CHAPTER THREE

OPTIMIZATION TECHNIQUES

Dear students, well come to the third chapter of the course Managerial Economics. This chapter
deals with the concept of optimizations. This chapter familiarizes you with the concepts of
differentiations, profit maximization conditions and techniques of solving constrained
optimization. At the end of the chapter there are self-test exercises designed to test your level of
understanding of the topics covered in this chapter. As usual we strongly advise you to attempt
them before you proceed to reading the next chapter.

At the end of this chapter the students will be able to:

 Understand the concept of optimization Techniques

 Use the method of Lagrange multiplier method in solving economic problems.
 Understand the concept of differential calculus
 Compute the partial derivatives.
 Apply the partial derivatives concepts in solving economic problems
3.1. Introduction

Many problems in economics involve the determination of “optimal” solutions. For example, a
decision maker might wish to determine the level of output that would result in maximum profit.
The process of economic optimization essentially involves three steps: Defining the goals and
objectives of the firm, identifying the firm’s constraints and analyzing and evaluating all possible
alternatives available to the decision maker. In essence, economic optimization involves
maximizing or minimizing some objective function, which may or may not be subject to one or
more constraints.
3.2. Unconstrained Optimization
3.2.1. Profit Maximization: The First-Order Condition
We are now in a position to use the rules for taking first derivatives to find the level of output Q
that maximizes . Consider the total revenue and total cost functions:
( ) = = 18 ; since P = $18
TC (Q) = 6 + 33Q- 9Q2 + Q3
Teklebirhan A. (Asst. Prof) Page 1
 = (18Q) - (6 + 33Q- 9Q2 + Q3) = -6 - 15Q + 9Q2 –Q3
The profit will be value of a function will be optimized (maximized or minimized) where the
slope of the function is equal to zero. In the present context, the first-order condition for profit
maximization is d /dQ = 0, thus

This equation is of the general form:

ax2 + bx + c = 0

Where a = -3, b = 18 and c = -15. Quadratic equations generally admit to two solutions, which
may be determined using the quadratic formula. The quadratic formula is given by the
expression:

After substituting the values, we get

The value of p reaches a minimum and a maximum at output levels of Q = 1 and Q = 5,

respectively. Substituting these values back into the Equation yields values of = -13 (at Q = 1)
and = 19 (at Q = 5). In this example, therefore, the entrepreneur of the firm would maximize
his profits at Q = 5. As this example illustrates, simply setting the first derivative of the function
equal to zero is not sufficient to ensure that we will achieve a maximum, since a zero slope is
also required for a minimum value as well. Thus, we need to specify the second-order conditions
for a maximum or a minimum value to be achieved.

Teklebirhan A. (Asst. Prof) Page 2

3.2.2. Profit Maximization: The Second-Order Condition

The second-order conditions for a function with a maximum or minimum is taking the second
derivative of the function yields.
Table 3.1 First-order and second order conditions for functions of one independent variable

Then, the second order condition of the profit function start with the second derivative the profit
function

At Q1 = 5,

This satisfied the condition. Thus, as we have already seen, the firm can maximize his profit by
producing 5 units.
At Q2 = 1,

This not satisfied the condition. Thus, as we have already seen, the firm can’t maximize his
profit by producing 1 unit.
Therefore, the optimal level of output is 5 units of output to maximize his/her profit.

Teklebirhan A. (Asst. Prof) Page 3

3.2.3. Partial Derivatives and Multivariate Optimization: The First-Order
Condition
Most economic relations involve more than one independent (explanatory) variable. For
example, consider the following sales (Q) function of a firm that depends on the price of the
product (P) and levels of advertising expenditures (A):
Q = f (P, A)

To determine the marginal effect of each variable, we take the first derivative of the function
with respect to each variable separately, treating independent the remaining variables as
constants. This process, known as taking partial derivatives, is denoted by replacing d with ∂.

Example

Consider the following explicit relationship of the above example:

Q = f (P, A) = 80P - 2P2 - PA- 3A2 + 100A

(Where A is in thousands of dollars).
Taking first partial derivatives with respect to P and A yields

= − − …….…………………………..( )

=− − + …………………………….( )

To determine the values of the independent variables that maximize the objective function, we
simply set the first partial derivatives equal to zero and solve the resulting equations
simultaneously.

