Optimization

Formal optimization was an

AgEc 301
elusive goal for businesses until
Agricultural Economics I the advent of computers.

Slide Set 2
Spreadsheet programs fostered
a revolution in data analysis and
Economic Optimization
record keeping for businesses.

Optimal Decisions Maximizing the Value of the Firm

Because managers face multiple
objectives and constraints, a We will assume the primary
decision that is “best” in one objective of management to
situation will not be “best” in be maximization of the value
others. of the firm. You will recall that
value equals:
The decision which produces a
result most consistent with n
πt n
TRt − TCt
managerial objectives is the ∑ (1 + i)
t =1
t or ∑ (1 + i ) t
t =1
optimal decision.

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 Optimization
Obviously, marketing, production
and financial decisions must all
be integrated within a decision
analysis framework in order to
maximize the value of the firm.
Basic Economic Relations
Basic economic relations can be
expressed in several ways. To
begin, we will use tables
(spreadsheets) and graphs.
The easiest way to examine
economic concepts is to consider
their functional relationships
Optimization
The optimization process
requires two steps:
• Important economic relations
must be expressed in analytical
terms
• Various optimization techniques
must be applied to determine
the best solution
Functional Relationships
Consider the relation between
output Q and Total Revenue TR.
Using functional notation, total
revenue is:
TR = f(Q)
Which simply says, total revenue
is a function of output.
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 Dependent and Independent
Note that by saying TR is a
function of Q we are defining:
™TR as a dependent variable
™Q as an independent variable
The dependent variable appears
on the left hand side of the equal
sign, the independent on the right
hand side.
Total, Average, and Marginal
Total, average, and marginal
relations are all useful in
optimization analysis.
A marginal relation is the change
in the dependent variable caused
by a one-unit change in the
independent variable
Functional Relationships
A more precise relationship
between TR and Q could be
defined as:
TR = P + Q
Where P represents the price of
the output
Marginal and Average
Marginal revenue is the change
in total revenue associated with
a one unit change in output.
Average revenue is simply the
total revenue divided by the
units of output.
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 Marginal Relations Tables and Graphs
A marginal relation is the The relationship between Total
change in the dependent Revenue and Output:
variable caused by a one-unit TR = $1.50 + Q
change in the independent Total Revenue Output

variable. 1.50 1
3.00 2
• Marginal revenue 4.50 3
• Marginal cost 6.00 4
7.50 5
• Marginal profit 9.00 6

Total, Marginal, Average Profit

Relation between Total Revenue and Output, Units of Total Profit Marginal Average
P=$1.50 Output Profit Profit
10
Q % % %/Q
9 0 0 0 -
8
1 19 19 19
7
2 52 33 26
Total Revenue

5 Total Revenue 3 93 41 31
4 4 136 43 34
3
5 175 39 35
2

1
6 210 35 35
0 7 217 7 31
0 1 2 3 4 5 6
8 208 -9 26
Output

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Geometric Representation of Total, Marginal, Geometric Representation of Total, Marginal,
and Average Relations: Total Profits and Average Relations: Marginal and Average
Profits
Max value of Max profit
average profit

Max value of
Marginal profit
Max value of Max value of
Marginal profit average profit

Max profit

Figure 2.2A Figure 2.2B

NOTE
The preceding graphs are of profit,
marginal profit and average profit
curves.
You are likely used to seeing similar
graphs or total product, marginal
product, average product. Those do
NOT embody the price of the output
and thus optimum points occur in
different places.

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 Important Points
C - where the inflection point
occurs in the Total profits
graph. This is the output
level at which marginal
profits are at a maximum
Important Points
E - The output level at which
Total Profits are at a
maximum and marginal
profits equal zero.
Profit is maximized where
marginal profit equals zero.
Why???
Important Points
D - tangency point on Total
Profits graph, indicates the
output level where average
profits are at a maximum,
and where average and
marginal profits are equal
(the curves intersect).
A word to the wise
Make sure you know which
function you are looking at. A
very similar set of graphs is
used to show how production
goes up when inputs are added.
In that case the optimal decision
will not be where the marginal
curve equals zero.
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 Calculus? Oh @#$%^
Tables and graphs are useful for
explaining concepts.
Equations are better suited for
problem solving and decision
support.
Differential calculus is the best
tool for finding optimums.
∆Y
∆X
Marginal values
Consider a function Y = f(X),
The concept of a derivative
A marginal value is simply the
change in a dependent variable
associated with a one-unit
change in an independent
variable.
This is the same as the concept
of a derivative.
Marginal Y
The graph of the marginal profit
using  (Delta) to denote curve illustrates the marginal
change, it is possible to express relation.
a change in Y in terms of X as
follows: If total profit is increasing –
marginal profit is positive.
∆Y
Marginal Y =
∆X If total profit is decreasing –
marginal profit is negative.

