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Chapter 2

ECONOMIC OPTIMIZATION
The purpose of managerial economics is to provide a systematic framework for problem analysis
and solution. The pluses and minuses of various decision alternatives must be carefully
measured and weighed. Costs and benefits must be reliably measured; time differences must be
accurately reflected. The collection and characterization of relevant information is the most
important step of this process. After all relevant information has been gathered, managers must
accurately state the goal or goals that they seek to achieve. Without a clear understanding of
managerial obectives, effective decision making is impossible. !nce all relevant information
has been gathered, and managerial obectives have been clearly stated, the managerial decision
making process can proceed to the consideration of decision alternatives. "ffective managerial
decision making is the process of efficiently arriving at the best possible solution to a given
problem. #f only one solution is possible, then no decision problem e$ists. When alternative
courses of action are available, the decision that produces a result most consistent with
managerial obectives is the optimal decision. The process of arriving at the best managerial
decision, or best problem resolution, is the focus of managerial economics.
This chapter introduces fundamental principles of economic analysis, which are essential
to all aspects of managerial economics and form the basis for describing demand, cost, and
profit relations. !nce basic economic relations are understood, the tools and techni%ues of
optimization can be applied to find the best course of action.
CHAPTER OUTLINE
MMMMMMMMMMMMMMMCDIV. ECONOMIC OPTIMIZATION PROCESS
A. Optimal Decisi!s" The best decision produces the result most consistent with
managerial objectives.
1. Economic concepts and methodology are used to select the optimal
course of action in light of available options and objectives.
B. Ma#imi$i!% the Val&e ' the (irm" In managerial economics, the primary
objective of management is maimi!ation of the value of the firm. Influences
that must be considered include"
1#$%$. prices and the &uantity sold.
1#$%1. cost relations.
1#$%'. the appropriate discount rate.
MMMMMMMMMMMMMMMCDV. REVENUE RELATIONS
(((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((.
Price a!) Ttal Re*e!&e" Total revenue is the amount sold in dollars.
1. )i*e all financial data, revenue figures are often studied using computer
spreadsheets that show functional relations using formulas and e&uations.
'. If price is constant regardless of the &uantity sold, the relation between
&uantity sold and total revenue is simply T& ' ( ) *.
a. +enerally spea*ing, T& , f -./.
b. Total revenue -T&/, the variable to the left of the e&ual sign, is
called the dependent variable. Its value depends on the si!e of the
variable variables to the right of the e&ual sign.
c. 0ariables on the right1hand side of the e&ual sign are called
independent variables. Their values are determined independently of
the functional relation epressed by the e&uation.
............................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................
Mar%i!al Re*e!&e" 2arginal revenue is the change in total revenue caused by a
one1unit change in the number of units sold -*/. In calculus terminology, +& '
,T&-,*.
3$3'. +enerally spea*ing, a marginal relation is the change in the dependent
variable caused by a one1unit change in an independent variable.
3$34. 5hen marginal revenue is positive, total revenue is increasing. If marginal
revenue is negative, total revenue is decreasing.
3$3%. 5hen a linear relation eists between price and the number of units sold,
both price and marginal revenue relations begin at the same point on the
.1ais, but marginal revenue falls twice as fast as price with respect to
output.
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Re*e!&e Ma#imi$ati! E#ample" 6evenue maimi!ation occurs at the point of
greatest total revenues.
'7%8'. 6evenue maimi!ation involves consideration of revenue relations
only. 9ost relations are not considered.
'7%84. To find the revenue1maimi!ing output level, set +& , $, and solve
for *.
'7%8%. To be consistent with long1run profit maimi!ation, the advantages
of short1run revenue maimi!ation must be at least sufficient to
compensate for the corresponding loss in short1run profitability.
MMMMMMMMMMMMMMMCDVI. COST RELATIONS
A. Ttal Cst" Total costs are comprised of fied costs and variable epenses that
fluctuate with output.
1. Because all costs are variable in the long run, long1run fied costs always
e&ual !ero. In the long run, the firm has complete fleibility with respect
to input use.
'. The short run is the operating period during which the availability of at
least one input is fied.
B. Mar%i!al a!) A*era%e Cst" 2arginal cost is the basis for short1run operating
decisions: average cost is the basis for long1run planning decisions.
1. 2arginal cost is the change in cost associated with a 11unit change in
output. In calculus terminology, +C ' ,TC-,*. 2arginal costs must be
covered by added revenues to justify production in the short run.
