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Optimization Techniques
Overview
• Unconstrained & Constrained Optimization
• Calculus of one variable
• Partial Differentiation in Economics
• Appendix to Web Chapter A:
» Lagrangians and Constrained Optimization
• Finding the maximum flying range for
the Stealth Bomber is an optimization
problem.
• Calculus teaches that when the first
derivative is zero, the solution is at an optimum.
• The original Stealth Bomber study showed that a
controversial flying Vwing design optimized the
bomber's range, but the original researchers failed to
find that their solution in fact minimized the range.
• It is critical that managers make decision that
maximize, not minimize, profit potential!
Slide 2
Unconstrained Optimization
• Unconstrained Optimization is a relatively
simple calculus problem that can be
solved using differentiation, such as
finding the quantity that maximizes profit
in the function:
π (Q) = 16∙Q Q2.
• The answer is Q = 8 as we will see.
Where dπ/dQ = 0.
Slide 3
Constrained Optimization
• Constrained Optimization involves one or more
constraints of money, time, capacity, or energy.
• When there are inequality constraints (as when
you must spend less than or equal to your total
income), linear programming can be used.
• Most often, managers know that some
constraints are binding, which means that they
are equality constraints.
» Lagrangian multipliers are used to solve these problems
(which appears in the Appendix to Web Chapter A).
Slide 4
Optimization Format
• Economic problems require tradeoffs forced on
us by the limits of our money, time, and energy.
• Optimization involves an objective function
and one or more constraints , b.
Maximize y = f(x1 , x2 , ..., xn )
Subject to g(x1 , x2 , ..., xn ) < b
or: Minimize y = f(x1 , x2 , ..., xn )
Subject to g(x1 , x2 , ..., xn ) > b
Slide 5
Using Equations
• profit = f(quantity) or Π = f(Q)
» dependent variable & independent variable(s)
» average profit = Π/Q
» marginal profit = ∆Π / ∆Q
• Calculus uses derivatives
» dΠ/dQ = lim ∆Π / ∆Q
∆Q 0
Slide 7
Quick Differentiation Review
• Sum Rule Y = G(X) + H(X) dY/dX = dG/dX + dH/dX
Slide 8
Quick Differentiation Review
• Quotient Rule Y = G(X) / H(X)
dY/dX = (dG/dX)•H - (dH/dX)•G
H2
Y = (5•X) / (5•X2) dY/dX = 5(5•X2) -(10•X)(5•X)
(5•X2)2
= -25X2 / 25•X4 = - X-2
Slide 12
Second Order Condition:
One Variable
• If the second derivative is negative, then
it’s a maximum
• If the second derivative is positive, then it’s
a minimum
Problem 1 Problem 2
●Max Π = 100•Q - Q 2 ●Max Π = 50 + 5•X2
100 -2•Q = 0 10•X = 0
second derivative is: -2 second derivative is: 10
implies Q =50 is a MAX implies Q = 0 is a MIN
Slide 13
Partial Differentiation
• Economic relationships usually involve
several independent variables.
• A partial derivative is like a controlled
experiment -- it holds the “other” variables
constant
• Suppose price is increased, holding the
disposable income of the economy constant
as in Q = f (P, I ), then ∂Q/∂P holds income
constant.
Slide 14
Problem:
• Sales are a function of advertising in
newspapers and magazines ( X, Y)
• Max S = 200X + 100Y -10X2 -20Y2 +20XY
• Differentiate with respect to X and Y and set
equal to zero.
∂S/∂X = 200 - 20X + 20Y= 0
∂S/∂Y = 100 - 40Y + 20X = 0
• solve for X & Y and Sales
Slide 15
Solution: 2 equations & 2 unknowns
• 200 - 20X + 20Y= 0
• 100 - 40Y + 20X = 0
• Adding them, the -20X and +20X cancel, so
we get 300 - 20Y = 0, or Y =15
• Plug into one of them:
200 - 20X + 300 = 0, hence X = 25
• To find Sales, plug into equation:
S = 200X + 100Y -10X2 -20Y2 +20XY =
3,250
Slide 16
International Import Restraints
• Import quotas of Japanese automobiles are
inequality constraints. The added constraint will
affect decisions.
• A Japanese manufacturer will shift more
production to U.S. assembly facilities and
increase the price of cars exported to the U.S.
• We may also expect that the exported cars will be
"top of the line" models, and we expect U.S.
manufacturers to raise domestic car prices.
Slide 17
Web Chapter A -- Appendix
Objective functions are often constrained
by one or more “constraints” (time,
capacity, or money)
Max L = (objective fct.) - λ{constraint set to zero}
Slide 19
∂L/∂X = Y2 - λ = 0 Y2 = λ
∂L/∂Y = 2XY - 4λ = 0 2XY = 4λ
∂L/∂λ = X + 4Y- 12 = 0
Three equations and three unknowns
Solve: Ratio of first two equations is:
Y/2X = 1/4 or Y = .5 X. Substitute into the third equation:
We get:
X = 4; Y = 2; and λ = 4
• Lambda is the marginal (objective function) of
the (constraint). In the parentheses, substitute the
words used for the objective function and constraint.
• Here, λ = the marginal utility of money.
Slide 20
Problem
Minimize crime in your town
• Police, P, costs $15,000 each.
• Jail, J, costs $10,000 each.
• Budget is $900,000.
• Crime function is estimated: C = 5600 - 4PJ
» Set up the problem as a Lagrangian
» Solve for optimal P and J, and C
» What is economic meaning of lambda?
Slide 21
Answer
• Min L= 5600 - 4PJ + λ{15,000•P + 10,000•J -900,000 }
• To Solve, differentiate
1. ∂L/∂P: - 4•J +15,000•λ = 0
2. ∂L/∂J: - 4•P +10,000•λ = 0
3. ∂L/∂λ : 15,000•P +10,000•J -900,000 =0
J/P = 1.5 so J = 1.5•P & substitute into (3.)
15,000•P +10,000•[1.5•P] - 900,000 = 0
solution: P = 30, J = 45, C = 200 and λ = -.012
• Lambda is the marginal crime (reduction) for a
dollar of additional budget spent Slide 22