Managerial Economics

(MBA 562/MAPMC 622)

Chapter One
Managerial Economics: An
Introduction

Dr. Maru Shete (Associate Professor)

Email: maru.bekele@gmail.com
 Chapter objectives
 Explain the meaning of managerial
economics
 Clarify on the characteristics and scope of
managerial economics
 Describe the basic tools and techniques of
managerial economics
 Explain the application of economic
optimisation tools in managerial decision
making
 Contents

 What is economics?
 What is managerial economics?
 Firms and managerial objectives
 Firms and profits
 Basic tools of economic analysis
 Optimization: concepts and techniques
 What is Economics?
 Scarcity: Human needs are unlimited, but
resources available to satisfy these needs are
scarce.
 Economics plays a role in managing scarce
resources to satisfy unlimited wants.
 Therefore, economics is the study of how
economic agents decides to use scarce
resources that have alternative uses to satisfy
unlimited needs (wants).
 The conditions in which
Scarcity resources are not available to
satisfy all the needs and wants of
specific group of people

Choices/Decisions made
in the use of scare
Choices/Decisions resources should consider
opportunity costs

The amount that must be

Opportunity Cost scarified in choosing
one activity over the
next best alternative 5
 Because of scarcity, an allocation decision
must be made. The allocation decision is
comprised of three separate choices:
1. What and how many goods and services
should be produced?
 The product decision – begin or stop providing goods and/or
services.
2. How should these goods and services be
produced?
 The hiring, staffing, procurement, and capital budgeting
decisions.
3. For whom should these goods and services
be produced?
 The market segmentation decision – targeting the customers
who likely purchase the goods and/or services.
 Economics is classified as: microeconomics and
macroeconomics.
 Microeconomics: studies the economic
behaviour of individual economic units (E.g.
Individual consumers, resource owners, business
firms, etc.) and their interactions.
 Macroeconomics: studies aggregate level of
output, income, employment, consumption,
investment and prices for the economy viewed
as a whole.
 Although managerial economics is part of
microeconomics, macroeconomic conditions are
also very important.
 What is Managerial Economics?
 Managerial economics is the application of
microeconomic theories and quantitative methods to find
optimal solutions to managerial problems faced by
managers of business firms.
 Examples of managerial problems
o a choice of a product to be produced or service to be
provided;
o the price of the product to maximize profit or to attain goal;
o The methods and techniques of production;
o The type of advertisement and its cost;
 In other words, it is the study of how to direct scarce
resources in the way that most efficiently achieves
managerial goals.
 While economics is primarily concerned with the
allocation of scarce resources so as to achieve
maximum social welfare, management science deals
particularly with organizing and allocating a firm’s
scarce resources so as to achieve the objective of
individual firm (profits).

