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- Managerial Economics Ch 2
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Karim

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,

determine the value of the objective function.

3) Any constraints that may restrict the values of

the choice variables (e.g., maximum total cost).

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.

TC

(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)

curves

1,22

1,00

5

0

600

0

d

200

350 = Q

*

600

Production Level

1,000

Marginal Revenue(MR)

The change in total revenue (TR) associated with a

one unit change in the level of the independent

variable (Q):

Curve

Marginal cost (MC)

The change in total cost (TR) associated with

a one unit change in the level of the

independent variable (Q):

TC

(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 cost (dollars)

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

*

totals

600

Production Level

800

1,000

Production Level

Production should be increased to reach highest

net benefit

Production should be decreased to reach highest

net benefit

When no further increase in profit is possible

Occurs when MR = MC

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

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

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=

Sum of Y = G(X) + H(X)

dH/dX

Two Functions

example Y = 5X + 5X2

dY/dX = dG/dX +

dY/dX = 5 + 10X

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

the rise (Y) over the run (X) =

Y /X.

Or the marginal at a point is

equal to the derivative at this

Marginal = Slope = Derivative

Max of Y

y

Slope = 0

the function

Y = -50 + 100X - 5X2

value of x

dx

10

20

i.e.,

0

dY = 100 - 10X

dX

dY = 0

if

dX

X = 10

Is the slope of y curve

the slope equals zero.

10

20

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

Max value of y

Since

dY

dX

minimum points.

Look at the

Min value of y

dY

dX

curve

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 )

negative. Hence

d 2Y = < 0

dX 2

( maximum point )

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

Profit Maximization Problem

Theprofitfunctionis(=50QQ2).Themaximizationofthefunction

occursif:

1) Firstderivative[d/dQ=502Q]atthatpointisequaltozero.

2) Secondderivative[(d/dQ)=2]is<=0.

Hence,Q=25willmaximizeprofits.

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.

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

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:

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/Y = 100 - 40Y + 20X = 0

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

MULTIVARIATE FUNCTIONS.

= f (Q1 , Q2 )

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.;

as constant; hence

Q1

Q2

= 80 - 20Q2 - 5Q1;

(1)

therefore

setting

both

simultaneously

partial

(2)

derivatives

equal

to

zero

and

solve

80 - 20Q2 - 5Q1 =0

________________

- 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

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)

-9Q1 - 9Q2 + 270 = 0

9Q1 - 11Q2

=0

____________________

-20Q2 +270 = 0

Q2 = 270/20 = 13.5

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.

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