Chapter 2

Optimal Decisions Using

Marginal Analysis
 What is economic
optimization?
 If there is only one solution to a
problem, then, there is no decision
problem.
 If there are alternative solutions, then
you have to decide about the “best”
solution.
 The best (optimal) solution is one that
produces the result most consistent
with the managerial objectives.
 Economic Optimization
 Economic optimization is the
process of arriving at the best
managerial decision.
 Managerial economics provides
tools for analyzing and evaluating
decision alternatives.
 Primary Objective of
Management
 In managerial economics, the primary
objective of management is assumed to
be
maximizing the value of the firm

 Maximize the following equation:

CF1 CF2 CFn
V= + + ... +
(1 + k) (1 + k)
1 2
(1 + k)n
 Total, Average, and
Marginal Relations
 In any mathematical relationship, there
is a “DEPENDENT VARIABLE” and one or
more “INDEPENDENT VARIABLE(S)”.
 A marginal relation is the change in the
dependent variable caused by a one-
unit change in an independent variable.
Total, Average, and
Marginal Relations

Units of Ou
π ∆π π

Q
 250

200

150
Profits ($)

100

50

0
0 2 4 6 8 10
Ou tp u t ( u nits )

Total Prof its 0 Marginal Prof its 0 A v erage Prof its -

 Total, Marginal, and
Average Relations
 When the marginal is positive, the
total is increasing; when the
marginal is negative, the total is
decreasing.
 Maximization of the total profit
function occurs at the point where
the marginal switches from
positive to negative.
 Total, Marginal, and
Average Relations
 When the marginal is greater than the
average, the average must be
increasing.
 E.g. You are operating 5 stores with
average annual sales of TL 100 billion
per store. If you open a 6th store that
generates sales of TL 120 billion (the
marginal sales), average sales per
store will increase.
 Total, Marginal, and
Average Relations
 Total Output is denoted by Q and
Total Profit is denoted by π .
 Marginal profit is expressed as
∆ π where ∆ denotes difference or
change.
 ∆π = π Q -π Q-1

 Average profit equals total profit

divided by total output (π / Q).
 Total, Marginal, and
Average Relations
 Marginal profit is the slope of the
total profit curve; it is maximized at
the inflection point.
 Total profit is maximized where
marginal profit is equal to zero.
 Average profit rises (falls) when
marginal profit is greater (less) than
average profit.
Marginals as Derivatives of
Functions
 In function Y = f(X), the marginal
value is the change in Y associated
with a one-unit change in X.
 Then, the general specification is
 Marginal Y = ∆ Y / ∆ X.
 A derivative is the precise
specification of the marginal
relation.
Marginals as Derivatives of
Functions
 A derivative is the value of ∆ Y/∆ X
for extremely small changes in X.
 The derivative is also equivalent to
the slope of a curve at a given point.
 The derivative is denoted as dY/dX.
 Since the derivative is the slope of a
curve, it will change as the slope of
the curve changes.
Marginals as Derivatives of
Functions
 E.g. When the dependent variable
is Total Profit (Y) and the
independent variable is Total
Output (X), the derivative will show
the exact mathematical relation
between π and Q at a specific
level of Q.
 Marginal Analysis
 To find the maximum or minimum
value of a function, we need to find the
point where the marginal value is equal
to zero.
 When the derivative is used to measure
the marginal, the function will be
maximized or minimized when the
derivative is equal to zero.
 Marginal Analysis
 E.g. π = -10,000 + 400 Q - 2 Q2
 Marginal Profit (M π ) = dπ /dQ
 dπ /dQ = 400 - 4Q
 Set the derivative equal to zero:
 400 - 4Q = 0
 Q = 100 units
 Total profit is maximized at an output
level of 100 units.
 Maximum and Minimum
Values
 The derivative is zero for both a
maximum and a minimum point.
 The second derivative is used to
distinguish maximums from minimums.
 The second derivative gives the slope of
the slope (shows the change in the slope
of the original function).
 The Second Derivative
 If the second derivative is
negative, this indicates a
maximum point on the original
function.
 The negative second derivative
shows that the marginal function is
changing from a positive slope to a
negative slope.
 The Second Derivative
 If the second derivative is positive,
this indicates a minimum point on
the original function.
 The positive second derivative
shows that the marginal function is
changing from a negative slope to
a positive slope.
 B
Inflectio Total Profit
n Point