 Therefore, managerial economics depend heavily on

economic theories and quantitative methods to solve
managerial problems.
Characteristics of Managerial Economics
 Microeconomic in character since it deals with individual
economic units.
 Despite it is microeconomic in character, it subscribes to the
wider economic environment (i.e takes into account
macroeconomic issues).
 Multidisciplinary in nature: It draws and uses knowledge
from diverse fields like statistics.
 Uses theory of the firm and profit theory since profit
making is the central objective of business firms.
 Applicable in both profit & not-for-profit sectors.
 Pragmatic: It is concrete, realistic and uses theories that are
highly linked to the real world
 Prescriptive than descriptive, i,e it diagnoses the root
causes of problems to come out with solutions.
 Scope of Managerial Economics
Managerial economics deals with
1. Demand and supply decision: it uses the theory of
demand, which deals with consumer behavior
2.Cost and production decision: uses the theory of
production, which deals with the input – output
relationships
3.Market decision: uses the theory of market structure
4.Pricing decision: uses pricing theory to analyze how
price is determined under different market conditions
5.Profit decision: uses profit theory to determine risk
premium and returns
6. Capital and investment decision: uses the theory of
capital and investment decisions
7.Macroeconomic problems and policies:
Macroeconomic trends (E.g. GDP, unemployment,
inflation, investment, etc).
 Firms and Managerial Objectives
 Firms are agents in the economy that produces goods and
services to satisfy wants of the people.
 They are economic entities that are analysed in the context of
an economic model. The model of business is called the
theory of the firm.
 There are six main areas of economic theories that explains
the nature of firms:
1. Transaction cost theory
2. Information theory
3. Motivation theory
4. Game theory
5. Principal - Agent theory
6. Property rights theory
 Theories cont...
1. Transaction cost theory:
o It examines the costs of undertaking transactions in
different ways.
o These include trading on spot markets, long-term
contracts with external parties and internalizing
transactions within the firm.
2. Information theory
o Explains how information and information systems
affect an economy and economic decisions.
o This is the issue of bounded rationality: how people
make decisions in an uncertain world.
o In decision making, rationality of individuals is
limited on the information they have, the cognitive
limitations of their mind, and the amount of time they
have to make a decision.
 Theory Cont...
3. Motivation theory:
o examines the underlying factors that cause people to
behave in certain ways.
o In economic terms we are searching for general
principles which can be used to explain and predict
behaviour.
4. Game theory:
o examines the strategic interaction of different agents.
agents
o The key to understanding this strategic interaction is
that the behaviour of one party affects the behaviour of
other parties, and parties must consider this in
determining their own strategy.
 Theory Cont...
5. Principal - Agent theory
 The principal-agent relationship is an arrangement in
which one entity (the Principal) legally appoints another
( the Agent) to act on its behalf.
 It examines the situation an agent is involved in
carrying out the wishes of the principal.
 In a principal-agent relationship, the agent acts on
behalf of the principal and should not have a conflict of
interest in carrying out the act.
 The nature of the resulting problem is that principal and
agent usually have goals that do not exactly coincide,
and that the principal can only partially observe the
behaviour of the agent.
 Therefore, principals have to engage in monitoring
activities and design incentives in ways that optimize
their own welfare.
 Theory cont...
6. Property rights theory
o It examines the nature of resource ownership,
ownership
and its relationship with incentives to invest
and bargain power.
o It predicts the allocation of property rights on
the basis of efficiency.
efficiency
 The Theory of Firm
 The theory of the firm explains that firms seek to
maximize profits and minimize cost
 On this basis, it predicts how much of a particular
commodity the firm should produce under
different forms of market structure or
organization.
 Combines and organizes resources for the purpose
of producing goods and/or services for sale.
 Internalizes transactions and strives to reduce
transaction costs.
 Value of the Firm
 Maximizing profits:
profits maximizing the value of the firm,
which is the present value of current and future profits.
 The Value of the Firm:
Firm is the Present Value (PV) of all
expected future profits
1 2 n n
t
PV     
(1  r )
1
(1  r ) 2
(1  r ) n
t 1 (1  r ) t

t
n n
TRt  TCt
Value of Firm   
t 1 (1  r ) t
t 1 (1  r ) t

Where,
r = Interest rate = Inflation rate + Real rate of return
 = TR – TC
 Cont...
 Total Revenue (TR) depends on:
– Product promotion and sales
– Demand and forecasting
– Pricing
– New product development
 Interest rate (r) depends on:
− Riskiness of the project
− Conditions of capital market
− Government policies
 Total Cost (TC) depends on:
– Production technique
– Cost function
– Process development
19
 Firms and profits
 Business (Accounting) Profit: Total revenue
minus the explicit or accounting costs of
production.
 Economic Profit: Total revenue minus all
economic costs (explicit and implicit costs) of
production, including opportunity costs..
 Opportunity Cost: Implicit value of a resource
in its best alternative use.
 Example:
 A person managing a dry-cleaning stores for birr 30,000
per year decides to open a new one. The revenue of the
store during the first year of operation is birr 100,000 and
the expenses are birr 10,000 for supplies, birr 35,000 for
salaries, birr 8,000 for rent, and birr 2,000 for utilities. The
person also used birr 5,000 for interest on a bank loan.
Assume that income and business taxes are zero and the
repayment of the principal of the loan does not start before
three years. Then calculate the following:
• the explicit cost
• the business profit
• the Economic profit
• indicate whether the person should open the dry-cleaning
store.
 Answer
Given:
1. Implicit cost (i,e. the entrepreneur’s foregone salary) = $30,000
2. TR = $100,000
3. Expenses is the explicit costs =
$ 10,000 for supplies,
$ 35,000 for salaries,
$ 8,000 for rent, and
$ 2,000 for utilities
$ 5,000 interest
(a)The total explicit cost is $ 60,000.
The business profit= total revenues - the explicit costs
(b) The business profit = $ 100,000 - $ 60,000= $ 40,000

