Managerial Economics: in A Global Economy

Managerial Economics Prof. M. El-Sakka CBA.
Kuwait University

Managerial Economics
in a Global Economy

Chapter 2
Optimization Techniques
and New Management Tools
Managerial Economics Prof. M. El-Sakka CBA. Kuwait University
OPTIMIZATION
Managerial economics is concerned with the ways in which
managers should make decisions in order to maximize the
effectiveness or performance of the organizations they
manage. To understand how this can be done we must
understand the basic optimization techniques.

Functional relationships:
relationships can be expressed by graphs:

P

Q

This form can be expressed in an equation:

Q = f ( P ) (1)

Though useful, it does not tell us how Q responds to P, but
this equation do.

Q = 200 - 5 p (2)

Marginal Analysis

The marginal value of a dependent variable is defined
as the change in this dependent variable associated
with a 1-unit change in a particular independent
variable. e.g.

units t marginal profit average profit

0 0 -
100
1 100 100
150
2 250 125
350
3 600 200
400
4 1000 250
350
5 1350 270
150
6 1500 250
50
7 1550 221
-50
8 1500 188
-100
9 1400 156

Note: Total profit is maximized when marginal profit shifts from positive to negative.
Average Profit = Profit / Q
Slope of ray from the
origin:

Rise / Run
Profit / Q = average profit

Maximizing average profit
doesnt maximize total
profit
MAX
C
B
profits
Q
PROFITS
quantity
Marginal Profits = AH/AQ
Q
1
is breakeven (zero profit)
maximum marginal profits
occur at the inflection point
(Q
2
)
Max average profit at Q
3
Max total profit at Q
4
where marginal profit is
zero
So the best place to
produce is where marginal
profits = 0.
profits
max
Q
2
marginal
profits
Q
Q
average
profits
Q
3
Q
4
(Figure 2.1)
Q
1
2005 South-Western Publishing
Differential Calculus in Management
A function with one decision variable, X, can
be written as:
Y = f(X)
The marginal value of Y, with a small
increase of X, is
M
y
= AY/AX
For a very small change in X, the derivative
is written:
dY/dX = limit AY/AX
AX B
Marginal = Slope = Derivative
The slope of line C-D
is AY/AX
The marginal at point
C is AY/AX
The slope at point C is
the rise (AY) over the
run (AX)
The derivative at point
C is also this slope
X
C
D
Y
AY

AX
Optimum Can Be Highest or Lowest
Finding the maximum flying range for the Stealth
Bomber is an optimization problem.
Calculus teaches that when the first derivative is zero, the
solution is at an optimum.
The original Stealth Bomber study showed that a
controversial flying V-wing design optimized the
bomber's range, but the original researchers failed to find
that their solution in fact minimized the range.
It is critical that managers make decision that maximize,
not minimize, profit potential!
Quick Differentiation Review

Constant Y = c dY/dX = 0 Y = 5
Functions dY/dX = 0

A Line Y = c X dY/dX = c Y = 5X
dY/dX = 5

Power Y = cX
b
dY/dX = bcX
b-1
Y = 5X
2
Functions dY/dX = 10X
Name Function Derivative Example
Sum of Y = G(X) + H(X) dY/dX = dG/dX + dH/dX
Functions
example Y = 5X + 5X
2
dY/dX = 5 + 10X

Product of Y = G(X) H(X)

Two Functions dY/dX = (dG/dX)H + (dH/dX)G

example Y = (5X)(5X
2
)
dY/dX = 5(5X
2
) + (10X)(5X) = 75X
2

Quotient of Two Y = G(X) / H(X)
Functions
dY/dX = (dG/dX)H - (dH/dX)G
H
2

Y = (5X) / (5X
2
) dY/dX = 5(5X
2
) -(10X)(5X)
(5X
2
)
2
= -25X
2
/ 25X
4
= - X
-2

Chain Rule Y = G [ H(X) ]
dY/dX = (dG/dH)(dH/dX) Y = (5 + 5X)
2

dY/dX = 2(5 + 5X)
1
(5) = 50 + 50X
USING DERIVATIVES TO SOLVE MAXIMIZATION AND
MINIMIZATION PROBLEMS

Maximum or minimum points occur only if the slope of the
curve equals zero.

