ME3

Optimization Techniques
• To achieve aims and objectives efficiently, using knowledge of economics is
what Managerial economics is all about
• Examples
• Firms maximize profit by producing and selling an optimal quantity of goods
• Firms minimize their cost of production by using an optimal combination of inputs
• Also as : Consumers maximize utility by purchasing an optimal combination of goods
• How to go about attaining these
• What are the optimization techniques
• Relation between Total, Average, Marginal is important
• Suppose a functional form : TR = 100Q - 10Q2
• Average is total divided by independent variable
• Marginal is change in total per unit change in independent variable.
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

200

Graphs: 150

100

50

0
0 1 2 3 4 5 6 7

Q
Total, Average, and Marginal Revenue

TR = PQ Q TR AR MR
0 0 - -
AR = TR/Q 1 90 90 90
MR = TR/Q 2 160 80 70
3 210 70 50
4 240 60 30
5 250 50 10
6 240 40 -10
• Relation between average and marginal
• If marginal is increasing then average will increase
• If marginal is decreasing, so long it is more than average, average keeps on
increasing
• Till marginal equals the average, whence average becomes maximum
• If marginal is below the average, the average starts decreasing
• Holds in case of average revenue and marginal revenue
• Holds in case of average product and marginal product
• Total revenue maximum when MR is = 0
• Total product maximum when MP is = 0
• In a similar fashion
• If marginal is decreasing, average keeps on decreasing
• Even if marginal is increasing, so long it is less than average, average
keeps on decreasing
• Till marginal becomes equal to average, whence average is minimum
• If marginal is above the average, the average starts increasing
• Holds in case of average cost and marginal cost
 TR
300

250

200
Total Revenue
150

100

50

0
0 1 2 3 4 5 6 7

AR, MR
120

100
Average and 80

Marginal Revenue 60

40

20

0
0 1 2 3 4 5 6 7
-20

-40

Q
Total, Average, and Marginal Cost

Q TC AC MC
0 20 - -
AC = TC/Q 1 140 140 120
2 160 80 20
MC = TC/Q 3 180 60 20
4 240 60 60
5 480 96 240
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
• 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
• Profit maximization: if MR> MC, then more inflow than outflow
if MR < MC, then inflow less than outflow
if MR = MC, then profit maximum

• Applies to any activity: essence of marginal analysis

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
Concept of the Derivative

The derivative of Y with respect to X is

equal to the limit of the ratio Y/X as X
approaches zero.
Rules of Differentiation
Constant Function Rule
The derivative of a constant, Y = f(X) =
a, is zero for all values of a (the
constant).

Y  f (X )  a

dY
0
dX
Rules of Differentiation
Power Function Rule
The derivative of a power function, where
a and b are constants, is defined as
follows.

Y  f (X )  aX b
dY
 b  a X b 1
dX
Rules of Differentiation
Sum-and-Differences Rule
The derivative of the sum or difference of two
functions, U and V, is defined as follows.

U  g(X ) V  h( X ) Y  U V

dY dU dV
 
dX dX dX
Rules of Differentiation
Product Rule
The derivative of the product of two
functions, U and V, is defined as follows.

U  g(X ) V  h( X ) Y  U V

dY dV dU
U V
dX dX dX
Rules of Differentiation
Quotient Rule
The derivative of the ratio of two
functions, U and V, is defined as follows.

U
U  g(X ) V  h( X ) Y
V

dY


V dU
dX  
 U dV
dX 
2
dX V
Rules of Differentiation
Chain Rule
The derivative of a function that is a function
of X is defined as follows.

Y  f (U ) U  g(X )

dY dY dU
 
dX dU dX
Optimization with Calculus
Univariate Optimization
Example 1
Example 2
Example 3
Example 4
• Given
TR = 45Q – 0.5Q2
TC = Q3 – 8Q2 + 57Q + 2
• Determine Q that maximizes profit (π):
π = 45Q – 0.5Q2 – (Q3 – 8Q2 + 57Q + 2)
Example 4: Solution
Quadratic Formula
• Write the equation in the following form:
aX2 + bX + c = 0

• The solutions have the following form:

