Economic Optimization Process

Effective managerial decision making is the process of arriving at the best solution to a problem. If only
one solution is possible, then no decision problem exists.
1. Optimal Decisions
When alternative courses of action are available, the decision that produces a result most consistent with
managerial objectives is the optimal decision.
- Recognize all available choices and portray them in terms of appropriate costs and benefits.
- Characterize the desirability of decision alternatives in terms of the objectives of the organization.
- Use managerial economics tools for analyzing and evaluating decision alternatives.
- Use Economic concepts and methodology to select the optimal course of action in terms of
available options and objectives.

Principles of economic analysis form the basis for describing demand, cost, and profit relations. Once
basic economic relations are understood, the tools and techniques of optimization can be applied to find
the best course of action.
For profit maximization, we need to increase total revenue and minimizer total cost.
Total profit function= Total revenue- Total cost
The first derivative of total profit function should be zero and second derivative should be negative.
So, the decision process, whether it is applied to fully integrated or partial optimization problems, involves
two steps.
- First, important economic relations must be expressed in analytical terms.
- Second, various optimization techniques must be applied to determine the best, or optimal,
solution in the light of managerial objectives.
2. Maximizing the Value of the Firm
In managerial economics, the primary objective of management is assumed to be maximization of the
value of the firm. This value maximization objective in Equation

Maximizing Equation is a complex task that involves consideration of future revenues, costs, and discount
rates. Value maximization requires serving customers efficiently.
- What do customers want?
- How can customers’ best be served?
Expressing Economic Relation

1. Tables and Equation:

Tables:
- A table is a list of economic data.
- When the underlying relation between economic data is simple, tables offer a compact means for
data description.
- In such instance, a simple graph or visual presentation of the data can provide valuable insight.
Equations:
- An equation is an expression of the functional relationship or connection among economic variables.
- When the underlying relation between economic data is complex, equation are helpful because they
allow mathematical and statistical analysis to be used.
Example:
Consider the relation between output, Q and total revenue, TR.
TR= f (Q)……… (1)
This equation is read, ‘Total revenue is a function of output’. The value of the dependent variable (total
revenue) is determined by the independent variable (Output)
The following equation provides a more precise expression of this functional relation.

1
 TR= P x Q, where P represents the price at which each unit of Q is sold.
If price is constant a $1.50, the relation between quantity sold and total revenue is
TR= 1.50Q…….. (2)
Data in the following table are specified by equation (2) and graphically illustrated in the figure.

Output Total Revenue (TR)= $1.50 x

(Q) Q
1 $1.50

2 $3.00

3 $4.50

4 $6.00

5 $7.50

6 $8.00

2. Total, Average, and Marginal Relations

- Total means complete amount and average means dividing total by the number of amount.
- A marginal relation is the change in the dependent variable caused by one unit change in
independent variable.
• Total increase when marginal is positive and total decrease when marginal is negative.
• When marginal is zero, total is maximized
• If marginal is above average, average is rising
• If marginal is below average, average is falling.
• When marginal is equal average, average reaches maximum
Following table shows the relation among total, marginal, and average for a revenue function.
Units of output Price, P Total revenue, Marginal revenue Average revenue,
(Q) (2) TR=PxQ (MR) AR=TR/Q
(1) (3) (4) (5)
0 0 0 0 -
1 8 8 8 8
2 7 14 6 7
3 6 18 4 6
4 5 20 2 5
5 4 20 0 4
6 3 18 -2 3
7 2 14 -4 2

In the above table,

- Column (1) and column (2) represent output (Q) and price (P).
- Column (3) represents Total revenue (TR) which is the total flow of income to a firm from selling a
given quantity of output (Q) at a given price (P).
- Column (4) represents marginal revenue (MR), which is the revenue generated from selling one extra
unit of a good or service.
- Column (5) represents average revenue (AR) which is revenue per unit, and is found by dividing TR
by the quantity sold, Q.

• When marginal revenue is positive total revenue increases & when marginal revenue is negative
total revenue decreases.
• Marginal revenue is less than average revenue, and so average revenue decreases.

