FIN 30210:

Managerial Economics

Optimization
Techniques
Economics is filled with optimization problems

Consumers make buying Businesses make hiring/capital

decisions to maximize utility investment decisions to
minimize costs Businesses make pricing
decisions to maximize profits

We need some tools

to analyze these
optimization
Consumers make labor Consumers make savings problems
decisions to maximize utility decisions to maximize utility
Example An airport shuttle currently charges $15 and
carries an average of 1,200 passengers per day. It
estimates that for each dollar it raises its fare, it
loses an average of 50 passengers.

Current Revenues: $15(1,200) = $18,000

Could we do better?
First, lets figure out the demand curve this business faces. For simplicity, lets assume
that the demand is linear.
Q  A  BP

Price
We also know that every dollar change in price alters passengers
by 50.

0  A  BP A
A B  50
P B
B
$15

1,200 A Passengers

Q  A  B *0  A
First, lets figure out the demand curve this business faces. For simplicity, lets assume
that the demand is linear.

We can use the one data point we have to find the

Price missing parameter

1,950
 $39 1, 200  A  50 15 
50

A  1,950 Q  1,950  50 P
$15

1,200 1,950 Passengers

The problem here is to maximize revenues.

Fare
Revenues  P * Q

1,950
 $39 Q  1,950  50 P
50

Revenues  P 1,950  50 P   1,950 P  50 P 2

$P

Revenues

So, we have revenues as a

Q Passengers
1,950
function of the price charged.
Now what?
 Q  1,950  50 P 1,950 P  50 P 2
Revenues

20000
Price Quantity Revenues
18000
0 1,950 0
16000
1 1,900 1,900
14000
2 1,850 3,700
12000
3 1,800 5,400
10000

8000
Price Quantity Revenues
6000
19.50 975 19,012.50
4000

2000

Price Quantity Revenues 0

15
1 5 9 13 17 21 25 29 33 37 Price
36 150 5,400 19.50

37 100 3,700
38 50 1,900 We could do better! Now, how do we find this
39 0 0 point without resorting to excel?
 “Take the derivative and set it equal
to zero!”
-Fermat’s Theorem

Pierre de Fermat
1607- 1665 Pierre de Fermat was actually a lawyer before he
was a mathematician….perhaps he was trying to
figure out how to maximize his legal fees!

But, what’s a derivative and why set it

equal to zero?
 The derivative is the result of the
Imagine calculating the slope
distance between those two
between two distinct points on a
points approaching zero
function

 f  x  x   f  x  
slope  lim    f '  x
f  x  x   f  x  x 0
 x 
slope 
x
f x 
f x 
Now, let those two points get
f  x  x  closer and closer to each
other

f '  x

f x 
f x 

x
x x  x x
x
Let’s try one numerically… 2

f  x  x   f  x 
36  4 slope 
slope  8 x
4
x f  x  x  Slope
f x  2
4 36 8
x 2 16 6
1 9 5
36
.5 6.25 4.5
.25 5.0625 4.25
.1 4.41 4.1
.05 4.2025 4.05
4
.01 4.0401 4.01
x .001 4.004001 4.001
2 6

x
The slope gets closer and closer to 4
 Or, in general… slope 
f  x  x   f  x 
x

 x  x   x2
2

slope 
x
f x 
x2

f  x  x  slope 
x 2  2 xx  x 2  x 2
x

2xx  x 2
f  x slope 
x

x slope  2 x
x x  x
slope  2 x  x
Let the change in x go to 0
f '  2  4
x
Some useful derivatives
Exponents
Linear Functions
f ( x)  Axn  f ' ( x)  nAxn1
f ( x)  Ax  f ' ( x)  A

Example: f ( x)  4 x
Example: f ( x)  3x 5
f ' x   4 f ' x   15 x 4

Logarithms
A
f ( x)  A ln( x)  f ' ( x) 
x
Example: f ( x)  12 ln x 

f ' x  
12
x
A necessary condition for a maximum or a minimum is that the
derivative equals zero

f x  f x 
f '  x  0

OR
f '  x  0

x *
x
x* x

But how can we tell which is which?

