1

MANAGERIAL
ECONOMICS
14th Edition

BY
MARK HIRSCHEY AND ERIC BENTZEN
 2

Economic
Optimization
CHAPTER 2
Chapter 2 3
OVERVIEW
 Economic Optimization Process
 Revenue Relations
 Cost Relations
 Profit Relations
 Incremental Concept in Economic Analysis
Chapter 2 4
KEY CONCEPTS
 optimal decision  marginal cost
 spreadsheet  average cost
 Equation  average cost minimization
 dependent variable  total profit
 independent variable  marginal profit
 marginal revenue  profit maximization rule
 revenue maximization  breakeven points
 cost functions  incremental change
 short-run cost functions  incremental profit
 long-run cost functions  breakeven point
 short run  average cost minimization
 long run  multivariate optimization
 total costs  constrained optimization
 fixed costs  Lagrangian technique
 variable costs  Lagrangian multiplier, λ
Economic Optimization 5

Process
 Optimal Decisions
 Best decision produces the result most consistent
with managerial objectives.
 Maximizing the Value of the Firm
 Produce what customers want.
 Meet customer needs efficiently.
 Greed vs. Self-interest
 Self-indulgence leads to failure.
 Customer focus leads to mutual benefit.
Revenue Relations 6

 Price and Total Revenue

 Total Revenue = Price  Quantity.
 Marginal Revenue
 Change in total revenue associated with
a one-unit change in output.
 Revenue Maximization
 Quantity with highest revenue, MR = 0.
 Do Firms Really Optimize?
 Inefficiency and waste lead to failure.
 Optimization techniques are widely
employed by successful firms.
7
8
Cost Relations 9

 Total Cost
 Total Cost = Fixed Cost + Variable Cost.
 Marginal and Average Cost
 Marginal cost is the change in total cost
associated with a one-unit change in
output.
 Average Cost = Total Cost/Quantity
 Average Cost Minimization
 Average cost is minimized when MC = AC.
 Reflects efficient production of a given
output level.
10
Profit Relations 11

 Total and Marginal Profit

 Total Profit (π ) = Total Revenue - Total Cost.
 Marginal profit is the change in total profit due
to a one-unit change in output, Mπ = MR - MC.
 Profit Maximization
 Profit is maximized when Mπ = MR – MC = 0 or
MR = MC, assuming profit declines as Q rises.
 Marginal v. Incremental Profits
 Marginal profit is the gain from producing one
more unit of output (Q).
 Incremental profit is gain tied to a managerial
decision, possibly involving multiple units of Q.
12
Concept of the Derivative 13

The derivative of Y with respect to X is

equal to the limit of the ratio Y/X as
X approaches zero.

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Rules of Differentiation 14

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
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 Constant Function Rule: 15

Example
 If Y = 2,
 Then

dY
0
dX

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Rules of Differentiation 16

Power Function Rule: The derivative

of a power function, where a and b are
constants, is defined as follows.

Y  f (X )  aX b

dY
 b  a X b 1
dX
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Power Function Rule: Example 17

 If y = 2x
dY
 Then
 baX b 1

dX
•So dY / dX = 2
•And if Y = X2
•Then dY / dX = 2X.
•Note that the answer could be greater than or less than or equal to
zero depending on the value of X.

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Differentiating Constant and 18
Product Functions
Y Y
Y

Y= 2X Y=X2

2
Y =2
1

X X X

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Rules of Differentiation 19

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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Sum-and-Differences Rule: 20
Examples
 (1) If Y = U + V = 2X + X2
 Where U = g (X) = 2X
 And V = h(X) = X2
 Then dY / dX = 2 + 2X
 (2) If Y = 0.04X3 – 0.9X2 + 10X + 5
 Then dY / dX = 0.12X2 – 1.8X + 10

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Rules of Differentiation 21

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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Product Rule: Example 22

