Basic Optimization Training

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 Mathematical Methods for Economics
 Optimization techniques is the most important mathematical
tool that a decision maker must understand well.
 As was discussed in the last session, every economic agent
maximizes (or minimizes) his objective function. For example,
 a firm maximizes its profits
 a consumer maximizes his utility Price per No. of units
 The objective function in the first case is unit sold

the profit function and in the second case 10 60

it is the utility function. An objective 20 40

function is nothing but a relationship 30 20

between two or more variables. 40 0

 Frequently, the relationship between two or more

economic variables can be represented by a
table or a graph.
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  An alternative way, (perhaps a better way!) of expressing
economic relationships is through the use of functions.
Example: The relationship between the number of ice-creams
sold by Magnum and the price charged by the company can
be expressed by using the following functional notation: Q
= f (P), where Q is the number of ice-creams sold and P is
the price of an ice-cream.
Here the number of ice-creams sold is the dependent
variable and price is the independent variable. We say that
the number of ice-cream sold is a function of price.
A specific representation: Q= 100- 4P

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 Average and Marginal
 The average value of a variable with respect to some measure is
the total value of the variable divided by the total quantity of the
measure.
 The marginal value of a dependent variable is defined as the
change in this dependent variable associated with a one-unit
change in a particular independent variable.
Example: Consider the profit function of a firm. Then the
dependent variable is the total profit of the firm and the
independent variable is the number of units of output produced.
-The average profit of the firm is the profit per unit of output
and its marginal profit is the change in total profit associated
with one- unit change in output.
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 Relationship between Total, Average and
Marginal Values
 Although the total profit increases till 5
units of output, both the marginal and No. of Total Margin Avera
average profit keeps going down with units of Profit al ge
each additional unit of output after 3 output Profit Profit
units of output.
0 0 - -
 But so long as marginal profit is
positive, the firm can raise its total 1 50 50 50
profit by increasing output.
2 110 60 55
 When marginal profit shifts from
positive to negative, total profit will fall 3 190 80 63.33
and not go up with further increase in
output. 4 240 50 60
 The central point to bear in mind about
5 260 20 52
a marginal relationship of this sort is
that the dependent variable – in this 6 250 -10 41.67
case, total profit – is maximized when
its marginal value shifts from positive to 7 200 -50 28.57
negative.
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 Relationship between Total, Average and
Marginal Values
 Because the marginal value represents the change in the total, the
average value must increase if the marginal value is greater than the
average value; by the same token, the average value must decrease if the
marginal value is less than the average value.
 The table in the previous slide also illustrates this relationship. For the
2nd to 3rd unit of output, the marginal profit of 80 is greater than the
average profit of 55 at two units; therefore, average profit increases to
63.33. On the other hand, the marginal profit of the 5th unit is below
the average profit at 4 units, causing average profit to fall. Since extra
profit from each additional unit is less than the average for the 3rd to 7th
unit, the average is pulled down as more is produced.
 The same relationship can be explored graphically as shown in the
following figure. It is quite simple to graphically derive the relationship
between average profit, marginal profit and total output from the
relationship between total profit and total output.

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 Relationship between Total, Average and
Marginal Values
 Take any output level, say Q0. At this output
the average profit equals the slope of the
straight line OE where E is the point on the
total profit curve corresponding to the
output level Q0.
 This slope is plotted on the y-axis of the
panel B (equals K0 when the output is Q0)
giving a point, H, on the average profit
curve. Repeating this procedure for all
output levels we obtain the average profit
curve.
 To derive the relationship between marginal
profit and output, take any output level, say
Q1. At this output level the marginal profit
equals the slope of the tangent to the total
profit curve (shown in panel A) at the point
G. (Why?)

