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Managerial Economics –ECO404 VU

Lesson 3
ECONOMIC OPTIMIZATION WITH CALCULUS

MARGINAL ANALYSIS IN DECISION MAKING

The marginal analysis is one of the most important concepts in managerial economics in
general and in optimization analysis in particular. According to marginal analysis, the firm
maximizes profits when marginal revenue equals marginal cost. Marginal cost (MC) is defined
as the- change in total cost per unit change in output and is given by the slope of the TC curve.
Marginal analysis gives clear rules to follow for optimal resource allocation. As a result,
geometric relations between totals and marginals offer a fruitful basis for examining the role of
marginal analysis in managerial decision making.

Geometric relations between totals and marginals offer a fruitful basis for examining the role of
marginal analysis in economic decision making. Managerial decisions frequently require finding
the maximum value of a function. For a function to be at a maximum, its marginal value (slope)
must be zero. Evaluating the slope, or marginal value, of a function, therefore, enables one to
determine the point at which the function is maximized.

TANGENTS AS LIMITS OF SECANT LINES

Slope is a measure of the steepness of a line and is defined as the increase (or decrease) in
height per unit of movement along the horizontal axis. The slope of a straight line passing
through the origin is determined by dividing the Y coordinate at any point on the line by the
corresponding X coordinate. Using ∆ (read delta) to designate change:

Slope = ∆Y/∆X

The marginal relation has a similar geometric association with the total curve. The slope of a
nonlinear curve varies at every point on the curve. Slopes of nonlinear curves are typically found
geometrically by drawing a line tangent to the curve at the point of interest and determining the
slope of the tangent. A tangent is a line that touches but does not intersect a given curve.

The basic problem that leads to differentiation is to compute the slope of a tangent line of the
graph of a given function f at a given point x0. The key observation, which allows one to
compute slopes of tangent lines, is that the tangent is a certain limit of secant lines as illustrated
in the figure below. A secant line intersects the graph of a function f at two or more points. x=x0
and x=x0 + h. As h approaches 0, the secant line in question approaches the tangent line at the
point (x0, f(x0)).

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Managerial Economics –ECO404 VU

CONCEPT OF THE DERIVATIVE

A marginal value is the change in a dependent variable associated with a 1– unit change in an
independent variable. If Y = f(X). Using ∆ to denote change, it is possible to express the change
in the value of the independent variable, X, by the notation ∆X and the change in the dependent
variable, Y, by ∆Y. The ratio ∆Y/∆X is a general specification of the marginal concept. A
derivative is a precise specification of marginal relation.

A marginal value is the change in a dependant variable associated with a 1-unit change in an
independent variable.
Marginal Y = ∆Y/ ∆X

Finding a derivative involves finding the value of the ratio ∆Y/ ∆X for extremely small changes in
X. In symbols:
dY/dX = Lim ∆Y/ ∆X as ∆X → 0

Lim of the slope of the Secant line as ∆X → 0 = slope of the Tangent

The derivative of a function is a very precise measure of its slope or marginal value at a
particular point. The terms derivative and marginal are interchangeable. Thus maxima or
minima of a function occur where its derivative or marginal value is equal to zero. Geometrically,
this corresponds to the point of graph, where the curve has zero slope.

RULES OF DIFFERENTIATION

1- Constant Function Rule: The derivative of a constant, Y = f(X) = a, is zero for all values of a
(the constant).

2- Power Function Rule: The derivative of a power function, where a and b are constants, is
defined as follows.

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Managerial Economics –ECO404 VU

3- Sum-and-Differences Rule: The derivative of the sum or difference of two functions, U and
V, is defined as follows.

4- Product Rule: The derivative of the product of two functions, U and V, is defined as follows:

5- Quotient Rule: The derivative of the ratio of two functions, U and V, is defined as follows:

6- Chain Rule: The derivative of a function that is a function of X is defined as follows:

DERIVATIVE OF A DERIVATIVE

Geometrically, the derivative refers to the slope of the function, while the second derivative
refers to the change in the slope of the function. The value of the second derivative can thus be
used to determine whether we have a maximum or a minimum at the point at which the first
derivative (slope) is zero. The rule is if the second derivative is positive, we have a minimum,
and if the second derivative is negative, we have a maximum.