 If Y = 2X2(3 – 2X)
 And letting U = 2X2 and V = 3 -2X
 Then dY / dX = 2x2 (dV/dX) + (3 -2x)
(dU/dX)
 = 2X2 (-2) + (3 – 2X) (4X)
 = -4X2 + 12X – 8X2
 = 12X – 12X2

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Rules of Differentiation 23

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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
 Quotient Rule: Example 24

 If Y = 3 – 2X
______
2X2

And letting U = 3 -2X and V = 2X2

2X2(-2) – (3-2X)4X
Then dY/dX = _________________
(2x2)2
-4X2 – 12X + 8X2
= _________________
4X4
4X2 – 12X
= ___________
4X4
= ___________
4X (X - 3)
4X(X)3
X–3
= _______
X3

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Rules of Differentiation 25

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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Chain Rule: Example 26

 If Y = U3 + 10 and U = 2X2
 Then dY/dU = 3U2 and dU/dX = 4X
 Therefore,
 dY/dX = (dY/dU) . dU/dX = (3U2)4X
 By substitution:
 dY/dX = 3(2X2)2(4X) = 3(4X4)4X = 48X5

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Summary: Rules of Differentiating Functions
27
Function Derivative
Constant Function Y = f(X) = a dY
 0
dX

Power Function dY
Y  f (X )  aX b  baX b 1

dX
Sum-and-Differences of functions dY dU dV
Y  U V
 
dX dX dX
Product of two functions dY dV dU
U V
Y  U V dX dX dX

Quotient of two functions

Y 
U dY

V  dU dX   U  dV dX 
2
V dX V

Function of a function (chain functions) dY dY dU

 
Y  f (U ) U  g(X ) dX dU dX
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 Logarithmic Functions 28
 The derivative of a logarithmic function Y = ln X is given by the expression:
 dY/dX = d ln Y/dX = 1/X
 This also implies that if Y = ln X, then dY = (1/X)dX= dX/X.
 Because dX is the change in X by definition, dX/X is the percentage
change in X.
 Derivatives of logarithmic functions have great practical relevance in
managerial economics given the prevalence of multiplicative (and
hence linear in the logarithms) equations used to describe demand,
production and cost relations.
 For example, the expression 𝒀 = 𝒂𝑿𝒃 has an equivalent logarithmic
function ln Y = ln a + b ln X, where d ln Y/d ln X = (dY/Y)/(dX/X) = b.
 Here b is called the elasticity of Y with respect to X, because it reflects the
percentage effect on Y of a 1 per cent change in X.
 The concept of elasticity is introduced and extensively examined in
Chapter 4 and discussed throughout the remaining chapters.
Optimization With 29

Calculus
Find X such that dY/dX = 0
Is X a minimum or a maximum value?
The first derivative refers to the slope of
the function, while the second derivative
refers to the change in the slope of the
function.

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Optimization With 30

Calculus

 Remember that the first derivative was zero.

 Second derivative rules:
 If d2Y/dX2 > 0, then X is a minimum.
 If d2Y/dX2 < 0, then X is a maximum.

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Optimization With Calculus: 31
Example

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 If TR = 100Q -10Q2
 Then MR = dTR/dQ = 100 – 20Q
 MR = 0, then Q = 100/20 = 5 units. That
is the MR equals zero when Q = 5.
Now the questions is: Is TR maximized
or minimized at Q= 5?
 Find 2nd derivative, d2TR/dQ2 = - 20
 Since 2nd derivative < 0, TR is
maximized at Q =5.
Optimization With Calculus: Exercise 32

 If MC = 3Q2 -16Q + 57, find Q at which MC is optimized!

Secondly, determine whether this is achieved at a
minimum or a maximum MC!

