Chapter Three

Optimization Techniques

3.1. Introduction

Normative economic decision analysis involves determining the action that best achieves a
desired goal or objective. This means finding the action that optimizes (that is, maximizes or
minimizes) the value of an objective function. For example, in a price-output decision-making
problem, we may be interested in determining the output level that maximizes profits. In a
production problem, the goal may be to find the combination of inputs (resources) that
minimizes the cost of producing a desired level of output. In a capital budgeting problem, the
objective may be to select those projects that maximize the net present value of the investments
chosen. There are many techniques for solving optimization problems such as these.

3.2. Types of differential optimization technique

3.2.1. Maximization with calculus

Profit maximization problem

Because the derivative of a function measures the slope or marginal value at any given point, an
equivalent necessary condition for finding the maximum value of a function Y = f(X) is that the
derivative dY/dX at this point must be equal to zero. This is known as the first-order condition
for locating one or more maximum or minimum points of an algebraic function.

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Find X such that dY/dX = 0 minimum or maximum. First order is necessary not sufficient for
minimum or maximum.
Second derivative rules:
If d2Y/dX2> 0, then X is a minimum.
If d2Y/dX2< 0, then X is a maximum.
E.g. Profit= 40 +140Q - 10Q2
First-Order Condition: Using the profit function (Equation A.6) π=40 +140Q -10Q2 discussed
earlier, we can illustrate how to find the profit-maximizing output level Q by means of this
condition. Setting the first derivative of this function (which was computed previously) to zero,
we obtain
dπ/dQ= 0
0+1*140Q1-1-2*10Q2-1
0 = 140-20Q
Solving this equation for Q yields Q* = 7 units as the profit-maximizing output level.

Second Derivatives and the Second-Order Condition: Setting the derivative of a function
equal to zero and solving the resulting equation for the value of the decision variable does not
guarantee that the point will be obtained at which the function takes on its maximum value. A
test to determine whether a point that has been determined from the first-order condition is
either a maximum point or a minimum point of the algebraic function.
In effect, we need to find the derivative of the derivative. That is, the second derivative of the
function and then test to see if it is less than zero. Formally, the second derivative of the function
Y = f(X) is written as d2Y/dX2 and is found by applying the previously described differentiation
rules to the first derivative. A maximum point is obtained if the second derivative is negative;
that is, d2Y/dX2<0.
dπ/dQ= d(140-20Q)
= -20
Because dπ2/dQ2<0, we know that a maximum-profit point has been obtained.

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Total revenue maximization
Eg. TR=100Q-10Q2
d (TR)/dQ=100-20Q
Setting d (TR)/dQ=0, we get
100-20Q=0
Q=5-This means that its slope is zero and total revenue is maximum at the o/p level of 5 units.
• Eg 2. TR=100Q-10Q2

Taking derivative of the function

d(TR)/dQ =100-20Q

Setting d(TR)/dQ =0 we get Q=5

Average cost minimization

Average cost will be minimized when the first derivative of the AC function is equal to zero. i.e,
d(AC)/dQ =0

Eg. C = 15 0. 040Q  0.000080Q2

Differentiating C with respect to Q gives

dC dQ = -0.04+0.00016Q

Setting this derivative equal to zero and solving for Q yields

0 =  0.040 +0.000160Q 0+0.04 = 0.00016

Therefore Q=250 unit

Taking the second derivative, we obtain

d2C d2Q = 0.00016

Because the second derivative is positive, the output level of Q = 250 is indeed the value that
minimizes average total costs.

Summarizing, we see that two conditions are required for locating a maximum or minimum
value of a function using differential calculus. The first-order condition determines the point(s) at
which the first derivative dY/dXis equal to zero. Having obtained one or more points, a second
order condition is used to determine whether the function takes on a maximum or minimum
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value at the given point(s). The second derivative d2Y/dX2 indicates whether a given point is a
maximum (d2Y/dX2 <0) or a minimum (d2Y/dX2 >0) value of the function.

Unconstrained Optimization Using Quadratic Equations

When there is cubic format in our objective function we can determine the optimum level of
output that maximizes the firm’s profit (TR) and that minimizes the firms total cost by using
quadratic equation.

First, we should determine the first order derivative of the objective function with respect to Q/
2
X and the result will becomes in the form of aX + bX + C = 0

Then after determining the value of a, b, and c we can apply the formula

−b ± √ b 2−4 ac
X=
2a

1 3 2
Example: Y = x −60 x +2000 X +50 , 000
3

dY/dX = x 2−120 x+ 2000

then a = 1 (the coefficient of X2)

b = -120(the coefficient of X)

c= 2000(the constant number

−b ± √b 2−4 ac
= −(−120)± √(−120) −4 (1∗2000) = −(−120) ± √14,400−8000
2
Then X=
2a 2(1) 2

120± √ 6400 120± 80

X= 100 and X= 20
2 2

Then 100 units is the maximum point and 20 unit is the minimum point that maximizes the firms

profit.

