Managerial  

Economics
MBAFT 6103
 Today

Optimization Techniques and New Management Tools

Chapter 2: Salvatore
 Content
•  Total, average, and marginal
•  Optimization --- graphically
•  Unconstrained Optimization
•  Constrained Optimization
•  New Management Tools
 Expressing  Economic  
Relationships
Equations: TR = 100Q - 10Q2
Q 0 1 2 3 4 5 6
Tables: TR 0 90 160 210 240 250 240
TR
300

250

Graphs:
200

150

100

50

0
0 1 2 3 4 5 6 7

Q
 Total, Average & Marginal:
Example: Cost
AC = TC/Q Q TC AC MC
0 20 - -
MC = ΔTC/ΔQ 1 140 140 120
2 160 80 20
TR=100Q-10Q2 3 180 60 20
4 240 60 60
5 480 96 240
Profit  Maximization
Q TR TC Profit
0 0 20 -20
1 90 140 -50
2 160 160 0
3 210 180 30
4 240 240 0
5 250 480 -230
Profit  Maximization
($) 300
TC

240
TR
180
MC

120

60

MR
0 Q
0 1 2 3 4 5
60
30
0
-30 Profit
-60
 Geometric  Relationships
•  The slope of a tangent to a total curve at a point is
equal to the marginal value at that point

•  The slope of a ray from the origin to a point on a total

curve is equal to the average value at that point
 Geometric  Relationships
•  A marginal value is positive, zero, and negative,
respectively, when a total curve slopes upward, is
horizontal, and slopes downward

•  A marginal value is above, equal to, and below an

average value, respectively, when the slope of the
average curve is positive, zero, and negative
 Derivative
For Y= f(X) the derivative of Y with respect to X
is equal to the limit of the ratio ΔY/ΔX as ΔX
approaches zero.
lim ΔX 0 ΔY/ΔX
 Rules  of  Differentiation
Re-read the following:
•  Derivative of a constant function
•  Derivative of a linear function
•  Derivative of a power function
•  Derivative of sum of functions
•  Derivative of product of functions
(corollary: derivative of ratio of functions)
•  Chain Rule
 Chain  Rule
Using this rule we can find out the derivative of a function Y
w.r.t. X where Y is a function of another variable (say U) and U
is a function of X

Y = f (U ) U = g( X )

dY dY dU
= ⋅
dX dU dX
 Optimization
For Y = f(X), to optimize:

First Derivative Rule:

Find X such that dY/dX = 0.

Second derivative rules:

Check, if d2Y/dX2 > 0, then X is a minimum.
If d2Y/dX2 < 0, then X is a maximum.
Constrained  Optimization
Maximize Y = f(X,Z),
subject to g(X,Z) = c (constant)

Substitution method: Express Z as a function of

X from the constraint and then substitute in
objective function. Then perform ordinary
optimization.
Example: Max ln x + ln z s.t. x+z = 100
Constrained  Optimization
Maximize Y = f(X,Z),
subject to g(X,Z) <= c (constant)

Lagrange Method:
Construct the Lagrangian, L = f(x,z) + λ{c – g(x,z)}
Then put: δL/δx=0, δL/δz=0, and δL/δλ=0 and solve.
(Note: we are taking partial derivatives here.)

Example: Max ln x + ln z s.t. x+z = 100

 Problem  1  
Find out the values of X and Y that optimizes the
following function:

Z = 80X – 2X2 – XY – 3Y2 + 100Y

Ans: X  =  16.52,    Y  =  13.92  

 Problem  2  
Find out the values of X and Y that optimizes the
following function subject the to given equality
constraint:

Z = 80X – 2X2 – XY – 3Y2 + 100Y

s.t.
X + Y = 12

Ans: X  =  5,    Y  =    7  
Problem  3:  Use  the  Lagrange  
Method  
Find out the values of X and Y that optimizes the
following function subject the to given inequality
constraint:

Z = 80X – 2X2 – XY – 3Y2 + 100Y

s.t.
X + Y <= 12

Ans: X  =  5,    Y  =    7  
 Problem
A  firm  produces  mobile  telephone  service  using  equipment  and  labor.  When  
it  uses  K  machine-­‐‑hours  of  equipment  and  hires  L  person-­‐‑hours  of  labor,  it  
can  produce  Q  units  of  telephone  service.  The  relationship  between  Q,  L  and  
K  is  as  follows:  
Q=√KL
The  firm  pays  PK  for  each  machine-­‐‑hour  of  equipment  it  uses  and  PL  for  each  
person-­‐‑hour  of  labor  it  hires.  

Suppose  the  production  manager  is  told  to  produce  Q=200  units  of  telephone  
service  and  that  she  wants  to  minimize  cost  while  achieving  the  production  
target.

a)  What  is  the  objective  function  for  this  problem?
b)  What  is  the  constraint?
c)  Which  of  the  variables  are  exogenous,  endogenous?  
d)  Write  a  statement  of  the  constrained  maximization  problem.
e)  Write  down  the  first  order  conditions.
New  Management  Tools
•  Benchmarking
•  Total Quality Management
•  The Learning Organization
 Next
Demand, Supply, and Market Equilibrium