While the first derivative measures the slope (change in the value of the function), the
second derivative measures the change in the first derivative (change in the slope)

f '  x  0
f x  f x 
f '  x  0

f '  x  0

f '  x  0
x *
x
x* x

As x increases, the
f ''
 x  0
As x increases, the
f ''  x   0
slope is decreasing slope is increasing
The B2 Bomber: A lesson in second derivatives
“The flying wing was the aerodynamically worst
possible choice of configuration”
--Joseph Foa

William Sears: “of course we were embarrassed by the error”

 R  1,950 P  50 P 2
Back to our revenue problem….
Take the
Revenues
derivative with
20000 respect to ‘P’
18000

16000 R '  1,950  100 P

14000
Set the derivative
12000
equal to zero and
10000 solve for ‘P’
8000
1,950  100 P  0
6000

4000
P  $19.50
2000 R  $19, 012.50
0
15
Note, the second derivative is
1 5 9 13 17 21 25 29 33 37
Price negative…a maximum!
19.50

R ''  100
After prices for almonds climbed to a record $4 per pound in 2014, farmers
across California began replacing their cheaper crops with the nut, causing
a huge increase in supply. Now, the bubble has popped. Since late 2014,
according to The Washington Post, almond prices have fallen by around
25%.

Lets suppose that almond prices

are currently $3/lb. and are falling
at the rate of $.04/lb. per week.

Let’s also suppose that your

orchard is current bearing 35
$3.00
pounds per tree, and that number
will increase by 1 lb. per week.

How long should you wait to

harvest your nuts to maximize your
revenues?
 We want to maximize revenues which is price
per pound times total pounds sold

Q  35  t P  3.00  .04t

Revenue  P * Q   35  t  3  .04t 

Now, take a
derivative with R  105  1.6t  .04t 2
respect to ‘t’ and set
it equal to zero
R '  1.6  .08t
P  $2.20
Then, solve for ‘t’
t  20
*
Q  55
R  $121
We want to maximize revenues which is price per pound times total pounds sold
125

120

115
Revenues

110

105

100

95
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 Weeks
 Suppose that you run a
trucking company. You have
the following expenses.

Expenses
• Driver Salary: $22.50 per hour What speed should you
• $0.27 per mile depreciation tell your driver to maintain
• v/140 dollars per mile for fuel
in order to minimize your
costs where ‘v’ is speed in miles
per hour cost per mile?
 What speed should you tell your driver to
maintain in order to minimize your cost per
mile?

22.50 v
Cost  .27  
Note that if I divide the v 140
driver’s salary by the speed, I
get the driver’s salary per
mile
$ Now, take a 22.50 1
$ derivative with C'  2  0
hr.  respect to ‘t’ and set v 140
miles mile it equal to zero
hr.
Then, solve for ‘t’ v  3,150  56 mph
Cost  $1.07 per mile
We want to minimize cost per mile
1.1

1.09

1.08
Cost Per Mile

1.07

1.06

1.05
40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 Speed
 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 A  .5 p 2 2

Choose the level of advertising AND price top maximize

sales
 Choose the level of advertising AND price to maximize sales

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

Now, we need
Q p  10  A  p  0
partial derivatives 40  p  1.6 A  0
with respect to both
‘p’ and ‘A’. Both are 10  A  p  0
set equal to zero QA  40  p  1.6 A  0
This gives us two
equations with two
unknowns
We could solve one of the equations
for ‘A’ and then plug into the other
40  p  1.6 A  0
40  p  1.6 A  0
10  A  p  0  A  p  10
10  A  p  0
Price

40  p  1.6 A  0
40

40  p  1.6  p  10   0
10 25 50
Advertising
24  .6 p  0
-10
p  40
A  50
-40
 The method of Lagrange multipliers is a strategy for
finding the local maxima and minima of a function
subject to equality constraints.