2
 Marginal as the derivative of function
Marginal Concept:
A marginal value is the change in a dependent variable associated with a 1unit change in an independent
variable. Consider the general function
Y= f(X)
The change in the value of the independent variable, X is denoted by ΔX and the change in the
dependent variable, Y, by ΔY.
The ratio ΔY/ ΔX is a general specification of the
marginal concept:
Marginal Y= ΔY/ ΔX
It indicates the change in the dependent variable
associated with a 1 unit change in the value of X.
In the figure (1),
For values of X close to the origin, a relatively small
change in X provides a large change in Y. Thus the
value of ΔY/ ΔX = (Y2-Y1)/(X2-X1) is relatively large.
Similarly a large increase in X (from X3 to X4)
produces only a small increase in Y (from Y3 to Y4),
so ΔY/ ΔX is small.
- When the curve is relatively steep the
dependent variable Y is highly responsive to
changes in the independent variable
- When the curve is relatively flat, Y does not
respond as notable to change in X
Derivative Concept:
A derivative is a precise specification of the marginal relation. Consider the general function
Y= f(X)
The change in the value of the independent variable, X is denoted by ΔX and the change in the
dependent variable, Y, by ΔY.
Finding a derivative involves finding the value of the ratio ΔY/ ΔX for extremely small change in X. The
mathematical notation for a derivative is:

The derivative of Y with respect to X equals the limit of

the ratio ΔY/ ΔX, as ΔX approaches zero.
In the figure (2) the average slope of the curve between
A and D is measured as:
ΔY/ ΔX = (Y4-Y1)/ (X4-X1)
Similarly the average slop of the curve can be
measured over smaller and smaller intervals of X, such
as those connecting points B and C with D.
At the limit, as ΔX approaches zero, the ratio ΔY/ ΔX is
equal to the slope of a line drawn tangent to the curve-
for example, at D point. The slope of this tangent is
defined as the derivative, dY/dX, of the function at point
D, it measures the marginal changes in Y associated
with a very small changes in X at that point,
For example,
If the dependent variable Y is total revenue and the
independent variable X is output, then the derivative
dY/dX precisely shows the change in revenue
associated with a change in output, which is defined as
marginal revenue.

3
Similarly
Derivative of total cost is marginal cost and
Derivative of total profit is marginal profit.
Marginal Analysis in Decision making
Finding Maximums or Minimums

- Maximization or minimization of a function occurs where its derivative or marginal value is equal
to zero.
To illustrate consider the following function:
Here, "π" is total profit and Q is output in units.

If output is zero, the firms incurs a $10000 loss (fixed costs are $10000), but as output rises, profit also
rises.
Breakeven points are output levels where profit is zero. And these output levels are 29 units and 171
units.
By calculating the value of function at a number of outputs, we found the profit maximizing output is 100
units where profit is maximized at $10000 and declines thereafter.

This maximum can also be

located by finding derivative,
or marginal, of the function,
then determining the value of
Q at which the derivative
(marginal) is equal to zero.

Marginal profit
Setting the marginal profit
equal to zero results in
$400-$4Q=0
$4Q=$400
Q=100 units
Distinguishing Maximums
from Minimums:
The first derivative of a total
function indicates whether the
function is rising or falling at
any point.
Setting the marginal relation
equal to zero indicates
inflection points or points of
maximum or minimum slope.
Because the marginal value (or derivatives) is zero for both maximum and minimum values of a function.
To distinguish maximums from minimums along a function, the concept of second derivative is used. The
second derivative is the derivative of a marginal relation.

The first derivative measures the slop of the total profit function, the second derivative measures the
slope of first derivative or in this case, the slope of marginal profit curve.
- Maximum is where first derivative is zero, second derivative is negative.
- Minimum is where first derivative is zero, second derivative is positive.

In our example, the second derivative of the total profit function is the derivative of the marginal profit
function:

= -$4

4
Since the second derivative is negative, therefore, when Q=100, marginal profit is zero and total profit is
at maximum.
Beyond Q=100, marginal profit is negative and total profit is decreasing.