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 Relationship between Total, Average and
Marginal Values
 This slope is plotted on the y-axis of the panel B and repeating this
procedure for each output level we obtain the marginal profit curve.
 In a similar way, total profit curve can also be obtained from the average
profit curve.
 To derive the total profit curve from the average profit curve, note that
total profit equals average profit times total output. Thus, at output level
Q0, for example, total profit= K0 times Q0 which is the area of the
rectangle OQ0HK0. Repeating the procedure for all output level yields
the total profit curve.
 Marginal profit curve is upward sloping till that output level (Q3) where
the slope of the total profit curve is increasing as output increases. When
the slope of the total profit curve is decreasing as output increases, the
marginal profit decreases and hence the marginal profit curve is
downward sloping.
 The average profit curve must be rising if it is below the marginal profit
curve, and it must be falling if it is above the marginal profit curve.

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 The Concept of a Derivative
 In the last few slides we used a table or a graph to find out the
level of output at which profit will be maximized. But often they
are not very convenient means.
 Instead, by using the functional representation of the relationship
one can employ concepts of differential calculus to find optimal
solutions to the decision maker’s problem.
 Recall, we defined marginal value of a dependent variable as the
change in this dependent variable resulting from a one-unit change
in a particular independent variable.
 Consider a function of the form Y=f(X). Using ∆ to denote
change, a change in the independent variable can be expressed as
∆X and a change in the dependent variable can be expressed as
∆Y.
 Thus marginal value of Y can be denoted by ∆Y/∆X.

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  For example, if a 4 unit increase in the value of X results in a 1
unit decrease in the value of Y, then ∆X=4 and ∆Y=-1. Therefore,
marginal value of Y is -1/4. Thus we can say that Y increases by
about ¼ unit if X decreases by 1 unit.
 The value of ∆Y/∆X need not be constant throughout the domain
of a function.
 The value of ∆Y/∆X depends on the steepness or flatness of the
curve representing a function.
 If the curve is relatively steep at some region then ∆Y/∆X will be
high because a small change in X results in a large change in Y
between any two points in that region. On the other hand,
∆Y/∆X will be lower for the region where it is flatter because
even a large change in X produces small change in the value of Y.

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 An Illustration:
 If a movement occurs from point G
to point H, a relatively small change
in X (from X1 to X2 ) causes a big
change in Y (from Y1 to Y2 ). Thus
between H and G, the value of
∆Y/∆X =(Y2- Y1 )/(X2-X1 )
is relatively large.
 If on the other hand, movement
occurs from point K to point L, a
relatively small change in X (from
X3 to X4 ) causes a big change in Y
(from Y3 to Y4 ). Thus between K
and L, the value of
∆Y/∆X =(Y4- Y3 )/(X4-X3 )
is relatively large.
Quick thinking: Can you think of
any function which will give a
constant ∆Y/∆X?

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 Derivative as slope
 The derivative of Y with respect to X is defined as the limit
of ∆Y/∆X as ∆X approaches zero. It is denoted by dY/dX.
Hence,
dY/dX= lim ΔX 0 ∆Y/∆X.
 Loosely, ∆X approaches zero refers to a change in X as small as
possible.
 Graphically, the derivative of Y w.r.t X equals the slope of
the curve showing Y (on the vertical axis) as a function of X
(on the horizontal axis).
 This will be illustrated in the following graph.

