Managerial Economics (2)

 √ Role and Scope of Managerial Economics

 √ Mathematics Review
 Basic Concepts and Tools for Economic
Analysis
 Optimal Decision: DMs Optimize
 The optimal decision in managerial
economics is one that brings the firm
closest to this goal.
 Decision Makers Optimize
 Practically in all managerial decisions the task of
the manager is the same - each goal involves an
optimization problem.
 The manager attempts either to maximize or
minimize some objective function, frequently
subject to some constraint(s).
 And, for all goals that involve an optimization
problem, the same general economic principles
apply!

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 Basic Concepts:

Maximizing the Value of a Firm

 Value of a firm
 Price for which it can be sold
 Equal to net present value of expected
future profit
 Risk premium
 Accounts for risk of not knowing future
profits
 The larger the rise, the higher the risk
premium, & the lower the firm’s value

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 Basic Concepts:

Maximizing the Value of a Firm

 Value of a firm =
π1 π2 πT T
πt
+ + ... + =∑
(1 + r ) (1 + r ) 2
(1 + r )T
t =1 (1 + r )
t

 Maximizing firm’s profit in each time period

leads to maximizing value of firm
 Only if Cost & revenue conditions are
independent across time periods
 If say for example in mining industry more
extraction in current time leads to higher cost
of extraction in future then higher profit now
will lead to lower profits in future.

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 Economic Optimization
 Our first assumption
 Abstraction from Reality? A Simplification?
 Economic agents (i.e., households, firms,
managers, etc.) have an objective that they
are trying to optimize.
 Individuals assumed to maximize utility.
 For-profit firms maximize profits and minimize
costs.
 Not-for-profit firms may maximize output given
the budget or minimize cost given the output
 Realistic?

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 Economic Model of the Firm
 Theory of the firm: Goal is to maximize
firm profits
 Use Π to represent profit
 Π = Total Revenue – Total Cost
= TR - TC or Simply R - C
 TR is determined by: sales and marketing
strategy, pricing, economy, etc.
 TC is determined by: production methods,
cost of capital, etc.

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 Marginal Analysis
 Marginal - change in the dependent
variable caused by a one-unit change in
an independent variable
 Marginal Revenue - change in total
revenue associated with a one-unit
change in output
 Marginal Cost - change in total cost
associated with a one-unit change in
output
 Marginal Profit - change in total profit
associated with a one-unit change in
output
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 An Example with Profits
Example:
Given Demand Function: P = 60 – 2Q
Derived Revenue Function: R = P*Q = 60Q-2Q2
Given Cost Function: C = 50Q - 12*Q2 + Q3
Derived Profit Function: Π = R-C = 10*Q + 10*Q2 – Q3
Dem and and Marginal Revenue Lines
70

60

50

40

30

20

10

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
-10
Quantity Demanded
Price Marginal Revenue

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 Total, Marg. and Avg. Revenue, Cost & Profit at Different
Outputs
Outpu Total Marginal Average Total Marginal Average Total Marginal Average
t Revenue Revenue Revenue Cost Cost Cost Profit Profit Profit

0 0 0 0

1 58 58 58 39 39 39 19 19 19

2 112 54 56 60 21 30 52 33 26

3 162 50 54 69 9 23 93 41 31

4 208 46 52 72 3 18 136 43 34

5 250 42 50 75 3 15 175 39 35

6 288 38 48 84 9 14 204 29 34

7 322 34 46 105 21 15 217 13 31

8 352 30 44 144 39 18 208 -9 26

9 378 26 42 207 63 23 171 -37 19

10 400 22 40 300 93 30 100 -71 10

11 418 18 38 429 129 39 -11 -111 -1

12 432 14 36 600 171 50 -168 -157 -14

13 442 10 34 819 219 63 -377 -209 -29

14 448 6 32 1092 273 78 -644 -267 -46

15 450 2 30 1425 333 95 -975 -331 -65

16 448 -2 28 1824 399 114 -1376 -401 -86

17 442 -6 26 2295 471 135 -1853 -477 -109

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 Revenue Maximizing Output = 15; Maxm.
Revenue= 450; Here MR=0 but Loss = 975
Maximization of Revenue
500

400
Total, Marginal and Average

300
Revenue

200

100

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
Output
-100

Total Revenue Marginal Revenue Average Revenue

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 Cost Per Unit or AC is Lowest when MC=AC at
output =6 but Profit = 204 (Below Max)
M inimization of Cost per unit
160