(c) The Economic profit= total revenues – (the explicit costs +

Implicit costs) = 100,000 – ($ 60,000 + $ 30,000) = $ 10,000
(d) We can conclude that the person would earn economic profit $
10,000 per year, therefore, the person should open the store.
 Why do profits vary among firms?
The following theories explain profit variations
among firms:
a. Monopoly theory of profit
b. Risk and uncertainty bearing theory of
profits
c. Innovation theory of profit
d. Frictional theory of profit
e. Compensatory (managerial efficiency)
theory of profits
 Theories that explain profit variation among
firms
a) Monopoly theory of profit
This theory asserts that some firms are sheltered from
competition by high barriers to entry (strategic and structural).
 Economies of scale,
 High capital requirements,
 Patents,
 Import protection
 Firms with monopoly positions enjoy above-normal profits
for extended periods that allow.

E.g. EEPCO, and Ethio telecom: The gov’t defends that no private
firms can deliver services better than these firms. So they are
enjoying monopoly position that brings them economies of scale
and a profit which is above normal
 Cont…
b) Risk & uncertainty bearing theory of profits
 Explains that profits are the necessary reward of the
entrepreneur for bearing risks and uncertainty in a changing
economy.

c) Innovation theory of profit

 Describes the above-normal profits that arise following
successful invention or modernization.
– For example, innovation profit theory suggests that
Microsoft Corporation has earned superior rates of return
because it successfully developed, introduced, and marketed
the user friendly software program.
 Cont…
d) Frictional theory of profit
 It states that markets are sometimes in disequilibrium

because of unanticipated changes in demand or cost

conditions.
 Unanticipated shocks produce positive or negative
economic profits for some firms.

e) Compensatory /managerial efficiency/ theory of profits

 “Organizations look like their leaders”
 describes above-normal rates of return that reward firms for extraordinary
success in meeting customer needs, and maintaining efficient operations.
operations
 If firms that operate at the industry’s average level of efficiency receive normal
rates of return, it is reasonable to expect firms operating at above-average
levels of efficiency to earn above-normal rates of return. Inefficient firms can be
expected to earn unsatisfactory, below normal rates of return.
 Basic Tools of Economic Analysis

1. Discounting Principle
2. Equi-marginal Principle
3. Marginal and incremental analysis
4. Opportunity Cost Principle
5. Time Perspective
 1. Discounting Principle
• A Birr now is worth more than a Birr earned after a year.
• To take decision regarding investment which will yield
return over a period of time it is necessary to find its
present worth by using discounting principle.
principle
• This principle helps to bring value of future birr to
present.
PV=FV__
[1+i]n
Present value of 100 birr next year at 8% interest
rate is:
PV=100/1.08=92.59
 2. Equimarginal Principle
 Deals with allocation of resources among alternative
activities.

 This principle suggests that the available resources (inputs)

should be allocated between the alternative options in such a
way that the marginal productivity gains (MP) from the
various activities are equalized.

