix
Objective functions are often constrained
by one or more “constraints” (time,
capacity, or money)
Max L = (objective fct.) - λ{constraint set to zero}

Min L = (objective fct.) +λ{constraint set to zero}

An artificial variable is created for each
constraint in the Lagrangian multiplier technique.
This artificial variable is traditionally called
Slide 18
Maximize Utility Example
example:
Max Utility subject to a money constraint
Max U = X•Y2 subject to a \$12 total budget with
the prices of X as \$1, the price of Y as \$4
(suppose X represents soda and Y movie
tickets).
Max L = X•Y2 - λ { X + 4Y - 12}
• differentiate with respect to X, Y and lambda, λ.

Slide 19
∂L/∂X = Y2 - λ = 0 Y2 = λ
∂L/∂Y = 2XY - 4λ = 0 2XY = 4λ
∂L/∂λ = X + 4Y- 12 = 0
Three equations and three unknowns
Solve: Ratio of first two equations is:
Y/2X = 1/4 or Y = .5 X. Substitute into the third equation:
We get:

X = 4; Y = 2; and λ = 4
• Lambda is the marginal (objective function) of
the (constraint). In the parentheses, substitute the
words used for the objective function and constraint.
• Here, λ = the marginal utility of money.
Slide 20
Problem
Minimize crime in your town
• Police, P, costs \$15,000 each.
• Jail, J, costs \$10,000 each.
• Budget is \$900,000.
• Crime function is estimated: C = 5600 - 4PJ
» Set up the problem as a Lagrangian
» Solve for optimal P and J, and C
» What is economic meaning of lambda?
Slide 21