Joseph-Louis Lagrange
1736-1813

Harold Kuhn and Albert Tucker later

extended this method to inequality
constraints

Harold W. Kuhn Albert W. Tucker

1925 - 2014 1905 - 1995
 The Lagrange method writes the constrained optimization
problem in the following form
Objective

Choice
max f  x, y  Constraint(s)
x, y
variables
subject to g  x,y  0

The problem is then rewritten as follows

 f  x, y    g  x, y 
Multiplier (assumed greater or equal to zero)
Here’ s how this would look in two dimensions…we’ve created a new function that includes
the constraints. This new function coincides with the original objective at one point – the
maximum of both!
f  x

 g  x  0

 f  x   g  x

f  x
x
x*
The new function is
x 0 maximized
Therefore, at the maximum,
two thigs have to be true g x  0 The new function coincides
with the original objective
 So, we have our Lagrangian function….

 f  x, y    g  x, y 

We need the derivatives with respect o both ‘x’ and ‘y’ to be zero

x  f x  x, y    g x  x, y   0
y  f y  x, y    g y  x, y   0

And then 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:

Profit  10 x  20 y  .1( x  y )
2 2 Objective
f  x, y 

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

and Y to maximize profits subject to your capacity constraints.

Constraint
x  y  100 g  x, y 
 First, for comparison purposes, lets solve this unconstrained….

Profit  10 x  20 y  .1( x 2  y 2 )

Take derivatives with respect to ‘x’ and ‘y’

y

Px  10  .2 x
P  1, 250
100 Py  20  .2 y
Set the derivatives equal to
zero and solve for ‘x’ and ‘y’

x*  50
y*  100
50 x
P  1, 250
 Now, add the constraint Profit  10 x  20 y  .1( x 2  y 2 )

Subject to x  y  100

y We need to get the problem in the right format….we need

unconstrained
solution g  x, y   0 x  y  100
P  1, 250
100 Subtract ‘x’ and ‘y’
from both sides

The constraint matters! 100  x  y  0

Acceptable Now, we can write the lagrangian
values for ‘x’
and ‘y’
 10 x  20 y  .1( x 2  y 2 )   (100  x  y )
50
x
100 Objective Constraint
Multiplier
Now, the mechanical  10 x  20 y  .1( x  y )   (100  x  y )
2 2

part
Take derivatives with respect to ‘x’ and ‘y’

x  10  .2 x    0
y
unconstrained
y  20  .2 y    0
solution
P  1, 250 And the multiplier conditions
100
0 100  x  y  0  (100  x  y )  0

Acceptable
values for ‘x’
and ‘y’

50
x
Now, the mechanical x  10  .2 x    0
part y  20  .2 y    0

0 100  x  y  0  (100  x  y )  0

y
unconstrained First, let’s suppose that lambda equals zero
solution
P  1, 250 10  .2 x  0 x*  50
100
That puts us here! 20  .2 y  0 y*  100
100  x  y  0 100  50  100  50  0
Acceptable
values for ‘x’
and ‘y’ Nope, that doesn’t work!! So, lambda
must be a positive number

50
x
Now, the mechanical x  10  .2 x    0  0  (100  x  y )  0 100  x  y  0
 20  .2 y    0
part y

So, we have three equations and three unknowns (‘x’, ‘y’, and lambda)

10  .2 x    0   10  .2 x
y 20  .2 y    0   20  .2 y
Solve the first
unconstrained two expressions
solution for lambda
P  1, 250
100 10  .2 x  20  .2 y
P  1,125
constrained solution
75 rearrange

y  x  50
x*  25
Plug into third equation
y*  75
x 100  x   x  50   0  5
25 50
P  1,125
Suppose that the x  10  .2 x    0
production constraint y  20  .2 y    0

increases from 100 to 101  0  (101  x  y )  0 101  x  y  0

y Resolve….
unconstrained x*  25.5
solution
P  1, 250 101  x   x  50   0 y*  75.5
100   4.9
P  1,125 (x + y = 100)
P  1,,129.5
75 P  1,129.5 (x + y = 101)

We optimize once again and, given the extra capacity,

profits up by 4.50. This is pretty close to the value of
lambda!
x
25 50
Let’s plot profits (optimized subject to the constraint) as a function of
the constraint

Profit Slope   x y #
unconstrained
P  1,125 P  1, 250 solution

Lambda measures the marginal impact of

the constraint on the objective function!

