Managerial Economics

Economic Optimization
 Optimization Techniques

The first step in presenting optimisation

techniques is to examine ways to express
economic relationships. Economic relationship
can be expressed in the form of equation, tables,
or graphs. When the relationship is simple, a
table and/ or graph may be sufficient. However,
if the relationship is complex, expressing the
relationship in equational form may be
necessary.

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 Optimization Techniques

Expressing an economic relationship in equational

form is also useful because it allows us to use the
powerful techniques of differential calculus in
determining the optimal solution of the problem.
More importantly, in many cases calculus can be
used to solve such problems more easily and with
greater insight into the economic principles underlying
the solution. This is the most efficient way for the firm
or other organization to achieve its objectives or reach
its goal.
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 Example

Suppose that the relationship between the total

revenue (TR) of a firm and the quantity (Q) of the
good and services that firm sells over a given
period of time, say, one year, is given by

TR= 100Q-10Q2

(TR= The price per unit of commodity times the

quantity sold; TR=f(Q), total revenue is a
function of units sold; or TR= P x Q).
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 Example

By substituting into equation various

hypothetical values for the quantity sold, we
generate the total revenue schedule of the firm,
shown in Table 1. Plotting the TR schedule of
table 1, we get the TR curve as in graph 1. In
this graph, note that the TR curve rises up to
Q=5 and declines thereafter.

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 Example

Equation1: TR = 100Q - 10Q2

Q 0 1 2 3 4 5 6
Table1: TR 0 90 160 210 240 250 240

TR
300

250

Graph1: 200

150

100

50

0
0 1 2 3 4 5 6 7

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Optimization deals with functions. A function is simply a
mapping from one space to another. (that is, a set of instructions
describing how to get from one location to another)

B
f :A B
Is the range

f is a function

A Is the domain
f
A B
For example

For 0 x5 f x 3x 5 5 y 20

Domain Range
Function

A 0,5 B [5,20]

3 f 3 14
x A

14
 y
20 y 3x 5
For 0 x5
Range

Y =14

x
Domain
0 5

X =3
 y max 3x 5
20 0 x5

Here, the optimum occurs at

Range

x = 5 (y = 20)

x
Domain
0 5

Optimization involves finding the maximum value for y over an allowable

domain.
What is the solution to this optimization problem?

y 1
max
5 x
0 x 10

x
5 10

There is no optimum because

f(x) is discontinuous at x = 5
What is the solution to this optimization problem?

max 2 x
y
12 0 x6

There is no optimum because

the domain is open (that is,
the maximum occurs at x = 6,
but x = 6 is NOT in the
domain!)

x
0 6
What is the solution to this optimization problem?

y
max x
12
x0

There is no optimum because

the domain is unbounded (x is
allowed to become arbitrarily
large)

x
0
The Weierstrass theorem provides sufficient conditions for an optimum
to exist, the conditions are as follows:

y
max f ( x) f x is continuous
over the domain of x

x
The domain for x is closed and bounded
Finding maxima/minima involves taking derivatives.

Formally, the derivative of f x is defined as follows:

f ( x x) f ( x)
f ' x lim
x 0
x

All you need to remember is the derivative represents a slope (a

rate of change)

Actually, to be more accurate, the derivative represents a

trajectory
 Graphically

y y

f x x

f x f x

x x
x x x x

f ( x x) f ( x) f ( x x) f ( x)
slope Now, let the change f ' x lim
x in x get arbitrarily
x 0
x
small
 First Order Necessary Conditions
If x* is a solution to the optimization problem

max f ( x) or min f ( x )
x
x
then
f ' ( x*) 0

f x f ' x 0
f x

f ' x 0
x x
x*
x*
f ' x 0 f ' x 0
f ' x 0 f ' x 0
 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 (X ) a

dY
0
dX
 Rules of Differentiation

Power Function Rule: The derivative of

a power function, where a and b are
constants, is defined as follows.

Y f (X ) aX b

dY
b a X b 1
dX
 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 ) Y U V

dY dU dV

dX dX dX
 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
 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
 Rules of Differentiation

Quotient Rule: The derivative of the

ratio of two functions U and V, is
defined as follows.
U
U g(X ) V h( X ) Y
V

dY


V dU
dX
U dV
dX
2
dX V
 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
Useful derivatives

Logarithms
Linear Functions
A
f ( x) Ax f ' ( x) A f ( x) A ln( x) f ' ( x)
x
Example: f ( x) 4 x Example: f ( x) 12 ln x
f ' x 4 f ' x
12
x

Exponents
f ( x) Axn f ' ( x) nAxn1

Example: f ( x) 3x 5
f ' x 15 x 4
An Example

Suppose that your company owns a corporate jet. Your

annual expenses are as follows:

You pay your flight crew (pilot, co-pilot, and navigator a

combined annual salary of $500,000.
Annual insurance costs on the jet are $250,000
Fuel/Supplies cost $1,500 per flight hour
Per hour maintenance costs on the jet are proportional to the
number of hours flown per year.
Maintenance costs (per flight hour) = 1.5(Annual Flight Hours)

If you would like to minimize the hourly cost of your jet, how
many hours should you use it per year?
Let x = Number of Flight Hours

$750,000
Hourly Cost $1500 $1.5 x
x

$750,000
min $1500 $1.5 x
x 0
x

First Order Necessary Condition

$750,000 750,000
2
$1.5 0 x 707hrs
x 1.5
An Example
Hourly Cost ($)

Annual Flight Hours

How can we be sure we are at a maximum/minimum?