Look at the following graph


y
dy/dx
10
10
20
20
0
Max of x
Slope = 0
value of x
Value of dy/dx which
Is the slope of y curve
Value of Dy/dx when y is max
x
x

the function
Y = -50 + 100X - 5X
2

i.e.,
dY
dX
= 100 - 10X
if
dY
dX
= 0
X = 10
i.e., Y is maximized when
the slope equals zero.

Note that this is not sufficient for maximization or minimization problems.

Min value of y
Max value of y
d2y/dx2 > 0
d2y/dx2 < 0
value of dy/dx
y
Dy/dx
x
x

Since
dY
dX
= 0 at two points, we need another
condition to distinguish between the maximum and
minimum points.

Look at the
dY
dX
curve

* at point 5 the curve is upward, i.e., its slope ( the
second derivative (the derivative of the derivative)) is
positive. Hence

d Y
dX
2
2
= > 0 ( minimum point )

* at point 10 the curve is downward, i.e., its slope is
negative. Hence

d Y
dX
2
2
= < 0 ( maximum point )

Graphs of an original third-order function and its first and second
derivatives. (what if the second order = 0)
Optimization Rules

Maximization conditions:
1 -
dY
dX
= 0
2 -
d Y
dX
2
2
= < 0

Minimization conditions:
1 -
dY
dX
= 0
2 -
d Y
dX
2
2
= > 0
Applications of Calculus in Managerial Economics
maximization problem:

A profit function might look like an arch, rising to a peak and then
declining at even larger outputs. A firm might sell huge amounts
at very low prices, but discover that profits are low or negative.
At the maximum, the slope of the profit function is zero. The first
order condition for a maximum is that the derivative at that point
is zero.
If t = 50Q - Q
2
,
then dt/dQ = 50 - 2Q, using the rules of differentiation.
Hence, Q = 25 will maximize profits
where
50 - 2Q = 0.
More Applications of Calculus
minimization problem: Cost minimization
supposes that there is a least cost point to produce. An
average cost curve might have a U-shape. At the least
cost point, the slope of the cost function is zero. The
first order condition for a minimum is that the
derivative at that point is zero.

If TC = 5Q
2
60Q,
then dC/dQ = 10Q - 60.
Hence, Q = 6 will minimize cost
Where:
10Q - 60 = 0.
More Examples
Competitive Firm: Maximize Profits
where H = TR - TC = P Q - TC(Q)
Use our first order condition:
dH/dQ = P - dTC/dQ = 0.
Decision Rule: P = MC.
a function of Q
Max H = 100Q - Q
2
First order = 100 -2Q = 0 implies
Q = 50 and;
H = 2,500
Second Order Condition: one variable
If the second derivative is negative, then its a maximum
If the second derivative is positive, then its a minimum
Max H = 100Q - Q
2

First derivative
100 -2Q = 0
second derivative is: -2
implies
Q =50 is a MAX
Max H = 50 + 5X
2
First derivative

10X = 0
second derivative is: 10
implies
Q = 10 is a MIN
Problem 1 Problem 2

e.g.;
Y = -1 + 9X - 6X
2
+ X
3

first condition
dY
dX
= 9 - 12X + 3X
2
= 0
Quadratic Function
Y = aX
2
+ bX + c
X =
+ b b ac
a
2
4
2

a = 3
b = -12
c = 9

Extra examples

X =
+ ( ) ( ) 12 12
2
4 9 3
6
= 2 + 1
therefore
Y = 0 at
X = 3 or X = 1
the second condition
d Y
dX
2
2
= -12 + 6X
at X = 3
d Y
dX
2
2
= -12 + 6(3) = 6 >0 ( minimum point)
at X = 1
d Y
dX
2
2
= -12 + 6(1) = - 6 <0 (maximum point)

Partial Differentiation
Economic relationships usually involve several
independent variables.

