CHAPTER THREE

OPTIMIZATION TECHNIQUES

By: Habtamu Legese ([Link])

 3.1 Introduction
An optimization technique is a technique of maximizing or minimizing a
function.
 In simple words, it is a technique of finding the value of the
independent variable(s) that maximizes or minimizes the value of the
dependent variable. For example,
Some firms may be interested in finding the level of output that
maximizes their total revenue;
Some firms facing a constant price may want to find the level of output
that would minimize the average cost; and
Most firms may be interested in finding the level of output that
maximizes their profits.
Differential calculus and optimization
3.2 The Rules of Differentiation
The nature of functions that are encountered in managerial
decisions are
(i) function of a constant,
(ii) power function,
(iii) function as a sum or difference of two functions,
(iv) function as a product of two functions,
(v) function of a function.
For describing the rules of differentiation, we will use Y as the
dependent variable, X as the independent variable, and a, b,
and c as constraints.
Cont.
Cont.
Cont.
Cont.
Types of optimization techniques

Now the problem is to find the value of Q that maximizes total revenue.
3.3.1 The Rule of Total Revenue Maximization
• The rule of maximization of total sales revenue is that, the
total revenue is maximum at the level of sales (Q) at which
MR = 0, that is, the marginal revenue (MR), i.e., the revenue
from the sale of the marginal unit of the product, must be
equal to zero.
• MR is given by the first derivative of the TR function. So, to
find the value Q that maximizes TR, we need to find the
derivative of the TR function with respect to Q; set it equal to
zero, and solve it for Q.
Cont.

• TR function in Equation (3.3), the first derivative of the TR function

can be obtained as follows
3.4 Technique of Optimizing Output: Minimizing Average Cost
 The optimum size of the firm minimizes the average cost of production. It
is also called the most efficient size of the firm. A prior knowledge of
the optimum size of the firm is very important for future planning under
at least three conditions.
 One, a businessman planning to set up a new production unit would like
to know the optimum size of the plant for future planning. This problem
arises because, as the theory of production tells us, the advantage cost of
production in most productive activities decreases to a certain level of
output and then begins to increase.
 Two, the firms planning to expand their scale of production would like
to know the most efficient level of the economies of scale so that they can
plan the marketing of the product accordingly.
Cont.
• Three, businessmen working in a competitive market are often faced
with a given market price. Their profit then depends on their ability to
reduce their unit cost of production.
• Given the technology and input prices, the prospect of reducing the
unit cost of production depends invariably on the size or production.
• The problem that decision-makers might face in this regard is how to
find the optimum level of output, i.e., the level of output that
minimizes the average of production.
• As already mentioned, under general production conditions, the
optimum level of output is the one that minimizes the average cost.
The average cost (AC) can be obtained by dividing the total cost (TC)
by the quantity produced (Q).
Cont.
Cont.
Mathematical derivation of the equilibrium condition

• Profit () = TR-TC

• TC is a function of output, TC = f (Q)

• TR is also a function of output, TR = f (Q)

• Thus, profit is a function of output,  = f (Q)

 = TR-TC

• To determine the profit maximizing output we find the first derivative of

the  function and equate the result to zero.
Thursday, January 25, 2024 By : Habtamu Legese Feyisa 23
 Cont’d

= MR – MC = 0
= MR = MC ----------------------------------- (First order condition necessary condition)

The equality of MC and MR is a necessary, but not sufficient condition. The sufficient condition
for maximization of II is that the second derivative of the II function should be less than zero (or
negative) i.e.
Thursday, January 25, 2024 By : Habtamu Legese Feyisa 24
 Cont’d
d 2 d 2TR d 2TC
 0 2
 2
0
dQ 2 dQ dQ
d 2TR dMR d 2TR
 , thus
dQ 2
dQ dQ 2 is the slope MR. Since MR is horizontal (or constant), the slope of