MPA=MPB=MPC=…MPN

This principle can be applied when:

1. Investable resources are limited
2. Resources have alternative uses
3. Alternative uses are subject to diminishing marginal
returns
 Example
 Suppose you have $100 million
 Unit price of a vehicle is $10 million
 $100 million will enable you to buy 10 cars
 You have 3 departments
 How many vehicles will you distribute to each?
 Use Marginal Productivity Gain to decide.
 Assume the following is the marginal
productivity for the 3 departments
 Dep’t A Dep’t B Dep’t C
1ST 50 40 35
2nd 40 35 30
3rd 35 20 20
4th 30 15 10
5th 15 8 2

 Start the allocation from the highest and keep on doing it until all
the vehicles are distributed.
 Eg. The first one goes to Dep’t A with a value of 50, 2 nd Dep’t B (40), 3rd
Dep’t A (40), 4th Dep’t C (35), 5th Dep’t B (35). 6th Dep’t A (35), 7th Dep’t C
(30), 8th Dep’t A (30), 9th Dep’t C (20) & 10th Dep’t B (20).
 A gets 4 vehicles ($40 million)
 B gets 3 vehicles ($30 million)
 C gets 3 vehicles ($30 million)
The more you consume, the lower will be the level of satisfaction. Eg.
The level of satisfaction you get when you have your first tea in the
morning is higher compared to the 2nd and 3rd cup of tea you had after
that. Therefore, keep on allocating to lower levels Eg. The first to the
highest (dep’t A with value of 50) followed by the second to Dep’t B
with value of 40)…
 3. Marginal Principle
 Refers to change (increase or decrease) in total of any
quantity due to a unit change in its determinant.

MC= TCn - TCn-1

MR = TRn-TRn-1
MR = TR/ Q = dTR/dQ
M = / Q

Decision Rule:
A business activity should be carried out so long till
its MR> MC
For Profit Maximization: MR=MC or M = 0
 Marginal Analysis: Example

Qt Price TR TC T MR MC M

1 18 18 7 11 - - -

2 15 30 11 19 12 4 8

3 13 39 19 20 9 8 1

4 10 40 20 20 1 1 0

5 6 30 34 -4 -6 10 -16

6 3 18 46 -28 -12 12 -24

 Limitations of Marginal Analysis
 When used in cost analysis MC refers to
change in variable cost only.

 Generally firms do not have knowledge of

MC & MR because most firms produce in
and sell their products in bulk except cases
such as airplanes, ships, etc.
 Incremental Principle
 Applied to business decisions which involve in bulk
production and large change in total cost or total
revenue.
 Incremental cost can be defined as the change in total
cost due to a particular business decision i.e. change in
level of output, investment, etc.
 Includes both fixed & variable cost but does not include
cost already incurred i.e. sunk cost (E.g. Money paid for
software).
 Incremental revenue is a change in total revenue
resulting from a change in level of output, price etc.
 The business decision is thus determined on the basis of
criterion that incremental revenue exceed incremental
cost i.e, IR > IC
 Incremental Principle
Example:
 Total cost before = 500 million
 Total cost after = 800 million
 Incremental cost is therefore 300 million
 Total revenue before = 700 million
 Total revenue after = 1.1 billion
 Incremental revenue is therefore 400 million
 400 million > 300 million
Decision: Keep on producing!
 4. Opportunity Cost Principle
 Is related to alternative uses of scarce resources -
choice

 Opportunity cost of a choice is what you gave

up to get it.

 To make good economic decision, choice has been

made with the greatest benefit and lowest cost.

 Difference between actual earning and its

opportunity cost is called economic gain/profit.
gain/profit
 5. Time Perspective
 The timing of many decisions involves a gap between
the time when the costs of a project are borne and the
time when the benefits of the project are received.
 Short run & long run time periods play an important
role in business decisions.
 Short run refers to the period within which some of
inputs cannot be altered (fixed inputs). However, in
the long run all inputs can be altered so they are
variable in long run.
 Determination of time perspective is of great
significance where projections are involved.
 Optimization Techniques

 Optimisation means finding the maximum

or minimum values of a quantity or finding
when these maximum/minimums occurs.

 What quantities are optimised in economics?

