Managerial Economics Chapter Three

CHAPTER THREE OPTIMIZATION TECHNIQUES

1. INTRODUCTION
In this chapter, we present methods for maximizing or minimizing the objective function
of a firm or other organizations. The first step in presenting optimization techniques is to
examine ways to express economic relationships (functional relationships and economic
models). The concept of derivative and the rules of differentiation, and their application
in finding optimal solution to firm’s optimization problem (unconstrained or constrained)
is analyzed here.
1.2. OPTIMIZATION ANALYSIS
Optimization (Maximization and Minimization) refers to finding the best way to allocate
resources given an objective function. For example, given the firm’s objective of
maximizing profits (Total Revenue – Total Cost), we determine how much output should
be produced.

DIFFERENTIAL CALCULUS: THE DERIVATIVE AND RULES OF DIFFERENTIATION

Optimization analysis can be conducted more efficiently and precisely with differential calculus, which
relies on the concept of the derivative.
1.3. THE CONCEPT OF THE DERIVATIVE
Suppose we have a function y = f(x) the first derivative of the function with respect to x
(denoted as dx/dy) is given by the change in y over the change in x, as the change in x
approaches zero.

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1.4. RULES OF DIFFERENTIATION

Differentiation is the process of determining the derivative of a function, i.e., finding the
change in y for a change in x, when the change in x approaches zero.
 Rule 1: Constant Function Rule

Note that the value of y is constant, and it does not change for any value of x.
 Rule 2: Power - Function Rule

 Rule 3: Sums and Difference Rule

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 Rule 4: Product Rule

 Rule 5: Quotient Rule

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 Rule 6: Chain Rule

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Summary of Rules for Differentiating Functions

1.5. USE OF CALCULUS IN OPTIMIZATION

Here the point at which a function is maximum or minimum is determined. We then show
how to distinguish between a maximum and a minimum. Optimization often requires

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finding the maximum or the minimum value of a function (e.g., maximum profit,
maximum revenue, or minimum cost).
1.6. UNCONSTRAINED OPTIMIZATION
1). First-Order Condition:
When a function is at maximum or minimum, the first derivative (dx/dy) equals to zero.
This is a necessary condition for a maximum or minimum, but it is not a sufficient condition
to determine if the function is at a minimum or a maximum.
2). Second-Order Condition:
The test for a maximum or a minimum using the second derivative is called the second
order condition. The first and second - order conditions together are sufficient to test for
either a maximum or a minimum point.

Example: 1

Find the level of output, Q, that maximize profit (Π)

Solution

Where the profit function is at maximum, first-order-condition

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Second-order condition for maximum:

Since the second derivative of the profit function is -2, we conclude that the profit is
maximized at Q = 8.
Example: 2

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Using quadratic formula: ax2 + bx + c = 0

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1.7. CONSTRAINED OPTIMIZATION

Unfortunately, most decision problems managers faced are not of the unconstrained
variety just discussed. The manager often is required to maximize some objective function
subject to one or more side constraints. A production manager, for example, may be
required to maximize the total output of a given commodity subject to a given budget
constraint and fixed prices of factors of production. Alternatively, the manager might be
required to minimize the total costs of producing some specified level of output. The cost
minimization problem might be written as:

There are generally two methods of solving constrained optimization problems:

1. The substitution method
2. The Lagrange multiplier method

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1. SUBSTITUTION METHOD

The substitution method involves first solving the constraint, say for x, and substituting
the result into the original objective function. Consider, again, the foregoing example.
Example:
The total cost function of a firm that produces its product on two assembly lines is given
as

Solution:

In other words, this problem reduces to one of solving for one decision variable, y, and
inserting the solution into the objective function. Taking the first derivative of the objective
function with respect to y and setting the result equal to zero, we get

Note also that the second-order condition for total cost minimization is also satisfied:

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Substituting y = 7 into the constraint yields

Finally, substituting the values of x and y into the original TC function Yields:

2. LAGRANGE MULTIPLIER METHOD

Sometimes the substitution method may not be feasible because of more than one side
constraint, or because the objective function or side constraints are too complex for
efficient solution. Here, the Lagrange Multiplier Method can be used, which directly
combines the objective function with the side constraint(s).
The first step in applying the Lagrange multiplier technique is to first bring all terms to the
right side of the equation.

With this, we can now form a new objective function called the Lagrange function, which
will be used in subsequent chapters to find solution values to constrained optimization:

Note that this expression is equal to the original objective function, since all we have done
is add zero to it. That is, L always equals f for values of x and y that satisfy g. To solve for

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optimal values of x and y, we now take the first partials of this more complicated
expression with respect to three unknowns x, y, and . The first-order conditions therefore
become:

Note that the values for x and y are the same as those obtained using the substitution
method. The Lagrange multiplier technique is more powerful, however, because we are
also able to solve for the Lagrange multiplier, . What is the interpretation of ?
It can be demonstrated that the Lagrange multiplier is defined as

That is, the Lagrange multiplier is the marginal change in the maximum value of the
objective function with respect to parametric changes in the value of the constraint. In the
context of the present example, = -71 says that if we relax our production constraint by,
say, one unit of output (i.e., if we reduce output from 20 units to 19 units), our total cost
of production will decline by 71 Birr. It is important to note that because marginal cost is
a nonlinear function, the value of  may be interpreted only in the neighborhood of Q =
20. In other words, the value of  will vary at different output levels.

Example 1
A profit-maximizing firm faces the following constrained maximization problem:

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Determine profit-maximizing output levels of commodities x and y subject to the condition

that total output equals 12 units.

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Example 2
Cost minimization

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Example 3

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