 b  b  4ac
2

2a
Multivariate Optimization
• Objective function Y = f(X1, X2, ..., Xk)
• Find all Xi such that ∂Y/∂Xi = 0
• Partial derivative:
∂Y/∂Xi = dY/dXi while all Xj (where j ≠ i) are held constant
Example 5
• Determine the values of X and Y that maximize the following profit
function:
π = 80X – 2X2 – XY – 3Y2 + 100Y
• Solution
∂π/∂X = 80 – 4X – Y = 0
∂π/∂Y = -X – 6Y + 100 = 0
Solve simultaneously
X = 16.52 and Y = 13.92
Constrained Optimization
• Define an objective mathematically as a function
of one or more choice variables
• Define one or more constraints on the values of
the objective function and/or the choice variables
• Determine the values of the choice variables that
maximize or minimize the objective function while
satisfying all of the constraints
Constrained Optimization
• Substitution Method
Substitute constraints into the objective function and then maximize the
objective function
• Lagrangian Method
Form the Lagrangian function by adding the Lagrangian variables and
constraints to the objective function and then maximize the Lagrangian
function
Example 6
• Use the substitution method to maximize the following profit
function:
π = 80X – 2X2 – XY – 3Y2 + 100Y
• Subject to the following constraint:
X + Y = 12
Example 6: Solution
• Substitute X = 12 – Y into profit:
π = 80(12 – Y) – 2(12 – Y)2 – (12 – Y)Y – 3Y2 + 100Y
π = – 4Y2 + 56Y + 672
• Solve as univariate function:
dπ/dY = – 8Y + 56 = 0
Y = 7 and X = 5
Example 7
• Use the Lagrangian method to maximize the following profit function:
π = 80X – 2X2 – XY – 3Y2 + 100Y
• Subject to the following constraint:
X + Y = 12
Example 7: Solution
• Form the Lagrangian function
L = 80X – 2X2 – XY – 3Y2 + 100Y + (X + Y – 12)
• Find the partial derivatives and solve simultaneously
dL/dX = 80 – 4X –Y +  = 0
dL/dY = – X – 6Y + 100 +  = 0
dL/d = X + Y – 12 = 0
• Solution: X = 5, Y = 7, and  = -53
Interpretation of the Lagrangian Multiplier, 

• Lambda, , is the derivative of the optimal value of

the objective function with respect to the
constraint
In Example 7,  = -53, so a one-unit increase in the value
of the constraint (from -12 to -11) will cause profit to
decrease by approximately 53 units
Actual decrease is 66.5 units
 New Management Tools
• Benchmarking refers to the finding out, in an open rd way, how other firms may
be doing something better (cheaper) so that your firm can copy and possibly
improve on its technique.
• Total Quality Management refers to constantly improving the quality of products
and the firm’s processes so as to consistently deliver increasing value to
customers. TQM constantly asks, “How can we do this cheaper, faster, or better?”
• Reengineering requires restructuring the firm to conform to that vision.
• Involves the radical redesign of all of the firm’s processes to achieve major gains in
speed, quality, service, and profitability.
• While TQM seeks how to do something faster, cheaper, or better, reengineering asks
first whether something should be done at all, and so it is more likely than TQM to
come up with novel solutions.
• A Learning Organization values continuing learning, both individual and collective, and
believes that competitive advantage derives from and requires continuous learning in
our information age.
• Based on five basic ingredients:
1.New mental model: People must put aside old ways of thinking and be willing to
change.
2.Personal mastery: Firm employees must learn to be open with others and listen,
rather than telling others what to do.
3.System thinking: Everyone in the organization must have an understanding of how the
firm really works.
4.Shared vision: All firm employees must share the same strategy.
5.Team learning: The organization must see how all the firm’s employees can be made
to work and learn together to realize the shared vision and carry out the strategy of
the firm.
• Broadbanding: The elimination of multiple salary grades to foster
movement among jobs within the firm, thus increasing labor flexibility and
lowering costs.
• Direct Business Model: The situation where a firm deals directly with the
consumer, thus eliminating the time and cost of third-party distribution
(i.e., eliminating distributors, as, for example, in the selling of Dell PCs).
• Networking: The forming of temporary strategic alliances where each
fi rm contributes its best competence, as in the case of virtual
integration (see next page).
• Performance management: The holding of executives and their
subordinates accountable for delivering the desired results and
superior competitive performance.
• Pricing Power: The ability of a firm to raise prices faster than
the rise in its costs or to lower its costs faster than the fall in
the prices at which the firm sells—thus increasing its profits.
• Process management: The coordination or integration under a
single umbrella of all the firm’s performance-improvement
initiatives, such as benchmarking, reengineering, TQM, and Six
Sigma.
• Small-world model: The idea or theory that a corporate giant
can be made to operate like a small firm by linking well-
connected individuals from each level of the organization to
one another, so as to improve the flow of information and the
operational efficiency of the firm.
• Strategic development: The idea that assessment and action should be under
continuous review and provide a direction and an agenda or continuous strategic
development, rather than a strategic plan.
• SWOT analysis: A strategic planning method used to evaluate the Strengths,
Weaknesses, Opportunities, and Threats involved in a project or in a business
venture. It involves specifying the objective of the business venture or project and
identifying the internal and external factors that are favorable and unfavorable to
achieving that objective.
• Virtual integration: The blurring of the traditional boundaries and roles between the
manufacturer and its suppliers, on the one hand, and the manufacturer and its customers,
on the other, in the value chain, thus treating suppliers and customers as if they were part
of the company.
• Virtual management: The ability of a manager to simulate consumer behavior using
computer models based on the emerging science or theory of complexity.