150
#
100
 If we continue to assume lambda is positive….
Suppose that the production
constraint is 160 x  10  .2 x    0
y  20  .2 y    0
y
160  0  (160  x  y )  0 160  x  y  0

x*  105
y*  155
P  1, 245
160  x   x  50   0
100   1
P  1, 245
unconstrained
solution
This is no good! Lambda must
P  1, 250 be zero then!
x*  50
y*  100
x  0
50 160 P  1, 250
Lambda measures the marginal impact of the constraint on the objective
function! So, when the constraint in irrelevant, lambda hits zero!

Profit Slope  

unconstrained
P  1, 250 solution

Profit

Lambda
# x y #
150
 Example Postal regulations require that a package whose length
plus girth exceeds 108 inches must be mailed at an
oversize rate. What size package will maximize the
volume while staying within the 108 inch limit?

Y Z max
x 0, y 0, z 0
xyz
Girth  2 x  2 y subject to 2 x  2 y  z  108
Volume  xyz

g  x, y , z   0 108  2 x  2 y  z  0
Remember, we need to write the
constraint in the right format!
 Postal regulations require that a package whose length
plus girth exceeds 108 inches must be mailed at an
X oversize rate. What size package will maximize the
volume while staying within the 108 inch limit?

Y Z
First, write down the lagrangian

 xyz   (108  2 x  2 y  z )
Now, take the derivatives with respect to ‘x’, ‘y’, and ‘z’

x  yz  2  0
Set the derivatives equal to zero
y  xz  2  0
z  xy    0

  0 108  2 x  2 y  z  0 Multiplier conditions

 108  2x  2 y  z   0
Lets assume that lambda is positive

yz  2  0 That leaves us four equations and 4 unknowns

xz  2  0
xy    0   xy
108  2 x  2 y  z  0

yz  2  0 2 x  2 y  z  108
yz  2 xy  0
z  z  z  108
z  2x
3 z  108
xz  2  0 y  18 Area  xyz  18 18  36   11, 664
xz  2 xy  0 x  18   xy  18 18   324
z  2y
z  36
Adding 1 inch to the girth/length will allow us to
increase the area by approximately 324 cubic inches
Example Suppose that you manufacture IPods. Your assembly
plant utilizes both labor and capital inputs. You can
write your production process as follows

yk l .5 .5

Labor inputs
Hourly output of
IPods Capital Inputs

Labor costs $10 per hour and capital costs $40 per unit. Your objective is to
minimize the production costs associated with producing 100 IPods per hour.

Total Costs  10l  40k

 Minimize the production costs associated with
producing 100 IPods per hour.
min 10l  40k
l 0,k 0

subject to k .5l .5  100

g  x, y , z   0 k .5l .5  100  0
Remember, we need to write the
constraint in the right format!

Minimizations need a minor adjustment…

 f  x, y    g  x , y 
A negative sign instead of a positive sign!!
 min 10l  40k
l 0,k 0

subject to k .5l .5  100

The shaded area is what the constraint
k look like

 200   50   100
.5 .5

100  100   100

.5 .5
200

16   625  100

.5 .5

100

16
100  k .5l .5

50 100 625
l
Minimize the production costs associated with
producing 100 IPods per hour.

So, we set up the lagrangian again…now with a negative sign

 10l  40   (k .5l .5  100)

Now, take the derivatives with respect to ‘k’ and ‘l’

l  10  .5 k .5l .5  0

Set the derivatives equal to zero
k  40  .5 k l  0
.5 .5

0 k .5l .5  100 Multiplier conditions

 (k .5l .5  100)  0
 Lets assume that lambda is positive. So we have three equations and three unknowns

10  .5 k .5l .5  0 Lets solve the first two for lambda

40  .5 k .5l .5  0 10  .5k .5l .5  0 40  .5k .5l .5  0

k .5l .5  100   20l .5 k .5   80k .5l .5

Set the two

Total Costs  10  200   40  50   $4, 000 expressions for
lambda equal to each
 20  200   50 
.5
  20l k .5
 40
.5 .5
other and simplify

