MANAGERIAL ECONOMICS:

THEORY, APPLICATIONS, AND CASES

W. Bruce Allen | Neil A. Doherty | Keith Weigelt | Edwin Mansfield

Chapter 18

OPTIMIZATION
TECHNIQUES
 FUNCTIONAL RELATIONSHIPS

• Q = f (P).
• Q is the number of units sold, and P is the Price.
• Equation is read as “The Number of units sold is
a function of price.”
• Q is the dependent variable.
• P is the independent variable.
 MARGINAL ANALYSIS

• Marginal Value is the change in the dependent

variable associated with a one-unit change in a
particular independent variable.
• Marginal Profit is the change in total profit
associated with a one-unit change in output.
• Average Profit is the total profit divided by
output.
 MARGINAL ANALYSIS

• The central point about a marginal relationship is

that the dependent variable is maximized when
its marginal value changes from positive to
negative.
• Thus, managers need not focus on averages, as
they would not be maximizing the function.
© 2013 W. W. Norton Co., Inc.
 RELATIONSHIPS AMONG TOTAL,
MARGINAL, AND AVERAGE VALUES.

• The average profit curve must be rising if it is

below the marginal profit curve.
• The average profit curve must be falling if it is
above the marginal profit curve.
• Hence, average profit must be a maximum
where marginal profit equals average profit.
RELATIONSHIPS AMONG TOTAL, MARGINAL,
AND AVERAGE VALUES.

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RELATIONSHIPS AMONG TOTAL, MARGINAL,
AND AVERAGE VALUES.

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 THE CONCEPT OF A DERIVATIVE

• Y = f(X)
• The derivative of Y with respect to X is defined
as the limit of Y/X, as  X approaches zero.
LINEAR RELATIONSHIPS BETWEEN Y AND X

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HOW THE VALUE OF ΔY>Δ X VARIES DEPENDING ON THE
STEEPNESS
OR FLATNESS OF THE RELATIONSHIP BETWEEN Y AND X

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DERIVATIVE AS THE SLOPE OF THE CURVE

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 HOW TO FIND A DERIVATIVE

• Constant Rule:
• If Y = a
• Then dY/dX = 0
• Product Rule:
• If Y = a.Xb
• Then dY/dX = b.a.Xb-1
• Sum Rule:
• If U= g(X) and W = h(X) and Y = U + W
• Then dY/dX = dU/dX + dW/dX
 HOW TO FIND A DERIVATIVE (CONT’D)

• Difference Rule:
• If U= g(X) and W = h(X) and Y = U - W
• Then dY/dX = dU/dX - dW/dX
• Product Rule:
• If Y = U.W
• Then dY/dX = U.dW/dX + W.dU/dX
• Quotient Rule:
• If Y = U/W
• Then dY/dX = [W.(dU/dX) – U.(dW/dX)]/W2
 HOW TO FIND A DERIVATIVE (CONT’D)

• Chain Rule:
• If Y = f(W) and W = g(X)
• Then dY/dX = (dY/dW).(dW/dX)
HOW TO FIND A DERIVATIVE (CONT’D)

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HOW TO FIND A DERIVATIVE (CONT’D)

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HOW TO FIND A DERIVATIVE (CONT’D)

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USING DERIVATIVES TO SOLVE MAXIMIZATION
AND MINIMIZATION PROBLEMS

• Maximum or minimum occurs only if the slope

equals zero.
• Whether maximum or minimum depends on the
sign of the second derivative.
• For maximum, dY/dX = 0, and d2Y/dX2 <0.
• For minimum, dY/dX = 0 and d2Y/dX2>0.
USING DERIVATIVES TO SOLVE MAXIMIZATION AND
MINIMIZATION PROBLEMS (CONT’D)

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USING DERIVATIVES TO SOLVE MAXIMIZATION AND
MINIMIZATION PROBLEMS (CONT’D)

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MARGINAL COST EQUALS MARGINAL REVENUE
AND THE CALCULUS OF OPTIMIZATION

•  = TR – TC, where  equals total profit, TR

equals total revenue and TC equals total cost.
• For  to be a maximum, d/dQ = 0 and d2/dQ2
must be <0.
• Thus, dTR/dQ = dTC/dQ or Marginal Revenue =
Marginal Cost.
MARGINAL REVENUE EQUALS MARGINAL COST
RULE FOR PROFI T

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 PARTIAL DIFFERENTIATION AND THE
MAXIMIZATION OF MULTIVARIATE FUNCTIONS

•  = f(Q1, Q2)
• Set partial derivatives equal to zero
• /Q1 = 0 and /Q2 = 0
• Results in two equations in two unknowns
• Solve simultaneously for the two unknowns
PARTIAL DIFFERENTIATION AND THE MAXIMIZATION OF
MULTIVARIATE FUNCTIONS (CONT’D)

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 CONSTRAINED OPTIMIZATION

• Managers face constraints that limit their options.

• With only one constraint, it is fairly easy to convert
the problem to one of unconstrained maximization
or minimization and solve as before.
• Or, use the Lagrangian method.
 LAGRANGIAN MULTIPLIERS

• Construct an additional equation—

Lagrangian function—that combines the function
to be maximized (minimized) and the constraint.
• Two things must be true of this new equation.
• When this equation is maximized (minimized)
the original function is in fact maximized
(minimized).
• All the constraints must be satisfied.
 LAGRANGIAN MULTIPLIERS (CONT’D)

•  is called the Lagrangian multiplier.

• It measures the change in the variable to be
maximized or minimized, if the constraint is
relaxed by one unit.
• This information is of great value to managers.
 COMPARING INCREMENTAL COSTS WITH
INCREMENTAL REVENUES

• Incremental Cost is the extra cost from an output

increase that may be substantial.
• Incremental Revenue is the extra revenue from
an output increase that may be substantial.
• Incremental Cost is NOT the same as Marginal
Cost.
• Incremental Revenue is NOT the same as
Marginal Revenue.
 COMPARING INCREMENTAL COSTS WITH
INCREMENTAL REVENUES(CONT’D)

• Common Error is the failure to recognize the

irrelevance of sunk costs.
• Another error is to assume that a capacity
constraint is binding, when it may not be so during
periods of slack.
• Incremental revenue is also frequently misjudged.
• Managers may not take proper account of the
impact of a new product’s sale on existing
products (think Apple iPhone).
 This concludes the Lecture
PowerPoint Presentation for
Chapter 18: OPTIMIZATION TECHNIQUES

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