MR is equal to zero.
d 2TC dMC d 2
TC
Like wise, dQ 2 is equal and thus, dQ 2 is the slope of MC, which is not constant
dQ

d 2TR d 2TC
Thus, 2
 2
means
dQ dQ

Thursday, January 25, 2024 By : Habtamu Legese Feyisa 25

 Cont’d
- Slope of MR < Slope of MC

- Slope of MC > 0

• Thus, the condition for profit maximization under perfect competition is

• MR = MC…………………. necessary condition and

• MC is increasing…………. sufficient condition

Thursday, January 25, 2024 By : Habtamu Legese Feyisa 26

Cont.
Cont.
Cont.
Cont.
Cont.
 Numerical example
• Suppose that the firm operates in a perfectly competitive market. The
market price of his product is $ 10. The firm estimates its cost of
production with the following cost function: TC = 10q - 4q2 + q3

A)What level of output should the firm produce to maximize its profit?

B)Determine the level of profit at equilibrium.

C)The minimum price required by the firm to stay in the market?

Thursday, January 25, 2024 By : Habtamu Legese Feyisa 36

 Solution
•  To determine equilibrium output just equate MC& MR

• Then solve for q.

10 – 8q + 3q2 = 10

- 8q + 3q2 = 0

q (-8 + 3q) = 0

q = 0 or q = 8/3

Thursday, January 25, 2024 By : Habtamu Legese Feyisa 37

Cont’d
To determine which level of output maximizes profit we have to use the second order test at
the two output levels i.e. we have to see which output level satisfies the second order condition
of increasing MC.
• To see this first we determine the slope of MC

dMC
Slope of MC = = -8 + 6q
dq

At q = 0, slope of MC is -8 + 6 (0) = -8 which implies that marginal lost is decreasing at q = 0. Thus, q = 0 is

not equilibrium output because it doesn’t satisfy the second order condition.

•  At q = 8/3, slope of MC is -8 + 6 (8/3) = 8, which is positive, implying that MC is increasing at q = 8/3

Thus, the equilibrium output level is q = 8/3

Thursday, January 25, 2024 By : Habtamu Legese Feyisa 38

 cont’d
B. TR = Price * Equilibrium out put
= $ 10 * 8/3= $ 80/3
TC at q = 8/3 can be obtained by substituting 8/3 for q in the TC function,
i.e.,
TC = 10 (8/3) – 4 (8/3)2 + (8/3)3  23.12
Thus the equilibrium (maximum) profit is
 = TR – TC
= 26.67 – 23.12 = $ 3.55

Thursday, January 25, 2024 By : Habtamu Legese Feyisa 39

 Cont’d
C) To stay in operation the firm needs the price which equals at least the
minimum AVC. Thus to determine the minimum price required to stay in
business, we have to determine the minimum AVC.
• AVC is minimal when derivative of AVC is equal to zero

dAVC
That is =0
dQ

Thursday, January 25, 2024 By : Habtamu Legese Feyisa 40

 Cont’d
• Given the TC function: TC = 10q – 4q2 +q3, there is no fixed cost i.e. TC is equal to the TVC.

Hence, TVC = 10q – 4q2 + q3

TVC 10q  4q 2  q 3
AVC = = = 10 – 4q2 + q2
q q

dAVC d (10  4q  q 2 )
0  0
dq dq

=-4 + 2q = 0

q = 2 i.e. AVC is minimum when out put is equal to 2 units.

The minimum AVC is obtained by substituting 2 for q in the AVC function i.e., Min AVC = 10 – 4 (2) +
22 = 6

Thus, to stay in the market the firm should get a minimum price of $ 6.
Thursday, January 25, 2024 By : Habtamu Legese Feyisa 41
 Exercise
Price MC
ATC
P=10
Q: Find Profit for the
AC=8
firm whose graph

e
DD

20 MR Quantity of output
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 Numerical example
• Assume a pure monopoly firm with Demand, p=40-Q,
TFC=50, and TVC=Q2
• Required:
a) the profit maximizing unit of output and price
b) the maximum profit
• Answer
a) Q=10, P=30
b) π= 150

1/25/2024 43
 Numerical example #2
• Suppose the monopolist faces the market demand
function given by 144
Q
P2
• The AVC of the firm is given as AVC = Q ½ and
the firm has a fixed cost of $ 5
• Required:
a) determine equilibrium P&Q
b) determine the maximum profit
• Answer: a)_____________ b) __________________