1 Additional
IPod would cost k .5l .5  100
$40 (wait, isn’t 20l .5 k .5  80k .5l .5
k .5 4k   100
.5
that marginal
cost?!) l  4k
2k  100
Plug into the last
k  50 expression and
l  200 simplify
 min 10l  40k
l 0,k 0
The shaded area is what the constraint
subject to k l  100
.5 .5
look like

k
Total Costs  10  50   40  200   8,500

Total Costs  10 100   40 100   5, 000

Total Costs  10  200   40  50   4, 000

200

Total Costs  10  625   40 16   6,890

100

50
16
100  k .5l .5

50 100 200 625

l
 Suppose that you are choosing purchases of apples and
bananas. Your total satisfaction as a function of your
consumption of apples and bananas can be written as

Utility  A.4 B.6

Weekly Banana
Happiness Consumption
Weekly Apple
Consumption

Apples cost $4 each and bananas cost $5 each. You want to maximize your
satisfaction given that you have $100 to spend

Total Expenditures  4 A  5B
 Total Expenditures  4 A  5B  100
A
$100
25 
$4

max A.4 B.6

A 0, B  0

subject to 100  4 A  5B  0
4 A  5 B  100
*Note: Technically, there are two
additional constraints here

A0 B0
But given that zero consumption of B
either apples or oranges yields zero 20 
$100
utility, we can ignore them $5
 Apples cost $4 each and bananas cost $5 each. You want to
maximize your satisfaction given that you have $100 to spend

max A.4 B.6

A 0, B  0

subject to 100  4 A  5B  0

So, we set up the lagrangian again

( A, B)  A.4 B.6   (100  4 A  5B)

Take derivatives with respect to ‘A’ and
Let’s again assume ‘B’ and set the derivatives equal to zero
lambda is positive!
100  4 A  5 B  0 A  .4 A.6 B.6  4  0
 0 B  .6 A.4 B .4  5  0
 So we have three equations and three unknowns

Lets solve the first two for lambda

.4 A B  4  0
.6 .6

.6 A.4 B .4  5  0 .4 A.6 B.6  4  0 .6 A.4 B .4  5  0

4 A  5 B  100   .1A.6 B.6   .12 A.4 B .4

Set the two

expressions for
Utility  A B  10  12   11.15
.4 .6 .4 .6
lambda equal to each
  .1A B  .110  12   .11
.6 .6 .6 .6 other and simplify

1 Additional
dollar would
4 A  5B  100 .1A.6 B .6  .12 A.4 B .4
provide an
additional .11 4 A  51.2 A  100 B  1.2 A
units of
happiness
A  10 Plug into the last
expression and
B  12 simplify
 Total Expenditures  4 A  5B  100
A
$100
25 
$4

Utility  A.4 B.6  10  12   11.15

.4 .6

max A.4 B.6 10

A 0 , B  0

subject to 100  4 A  5B  0

B
12 $100
20 
$5
Non-Binding Constraints
 Suppose that you manufacture IPods. Your assembly plant utilizes both
labor and capital inputs. You can write your production process as follows

yk l .5 .5

Labor inputs
Hourly output of
IPods Capital Inputs

Labor costs $10 per hour and capital costs $40 per unit. Your objective is to minimize the
production costs associated with producing 100 IPods per hour.

TC  10l  40k

The local government will not allow you to fully automate your plant. That is, you have
to use at least 1 hour in your production process

l 1
 min 10l  40k
l 0,k 0

subject to k .5l .5  100

l 1
k
l 1

Possible
Choices

100  k .5l .5
l
1
 Minimize the production costs associated with
producing 100 IPods per hour while utilizing at least 1
hour of labor.

