Chapter-Six

Objectives of Firms and Optimization Techniques

for Decision Making

11/25/2023 By: Adugna T. Arfassa 1

 Objectives of Firms
Effective economic decision making requires an understanding of

the goal(s) of the firm.

What objective(s) guide business decision making? That is, what

should management try to achieve for the owners of the firm?

Firms ‟managers would like to achieve different objectives

according to the market situation and the nature of their

investment.
However, in this section profit maximization objective, wealth

maximization objective and not for profit object will be discussed.

11/25/2023 By: Adugna T. Arfassa 2

 Profit Maximization Objective
Traditionally, economists have assumed the objective of the

firm is to maximize profit (revenue - cost).

Profit maximization as the objective of business firms is

regarded as the most reasonable and analytically the most

productive business objective.
This profit maximization assumption helps in predicting the

behavior of business firms in the real world and also the

behavior of price and output under different market
condition.
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 Cont’d
Thus it is assumed that managers consistently make decisions in

order to maximize profit, but profit in which period, current or

future?
Managers often are observed making decisions that reduce current

year profit in an effort to increase profit in future period for

example investments in marketing program cut current profit but
will significantly increases profit in later years.
The profit maximization objective of the firm has provided decision

makers with useful insights regarding efficient resource

management and allocation.
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 Cont’d
 However, the profit maximization assumption is limited since it does not

incorporate the time dimension. A firm could always raise total profits and
maximize earnings per share, however, is not a fully appropriate objective, partly
because it does not specify the timing or duration of expected returns.
 Another shortcoming of the objective of profit maximizing is that it does not

consider the risk or uncertainty of the prospective earnings stream. Some

investment projects are far more risky than others. As a result, the prospective
stream of earnings per share would be more uncertain if these projects were
undertaken.
 As both current and future profits are important the goal should focus on

maximizing the present value of all future profits. The shareholder wealth-
maximization model of the firm concentrates on this issue.
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Profit Maximization as a Business Objective Illustrations

 The conventional economic theory assumes that profit maximization is

the main objective of business firms. The Profit-Maximizing

Conditions.
 We first define profit as: ∏ = TR – TC,………(1)

 Where TR = Total Revenue = Unit price (P) x Quantity (Q) = PQ, and,

 TC = Total cost = Variable Cost (VC) + Fixed Cost (FC).

 There are two major conditions that must be fulfilled for equation (1) to

be a maximum profit: (i) the first-order (or necessary) condition, and

(ii) the second order (or supplementary) condition.

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 Cont’d
 The first-order condition requires that at a maximum profit, marginal

revenue (MR) must equal marginal Cost (MC).

 Note that by the term marginal revenue, we mean the revenue obtained from

the production and sale of one additional unit of output, while marginal cost
is the cost arising from the production of the one additional unit of output.
 The second-order condition requires that the first-order condition must be

satisfied under the condition of decreasing marginal revenue (MR) and

increasing marginal cost (MC).
 Fulfillment of this two conditions makes the second-order condition the

sufficient condition for profit maximizations. The first-and second-order

conditions can be illustrated as in figure below:

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 Cont’d
In technical terms, the profit-maximizing conditions can

be formulated as follows: Given profit (∏ ) = TR –TC to

be maximized, let: TR = f(Q) and, TC = f(Q) where Q =
Quantity produced and sold.
Then ∏ = F(Q) = f(Q)TR – f(Q)TC ….. (2)

The first-order condition requires that the first derivative

of equation (2) should be zero, so that: Δ∏ = - 0

………………(3)

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 Cont’d
You can observe that this condition holds only when:

dTR = - or MR = MC.
To get the second-order condition, we take the second

derivative of the profit function to get: d2∏ = -

------------------------------------------ (4)

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 Cont’d
 The second-order condition requires that equation (4) is negative, so

that:

- ------------------------------------------------------------------- (5)
 Equation (5) may also be written as: Slope of MR < Slope of MC, since

the left-hand side of equation (5) represents the slope of MR and the
right-hand side represents the slope of MC.
 This implies that at the optimum point of profit maximization, marginal

cost (MC) must intersect the marginal revenue (MR) from below.
 We conclude that maximum profit occurs where the first- and second-

order conditions are satisfied.

