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Optimization
Managerial economics is concerned
with the ways in which managers
should make decisions in order to
optimize the performance of the
organizations they manage.
Optimization Problems
An optimization problem involves the specification
of three things:
1) Objective function to be maximized (e.g. profit
function) or minimized (e.g., cost function).
2) Activities
or
choice
variables
(e.g.,
labor,
4,000
D
3,000
B
2,310
2,000
1,085
1,000
C
0
200
TR
* = $1,225
Q
350 = Q
*
600 700
1,000
Production Level
Profit (dollars)
1,22
1,00
5
0
600
0
d
200
350 = Q
*
600
Production Level
1,000
4,000
100 F
320
3,000
100
520
100
2,000
640
1,000
C
D
D
TR
820
100
520
100
340
100
200
350 = Q
*
800
600
1,000
Production Level
MC (= slope of TC)
8
c (200, $6.40)
6
5.2
0
4
2
d (600, $8.20)
c (200, $3.40)
d (600, $3.20)
MR (= slope of TR)
g
200
350 = Q
*
600
Production Level
800
1,000
MR = MC
Profit (dollars)
MR > MC
100
300
c
200
MR < MC
M
100
d
350 = Q *
500
600
Production Level
Q
800
1,00
Profit curve 0
Function
Derivative
Example
Constant Y = c dY/dX = 0Y = 5
Functions dY/dX = 0
A Line
Y = c X dY/dX = c Y = 5X
dY/dX = 5
Power Y = cXb
5X2
Functions
dY/dX = bcX
b-1
dY/dX = 10X
Y=
dY/dX = dG/dX +
dY/dX = 5 + 10X
M a rg i n a l , S l o p e , D e r i v a t i v e
The marginal at point C is Y /X
The slope of the curve at point C
is equal to the slope of the
Max of Y
y
Slope = 0
the function
Y = -50 + 100X - 5X2
value of x
dx
10
20
i.e.,
dY = 100 - 10X
dX
dY = 0
if
dX
X = 10
10
20
when
the
derivative
of
the
curve
Max value of y
Since
dY
dX
Look at the
Min value of y
dY
dX
curve
dx
value of dy/dx
d2y/dx2 > 0
d2y/dx2 < 0
d 2Y = > 0
dX 2
( minimum point )
d 2Y = < 0
dX 2
( maximum point )
Optimization Rules
Maximization conditions:
12-
dY = 0
dX
d 2Y = < 0
dX 2
Minimization conditions:
12-
dY = 0
dX
d 2Y = > 0
dX 2
iszero.
2) Thesecondorderconditionisthatthesecondderivativeis>=0.
TC=5Q260Q,thendC/dQ=10Q60and(dC/dQ)=10.
Hence,Q=6willminimizecost
Where:
10Q60=0.
Maximize = 100Q - Q2
First order = 100 -2Q = 0 implies
Q = 50 and;
= 2,500
Max = 100Q - Q2
First derivative
100 -2Q = 0
second derivative is: -2
implies
Q =50 is a MAX
Problem 2
Max= 50 + 5X2
First derivative
10X = 0
second derivative is:
10 implies
Q = 10 is a MIN
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.
Problem:
= f (Q1 , Q2 )
vice versa.
In order to do that we use partial derivative of
Q1 denoted by
with respect to
( treating Q as constant )
2
Q1
e.g.;
as constant; hence
Q1
Q2
= 80 - 20Q2 - 5Q1;
(1)
therefore
setting
both
simultaneously
partial
(2)
derivatives
equal
to
zero
and
solve
________________
- 220 + 75Q2 = 0
hence
Q2 = 2.933
substitute for Q2 at any of the eq. 1
100 - 20Q1 - 14.665;
hence
Q1 = 4.267.
i.e.,
profit is maximized when the firm produces 4.267 of Q 1 and 2.933 of Q2.
CONSTRAINED OPTIMIZATION
We assume that the firm can freely produce 4.267 of Q1 and 2.933
of Q2. Quite often this may not be the case.
e.g.
Minimize TC = 4Q12 + 5Q22 - Q1Q2;
subject to:
Q1 + Q2 = 30
Solution:
The lagrangian multiplier:
Steps:
1 - set the constraint function to zero
2 - form the lagrangian function by adding the constraint function
after multiplication with an unknown factor to the original
function.
3 - take the partial derivatives and set them equal to zero
4 - solve the resulting equations simultaneously
step 1:
30 - Q1 - Q2 = 0
step 2:
L = 4Q12 + 5Q22 - Q1Q2 + ( 30 - Q1 - Q2)
step 3:
L
Q1
L
Q2
L
= 8Q1 - Q2 -
= -Q1 + 10Q2 -
= -Q1 - Q2 + 30
8Q1 - Q2 - = 0
(1)
-Q1 + 10Q2 - =0
(2)
-Q1 - Q2 + 30
(3)
=0
step 4
multiply eq(2) by -1 and subtract from eq(1)
9Q1 - 11Q2 = 0
(4)
=0
____________________
-20Q2 +270 = 0
Q2 = 270/20 = 13.5