ECONOMIC

OPTIMIZATION
CHAPTER 2
MARK HIRSCHEY
 OVERVIEW

• Economic Optimization Process

• Expressing Economic Relations
• Marginals as the Derivatives of Functions
• Marginal Analysis in Decision Making
• Incremental Concept in Economic Analysis
 KEY CONCEPTS

• optimal decision • derivative

• table • inflection point
• spreadsheet • second derivative
• graph • profit maximization
• equation • breakeven point
• dependent variable • revenue maximization
• independent variable • average cost minimization
• marginal • multivariate optimization
• marginal revenue • constrained optimization
• marginal cost • Lagrangian technique
• marginal profit • Lagrangian multiplier, λ
ECONOMIC OPTIMIZATION PROCESS

• Optimal Decisions – Best decision helps achieve objectives

most efficiently.
• Maximizing the Value of the Firm
• Value maximization requires serving customers efficiently.
• What do customers want?
• How can customers best be served?
EXPRESSING ECONOMIC RELATIONS

• Tables and Equations

– Simple graphs and tables are useful.
– Complex relations require equations.
• Total, Average, and Marginal Relations
• Total : Total Product, Total Revenue, Total Cost, Total Profit.
• Average : Total profit per unit of output, total cost per unit of
output,
• Marginal is change in the dependent variable caused by a one
unit change in independent variable. Y = a + bX
• Marginal Revenue: is the change in total revenue associated
with a one unit change in output.
• Marginal Cost : Change in total cost following by a one unit
change in output.
• Marginal Profit: Change in total profit due to a one unit
change in output
• TP
  = Total Production
• MP=
• The change in TP caused by the addition of one more unit of variable
input.
• AP =
 TABLE 2.2

Units of Output Total Profit (TP)= Marginal Profit (MP) = Average Profit
Q π π AP = TP / units of
output

0 $0 $0 --

1 19 19 $19

2 52 33 26

3 93 41 31

4 136 43 34

5 175 39 35

6 210 35 35

7 217 7 31

8 208 -9 26
 GEOMETRIC REPRESENTATION OF TOTAL, MARGINAL,
AND AVERAGE RELATIONS: TOTAL PROFITS

Geometric Representation of Total, Marginal & Average Relations: Marginal and Average Profits
• Marginal
  = change in dependent variable caused by a one unit
change in an independent variable.
• Total Revenue:
• TR = Price X Output
• Marginal Revenue = change in total revenue associated with one
unit change in output
• =
• Total Cost:
• TC = variable cost + fixed cost
• Marginal Cost = change in total cost following a one unit change
in output
• Total Profit:
• TP = TR – TC
• MP = change in TP due to a one unit change in output.
RELATION BETWEEN TR AND OUTPUT

Table 2.1
Total Revenue Output
$1.50 1
3.002
4.503
6.004
7.505
9.006
Quantity Price $ Total revenue Marginal Revenue
TR = PXQ MR = ∂TR/∂Q

0 24.00 $0.00  -

1 22.50 22.50 22.50

2 21.00 42.00 19.50

3 19.50 58.50 16.50

4 18.00 72.00 13.50

5 16.50 82.50 10.50

6 15.00 90.00 7.50

7 13.50 94.50 -4.50

8 12.00 96.00 -1.50

9 10.50 94.50 -1.50

10 9.00 90.00 -4.50

• Maximization occurs when marginal switches from positive to
zero or negative.
• If MP=0, TP is maximum
• If marginal is above average, average is rising.
• If marginal is below average, average is falling.
• MP cuts AP at its maximum
• Graphing Total, Marginal, and Average Relations
• Deriving Total from Marginal and Average Curves
• Total is sum of marginal.
 MARGINAL AS A DERIVATIVE OF
FUNCTIONS

•  Concept of a Derivative
– Derivative is a marginal relation.
• Derivatives and Slope
• Derivative of total revenue is marginal revenue.
• Derivative of total cost is marginal cost.
• Derivative of total profit is marginal profit.
• Slope: Measure of the steepness of a line
CHANGING OVER THE RANGE OF A
 