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 Example
Suppose that the unit price of a commodity is defined by:

P = 100 – 2Q
Then, TR = PQ = (100 – 2Q)Q = 100Q – 2Q2

Suppose also that the total cost of producing this commodity is

defined by the cost function: TC = 100 + 0.5Q2

You are required to apply the first-order condition for profit

maximization and determine the profit maximizing level of

output. According to the first order condition, profit is
maximized where: MR = MC
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 Cont’d
Or

-
Given equations above and , we get:
MR = = 100 – 4Q
MC = = 1Q = Q
 It follows that profit is maximized where: MR = MC

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 Cont’d
Or

100 – 4Q = Q
Solving for Q in equation above, we get: 100 = 5Q

5Q = 100 Q = 100/5 = 20.

The output level of 20 units satisfies the first order condition.

Let us see if it satisfies the second-order condition.

Recall that the second-order condition requires that:

-<0

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 Cont’d
 or

 - <0 or - <0 -4 -1 = -5 < 0

 Thus the second-order condition is also satisfied at the output level of 20

units. We therefore conclude that the profit-maximizing level of output in

this problem is 20 units.
 To determine the maximum profit, you will substitute 20 for Q in the

original profit function. Thus, the maximum profit will be:

 ∏ * = TR – TC = 100Q – 2Q2 – (100 + 0.5Q2)

 100Q – 2.5Q2 – 100 = 100(20) – 2.5(20)2 – 100 = 2000 – 1000 – 100 =

900.
 We conclude that the maximum profit is 900 only.
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 Technique of Output Maximization
 Minimization of Average Cost

 The optimum size of the firm is the size minimizes the average cost of

production. This is also referred to as the most efficient size of the firm.
 Knowledge of the optimum size of a firm is very important for future

planning under three important conditions:

 First, a businessperson planning to set up a new production unit would

like to know the optimum size of the plant for future planning.
 This issue arises because, as the theory of production indicates, the

average cost of production in most productive activities decreases to a

certain level of output and then begins to increase.

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 Cont’d
Second, 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 be able to plan the marketing of the product
accordingly.
Third, businesspeople working under competitive business

environment are faced with a given market price.

Their profit therefore, depends on their ability to reduce their unit

cost of production. And, given the technology and input prices, the
prospect of reducing unit cost of production depends on the size of
production.
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 Cont’d
The problem decision makers face under this condition is

how to find the optimum level of output or the level of

output that minimizes the average cost of production.
As implied earlier, under general production conditions, the

optimum level of output is the one that minimizes the

average cost (AC), where the average cost can be defined as
the ratio between total cost (TC) and quantity produced (Q).
Thus, AC = ------------------------------------------------ (6)

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 Cont’d
Suppose the total cost function of a firm is given by:

TC = 100 + 60Q + 4Q2….…. (7) then,

AC = = + 60 + 4Q

The problem here is to find the value of Q that minimizes

the average cost, as represented in equation (8).

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 Cont’d
 The Minimization Rule: Like the maximization rule, the minimization

rule is that the derivative of the function to be minimized must be equal to

zero.
 It follows that the value of output (Q) that minimizes average cost (AC)

can be obtained by taking the first derivative of the AC function and setting
it equal to zero and solving for Q.
 Thus, in the current example, dAC = = -------------------------(9)

 Setting equation (9) equal to zero, we get: -100/Q2 + 4 = 0 -100/Q2 = -4 -

4Q2
-100Q2 = 100/4 = 25 Q = √25 = 5 Thus, the level of output that minimizes
average cost is 5 units.
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 Constrained Optimization
The maximization and minimization techniques as referred to

and discussed in the previous sections were generally referred

to in economics as unconstrained optimization or
minimization, as the case may be.
They are unconstrained in the sense that firms are assumed to

operate under no constraints on their activities.

