Business Economics

Lecture 2
(Optimization)

Teacher:
ISMATULLAH BUTT
Business Economics-Optimization
Lecture Contents:
 Role and Scope of Managerial Economics
 Review
 Basic Concepts and Tools for Economic Analysis

2
Optimal Decision: DMs Optimize
• The optimal decision in managerial economics is one that brings the
firm closest to this goal.
• Decision Makers Optimize
– Practically in all managerial decisions the task of the
manager is the same - each goal involves an
optimization problem.
– The manager attempts either to maximize or minimize
some objective function, frequently subject to some
constraint(s).
– And, for all goals that involve an optimization problem,
the same general economic principles apply!
3
Basic Concepts:
Maximizing the Value of a Firm

• Value of a firm
– Price for which it can be sold
– Equal to net present value of expected future
profit
• Risk premium
– Accounts for risk of not knowing future profits
– The larger the rise, the higher the risk premium,
& the lower the firm’s value

4
Economic Optimization
• Our first assumption
– Abstraction from Reality? A Simplification?
• Economic agents (i.e., households, firms, managers, etc.)
have an objective that they are trying to optimize.
– Individuals assumed to maximize utility.
– For-profit firms maximize profits and minimize
costs.
– Not-for-profit firms may maximize output given
the budget or minimize cost given the output
– Realistic?

5
Economic Model of the Firm
• Theory of the firm: Goal is to maximize
firm profits
– Use  to represent profit
•  = Total Revenue – Total Cost
= TR - TC or Simply R - C
– TR is determined by: sales and marketing
strategy, pricing, economy, etc.
– TC is determined by: production methods, cost
of capital, etc.

6
Marginal Analysis
• Marginal - change in the dependent variable
caused by a one-unit change in an
independent variable
• Marginal Revenue - change in total revenue
associated with a one-unit change in output
• Marginal Cost - change in total cost
associated with a one-unit change in output
• Marginal Profit - change in total profit
associated with a one-unit change in output

7
An Example with Profits
Given Demand Function: P = 60 – 2Q
Derived Revenue Function: R = P*Q = 60Q-2Q2
Given Cost Function: C = 50Q - 12*Q2 + Q3
Derived Profit Function: P = R-C = 10*Q + 10*Q2 – Q3

70
Dem and and M arginal Re venue Lines

60

50

40

30

20

10

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
-10
Q u a n t it y D e m a n d e d
Price M arginal Revenue

8
Total, Marg. and Avg. Revenue, Cost & Profit at Different Outputs
Out Total Marginal Average Total Marginal Average Total Marginal Average
put Revenue Revenue Revenue Cost Cost Cost Profit Profit Profit

0 0     0     0    

1 58 58 58 39 39 39 19 19 19

2 112 54 56 60 21 30 52 33 26

3 162 50 54 69 9 23 93 41 31

4 208 46 52 72 3 18 136 43 34

5 250 42 50 75 3 15 175 39 35

6 288 38 48 84 9 14 204 29 34

7 322 34 46 105 21 15 217 13 31

8 352 30 44 144 39 18 208 -9 26

9 378 26 42 207 63 23 171 -37 19

10 400 22 40 300 93 30 100 -71 10

11 418 18 38 429 129 39 -11 -111 -1

12 432 14 36 600 171 50 -168 -157 -14

13 442 10 34 819 219 63 -377 -209 -29

14 448 6 32 1092 273 78 -644 -267 -46

15 450 2 30 1425 333 95 -975 -331 -65

16 448 -2 28 1824 399 114 -1376 -401 -86

17 442 -6 26 2295 471 135 -1853 -477 -109

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Revenue Maximizing Output = 15; Maxm.
Revenue= 450; Here MR=0 but Loss = 975
Maximization of Revenue
500

400
Total, Marginal and Average

300
Revenue

200

100

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
Output
-100

Total Revenue Marginal Revenue Average Revenue

10
Cost Per Unit or AC is Lowest when MC=AC at output
=6 but Profit = 204 (Below Max)
M inimization of Cost pe r unit
160