A partial derivative is like a controlled experiment-
it holds the other variables constant

Suppose price is increased, holding the
disposable income of the economy constant as in

Q = f (P, I )

then cQ/cP holds income constant.
Problem:
Sales are a function of advertising in newspapers
and magazines ( X, Y)
Max S = 200X + 100Y -10X
2
-20Y
2
+20XY

Differentiate with respect to X and Y and set equal to zero.
cS/cX = 200 - 20X + 20Y= 0
cS/cY = 100 - 40Y + 20X = 0

solve for X & Y and Sales
Solution: 2 equations & 2 unknowns
200 - 20X + 20Y= 0
100 - 40Y + 20X = 0

Adding them, the -20X and +20X cancel, so we
get 300 - 20Y = 0, or Y =15

Plug into one of them:
200 - 20X + 300 = 0, hence X = 25
To find Sales, plug into equation:

S = 200X + 100Y -10X
2
-20Y
2
+20XY = 3,250

PARTIAL DIFFERENTIATION AND MAXIMIZATION OF
MULTIVARIATE FUNCTIONS.
t = f (Q
1
, Q
2
)
To know the marginal effect of Q
1
on t we hold Q
2
constant, and
vice versa.
In order to do that we use partial derivative of t with respect to
Q
1
denoted by
ct
cQ
1
( treating Q
2
as constant )
e.g.;
t = -20 + 100Q
1
+ 80Q
2
- 10Q
1
2
- 10Q
2
2
- 5Q
1
Q
2
;
to find the partial derivative of t with respect to Q
1
we treat Q
2

as constant; hence
ct
cQ
1
= 100 - 20Q
1
- 5Q
2
; (1)
therefore
ct
cQ
2
= 80 - 20Q
2
- 5Q
1
; (2)
setting both partial derivatives equal to zero and solve
simultaneously

100 - 20Q
1
- 5Q
2
=0

80 - 20Q
2
- 5Q
1
=0
multiply by -4 and add

________________
- 220 + 75Q
2
= 0

hence
Q
2
= 2.933

substitute for Q
2
at any of the eq. 1
100 - 20Q
1
- 14.665; hence

Q
1
= 4.267.
i.e.,
profit is maximized when the firm produces 4.267 of Q
1
and 2.933 of Q
2
.


CONSTRAINED OPTIMIZATION

We assume that the firm can freely produce 4.267 of Q
1
and 2.933
of Q
2
. Quite often this may not be the case.

e.g.
Minimize TC = 4Q
1
2
+ 5Q
2
2
- Q
1
Q
2
;
subject to:
Q
1
+ Q
2
= 30 The constraint function
Solution:
The lagrangian multiplier:
Steps:
1 - set the constraint function to zero
2 - form the lagrangian function by adding the constraint function
after multiplication with an unknown factor to the original
function.
3 - take the partial derivatives and set them equal to zero
4 - solve the resulting equations simultaneously


step 1:
30 - Q
1
- Q
2
= 0

step 2:
L
t
= 4Q
1
2
+ 5Q
2
2
- Q
1
Q
2
+ (

30 - Q
1
- Q
2
)

step 3:
c
t
c
L
Q
1
= 8Q
1
- Q
2
-
2 Q
L
c
t
c
= -Q
1
+ 10Q
2
-
c
t
cL
= -Q
1
- Q
2
+ 30


8Q
1
- Q
2
- = 0 (1)
-Q
1
+ 10Q
2
- =0 (2)
-Q
1
- Q
2
+ 30 =0 (3)

step 4

multiply eq(2) by -1 and subtract from eq(1)

9Q
1
- 11Q
2
= 0 (4)

multiply (3) by 9 and add to eq(4)

-9Q
1
- 9Q
2
+ 270 = 0
9Q1 - 11Q2 = 0
____________________
-20Q
2
+270 = 0

Q
2
= 270/20 = 13.5


substituting in eq (3) Q
1
= 16.5

the values of Q
1
and Q
2
that minimizes TC are 16.5 and 13.5
respectively.

substituting Q
1
and Q
2
in eq(1) or eq(2) we find that

= 118.5

the interpretation of

measures the change in TC if the constraint is to be relaxed by one
unit.

i.e., TC will increase ( has a positive sign ) by 118.5 if the constraint
becomes 29 or 31.

Key Terms
Marginal profit
Average profit
Marginal cost
Marginal revenue
Marginal analysis
Optimization
Derivative of Y with respect to X (dy/dx)
Differentiation
Second derivative
Partial derivative
Constrained optimization
Lagrangian multiplier method
Lagrangian function

Managerial Economics: in A Global Economy

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Managerial Economics Prof. M. El-Sakka CBA.

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