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EC611--Managerial Economics

Optimization Techniques
and New Management Tools

Dr. Savvas C Savvides, European University Cyprus


Models and Data

Model
a framework based on simplifying assumptions
Î it helps to organize our economic thinking
based on a simplified picture of reality
Î We focus on key elements

Data
the economist’s link with the real world
1. time series
2. cross section

Managerial Economics DR. SAVVAS C SAVVIDES 1


Real and Nominal Variables

Many economic variables are measured


in money terms
Nominal values
measured in current prices
Real values
adjusted for price changes compared with
a base year
measured in constant prices

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Real & Nominal Values--Example

1960 1975 2003

Land Prices (Hilton £2,500 £27,000 £125,000


Park Area, Nicosia)
Price Index 7.4 39.3 100.0
(2000=100)
Real Land Price (in £33,783 £68,702 £125,000
2000 prices)
Real Land Price (in £2,500 £5,084 £9,250
1960 prices)

(2,500*100) / 7.4 = 33,783 (125,000*7.4) / 100 = 9,250

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Evidence in Economics

Evidence collected and produced from empirical


observation and testing may allow us to
accumulate support for a theory, or to reject it,
or indicate points for further research and
investigation
Scatter diagrams help us to test and validate
economic theory with empirical reality
Econometrics is a more sophisticated method
that takes this task of empirically validating
theory further using statistical techniques

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Data & Scatter Diagrams

Price
Year Price Quantity

1 6.0 100

2 5.5 105 7.0 X (7.0, 80)

3 6.0 90
X X
4 6.5 85
X X
5 6.0 87 6.0 X (6.0, 100)
X
6 7.0 80

7 6.5 88
80 100
Quantity
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Economic Models: An Example

Examples:
1. Quantity of CDs demanded depend on
(or is a function of):
Î f (Prices, income, preferences)
2. Revenues are a function of Sales:
Î f (Q)

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Expressing Economic Relationships

Equations: TR = 100Q - 10Q2


e.g. if Q=1 Î TR = 100(1) – 10(31)2 = 90
if Q=3 Î TR = 100(3) – 10(3)2 = 210
Q 0 1 2 3 4 5 6
Tables: TR 0 90 160 210 240 250 240
TR
300

250

Graphs: 200

150

100

50

0
0 1 2 3 4 5 6 7

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25

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Total, Average, & Marginal Cost

AC = TC/Q
Q TC AC MC
e.g. for Q=3 0 20 - -
ÎAC = 180/3 =60 1 140 140 120
2 160 80 20
MC = ∆TC/∆Q 3 180 60 20
For ∆Q from 3 to 4: 4 240 60 60
ÎMC = (240-180)/(4-3) 5 480 96 240
=60 / 1 = 60
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Total, Average, & Marginal Cost

TC
TC ($)
240

180

120

60

0
0 1 2 3 4
Q

AC, MC ($)
MC
120

AC
60

0
0 1 2 3 4 Q

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Profit Maximization
Profit = TR - TC
Q TR TC Profit
0 0 20 -20
1 90 140 -50
2 160 160 0
3 210 180 30
4 240 240 0
5 250 480 -230
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Profit Maximization

($) 300 TC

TR
240

180

120

60

0 Q
0 1 2 3 4 5
60
30
0
-30 Profit

-60

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Slope of a Line

Slope between A & B


∆P/∆Q = -5 / +5 = - 1

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Slope of a Line

Price

Quantity

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Slope of Non-Linear Relationships

Total Revenue Slope of TR at A is positive:


Î Slope of tangency at pt. A

Slope of TR at B is negative
Î Slope of tangency at pt. B

A B

TR

Quantity
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Concept of the Derivative (1)

Optimization analysis can be conducted much


more efficiently using differential calculus.
This relies on the concept of the derivative,
which resembles the concept of the margin.
For example, if TR = Y and Q =X,
Î the derivative of Y with respect to X is equal to
the ∆Y w.r.t. X, as the ∆X approaches zero.