CURVE
• Tangent
  : A straight line that touches a curve at only one point
• Point of Inflection: Point of maximum or minimum slope.
• Derivative: A marginal value is the change in dependent
variable associated with a one unit change in an independent
variable.
= =
• The derivative of Y with respect to X identifies the slope of
the curve.
 DERIVATIVE AS THE SLOPE OF THE
CURVE

The derivative of Y with respect to X identifies the slope of the curve

 MARGINAL ANALYSIS IN DECISION
MAKING
•  Finding Maximums or Minimums
• Managerial decision making frequently requires one to find a maximum
or minimum value of a function.
• For a function to be at its maximum or minimum, its slope, its
derivative or marginal value must be equal to zero.
• Consider the following profit function:

• Marginal Profit (M) = = 400 – 4Q

• Setting MP equal to zero results in
400 – 4Q = 0
400 = 4Q
Q = 100
• At Q = 100, marginal profit is zero & total profit is at a
maximum.
• Beyond Q = 100, marginal profit is negative and total profit is
decreasing.
PROFIT AS A FUNCTION OF OUTPUT
• A problem can arise when marginal relations (derivatives) are
used to locate maximums or minimums.
• The marginal of a function indicates whether the function is
rising or falling at any point.
• To be maximized or minimized, the function must be neither
rising nor falling
• Slope as measured by the marginal must be zero.
• Setting this marginal relation equal to zero indicates inflection
points.
• The marginal value (or derivative) is zero for both maximum
and minimum values of a function therefore further analysis is
necessary to determine whether the point is a maximum or a
minimum.
LOCATING MAXIMUM AND MINIMUM
VALUES OF A FUNCTION
• The concept of second derivative is used to distinguish
maximums from minimums along a function.
• The second derivative is simply the derivative of the marginal
relations. The derivative of a derivative.
• Distinguishing Maximums from Minimums
• Maximum is where first derivative is zero, second derivative is
negative.
• Minimum is where first derivative is zero, second derivative is positive.

•
• Maximum profit requires MR = MC.
 OPTIMIZATION WITH CALCULUS

•  Find X such that = 0

Second Derivative rules:
• If > 0, then X is a minimum
• If < 0, then X is a maximum
• In Cost functions, we attempt to find the minimum value.
• In Profit functions, we attempt to find the maximum value.
• Hence, the objective is to minimize costs and maximize
profits.
•  • Consider the following Total profit function:

• First derivative :
• Marginal Profit (M) = = -b +2cQ – 3d

• Second derivative:
• = 2c – 6dQ
 USE OF MARGINALS TO MAXIMIZING THE
DIFFERENCE BETWEEN TWO FUNCTIONS

• Another example of importance of the marginal concept in

managerial economics is provided by the fundamental
proposition that MR = MC at a point of Profit Maximization.
• Break even Point: output level at which total profit is zero
TOTAL REVENUE, TOTAL COST AND PROFIT
MAXIMIZATION
INCREMENTAL CONCEPT IN ECONOMIC
ANALYSIS
• Marginal v. Incremental Concept :
• Both the concepts are almost.
• Incremental change refers to total difference resulting from a
decision.

• Incremental Profits
– Profits tied to a managerial decision.
 APPENDIX
CONCEPT OF A 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

•1. 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
=0
 RULES OF DIFFERENTIATION

•2. Power Function Rule:

The derivative of a power function, where a and b are constants,
is defined as follows.
Y=f(x)=a
= b∙a
 RULES OF DIFFERENTIATION

•3. 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

= +
 RULES OF DIFFERENTIATION

•4. 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

=U +V
 RULES OF DIFFERENTIATION

•5. Quotient Rule:
The derivative of the ratio of two functions U and V, is defined
as follows.
U=g(X) V=h(X) Y=
= (U + V ) ÷
 RULES OF DIFFERENTIATION

•6. Chain Rule:
The derivative of a function that is a function of X is defined as
follows.
Y = f(U) U = g(X)

= ∙