We want to minimize costs or maximise the
revenue.
 Key concepts
Economic variables
 Dependent variable - effect
 Independent variable - cause
The Function
 Bi-variable function: Involves only two
variables Y = f (X)
 Multi-variable function: One dependent and
more than one independent variables.
Y = f (X1, X2, X3, X4… Xn )
 Optimization decision-criteria
1. Profit maximization - Activity level that
generates the highest profit:
MR = MC and Mπ = 0
2. Revenue maximization-Activity level that
generates the highest revenue:
MR = 0
3. Average cost minimization- Activity level that
generates the lowest average cost:
MC = AC = TC/Q
 Suppose,
• P= 600-3Q
• TR= 600Q-3Q2
• TC = 1000 + 100Q+2Q2
• MR=600-6Q
• MC=100+4Q

 What is the level of quantity that maximize

profit?
 Calculate Q, P, TR, TC and Tπ ?
Use the rule: MR=MC
600-6Q = 100+4Q
600-6Q+6Q = 100+4Q+6Q
100+10Q = 600
100-100+10Q = 600-100
10Q = 500
Q=500/10 = 50
 Exercise
Suppose the data from independent marketing consultants
retained by Company X indicate the following monthly
demand, total revenue, marginal revenue, total cost and
marginal cost relations:
– P = 7,500 – 3.75Q (Demand)
– TR = 7,500Q – 3.75Q2 (Total revenue)
– MR = TR/Q = 7,500 – 7.5Q (Marginal revenue)
– TC = 1,012,500 + 1,500Q + 1.25Q2 (Total cost)
– MC = TC/Q = 1,500 + 2.5Q (Marginal cost)
Where P is price and Q is output.
Calculate the level of quantity and price that maximizes
profit, maximizes revenue and minimizes the cost.
Calculate the TR, TC and Tπ for each strategy.
1. Calculate the level of quantity and price that maximizes profit
• Use ….. MR = MC
• 7,500 – 7.5Q = 1,500 + 2.5Q
• 7,500 – 7.5Q+ 7.5Q = 1,500 + 2.5Q + 7.5Q
• 7500 = 1500 + 10Q
• 1500-1500 + 10Q = 7500-1500
• 10Q = 6000
Q=6000/10 = 600
The Price that maximizes profit will be: P = 7,500 – 3.75*600= Birr 5,
250
2. Revenue maximization strategy is quite different from profit maximization.
Therefore, we use MR = 0
• Use ….. MR = 0
• 7,500 – 7.5Q = 0
• 7,500 – 7.5Q+ 7.5Q = 0 + 7.5Q
• 7500 = 7.5Q
Q = 7500/7.5 = 1000

3. Calculate the level of quantity that minimize COST?

• Use ….. MC = TC/Q (Average Cost)
Answer:
Profit max: Revenue max: Cost min:
• Q= 600 1000 900
• P= 5250 3750 4125
• TR= 3,150,000 3,750,000 3,712,500
• TC= 2,362,500
• Tπ = 787,500 - 12,500 337,500
Two approaches can be followed to optimize
using calculus:
1. Unconstrained optimisation
2. Constrained optimisation.
•

Unconstrained optimisation methods:

• 1st derivative
• 2nd derivative
Constrained Optimisation methods.
• Substitution method
• Lagrangian method
 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 to
zero.
Mathematically,
dY Y Marginal Analysis
 lim
dX X 0 X 1) MR = TR/Q
= dTR/dQ
2) MC = TC/Q
= dTC/dQ
3) Mπ = π/Q
= dπ/dQ
 Rules of Differentiation
1. 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
Example, Y = f(X) = 2.5
dY/dX = 0
 Rules Cont…
2. Power Function Rule: The derivative of a
power function, where a and b are constants,
is defined as follows.
Example,
Y  f (X )  aX b
If Y = 1.5 X
then, dY/dX = 1.5
dY If Y=X2
 b  a X b 1 then, dY/dX = 2x
dX
If Y=3X2
then, dY/dX = 6x
 Rules Cont…
3. 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 ) Example,
Y  U V If U = 3X2 & V=4X3
dY dU dV
  then, dY/dX = 6x + 12X2
dX dX dX
 Rules Cont…
4. Product Rule: The derivative of the product
of two functions U and V, is defined as
follows.