 10l  40k   (k .5l .5  100)    l  1

Labor constraint

Take derivatives with respect to ‘k’ and

‘l’ and set the derivatives equal to zero
Multiplier Conditions

0 k l  100  0
.5 .5
  k l  100  = 0
.5 .5
k  40   .5k .5l .5   0

 (l  1)  0  0 l -1  0 l  10   .5k .5l .5     0

 We already know that that lambda is positive, but what about the other multiplier?.
Suppose that mu is positive as well (i.e. the second constraint is binding)

40   .5k .5l .5   0 k .5l .5  100  0

10   .5k .5l .5     0 l 1

So, we can plug in labor equals 1

40   .5k .5   0 Plug in capital equals 10 and solve for lambda and mu
10   .5k .5     0
40   .5k .5   0   8, 000
k  100  0
.5
k  10, 000
10   .5k .5     0   399,990

This doesn’t work. That means the second constraint is not binding and so we can ignore it
 min 10l  40k
l 0,k 0

subject to k .5l .5  100

l 1
k
l 1

Total Costs  10  200   40  50   4, 000

50
100  k .5l .5
l
1 200
 Lets make sure the constraint binds… suppose that
labor costs $500,000 per hour!!

 500, 000l  40k   (k .5l .5  100)    l  1

Labor constraint

Take derivatives with respect to ‘k’ and

‘l’ and set the derivatives equal to zero
Multiplier Conditions

0 k .5l .5  100  0   k .5l .5  100  = 0 k  40   .5k .5l .5   0

 (l  1)  0  0 l -1  0 l  500, 000   .5k .5l .5     0

 We already know that that lambda is positive, but what about the other multiplier?.
Suppose that mu is positive as well (i.e. the second constraint is binding)

40   .5k .5l .5   0 k .5l .5  100  0

500, 000   .5k .5l .5     0 l 1

So, we can plug in labor equals 1

40   .5k .5   0
Plug in capital equals 10 and solve for lambda and mu
500, 000   .5k .5     0
40   .5k .5   0   8, 000
k  100  0
.5
k  10, 000
500, 000   .5k .5     0   100, 000

Now the constraint binds!

 min 500, 000l  40k
l  0, k  0

subject to k .5l .5  100

l 1
k
l 1
Total Costs  500, 000 1  40 10, 000   900, 000

10, 000

100  k .5l .5
l
1
 So, when does the constraint bind? Lets solve the problem for a generic price of capital, wage,
and production requirement

min wl  pk
l  0, k  0

subject to k .5l .5  y
l 1
Assuming L = 1

p   .5k .5   0
w   .5k .5     0
yk 0 .5
ky 2

  2 p k  2 py w  py 2    py 2
Whether or not the constraint binds depends on prices!!

Hourly
w w  py 2
Wage Constraint is Binding

k  y2
l 1

Constraint is Non-Binding

 p  w
ly   k  y  
 w  p

p
Price of
capital
per unit
 Let’s go back to the banana/apple problem. However,
lets change up the utility function.


max A.5  2 B
A, B

subject to
PA A  PB B  $100
A0 B0

With the new utility function, we can no longer assume that

positive amounts of apples and bananas are consumed!
 
max A.5  2 B
A, B

subject to
PA A  PB B  $100
A0 B0
Write out the lagrangian….we have three
constraints, so we have three multipliers

( A, B)  A.5  2B   ($100  PA A  PB B)  1 A  2 B

Possible Multiplier Conditions Take derivatives with respect to ‘A’ and

‘B’ and set equal to zero
0 100  PA A  PB B  0  100  PA A  PB B  = 0
1  0 A0 1 A  0 .5 A.5   PA  1  0
2  0 B0 2 B  0 2   PB  2  0
 Possible Multiplier Conditions

0 100  PA A  PB B  0  100  PA A  PB B  = 0

1  0 A0 1 A  0

2  0 B0 2 B  0

We can simplify this down a bit....we already know that the constraint on income will bind

 0 100  PA A  PB B  0

Further, consider the change in utility with respect to a change in apple consumption. Zero consumption of apples
would make this infinite, so the zero apple constraint will never bind

U
 .5 A.5  .5  0   
.5
A0 1 =0
A
Now, let’s solve for the conditions under which the zero
banana condition binds
.5 A.5
.5 A.5   PA  0 
PA
2   PB  2  0 2   PB  2  0
PA A  PB B  100 A
100
B0 PA

2  0

 .5 A.5  PB  40 PA
  PB  2  0
 PA 
Once again, prices determine whether or not the constraint is binding!

PB Constraint is Binding

B0

A
$100 PB  40 PA
PA

Constraint is Non-Binding

2
 P  $100  PA A
A   .25 B  B
 PA  PB

PA