In the real business world however, firms face serious resource

constraints. They need, for example, to maximize output with

given quantity of capital and labor time
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 Cont’d
 The techniques used to optimize the business objective(s) under

constraints are referred to as constrained optimization techniques.

 The two common techniques of optimization include: (i) Constrained

optimization by substitution, and (ii) Lagrangian multiplier. The

linear programming technique has a wide range of applications and
should be a subject in itself, usually discussed in detail under
quantitative techniques .
 This discussion will attempt to summarize the two other important

techniques, that is, constrained optimization by substitution and

Lagrangian multiplier.

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 Constrained Optimization by Substitution Method
This technique will be illustrated in two ways: (i) constrained

profit maximization problem, and (ii) constrained cost

minimization problems. (i) Constrained Profit Maximization.
Let the profit function of an hypothetical firm be given as:
∏ = f(X,Y) = 100X – 2X2 – XY + 180Y – 4Y2 …...(1) Where

X and Y represent two products. We wish to maximize equation

(1) subject to the constraint that the sum of the output of X and
Y be equal to 30 units.
That is, X + Y = 30 …………………….. (2)

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 Cont’d
 Solving by the substitution method, we obtain as follows:

 First note that the process of the substitution method involves two steps

a. Express one of the variables (X or Y in this case) in terms of the other

and solve the constraint equation for one of them (X or Y), and

b. Substitute the solution obtained into the objective function (that is, the
function to be maximized or the profit function) and solve the outcome
for the other variable.
 Solution: Given the constraint equation (2), we solve for the values of X

and Y in terms of one another to obtain: X = 30 –Y or Y = 30 – X

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 Cont’d
 By substituting the value of X into the profit equation (1), we obtain:

 ∏ = 100(30 –Y) – 2(30 –Y)2 – (30 –Y)Y + 180Y – 4Y2

= 3000 – 100Y – 2(900 – 60Y + Y2 ) – 30Y + Y2 + 180Y – 4Y2

= 3000 – 100Y – 1800 + 120Y – 2Y2 – 30Y + Y2 + 180Y – 4Y2 = 1200 +

170Y – 5Y2
 Equation (3) can now be maximized by obtaining the first derivative and

setting it equal to zero and solving for Y: d∏ = 170 – 10Y = 0

………………………………….(4) dY Solving equation (4) for Y, we get:
10Y = 170 Y = 17.
 Substituting 17 for Y into the constraint equation (2), we get: X + 17 = 30

X = 13
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 Cont’d
 It follows that the optimum solution for the constrained profit maximization

problem is X= 13 units and Y = 17 units.

 This values of X and Y satisfy the constraint. Expressed differently, the firm

maximizes profit by producing and selling 13 units of product X and 17 units of

product Y.
 The maximum profit under the given constraint can now be obtained by

substituting the above values of X and Y into the profit function, equation (1):
 ∏(X,Y) = ∏(13, 17) = 100(13) – 2(13) 2 – (13)(17) + 180(17) – 4(17) 2 = 2,645.

 Thus, the maximum profit under constraint is 2,645. It can be shown that

maximum profits under constraints is less than maximum profits without

constraints.

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 Constrained Cost Minimization
 We now apply the substitution method to the problem of constrained cost minimization.

