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Dr.

Karim

Chapter 3: Optimization Techniques

Optimization
Managerial economics is concerned
with the ways in which managers
should make decisions in order to
optimize the performance of the
organizations they manage.

Optimization Problems
An optimization problem involves the specification
of three things:
1) Objective function to be maximized (e.g. profit
function) or minimized (e.g., cost function).
2) Activities

or

choice

variables

(e.g.,

labor,

quantity produced, price, advertising) that


determine the value of the objective function.
3) Any constraints that may restrict the values of
the choice variables (e.g., maximum total cost).

Optimum Level of Production


Profit ()
Difference between total revenue (TR) and total
cost (TC):
Profit = TR TC
Optimal level of production (Q*) is the level that
maximizes the profit.

Optimal Level of Production


TC

Total revenue and total cost


(dollars)

4,000
D

3,000
B

2,310
2,000
1,085

1,000

C
0

200

TR

* = $1,225

Q
350 = Q
*

600 700

1,000

Production Level

Profit (dollars)

Panel A Total revenue and total cost


curves

1,22
1,00
5
0
600
0

Panel B Profit curve

d
200

350 = Q
*

600

Production Level

1,000

Marginal Benefit & Marginal Cost


Marginal Revenue(MR)
The change in total revenue (TR) associated with a
one unit change in the level of the independent
variable (Q):

MR = /Q = Slope of Total Revenue


Curve
Marginal cost (MC)
The change in total cost (TR) associated with
a one unit change in the level of the
independent variable (Q):

Relating Marginals to Totals


TC

Total revenue and total cost


(dollars)

4,000

100 F
320

3,000

100

520
100

2,000
640

1,000
C

D
D

TR

820

100

520

100
340

100

200

350 = Q
*

800

600

1,000

Production Level

Marginal revenue and


marginal cost (dollars)

Panel A Measuring slopes along TR


and TC

MC (= slope of TC)

8
c (200, $6.40)

6
5.2
0
4
2

d (600, $8.20)

c (200, $3.40)

d (600, $3.20)

MR (= slope of TR)
g

200

350 = Q
*

Panel B Marginals give slopes of


totals

600

Production Level

800

1,000

Using Marginal Analysis to Find the Optimal


Production Level

If marginal benefit > marginal cost


Production should be increased to reach highest
net benefit

If marginal cost > marginal benefit


Production should be decreased to reach highest
net benefit

Optimal level of production


When no further increase in profit is possible
Occurs when MR = MC

Using Marginal Analysis to Find Q*

MR = MC

Profit (dollars)

MR > MC
100
300

c
200

MR < MC
M

100

d
350 = Q *

500

600

Production Level

Q
800

1,00
Profit curve 0

Differential Calculus in Management


A function with one decision variable, X, can be written
as:
Y = f(X)
The marginal value of Y, associated with a small
increase of X, is
My = Y/X
For a very small change in X, the derivative is written:
dY/dX = limit Y/X
X

Quick Differentiation Review


Name

Function

Derivative

Example

Constant Y = c dY/dX = 0Y = 5
Functions dY/dX = 0
A Line
Y = c X dY/dX = c Y = 5X
dY/dX = 5
Power Y = cXb
5X2
Functions

dY/dX = bcX

b-1

dY/dX = 10X

Y=

Quick Differentiation Review


Sum of Y = G(X) + H(X)
dH/dX
Two Functions
example Y = 5X + 5X2

dY/dX = dG/dX +
dY/dX = 5 + 10X

Product of Y = G(X) H(X)


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

M a rg i n a l , S l o p e , D e r i v a t i v e
The marginal at point C is Y /X
The slope of the curve at point C
is equal to the slope of the

tangent to the curve at point C =


the rise (Y) over the run (X) =
Y /X.
Or the marginal at a point is
equal to the derivative at this

point The derivative at point C

is also equal to its slope:


Marginal = Slope = Derivative

Max of Y
y
Slope = 0

the function
Y = -50 + 100X - 5X2
value of x

dx

10

20

i.e.,

Value of dy/dx when y is max


0

dY = 100 - 10X
dX
dY = 0
if
dX
X = 10

Value of dy/dx which


Is the slope of y curve

i.e., Y is maximized when


the slope equals zero.

10

20

Note that this is not sufficient for optimization


problems.
In fact, the maximum / minimum points of a
function (e.g., profit function) occur when the
slope of the curve representing the function is
equal to zero Maximum / Minimum profit
occur

when

the

derivative

of

the

curve

representing the profit function is equal to zero.

Max value of y

Since

dY
dX

= 0 at two points, we need another

condition to distinguish between the maximum and


minimum points.