dY ∆Y
= lim
dX ∆X → 0 ∆ X

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Concept of the Derivative (2)
Let’s expand on the right hand side. Since Y
depends on X, Î Y = f ( X ) Î ∆Y = ∆X
∆X = ∆X (tautology). Î Add & subtract X on RHS.
∆X = (X+∆X) – (X)
∆Y = f(X+∆X) – f(X) Î Divide both sides by ∆X
Î ∆Y/ ∆X = [f(X+∆X) – f(X] / ∆X
Substituting the RHS of the last expression in the
derivative expression, we get
Î dY/ dX = [f(X+∆X) – f(X] / ∆X

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The Derivative – An Example
If Y = X2 Î dY/ dX = [(X+∆X)2 – X2 ] / ∆X
Î dY/ dX = [ X2+ 2X * ∆X) + (∆X)2 - X2 ] / ∆X

Î dY/ dX = [ (2X * ∆X) + (∆X)2 ] / ∆X

Î dY/ dX = [ (2X * ∆X)/ ∆X ] + [(∆X)2 / ∆X]

Cancelling the ∆X terms Î dY/ dX = (2X + ∆X)


This says that at the limit, i.e., as ∆X Î 0, the whole
expression will approach 2X (since ∆X=0)
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Rules of Differentiation
Constant Function Rule: The
derivative of a constant, Y = f(X) = a, is
zero for all values of a (the constant).
Y = f (X ) = a dY
=0
dX
Y Changes in X do not affect the value
of Y. Horizontal lines have zero slope!

10 Y = 10

X
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Rules of Differentiation

Power Function Rule: The derivative


of a power function, where a and b are
constants, is defined as follows.
dY
Y = f (X ) = aX b
= b ⋅ a X b −1
dX

Example: Y = 3X2
Derivative: Î dY/dX = 2 * 3X2-1
Î = 6X
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Power Function --Example

Equations: TR = 100Q - 10Q2


Q 0 1 2 3 4 5 6
Tables: TR 0 90 160 210 240 250 240

TR
300

Graphs: 250

200 TR
150

100

50

0
0 1 2 3 4 5 6 7

MR Q

MR = dTR/dQ = 100 – 20Q


Q 0 1 2 3 4 5
MR 100 80 60 40 20 0

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Rules of Differentiation

Sum-and-Differences Rule: The


derivative of the sum or difference of two
functions U and V, is defined as follows.
U = g( X ) V = h( X ) Y = U ±V

dY dU dV
= ±
dX dX dX

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Rules of Differentiation

Product Rule: The derivative of the


product of two functions U and V, is
defined as follows.
U = g( X ) V = h( X ) Y = U ⋅V

dY dV dU
=U +V
dX dX dX

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Rules of Differentiation

Quotient Rule: The derivative of the


ratio of two functions U and V, is
defined as follows.
U
U = g( X ) V = h( X ) Y=
V

dY
=
(
V dU
dX ) (
− U dV
dX )
2
dX V
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Rules of Differentiation

Chain Rule: The derivative of a function


that is a function of X is defined as follows.

Y = f (U ) U = g( X )

dY dY dU
= ⋅
dX dU dX

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Optimization With Calculus (1)
Optimization often requires finding the max. or the min. of
a function (e.g. maxTR, minTC, or maxΠ)
Find X such that dY/dX = 0. This means that the curve of
the function has zero slope
Example: Given that TR = 100Q – 10Q2
Îd(TR) / dQ = 100 – 20Q ÎSetting dTR/dQ =0,
we get 0 =100 – 20Q Î 20Q = 100 Î Q* = 5
Therefore, Total Revenues are maximized at Q* = 5
To find the optimum Price, we go to the demand equation
from which the TR function derived:
P = 100 – 10Q Î P* = 100 – 10 (5) = 50
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Optimization With Calculus (2)
Equation: TR = 100Q - 10Q2
TR
300

250
TR
200

150

100

50

0
0 1 2 3 4 5 6 7

Q
MR = dTR/dQ = 100 – 20Q = 0 MR

20Q = 100
Q=5
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Optimization With Calculus (2)
To distinguish between a max and a min, we
use the second derivative.
Second derivative rules:
If d2Y/dX2 > 0 (positive), then X is a minimum.
If d2Y/dX2 < 0 (negative), then X is a maximum.
In the example, we found d(TR) / dQ = 100 – 20Q

Îd2(TR)/dQ2 = - 20 (negative)
Therefore, we know that the TR function is at a
maximum (“top of the hill”) at Q = 5
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Multivariate Optimization

Multivariate functions:
TR = f (Sales, Advertising, prices, …)
TC = f ( wages, interest, raw materials, …)
Demand = f (price, income, P of substitutes, …)

To optimize a function that has more than one


independent variables, we use the partial
derivative.