U  g(X ) V  h( X ) Example,

Y  U V If U = 5X2 & V= 7 - X

dY dV dU then, dY/dX = 70x - 15X2

U V
dX dX dX
 Rules Cont…
5. Quotient Rule: The derivative of the ratio of
two functions U and V, is defined as follows.

Example,
U  g ( X ) V  h( X )
If U = 5X – 9 & V= 10X2
U
Y
V then, dY/dX = 18- 5x

dY

VdU
dX  
 U dV
dX  10X3

2
dX V
 Rules Cont…
6. Chain Rule: The derivative of a function that
is a function of X is defined as follows.

Y  f (U ) U  g ( X ) Example,
If Y = U3 + 15 and U = 3X2
dY dY dU
  then, dY/dX = 3U2. 6X
dX dU dX = 162X5
 Optimization using 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.
 Example
 Suppose the total revenue function and the total cost
function for a product is given by:
 TR = – 4x2 + 300x
 TC = x2 –150x + 5000
Required:
1. Find the profit equation
2. Find MR, MC, M ?
3. How many units should be produced to maximize
profit?
4. What is the maximum profit?
Answers
1. Find the profit equation
π = TR-TC
π = (– 4x2 + 300x) – (x2 –150x + 5000)
π = – 5x2 + 450x – 5000
dY
2. Find MR, MC, M ?  b  a X b 1
dX
MR= dTR/dx …use the power function….. =
– 4x2 + 300x
= 2*(– 4x2-1) + 1*300x1-1
= – 8x1 + 300x0
= – 8x + 300*1
MR = – 8x + 300
2. Find MR, MC, M ?
MC=
MC dTC/dx …use the power function
= x2 –150x + 5000
= 2*(x2-1) - 1*150x1-1
= 2x1 - 150x0
= 2x - 150 * 1
MC = 2x - 150

3. What is the M π?
M π = MR – MC
= (– 8x + 300 )- (2x - 150 )
= (– 8x-2x + 300 - -150)
= (– 10x+ 300 +150)
M π = – 10x + 450
4. How many units should be produced to maximize profit?
Hint: You can use either MR = MC Or M π =0
Since we captured marginal revenue, better to go for that
M π =0
– 10x + 450 = 0
-10x + 450 - 450 = 0 – 450
-10x = -450
x = 450/10
x = 45

Important reminder again!

1.Profit maximization: MR=MC or M π =0
2.Revenue maximization: MR=0
3.Cost minimization: MC=AC= TC/Q
 Exercise
Suppose the monthly demand and total cost function of
company X are as given below:
P = 7,500 – 3.75Q
TC = 1,012,500 + 1,500Q + 1.25Q2

Required
1.Find the revenue function (Hint: Revenue is a function of
price and quantity)
2.Find the profit function
3.Find the level of quantity (Q) that optimize profit, revenue
and cost.
 Partial derivatives
 The rules of differentiation helps to deal with
functions with one independent variables.
 Partial derivatives helps to deal with functions with
several independent variables.
 Example: Y= f (x, z) and the functional relationship
between Y (the dependent variable) and the
independent variables, x and z can be dealt through the
technique of partial derivatives.
 Rules of partial differentiation
 Only one of the independent variables is
allowed to change at a time and all other
independent variables are held constant.