140
Total, Marginal and Average

120

100
Cost

80

60

40

20

0
0 1 2 3 4 Output5 6 7 8

Total Cost Marginal Cost Average Cost

11
Maximum Total Profit 217 is at Output = 7
Total Profit =Total Rev e nue - Total Cost
700

600
500
Total Revenue, Cost and Profit

400
300

200

100
0

-100 0 1 2 3 4 5 6 7 8 9 10 11 12
Output
-200

-300
Total Cost Total Revenue Total Profit

12
Maximum Profit =217 at output level of 7 units at
this Marg. Profit = MR - MC = 0
250

200
Total, Marginal and Average Profit

150

100

50

0
0 1 2 3 4 5 6 7 8
Output
-50
Total Profit Marginal Profit Average Profit

13
Profit Maximizing Output = 7 where MR = MC i.e. MC
curve cuts MR from below
Marginal Profit = MR - MC
80
• If MR>MC: increase
output, increase
60 profit
40 • If MR<MC: increase
output, decrease
Marginal Revenue, Cost and

20
profit
Profit

0 • MR=MC: profit
0 1 2 3 4 5 6 7 8 9
-20 Output maximization
assured
-40

-60

Marginal Revenue Marginal Cost Marginal Profit

14
Optimization Using Calculus
• If y = f(x), the maxima or minima of y exists
for that value of x (say at x=x*) where
– First derivative, dy/dx = 0
• The second and sufficient condition for
maxima or minima is
– For maxima, 2nd derivative should be negative
i.e. d2y/dx2 < 0 at x= x*
– For minima, 2nd derivative should be positive
i.e. d2y/dx2 > 0 at x= x*

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Example: Maximize R= 60Q-2Q2
• Here dR/dQ = 60 – 4Q
(dR/dQ is basically MR)
– For maxima or minima dR/dQ=0
– or 60-4Q=0 i.e. Q*=60/4 = 15
– 2nd derivative, d2R/dQ2 = -4 <0 therefore
maximum of R exists at Q=15
– The maximum revenue, Rmax= 60xQ*-2Q*2
=60x15 -2x152 = 900-450 = 450.
– (What’s the profit at this output?)

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Marginal Revenue, Cost and Profit
• Marginal Revenue, Cost & Profit:
dR R
MR  and AR   P
dQ Q
dC C
MC  and AC 
dQ Q
Profit,   R  C
d d (R - C) dR dC
 Marginal Profit    
dQ dQ dQ dQ
Marginal Profit  MR - MC
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Optimizing: Maximizing
•
Revenue
For maximum revenue,
dR
(i)  0 i.e. MR  0
dQ
i.e. Slope of revenue curve  0
d 2R d  dR 
(ii) 2
 0     0
dQ dQ  dQ 
d(MR)
Or, 0
dQ
i.e. Slope of MR curve should be negative

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Optimizing: Minimizing Cost
• For minimizing cost per unit (i.e. C/Q)
d ( AC )
(i)  0 i.e. Slope of avg. cost curve  0
dQ
(Check out that this means AC  MC )
2
d ( AC )
(ii) 2
0
dQ
(Check out : this is possible when Slope of MC  Slope of AC.
1st and 2nd Condition together means that AC is minimum at
level of output at which MC curve cuts AC curve from below.)
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Optimizing: Maximizing Profit or Minimizing
Loss
d  dR dC
(i) Marginal Profit    0
dQ dQ dQ
 MR - MC  0 or MR  MC, and
d 
2
d(MR) d ( MC )
(ii) 2
0   0
dQ dQ dQ
i.e. Slope of MR curve  Slope of MC curve
Graphicall y this means that profit maximizing
output is given by the point wher e MC curve
intersects the MR curve from below
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Applying Derivatives for Cost Optimization: Last
Numerical Example

• Cost Function given was:

C = 50Q - 12*Q2 + Q3
• Firms normally will optimize (i.e. minimize) cost per unit. So objective
function here is:
AC = 50 - 12*Q + Q2
– For minimum, d(AC)/dQ = -12 + 2Q =0
Or, Q = 12/2=6
– Checking out 2nd derivative d(AC)/dQ = 2 which is +ve so
we have minimum at Q* = 6.
– Calculating minimum AC,
ACMin = 50-12*6+62 = 14
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Maximizing Profit: Applying Derivative on
Last Numerical Example
• Profit Function we have here
P = R – C = (60Q-2Q2) – (50Q - 12*Q2 + Q3)
P = 10*Q + 10*Q2 – Q3
• For Maximization, taking first derivative of above
– dP/dQ = 10 + 20Q – 3Q2 = 0
 Q = 7.1 ≈ 7
– d2P/dQ2 = 20 – 6Q
at Q=7.1, d2P/dQ2 = 20- 6 x 7 = -22 < 0
– Therefore we have maximum at Q= 7, and
maximum profit, PMax= 10x7 – 10x72 – 73= 217
22
Generalization: Using Marginal Analysis to Find
Optimal Activity Level A*