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Multivariate Optimization (2)

The Partial Derivative:


The partial derivative (indicated by ∂) is used
in order to isolate the marginal effect of each
one of the independent variables.
The same rules of differentiation apply, except
that when we differentiate the dependent
variable w.r.t. one variable, we hold all other
variables constant.

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Partial Derivative--Example
Suppose that Profits (π) are a function of the
sales of products X and Y as follows:
π = f (X, Y) = 80X – 2X2 – XY – 3Y2 + 100Y
ÎTo find the partial derivative of Π w.r.t X, we
hold Y constant (i.e. ∆Y =0) to get:
∂π / ∂X = 80 – 4X – Y
ÎTo find the partial derivative of Π w.r.t Y, we
hold X constant (i.e. ∆X =0) to get:
∂π / ∂Y = 100 – X – 6Y
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Max or Min Multivariate Functions
Example (cont)
To max or min a multivariate function, we set each partial
derivative equal to zero and solve the resulting simultaneous
equations:
∂ π / ∂ X = 80 – 4X – Y = 0
∂ π / ∂ Y = 100 – X – 6Y = 0
To solve these simultaneous equations, we multiply the 1st by
(-6) and the 2nd by (-1) to get:
- 480 + 24X +6Y = 0
100 – X – 6Y = 0
- 380 + 23X =0
Î Therefore, X = 380 / 23 = 16.52
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Max or Min Multivariate Functions
Example (cont)
Substituting X = 16.52 into the first equation, we find the
value of Y:
80 – 4 (16.52) – Y = 0
80 – 66.08 – Y = 0
Y = 13.92
Thus, the firm maximize Profits when it sells 13.92 unit of
Y and 16.52 units of X. Thus:
π = 80X – 2X2 – XY – 3Y2 + 100Y
π = 80(16.52) – 2(16.52)2 – 16.52 * 13.92 –
3(13.92)2 + 100(13.92)
π = 1,356.52
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Constrained Optimization
So far, we dealt with unconstrained optimization
However, in most real life situations, firms are faced with
a series of constraints (budget, capacity, lack of raw
materials, etc).
In these cases, we need to optimize (max or min) the
objective function (profits, revenues, costs, market
share, etc) subject to the constraints faced by the firm.
We have two methods to solve constrained optimization
problems:
1. Substitution Method (used for simple functions)
2. Lagrangian Method (used for complex functions)
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New Management Tools
Benchmarking: finding out what processes or
techniques “excellent” firms use and adopt & adapt
Total Quality Management: the constant
improvements in product quality and processes to deliver
consistently superior service and value to customers
Reengineering: seeks to completely reorganize the
firm (processes, departments, entire firm). Radically
redesigning processes to achieve significant gains in
speed, quality, service, profitability
The Learning Organization: continuous learning
both on the individual level as well as on the collective
level.
Î It is based on five ingredients: a new mental model -
achieve personal mastery – develop system thinking –
develop shared vision – strive for team learning
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Other Management Tools
Broad Banding: eliminating multiple layers of salary levels, and
increasing labor flexibility
Direct Business Model: dealing directly with the consumer,
eliminating distributors and saving on time and costs (e.g, Dell )
Networking: the formation of strategic alliances to increase the
synergies and capitalize on individual competences
Pricing Power: being able to increase prices faster than costs thus
increasing profits
Small-World Model: large firms may gain efficiency by simulating the
operation of small firms by breaking up the process in smaller scale and
linking the units or individuals through organizational systems
Virtual Integration: the blurring of traditional boundaries between
manufacturer and its suppliers and manufacturer and customer Î
supply chain management
Virtual Management: the simulation of the production process and
consumer behavior using computer models
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