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In Optimization decision analysis involves determining the action that best achieves a desired goal or objective. This
means finding the action that optimizes (that is, maximizes or minimizes) the value of an objective function. For
example, in a price output decision-making problem, we may be interested in determining the output level that
maximizes profits.In a production problem, the goal may be to find the combination of inputs (resources) that minimizes
the cost of producing a desired level of output. In a capital budgeting problem,select those projects that maximize the net
present value of holder wealth.the investments chosen. There are many techniques for solving optimization problems such
as these. This chapter (and appendix) focuses on the use of differential calculus to solve certain types of optimization
problems. In Web Chapter B, linear programming techniques, used in solving constrained optimization problems, are
examined. Optimization techniques are a powerful set of tools that are important in efficiently managing an enterprises
resources and thereby maximizing share holder wealth
bj
j 1, 2, . . . , m
[A.1]
[A.2]
where Equation A.1 is the objective function and Equation A.2 constitutes the set of constraints imposed on the solution. The xi variables, x1, x2, . . ., xn, represent the set of decision variables, and y f(x1, x2, . . ., xn) is the objective function expressed in terms of
these decision variables. Depending on the nature of the problem, the term optimize
means either maximize or minimize the value of the objective function. As indicated in
Equation A.2, each constraint can take the form of an equality () or an inequality (
or ) relationship.
() relationships. The technique of Lagrangian multipliers can be used to find the
optimal solution to many of these problems.
Often, however, the constraints in an economic decision-making problem take the
form of inequality relationships ( or ) rather than equalities. For example, limitations
on the resourcessuch as personnel and capitalof an organization place an upper
bound or budget ceiling on the quantity of these resources that can be employed in maximizing (or minimizing) the objective function. With this type of constraint, all of a
given resource need not be used in an optimal solution to the problem. An example of a
lower bound would be a loan agreement that requires a firm to maintain a current ratio
(that is, ratio of current assets to current liabilities) of at least 2.00. Any combination of
current assets and current liabilities having a ratio greater than or equal to 2.00 would
meet the provisions of the loan agreement. Such optimization procedures as the
Lagrangian multiplier method are not suited to solving problems of this type efficiently; however, modern mathematical programming techniques have been developed
that can efficiently solve several classes of problems with these inequality restrictions.
Linear-programming problems constitute the most important class for which efficient
solution techniques have been developed. In a linear-programming problem, both the
objective and the constraint relationships are expressed as linear functions of decision
variables.2 Other classes of problems include integer-programming problems, in which
some (or all) of the decision variables are required to take on integer values, and
quadratic programming problems, in which the objective relationship is a
quadraticfunction of the decision variables. Generalized computing algorithms
exist forsolving optimization problems that meet these requirements.
The remainder of this chapter deals with the classical optimization procedures of
differential calculus. Lagrangian multiplier techniques are covered in the Appendix.
Linear programming is encountered in Web Chapter B.
One problem that faces major airlines, such as American Airlines, is the development of
a schedule for airline crews (pilots and flight attendants) that results in a high level of
crew utilization. This scheduling problem is rather complex because of Federal Aviation
Administration (FAA) rules designed to ensure that a crew can perform its duties
without risk from fatigue. Union agreements require that flight crews receive pay for a
contractually set number of hours of each day or trip. The goal for airline planners is to
construct a crew schedule that meets or exceeds crew pay guarantees and does not
violate FAA rules. With the salary of airline captains at $140,000 per year or more, it is
important that an airline make the maximum possible usage of its crew personnel.
Crew costs are the second largest direct operating cost of an airline.
The nature of the constrained optimization problem facing an airline planner is to
minimize the cost of flying the published schedule, subject to the following constraints:
1. Each flight is assigned only one crew.
2. Each pairing of a crew and a flight must begin and end at a home crew base,
such as Chicago or Dallas for American.
3. Each pairing must be consistent with union work rules and FAA rules.
4. The number of jobs at each crew base must be within targeted minimum and
maximum limits as specified in Americans personnel plan.
American was able to develop a sophisticated constrained optimization model that saved
$18 million per year compared with previous crew allocation models used.
DIFFERENTIAL CALCULUS
In Chapter 2, marginal analysis was introduced as one of the fundamental concepts of
economic decision making. In the marginal analysis framework, resource-allocation
decisions are made by comparing the marginal benefits of a change in the level of an
activity with the marginal costs of the change. A change should be made as long as the
marginal benefits exceed the marginal costs. By following this basic rule, resources
can be allocated efficiently and profits or shareholder wealth can be maximized.
In the profit-maximization example developed in Chapter 2, the application of the
marginal analysis principles required that the relationship between the objective (profit)
and the decision variable (output level) be expressed in either tabular or graphic form.