140

120
Total, Marginal and Average

100
Cost

80

60

40

20

0
0 1 2 3 4 Output5 6 7 8

Total Cost Marginal Cost Average Cost

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 Maximum Total Profit 217 is at Output = 7
Total Profit =Total Rev enue - Total Cost
700

600

500
Total Revenue, Cost and Profit

400
300

200

100
0

-100 0 1 2 3 4 5 6 7 8 9 10 11 12
Output
-200

-300
Total Cost Total Revenue Total Profit

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 Maximum Profit =217 at output level of 7
units at this Marg. Profit = MR - MC = 0
250

200
Total, Marginal and Average Profit

150

100

50

0
0 1 2 3 4 5 6 7 8
Output
-50
Total Profit Marginal Profit Average Profit

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 Profit Maximizing Output = 7 where MR
= MC i.e. MC curve cuts MR from below
M a rg in a l P ro fi t = M R - M C
80  If MR>MC:
60
increase output,
40
increase profit
Marginal Revenue, Cost and

If MR<MC:
20

Profit

0
0 1 2 3 4 5
O u tp u t
6 7 8 9 increase output,
-20

-40
decrease profit
-60
 MR=MC: profit
M a rg in a l R e ve n u e M a rg in a l C o s t M a rg in a l P ro fit maximization
assured

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 Optimization Using Calculus
 If y = f(x), the maxima or minima of y
exists for that value of x (say at x=x*)
where
 First derivative, dy/dx = 0
 The second and sufficient condition for
maxima or minima is
 For maxima, 2nd derivative should be
negative i.e. d2y/dx2 < 0 at x= x*
 For minima, 2nd derivative should be
positive i.e. d2y/dx2 > 0 at x= x*

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 Example: Maximize R= 60Q-2Q2
 Here dR/dQ = 60 – 4Q
(dR/dQ is basically MR)
 For maxima or minima dR/dQ=0
 or 60-4Q=0 i.e. Q*=60/4 = 15
 2nd derivative, d2R/dQ2 = -4 <0 therefore
maximum of R exists at Q=15
 The maximum revenue, Rmax= 60xQ*-2Q*2
=60x15 -2x152 = 900-450 = 450.
 (What’s the profit at this output?)

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 Marginal Revenue, Cost and Profit
 Marginal Revenue, Cost & Profit:
dR R
MR = and AR = = P
dQ Q
dC C
MC = and AC =
dQ Q
Profit, Π = R − C
dΠ d (R - C) dR dC
∴ Marginal Profit = = = −
dQ dQ dQ dQ
Marginal Profit = MR - MC

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 Optimizing: Maximizing Revenue
 For maximum revenue,
dR
(i) = 0 i.e. MR = 0
dQ
i.e. Slope of revenue curve = 0
d 2R d  dR 
(ii) 2
<0 ⇒ 
 
 <0
dQ dQ  dQ 
d(MR)
Or, <0
dQ
i.e. Slope of MR curve should be negative

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 Optimizing: Minimizing Cost
 For minimizing cost per unit (i.e. C/Q)
d ( AC )
(i) = 0 i.e. Slope of avg. cost curve = 0
dQ
(Check out that this means AC = MC )
2
d ( AC )
(ii) 2
>0
dQ
(Check out : this is possible when Slope of MC > Slope of AC.
1st and 2nd Condition together means that AC is minimum at
level of output at which MC curve cuts AC curve from below.)
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 Optimizing: Maximizing Profit or
Minimizing Loss
dΠ dR dC
(i) Marginal Profit = = − =0
dQ dQ dQ
⇒ MR - MC = 0 or MR = MC, and
dΠ
2
d(MR) d ( MC )
(ii) 2
<0 ⇒ − <0
dQ dQ dQ
i.e. Slope of MR curve < Slope of MC curve
Graphically this means that profit maximizing
output is given by the point where MC curve
intersects the MR curve from below
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 Applying Derivatives for Cost
Optimization: Last Numerical Example
 Cost Function given was:
C = 50Q - 12*Q2 + Q3
 Firms normally will optimize (i.e. minimize)
cost per unit. So objective function here is:
AC = 50 - 12*Q + Q2
 For minimum, d(AC)/dQ = -12 + 2Q =0
Or, Q = 12/2=6
 Checking out 2nd derivative d(AC)/dQ = 2 which
is +ve so we have minimum at Q* = 6.
 Calculating minimum AC,
ACMin = 50-12*6+62 = 14