Suppose the cost function of a firm producing two goods, X and Y, is given by:
C = 2X2 – XY + 3Y2
 And the firm must meet a combined order of 36 units of the two goods. The problem is

to find and optimum combination of the products X and Y that minimizes the cost of
production.
 Alternatively stated, we Minimize C = 2X2 – XY + 3Y 2 ------------------------ (5)

 Subject to X +Y = 36 -------------------------------------------------------------------------------

(6)
 Again, substitution method requires that the constraint equation (6) is expressed in

terms of any of the two goods, X and Y, and then substituted into the objective function
(equation (5)).
 Expressing X in terms of Y, we get: X = 36 –Y --------------------------------------(7)
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 Cont’d
 Substituting equation (7) for X in the objective function, you get:

 C = 2(36 –Y)2 – (36 –Y)Y + 3Y2

= 2(1296 – 72Y +Y2 ) – 36Y +Y2 + 3Y2 = 2592 – 144Y + 2Y2 – 36Y +Y2
+ 3Y2
= 2592 – 180Y + 6Y2 ………………………………….(8)
 According to the optimization rule, for the now objective function

(equation (8)) to be minimized, the first derivative must be equal to zero,

viz: dC = 180 + 12Y = 0 ……………………………………(9) dY Solving
forY in equation (9), we get the value of Y as follows: 12Y = 180 Y = 15
Substituting this value into the constraint equation (6), you get: X + 15 = 36
X = 21
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 Cont’d
Thus, the optimum solution demands that 21 units of X and 15

units of Y minimize the cost of meeting the combined order of 36

units (that is, 21 + 15 = 36 units).
The minimum cost of producing 21 units of X and 15 units of Y

can be obtained as follows, using equation (5), the objective

function:
Minimum Cost = 2X2 – XY + 3Y2

= 2(21)2 – (21)(15) + 3(15)2 = 882 – 315 + 675 = 1,242

Thus, the minimum cost of producing the combined order is 1,242.

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Constrained Optimization by Lagrangian Multiplier Method

The Lagrangian method is most useful in solving complex

optimization problems. In this discussion, we summarize this

method using two illustrations: a. a constrained profit
maximization problem, and b. a constrained cost minimization
problem
Constrained Profit Maximization: We refer to the profit function

of equation (1), with some constraint imposed, so that we:

Maximize ∏(X, Y) = 100X – 2X2 – XY + 180Y – 4Y2 ….(1)

Subject to X + Y = 30…………...….. (2)

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 Cont’d
 The basic approach of the Lagrangian method is to combine the

objective function and the constraint equation to form a Lagrangian

function. This is then solved using partial first-order derivatives.
 The Lagrangian function is formulated simply by: -First, setting the

constraint equation (2) equal to zero: X + Y – 30 = 0

 Second, multiplying the resulting equation by λ (Greek letter,

“lambda”): λ(X + Y – 30).

 Adding this to the objective function, we get the Lagrangian

function as:

Z = 100X – 2X2 – XY + 180Y – 4Y2 + λ(X + Y – 30) …(3)

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 Cont’d
 Equation (3) is the Lagrangian function with three unknowns, X, Y, and λ.

The values of these unknowns that maximize Z will also maximize Profit
(∏).
 The Greek letter, λ, is referred to as the Lagrangian multiplier. It measures

the impact of a small change in the constraint on the objective functions.

 We are now required to maximize Z (equation (3). To do this, we first

obtain the partial derivatives of Z with respect to X, Y, and λ and set each
equal to zero to satisfy the first-order condition for optimization. This will
give rise to a simultaneous equation system in three unknowns, X,Y, and
λ as indicated below:

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 Cont’d
 Z = 100X – 2X2 – XY + 180Y – 4Y2 + λ(X + Y – 30)

dZ = 100 – 4X –Y + λ = 0 …………………………………. (4)

 dX d Z = -X +180 – 8Y + λ = 0 ……………………………(5)

 dY d Z = X + Y – 30 = 0 …………………………………….(6)

 dλ Solving for X, Y, and λ in the above simultaneous equation system, you

obtain the values of X, Y, and λ that maximize the objective function in

equation (1).
 Using the necessary technique of solving simultaneous equation systems, you

obtain the solutions: X = 13 Y = 17, and λ = 31.

 The value of λ implies that if output is increased by 1 unit, that is, from 30 to

31 units, profit will increase by about 31, and if output is decreased from 30 to
29 units, profit will decrease by about 31.
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 Constrained Cost Minimization
 Suppose a firm has to supply a combined order of 500 units of

products X and Y. The joint cost function for the two products is
given by:
 C = 100X2 + 150Y2 ………………………….(7)

 Since the quantities to be produced of X and Y are not specified in

the order, the firm is free to supply X and Y in any combination.