This framework, however, can become cumbersome when dealing with several decision
variables or with complex relationships between the decision variables and the
objective. When the relationship between the decision variables and criterion can
be expressed in algebraic form, the more powerful concepts of differential calculus
can be used to find optimal solutions to these problems.
[A.3]
Recall that marginal profit is defined as the change in profit resulting from a one-unit
change in output. In general, the marginal value of any variable Y, which is a function of
another variable X, is defined as the change in the value of Y resulting from a one-unit
change in X. The marginal value of Y, My, can be calculated from the change in Y, Y,
that occurs as the result of a given change in X, X:
My
Y
X
[A.4]
When calculated with this expression, different estimates for the marginal value of Y
may be obtained, depending on the size of the change in X that we use in the computation. The true marginal value of a function (e.g., an economic relationship) is obtained
from Equation A.4 when X is made as small as possible. If X can be thought of as a continuous (rather than a discrete) variable that can take on fractional values,5 then in calculating My by Equation A.4, we can let X approach zero. In concept, this is the approach
For example, if X is a continuous variable measured in feet, pounds, and so on, then X can in theory take
on fractional values such as 0.5, 0.10, 0.05, 0.001, 0.0001 feet or pounds. When X is a continuous variable,
X can be made as small as desired.
Y1
Y = f(X)
Y0
X0
X1
X2
D
Y
X
Y = f(X)
Y0
X0
taken in differential calculus. The derivative, or more precisely, first derivative,6 dY/dX, of
a function is defined as the limit of the ratio Y/X as X approaches zero; that is,
dY
Y
limit
dX
X
[A.5]
X0
Graphically, the first derivative of a function represents the slope of the curve at a
given point on the curve. The definition of a derivative as the limit of the change in
Y (that is, Y) as X approaches zero is illustrated in Figure A.1(a). Suppose we are
interested in the derivative of the Y f(X) function at the point X0. The derivative
dY/dX measures the slope of the tangent line ECD. An estimate of this slope, albeit a
poor estimate, can be obtained by calculating the marginal value of Y over the
interval X0 to X2. Using Equation A.4, a value of
M y
Y
Y Y0
2
X
X2 X0
is obtained for the slope of the CA line. Now let us calculate the marginal value of Y using
a smaller interval, for example, X0 to X1. The slope of the line C to B, which is equal to
M y
Y
Y Y0
1
X
X1 X0
gives a much better estimate of the true marginal value as represented by the slope of the ECD
tangent line. Thus we see that the smaller the X value, the better the estimate of the slope of
the curve. Letting X approach zero allows us to find the slope of the Y f(X) curve at point
C. As shown in Figure A.1(b), the slope of the ECD tangent line (and the Y f(X) function at
point C) is measured by the change in Y, or rise, Y, divided by the change in X, or run, X.
Process of Differentiation
The process of differentiationthat is, finding the derivative of a functioninvolves determining the limiting value of the ratio Y/X as X approaches zero. Before offering
some general rules for finding the derivative of a function, we illustrate with an example
the algebraic process used to obtain the derivative without the aid of these general
rules. The specific rules that simplify this process are presented in the following section.
[A.6]
[A.7]
Expanding this expression and then doing some algebraic simplifying, we obtain
( ) 40 140Q 140Q 10[Q2 2QQ (Q)2]
40 140Q 10Q2 140Q 20QQ 10(Q)2
[A.8]
[A.9]
Forming the marginal-profit ratio /Q, and doing some canceling, we get
140Q 20QQ 10 Q 2
Q
Q
140 20Q 10Q
[A.10]
Taking the limit of Equation A.10 as Q approaches zero yields the expression for the
derivative of Illinois Powers profit function (Equation A.6)
d
limit 140 20Q 10Q
dQ Q0
[A.11]
140 20Q
If we are interested in the derivative of the profit function at a particular value of Q,
Equation A.11 can be evaluated for this value. For example, suppose we want to know
the marginal profit, or slope of the profit function, at Q 3 units. Substituting Q 3
in Equation A.11 yields
Marginal
d
140 20 3 $80 per unit
dQ
profit
Rules of Differentiation
Fortunately, we do not need to go through this lengthy process every time we want the
derivative of a function. A series of general rules, derived in a manner similar to the
process just described, exists for differentiating various types of functions.7
Constant Functions
[A.12]
[A.13]
[A.14]
where a and b are constants. The derivative of a power function is equal to b times a,
times X raised to the (b 1) power:
dY
b a Xb1
dX
[A.15]
A couple of examples are used to illustrate the application of this rule. First, consider
the function
Y 2X
FIGURE
A.2
10
10
10
6
Y=4
8 X
Y = X2
8
6
Y = 2
4
4
X = 1
2
0
Y = 2X
2
6
8 X
4 X
which is graphed in Figure A.2(b). Note that the slope of this function is equal to 2 and
is constant over the entire range of X values. Applying the power function rule to this
example, where a 2 and b 1, yields
dY
1 2 X11 2X0
dX
2
Note that any variable to the zero power, e.g., X0, is equal to 1.