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 Numerical Example #3
• Given: TC and DD as:
• and
• Required:
a) determine equilibrium P&Q
b) determine the maximum profit
• Answer: a Qe= 6.7 b) Pe=13.3

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 The multi- plant monopolist
• It is a monopoly which operates in more than one plant
• The cost conditions may differ from one plant to another.
• Firms produce the same product in different plants which sold
in the same market
• Reasons – to minimize cost of transportation
- to make the product accessible quickly etc

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 Assumptions of Multi-plant monopoly
• Two plants
• Homogeneous product
• Different Marginal cost of production in the two plants
• The firm knows its average and marginal revenue
functions ( single AR=DD)

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 The firm decision
• Equilibrium quantity( Qe)
• Equilibrium price(Pe)
• Allocation of the output between
the two plants(q1 and q2)

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 Equilibrium ……. Cont’d
• How can the monopolist decide the total
production and how much of that output each
plant should produce?
• Total Q produced where MR=MC, but there
are two different MC (MC1 & MC2)
MR=MC1=MC2
If their MC are equal, the firm produces in
both plants equal units.

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 Algebraically
• TR=PQ where Q=Q1+Q2
• TC=TC1 + TC2
TC1 =f(Q1)
TC2=f(Q2)
π= TR-TC
π= TR-(TC1+TC2)
π= TR- TC1-TC2
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 Continued…
• Profit is maximum where first derivation is equal to zero

d d  
0    0  or
dQ dQ Q1 Q 2
 dTR dTC1 dTC 2
    0  MR1  MC1  0
Q1 dQ1 dQ1 dQ1

 dTR dTC1 dTC 2

    0  MR2  MC 2  0
Q 2 dQ2 dQ2 dQ2

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 Continued…
Thus , MR1  MC 1  MR 2  MC 2
But , MR1...and ..MR 2, are...equal
thus , MR1  MR 2  MR  MC 1  MC 2

• Then the above equilibrium condition can be

written as:
MR = MC1 and MR = MC2

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 Numerical example #1
• Given of the cost functions in the two plants and demand curve as follows
answer questions that follow.

Answer Key:
a)________
b)________
C)________
• Required: d)_______

– Equilibrium output (Q)

– Equilibrium price(P)
– Corresponding output at each plant(q1, q2)
– Profit generated from each plant and total profit .

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 Numerical example #2
• Given of the cost functions in the two plants and demand curve as follows answer
questions that follow.

Answer Key:
a)________
b)________
• Required: C)________
d)_______
– Equilibrium output (Q)
– Equilibrium price(P)
– Corresponding output at each plant(q1, q2)
– Profit generated from each plant and total profit .

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 Numerical example #3

• Suppose Ethiopian Electric Light and Power Corporation

(EELPC) is a multi plant monopolist having two plants,
Tekeze plant (plant1) and Fincha plant (Plant2).
• The operating costs of the two plants are given as follows:

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 Continued…
• Tekeze Plant: TC1 = 10 Q12
• Fincha plant: TC2 = 20 Q22 where
– Q1 - Amount of electric power produced in Tekeze and
– Q2 – amount of electric power produced in Fincha
• EELPC estimates the demand for electric power by
the following function
• P= 700 – 5Q where
– P - is price (total in million birr) per Giga watt and
– Q – is the total amount of Giga watt sold and Q = Q1 + Q2
• Note that a Giga watt of electric power, whether it
comes from Fincha or Tekeze plant worth equal price
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 Required
a) What level of output (electric power) should EELPC produce
and what price per Kilowatt should it charge to maximize its
profit?
b) How much of the total output should be produced in each
plant?
c) Suppose that recently the Tekeze plant is suffering from
siltation problem (which leads to additional cost of cleaning
the dum), but Fincha plant is not. How should EELPC adjust
Q1, Q2 and QT and P to maximize its profit?
Answer Key:
a)________
b)________
C)________

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Thank You!