For a maximization For a minimization

f x f ' x 0 f x

f ' x 0

x x
x* x*
f ' x 0 f ' x 0 f ' x 0 f ' x 0

f ' ' ( x*) 0 f ' ' ( x*) 0

Slope is decreasing Slope is increasing
Let x = Number of Flight Hours

$750,000
min $1500 $1.5 x
x
x

First Order Necessary Conditions

$750,000 750,000
2
$1.5 0 x 707hrs
x 1.5
Second Order Necessary Conditions

$1,500,000
3
0 For X>0
x
Suppose you know that demand for your product depends on the
price that you set and the level of advertising expenditures.

Q p, A 5,000 10 p 40 A pA .8 A2 .5 p 2

Choose the level of advertising AND price to

maximize sales
When you have functions of multiple variables, a partial derivative is the
derivative with respect to one variable, holding everything else constant

max 5,000 10 p 40 A pA .8 A2 .5 p 2
p 0 , A 0

First Order Necessary Conditions

Q p ( p, A) 10 A p 0

QA ( p, A) 40 p 1.6 A 0
With our two first order
conditions, we have two Q p ( p, A) 10 A p 0
variables and two unknowns
QA ( p, A) 40 p 1.6 A 0

10 A p 0
40 p 1.6 A 0
A p 10
40 p 1.6 p 10 0
24 .6 p 0
p 40
A 50
How can we be sure we are at a maximum?

f ' ' ( x*) 0

its generally sufficient to see if all the second derivatives are negative

Q p ( p, A) 10 A p
QA ( p, A) 40 p 1.6 A

Q pp ( p, A) 1 0

QAA ( p, A) 1.6 0
Practice Questions

1) Suppose that profits are a function of quantity produced and can be

written as

10 20Q 2Q 2

Find the quantity that maximizes profits

2) Suppose that costs are a function of two inputs and can be written as

C 4 3X1 4 X 2 2 X 3X X1 X 2 1
2 2
2

Find the quantities of the two inputs to minimize costs

Constrained optimizations attempt to maximize/minimize a function subject
to a series of restrictions on the allowable domain

max f x, y
x, y

subject to g x,y 0

To solve these types of problems, we set up the lagrangian

( x, y) f x, y g x, y

Function to be
maximized Constraint(s)
Multiplier
To solve these types of problems, we set up the lagrangian

( x) f x g x

(x ) f x
0

We know that at the

maximum
(x )
x ( x) 0
f x g x 0
x
x*
Once you have set up the lagrangian, take the derivatives and set
them equal to zero

( x, y) f x, y g x, y
First Order Necessary Conditions

x ( x, y ) f x x , y g x x, y 0
y ( x, y ) f y x, y g y x, y 0

Now, we have the Multiplier conditions

0 g x, y 0 g x, y 0
Example: Suppose you sell two products ( X and Y ). Your profits as a
function of sales of X and Y are as follows:

( x, y) 10 x 20 y .1( x 2 y 2 )

Your production capacity is equal to 100 total units. Choose X and Y

to maximize profits subject to your capacity constraints.

x y 100
The key is to get

f x, y
the problem in the
right format

max 10 x 20 y .1( x 2 y 2 )
x 0, y 0

subject to 100 x y 0

g x, y
Multiplier
The first step is to create a Lagrangian

( x, y) 10 x 20 y .1( x y ) (100 x y)
2 2

Constraint
Objective Function
Now, take the derivative with respect to x and y

( x, y) 10 x 20 y .1( x y ) (100 x y)
2 2

First Order Necessary Conditions

x ( x, y ) 10 .2 x 0
y ( x, y ) 20 .2 y 0

Multiplier conditions

0 100 x y 0 (100 x y ) 0
First, lets consider the possibility that 0
lambda equals zero
100 x y 0
100 x y 0
10 .2 x 0
20 .2 y 0

10 .2 x 0 20 .2 y 0
x 50 y 100

100 50 100 50 0 Nope! This cant work!

 The other possibility is that lambda is 0
100 x y 0
positive

100 x y 0
10 .2 x 0
20 .2 y 0

100 x y 0
10 .2x 20 .2 y
100 x x 50 0
10 .2 x 20 .2 y 50 2 x 0
y x 50 x 25
y x 50 y 75
Lambda indicates the marginal value of relaxing the constraint. In this
case, suppose that our capacity increased to 101 units of total
production.

10 .2 x 20 .2 y

y 75
50
x 25

Assuming we respond optimally, our profits increase by $5

The End