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 Maximizing Profit: Applying Derivative
on Last Numerical Example
 Profit Function we have here
Π = R – C = (60Q-2Q2) – (50Q - 12*Q2 + Q3)
Π = 10*Q + 10*Q2 – Q3
 For Maximization, taking first derivative of
above
 dΠ /dQ = 10 + 20Q – 3Q2 = 0
⇒ Q = 7.1 ≈ 7
 d2Π /dQ2 = 20 – 6Q
at Q=7.1, d2Π /dQ2 = 20- 6 x 7 = -22 < 0
 Therefore we have maximum at Q= 7, and
maximum profit, Π Max= 10x7 – 10x72 – 73= 217

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 Generalization: Using Marginal Analysis
to Find Optimal Activity Level A*
 If marginal benefit > marginal cost
 Activity should be increased to reach highest
net benefit
 If marginal cost > marginal benefit
 Activity should be decreased to reach
highest net benefit
 Optimal level of activity
 When no further increases in net benefit are
possible
 Occurs when MB = MC

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 Constraints on Optimization
 Resource Constraints – Limited
Availability
 Output Quantity and Quality Constraints
 Legal Constraints
 Environment Constraints

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 Constrained Optimization: Equi-
marginal Principle
 The ratio MB/P represents the
additional benefit per additional Re
spent on the activity
 Ratios of marginal benefits to prices
of various activities are used to
allocate a fixed amount of fund
among activities

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 Constrained Optimization: Equi-marginal
Principle
 To maximize or minimize an objective
function subject to a constraint
 Ratios of the marginal benefit to price
must be equal for all activities

MBA MBB MBZ

= = ... =
PA PB PZ
 Constraint must be met

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 Constrained Maximization: An Example
 Suppose that a firm’s production function is
by Q = KL2 and the costs are given by C = wL
+ rK, where K = capital, L = labor and w and
r their per-unit costs.
a) Suppose that w = Rs.40, r = Rs.10 and that
the desires to produce 2000 units of output.
How much capital and labor should be used, if
the firm wants to produce at minimum cost?
b) Suppose now that instead of having the
objective of producing 2000 units the firm
decides to produce with a total cost budget of
Rs.1800. How much capital and labor should be
used to maximize output?

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 Solution: Constrained Maximization
Example
a) Objective Function
 Minimize C = wL + rK
Subject to Q = KL2 = 2000
 Since Q = KL2
 MPL = dQ/dL = 2KL and MPK = dQ/dK = L2
 Cost will be minimum
 when MPL/w = MPK/r ⇒ MPL/MPK=w/r …(1)
 MPL/MPK= 2KL/ L2 =2K/L & w/r = 40/10 =4
 Putting into eq. (1), we get 2K/L = 4
i.e. K = 2L

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 Solution: Constrained Maximization
Example (Contd.)
 Therefore Q = KL2 = 2L L2 = 2L3
 Since Q = 2000, therefore 2000 = 2L3
Or, L3 = 1000 => L =10
 Now, K = 2L = 2 x 10 = 20
 Optimal combination is 20 units of K and
10 units of L.
(The least cost C = wL + rK = 40x10 +
10x20 = 600 i.e. Rs. 600)

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 Solution: Constrained Maximization
Example (Contd.)
b) Objective Function:
Maximize output Q = KL2
Subject to C = wL + rK = 1800
 As in (a), the condition for maximizing
output MPL/w = MPK/r yields K = 2L
 Putting K=2L, w= 40 and r =10 in cost
constraint,
 wL + r 2L = 1800
 40L + 10 x 2L =1800
 L = 1800/60 = 30
 And therefore K = 2L = 2 x 30 = 60
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 Solution: Constrained Maximization
Example (Contd.)
 Optimal combination is K=60 units and
L= 30 units.
(Maximum output, Qmax = KL2 = 60 x 302 =
54000 units)

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 Problem Set #1: (DUE Wed, July 15th )

1. Find the derivatives of:

a. Y = √X
b. Y = 100
c. Y = 1/X2
d. Y = 2X + 3X2
e. Y = LogX/3X2
2. Profit (Π )= -25 + 75Q - 5Q2
a. Compute the optimal profit maximizing
output rate
b. Demonstrate that you have found a
maximum (not a minimum)
c. Calculate the total profit at the profit
maximizing output
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