Next, consider the function
Y X2
which is graphed in Figure A.2(c). Note that the slope of this function varies depending on
the value of X. Application of the power function rule to this example yields (a 1, b 2):
2X
dY
2 1 X21
dX
dY
df X
df X
1
2
This result can be extended to finding the
of
dX derivative
dX
dX the sum of any number of
functions.
Example
RULES OF DIFFERENTIATION: PROFIT MAXIMIZATION
AT ILLINOIS POWER (CONTINUED)
As an example of the application of these rules, consider again the profit function for
Illinois Power, given by Equation A.6, that was discussed earlier:
40 140Q 10Q2
In this example Q represents the X variable and represents the Y variable; that is,
f(Q). The function f(Q) is the sum of three separate functionsa constant function,
f1(Q) 40, and two power functions, f2(Q) 140Q and f3(Q) 10Q2. Therefore,
applying the differentiation rules yields
d
df Q
df Q
df Q
1
2
3
dQ
dQ
dQ
dQ
0 1 140 Q1 1 2 (10) Q2 1
140 20Q
This is the same result that was obtained earlier in Equation A.11 by the differentiation process.
Product of Two Functions Suppose the variable Y is equal to the product of two separate functions f1(X) and f2(X):
Y f1(X) f2(X)
[A.18]
In this case the derivative of Y with respect to X is equal to the sum of the first function
times the derivative of the second, plus the second function times the derivative of the first.
dY
df X
df X
f1 X 2
f2 X 1
dX
dX
dX
[A.19]
f1 X
f2 X
[A.20]
f2 X
df X
df1 X
f1 X 2
dX
dX
f2 X 2
[A.21]
10X2
5X 1
50X2 20X
5X 1 2
10X 5X 2
5X 1 2
dX
dZ dX
df Z df2 X
1
dZ
dX
[A.22]
To illustrate the application of this rule, suppose we are interested in finding the derivative (with respect to X) of the function
Y 10Z 2Z2 3
where Z is related to X in the following way:
Z 2X2 1
First, we find (by the earlier differentiation rules)
dY
10 4Z
dZ
dZ
4X
dX
and then
dY
10 4Z 4X
dX
TA B L E
A.1
Function
Derivative
1. Constant Function
dY
0
dX
Ya
2. Power Function
dY
b a Xb 1
dX
Y aXb
3. Sums of Functions
dY
df X
df X
1
2
dX
dX
dX
Y f1(X) f2(X)
4. Product of Two Functions
dY
df X
df X
f1 X 2
f2 X 1
dX
dX
dX
Y f1(X) f2(X)
5. Quotient of Two Functions
Y
f1 X
f2 X
dY
dX
f2 X
df X
df1 X
f1 X 2
dX
dX
f2 X 2
6. Functions of a Function
Y f1(Z), where Z f2(X)
dY
dY dZ
dZ dX
dX
Maximization Problem
Recall from the discussion of marginal analysis, a necessary (but not sufficient) condition
for finding the maximum point on a curve (for example, maximum profits) is that the
marginal value or slope of the curve at this point must be equal to zero. We can now
express this condition within the framework of differential calculus. Because the derivative of a function measures the slope or marginal value at any given point, an equivalent
necessary condition for finding the maximum value of a function Y f(X) is that the
derivative dY/dX at this point must be equal to zero. This is known as the first-order condition for locating one or more maximum or minimum points of an algebraic function.
Example
FIRST-ORDER CONDITION: PROFIT
AT ILLINOIS POWER (CONTINUED)
MAXIMIZATION
($)
d = 140 20Q
dQ
=0
= Marginal profit at Q = 7
500
400
300
= 40 + 140Q 10Q2
200
Total profit ()
100
0
10
10 11 12 13
14
10 11 12 13 14
Q units
d ($/unit)
dQ
200
d = 140 20Q
dQ
150
100
50
0
50
7
Q units
100
150
200
FIGURE
A.3
dY = 0
dX
Y = f(X)
X
A
dY = 0
dX
dY
dX
dY
dX
FIGURE
Minimum Values of
a Function
the slope) is declining. A test to see whether the marginal value is decreasing is to take
the derivative of the marginal value and check to see if it is negative at the given point
on the function. In effect, we need to find the derivative of the derivativethat is, the
second derivative of the functionand then test to see if it is less than zero. Formally, the
second derivative of the function Y f(X) is written as d2Y/dX2 and is found by applying the previously described differentiation rules to the first derivative. A maximum point
is obtained if the second derivative is negative; that is, d2Y/dX2
0.
