Optimisation

Techniques
Mathematics of ‘Optimization’
‘Optimization’  a decision maker wishes to either MAXimize or
MINimize a goal (i.e. objective function)

A manager’s goal is to increase profit.

Profits increase take place by
a. Maximising output
b. Minimise cost
 Optimization Techniques
Methods for maximizing or minimizing an objective function.
Examples:
◦ Consumers maximize utility by purchasing an optimal
combination of goods.
◦ Firms maximize by producing and selling an optimal quantity of
goods.
◦ Firms minimize their cost of production by using an optimal
combination of inputs.
Optimisation
Ways of expressing economic relationships
total, average, marginal
Process of optimisation – Total and marginal approach
Differentiation
Optimisation with calculus
New Management tools for optimisation
 Expressing Economic
Relationships
Q 0 1 2 3 4 5 6
TR 0 90 160 210 240 250 240

FIGURE 3-1 The Total-Revenue Curve

of a Firm The total-revenue curve
shows the total revenue (TR) of the firm
at each quantity sold (Q). It is obtained
by plotting the total-revenue schedule of
Table 3-1. Note that TR rises to Q = 5
and declines thereafter.
Table 3.1: The Total-Revenue Schedule of the Firm
Total, Average, and Marginal
Revenue

Q TR AR MR
0 0 - -
1 90 90 90
2 160 80 70
3 210 70 50
4 240 60 30
5 250 50 10
6 240 40 -10
Total, Average, and Marginal Revenue
Relationships

MODIFIED FIGURE 3-1 The Total, Average and Marginal Revenue Curves
Relation between total, average and
marginal
Total, Average, and
Marginal Cost
TC ($)
240

180

120

60

0
0 1 2 3 4
Q

AC, MC ($) MC
AC

120

60

0
0 1 2 3 4 Q
 Profit Maximization
Optimization: process by which a firm determines the
output level at which it maximizes total profit.
Optimization techniques or approaches:
◦ Using total-revenue and total-cost curves
◦ Using marginal analysis
OPTIMISATION
Profit Maximisation
Π = TR – TC (PQ – CQ)
MC = MR (mc should cut mr from below)

a. What output should be produced

b. What price should be charged
c. What is minimum cost of production

For a, b, we need to know demand function

For c, we need to know cost function
Optimization by Marginal
Analysis
Profit Maximization
($) 300
TC

240
TR
180
MC

120

60

MR
0 Q
0 1 2 3 4 5
60
30
0
-30 Profit
-60
Marginal Analysis
Two types of decisions
either – or
How much

How much decisions – solved by marginal analysis

Marginal Analysis
Analysis of ‘marginal’ costs and ‘marginal’ benefits due to a change
Marginal = additional
Costs and benefits that are constant (i.e. fixed, don’t change) are
excluded from the analysis
Changes occurring at ‘the margin’ are all that matter
Marginal Analysis
(Examples)
Incremental Y/
Y X Incremental X
TR Units of output MR
TC Units of output MC
TP Units of input MP
TRP Units of input MRP
TC Units of input MFC
TU Units of good MU
Profit Units of output MP
Optimal level of output
a. Mπ= 0
b. MR = MC

Once output has been determined, the firm’s optimal price is found
from price equation and profit can be estimated accordingly
Rules of Differentiation
Constant Rule If y = f(x) = C then dy/dx = 0
Power Function Rule If y = f(x) = Cxn then dy/dx = nCxn-1
Sum-Difference Rule If y = f(x) +g(x)
then dy/dx = df(x)/dx + dg(x)/dx
Product Rule If y = f(x)·g(x) then
dy/dx = df(x)/dx·g(x) + f(x)·dg(x)/dx
Chain Rule If y = f(z) and z = g(x)
then dy/dx = dy/dz·dz/dx

If y = f(x)/g(x) then
Quotient Rule
Differential Analysis
Optimisation analysis is conducted more efficiently
with differential analysis. For a function to be at its
maximum or minimum, the derivative of the
function must be zero.
To distinguish between maximum and minimum,
use the second derivative. If the 2nd derivative is
positive, it is minimum point. If 2nd derivative is
negative, it is maximum point
Optimization With Calculus

Find X such that dY/dX = 0

Second derivative rules:
If d2Y/dX2 > 0, then X is a minimum.
If d2Y/dX2 < 0, then X is a maximum.
Partial derivative
For a function having 2 or more independent
variables y= f (x, z), the partial derivative dy/dx is
the slope of the relationship between y and x,
assuming z to be constant
Optimising a multivariate function requires setting
each partial derivative equal to zero and then
solving the resulting system of equations
simultaneously for values of each independent
variable
Constrained Optimisation
A constrained optimisation problem may be solved by first solving the
constraint equation for one of the decision variables, and then
substituting the expression for this variable into the objective function
that the firm seeks to maximise or minimise
Probability
A probability distribution lists the possible outcomes of experiment and
prob associated with each outcome
Prob of outcome is 0< P (Xi)<1
Sum of all prob =1
 Common Math Functions Used in
Economics
Name of
Function Form Function Graph of Function
Y = a0 Constant Horizontal straight line with
slope = 0

Y = a0 + a1x Linear Straight line with slope = a1 (or

(or y = mx + b) = m)

Y=a0+a1x+a2x2 Quadratic Parabola (u-shaped curve) with

either minimum or maximum
value
Y=a0+a1x+a2x2+a3x3 Cubic Curved line (e.g. slope changes
from getting flatter to steeper

Y=a0x-n Hyperbola Curved line (u-shaped) bowed

towards origin
Revenue under Linear Demand800

Linear Demand Function 600

400
P or AR
P  700  .01Q 200
0
-200 0 10 20 30 40 50 60 70

 Total Revenue -400 MR

-600

TR  700Q  .01Q 2 -800

14

 Marginal Revenue 12

dTR 10
MR   700  .02Q 8
dQ
6
4

2
0
0 10 20 30 35 40 50 60 70
Key concepts
The value of average function at any point is the
slope of a ray drawn from origin to total function at
that point
The value of marginal function at any point is the
slope of a ray drawn tangent to total function at
that point
Marginal function will intersect average function at
either minimum or maximum point of average
function
Contd…
If marginal function is positive, the total function
will be increasing. If marginal function is negative,
total function will be decreasing
The total function reaches a maximum or minimum
when marginal function equals zero
 New Management Tools for
Optimization
Benchmarking
◦ Finding out how other firms may be doing something better
Total Quality Management
◦ Constantly improving the quality of products and processes
Reengineering
◦ Complete reorganization o the firm
The Learning Organization
◦ Placing value in continued learning
 Big Data and Big Data
Analytics

Big Data
Large and complex data sets
Big Data Analytics
Seeks to extract crucial knowledge and identify unseen
correlations, trends and patterns that can improve firm’s
decision making and performance.
 Other Management Tools for
Optimization
Broadbanding
Direct business model
Networking
Performance management
Pricing power
Process Management
Small-world model
Strategic development
SWOT analysis
Virtual integration and management