• If marginal benefit > marginal cost

– Activity should be increased to reach highest net
benefit
• If marginal cost > marginal benefit
– Activity should be decreased to reach highest net
benefit
• Optimal level of activity
– When no further increases in net benefit are possible
– Occurs when MB = MC

23
Generalization: Using Marginal Analysis to Find
Optimal Activity Level A*

• If marginal benefit > marginal cost

– Activity should be increased to reach highest net
benefit
• If marginal cost > marginal benefit
– Activity should be decreased to reach highest net
benefit
• Optimal level of activity
– When no further increases in net benefit are possible
– Occurs when MB = MC

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Constraints on Optimization
• Resource Constraints – Limited Availability
• Output Quantity and Quality Constraints
• Legal Constraints

• Environment Constraints

25
Constrained Optimization: Equi-
marginal Principle

• The ratio MB/P represents the additional

benefit per additional Re spent on the activity

• Ratios of marginal benefits to prices of

various activities are used to allocate a fixed

amount of fund among activities

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Constrained Optimization: Equi-
marginal Principle

• The ratio MB/P represents the additional

benefit per additional Re spent on the activity

• Ratios of marginal benefits to prices of

various activities are used to allocate a fixed

amount of fund among activities

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Constrained Optimization: Equi-marginal
Principle
• To maximize or minimize an objective function
subject to a constraint
– Ratios of the marginal benefit to price must be equal
for all activities

MBA MBB MBZ

  ... 
PA PB PZ

– Constraint must be met

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Constrained Maximization: An Example
• Suppose that a firm’s production function is by Q =
KL2 and the costs are given by C = wL + rK, where K =
capital, L = labor and w and r their per-unit costs.
a) Suppose that w = Rs.40, r = Rs.10 and that the
desires to produce 2000 units of output. How
much capital and labor should be used, if the
firm wants to produce at minimum cost?
b) Suppose now that instead of having the objective
of producing 2000 units the firm decides to
produce with a total cost budget of Rs.1800.
How much capital and labor should be used to
maximize output?
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Solution: Constrained Maximization Example

a) Objective Function
– Minimize C = wL + rK
Subject to Q = KL2 = 2000
• Since Q = KL2
– MPL = dQ/dL = 2KL and MPK = dQ/dK = L2
• Cost will be minimum
– when MPL/w = MPK/r  MPL/MPK=w/r …(1)
– MPL/MPK= 2KL/ L2 =2K/L & w/r = 40/10 =4
– Putting into eq. (1), we get 2K/L = 4
i.e. K = 2L
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Solution: Constrained Maximization Example
(Contd.)
– Therefore Q = KL2 = 2L L2 = 2L3
– Since Q = 2000, therefore 2000 = 2L3
Or, L3 = 1000 => L =10
– Now, K = 2L = 2 x 10 = 20
• Optimal combination is 20 units of K and 10
units of L.
(The least cost C = wL + rK = 40x10 + 10x20 =
600 i.e. Rs. 600)

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Solution: Constrained Maximization
Example (Contd.)
b) Objective Function:
Maximize output Q = KL2
Subject to C = wL + rK = 1800
• As in (a), the condition for maximizing output
MPL/w = MPK/r yields K = 2L
• Putting K=2L, w= 40 and r =10 in cost constraint,
– wL + r 2L = 1800
– 40L + 10 x 2L =1800
– L = 1800/60 = 30
– And therefore K = 2L = 2 x 30 = 60

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Solution: Constrained Maximization
Example (Contd.)

• Optimal combination is K=60 units and L=

30 units.
(Maximum output, Qmax = KL2 = 60 x 302 =
54000 units)

33
Problem Set #1: (DUE Wed, July 15th)
1. Find the derivatives of:
a. Y = X
b. Y = 100
c. Y = 1/X2
d. Y = 2X + 3X2
e. Y = LogX/3X2
2. Profit (P)= -25 + 75Q - 5Q2
a. Compute the optimal profit maximizing output rate
b. Demonstrate that you have found a maximum (not a
minimum)
c. Calculate the total profit at the profit maximizing output

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