If you are ready to proceed, the next lesson will discuss the Economic Optimization.

MODULE 1 Introduction to Economics and the Scope of

Module No. and Title
Managerial Economics
Lesson No. and Title LESSON 3 Economic Optimization
1. Explain optimization process by a firm.
Learning Outcomes 2. Compute optimal solution problems using the concept of
derivatives and the rules of differentiation.
Time Frame The lesson will take you about two hours to complete.

Introduction
In the previous lessons, we defined managerial economics as a tool that helps managers in
decision making by applying economic theory and the tools of decision sciences in achieving the
firm’s objectives most efficiently. In the case of a for-profit firm, its objective is to maximize the
value of the firm.
This chapter introduces you to the techniques of optimization: the methods for maximizing or
minimizing the objective function of a firm.

Activity
Answer the following.
1. What reward or rewards do you hope to obtain by attending college or university?
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2. What sacrifices are you personally making to attend college or university?

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Analysis

✔ Think of some things that you cannot do because you attending college? How do you feel
about the situation?
✔ List some possible rewards of your decision? Will the rewards outweigh the sacrifices?
✔ Based on the activity above, discuss the techniques of optimization to come up with the the
most efficient decision.

Abstraction
Managers make difficult decisions. Recall the concept of scarcity in the previous lesson. The fact
it is difficult is due to scarcity. Managers must choose among the alternative uses of the firm’s
resources. Thus, a manager’s decision involves opportunity cost: the cost of something is what
you give up in order to get it. In other words, decisions involve trade-offs.
Effective managerial decision making is the process of achieving at the optimal (or best)
solution to a problem in the face of scarcity.

Optimization: Methods for maximizing or minimizing an objective function

The market is filled with optimization problems. Some of the real-world problems of
optimization are as follows:
▪ Consumers make buying decisions to maximize utility (or satisfaction).
▪ Consumers make labor decisions to maximize utility (in terms of earnings).
▪ Businesses make capital investment decisions to minimize costs.
▪ Businesses make pricing decisions to maximize revenues.
▪ Government makes procurement decisions to maximize government efficiency.
All these are some optimization problems which require tools to analyse them and provide a best
solution.
The first step in presenting optimization techniques is to examine ways to express economic
relationships. Economic relationship can be expressed in the form of equation, tables, or graphs.
When the relationship is simple, a table and/ or graph may be sufficient. However, if the
relationship is complex, expressing the relationship in equational form may be necessary.
Expressing an economic relationship in equational form is also useful because it allows us to use
the powerful techniques of differential calculus in determining the optimal solution of the
problem.
The process by which a firm determines the output level at which it maximizes its wealth or
value (theory of the firm model) is called optimization analysis.
Profit maximization by total-revenue and total-cost approach
Total profit (π) is the difference between total revenue (TR) and total cost (TC). Mathematically,
π = TR – TC. When TR exceeds TC, the firm earns a profit. Otherwise, the firm losses. A
breakeven is achieved when TR = TC. This means the firm is neither profiting nor losing.
Optimization by marginal analysis
According to marginal analysis, the firm maximizes profits when marginal revenue equals
marginal cost. Marginal revenue (MR) is the change in total revenue over a change in output or
sales. Geometrically, this is given by the slope of the TR curve. Marginal cost (MC) is the
change in total cost per unit change in output or sales and is given by the slope of the TC curve.
According to marginal analysis, as long as the slope of the TR curve or MR exceeds the slope of
the TC curve or MC, the firm has to continue to produce more output and generate sales. As long
as MR exceeds MC, the firm would be increasing its total revenue than its total cost, and so its
total profit would increase.
The total profit is maximized when the marginal revenue equals the marginal cost.
The derivative and rules of differentiation
Optimization analysis can be examined more efficiently using the concept of derivative. The
concept of derivate is closely related to the concept of margin discussed earlier.
In general, if we let TR=Y and Q=X, the derivative of Y with respect to X is given by the
change in Y with respect to X, as the change in X approaches zero. So we define this concept in
the following expression:

This is read as: “the derivative of Y with respect to X is equal to the limit of the ratio ∆ Y/∆ X as ∆
X approaches zero”. This concept as the limit of a ratio is equivalent to the slope of a curve at a
point.
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).

For example, Y=5

dY/dX=0, the slope of the line Y is zero.
2. Power function rule. The derivative of a power function, where a and b are constants, is
defined as follows:

For example, Y=5x

dY/dX=5

3. Sum-and-Differences Rule. The derivative of the sum or difference of two functions U and
V, is defined as follows.

For example, Y=U+V=4x+ x3

dY/dX=4+3x2

4. Product rule. The derivative of the product of two functions U and V, is defined as follows

For example, Y=4x2(3-2x)

dY/dX =4x2(dV/dX)+(3-2x)(dU/dX)
=4x2(-2) + (3-2x)(8x)
=-8x2+ 24x-16x2
= -24x2+24x
= -24x(x-1)

5. Quotient rule. The derivative of the ratio of two functions U and V, is defined as follows.

3−2 x
For example, Y=
4 x2
2
dy 4 x (−2 ) −( 3−2 x ) 8 x
=
dx (4 x 2 )2
−8 x2 −24 x+ 16 x 2
¿
4 x4
 2
8 x −24 x 8 x ( x−3) x−3
¿ = =
16 x
4
8 x(2 x ¿¿ 3)¿ 2 x 3

Optimization with calculus

We now apply the rules of differentiation to the process of optimization. First, we determine
the point at which a function is maximum or minimum. Then, we distinguish between a
maximum and a minimum.