 For differentiating the dependent variable

with respect to one independent variable, the
rule of differentiation is followed.
 Example:
The profit function in the case of two products, say x and
y, stated as:
π = f (x, y)
π = 100x-2x2-xy+180y-4y2
The partial derivate of π with respect to x, holding y
constant, is
dπ/dx= 1*100x1-1- 2*2x2-1-1*x1-1y
N.B. Here you will disregard the variable Y, which in
this case is 180y-4y2
dπ/dx= 100x0- 4x1-x0y
dπ/dx= 100- 4x-1y
dπ/dx= 100- 4x-y
 Example Cont…
The partial derivate of π with respect to y, holding x
constant, is
π = 100x-2x2-xy+180y-4y2
dπ/dy= -xy+180y-4y2
N.B. Here you will disregard the variable x, which in
this case is 100x-2x2
dπ/dy= -x*1*y1-1+1*180*y1-1- 2*4y2-1
dπ/dy= -x*1*y0+1*180*y0- 8y1
dπ/dy= -x*1*1+1*180*1- 8y
dπ/dy= -x+180- 8y
The next step is to set each of the partial derivatives equal
to zero. Then, we get:
100-4x-y = 0
180-x-8y = 0
Use simultaneous equation method to solve it. How?
Multiply by -4 to make the lower equation of the x variable the same
100-4x-y = 0
-4(180-x-8y) = 0
= 100-4x-y = 0
-720+4x+32y = 0
-620+31y = 0
620-620+31y=0+620 …… 31y=620……y=620/31 y= 20
To get the value of x, just replace y with a value of 20
100-4x-y=0
100-4x-20=0
100-4x+4x-20=0+4x
100-20=4x …. x=80/4 ….. x=20
Based on the simultaneous question,
question
y=20 and x=20
This means, the firm can maximise its profit function by
producing 20 units of x and 20 units of y.

π = 100x-2x2-xy+180y-4y2
= 100(20) – 2(20)2 – (20) (20) + 180(20) –4 (20)2
= 2800
Remark: Any other combination of x and y will reduce
the profit. Whether the profit is maximum can be
checked by substituting any value other than 20 for x
and y.
 Exercise
Suppose the profit function is stated as follows:
π = 20 + 2x – 2x2 + 2xy+ 4y –y2

What value of X and Y maximises profit? use

partial derivative to find X and Y.
 Constrained optimization
 So far we have seen the optimization techniques with
the assumption that firms operate under no constrains
in their activity.
 But in the real world, managers face serious resource
constraints. For example, they need to maximize the
output with given quantity of capital and labor time.
 The technique that is used to optimize the business
objectives under constraints is called constrained
optimization
Techniques of constrained optimization
 There are three very common techniques of
constrained optimization:
1. Substitution method
2. Lagrangian methods
3. Simplex method (Matrix algebera)
4. Linear programming (Excel Solver)

 Substitution method: is used when the

constraint equation is simple and not too
complex.
 Lagrangian method: is used when the
constraint equation is very complex.
 The Substitution Method
 Suppose a manager of a firm which is producing two
products x and y seeks to maximize total profits
function which is given by:
π = 50x – 2x2 – xy – 3y2 + 95y (Objective function)
Subject to the constraint (In this case, the firm can not
produce more than 25 units of X and Y due to some
reasons; E.g. demand constraint):
x + y = 25 (Constraint function)
What quantities of x and y maximize profit?
What is the total profit?
 To solve this constrained optimisation problem through
substitution we first solve the constraint equation for x.
Thus
x+y=25, which means x+y-y=25-y
x = 25 – y
 The next step in the substitution method is to substitute this
value of x = 25 – y in the objective function
• Thus, substituting the constrained value of x in the profit
function we have:
π = 50x – 2x2 – xy – 3y2 + 95y
π = 50 (25 – y) – 2 (25 – y) 2 – (25 – y) y – 3y2 + 95y
= 1250 – 50y – 2 (625 –50y + y2) – 25y + y2 – 3y2 + 95y
= 1250 – 50y – 1250 + 100y – 2y2 – 25y + y2 – 3y2 + 95y
Categorize like terms and it will be
125—1250-50y+100y-25y+95y- 2y2 + y2 – 3y2
= 120y – 4y2
 To maximise the above profit function, which is converted into unconstrained
form, we differentiate it with respect to y and set it equal to zero and solve for y.
Thus,
Apply the law of derivative
120y – 4y2
Since we are working on Y, it means it is marginal profit
Mπ = 0
dπ/dy =1*120Y1-1 – 1*8y2-1 = 0
dπ/dy =1*120*Y0– 1*8*y1 = 0
dπ/dy =120*1– 8*Y = 0
=120 – 8y = 0
=120 – 8y+8y = 0+8y
8y = 120
Y=120/8 = 15

Substituting y = 15 in the given constraint equation (x + y = 25) we have, X + 15 =25