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  A rough measure of the derivative of Y
w.r.t X when X=X5 can be taken as
∆Y/∆X between points A and C which is
the slope of the line segment (chord) AC is
(Y7-Y6)/(X7-X6).
 A better measure is the slope of the line
AB which is equal to (Y6-Y5)/(X6- X5).
 The second measure is better precisely
because ∆X is much smaller in this case.
(After all we want ∆X to be as small as
possible!)
 In the limit, as ∆X approaches zero, the
ratio ∆Y/∆X is equal to the slope of the
line M, which just touches the curve at A
(and is called the tangent to the curve at
A).
 Thus, at the point X5 the derivative of Y
w.r.t X equals the slope of line M, the
tangent to the curve at point A.
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 Rules of derivative
 Constant Functions: If Y=c, where c is a constant, dY/dX= 0.
Eg.Y=100 dY/dX =0.
 Power Functions: If Y= aXb where a and b are constants, dY/dX= baXb-1.
Eg.Y= 4x2 dY/dX= 8x.
 Sum of two functions: If Z and W are two variables which are both functions of
X, i.e., Z= f(X) and W= g(X) and Y is another variable which is defined as Y=
aZ+ bW where a and b are constants, then
dY/dX= a dZ/dX+ b dW/dX. Eg.Y= 6x4+ 4x2 dY/dX= 24x3+8x
 Products of two functions: If Z and W are two variables which are both
functions of X, i.e., Z= f(X) and W= g(X) and U is another variable which is
defined as U= aZW, then dU/dX= aW dZ/dX+ aZ dW/dX.
Eg.Y= 5x2(x-3) dY/dX= 10x(x-3)+ 5x2 = 15x3- 30x.
 Quotient of two functions: If Z and W are two variables which are both
functions of X, i.e., Z= f(X) and W= g(X) and V is another variable which is
defined as V= Z/W, then dV/dX= (WdZ/dX- ZdW/dX)/ W2.
Eg.Y= 3x/2-x3 dY/dX= 3(2-x3)- 3x(-3x2)\ (2-x3)2= 6(1+ x3)/(2- x3)2.

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 Derivative in Economics: An example
 Chain Rule (Derivative of a function of a function): If Y=f(W) and
W= g(X), then dY/dX= (dY/dW)(dW/dX).
Eg.Y= 3w2+ 5w, w= 2x dY/dX= [6(2x) + 5][2]= 24x+ 10.
Example: Suppose the profit function of a firm is given by
π= -50+ 100Q -5Q2 where π denotes the profit (in millions of
dollars) and Q denotes the output (in millions of units). Since
marginal profit equals the slope of the tangent to the total profit
curve, the marginal profit function, Mπ, is given by the function
dπ/dQ. So here the marginal profit function is given by
Mπ =100-10Q.
 Recall that the objective of the firms is to maximize profits and the
decision variable is output/ level of production. Since the profit
function shows the relationship between the manager’s decision
variable (Q) and his objective (), we call it the objective function
of the firm. Therefore, firms would want to find a point on the
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total profit curve at which it will attain its maximum.
 Optimization problems and Derivatives
 The central point to recognize is that an optimum
(maximum or minimum) point can occur only if the slope of
the curve showing Y on the vertical axis and X on the
horizontal axis at that point, i.e., the derivative at that
point, equals zero.
 Therefore, in case of profit maximization, to find the
profit maximizing output level we first find out at what
level of output, dπ/dQ=0, i.e., the point at which
marginal profit equals zero.
 In our example, we set 100- 10Q= 0 which gives Q=
10.
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  But is the profit maximized or minimized at Q=10?
 To distinguish between a maximum and a minimum, one
must find the second order derivative of the function, d2
π/dQ2 .
 If d2 π/dQ2 < 0 at the optimum then it is in fact a
maximum and if d2 π/dQ2 > 0, then it is a minimum.
 In our example, d2 π/dQ2 = -10. Hence we can say that
profit is indeed maximized if 10 million units of output
is being produced.

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 Profit maximization: Some more
examples
 Some objective functions may be such that both maximum
and minimum points exist.
Example: Suppose the profit function of a firm is given by
π= 6Q2-(1/3) Q3-20Q+10.
 To find the values of output at which profit is maximized or
minimized, we first set dπ/dQ=0 which gives us Q=2,10.
 To determine which of these output levels maximizes or
minimizes profit, we find the second derivative, d2 π/dQ2, at
these two values of Q. At Q=2, d2 π/dQ2 = 8 and at Q=10,
d2 π/dQ2 =-8. Hence we conclude that profit is maximized
at Q=10 and minimized at Q=2.

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