Chapter 3

Optimization Techniques and New

Management Tools

Presented
By
Raheel Anjum

Optimization Techniques and New

Management Tools
Economic relationship can be expressed in
Equation
Tables
Graphs

Simple relationship
Tables or graph

 Complex relationship
Equations
Y = a + bX - cX2
Quadratic eq:
If c +ve concave upward
If c ve Concave downward

Suppose that the relationship between the total

revenue (TR) of a firm and the quantity (Q),
given by

 TR= 100Q-10Q2
Q
TR

0
0

1
90

2
3
4
5
6
160 210 240 250 240

TR
300
250
200
150
100
50
0
0

7
Q

Total, Average, and

Marginal Cost
Average cost= TC/Q
Q=1, AC=TC/1= $140/1=
$140
Marginal Cost= TC/Q
TC increases from $ 20 to
$ 140 when the firm
produces the first unit of
output. Thus MC=(14020/1) =120 and so forth
AC & MC first falls then
rises

Q
0
1
2
3
4
5

TC AC MC
20 140 140 120
160 80 20
180 60 20
240 60 60
480 96 240

 AC curve is U
shaped
MC are plotted
half way between
successive levels
of output.
MC = 120 from Q
(0 1)
MC= 20 from Q
(1 2)
MC is also U
shaped
MC reaches
smallest point at
smaller level
Intercepts the AC
curve through the
lowest point.
This is always the
case.

TC ($)
240
180
120
60
0
0

AC, MC ($)

Q
MC

AC

120

60

0
0

Derivation
of AC &
AC curve is derived
from
TC by TC
the slope of
MC from

a ray from origin to the

corresponding point.
Slope of OH provides H.
H, B, C, K and D
provide AC.
AC falls up to point K
and then rises.
MC is given by the
slope of tangent on TC
at that point.
As MC= TC/Q
H*= (180 140 /0.5)= 80
H*, B*, C*, K, D* provide
MC curve.
TC declines to point B
(Inflection Point) then rises.
MC declines till point B
then rises
TC or MC at point K are
equal to slope of the ray
from origin.

TC ($)
240
180

120
60
0
0

AC, MC ($)

D*

120

H*

0
0

Q
MC

AC

60

C K

B*

*2

C*
3

Relationship B/W AC & MC

As long MC is below AC, the AC falls.
When MC is above AC, the AC rises.
AC neither falling nor rising, AC is
minimum.
MC intersects AC from below
(AC=MC)

Profit Maximization By TR & TC

App:
TP=TR-TC
At Q=0, =0-20=20
Firm incurs losses
At Q=2, TR=TC,
=0
Break even point.
B/w Q=2 & Q=4,
TR>TC
Shows profit for
Firm, At Q=3, =30

Q
0
1
2
3
4
5

TR
0
90
160
210
240
250

TC Profit
20 -20
140 -50
160
0
180 30
240
0
480 -230

OPTIMIZATION BY
MARGINAL
ANALYSIS
Most important concepts in managerial
economics & optimisation analysis.
Firm Max: when (MC=MR).
MC given by the slope of TC, falls till B*
(Point of inflection) rises again.
MR is given by the slope of TR, the MR
decreases, at E, the TR is highest and
MR=0. ve.
As long slope of MR > MC firm expand
output.
Firm adds to revenue, than cost. As Q=1 and
Q=3 (Profit goes up)
At Q=3, slope of MR=MC orTR=TC &
vertical distance is profit.
Max: profit at C*, Q=3 (MC=MR)
Slope of TR=TC or MR=MC at Q=1
Firm Profit Max: Conditions..
MC=MR
MC must intersect MR from below.

Concept of derivatives

The concept of
derivation
It is closely related to the concept of
margin.
When output increases from 2 to 3 units,
total revenue from $160 to $ 210. Thus,
MR= TR/ Q = $ 210-$ 160/3-2 =$ 50.
The slope of chord BC on the totalrevenue.
When Q assumes values smaller than
unity, as small as we want and even
approaching zero in the limit, MR is
given by the slope of shorter chords,
and it approaches the slope of the TR
curve at a point in the limit.
At B, as the change in quantity
approaches zero, the change in total
revenue or marginal revenue approaches
the slope of the TR curve at point B.
MR= TR/ Q = $ 60- the slope of
tangent BK to the TR curve at point B.
Similarly MR at Pt C,D,E are 40, 20, 0.

