Optimising profit and revenue: Mathematical

principles to maximise revenue.

Words: 1997
Introduction

The idea for this internal assessment came from my interest in economics and economic
systems. While avoiding having my internal assessment become one of economics but still
incorporating it, I decided to use what mathematical principles I have learnt to solve a
problem relating to an economic system. It was with this idea in mind, that I came to this
investigation, which would make use of these ideas in order to optimise and maximise profit
and revenue.

In this investigation, I will be applying principles such as differentiation and integration in a

real-world context to demonstrate the role of calculus in determining the mathematics
involved in the economics of a business. To further explore this topic and the use of these
mathematical principles, I will be taking elasticity into account in this internal assessment.
This will all allow me to develop, interpret and analyse a profit function derived from costs,
pricing and demand.

The aim of this investigation will be to:

● Make use of the concept of elasticity of demand to understand the relationship
between price, quantity and revenue.
● Provide meaningful insight that a business could realistically use in determining
pricing or production decisions.
● Improve the investigation against the backdrop of a realistic scenario through the
introduction of a non-linear model.
● Maximise theoretical profit based on calculus-based optimisation.

Creating the revenue, cost and profit functions

Revenue function

R(x) = px
In which:
R represents the revenue as a product of the quantity sold
p represents price
x represents quantity

To add a further level of realism to this, I will use a demand function to describe the
relationship between price p and quantity x:

p = a - bx

In this, a and b are constants that depend on consumer patterns. As such the revenue function
can be simplified as follows:
R(x) = (a - b · x)x
R = bx2 · ax

This creates a quadratic function that will be useful later.

Cost function

Assuming that the cost function is based on fixed and variable prices.

C(x) = F + vx

In which:
C represents the cost
F represents the fixed cost
v represents the variable prices.

Profit function

P(x) = R - C
P(x) = (ax · bx2) - (F + vx)
 P(x) = -bx2+x(a-v) - F

In which:
P represents the price

This function forms another quadratic equation, to be used in further calculations.

Differentiation to find Critical Points

Through the use of more advanced mathematics, starting with simple differentiation, I can
find critical points related to the above functions such as maximum points for the profit and
revenue and the minimum points of the cost. Thus, the use of differentiation can be used to
optimise the functions as they relate to maximising revenue.

Revenue maximisation

R’(x) = 2b(x) - a

Setting R’(x) to 0 to find the maximum:

0 = 2b(x) - a
𝑎
x= 2𝑏

Profit maximisation

The same process of differentiation that was applied to find the critical point and thus
maximum of the revenue can be applied to find the maximum profit:
 P’(x) = (a-v) - 2bx

Setting P’(x) to 0 once again allows me to determine the maximum profit:

(a-v) - 2bx = 0
- 2bx = v-a
𝑎−𝑣
x= 2𝑏

These values are thus considered to be the theoretical maximum value.

Second derivative

To confirm the above derivations, I differentiate R’(x) and P’(x) again to obtain the second
derivatives of each:

𝑎
R’’(x) = -2b — since -2b > 0, R’’x < 0 confirms that x = 2𝑏
is the maximum value for

revenue.
𝑎−𝑣
P’’(x) = -2b — similarly to revenue, confirming that x = 2𝑏
is a maximum for profit if b >

0.

Elasticity of demand

The previously discussed functions do, however, fail to take elasticity of demand into
account. This value represents the change in demand of a product in how sensitive the change
in demand is in relation to the price of the product. By this, the price is inversely proportional
to the demand. Mathematically, price elasticity of demand Ed is given by the following
formula:

𝑑(𝑥) 𝑝
Ed = 𝑑(𝑝)
· 𝑥
 𝑑𝑥
In order to calculate the elasticity, I will need to find 𝑑𝑝
, which is the rate of change of the
𝑑𝑥
quantity in relation to the price. This ( 𝑑𝑝 ) is found by first using the demand function,

rearranging to make x the subject and differentiating the equation:

p = a - bx
𝑎−𝑝
x= 𝑏

𝑑𝑞 1
𝑑𝑝
=-𝑏*

𝑑𝑞 1 𝑎−𝑝
Now, by substituting 𝑑𝑝
= - 𝑏 and x = 𝑏
back into the elasticity of demand equation, I

can solve for and simplify the elasticity of demand:

1 𝑝
Ed = - 𝑏 · 𝑎−𝑝
𝑏

1 𝑝· 𝑏
Ed = - 𝑏 · 𝑎−𝑝

𝑝
Ed = - 𝑎−𝑝

With this formula, it can be determined whether the demand is elastic or not:
If Ed > 1, the demand is elastic and a price increase will have an adverse effect on the
demand.
If Ed < 1, the demand is inelastic and a price increase will increase revenue.
If Ed = 1, the revenue is at a maximum as the percentage change in quantity demanded is
equal to the percentage change in price.

