BASIC TOOLS OF
EC O N O M IC A N A LYSIS
A N D OPTIMIZATION
TECHNIQUES
Learning
Objectives
Functional relationship between the economic
variables
Some important economic functions
Slope and its use in economic analysis
Derivatives of various functions
Optimization techniques
Constrained optimization
Optimization
Technique
• It states that the marginal • It states that the
revenue from each marginal firm should
unit of the product should optimize its output
be zero for maximizing the for minimizing the
TR. Average Cost (AC).
Its output can be
2 optimized by setting
1
Techniques the first derivative
Technique of the average cost
of
of function to zero.
optimizing
maximizing
output and
total
minimizing
revenue
average cost
(TR)
3
4 Maximizatio
Maximizatio n of profit:
n of profit the two
function conditions • The first derivative
considered of TR function
• The first derivative of the here are:
profit function must be =first derivative of
equal to zero for Total Cost (TC)
maximizing the profit. function.
• Second derivative of
the TR function -
Second derivative
of the TC <0
Kinds of Economic
Variables
A variable is a quantity, value or rate that changes
according to
the changes in their determinants
VARIABLES-CLASSIFIED ON THE BASIS OF ECONOMIC
ANALYSIS
Independent Endogenous Exogenous
Dependent variables: The variables: The variables: The
variables: value of these value of these value of these
The value of variables variables is variables is
these changes on determined determined
variables their own or within the outside the
depend on due to some framework of framework of
the value of exogenous the analysis the analysis
other factors. model. model.
variables.
Presentation of Relationship between
Variables
Tabular
Graphical
Price Demand Supply
Functional
1 10 2
2 8 4
3 6 6
QD=a-bP 4 4 8
Cause-and-Effect
Relationship
Functio
n
Function Uses
• It is a mathematical tool • It determines the
used for expressing the relationship between the
relationship between dependent and
economic variables that independent variables for
have a cause-and-effect effective use of economic
relationship. functions properly in
• It has two variables: business decisions.
• Bi-variable function • A specific function is
• Multi-variable function used for determining the
• An example can be stated if nature and measuring
the relationship between
the value of variable X the variables.
depends on the value of
• It quantifies the
variable Y, then the
relationship between the relationship between the
two is: variables with the help of
Y = f(X) where, Y is a statistical technique
the function of X. called regression
technique.
Some Important Economic
Functions
Demand function: It represents the
relationship between the price and
quantity of the product.
Production function: It represents the
relationship between input like labour, capital,
etc. and output.
Cost function: It represents the
relationship between
the output and the cost of production.
Total revenue function: It represents the
combined function of quantity produced and
price function derived from the demand
function.
Profit function: It represents the PROFIT
obtained by subtracting the total cost function
from the total revenue function.
General Forms of Function used in
Economic Analysis
Polynomial Linear
function: It function: It is
represents used when the
those functions relationship
that have between the
various terms of dependent and
measure for the independent
same variables
independent remains
variables. constant
Nonlinear function:
Used where relationship
between the dependent
& the independent
variables does not
remain constant. It shows
a curvilinear relationship
between the two
variables.
Solving Quadratic and Cubic
Equations
Quadratic formula: It
Factoring method: It
involves determining
involves the following
the values of the
two steps:
variables using the
formula:
• The quadratic
equation is set • The quadratic
equal to zero. equation is set
equal to zero.
• The equation is • The equation is
factored for factored for
obtaining two values obtaining
b two 4a values
of the variables x X
of the 2
and y. ± variables
b c x
and y.
2a
Differential
Calculus
It is used for finding an optimum solution to a
problem
Derivative of constant function: The derivative of a constant
function is Y
0
always equal to zero. X
Derivative of a power function:Y = f(X) = aXb where, a and b are
constants.
Derivatives of functions of sum and difference of functions
Y = f(X) + g(X) and Y = f(X) – g(X) where, f(X) and g(X) are two different
functions.
Derivative of a function as a product of two functions:
δY/δX = f(X) × δg(X)/δX + g((X) × δf(X)/δX
Derivative of a
a function
quotient of a
Derivative of Y Y U
δY/δX
function = [g(X).δf(X)/δX - f(X).δg(X)/δX]/[δg(X)] 2
X U X
Constrained
Optimization
The techniques used for achieving a target under
constrained situations or conditions is called
constrained optimization
Substituti
on Lagrangi
techniqu an
e multiplie
r
method
Substitution
Technique
Applied to the Problem of
Profit Maximization and Cost
Minimization
For Profit Maximization
• One of the variable is expressed in the terms of other
variable and solve the constraint equation for obtaining
value of one variable.
• The value obtained is substituted in the objective
function, which is
maximized and solved for obtaining value of the other
variable.
For Cost Minimization
Lagrangian Multiplier
Method
Method of solving constrained optimization
problems
Combining of
Solving by
objective
It using partial
function and the
involves derivative
constrained
method
equation
Steps for Cost Minimization:
The problem
The equation
is converted
is then
into a
multiplied
Lagrangian
with λ and
function and
the results is
the
added to the
constrained
objective
equation is
function.
set equal to
zero.
Summar
y
Optimization Technique involves technique of
maximizing total revenue, techniques of
optimizing output & minimizing average cost &
maximization of profit function
Functional Relationship between Economic
Variables states the relationship between a
quantity, a value or a rate that changes according
to the changes in their determinants
Slope is the rate of change in the dependent
variable as a result of changes in the
independent variables
The techniques used for maximizing output
under constrained situations is called
constrained optimization
