LESSON 2

OPTIMIZATION TECHNIQUES

2.1 Functional Relationships and Economic Models

The functional relationship
y=f ( X 1 , X 2 ,..., X n )..............................................................(2.1)

Means that there is a systematic relationship between the dependent variable y and the
independent variables X1, X2,…, Xn and that there is a unique value of y for any set of values of
the independent variables.

Examples:
General Function Specific Function
y=f ( x ) y=2 x
y=3 x 2 +10
y=g (x , z ) y=3 x +2 z
y=100 x 2 z 3
y=f ( x 1 , x 2 ,. . ., x n ) y=x 1 + 2 x 2 +. .+nx n

An Economic Model typically consists of one or more related functions. It is used to explain an
economic phenomenon. For example: the concepts of supply and demand.

Demand function: Qd =f ( p)=B−aP............................................(2.2)

Supply Function: Q s=f ( p)=D+cP ..............................................(2.3)

ΔQ d
=−a
The slope of the demand curve is given as ΔP .
From economic theory, the demand curve has a negative slope and shows that the quantity of
output that consumers are willing to buy increases as price decreases.

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 ΔQ s
( =c )
The supply curve slopes upwards from left to right ΔP . This shows that the quantity of
output that firms will produce and offer for sale at each price increases as price rises.

Figure 2.1: Graphical Representation of Supply and Demand Curves

Price
Per
unit S

Pe

Q Quantity
e Per unit
of time
(Q)

Equilibrium Condition:

Qd =Qs .........................................................................(2.4 )

This condition enables us solve for the equilibrium price Pe.

B−aP=D+cP
B−D=(a+c)P
B−D
Therefore , Pe = ...................................................(2.5)
a+c

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The equilibrium quantity is found by substituting the equilibrium price into either the supply or
demand function and solving for quantity. Using the supply function, equilibrium quantity is

Qe =D+cP e

=D+c ( B−D
a+c )
. .. .. . .. .. .. . .. .. . .. .. . .. .. . .. .. . .. .. . .. .. .. . .. .. . .. ..(2 . 6 )

Numerical Example:
Q d =14−2 P
Q s=2+ 4 P

Determine equilibrium price and quantity.

Solution:

At equilibrium Qd=Qs.

14 −2 P =2+ 4 P
14 −2=2 P + 4 P
12=6 P
12
Pe + =2
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Substituting Pe=2 into the supply function yields equilibrium quantity

Q e =2 +4 P e
=2 + 4 ( 2 )
=10

2.2 Optimization Analysis

Optimization refers to finding the best way to allocate resources given an objective function. For
example, given the firm’s objective of maximizing profits (Total Revenue – Total Cost), we
determine how much output should be produced.

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One approach would be to graph both the total revenue and total cost functions. The vertical
distance between the two functions is profit. By finding that point where this vertical distance is
the largest, the profit-maximizing output is found.

Figure 2.3: Profit Maximization by the TR and TC Approach

TR, TC TC

E
c
D

TR
H J
B
G A

Output (Q)
0
Π C’
(Profit)

D’
0 Q1 Q* Q Q
3
G’ Π

H’

In the top panel of figure 2.3, the total cost (TC) of the firm is greater than zero when output (Q)
is zero and rises as output increases. Total cost is simply the sum of total variable costs and total
fixed costs.

Total variable costs are costs incurred on variable factors of production such as labor and raw
materials. On the other hand, total fixed costs are costs incurred on fixed factors of production
such as machinery. The fixed factors are not changeable in the short-run. As a result, when no
output is produced, the firm only incurs the fixed costs.

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Total revenue rises up to
Q=Qalignl ¿3 ¿¿ ¿and declines thereafter.
Total profit (Π) = TR-TC.

When Q = 0, TR = 0, but TC =0G. Therefore, Π = TR-TC < 0.

The firm maximizes total profit at Q = Q*, where the positive difference between TR and TC is
greatest.

2.3 Differential Calculus: The Derivative and the rules of Differentiation

Optimization analysis can be conducted more efficiently and precisely with differential calculus,
which relies on the concept of the derivative.

2.3.1 The Concept of the Derivative

2.3.2 Rules of Differentiation

Differentiation is the process of determining the derivative of a function, i.e., finding the change
in y for a change in x, when the change in x approaches zero.
Rule 1: Constant Function Rule

y = f ( x )=a
dy
=0
dx

For example, y = 2

dy
=0
dx

Note that the value of y is constant, and it does not change for any value of X.
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Rule 2: Power-Function Rule

y=aX b , where a and b are cons tan ts .

dy
=b . a . X( b−1)
dx

dy
=1( 2) X 1−1 =2 X 0 =2
dx
Example (1) Y = 2X,

dy
=3( 2) X 3 −1= 6 X 2
Example (2) Y=2X3, dx

Rule 3: Sums-and-Difference Rule

U =g ( x )V =h( x )

Y =U ±V

dy dU dV
= ±
dx dX dX
3 2
Example: U =g ( X )=2 X V = h( X )= X

Y =U +V =2 X 3 + X 2
dY
=3( 2 )( X )3−1 +2 X 2−1
dX
=6 X 2 +2 X
HIGHER-ORDER DERIVATIVES
dY
The first derivative of a function is simply dX

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The second derivative of a function is the slope of the first derivative or the rate at which the
marginal function is changing. It is written as

d2 Y d dY
2
= ( )
dX dX dX

Example:

Y = 10X3 + 3X2 – 5X + 6

dY
=30 X 2 + 6 X−5
The first derivative is dX

d2 Y d
2
= (30 X 2 +6 X −5)=60 X +6
The second derivative is dX dX

The second derivative has an important application in finding the maximum and\or minimum of
a function.