Since revenue is maximised when the unit is elastic (Ed = -1), set Ed to -1 and solve for price
p.

𝑝
-1 = - 𝑎−𝑝
𝑎
p= 2
 𝑎
Therefore, the optimal price that maximises the revenue in this linear demand model is p = 2

𝑎−𝑝
, which corresponds to x = 𝑏
as was found earlier.

Non-linear demand functions

The above work presents the formulae and functions that would apply to the problem as
presented as linear functions. In most cases, this fails to adequately apply to real-life
scenarios and thus a more realistic model must be developed, making use of the non-linear
model:

Exponential demand: p = ae-bx

Where:
a still represents the maximum price when x = 0
e−bx indicates that demand decreases exponentially as quantity 𝑥 increases, which can model
price sensitivity more realistically than a linear demand function.

Profit, Revenue and Elasticity with non-linear demand

For p = ae-bx
The revenue function is:

R(x) = px = ae-bx · x

The profit function is:

P(x) = R(x) - C(x) = ae-bx · x - cx

Non-Linear Revenue maximisation

As non-linear revenue function undergoes differentiation and is set to zero, it can be used to
find the maximum revenue (and thus profit), similarly to as was done with the linear model.

R’(x) = ae-bx - abxe-bx

R’(x) =ae-bx (1-bx)
0 = ae-bx (1-bx)
1 = bx
1
x= 𝑏

1
Substituting x - 𝑏
into the demand function p = ae-bx results in the price p = ae-1 ≈ 0.368a,

the price which would result in the greatest revenue for an exponential demand model.

Elasticity for exponential demand

For p = ae-bx
1 𝑝
x = - 𝑏 In( 𝑎 )

Differentiate x with respect to p using the chain rule, then substitute it into the elasticity
formula to obtain a more complex and realistic elasticity measure:

𝑑𝑥 1 1
𝑑𝑝
=− 𝑏
·𝑝
𝑑𝑥 1
𝑑𝑝
= - 𝑏𝑝

This reveals that the use of exponents changes the elasticity model over different prices.

Integration for total revenue and profit over a range

Integration can be used to calculate the cumulative revenue and/or profit over a range of
quantities, providing financial insight over a range of time.
To find the total revenue of selling X units, R(x) is integrated from 0 to X:

● Linear model:
𝑋 𝑋 𝑥
2 3
2 𝑎𝑥 𝑏𝑥
∫ 𝑅(𝑥)𝑑𝑥 = ∫ (𝑎𝑥 − 𝑏𝑥 )𝑑𝑥 = [ 2
− 3
]
0 0
0
2 3
𝑎𝑥 (𝑏)𝑋
= 2
+ 3

● Non-linear model: Using integration by parts for R(x) = ae-bx · x.

𝑋 𝑥
−𝑏𝑥 −𝑏𝑥
−𝑏𝑥 𝑎𝑒 ·𝑥 𝑎𝑒
∫ (𝑎𝑒 · 𝑥)𝑑𝑥 = [− 𝑏
− 2 ]
0 𝑏
0
−𝑏𝑥 −𝑏𝑥
𝑎𝑒 ·𝑥 𝑎𝑒
= − 𝑏
− 2
𝑏

To find the total profit, the function P(x)=ax−bx2−cx is integrated:

● Linear model:

𝑋 𝑋 𝑥
2 3
2 (𝑎−𝑐)𝑥 𝑏𝑥
∫ 𝑃(𝑥)𝑑𝑥 = ∫ (𝑎𝑥 − 𝑏𝑥 − 𝑐)𝑑𝑥 = [ 2
− 3
]
0 0
0

2 3
(𝑎−𝑐)𝑋 (𝑏)𝑋
= 2
+ 3

● Non-linear model:

𝑋 𝑋 𝑋
−𝑏𝑥 −𝑏𝑥
∫ (𝑎𝑒 · 𝑥 − 𝑐𝑥)𝑑𝑥 = ∫ (𝑎𝑒 · 𝑥)𝑑𝑥 − ∫ 𝑐𝑥 · 𝑑𝑥
0 0 0
−𝑏𝑥 −𝑏𝑥 2
𝑎𝑒 ·𝑥 𝑎𝑒 𝑎 𝑥 ·𝑐
= − 𝑏
− 2 +− 2 − 2
𝑏 𝑏 𝑏
Consumer and Producer Surplus

The consumer surplus (CS) is the amount less that a consumer pays than they are willing to
pay - essentially lost revenue. Similarly, the producer surplus (PS) consists of the surplus
product that exceeds the demand and is thus lost revenue. As such, in seeking to optimise
profit and revenue, the consumer surplus and producer surplus must be ascertained to limit
both as much as possible.

The consumer surplus is the area between the demand curve and the market price line. For a
market price of p0 and demand, CS is:

● Linear model: p = a - bx

𝑥0

CS = ∫(𝑎 − 𝑏𝑥)𝑑𝑥 - p0 x0
0
2
𝑏𝑥0
= ax0 - 2
- p0x0

● Non-linear model: p = ae-bx

𝑥0
−𝑏𝑥
CS = ∫ 𝑎𝑒 𝑑𝑥 - p0 x0
0
−𝑏𝑥0
𝑎(1−𝑒
= 𝑏
- p0 x0

The producer surplus is the area between the supply curve and the market price line. PS is:

● Linear model: supply curve p = d + ex

𝑥0

PS = p0 x0 - ∫(𝑑 − 𝑒𝑥)𝑑𝑥
0
2
𝑒𝑥0
= p0 x0 - dx0 - 2

● Non-linear model: supply curve p = ae-bx

 𝑥0

PS = p0 x0 - ∫(𝑑 + 𝑒𝑥)𝑑𝑥
0

Conclusion and evaluation

Through the use of calculus techniques consisting of derivation, integration, elasticity

analysis and further mathematical principles in this investigation, I have illustrated the
practical uses of mathematics in optimising revenue and profits under linear and non-linear
demand models. The initial linear model provides a basic understanding of the economic
formulae and mathematical principles involved, with the exponential model providing a
closer approximation of real-life demand and therefore application. The use of both models
also allowed me to illustrate the difference between the values of both models in application
with a maximum revenue occurring at a lower price for the exponential model underscoring
the effect of price sensitivity on the demand, particularly in how higher price reductions
won’t proportionally increase demand.

Additionally, the use of integration proves the further use of advanced mathematical
principles. The integration of the revenue and profit functions allowed me to use these
principles to provide an apt measure of the total revenue and profit functions—providing a
cumulative view of the financial performance within a given range for each model. Finally,
the inclusion of consumer surplus and producer surplus for both models added a further
dimension to the investigation, providing a way to measure economic welfare with different
ideas and strategies that might better suit a real scenario. The use of both models in doing this
also highlighted the differences between them, with the non-linear model showing a lower
equilibrium price than the linear model, providing greater consumer surplus and maintaining
a producer surplus, better reflecting real-world demand and supply dynamics.

With these principles, the investigation has demonstrated the accuracy of non-linear
mathematical models in revenue and profit optimization under realistic conditions as well as
providing better economic insight through the surplus calculations. The use of calculus has
highlighted the importance of advanced mathematical tools in making informed decisions on
pricing and production.

Evaluation
Assumptions:
● Linear demand model: While used to introduce the necessary formulae and simpler, it does
not sufficiently portray the complexities of a real-world scenario. As such, this model lacks
accuracy but helped in leading on to the non-linear model.

● Non-linear model: The non-linear model provides a far more accurate assumption of real
world conditions. That being said, real-world demand may vary in a more complex manner
and require more advanced functions for further accuracy.

● Consumer and Producer surplus: The consumer and producer surplus provide further insight
on economic welfare as a further extension to optimise revenue and profits. However, these
surpluses assume that external factors are not taken into account, particularly inflation, market
conditions, regulations, etc. Including these variables would expand the investigation beyond
its original scope.

First draft notes:

- Due to time constraints, I still need to go over the calculations and expand them.
- Descriptions of the steps
- Creation and use of graphs to illustrate work (especially relation to the integrations).
Bibliography:
[To be added after first draft]