 The problem is therefore, to find the combination of X and Y that

minimizes cost of production, subject to the constraint, X +Y = 500.

 Thus, we are required to: Minimize C = 100X2 + 150Y2

 Subject to X + Y = 500…………………………………………… (8)

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 Cont’d
The Lagrangian function can be formulated as in equation (9)

below:

Zc = 100X2 + 150Y2 + λ(500 – X –Y) ………………………………

(9)
As before, the first-order partial derivatives yield:

=200X - λ = 0…………………………………………………. (10)

=300Y - λ = 0 ------------------------------------------------------------ (11)

=500 – X - Y = 0 ------------------------------------------------------- (12)

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 Cont’d
 Again, solving the above simultaneous equations for X, Y, and λ, we get the
solution to the cost minimization problem.
 For simplicity, subtract equation (11) from equation (10), you get:
 200X - λ - (300Y - λ) = 0 200X – 300Y = 0 200X = 300Y X = 1.5Y…………. (13)
 Substituting 1.5Y for X in equation (12), we get: 500 – 1.5Y –Y = 0 500 – 2.5Y =
0 2.5Y = 500 Y = 200 Substituting Y = 200 into the constraint equation (8), you
get: X + 200 = 500
X = 300.
 It follows that the solution to the minimization problem is that X = 300 and Y =
200 will minimize the cost of producing the combined 500 units of the products X
and Y.
 The minimum cost is obtained by using the objective function (equation (7)) as
follows:
C = 100X2 + 150Y2 = 100(300)2 + 150(200)2 = 9,000,000 + 6,000,000
= 15,000,000
 Thus the minimum cost of supplying the combined 500 units of products X and Y
is 15million

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Shareholder Wealth-Maximization Objective
The most widely accepted objective of the firms is to maximize the

value of the firm for its owners; that is, to maximize shareholder
wealth.
The shareholder wealth maximization goal states that a firm’s

management should maximize the present value of the expected

future returns to the owners (share-holders).
Shareholder wealth is measured by the market price of a firm’s

common stock. Hence, the value of a firm’s stock is equal to the

present value of all expected future profits, discounted at the
shareholders required rate of return
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 Cont’d

• Where V(π) is the current (present) value of a share of stock, πt

represents the profits expected in each of the future periods (n) and i
equals the investors‟ required rate of return.
• The time value of money refers to the fact that a dollar to be received
in the future is not worth a dollar to day.
• Therefore, it is necessary to have techniques for measuring the value
today (i.e. the present value) of dollar to be received or paid at
different points in the future.
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 Cont’d
 For the purposes of analysis here, it is only necessary to recognize

that $1 received one year from today is generally worth less than $1
received today because $1 today can be invested at some rate of
interest, for example, 15 percent, to yield $1.15 at the end of one year.
 Thus, an investor who requires (or has an opportunity to earn) a 15

percent annual rate of return on an investment would place a current

value of $1 on $ 1.15 expected to be received in one year. This
example explicitly considers the timing of future profits and
recognizes that a dollar received in the future is worth less than a
dollar received now.

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 Cont’d

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 Solution
Both profit streams are assumed to be functions of output

levels and to represent the results of alternative production

schedules.
Note that although the first profit stream appears to be

preferable to the second, since it yields $9 more in profit

over the two periods, computation of present values (PV)
reveals that, in fact, the second p stream is preferable to
the first.

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 3. Not for Profit Firms Objective
A number of firms as an objective give attention to social

responsibility as well.
Social responsibility concerns such things as protecting

the consumer by maximizing the quantity and quality of

output, paying fair wages to employees, maintaining fair
hiring practices, supporting education, and becoming
actively involved in environmental issues like clean air
and water.

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 Thank you!!

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