JOINT OPTIMIZATION

Traditionally, the firm’s focus has been only on production and marketing only helped in
generating the sale for profits without observing it’s after effects i.e. quality, availability,
advertising etc. of the product, whereas in today’s scenario generating only sales will not help
the firm if they ignore the factors like quality, availability, advertising etc. which are very
much within the firm’s area of control for more profits. Thus, in today’s market situation a
firm must make specific decisions with respect to price (p), advertising budget or promotional
efforts (s), quality index (x), availability or distribution (a) and the quality produced.

Further, expenditure on promotional efforts is constant and does not depend upon the amount
produced but expenditure in improving the quality is dependent on cost. Moreover,
expenditure in improving the quality is long term one whereas in promotional efforts it’s a
short term. Therefore, for short term profits better promotional efforts are required whereas to
get long term profits quality improvement is necessary. It is further assumed that price and
quality are independent in the sense that if quality of the product is improved by an extra
burden and price is kept unchanged then cost of the product is to increase, which means profit
per unit decreases, but the total profit is going to be more as with the better quality, overall
sales are to increase. Hence, the price and quality can be treated as independent variables.
Further, as cost of the product is directly proportional to the quality; they can be treated as
dependent variables.

Assume a firm that faces general marketing demand function D as:-

D  f ( p, s, a, x) (1)

and unit cost of the firm is a function of level of production or demand and quality of the
product, i.e.

C  g ( f ( p, s, a, x), x) (2)

Therefore, the cost of D units = C.D

= g ( f ( p, s, a, x), x). f ( p, s, a, x) (3)

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Hence, firm’s cost function

Cˆ  C.D  s  a  fixed cos ts ( F ) (4)

Here, advertising and availability are treated as discretionary fixed cost and F represents the
sum of non-discretionary fixed costs.
If p is the selling price of the product; then the next profit function, P, is given by:
P = Revenue – Total Costs
= p. f ( p, x, a, s)  g ( f ( p, x, a, s). f ( p, x, a, s))  s  a  f 1 (5)

The firm’s objective is to have a joint optimization of p, s, x and a , so as to maximize its

total profit. The necessary conditions for joint optimization of these variables are:-

P f f g f
 f ( p, a, x, s)  p  g ( f ( p, a, x, s)  f . 0
p p p f p

P f f g f
  g ( f , x)  1* .  1  0
s s s f s (6)

P f f g f
 p  g ( f , x)  f * .  1  0
a a a f a

P f f  g f g 
 p  g ( f , x)  f  .    0
x x x  f a x 

Solving equations, we get

g
f
 f x  0
1 1
  (7)
P f f f
p s a x

In order to interpret (7), we need to define the following:

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 f
f  p f
Ordinary price elasticity of demand =  =  . (8)
p f p
p
Elasticity of demand w.r.t. change in quality =  x

f
x f
 . x
f g
x  (9)
g f g
x x
g
Marginal revenue w.r.t. change in advertising = 

R ( p. f ( p, a, s, x)) f
  p (10)
s s s

Marginal revenue w.r.t. distribution/availability = 

( p. f ( p, a, s, x)) f
 p (11)
a a
Using these in equation (7), we get
p p p g
  
   x
p
      x (12)
g
The above necessary condition for profit maximization states that value of price, advertising,
distribution and product quality must be set at such a level that price elasticity, marginal
revenue w.r.t. quality are equal. This theorem is known as the Dorfman-Steiner theorem
which does not give the optimal values of these variables rather gives the condition that must
be satisfied when the optimal values are found.

Optimal Advertising:
If the price which a firm can charge is predetermined for a product of a given quality and if
the firm can influence its demand curve by advertising in order to maximize its profit should
choose its advertising budget in such a way, so that _________

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Further, Dorfman and Steiner made the following interesting observations which may be
taken a note of. If    it will be profitable to increase both s and p until equality is once
more restored. However, in the later case if s were originally zero, then clearly we could not
decrease both s and p, nor would there be any point to a decrease in p alone, since we are still
assuming that quantity is constant. Thus, we need the two equilibrium conditions, namely,
   if s  0 and    if s  0 is always guaranteed that changes in s and p will reach an
equilibrium in  and  , since  declines (after a point) as s increases and will ultimately
reaches zero (or less), whereas a maximum profit price cannot occur unless   1 for if   1 ,
marginal revenue is negative and presumably production costs never are. Thus,  will
always be either below  (as in Figure A) or will be equal to  at least one point (as in
Figure B and C)
 * , *

The theorem also helps rationalize in clearer fashion than the general marginalist principal,
the degree of advertising expenditure in the various market types which economists
emphasize. For example, impure competition elasticity of demand facing each firm is infinite,
hence    for all levels of s and thus the optimal situation is one involving s  0.

 1
Marginal Cost (M.C.) = p 1  
 
Since, price and quality are assumed to be fixed, the only variable which can affect the
demand is advertising budget
 D  f s (13)

And unit cost= C= g  f  s   (14)

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If p is the selling price of the product then the net profit, P , is
P  p.D  C.D  s  F
 p. f  s   g  f  s   . f  s   s  F
(15)

The necessary condition for the maximization of profit w.r.t ' s ' is
P f g f f
 0  p.  . . f  g.  1  0
s s f s s
1 g (16)
 p  .f  g
f f
s
Marginal Cost is defined as change in total cost of units due to change in demand.

M .C. 

 g  f  s . f  s    g . f  g (17)
f f
Using equation (17) and (10) in (16), we get
p
p  M .C

 1
 M .C  p 1  
 
which is the equilibrium condition.
Further,
p 1 1
   (18)
p  M .C p  M .C Mark up
p

 p  MC 
where  p  MC  is the profit on marginal units and   is the profit on marginal units
 p 
taken as the fraction of unit selling price, which is also termed as marginal units.

Optimal Quality

In this section firm wants to know the optimal level of quality to maximize its profit keeping
the price and advertising budget at constant level.
Here, demand is going to be function of quality index x , only as
D  f  x (19)
And unit cost C , will be the function of level of production/demand and the quality of the
product i.e.
C  g  f  x , x (20)
Therefore, profit function P is given by
P  p.D  C.D  F
 p. f  x   g.  f  x  , x  f  x   F
(21)

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In order to maximize the profit, the necessary condition is
p f  g f g  f
 0  p   .   f  g  f  x  , x .
x x  f x x  x

g
g
 pg f  f x (22)
f f
x
Using equation (9) and (17), equation (22) reduces to
g
p  M .C 
x
1 1 1
 x   
p  M .C p  M .C Markup
g C
 p  M .C 
Where   is the profit on marginal units taken as the fraction of unit cost, which is a
 C 
other form of mark-up on marginal units.