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1

Optimization Techniques

Methods for maximizing or minimizing an objective function Examples

± Consumers maximize utility by purchasing an optimal combination of goods ± Firms maximize profit by producing and selling an optimal quantity of goods ± Firms minimize their cost of production by using an optimal combination of inputs

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Slide 2

**Expressing Economic Relationships
**

Equations: Tables: Graphs:

Q TR

300 250 200 50 00 50

**TR = 100Q - 10Q2
**

0 0

TR

1 90

2 3 4 5 6 160 210 240 250 240

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¡

¡ ¡

0

2

3

4

5

6

7

Q

Slide 3

**Total, Average, and Marginal Revenue
**

TR = PQ AR = TR/Q MR = (TR/(Q

Q 0 1 2 3 4 5 6 T 0 90 160 210 240 250 240 A 90 80 70 60 50 40 M 90 70 50 30 10 -10

Slide 4

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Slide 5

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Slide 6

TR 300 250

Total Revenue

200 150 100 50 0 0 1 2 3 4 5 6 7 Q

AR, 120 100

R

Average and Marginal Revenue

80 60 40 20 0 -20 -40 Q 0 1 2 3 4 5 6 7

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Slide 7

**Total, Average, and Marginal Cost
**

Q AC = TC/Q MC = (TC/(Q 3 4 5 TC 4 6 8 4 48 AC MC 4 8 6 6 96

6 4

Slide 8

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Slide 9

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Slide 10

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Slide 11

Geometric Relationships

The slope of a tangent to a total curve at a point is equal to the marginal value at that point The slope of a ray from the origin to a point on a total curve is equal to the average value at that point

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Slide 12

Geometric Relationships

A marginal value is positive, zero, and negative, respectively, when a total curve slopes upward, is horizontal, and slopes downward A marginal value is above, equal to, and below an average value, respectively, when the slope of the average curve is positive, zero, and negative

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Slide 13

Profit Maximization

Profit

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Slide 15

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Slide 16

Steps in Optimization

Define an objective mathematically as a function of one or more choice variables Define one or more constraints on the values of the objective function and/or the choice variables Determine the values of the choice variables that maximize or minimize the objective function while satisfying all of the constraints

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Slide 17

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Slide 18

**New Management Tools
**

Benchmarking Total Quality Management Reengineering The Learning Organization

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Slide 19

**Other Management Tools
**

Broadbanding Direct Business Model Networking Performance Management

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Slide 20

**Other Management Tools
**

Pricing Power Small-World Model Strategic Development Virtual Integration Virtual Management

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Slide 21

Chapter 2 Appendix

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Slide 22

**Concept of the Derivative
**

The derivative of Y with respect to X is equal to the limit of the ratio (Y/(X as (X approaches zero.

(Y dY ! lim dX (X p0 (X

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Slide 23

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Slide 24

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Slide 25

Rules of Differentiation

Constant Function Rule: The derivative of a constant, Y = f(X) = a, is zero for all values of a (the constant).

Y ! f( )!a

dY !0 dX

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Slide 26

Rules of Differentiation

Power Function Rule: The derivative of a power function, where a and b are constants, is defined as follows.

Y ! f( )!a dY ! b a X b 1 dX

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b

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Slide 27

Rules of Differentiation

Sum-and-Differences Rule: The derivative of the sum or difference of two functions, U and V, is defined as follows.

U ! g(X ) V ! h( X )

dY dU dV ! s dX dX dX

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Y ! U sV

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Slide 28

Rules of Differentiation

Product Rule: The derivative of the product of two functions, U and V, is defined as follows.

U ! g(X ) V ! h( X ) Y ! U V

dY dV dU !U V dX dX dX

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Slide 29

Rules of Differentiation

Quotient Rule: The derivative of the ratio of two functions, U and V, is defined as follows.

U ! g(X ) dY ! dX V ! h( X ) V dU U Y! V dX

dX

V

2

U dV

Slide 30

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Rules of Differentiation

Chain Rule: The derivative of a function that is a function of X is defined as follows.

Y ! f (U ) U ! g(X )

dY dY dU ! dX dU dX

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Slide 31

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Slide 32

**Optimization with Calculus
**

Find X such that dY/dX = 0 Second derivative rules: If d2Y/dX2 > 0, then X is a minimum. If d2Y/dX2 < 0, then X is a maximum.

