Managerial

Economics
Principles and Worldwide
Applications, 7th Edition

Dominick Salvatore
&
Ravikesh Srivastava
 Chapter 2:
Optimization Techniques
and New
Management Tools
 Optimization Techniques
 Methods for maximizing or minimizing an
objective function
 Examples
 Consumers maximize utility by purchasing an
optimal combination of goods
 Firms maximize profit by producing and selling an
optimal quantity of goods
 Firms minimize their cost of production by using an
optimal combination of inputs
 Expressing Economic
Relationships

Equations: TR = 100Q - 10Q2

250

200

Graphs: 150

100

50

0
0 1 2 3 4 5 6 7

Q
 Total, Average, and Marginal
Revenue
TR = PQ Q TR AR MR
0 0 - -
AR = TR/Q 1 90 90 90
MR = TR/Q 2 160 80 70
3 210 70 50
4 240 60 30
5 250 50 10
6 240 40 -10
 TR
300

250

200
Total Revenue
150

100

50

0
0 1 2 3 4 5 6 7

AR, MR
120

100
Average and 80

Marginal Revenue 60

40

20

0
0 1 2 3 4 5 6 7
-20

-40

Q
 Total, Average, and
Marginal Cost
Q TC AC MC
0 20 - -
AC = TC/Q 1 140 140 120
2 160 80 20
MC = TC/Q 3 180 60 20
4 240 60 60
5 480 96 240
Geometric Relationships
 The slope of a tangent to a total curve at
a point is equal to the marginal value at
that point
 The slope of a ray from the origin to a
point on a total curve is equal to the
average value at that point
Geometric Relationships
A marginal value is positive, zero, and
negative, respectively, when a total curve
slopes upward, is horizontal, and slopes
downward
 A marginal value is above, equal to, and
below an average value, respectively,
when the slope of the average curve is
positive, zero, and negative
Profit Maximization
Q TR TC Profit
0 0 20 -20
1 90 140 -50
2 160 160 0
3 210 180 30
4 240 240 0
5 250 480 -230
Steps in Optimization
 Define an objective mathematically as a
function of one or more choice variables
 Define one or more constraints on the values of
the objective function and/or the choice
variables
 Determine the values of the choice variables
that maximize or minimize the objective function
while satisfying all of the constraints
New Management Tools
 Benchmarking
 TotalQuality Management
 Reengineering
 The Learning Organization
Other Management Tools
 Broadbanding
 DirectBusiness Model
 Networking
 Performance Management
Other Management Tools
 Pricing Power
 Small-World Model
 Strategic Development
 Virtual Integration
 Virtual Management
Chapter 2

Appendix
Concept of the 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
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

dY
0
dX
Rules of Differentiation
Power Function Rule: The derivative of a
power function, where a and b are
constants, is defined as follows.

Y  f (X )  aX b

dY
 b  a X b 1
dX
 Rules of Differentiation
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

dY dU dV
 
dX dX dX
Rules of Differentiation
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

dY dV dU
U V
dX dX dX
Rules of Differentiation
Quotient Rule: The derivative of the ratio
of two functions, U and V, is defined as
follows.
U
U  g(X ) V  h( X ) Y
V

dY


V dU
dX  
 U dV
dX 
2
dX V
 Rules of Differentiation
Chain Rule: The derivative of a function that is
a function of X is defined as follows.

Y  f (U ) U  g(X )

dY dY dU
 
dX dU dX
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.
Univariate Optimization
Given objective function Y = f(X)
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.
Example 1
 Given the following total revenue (TR)
function, determine the quantity of output
(Q) that will maximize total revenue:
 TR = 100Q – 10Q2
 dTR/dQ = 100 – 20Q = 0
 Q* = 5 and d2TR/dQ2 = -20 < 0
Example 2
 Given the following total revenue (TR)
function, determine the quantity of output
(Q) that will maximize total revenue:
 TR = 45Q – 0.5Q2
 dTR/dQ = 45 – Q = 0
 Q* = 45 and d2TR/dQ2 = -1 < 0
Example 3
 Given the following marginal cost function
(MC), determine the quantity of output
that will minimize MC:
 MC = 3Q2 – 16Q + 57
 dMC/dQ = 6Q - 16 = 0
 Q* = 2.67 and d2MC/dQ2 = 6 > 0
Example 4
 Given
 TR = 45Q – 0.5Q2
 TC = Q3 – 8Q2 + 57Q + 2
 Determine Q that maximizes profit (π):
 π = 45Q – 0.5Q2 – (Q3 – 8Q2 + 57Q + 2)
Example 4: Solution
 Method 1
 dπ/dQ = 45 – Q - 3Q2 + 16Q – 57 = 0
 -12 + 15Q - 3Q2 = 0
 Method 2
 MR = dTR/dQ = 45 – Q
 MC = dTC/dQ = 3Q2 - 16Q + 57
 Set MR = MC: 45 – Q = 3Q2 - 16Q + 57
 Use quadratic formula: Q* = 4
Quadratic Formula
 Write the equation in the following form:
aX2 + bX + c = 0
 The solutions have the following form:

 b  b  4ac 2

2a
Multivariate Optimization
 Objective function Y = f(X1, X2, ...,Xk)
 Find all Xi such that ∂Y/∂Xi = 0
 Partial derivative:
 ∂Y/∂Xi = dY/dXi while all Xj (where j ≠ i) are
held constant
Example 5
 Determinethe values of X and Y that
maximize the following profit function:
 π = 80X – 2X2 – XY – 3Y2 + 100Y
 Solution
 ∂π/∂X = 80 – 4X – Y = 0
 ∂π/∂Y = -X – 6Y + 100 = 0
 Solve simultaneously
 X = 16.52 and Y = 13.92
Constrained Optimization
 Substitution Method
 Substitute constraints into the objective
function and then maximize the objective
function
 Lagrangian Method
 Form the Lagrangian function by adding
the Lagrangian variables and constraints to
the objective function and then maximize
the Lagrangian function
Example 6
 Usethe substitution method to maximize
the following profit function:
 π = 80X – 2X2 – XY – 3Y2 + 100Y
 Subject to the following constraint:
 X + Y = 12
Example 6: Solution
 Substitute X = 12 – Y into profit:
 π = 80(12 – Y) – 2(12 – Y)2 – (12 – Y)Y – 3Y2 + 100Y
 π = – 4Y2 + 56Y + 672
 Solve as univariate function:
 dπ/dY = – 8Y + 56 = 0
 Y = 7 and X = 5
Example 7
 Usethe Lagrangian method to maximize
the following profit function:
 π = 80X – 2X2 – XY – 3Y2 + 100Y
 Subject to the following constraint:
 X + Y = 12
Example 7: Solution
 Form the Lagrangian function
 L = 80X – 2X2 – XY – 3Y2 + 100Y + (X + Y –
12)
 Find the partial derivatives and solve
simultaneously
 dL/dX = 80 – 4X –Y +  = 0
 dL/dY = – X – 6Y + 100 +  = 0
 dL/d = X + Y – 12 = 0
 Solution: X = 5, Y = 7, and  = -53
 Interpretation of the
Lagrangian Multiplier, 
 Lambda, , is the derivative of the optimal value
of the objective function with respect to the
constraint
 In Example 7,  = -53, so a one-unit increase in the
value of the constraint (from -12 to -11) will cause
profit to decrease by approximately 53 units
 Actual decrease is 66.5 units