2.7 Use of Calculus in Optimization.

Here the point at which a function is maximum or minimum is determined. We then show how to
distinguish between a maximum and a minimum.

Optimization often requires finding the maximum or the minimum value of a function (e.g.,
maximum profit, maximum revenue, or minimum cost).

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 Figure 2.5: Relationship of Total and Marginal Functions at Minimum and Maximum Points

Y max
a

Total Function
d
min

Marginal function

x x X
1 2

The figure shows the total function and its associated marginal function.

At point a, which corresponds to X = X 1, the total function is at a maximum and the marginal
function is zero.

At point b, corresponding to X = X 2, the total function is minimized and the marginal function is
again zero.

Note, however, that the slope of the marginal function at X 1 (maximized point) has a negative
slope, whereas at X2 (minimized point), the slope is positive.
This brings us to two main conditions for determining a maximum and a minimum of a function
1). First-Order Condition:
dY
When a function is at maximum or minimum, the first derivative ( dX ) equals to zero. This is a
necessary condition for a maximum or minimum, but it is not a sufficient condition to determine
if the function is at a minimum or a maximum.

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2). Second-Order Condition:
The test for a maximum or a minimum using the second derivative is called the second-order
condition.

The first-and second-order conditions together are sufficient to test for either a maximum or a
minimum point
Maximum Minimum
First-order Condition dY dY
=0 =0
dX dX
Second-Order Condition d2 Y d2 Y
<0 >0
dX 2 dX 2

NUMERICAL EXAMPLE 1:

TR = 20Q – Q2
TC = 50 + 4Q

Find the level of output, Q, that maximize profit (Π)

Solution

To be done in class

NUMERICAL EXAMPLE 2:

TR = 45Q – 0.5Q2
TC = Q3 – 8Q2 + 57Q + 2

Find Q that maximizes profit (Π).

Solution

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To be done in class

2.8 Multivariate optimization

We examine the process of determining the maximum or minimum point of a function of more
than two variables. To do this, we introduce the concept of the partial derivative, and then use it
to examine the process of maximizing a multivariable function.

2.8.1 Partial Derivatives

Many economic relationships are described by a function having two or more independent
variables. For example, total revenue may be a function of or depend on both output and
advertising, total costs may depend on expenditures on both labor and capital.

Given a general function Y = f (X,Z), the marginal effect on Y resulting from changes in
quantities of each individual variable X and Z is measured by the partial derivative, which is
indicated by the symbol ∂ (as compared to d for the derivative).

∂Y
Therefore, given Y = f (X, Z), the partial derivative ∂ X is the slope relationship between Y and
X, assuming Z to be held constant.

Example:
Π = f (X, Y) = 80X – 2X2 – XY – 3Y2 + 100Y

∂Π
( )
To find the partial derivative of Π with respect to X ∂ X we hold Y constant.

∂Π
=80−4 X−Y
∂X

Similarly, to isolate the marginal effect of a change of Y on Π, we hold X constant and obtain

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∂Π
=− X−6 Y +100
∂Y

2.8.2 Maximizing a Multivariable Function

To maximize or minimize a multivariable function, set each partial derivative equal to zero and
solve the simultaneous equations for the optimal value of the independent variables.
Example:
If Π = 80X – 2X2 – XY – 3Y2 + 100Y, at maximum,

Solution

To be done in class

2.9 Constrained Optimization

Managers face constraints that limit the options available to them in their optimization decisions.
For example, a firm may face limitation on its production capacity or on availability of skilled
personnel and crucial raw materials. In such cases, maximizing or minimizing of objective
function will be subject to some constraints.

Constrained optimization problems can be solved by substitution or by the lagrangian multiplier

method.

2.9.1 Constrained Optimization by Substitution

Supposing a firm faces the following constraint optimization problem

Maximize profit ( Π )=80 X−2 X 2− XY −3Y 2 +100Y ....................(2.10)

Subject to : X +Y =12 .....................................................................(2.11)
To solve this optimization problem by substitution method
solve the constraint function for X

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Solution

To be done in class

Note:
The firm maximizes total profit when it produces 5 units of commodity X and 7 units of
commodity Y, as compared with X = 16.52 and Y = 13.92 when the firm is faced with no output
constraint (see previous example).

The profit with constraint is lower than 1356.52 found in the earlier example without constraint.

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