Look at the

Min value of y

dY
dX

curve

* at point 5 the curve is upward, i.e., its slope ( the


second derivative (the derivative of the derivative)) is
positive. Hence

dx

value of dy/dx
d2y/dx2 > 0

d2y/dx2 < 0

d 2Y = > 0
dX 2

( minimum point )

* at point 10 the curve is downward, i.e., its slope is


negative. Hence

d 2Y = < 0
dX 2

( maximum point )

Graphs of an original third-order function and its first and


second derivatives. (what if the second order = 0)

Optimization Rules
Maximization conditions:
12-

dY = 0
dX
d 2Y = < 0
dX 2

Minimization conditions:
12-

dY = 0
dX
d 2Y = > 0
dX 2

Applications of Calculus in Managerial Economics


Profit Maximization Problem
Theprofitfunctionis(=50QQ2).Themaximizationofthefunction
occursif:
1) Firstderivative[d/dQ=502Q]atthatpointisequaltozero.
2) Secondderivative[(d/dQ)=2]is<=0.
Hence,Q=25willmaximizeprofits.

More Applications of Calculus

Minimization problem: Cost Minimization


Supposes that there is a least cost point to produce. An average cost curve
mighthaveaUshape.Attheleastcostpoint,theslopeofthecostfunction
iszero.
1) Thefirstorderconditionforaminimumisthatthederivativeatthatpoint

iszero.
2) Thesecondorderconditionisthatthesecondderivativeis>=0.

TC=5Q260Q,thendC/dQ=10Q60and(dC/dQ)=10.
Hence,Q=6willminimizecost
Where:
10Q60=0.

More Examples - Competitive Firm


Maximize Profits ()
Where = TR - TC = (P Q)- (C Q)
Use our first order condition:
d/dQ = 0 P-C = 0 PRICE = MC

Maximize = 100Q - Q2
First order = 100 -2Q = 0 implies
Q = 50 and;
= 2,500

Second Order Condition: one variable


If the second derivative is negative, then its a maximum
If the second derivative is positive, then its a minimum
Problem 1

Max = 100Q - Q2
First derivative

100 -2Q = 0
second derivative is: -2
implies
Q =50 is a MAX

Problem 2

Max= 50 + 5X2
First derivative

10X = 0
second derivative is:
10 implies
Q = 10 is a MIN

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.

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

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

PARTIAL DIFFERENTIATION AND MAXIMIZATION OF


MULTIVARIATE FUNCTIONS.

= f (Q1 , Q2 )

To know the marginal effect of Q 1 on

we hold Q2 constant, and

vice versa.
In order to do that we use partial derivative of
Q1 denoted by

with respect to

( treating Q as constant )
2
Q1

e.g.;

= -20 + 100Q1 + 80Q2 - 10Q12 - 10Q22 - 5Q1Q2;

to find the partial derivative of

with respect to Q1 we treat Q2

as constant; hence

Q1

= 100 - 20Q1 - 5Q2;

Q2

= 80 - 20Q2 - 5Q1;

(1)

therefore

setting

both

simultaneously

partial

(2)
derivatives

equal

to

zero

and

solve

100 - 20Q1 - 5Q2 =0


80 - 20Q2 - 5Q1 =0

multiply by -4 and add

________________
- 220 + 75Q2 = 0
hence
Q2 = 2.933
substitute for Q2 at any of the eq. 1
100 - 20Q1 - 14.665;

hence

Q1 = 4.267.
i.e.,
profit is maximized when the firm produces 4.267 of Q 1 and 2.933 of Q2.

CONSTRAINED OPTIMIZATION
We assume that the firm can freely produce 4.267 of Q1 and 2.933
of Q2. Quite often this may not be the case.
e.g.
Minimize TC = 4Q12 + 5Q22 - Q1Q2;
subject to:
Q1 + Q2 = 30

The constraint function

Solution:
The lagrangian multiplier:
Steps:
1 - set the constraint function to zero
2 - form the lagrangian function by adding the constraint function
after multiplication with an unknown factor to the original
function.
3 - take the partial derivatives and set them equal to zero
4 - solve the resulting equations simultaneously

step 1:
30 - Q1 - Q2 = 0
step 2:
L = 4Q12 + 5Q22 - Q1Q2 + ( 30 - Q1 - Q2)
step 3:

L
Q1
L
Q2
L

= 8Q1 - Q2 -

= -Q1 + 10Q2 -

= -Q1 - Q2 + 30

8Q1 - Q2 - = 0

(1)

-Q1 + 10Q2 - =0

(2)

-Q1 - Q2 + 30

(3)

=0

step 4
multiply eq(2) by -1 and subtract from eq(1)
9Q1 - 11Q2 = 0

(4)

multiply (3) by 9 and add to eq(4)


-9Q1 - 9Q2 + 270 = 0
9Q1 - 11Q2

=0

____________________
-20Q2 +270 = 0
Q2 = 270/20 = 13.5

substituting in eq (3) Q1 = 16.5


the values of Q 1 and Q2 that minimizes TC are 16.5 and 13.5
respectively.
substituting Q1 and Q2 in eq(1) or eq(2) we find that
= 118.5
the interpretation of
measures the change in TC if the constraint is to be relaxed by one
unit.
i.e., TC will increase ( has a positive sign ) by 118.5 if the constraint
becomes 29 or 31.