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Slide 33

Univariate Optimization

Given objective function Y = f(X) Find X such that dY/dX = 0 Second derivative rules: If d2Y/dX2 > 0, then X is a minimum. If d2Y/dX2 < 0, then X is a maximum.

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Slide 34

Example 1

Given the following total revenue (TR) function, determine the quantity of output (Q) that will maximize total revenue: TR = 100Q ± 10Q2 dTR/dQ = 100 ± 20Q = 0 Q* = and d2TR/dQ2 = -20 < 0

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Slide 35

Example 2

Given the following total revenue (TR) function, determine the quantity of output (Q) that will maximize total revenue: TR = Q ± 0. Q2 dTR/dQ = ±Q=0 and d2TR/dQ2 = -1 < 0 Q* =

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Slide 36

Example

Given the following marginal cost function (MC), determine the quantity of output that will minimize MC: MC = Q2 ± 1 Q + 7 dMC/dQ = Q - 1 = 0 Q* = 2. 7 and d2MC/dQ2 = > 0

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Slide 37

Example

Given

± TR = Q ± 0. Q2 ± TC = Q ± Q2 + 7Q + 2

** Determine Q that maximizes profit ( ):
**

± = Q ± 0. Q2 ± (Q ± Q2 + 7Q + 2)

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Slide 38

Example : Solution

Method 1

± d /dQ = ± Q - Q2 + 1 Q ± 7 = 0 ± -12 + 1 Q - Q2 = 0

Method 2

± MR = dTR/dQ = ±Q ± MC = dTC/dQ = Q2 - 1 Q + 7 ± Q = Q2 - 1 Q + 7 ± Set MR = MC:

** Use quadratic formula: Q* =
**

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Slide 39

Quadratic Formula

Write the equation in the following form:

aX2 + bX + c = 0

The solutions have the following form:

b s b 4ac 2a

2

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Slide 40

Multivariate Optimization

Objective function Y = f(X1, X2, ...,Xk) Find all Xi such that Y/Xi = 0 Partial derivative:

± Y/Xi = dY/dXi while all Xj (where j i) are held constant

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Slide 41

Example

Determine the values of X and Y that maximize the following profit function:

± = 0X ± 2X2 ± XY ± Y2 + 100Y

Solution

± /X = 0 ± X ± Y = 0 ± /Y = -X ± Y + 100 = 0 ± Solve simultaneously ± X = 1 . 2 and Y = 1 . 2

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Slide 42

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Slide 43

Constrained Optimization

Substitution Method

± Substitute constraints into the objective function and then maximize the objective function

Lagrangian Method

± Form the Lagrangian function by adding the Lagrangian variables and constraints to the objective function and then maximize the Lagrangian function

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Slide 44

Example

Use the substitution method to maximize the following profit function:

± = 0X ± 2X2 ± XY ± Y2 + 100Y

** Subject to the following constraint:
**

± X + Y = 12

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Slide 45

Example : Solution

Substitute X = 12 ± Y into profit:

± = 0(12 ± Y) ± 2(12 ± Y)2 ± (12 ± Y)Y ± Y2 + 100Y

±

= ± Y2 +

Y + 72 =0

** Solve as univariate function:
**

± d /dY = ± Y + ± Y = 7 and X =

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Slide 46

Example 7

Use the Lagrangian method to maximize the following profit function:

± = 0X ± 2X2 ± XY ± Y2 + 100Y

** Subject to the following constraint:
**

± X + Y = 12

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Slide 47

Example 7: Solution

Form the Lagrangian function

± L = 0X ± 2X2 ± XY ± Y2 + 100Y + P(X + Y ± 12)

** Find the partial derivatives and solve simultaneously
**

± dL/dX = 0 ± X ±Y + P = 0 ± dL/dY = ± X ± Y + 100 + P = 0 ± dL/dP = X + Y ± 12 = 0

Solution: X = , Y = 7, and P = PowerPoint Slides Prepared by Robert F. Brooker, Ph.D.

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Slide 48

**Interpretation of the Lagrangian Multiplier, P
**

Lambda, P, is the derivative of the optimal value of the objective function with respect to the constraint

± In Example 7, P = - , so a one-unit increase in the value of the constraint (from -12 to -11) will cause profit to decrease by approximately units ± Actual decrease is . units

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Slide 49

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UsefulNot usefulMuhammad Riaz Danish
raqqi148.imsc@yahoo.com

Muhammad Riaz Danish

raqqi148.imsc@yahoo.com

raqqi148.imsc@yahoo.com

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