Economic Optimization

For SPSPS students in Managerial Economics

1st sem 2019-2020
Economic Optimization
Managers make tough choices that involve benefits
and costs.
Effective managers must collect, organize, and process
relevant operating information
Requires fundamental understanding of basic
economic relations
Economic Optimization Process
Effective managerial decision-making is the process of
arriving at the best solution to a problem
There is no single “best” investment decision for all
managers at all times
When alternative courses of action are available, the
decision that produces a result most consistent with
the managerial objectives is the optimal decision.
Decision makers must recognize all available choices
and portray them in terms of appropriate costs and
benefits.
Economic Optimization Process
Principles of economic analysis form the basis for
describing demand, cost, and profit relations.
Once basic economic relations are understood, the tools
and techniques of optimization can be applied to find the
best course of action.
Most important, the theory and process of optimization
gives practical insight concerning the value maximization
theory of the firm.
Optimization techniques are helpful because they offer a
realistic means for dealing with the complexities of goal-
oriented managerial activities
 Revenue Relations
The primary objective of management is the
maximization of the value of the firm
Effective production and pricing decisions depend
upon a careful understanding of revenue relations
P = α+bQ
Output (Q) and Total Revenue (TR)
TR = f(Q); TR = P x Q
 Marginal Revenue – change in total revenue associated
with a 1 unit change in output
MR = ΔTR/ ΔQ
Revenue and Price Relations
Quantity sold Price ($) Total Revenue Marginal
Revenue
0 24.00 50.00 -
1 22.50 22.50 22.50
2 21.00 42.00 19.50
3 19.50 58.50 16.50
4 18.00 72.00 13.50
5 16.50 82.50 10.50
6 15.00 90.00 7.50
7 13.50 94.50 -4.50
8 12.00 96.00 -1.50
9 10.50 94.50 -1.50
10 9.00 90.00 -4.50
Revenue Maximization
The activity level that generates the highest revenue.
Cost Relations
Meeting customer demand efficiently depends upon a
careful understanding of cost relations.
Cost functions – relations between costs and output
Short-run cost functions – cost relations when fixed
costs are present; used for day to day operating
decisions.
Long-run cost functions – cost relation when all costs
are variable; used for long-term planning
Short-run – operating period during which the
availability of at least one input is fixed.
Cost Relations
Long-run – a period of complete flexibility with
respect to input use.
Total costs – sum of fixed and variable expenses
Marginal cost – change in total cost associated with a
i-unit change in output.
Average cost – total cost divided by the number of
units produced.
Average Cost Minimization – activity level that
generates the lowest average cost (MC = AC)
Cost Output Relations
Quantity Fixed Cost Variable Total Cost Marginal Average
Sold Cost Cost Cost
0 8.00 0.00 8.00 - -
1 8.00 4.50 12.50 4.50 12.50
2 8.00 10.00 18.00 5.50 9.00
3 8.00 16.50 24.50 6.50 8.17
4 8.00 24.00 32.00 7.50 8.00
5 8.00 32.50 40.50 8.50 8.10
6 8.00 42.00 50.00 9.50 8.33
7 8.00 52.50 60.50 10.50 8.64
8 8.00 64.00 72.00 11.50 9.00
9 8.00 76.50 84.50 12.50 9.39
10 8.00 90.00 98.00 13.50 9.80
Average Cost Minimization
From a strategic point of view, the point of minimum
average cost is important because it shows the level of
output necessary to achieve maximum productive
efficiency.
It is important to recognize that average cost
minimization involves consideration of cost relations
only; no revenue relations are considered in the
process of minimizing average costs.
To determine the profit maximizing activity level,
both revenue and cost relations must be considered.
Profit Relations
Total Profit (π)- difference between total revenue and
total cost; π = TR-TC
Marginal Profit – is the change in total profit due to a
1-unit change in output/units sold;
Mπ = Δπ/ΔQ, or Mπ = MR-MC
Profit Maximization Rule
Profit is maximized when Mπ=MR-MC=0 or MR=MC
assuming profit declines with further expansion in
output (Q)
 Quantity, Revenue, Cost and Profit Relations
Q sold FC VC P TR MR TC MC AC TProfit MProfit

0 8 16.50 24.00 0.00 - 8.00 - - -8.00 -

1 8 14.50 22.50 22.50 22.50 12.50 4.50 12.50 10.00 18.00
2 8 13.00 21.00 42.00 19.50 18.00 5.50 9.00 24.00 14.00
3 8 11.50 19.50 58.50 16.50 24.50 6.50 8.17 34.00 10.00
4 8 10.00 18.00 72.00 13.50 32.00 7.50 8.00 40.00 6.00
5 8 8.50 16.50 82.50 10.50 40.50 8.50 8.10 42.00 2.00
6 8 7.00 15.00 90.00 7.50 50.00 9.50 8.33 40.00 -2.00
7 8 5.50 13.50 94.50 -4.50 60.50 10.50 8.64 34.00 -6.00
8 8 4.00 12.00 96.00 -1.50 72.00 11.50 9.00 24.00 -10.00
9 8 2.50 10.50 94.50 -1.50 84.50 12.50 9.39 10.00 -14.00
10 8 1.00 9.00 90.00 -4.50 98.00 13.50 9.80 8.00 -18.00
 Incremental Concept in Economic
Analysis
When economic decisions have a lumpy rather than
continuous impact on output, use of incremental
concept is appropriate.
Incremental change – change resulting from a given
managerial decision
Incremental profit – gain or loss associated with a
given managerial decision.
Incremental analysis involves examining the impact of
alternative managerial decisions or courses of action
on revenues, costs, and profit.
Incremental Concept in Economic Analysis
It focuses on changes or differences among available
alternatives.
The economists’ generalization of the marginal
concept
Incremental Concept in Economic Analysis
Incremental change is the change resulting from a
given managerial decision.
For example: The incremental revenue of a new item in
a firm’s product line is measured as the difference
between the firm’s total revenue before and after the
new product is introduced.
Incremental profit is the profit gain or loss
associated with a given managerial decision.
Total profit increases so long as incremental profit is
positive.
Incremental Concept in Economic Analysis
When incremental profit is negative, total profit
declines
Incremental profit is positive if the incremental
revenue associated with a decision exceeds the
incremental cost.
Incremental decisions involve a time dimension that
cannot be ignored.
Future events and costs must be incorporated in the
analysis aside from the current revenues and costs.