Determining a maximum or a minimum

Optimization seeks to find the maximum or the minimum value of a function. For example, a
firm may seek to maximize its sales, minimize the total cost, and eventually, maximize its
profits. For a function to be at its maximum or minimum, the derivative of the function (that
is, the objective function) must be zero. This is equivalent to the point where the curve has
zero slope.

Suppose, the total-revenue function is given by,

TR = 200Q – 20Q2
d (TR)
=200−40Q
dQ
d (TR)
Setting =0 , we get , 200 – 40Q = 0
dQ
Therefore, Q=5

This means that for the total-revenue function given above, the TR function has zero slope at
5 units of output produce.
Distinguishing between a maximum and a minimum
When the derivative (slope) of a function is zero, we find its maximum or minimum point.
This is the first order derivative. To distinguish between a maximum and a minimum point,
finding the second derivative is necessary.

d2 y
For the general function Y = f(x), the second derivative is written as 2 and is found by
dx
taking the derivative of the first derivative using the rules of differentiation presented above.
The rule is if the second derivative is positive (d2Y/dX2 > 0), then we have a minimum, and if
the second derivative is a negative (d2Y/dX2 < 0), then we have a maximum.
Suppose, TR = 200Q – 20Q2
 d (TR)
=200−40Q
dQ
2
d (TR)
and 2
=−40
dQ
This means that TR function has zero slope at 5 units of output. Since d2(TR)/dQ2= -20, this
TR function reaches a maximum at Q=5.

Optimization involving multivariable functions

To maximize or minimize of multivariable functions, first we find the partial derivatives
(denoted by the symbol ∂ ¿ of the dependent variable (say, profit π ¿ with respect to each of
the independent variables (say, price and advertising), then we set all first-order partial
derivatives equal to zero, and then solve the resulting set equations simultaneously for the
optimal value.
Rules for determining the partial derivatives are the same as those discussed in the previous
section. Note that the partial derivatives measure the marginal effects of each of the
independent variables to the dependent variable.
Suppose that the firm has the following profit function
 = 100X-2X2-XY-3Y2+100Y
We set ∂ /∂ X and ∂ /∂ Y equal to zero and solve for X and Y
∂ /∂ X = 100-4X-Y=0
∂ /∂ Y = -X-6Y+100=0
 Then solve simultaneously by multiplying the first of the above expressions by – 6,
rearranging the second and adding, we get
-600+24X+ 6Y = 0
100 – X –6Y= 0
-500 +23X =0

Thus, X = 500/23 = 21.74. Substituting the value of X into any of the partial equations set
equal to zero, and solving for Y, we get Y = 13.04.

Therefore, the firm maximizes  when it sells 21.74 units of commodity X and 13.04 units of
commodity Y. By substituting these values into the profit function above, the total profit
would then be $2,249.25.

Application
Solve the following.

For the following profit function of a firm:  = 175X – 2X2 – XY – 3Y2 + 75Y + 100
Determine:
1. The level of output of commodities X and Y to maximize the firm’s profit.

2. The maximum profit that the firm may realize from producing such commodities.
 Congratulations! You are done with Module 1.

MODULE SUMMARY
▪ Economics is the study of how people make choices among the competing uses of resources
in order to satisfy their needs.
▪ Microeconomics is the study that examines the behavior of the basic decision making unit:
the firm and its industry, and the household.
▪ Macroeconomics is the study that examines the behavior of the national aggregates: income,
prices, output, and employment, among others.
▪ Decision making lies at the core of most management problems. Managerial economics uses
economic theory and quantitative tools to find most efficient (optimal) solution to a
managerial problem.
▪ The market is filled with optimization problems. The process by which a firm determines the
output level at which it maximizes its wealth or value (theory of the firm model) is called
optimization analysis.
▪ The firm maximizes profits when marginal revenue equals marginal cost.
▪ Calculus can be a very useful tool to use in analyzing optimization problems.

REFERENCES
Case, K., Fair, R., & Oster, S. (2017). Principles of Microeconomics 12ed. Pearson Education
Ltd
Coase, R.H. (1937) The nature of the firm, Economica, 4, 386–405.
Hirschey, Mark and Bentzen, Eric (2016). Managerial economics 14 ed. Cengage Learning Asia
Pte Ltd
Salvatore, Dominick (2004). Managerial economics in a global economy 4ed. South-Western
Cengage Learning
Wilkinson, Nick (2005). Managerial economics A problem-solving approach. Cambridge
University Press