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.
