OPTIMAL DECISIONS
USING MARGINAL
ANALYSIS
Make a “small” move to a nearby alternative
if and only if the move will improve one’s
objective. Keep moving, always in the
direction of an improved objective, and stop
when no further move will help (Samuelson &
Marks, 2012)
01
DEFINITION OF TERMS
DEFINITION OF TERMS
➢ Marginal function - in economics is defined as
the change in total function due to a one unit
change in the independent variable.
➢ Marginal cost - is the change in total cost
incurred from the production of an additional
unit.
➢ Marginal revenue - is the change in total
revenue brought about by selling one extra unit
of output.
DEFINITION OF TERMS
➢ Marginal benefit - is the added satisfaction or
utility a consumer enjoys from an additional
unit of a good or service.
➢ Marginal analysis - analytical technique for
solving optimization problems that involves
changing values of choice variables by small
amounts to see if the objective function can be
further improved.
DEFINITION OF TERMS
➢ Objective function - the function the decision maker
seeks to maximize or minimize.
➢ Maximization problem - an optimization problem that
involves maximizing the objective function.
➢ Minimization problem - an optimization problem that
involves minimizing the objective function.
➢ Activities/Choice variables - variables that determine the
value of the objective function.
➢ Constraints – a restraint or limit, example the budget
constraint indicates a limited amount that can be spent.
DEFINITION OF TERMS
➢ Unconstrained optimization - An optimization
problem in which the decision maker can choose the
level of activity from an unrestricted set of values.
➢ Constrained optimization - An optimization problem
in which the decision maker chooses values for the
choice variables from a restricted set of values.
➢ Derivatives – in calculus, the change in a dependent
variable that comes with a very small change in the
independent variables.
02
UNCONSTRAINED
MAXIMIZATION
Unconstrained Maximization
● Any activity that decision makers might wish to
undertake will generate both benefits and costs.
● Consequently, decision makers will want to
choose the level of activity to obtain the
maximum possible net benefit from the activity.
NB = TB - TC
Unconstrained Maximization
● Optimal level of activity - The level of activity that maximizes
net benefit (A*).
● Marginal benefit - The change in total benefit caused by an
incremental change in the level of an activity.
○ Positive benefit - Marginal benefit increases as additional
units are consumed.
○ Negative benefit - Marginal benefit decreases as additional
units are consumed.
○ Zero/Neutral Benefit - No marginal benefit is gained or lost
with each additional unit.
Example
ABC Corporation produces Product X and has developed the
following details illustrating the relationship between the
number of workers producing the product, the number of
units produced and the revenue generated.
Number of Products Revenue
workers produced generated
8 100 500,000.00
9 120 600,000.00
10 139 687,500.00
11 157 750,000.00
Unconstrained Maximization
Marginal cost - the change in total cost caused by an
incremental change in the level of an activity.
Let's say a company currently manufactures 100 shoes for a
total cost of P10,000 (P100/each). It also costs P11,000 to
manufacture 120 shoes. The change in total cost (P11,000 -
P10,000) divided by the change in units manufactured (120
units - 100 units) yields the marginal cost of the additional
20 shoes (P1,000 / 20 units = P50).
Unconstrained Maximization
Marginal Analysis Decision Rules
Optimization with a Discrete Choice Variable
Optimization with a Discrete Choice Variable
Optimization with a Discrete Choice Variable
● Sunk costs are costs that have previously
been paid and cannot be recovered.
● Fixed costs are costs that are constant and
must be paid no matter what level of an
activity is chosen.
Example:
Suppose you head your company’s advertising department and you
have just paid $2 million to an advertising firm for developing and
producing a 30-second television ad, which you plan to air next
quarter on broadcast television networks nationwide. The $2 million
one-time payment gives your company full ownership of the 30-
second ad, and your company can run the ad as many times as it
wishes without making any further payments to the advertising firm
for its use. Under these circumstances, the $2 million payment is a
sunk cost because it has already been paid and cannot be recovered,
even if your firm decides not to use the ad after all.