Units of output
doi r ep
i t r ep ti f or P

A
em

A B Units of output

Marginal Profit
pt uo
i f or P
 Multivariate Optimization
 It is the process of optimization for
equations with three or more
variables.
 E.g. Demand is a function of (1)
product’s own price, (2) price of
other goods, (3) advertising, and
(4) income.
 Partial Derivatives
 Optimization requires an analysis of
how a change in each independent
variable affects the dependent variable,
holding constant the effect of all
other independent variables.
 Partial derivatives are used for finding
this type of an “isolated” effect.
 Partial Derivatives
 E.g. Q = 5000 - 10P + 40A + PA - 0.8A2 -
0.5P2
 In order to find the effect of each
independent variable, we will assume that
all variables except the one under analysis
remain unchanged (constant). Other
variables will be treated as constants when
taking the partial derivatives.
 Partial Derivatives
 Q = 5000 - 10P + 40A + PA - 0.8A2 -
0.5P2

 δ Q/δ P = 0 - 10 + 0 + A - 0 - P = -10 +
A-P

 δ Q/δ A = 0 - 0 + 40 + P - 1.6A - 0
= 40 + P - 1.6A
 Maximizing Multivariate
Functions
 All first-order partial derivatives are
set equal to zero to find the
maximum of a multivariate function.
δ Q/δ P = -10 + A - P = 0
δ Q/δ A = 40 + P - 1.6A = 0

P = 40, A = 50, Q* = 5,800

 E.g. TC = 200,000 + 30Q + 0.002Q2
TR = 250Q - 0.02Q2
Q = 12,500 - 50P
 Calculate the revenue-maximizing
price/output combination and the profit
at this level.
dTR/dQ = 250 - 0.04Q → Q = 6,250
→ P = 125
π = TR - TC = -200,000 + 220Q -
0.022Q2
π = 315,625
 Calculate the profit-maximizing
price/output combination and the profit
at this level.
π = -200,000 + 220Q - 0.022Q2
dπ /dQ = 220Q - 0.044Q →Q = 5,000
→P = 150
→π = 350,000
 Calculate the average cost-minimizing
output level and the profit at this level.
TC = 200,000 + 30Q + 0.002Q2
AC = TC/Q = 200,000Q-1 + 30 + 0.002Q
dAC/dQ = -200,000Q-2 + 0.002
→Q = 10,000
→P = 50
→π = -200,000 (loss)
 Revenue-maximizing and profit-maximizing
results show that revenue-maximizing
prices are lower (demand curve slopes
downward) and output levels are higher
than the case of profit-maximization.
 Profit-maximizing and average cost-
minimizing results show that the output
level where average costs are minimized is
not necessarily the point where profits are
maximized.
 Constrained Maximization
 In many decisions, there are constraints
imposed that limit the options available
to the decision maker.
 E.g. Minimizing cost while producing a
given level of output.
 E.g. Maximizing output while utilizing a
given level of inputs.
 E.g. Maximizing sales with a fixed
advertising budget.
 Constrained Optimization
 Managers are faced with decision
situations that involve limited choice
alternatives.
 Managers are still expected to optimize
while taking into account the
constraints.
 The decision will be the best decision
and it will also satisfy the constraint.
 Constrained Optimization
 If the constraint can be expressed as an
equation, then it can be included in the
optimization process in the following
way:
 Solve the constraint for one of the
independent variables
 Substitute that variable in the objective
function that the firm wants to maximize or
minimize.
Constrained Maximization
 E.g. minimize TC = 3X2 + 6Y2 - XY
subject to X + Y = 20.
 From the constraint X = 20 - Y.
 Substituting:
TC = 3(20 - Y)2 + 6Y2 - (20-Y)Y
TC = 1200 - 140Y + 10Y2
 Minimize this objective function by
taking derivatives:
 TC = 1200 - 140Y + 10Y2
 dTC/dY = -140 + 20Y = 0 → Y = 7
 Check the second derivative to see that
this is a minimum:
 d2TC/dY2 = 20 (it is positive)
 Substitute for X: X = 20 - Y → X = 13.
 TC = 3(13)2 + 6(7)2 - 3(7) = 710.
 The total cost of producing this
combination is $710.
 Constrained Maximization
Lagrangian Multipliers
 When the constraints are too complex or
numerous, the substitution method is not
feasible.
 The Lagrangian method creates a new objective
function by incorporating the original objective
function and all the constraint conditions.
 When the new Lagrangian function is maximized
or minimized, the original objective function is
maximized or minimized and all the constraints
are satisfied.
 Lagrangian Multipliers
 E.g. minimize TC = 3X2 + 6Y2 - XY
subject to X + Y = 20.
 Step 1: Rearrange the constraint:
0 = 20 - X - Y
 Step 2: Multiply the constraint by the
unknown factor λ and add the result to
the original objective function to create
the Lagrangian function:
 LTC = 3X2 + 6Y2 - XY + λ (20 - X - Y)
 Step 3: Treat the Lagrangian function as an
unconstrained optimization problem since it
already incorporates the constraint.
 Step 4: Solve the optimization problem by the