Maximizing the difference between two functions:

• Profit is equal to total revenue minus total cost. So the profit maximizing output level is where
there is the greatest vertical distance between total revenue and total cost.
• This distance between the total revenue and total cost curves is greatest when their slopes are
equal.
• The slope of the total revenue is the marginal revenue and the slope of the total cost curve is the
marginal cost.
• So at that point, marginal revenue equals marginal cost, marginal profit equals zero and profit is
maximized.
In the figure the distance is maximized
at Qb, where the slopes of revenue and
cost curves are equal. So profits are
maximized and marginal revenue
equals marginal cost at Qb.

At Qa, total revenue is equal to total

cost. The intersect point of the total
revenue and total cost is a break-even
point where profit equals zero.

Beyond Qa, total revenue is rising faster

than total cost, profit are increasing, and
the curves are spreading farther apart.
This divergence of the curves continues
as long as MR>MC

Once the slope of the total revenue

curve is exactly equal to the slop of the total cost (MR=MC), the two curves are parallel and no more
diverging. This occurs at Qb

Beyond Qb, the slope of the cost curve is greater than the slope of the revenue curve. That means
marginal cost is greater than marginal revenue. So the distance is decreasing and total profit declines.
Note that,

- Marginal revenue is zero at the point of revenue maximization, as long as total revenue is falling
beyond that point.
- Average cost minimization occurs when marginal and average cost are equal and average cost is
increasing as output expands.
Incremental Concept

 Incremental analysis involves

- Examining the impact of alternative marginal decisions on revenue, cost and profit.
- How to select the best alternative among several potential alternatives.
 It focuses on changes or differences between the available alternatives.
 The incremental change is the change resulting from a given managerial decision.
 For example: The incremental revenue of a new item in a firm’s product line is measured as the
difference between the firm’s total revenue before and after the new product is introduced.
 When economic decision have a lumpy rather than continuous impact on output, use of incremental
concept is appropriate.

5
 Marginal v. Incremental Concept
Both approaches can be used in business financial decision-making and can be applied to different
economic concepts such as cost, revenue, utility.

Marginal Analysis Point of differences Incremental Concept

Marginal analysis involves determining
incremental change of a particular
variable to the change in another
independent variable.
Marginal relates to one unit of output.
Marginal Analysis is used in
maximizing / minimizing decisions (Ex:
identifying profit maximizing quantity,
Break-even point etc.).
Marginal Analysis examines the costs
and benefits of specific business
decisions.
Marginal Analysis considers the
relationship between economic
variables against change in quantity.
Marginal Analysis primarily consider
variable costs / revenues
Marginal Analysis is widely used in
microeconomics.
Definition Incremental analysis involves
- Examining the impact of alternative
marginal decisions on revenue,
cost and profit.
- How to select the best alternative
among several potential
alternatives.
Output Multiple units of output is possible
Function Incremental Analysis will be used to
select the best option among different
alternatives (Ex: limited resource
decisions, Make or buy decisions,
special order decisions etc.).
Decision Making Incremental Analysis examines the
most effective decision in term of
maximizing potential benefits.
Information Incremental Analysis consider
Considered accounting information to select the
best alternative.
Types of Costs Incremental Analysis considers
Considered opportunity costs and relevant costs. All
the sunk costs are eliminated as they
are already incurred and cannot be
taken for future decision-making.
Use Incremental Analysis is widely used by
business decision makers, especially in
investment decisions.

Incremental Profit:
 Incremental profit is the profit- gain or loss associated with a given managerial decision.
 Total profit increases when incremental profit is positive. When incremental profit is negative, total
profit declines.
 Similarly, incremental profit is positive (and total profit increases) if the incremental revenue
associated with a decision exceeds the incremental cost.
Incremental decisions involve a time dimension that simply cannot be ignored. Not only all current
revenues and cost associated with a given decision must be considered, but any future revenues and
costs also bust be incorporated in the analysis.

KUMKUM SULTANA
Department Of Management (26th Batch)
Session 2012-13
University of Chittagong
6