Example:
To decide how many times to run the ad next quarter, you call a
meeting of your company’s advertising department. At the meeting,
the company’s media buyer informs you that 30-second television
spots during American Idol will cost $250,000 per spot. The
marketing research experts at the meeting predict that the 24th time
the ad runs it will generate $270,000 of additional sales, while
running it a 25th time will increase sales by $210,000. Using the
logic of marginal analysis, the marketing team decides running the
new ad 24 times next quarter is optimal because the 24th showing
of the ad is the last showing for which the marginal benefit exceeds
the marginal cost of showing the ad.
03
CONSTRAINED
MAXIMIZATION
Marginal Benefit per Dollar Spent on an Activity
Phrases such as “most value for your money,” “best buy,”
and “greatest bang per buck” mean that a particular activity
yields the highest marginal benefit per dollar spent.
Example: Need for a new copy machine (with identical
features)
Copy Machine Printouts Cost
Brand A 500,000 2,500
Brand B 600,000 4,000
Brand C 580,000 2,600
Example:
Consider a situation in which there are two activities, A and B.
Each unit of activity A costs $4 to undertake, and each unit of
activity B costs $2 to undertake. The manager faces a constraint
that allows a total expenditure of only $100 on activities A and B
combined. The manager wishes to allocate $100 between
activities A and B so that the combined total benefit from both
activities is maximized.
The manager is currently choosing 20 units of activity A and 10
units of activity B. The constraint is met for the combination 20A
and 10B since ($4x20) + ($2x10) = $100.
Example:
For this combination of activities, suppose that the
marginal benefit of the last unit of activity A is 40 units
of additional benefit and the marginal benefit of the last
unit of B is 10 units of additional benefit. In this
situation, the marginal benefit per dollar spent on
activity A exceeds the marginal benefit per dollar spent
on activity B:
Example:
To take advantage of this fact, the manager can increase
activity A by one unit and decrease activity B by two units (now,
A=21 and B=8). This combination of activities still costs $100
[($4x21) + ($2x8) = $100]. Purchasing one more unit of activity
A causes total benefit to rise by 40 units, while purchasing two
less units of activity B causes total benefit to fall by 20 units.
The combined total benefit from activities A and B rises by 20
units (= 40-20) and the new combination of activities (A=21 and
B=8) costs the same amount, $100, as the old combination.
Total benefit rises without spending any more than $100 on the
activities.
04
A SIMPLE MODEL OF THE
FIRM
The decision setting that we will investigate can be
described as follows:
❖ A firm produces a single good or service for a single
market with the objective of maximizing profit.
❖ Its task is to determine the quantity of the good to
produce and sell and to set a sales price.
❖ The firm can predict the revenue and cost
consequences of its price and output decisions with
certainty.
For example, let us assume that the manager knows the
demand curve function and let us find out how he will use
it to maximize profit. The equation is: Q =8.5 - 0.05P
For any price the firm charges, the demand equation
predicts the resulting quantity of the good that will be
sold. We can find the inverse demand function by using
algebra and make the variable Price (P) on the left side of
the equation. Note that it is still the same equation. We do
this “Inverse Demand Function” in order to simplify the
Revenue Function. P=170 - 20Q
➢ Revenue is defined as the money the company
receives given the quantity sold and the price so to
put it mathematically: Revenue is equal to Price
multiplied by the quantity. R= P*Q, where, R= Revenue;
P= price; Q= Quantity
➢ We can then get the revenue by substituting the
inverse demand function and multiply it by the
variable Q (Quantity). So, in the example, R = (170 -
20Q) x Q or R= 170Q – 20Q2
COST
➢ Generally cost are categorize in to fixed cost,
those that do not depend on the number of
production and variable cost, where cost is
dependent on quantity (Q).
➢ We can also express cost mathematically
and it is the combination of the fixed costs
and the variable cost. C= 100 + 38Q
PROFIT
We can now get the profit by deducting the cost
from the revenue. Profit is equal to revenue
minus cost expressed as
π = (170Q – 20Q2) – (100 + 38Q) or
π = - 100 + 132Q – 20Q2