Slope of BD= 40
Slope of BC= 50
Slope at B = 60

 In general, if TR=Y and Q=X,

Derivative of Y with respect to X is given by
the change in Y with respect to X, as the
change in X approaches zero.
dY
Y
lim
dX X 0 X

The derivative of Y with respect to X is equal

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

 Note: Smaller the change in X, closer

will be the value of derivative at a
point on the curve.
Example: Change in X from 2-4 the
average dY/dX =40 (Slope of chord
BD).
While, Change in X from 2-3 the
average change =50 (slope of chord
BC) i-e closer to the slope of curve at
point B i-e (60).

Differentiation
Differentiation:
The process of determining
derivatives of a function,
(Finding change in Y for a change in
X, when change in X approaches
Zero).

Rules of Differentiation
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

Example
Y=2
dY/dX=0
The slope of the line Y is zero.
Y

2.5
2
1.5

1
0.5
0

Power Function Rule

The derivative of a power function, where
a and b are constants, is defined as:
Exponent b multiplied by coefficient a times the
variable X raised to the power b-1.

Y f (X ) aX b
dY
b a X b 1
dX

Example
Y=2x1
dY/dX=1.2X1-1
dY/dX=2
5
4
3
2
1
0

Y=2x

Sum-and-Differences Rule
The derivative of the sum or difference of
two functions U and V, is defined as:
U g(X )

V h( X )

Y U V
dY dU dV

dX dX dX

Example
U=2x and V=x2
Y=U+V=2x+ x2
dY/dX=1.2.x1-1+2.1.x2-1
(By power rule)

dY/dX=2+2x

U=2x and V=x2

Product Rule
The derivative of the product of two
functions U and V, is defined as;
First function multiplied by derivative of the second
function plus second function multiplied by derivative of
the first function.

U g(X )

V h( X )
Y U V

dY
dV
dU
U
V
dX
dX
dX

Example

Y=2 x2 (3-2 x)
Let U=2 x2 and V=3-2 x

dY/dX=2x2(dV/dX)+(3-2x)(dU/dX)

dY/dX=2 x2(0-1*2x1-1)+ (3-2 x) (2*2x2-1)

dY/dX=2 x2(-2)+ (3-2 x) (4x)

dY/dX= - 4x2+ 12x - 8 x2

dY/dX= 12x-12 x2

 Y=2 x2 (3-2 x)
Let U=2 x2 and V=3-2 x

Quotient Rule
The derivative of the ratio of two functions
U and V, is defined as
Denominator multiplied by derivative of the numerator, minus the
numerator times derivative of denominator, all divided by the
denominator squared.

U g(X )

V h( X )

U
Y
V

dY

dX

V dU

U dV

dX
dX
V

Example

Y=3-2x / 2x2
Let V=2 x2 and U=3-2 x

dY/dX= (2 x2(dU/dX)- (3-2 x) (dV/dX)) / V2

dY/dX= 2 x2(-2)- (3-2 x) (4x) / (2 x2)2

dY/dX= -4x2-12x+ 8x2 /4x4

dY/dX= 4x2 -12x / (4x4)

dY/dX= 4x (x-3) / 4x(x3)

= x-3 / x3

Chain Rule
The derivative of a function that is a
function of X is defined as,
If Y=f(U) and U=g(X) then the derivative of Y
with respect equals, derivative of Y with
respect to U, multiplied by the derivative of U
with respect to X.

Y f (U )
dY dY dU

dX dU dX

U g(X )

Example
Y=U3+10 and U=2X2
then
dY/dU=3U2 and dU/dX=4X
dY/dX=dY/dU.dU/dX=(3U2) 4X
dY/dX=3(2X2)2(4X)=48X5