Basics of Macroeconomics

Optimization Techniques
Methods for maximizing or minimizing an objective function Examples

Consumers maximize utility by purchasing an optimal combination of goods Firms maximize profit by producing and selling an optimal quantity of goods Firms minimize their cost of production by using an optimal combination of inputs
PowerPoint Slides Prepared by Robert F. Brooker, Ph.D.
Copyright 2007 by Oxford University Press, Inc.
Slide 1
Concept of the Derivative

The derivative of Y with respect to X is equal to the limit of the ratio Y/X as X approaches zero
dY Y = lim dX X 0 X
Slide 2
Slide 3
Total Revenue Equation

Equation: Table: Graph:
Q TR
300 250 200 150 100 50 0 0 1 2 3 4 5 6 7 Q
TR = 100Q - 10Q2
0 0
TR
1 90
2 3 4 5 6 160 210 240 250 240
Slide 4
Total, Average, and Marginal Revenue

TR = PQ AR = TR/Q MR = TR/Q
Slide 5
Total Revenue Schedule of a Firm
Slide 6
Total Revenue Curve of a Firm
Slide 7
TR 300 250
Total Revenue
200 150 100 50 0 0 1 2 3 4 5 6 7 Q
AR, MR 120
Average and Marginal Revenue
100 80 60 40 20 0 -20 -40 Q 0 1 2 3 4 5 6 7
Slide 8
Total, Average, and Marginal Cost

AC = TC/Q MC = TC/Q
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

Slide 9
Total, Average, and Marginal Cost
Slide 10
Slide 11
Geometric Relationships
The slope of a tangent to a total curve at a point is equal to the marginal value at that point The slope of a ray from the origin to a point on a total curve is equal to the average value at that point
Slide 12
Geometric Relationships
A marginal value is positive, zero, and negative, respectively, when a total curve slopes upward, is horizontal, and slopes downward A marginal value may be negative, but an average value can never be negative
Slide 13
Profit Maximization
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

Slide 14
Slide 15
Steps in Optimization
Define an objective function of one or more choice variables Define the constraint on the values of the objective function Determine the values of the choice variables that maximize or minimize the objective function while satisfying the constraint
Slide 16
New Management Tools for Optimization

Benchmarking (tool for improving productivity and quality) Total Quality Management (constantly improving the quality of products and the firms processes to deliver more value to customers; e.g. Six Sigma) Reengineering (radical redesign of all the firms processes to achieve major gains) Learning Organization (values continuing learning, both individual and collective)
Slide 17
Other Management Tools for Optimization

Broad-banding (elimination of multiple salary grades to foster movement among jobs within the firm and lower cost) Direct Business Model (eliminating the time and cost of third-party distribution) Networking (forming of temporary strategic alliances among firms as per their core competence) Performance Management (holding executives and their subordinates accountable for delivering the desired results)
Slide 18
Pricing Power (ability of a firm to raise prices faster than the rise in its costs and vice-versa) Small-World Model (linking well-connected individuals from each level of the organization to one another to improve flow of information and the operational efficiency) Strategic Development (continuous review of strategic decisions) Virtual Integration (treating suppliers and customers as if they were part of the company which reduces the need for inventories) Virtual Management (ability of a manager to simulate consumer behavior using computer models)
Other Management Tools for Optimization
Slide 19
Univariate Optimization
Given objective function Y = f(X) Find X such that dY/dX = 0 Second derivative rules: If d2Y/dX2 > 0, then X is a minimum If d2Y/dX2 < 0, then X is a maximum
Slide 20
Example 1
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
Slide 21
Example 2
Given the following total revenue (TR) function, determine the quantity of output (Q) that will maximize total revenue: TR = 45Q 0.5Q2 dTR/dQ = 45 Q = 0 Q* = 45 and d2TR/dQ2 = -1 < 0
Slide 22
Example 3
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
Slide 23
Example 4
Given
TR = 45Q 0.5Q2 TC = Q3 8Q2 + 57Q + 2
Determine Q that maximizes profit ():

= 45Q 0.5Q2 (Q3 8Q2 + 57Q + 2)
Slide 24
Example 4: Solution
Method 1
d/dQ = 45 Q 3Q2 + 16Q 57 = 0 12 + 15Q 3Q2 = 0
Method 2
MR = dTR/dQ = 45 Q MC = dTC/dQ = 3Q2 16Q + 57 Set MR = MC: 45 Q = 3Q2 16Q + 57
Use quadratic formula: Q* = 4

Slide 25
Quadratic Formula
Write the equation in the following form:
aX2 + bX + c = 0
The solutions have the following form:
b b 4ac 2a
2
Slide 26
Multivariate Optimization
Objective function Y = f(X1, X2, ...,Xk) Find all Xi such that Y/Xi = 0 Partial derivative:
Y/Xi = dY/dXi while all Xj (where j i) are held constant
Slide 27
Example 5
Determine the values of X and Y that maximize the following profit function:
= 80X 2X2 XY 3Y2 + 100Y
Solution
/X = 80 4X Y = 0 /Y = X 6Y + 100 = 0 Solve simultaneously X = 16.52 and Y = 13.91
Slide 28
Constrained Optimization
Substitution Method
Substitute constraints into the objective function and then maximize the objective function
Lagrangian Method
Form the Lagrangian function by adding the Lagrangian variable and constraint to the objective function and then maximize the Lagrangian function
Slide 29
Example 6
Use the substitution method to maximize the following profit function:
= 80X 2X2 XY 3Y2 + 100Y
Subject to the following constraint:

X + Y = 12
Slide 30
Example 6: Solution
Substitute X = 12 Y into profit:
= 80(12 Y) 2(12 Y)2 (12 Y)Y 3Y2 + 100Y
= 4Y2 + 56Y + 672
Solve as univariate function:

d/dY = 8Y + 56 = 0 Y = 7 and X = 5
Slide 31
Example 7
Use the Lagrangian method to maximize the following profit function:
= 80X 2X2 XY 3Y2 + 100Y
Subject to the following constraint:

X + Y = 12
Slide 32
Example 7: Solution
Form the Lagrangian function
L = 80X 2X2 XY 3Y2 + 100Y + (X + Y 12)
Find the partial derivatives and solve simultaneously

dL/dX = 80 4X Y + = 0 dL/dY = X 6Y + 100 + = 0 dL/d = X + Y 12 = 0
Solution: X = 5, Y = 7, and = -53

Slide 33
Interpretation of the Lagrangian Multiplier,

Lambda, , is the derivative of the optimal value of the objective function with respect to the constraint
In Example 7, = -53, so a one-unit increase in the value of the constraint (from -12 to -11) will cause profit to decrease by approximately 53 units
Slide 34

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Optimization Techniques

Methods for maximizing or minimizing an objective function Examples

Copyright 2007 by Oxford University Press, Inc.

Concept of the Derivative

PowerPoint Slides Prepared by Robert F. Brooker, Ph.D.

Copyright 2007 by Oxford University Press, Inc.

PowerPoint Slides Prepared by Robert F. Brooker, Ph.D.

Copyright 2007 by Oxford University Press, Inc.

Total Revenue Equation

2 3 4 5 6 160 210 240 250 240

PowerPoint Slides Prepared by Robert F. Brooker, Ph.D.

Copyright 2007 by Oxford University Press, Inc.

Total, Average, and Marginal Revenue

PowerPoint Slides Prepared by Robert F. Brooker, Ph.D.

Copyright 2007 by Oxford University Press, Inc.

Total Revenue Schedule of a Firm

PowerPoint Slides Prepared by Robert F. Brooker, Ph.D.

Copyright 2007 by Oxford University Press, Inc.

Total Revenue Curve of a Firm

PowerPoint Slides Prepared by Robert F. Brooker, Ph.D.

Copyright 2007 by Oxford University Press, Inc.

200 150 100 50 0 0 1 2 3 4 5 6 7 Q

Average and Marginal Revenue

100 80 60 40 20 0 -20 -40 Q 0 1 2 3 4 5 6 7

PowerPoint Slides Prepared by Robert F. Brooker, Ph.D.

Copyright 2007 by Oxford University Press, Inc.

Total, Average, and Marginal Cost

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

PowerPoint Slides Prepared by Robert F. Brooker, Ph.D.

Copyright 2007 by Oxford University Press, Inc.

Total, Average, and Marginal Cost

PowerPoint Slides Prepared by Robert F. Brooker, Ph.D.

Copyright 2007 by Oxford University Press, Inc.

PowerPoint Slides Prepared by Robert F. Brooker, Ph.D.

Copyright 2007 by Oxford University Press, Inc.

PowerPoint Slides Prepared by Robert F. Brooker, Ph.D.

Copyright 2007 by Oxford University Press, Inc.

PowerPoint Slides Prepared by Robert F. Brooker, Ph.D.

Copyright 2007 by Oxford University Press, Inc.

TR 0 90 160 210 240 250

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

Copyright 2007 by Oxford University Press, Inc.

PowerPoint Slides Prepared by Robert F. Brooker, Ph.D.

Copyright 2007 by Oxford University Press, Inc.

Copyright 2007 by Oxford University Press, Inc.

New Management Tools for Optimization

Copyright 2007 by Oxford University Press, Inc.

Other Management Tools for Optimization

Copyright 2007 by Oxford University Press, Inc.

Other Management Tools for Optimization

Copyright 2007 by Oxford University Press, Inc.

PowerPoint Slides Prepared by Robert F. Brooker, Ph.D.

Copyright 2007 by Oxford University Press, Inc.

PowerPoint Slides Prepared by Robert F. Brooker, Ph.D.

Copyright 2007 by Oxford University Press, Inc.

Copyright 2007 by Oxford University Press, Inc.

PowerPoint Slides Prepared by Robert F. Brooker, Ph.D.

Copyright 2007 by Oxford University Press, Inc.

Determine Q that maximizes profit ():

PowerPoint Slides Prepared by Robert F. Brooker, Ph.D.

Copyright 2007 by Oxford University Press, Inc.

Use quadratic formula: Q* = 4

Copyright 2007 by Oxford University Press, Inc.