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Multivariate Optimization 33

 Partial derivative
 Maximizing a multivariable function

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 Partial Derivative 34
 Most economic relationships involve more than two
variables.
 It is important to determine the marginal effect on the
dependent variable resulting from changes in the
quantities of each independent variable separately.
 These marginal effects are measured by the partial
derivative which is indicated by the symbol .
 We use the same derivative rules to find the partial
derivative, however, you have to hold all independent
variables other than the one with respect to which we
are finding the partial derivative constant.
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 Partial Derivative 35

 For example, suppose that the objective function is the total

profit () function of a firm and that it depends on sales of
commodities X and Y as follows:
  = f(X, Y) = 80X – 2X2 –XY -3Y2 + 100Y
 Holding Y constant, the partial derivative of  with respect to X,
/X = 80 – 4X –Y
 Holding X constant, the partial derivative of  with respect to Y,
/Y = - X – 6Y + 100

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Maximizing a Multivariable Function 36
 We set each partial derivative equal to zero and solve for
the unknown (X and Y for example).
 /X = 80 – 4X –Y = 0
 /Y = - X – 6Y + 100 = 0
 Multiplying the first expression by -6, rearranging the second,
and add them together, we will get
 - 480 + 24X + 6Y = 0
 100 – X – 6Y = 0
 - 380 + 23X = 0
 Therefore X = 16.52
 By substitution, Y = 13.92
 Inserting the values of X and Y into the original profit
equation () will yield a maximum profit of $1,356.52
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 Constrained Optimization 37

 What we just did was unconstrained maximization of profit

because there was no constraint on how much to produce of
both X and Y.
 Constraints are normal as we have learned in chapter 1. We
solve constrained optimization problems by either:
 (1) substitution method, or
 (2) the Lagrangian multiplier method.

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Constrained Optimization by Substitution 38
 Steps:
 (1) Solve the constraint equation for one of the decision

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variables. If X + Y = 12, then X = 12 – Y
 (2) Substitute the expression for this variable into the objective
equation that the firm seeks to maximize or minimize.
  = 80(12-Y) – 2(12-Y)2 – (12-Y)Y – 3Y2 + 100
 Therefore  = -4Y2 + 56Y + 672
 To maximize this function, find the partial derivative of  with
respect to Y, set it equal to zero, and solve for Y. That is:
 /Y = -8Y + 56 = 0
 Therefore, Y = 7
 And by substitution X = 12 -7 = 5
 And  = $868 which is less than the maximum profit under
unconstrained optimization.
Constrained Optimization by the Lagrangian Multiplier
Method
39
 In complex constrained equations, substitution method becomes
burdensome or impossible. Therefore, we have to learn how to
use the Lagrangian multiplier method.
 (1) Form a Lagrangian function. This is given by the original
objective function that the firm seeks to maximize or minimize plus
 (which is the Lagrangian multiplier Greek letter lambda) times
the constraint function set equal to zero.
 (2) So If the constraint function is X + Y = 12, then X + Y – 12 = 0
 (3) L = 80X – 2X2 –XY -3Y2 + 100Y + (X + Y – 12). This can be
treated as a form of unconstrained function with 3 unknowns: X,
Y, and . Now the solution that maximizes L also maximizes .
 (4) Find the partial derivatives of L with respect to X, Y and ,
and set them equal to zero. We get

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Constrained Optimization by the Lagrangian Multiplier
Method 40
 L/X = 80 - 4X – Y +  = 0

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 L/Y = - X – 6Y + 100 +  = 0
 L/ = X + Y – 12 = 0
 (5) By subtracting the second equation from the first
equation you get -20 -3X + 5Y = 0
 Multiply the third equation by 3 and add it to the
equation in step 5. You will get:

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 3X + 3Y – 36 = 0
 -20 – 3X + 5Y = 0
 8Y – 56 = 0
 Therefore, Y = 7. Then X = 12 – 7 = 5. And then  = -53
(from equation 2 above), while  = $868.
Constrained Optimization by the Lagrangian Multiplier
Method 41

 The value of  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 the above problem, this means that a
decrease in the output capacity constraint from
12 to 11 units or an increase to 13 units will reduce
or increase, respectively, the total profit of the
firm () by about $53.

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