Chapter 2 Math Review
Marginal Analysis
Most daily business and economic decisions are based
on marginal analysis, not on totals or averages.
Decisions are made by comparing marginal benefit of
an action (MB) to its marginal cost (MC). If MB > MC
it is rational to take the action, otherwise, discard it.
Example: Consumer Theory; To maximize total
utility (satisfaction that consumer receives from buying or
consuming a good), a consumer compares marginal utility
(MU) of the good to MU of the price (Mup) that
consumer pays to buy the good. If MU > MUP,
consumer buys more units of the good. If MU < MUP,
consumer buys less. Consumer’s utility is
Chapter 2: Optimization
Example: Theory of Firm and Production: A business
will hire more labor so long as the value of the
marginal product of labor (VMPL) is greater than
wages (W) paid to labor, VMPL > W. If VMPL < W,
business will layoff the labor. When VMPL = W, an
optimum level of hiring is achieved.
Example: A firm earns marginal profit from selling a
good as long as marginal revenue from selling the
good (MR) is greater than marginal cost of the good
(MC), MR > MC. If MR < MC, the firm should sell
less. The profit of the firm is is maximized when MR
= MC.
Chapter 2 Math Review
Example Continued:
If MR > MC, the firm will sell more goods. If MR <
MC, the firm will sell less goods. Profit is
maximized or loss is minimized when MR = MC.
What is Marginal? Marginal means incremental.
Marginal utility of a good for a consumer is the
increase in total utility for one more unit increase in
consumption of the good. Marginal product of labor
is increase in total product due to one more unit
increase in labor, and marginal cost of producing a
good is addition to total cost due to one more unit
increase in production of that good, and so on.
Chapter 2 Math Review
Marginal and Derivative
For a mathematical function y = f(x) derivative of the
function, dy/dx, is the rate of change in y per small
units of change in x. That is, Limit of dy/dy, as dx 0.
Note That:
Marginal in Economics is the same as Derivative in
Mathematics.
Examples: For a total utility function U = u(Q), marginal
utility (MU) is MU = dU/dQ.
For an output or production function Q = f(L) , marginal
product of labor MPL = dQ/dL.
For a cost function TC = f(Q), marginal cost (MC)
MC = dC/dQ.
Chapter 2 Math Review
Optimizing with Marginal:
Economics deal with optimizing principles. For
example, the objective of firms is assumed to be
maximizing profit. Profit Π = TR - TC.
TR = P.Q.
TR = f(Q); Total revenue is a function of Q,
TC = g(Q); Total cost is a function of Q,
Π = h(Q); Profit will be a function of Q.
Note That: Most Economic Functions are Written in
Terms of Quantity Not Price.
Two Types of Optimizing Problems:
Unconstrained and Constrained Optimization
Chapter 2 Math Review
Unconstrained Optimization:
Most of the optimizing problems in economics are
constrained optimizing problems. However, there are
many occasions in which the problem may be that of
finding the optimum values of an objective function
with no constraint attached.
Examples:
Max. TR = P.Q Or Max. Π = TR – TC Or Min. TC.
Problems of this nature are simply that of finding the
critical values of a function in differential calculus.
Chapter 2 Math Review
Unconstrained Optimization: Max. Q = q(L)
Chapter 2 Math Review
Constrained Optimization:
In a constrained optimizing problem, the economic unit
optimizes an objective function given that certain
constraints to be satisfied.
Examples: A consumer either maximizes utility
subject to her income constraint or minimizes spending
subject to target level of utility.
Primal Dual
Maximize: U = u(x1, x2) Minimize E = p1x1 + p2x2
Subject To: p1x1 + p2x2 = M Subject To: u(x1, x2) = Uo
Chapter 2 Math Review
Constrained Optimization:
Examples: In the theory of production, a producer
maximizes output subject to a given cost level or
minimizes the cost of production subject to a given
level of output.
Primal Dual
Maximize: Q = q(L, K) Minimize C = wL + rK
Subject To: wL + rK = C Subject To: q(L, K) = Qo
Chapter 2 Math Review
Constrained Optimization: Binding Constraint
Max. Q = q(L) Subject to L < 20
Chapter 2 Math Review
Constrained Optimization: Non-binding
Constraint
Max. Q = q(L) Subject to L < 40
Chapter 2 Math Review
Solving Unconstrained Optimizing Problem:
Example: Profit maximizing problem of a firm can be
expressed as: Maximize Π = TR – TC = P.Q – C(Q)
To find the solution, set the derivative of the function
with respect to Q equal to zero:
dΠ/dQ = dTR/dQ – dTC/dQ = MR – MC = 0
Note that: dTR/dQ, which is the derivative of total
revenue with respect to Q is the same as Marginal
Revenue (MR) , and dTC/dQ which is the derivative of
total cost function with respect to output is Marginal
Cost (MC).
Therefore, to maximize the profit, a producer should
set MR = MC.
Chapter 2 Math Review
Solving Unconstrained Optimizing Problem:
In the optimizing rule MR = MC, MR = dTR/dQ. Since TR = P.Q,
and P is a function of Q, differentiating P.Q with respect to Q results
in (dP/dQ)Q + P. Therefore, the profit- maximizing rule
can be written as:
(dP/dQ)Q + P – dC/dQ = 0.
Case 1: Perfectly Competitive Market In a perfectly
competitive market price is fixed, MR = P. In equation
(dP/dQ)Q + P – dC/dQ = 0, dP/dQ = 0, and profit
maximized when MR = P = MC.
Case 2: Monopoly In a monopoly market, (dp/dQ)(P/Q)
= -1/ep. Thus, profit is maximized when: MR = P(1 +
1/ep) = MC < P
Chapter 2 Math Review
Solving Constrained Optimization
Example: Maximize Q = f(L, K)
Subject To: wL + rK = C
Steps:
• Find Marginal Product of Labor, MPL and Marginal
Product of Capital, MPK.
• Find MPL per dollar as MPL/w, where w is wage paid
to labor. Find MPK/r, where r is the rental cost of
capital.
• The most efficient number of labor and capital is
derived by allocating the Firm’s cost or budget
constraint (C) between labor and capital in a way
that MPL/w = MPK/r and wL + rK = C.
Chapter 2 Math Review
This solution implies that at the optimum point, the firm
is getting the same productivity from spending a dollar
on labor as it gets from spending a dollar on capital. If
MPL/w > MPK/r, the firm should hire more labor or
reduce the capital. If MPL/w < MPK/r, the firm should
spend more on capital or hire less labor.