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 The derivative
A derivative is a precise
specification of the marginal
relation. Finding a derivative
involves finding the value of the
ratio ∆Y for extremely small
∆X
changes in X.

The derivative The derivative

The mathematical notation for a The derivative can be thought of
derivative is: as the limit of a ratio and is
dY limit ∆Y precisely equivalent to the slope
=
dX ∆X → 0 ∆X of a curve at a point.
Which reads, the derivative of Y with
respect to X equals the limit of the
ratio of Y/
Y/X as X approaches
zero.

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 For the general function y = f(x)
dY
= nx n −1
dX
So if y = x2 then dy/dx = 2x

If y = 3x – x3 then
dy/dx = 3 – 3x2

Finding Maximums and Minimums An Example

The derivative as a precise
measure of slope is a good tool
to determine that point at which
a curve reaches a maximum or
minimum value.
Max. or Min. points occur when
the slope of a function isn’t
changing… that is, when the
derivative equals zero.
Consider the profit function:
% = -$10,000 + $400Q - $2Q2
™ We want to know how %
changes in response to
changes in Q.
™ What we need to know is
d%/dQ.

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 An Example An Example
Here % is profit and Q is output. The marginal profit function is:
Logically, if Q is zero, the firm d%/dQ = $400 - $4Q
incurs a loss of $10,000 (fixed
costs). Setting MP equal to zero and
solving:
Profit maximizing output can be
found by setting the marginal 0 = $400 - $4Q
profit function equal to zero and $4Q = $400
solving for Q
Q = 100

An Example

Therefore when Q = 100,

marginal profit equals zero and
profit is at a maximum.

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 Max or Min??!? Max or Min??!?

A problem can arise in relying

In order to determine if a point
solely on marginal relations to
is a maximum or minimum, we
locate maximum points.
must use the second derivative
Slope can be zero at either a of the function.
maximum or a minimum point
(top or bottom of a curve).

An Example
Assume total profit can be
modeled by:
MP = zero at % = -3000 - 2400Q + 350Q2 -
MP = zero at
maximum point
8.33Q3
minimum point

Marginal Profit then is equal to:

d%/dQ = -2400 + 700Q – 25Q2

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 An Example An Example
Output quantities of either 4 or If you evaluate the second
24 will cause the value of the derivative at Q=4
marginal profit equation to be
zero. (may be solved using the d2%/dQ2 = 500
quadratic equation) and Q=24 you get
d2%/dQ2 = -500
So the maximum occurs at
Q=24

Difference Between Functions MR = MC

An important concept is that
marginal revenue equals
marginal cost at the point of
profit maximization.
• MR = d%/dQ,
/dQ, the slope of the
revenue function
• MC = dC/dQ,
dC/dQ, the slope of the
cost function
This point of profit maximization
is based on the fact that the
distance between the revenue
and cost functions is maximized
at the point where there slopes
are the same.

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 One more example
Consider the following revenue
cost and profit functions:
Slopes are
the same TR = 41.5Q – 1.1Q2
TC = 150 + 10Q – 0.5Q2 + 0.02Q3
% = TR - TC
Profit maximizing output is found
by substituting TR and TC into the
profit function and analyzing
marginal profits.

One more example One more example

In this case:
d%/dQ = 31.5 – 1.2Q – 0.06Q2
Using the quadratic equation we
find that two solutions are
possible:
Q1 = -35 and Q2 = 15
Negative output quantities are
not feasible, so we can reject
Q1 without further analysis.
Checking the second derivative:
d2%/dQ2 = -1.2 – 0.12Q
At Q = 15, the second derivative
equals -3, therefore Q=15 is a
point of maximization

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 One more example
This numeric example
corresponds the case shown in
the previous graphs (figure 2.7).
The Incremental Concept
For example, managers may
wish to consider:
• A large increase in production
level
• Introducing a new product line
• Changing to new production
technology
The Incremental Concept
Obviously marginal concepts are
important to management
decision making.
• Involve unit changes
• Many decisions are necessarily
broader in scope
The Incremental Concept
The incremental concept is a
generalization of the marginal
concept.
Incremental change is the
change resulting from a given
managerial decision, for
example, revenue from a new
product line.
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 Incremental Profits
Incremental profit is the profit or
loss associated with a managerial
decision.
Incremental analysis is not always
obvious or easy. Care should be
taken.
• e.g. Income from a new product
line should include any changes in
income from existing products.

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