To determine the values of P and A that maximize the firm’s total sales, Q, set the first partial
derivatives in Equations (1) and (2) equal to zero.
80 - 4P - A = 0
-P - 6A+ 100 = 0
The above equations are the first-order conditions for a maximum. Solving these two linear
equations simultaneously in two unknowns yields (in thousands of dollars).

P = $16.54 A = $13.91

Teklebirhan A. (Asst. Prof) Page 4

Substituting these results back into the original function yields the optimal value of Q.
Q*= 80(16.52) – 2(16.52)2 – (16.52) (13.92) - 3(13.92)2 + 100(13.92)
= $1,356.52

3.3. Constrained Optimization

The techniques used to optimize the business objective(s) under constraints are referred to as
constrained optimization techniques. The three common techniques of optimization include: (i)
Linear Programming, (ii) constrained optimization by substitution, and (iii) Lagrangian
multiplier. This unit has attempted to outline the two other important techniques, that is,
constrained optimization by substitution and Lagrangian multiplier. Both techniques were
illustrated by profit maximization and cost minimization problems. Under the Lagrangian
method, a very important multiplier, the Lagrangian multiplier, λ, was introduced. The value of λ
would imply that if a business firm increases output by 1 unit, all things being equal, profit will
increase by λ, and vice versa.

Solution Methods to Constrained Optimization Problems

There are generally two methods of solving constrained optimization problems:
1. The substitution method
2. The Lagrange multiplier method
1) Substitution Method
The substitution method involves first solving the constraint, say for x, and substituting the result
into the original objective function. Consider the following example.
Minimize: ( , ) = 3 + 6 −
Subject to: + = 20
From the constrained function, we have
( )= = 20 –
Substituting into the objective function yields
TC = f [g(y)] = F (y) = 3(20-y)2 + 6y2 – (20-y)y
= 3(400-40y+y2) + 6y2 - (20y - y2)
TC = 1200 - 140y + 10y2

Teklebirhan A. (Asst. Prof) Page 5

In other words, this problem reduces to one of solving for one decision variable, y, and inserting
the solution into the objective function. Taking the first derivative of the objective function with
respect to y and setting the result equal to zero, we get

20y = 140
y=7
Substituting y = 7 into the constraint yields
x + 7 = 20
x = 13
Finally, substituting the values of x and y into the original TC function yields:
TC = 3(13)2 + 6(7)2 - (13) (7) = 507 + 294 - 91 = 710
2) The Lagrange multiplier method
Sometimes the substitution method may not be feasible because of more than one side constraint,
or because the objective function or side constraints are too complex for efficient solution. Here,
the Lagrange multiplier method can be used, which directly combines the objective function with
the side constraint(s).
Minimize: ( , ) = 3 + 6 −
Subject to: + = 20
Steps of Lagrange multiplier method
1. Set the constraint function
2. Form the lagrangian function by adding the constraint function after multiplication with
unknown factor 
3. Take the partial derivatives and set them equal to zero
4. Solve the resulting equations simultaneous

Minimize: ( , ) = 3 + 6 −
Subject to: + = 20
=( , ) = + − + ( − − )

Teklebirhan A. (Asst. Prof) Page 6

The first order condition is

= = − − =

= − … … … … … … … … … .. ( )

= = − − =
= − … … … … … … … … . … … … .. ( )

= = − − = … … … … … … … … … .. ( )

Then from equation (1) and (2), we have =

− = −

= ……………………………………….( )

Then insert equation (4) in (3)

− − =

=
And = , =
 Note that the values for x and y are the same as those obtained using the substitution method.

Interpretation: The value of X and Y that minimize the total cost are, 13 and 7 respectively,
and  measures the change in the total cost if the constraint relaxed by one unit, say increased
from an output level of 20 units to 21 units, the firm’s total cost will increase by $ 71 Similarly,
if output is reduced from say 20 units to 19 units, total cost will be decreased by $71

Teklebirhan A. (Asst. Prof) Page 7