Given objective function Y = f(X)


First Order Condition (F O C)
Find X such that dY/dX = 0
Second Order Condition (S O C)
If d2Y/dX2 > 0, then X is a minimum.
If d2Y/dX2 < 0, then X is a maximum.

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Managerial Economics –ECO404 VU

EXAMPLE 1 MAXIMIZATION
Given the following total revenue (TR) function, determine the quantity of output (Q) that will
maximize total revenue:
TR = 100Q – 10Q2
dTR /dQ = 100 – 20Q = 0
Q* = 5 and d2TR/dQ2 = -20 < 0

EXAMPLE 2 MINIMIZATION
Given the following marginal cost function (MC), determine the quantity of output that will
minimize MC:
MC = 3Q2 – 16Q + 57
dMC/dQ = 6Q - 16 = 0
Q* = 2.67 and d2MC/dQ2 = 6 > 0

MULTIVARIATE OPTIMIZATION
Objective function Y = f(X1, X2, X3)
Find all partials w.r.t X1, X2 & X3 & set them equal to zero

PARTIAL DERIVATIVE:
∂Y/∂X1 = dY/dX1 while keeping X2 and X3 constant. Partial derivatives follow the same pattern as
the rules that we have described for ordinary derivatives.

OPTIMIZATION OF MULTIVARIATE FUNCTIONS

Example 3
Determine the values of X and Y that maximize the following profit function:
π = 80X – 2X2 – XY – 3Y2 + 100Y

Solution
∂π/∂X = 80 – 4X – Y = 0
∂π/∂Y = -X – 6Y + 100 = 0
Solve simultaneously
X = 16.52 and Y = 13.92
π = 80(16.52) – 2(16.52)2 – (16.52)(13.92) – 3(13.92)2 + 100(13.92)
= $ 1,356.52

ROLE OF CONSTRAINTS

Solution to economic problems frequently have to be found under constraints e.g. maximizing
utility subject to a budget constraint or minimizing costs subject to production quota constraint.
Managers frequently face constrained optimization problems, decision situations with limited
choice alternatives. e.g.; marketing managers are assumed to maximize sales, subject to the
constraint that they do not exceed a fixed advertising budget.
Mathematically, what the constraint does is to narrow down the domain, and hence the range of
the objective function.

STEPS IN CONSTRAINED OPTIMIZATION

• Define an objective mathematically as a function of one or more choice variables

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Managerial Economics –ECO404 VU

• Define one or more constraints on the values of the objective function and/or the choice
variables
• Determine the values of the choice variables that maximize or minimize the objective
function while satisfying the constraint.

LAGRANGIAN METHOD

Form the Lagrangian function by adding the Lagrangian multiplier and constraint to the objective
function and then optimize the Lagrangian function. The solution to the Lagrangian function will
automatically satisfy the constraint.

Example 4: Lagrangian Method

Use the Lagrangian method to maximize the following profit function:


π = 80X – 2X2 – XY – 3Y2 + 100Y
Subject to the following constraint:
X + Y = 12 (output capacity constraint)

Set the constraint function equal to zero and obtain


0 = 12 – X –Y
Form the Lagrangian function
L = 80X – 2X2 – XY – 3Y2 + 100Y + λ(12 - X - Y)

Find the partial derivatives and solve simultaneously


∂L/∂X = 80 – 4X –Y - λ = 0 1
∂L/ ∂Y = – X – 6Y + 100 - λ = 0 2
∂L/ ∂λ = 12 - X – Y = 0 3
Subtract Eq 2 from Eq 1, we get Eq 4
- 3X + 5Y -20 = 0 4
Solution: X = 5, Y = 7, and λ = 53

Interpretation of the Lagrangian Multiplier, λ

The value of Lambda, λ, has an important economic interpretation. It is the marginal effect on
the objective-function solution associated with a 1-unit change in the constraint. In our example,
λ = 53, so a 1-unit increase in the output capacity constraint from 12 to 13 units will cause profit
to increase by approximately $53 i-e by λ times.

To generalize, a Lagrangian multiplier,λ, indicates the marginal effect of decreasing or


increasing the constraint requirement by one unit. This will decrease or increase the optimal
value of the objective-function by λ times. So it helps managers to evaluate the potential benefit
or cost of relaxing constraints.

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