X = 25- 15 =10
We can find the total profits in this constrained optimum situation by substituting the
values of x and y obtained in the given profit function.
π = 50x- 2x2 – xy – 3y2 + 95y
π = 50 x 10 – 2(10)2 – 10 x 15 – 3(15)2 + 95 x 15
= 500 – 200 – 150 – 675 + 1425
= 1925 – 1025 = 900
 Lagrangian Method
 Uses a lagrangian multiplier (an artificial variable
)
π = 50x – 2x2 – xy – 3y2 + 95y

Subject to the constraint:

x + y = 25
What quantities of x and y maximize profit?
What is the total profit?
 In this case, we first set the constraint function equal to
zero by bringing all the terms to the left side of the
equation. In doing so we have,
x + y – 25 = 0
 The next step is multiplying the constraint function by
the unknown artificial factor λ (Lagrangian multiplier)
 Then, add the result to the given objective function.

Lπ = 50x – 2x2 – xy – 3y2 + 95y + λ (x + y – 25)

Where Lπ is Lagrangian function.
 In this function there are three unknowns x, y
and λ.
 For maximising Lπ, we first find partial
derivatives of Lπ with respect to three unknown
x, y and λ and then set them equal to zero. Thus
dLπ/dx = 50 – 4x – y + λ =0 ……..(1)
dLπ /dy = – x – 6y + 95 + λ =0 …..(2)
dLπ /dλ = x + y – 25 = 0 ………….(3)

NB: Using substitution or lagrangian method enables you to

reach to the same value. So you can go for either of them
 Let us now solve the above system of three equations with three
unknowns to find the optimal values of x and y. To do so we first
subtract the equation (2) from equation (1) and get,
- 45 – 3x + 5y = 0 ….(4)
 Now, multiplying equation (3) by 3 and adding it to equation (4) we
have,
- 45 – 3x + 5y =0
-75 + 3x + 3y =0
-120 + 8y =0
Thus, 8y = 120
y= 15
Substituting the value of y = 15 in the constraint function x + y = 25 we
get x equal to 10 and λ = 5. Thus, we find the same optimal values of x
and y as we obtained in the substitution method.

The value of λ shows if the firm is required to produce 24 units instead of

25 units, its profits will fall by 5. On the other hand, if firm were to
produce 26 instead of 25 units, its profits will increase by about 5.
 Exercises
Exercise 1: Assume profit function is stated as follows:
π = 100x – 2x2 – xy +180y – 4y2
Subject to: x+y = 30
Maximize profit based on substitution and Lagrangian
methods?

Exercise 2: Assume the total cost function is stated as

follows:
TC = 2x2 – xy + 3y2
Subject to: x+y = 36
Minimize cost based on substitution and Lagrangian
methods?
 Exercise
 Assume that a firm’s cost function is given by the
following relationship: TC = 20 + 5 Q + Q2, where
Q represents the level of output produced and sold.
 Demand for the product of the firm is given by: Q
= 25 – P
a) Determine the output level where total profits are
maximized
b)Calculate the total profits and selling price of the
product at profit- maximizing output level.
c) If the fixed costs increase from birr 20 to birr 25,
what would be its effect on profit maximizing
output level and total profits earned by the firm.
 Exercise
Suppose Pepsi Cola estimates that sales of its drink is the function
of the amounts of advertisement expenditure (measured in
millions of birr) in two different media, television and
newspapers. If x stands for advertisement expenditure in millions
of birr on advertisement on television and Y stands for
expenditure in millions on advertisement in newspapers, sales of
Pepsi Cola is given by:
•S = 200x + 100y - 10x2 – 20y2 +20xy
•Assume that adverting budget is restricted to Birr 20 in millions
so that x + y = 20
a) Using lagrangian multiplier technique find the amount of
expenditure incurred on television and newspaper adverting
separately to maximize sales subject to the budget constraint.
b) Calculate the sales of the firm at this constrained optimum level.
c) What economic interpretation will you give for the value of the
lagrangian multiplier obtained?
End of Chapter One!

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