The Constrained Optimization Techniques

There are basically two mostly used optimization techniques including: the substitution method;
and, the Lagrangian multiplier method

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8. 3.1. Constrained Optimization by Substitution Method
This technique will be illustrated in two ways: (i) constrained profit maximization problem, and
(ii) constrained cost minimization problems.

8.3.1.1 Constrained Profit Maximization using substitution method

Let the profit function of a hypothetical firm is given as:
p= f(X, Y) = 100X – 2X2 – XY + 180Y – 4Y2 …………… (3.1.1)
Where, X and Y represent two products.
We wish to maximize equation (8.1.1) subject to the constraint that the sum of the output of X
and Y be equal to 30 units. That is,
X + Y = 30 ………………………………………………………. (3.1.2)
Solving by the substitution method, we obtain as follows:
First note that the process of the substitution method involves two steps
1. Express one of the variables (X or Y in this case) in terms of the other and solve the constraint
equation for one of them (X or Y), and
2. Substitute the solution obtained into the objective function (that is, the function to be
maximized or the profit function) and solves the outcome for the other variable.
Solution
Given the constraint equation 3.1.2), we solve for the values of X and Y in terms of one another
to obtain:
X = 30 – Y
Or
Y = 30 – X
By substituting the value of X into the profit equation (3.1.1), we obtain:
p= 100(30 – Y) – 2(30 – Y) 2 – (30 – Y) Y + 180Y – 4Y2
p = 3000 – 100Y – 2(900 – 60Y + Y2) – 30Y + Y2 + 180Y – 4Y2
p = 3000 – 100Y – 1800 + 120Y – 2Y2 – 30Y + Y2 + 180Y – 4Y2
p = 1200 + 170Y – 5Y2 ………………………………………………………. (3.1.3)
Equation (8.1.3) can now be maximized by obtaining the first derivative and setting it equal to
zero and solving for Y: dp/dY= 170 – 10Y = 0 …………………………. (3.1.4)
Solving equation (8.1.4) for Y, we get:

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10Y = 170
Y = 17
Substituting 17 for Y into the constraint equation (3.1.2), we get:
X + 17 = 30
X = 13
It follows that the optimum solution for the constrained profit maximization problem is X = 13
units and Y = 17 units. This values of X and Y satisfies the constraint. Expressed differently, the
firm maximizes profit by producing and selling 13 units of product X and 17 units of product Y.
The maximum profit under the given constraint can now be obtained by substituting the above
values of X and Y into the profit function, equation (3.1.1): p(X, Y) = p(13, 17) = 100(13) –
2(13)2 – (13)(17) + 180(17) – 4(17)2 = 2,645.
Thus, the maximum profit under constraint is 2,645. It can be shown that maximum profits under
constraints are less than maximum profits without constraints.
3.3.1.2 Constrained Cost Minimization using substitution method
We now apply the substitution method to the problem of constrained cost minimization. Suppose
the cost function of a firm producing two goods, X and Y, is given by: C = 2X2 – XY + 3Y2 and
the firm must meet a combined order of 36 units of the two goods. The problem is to find and
optimum combination of the products X and Y that minimizes the cost of production.
Alternatively stated, we Minimize C = 2X2 – XY + 3Y2 (3.1.5)
Subject to X + Y = 36 (3.1.6)
Again, substitution method requires that the constraint equation (3.1.6) is expressed in terms of
any of the two goods, X and Y, and then substituted into the objective function (equation (3.1.5)).
Expressing X in terms of Y, we get: X = 36 – Y …………………………. (3.1.7)
Substituting equation (3.1.7) for X in the objective function, you get:
C = 2(36 – Y) 2 – (36 – Y) Y + 3Y2
= 2(1296 – 72Y + Y2) – 36Y + Y2 + 3Y2
= 2592 – 144Y + 2Y2 – 36Y + Y2 + 3Y2
= 2592 – 180Y + 6Y2………………………………………………….. (3.1. 8)
According to the optimization rule, for the now objective function (equation (8.1.8)) to be
minimized, the first derivative must be equal to zero,
dC/ dY = 180 + 12Y = 0 ………………………………………… (3.1.9)
Solving for Y in equation (3.1.9), we get the value of Y as follows:
12Y = 180
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Y = 15
Substituting this value into the constraint equation (3.1.6), you get:
X + 15 = 36
X = 21
Thus, the optimum solution demands that 21 units of X and 15 units of Y minimize the cost of
meeting the combined order of 36 units (that is, 21 + 15 = 36 units). The minimum cost of
producing 21 units of X and 15 units of Y can be obtained as follows, using equation (3.1.5), the
objective function:
Minimum Cost = 2X2 – XY + 3Y2
= 2(21)2 – (21)(15) + 3(15)2
= 882 – 315 + 675
= 1,242 Thus, the minimum cost of producing the combined order is 1,242.
8.3.2 Constrained Optimization by Lagrangian Multiplier Method
The Lagrangian method is most useful in solving complex optimization problems. In this
discussion, we summarize this method using two illustrations:
 constrained profit maximization problem, and
 constrained cost minimization problem
8.3.2.1 Constrained Profit Maximization
Suppose that a firm seeks to maximize its total profit and the function as follows:
p = 80X-2X2-XY-3Y2+100Y, but faces the constraint that the o/p of commodity X plus the o/p of
commodity Y must be 12. That is, X+Y=12
First we can write X as a function of Y, such as X=12-Y
And substituting X=12-Y into the profit function in inspection.
Finally, we get: p=-4Y2+56Y+672
Solving y, we find the first derivative of: p with respect to Y and then set it equal to zero,
dp/dY=-8Y+56=0 Y=7 and X=5 and the profit is p=80X-2X2-XY-3Y2+100Y=$868.
Example for Lagrangian method
Suppose that we have a Lagrangian function as follows:
Lagrangian=profit fuction +l(constraint function is set to equal to zero)
Lp=80X-2X2-XY-3Y2+100Y+l(X+Y-12)
First we have to find the partial derivative of Lp with respect to X,Y, and land setting them
equal to zero:

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dLp/dX=80-4X-Y+l=0 (1)
dLp/dY=-X-6Y+100+l=0 (2)
dLp/dl=X+Y-12=0 (3)
First subtract eq2 from eq1 and get
–20-3X+5Y=0 (4)
Now, multiplying eq3 by 3 and adding with eq4 and get the followings
3X+3Y-36=0
-3X+5Y-20=0
8Y-56=Y=7 X=5 into eq2 to get the value of l
-X-6Y+100+l=0 l=X+6Y-100 l=-53 (economic interpretation?)
The total profit of the firm increase or decrease by about $ 53
In order to find the total profit of the firm, subs the relevant figures ($868)
3.3.2.2 Constrained Cost Minimization
Suppose a firm has to supply a combined order of 500 units of products X and Y. The joint cost
function for the two products is given by:
C = 100X2 + 150Y2 (3.2.7)
Since the quantities to be produced of X and Y are not specified in the order, the firm is free to
supply X and Y in any combination. The problem is therefore, to find the combination of X and
Y that minimizes cost of production, subject to the constraint, X + Y = 500. Thus, we are
required to: Minimize C = 100X2 + 150Y2
Subject to X + Y = 500 (3.2.8)
The Lagrangian function can be formulated as in equation (3.2.9) below:
Zc = 100X2 + 150Y2 + l (X + Y - 500) (3.2.9)
As before, the first-order partial derivatives yield:
dZc/dX = 200X + l = 0 (3.2.10)
dZc/Y = 300Y + l = 0 (3.2.11)
dZc/dl= X + Y – 500 = 0 (3.2.12)
Again, solving the above simultaneous equations for X, Y, and l, we get the solution to the cost
minimization problem.
For simplicity, subtract equation (3.2.11) from equation (3.2.10), you get:
200X + l - (300Y + l ) = 0
200X – 300Y = 0
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200X = 300Y
X = 1.5Y (3.2.13)
Substituting 1.5Y for X in equation (3.2.12), we get:
X + Y – 500 = 0
1.5Y + Y – 500 = 0
2.5Y = 0 + 500
2.5Y = 500
Then Y = 200
Substituting Y = 200 into the constraint equation (8.2.8), you get:
X + 200 = 500
X = 300.
It follows that the solution to the minimization problem is that X = 300 and Y = 200 will
minimize the cost of producing the combined 500 units of the products X and Y.
The minimum cost is obtained by using the objective function (equation (3.2.7)) as follows:
C = 100X2 + 150Y2
= 100(300)2 + 150(200)2
= 9,000,000 + 6,000,000
= 15,000,000
Thus the minimum cost of supplying the combined 500 units of products X and Y is 15 million.