use of partial derivatives:

δ LTC /δ X = 6X - Y - λ
δ LTC /δ Y = 12Y - X - λ
δ LTC /δ λ = 20 - X - Y
 Step 5: Set the partial derivatives equal to
zero and solve the system of equations:
6X - Y - λ = 0
12Y - X - λ = 0
20 - X - Y = 0
(three equations and three unknowns)
 X = 13, Y = 7, TC = 710.
 The Lagrangian Multiplier
(λ )
 The Lagrangian multiplier has an
economic interpretation:
 From the example, λ = 71. Since the
original objective function is a total cost
function, λ is interpreted as the
marginal cost of producing 20 units of
output.
 So, if the firm could produce 19 units, TC
would decrease by approximately 71. Or, if
the firm could produce 21 units, TC would
increase by approximately 71.
 E.g. maximize π = -10,000 + 400Q - 2Q2
subject to 4Q = 300
 Rearrange and write out the Lagrangian

function:
Lπ = -10,000 + 400Q - 2Q2 + λ (300 - 4Q)
 Take the partial derivatives and set them equal

to zero:
δ Lπ /δ Q = 400 - 4Q - 4λ = 0
δ Lπ /δ λ = 300 - 4Q = 0
 Q = 75, λ = 25, π = 8,750.

 If the right-hand-side of the constraint can be

increased by one unit, the profits will increase

by 25.
 E.g. TR = 20T + 5N + 20TN - T2
where
T = units of television advertising
(cost = $10 per unit)
N = units of newspaper advertising
(cost = $5 per unit)
 There is a $100 advertising budget
constraint.
 Calculate the revenue-maximizing
combination of television and newspaper
advertising.
 Maximize TR = 20T + 5N + 20TN - T2
subject to 10T + 5N = 100
 Rearrange the constraint and write out the Lagrangian function:
 LTR = 20T + 5N + 20TN - T2 + λ (100 - 10T - 5N)
 Take the partial derivatives and set them equal to zero:
dLTR /dT = 20 + 20N - 2T - 10λ = 0
dLTR /dN = 5 + 20T - 5λ = 0
dLTR /dλ = 100 - 10T - 5N = 0
 Solve the system of equations:
→T = 5 units, N = 10 units, TR = $1,125
 Interpret the value of the Lagrangian multiplier:
λ = $21
Lambda measures the marginal revenue to be
gained by increasing the advertising budget by
$1. It is not the revenue gain associated with a
unit increase in either television or newspaper
advertising, but rather the revenue increase
following a $1 increase in expenditures on an
appropriate combination of television and
newspaper ads.