Example
SECOND-ORDER CONDITION: PROFIT MAXIMIZATION
AT ILLINOIS POWER (CONTINUED)
Returning to the profit-maximization example, the second derivative is obtained from
the first derivative as follows:
d
140 20Q
dQ
d2
0 1 20 Q1 1
dQ2
20
Because d2/dQ2
0, we know that a maximum-profit point has been obtained.
An opposite condition holds for obtaining the point at which the function takes on a
minimum value. Note again in Figure A.4 that the marginal value (slope) is continually
increasing in the neighborhood of the minimum value (point A) of the Y (X) function.
First the slope is negative up to the point where dY/dX 0, and thereafter the slope becomes positive. Therefore, we test to see if d2Y/dX2 0 at the given point. A minimum
point is obtained if the second derivative is positive; that is, d2Y/dX2 0.
Minimization Problem
In some decision-making situations, cost minimization may be the objective. As in
profit-maximization problems, differential calculus can be used to locate the optimal
points.
Example
COST MINIMIZATION: KEYSPAN ENERGY
Suppose we are interested in determining the output level that minimizes average total
costs for KeySpan Energy, where the average total cost function might be approximated
by the following relationship (Q represents output):
C 15 .040Q .000080Q2
Differentiating C with respect to Q gives
dC
.040 .000160Q
dQ
Setting this derivative equal to zero and solving for Q yields
0 .040 .000160Q
Q* 250
[A.23]
Summarizing, we see that two conditions are required for locating a maximum or
minimum value of a function using differential calculus. The first-order condition determines the point(s) at which the first derivative dY/dX is equal to zero. Having obtained one or more points, a second-order condition is used to determine whether the
function takes on a maximum or minimum value at the given point(s). The second derivative d2Y/dX2 indicates whether a given point is a maximum (d2Y/dX2
0) or a minimum (d2Y/dX2 0) value of the function.
PARTIAL DIFFERENTIATION
OPTIMIZATION
AND
MULTIVARIATE
Thus far in the chapter, the analysis has been limited to a criterion variable Y that can
be expressed as a function of one decision variable X. However, many commonly used
economic relationships contain two or more decision variables. For example, a production function relates the output of a plant, firm, industry, or country to the inputs employedsuch as capital, labor, and raw materials. Another example is a demand function,
which relates sales of a product or service to such variables as price, advertising, promotion expenses, price of substitutes, and income.
Partial Derivatives
Consider a criterion variable Y that is a function of two decision variables X1 and X2:
Y f (X1,X2)
Let us now examine the change in Y that results from a given change in either X1
or X2. To isolate the marginal effect on Y from a given change in X1that is,
Y/X1we must hold X2 constant. Similarly, if we wish to isolate the marginal effect on Y from a given change in X2that is, Y/X2the variable X1 must be held
constant. A measure of the marginal effect of a change in any one variable on the
change in Y, holding all other variables in the relationship constant, is obtained from
the partial derivative of the function. The partial derivative of Y with respect to X1 is
written as Y/X1 and is found by applying the previously described differentiation
rules to the Y f(X1,X2) function, where the variable X2 is treated as a constant. Similarly, the partial derivative of Y with respect to X2 is written as Y/X2 and is found
by applying the differentiation rules to the function, where the variable X1 is treated
as a constant.
Example
PARTIAL DERIVATIVES: INDIANA PETROLEUM COMPANY
To illustrate the procedure for obtaining partial derivatives, let us consider the following relationship in which the profit variable, , is a function of the output level of two
products (heating oil and gasoline) Q1 and Q2:
60 140Q1 100Q2 10Q21 8Q 22 6Q1Q2
[A.24]
[A.25]
[A.26]
Example
PARTIAL DERIVATIVES: DEMAND FUNCTION
FOR
SHIELD TOOTHPASTE
[A.27]
Maximization Problem
The partial derivatives can be used to obtain the optimal solution to a maximization or minimization problem containing two or more X variables. Analogous to the first-order conditions discussed earlier for the one-variable case, we set each of the partial derivatives equal
to zero and solve the resulting set of simultaneous equations for the optimal X values.
Example
[A.28]
[A.29]
This system of equations can be solved for the profit-maximizing values of Q1 and
Q2.10 The optimal values are Q *1 5.77 units and Q *2 4.08 units.11 The optimal
total profit is equal to
* 60 140(5.77) 100(4.08) 10(5.77)2 8(4.08)2 6(5.77)(4.08) 548.45