Managerial Economics

OPTIMIZATION is the process of either maximizing

or minimizing a commercial quantity.

This is most important application of managerial

economics. We use derivatives to find the absolute
maximum or minimum value of a function.

Suppose, an economist may be interested in the price

or production level of a commodity that will bring a
maximum profit;
A city planner might be interested in the location of
heavy industry in a city to produce minimum
pollution in residential and business areas.
OPTIMIZATION

A manager has to either maximize or minimize an outcome. It is

referred to as optimization technique.

Techniques and tools of optimization involve finding the value of an

independent variable (or determining the value of business
variable) that would result into maximization of the value of the
dependent variable.

For example, a competitor firm has to determine the level of output

(Q), at a given price, that would maximize its profit.

Similarly the product cost is to be minimized.

We develop a simple economic
model (i.e., a description) of the
private, profit-maximizing firm.
Almost all firms face the problem of pricing their products.
Consider a U.S. multinational carmaker that produces and sells
its output in two geographic regions. It can produce cars in its
home plant or in its foreign subsidiary.
It sells cars in the domestic market and in the foreign market.
For the next year, it must determine the prices to set at home
and abroad, estimate sales for each market, and establish
production quantities in each facility to supply those sales.
It recognizes that the markets for vehicles at home and abroad
differ with respect to demand. Also, the production facilities have
different costs and capacities. Finally, at a cost, it can ship
vehicles from the home facility to help supply the foreign
market, or vice versa.
Based on the available information, how can the company
determine a profit maximizing, pricing and production plan for
the coming year?
• The basic building blocks of the firm’s price and
output problem are its demand curve and cost
function.
• The demand curve describes
– The quantity of sales for a given price or, conversely,
the price needed to generate a given level of sales.
– Multiplying prices and quantities along the demand
curve produces the revenue function.
• The cost function estimates
– the cost of producing a given level of output.
– combining the revenue and cost functions generates
a profit prediction for any output Q.
Rule of Maximization
As a rule, total profit (P) of a firm is maximized when the difference between its total
revenue (R) and total cost (C), thus; R(q) – C(q) is maximum.

Since, profit function P(q) = R(q) – C(q),

In order to maximize profit (P) we have to maximize total revenue (R) and minimize
total cost (C).

Total revenue is maximized, when marginal revenue is zero i.e. R’(q) = 0

R(q) = PQ When Q = 50, total revenue (TR) is

Where, P= Price and
Q = Quantity of output.
Let, a price f P = 600 – 6Q
Then R(q)= (600 – 6Q) Q
OR R(q)= 600Q – 6Q2
R’(q) = 600 – 12Q
If we set above equation to zero, then:
600 –12Q = 0
Q = 50
maximum.
Substituting Q = 50 in the equation
R(q)= 600Q – 6Q2
R(50) = 600 (50) – 6 (50)2
= 30,000 – 15,000
= 15,000
If we change Q by 1 unit more or less, the
total revenue will decline in this case.
Check:
A Microchip Manufacturer
A firm that produces and sells a highly sophisticated
microchip. The firm wants to determine the quantity
of chips to produce & sell and the price.

To tackle this problem, we begin by examining the

manager’s basic objective: profit.
A simple accounting identity states that
Profit = Revenue – Cost
REVENUE The analysis of revenue rests on the
most basic empirical relationship in economics: the
law of demand.
This law states:
All other factors held constant, the higher the unit price of a
good, the fewer the number of units demanded by
consumers and, consequently, sold by firms.
What would happen if the firm makes a significant reduction in the
price of its chips? The law of demand predicts that its microchip sales
would increase.
The sources of the increase are threefold:
(1) increased sales to the firm’s current customers,
(2) sales gained from competing suppliers, and
(3) sales to new buyers.
An algebraic representation of the demand curve
Q= 8.5 - 0.05P
From the table, we observe that revenue is zero when sales are zero (obviously).
Then as Q increases, revenue initially rises, peaks, and eventually begins to fall,
finally falling to zero at Q = 8.5 lots.
In short, the law of demand means that there is a fundamental trade-off between P and Q in
generating revenue. An increase in Q requires a cut in P, the former effect raising revenue but
the latter lowering it. Operating at either extreme—selling a small quantity at high prices or a
large quantity at very low prices—will raise little revenue.
COST To produce chips, the firm requires a plant, equipment, and labor.
The firm estimates that it costs $380 (in materials, labor. and so on) for each
chip it produces; this is $38,000 per lot. In addition, it incurs fixed costs of
$100,000 per week to run the plant whether or not chips are produced.

Then, the total cost of producing a given quantity of output is given by the
equation:
C= 100 + 38Q
PROFIT From the preceding analysis of revenue
and cost, we now have
Profit = Revenue – Cost
Question: A company manufactures and sales q transistor
radios per week. If the weekly cost and demand equations are:
C(q) = 5000 + 2q
P = 10 – q/1000
Find for each week
(i) The maximum revenue
(ii) The maximum profit and production level that
will realize the maximum profit, and the price
that the company should charge for each radio.
Solution (i):
The revenue received for selling x radios at $P per week is R(q) = Pq
R(q)= (10 – q/1000)q
R(q) = 10q – q2/1000

R’(q) = 10 – q/500
= 10 – q/500 = 0
q = 5000 , only critical value
Now we find second order derivative of R(x)
R’’(q) = –1/500 < 0
R’’(5000) = –1/500 < 0 then R(x) attains a maximum at x=5000

Thus, the maximum revenue is

R(q) = R(5000) = 10 *5000 – (5000)2 /1000
• R(5000) = $25,000
Solution (ii):
(ii) Profit = Revenue - Cost
P(q) = R(q) – C(q) = 10q – q2/1000 – (5000 + 2q)
P(q) = – q2/1000 + 8q - 5000

P’(q) = 8 – q/500
8 – q/500= 0 OR q = 4000 , only critical value
Now we find second order derivative of P(q)
P’’(q) = – 1/500 < 0 , then P(q) attains a maximum at q=4000
Thus maximum profit is :
P(q) = P(4000) = – (4000)2/1000 + 8(4000) – 5000 = $11,000
To get the price of each radio, put x=4000 in price-demand eq:
P = 10 – 4000/1000 = $6
Thus a maximum profit of $11,000 per week is realized when 4000
radios are produced weekly and sold for $6 each.
Question: The total cost in dollars for a particular
operation is given by:
C(x) = x3 – 21x2 + 360x + 3025 ,
where x represents the number of units made.
Determine:
a)The marginal cost at production level of tenth unit
b)The number of units for which the marginal cost
is minimum.
c)The minimum marginal cost
d)The total cost and average cost for the number of
units which minimizes the marginal cost
e)The total cost and average cost for 10 units