'. Average cost is total cost divided by output, or AC ' TC-*. In the long
run, average costs must be covered by revenues or the company will go
out of business.
4. 5hen marginal cost is greater -less/ than average cost, average cost is
increasing -decreasing/.
9. A*era%e Cst Mi!imi$ati! E#ample" The average1cost minimi!ing activity
level is the optimal production level for a target level of output.
1. Average cost is minimi!ed when +C ' AC.
'. Average cost maimi!ation involves consideration of cost relations only.
6evenue relations are not considered.
MMMMMMMMMMMMMMMCDVII. PRO(IT RELATIONS
A. Ttal a!) Mar%i!al Pr'it" Total profit is maimi!ed when the optimal level of
output is produced efficiently.
1. Total profit e&uals total revenue minus total cost. +raphically, it is
e&uivalent to the vertical distance between the total revenue and total cost
curves at any output level.
'. 2arginal profit is the change in total profit associated with a 11unit change
in output. In calculus terminology, +/ ' ,/-,*. -Economists use the
6oman letter ;(< for price and the +ree* letter pi for profit./.
B. Pr'it Ma#imi$ati! E#ample" The profit1maimi!ing activity level is the
optimal production level for an optimal level of output.
4'##$. Total profit is maimi!ed when +/ ' +& 0 +C , $. E&uivalently,
profits are maimi!ed when +& ' +C.
4'##1. The slopes of the total revenue and total cost curves measure
marginal revenues -+&/ and marginal costs -+C/. 5here these slopes are
e&ual, +& , +C and profit is maimi!ed.
4'##'. 5hereas revenue maimi!ation involves consideration of revenue
relations only and average cost maimi!ation involves consideration of
cost relations only, profit maimi!ation involves consideration of both
revenue and cost relations.
MMMMMMMMMMMMMMMCDVIII. THE INCREMENTAL CONCEPT IN
ECONOMIC ANAL+SIS
. Mar%i!al Vers&s I!creme!tal C!cept" Incremental analysis involves
eamining the impact of alternative managerial decisions on revenues, costs, and
profits. It focuses on changes or differences between available alternatives.
. The incremental change is the difference resulting from a given decision.
. 2arginal relations measure only the effect associated with unitary
changes in output.
. I!creme!tal Pr'its" Incremental profit is the profit gain or loss associated
with a given managerial decision.
1. 5hen incremental profit is negative, total profit declines.
'. Incremental profit is positive -and total profit increases/ if the incremental
revenue associated with a decision eceeds incremental cost.
. I!creme!tal C!cept E#ample" The incremental concept is important for
managerial decision ma*ing because it focuses attention on the differences
among available alternatives.
1. 6evenues and costs that are unaffected by a decision are irrelevant and
should be ecluded from analysis.
MMMMMMMMMMMMMMMCDI,. SUMMAR+
PROBLEMS & SOLUTIONS
P2.1 Marginal Analysis. Characterize each of the following statements as true or false,
and e$plain your answer.
A. #f marginal revenue is greater than average revenue, the demand curve is
downward sloping.
B. (rofit is minimized when total revenue e%uals total cost.
C. 1iven a downward2sloping demand curve and positive marginal costs, profit2
ma$imizing firms always sell more output at lower prices than revenue2
ma$imizing firms.
D. +arginal cost must be less than average cost for average cost to decline as
output e$pands.
E. +arginal profit is the difference between marginal revenue and marginal cost,
and always e$ceeds zero at the profit2ma$imizing activity level.
P2.1 SOLUTION
A. =alse. Because average revenue is falling along a downward sloping demand
curve, marginal revenue must be less than average revenue for the demand curve
to slope downward.
-. =alse. (rofits are maimi!ed when marginal revenue e&uals marginal cost.
(rofits e&ual !ero at the brea*even point where total revenue e&uals total cost.
(rofits are minimi!ed when the difference between total revenue and total cost
is at a maimum.
C. =alse. (rofit maimi!ation involves setting marginal revenue e&ual to marginal
cost. 6evenue maimi!ation involves setting marginal revenue e&ual to !ero.
+iven a downward sloping demand curve and positive marginal costs, revenue
maimi!ing firms charge lower prices and offer greater &uantities of output than
firms that maimi!e profits.
D. True. Average cost falls as output epands so long as marginal cost is less than
average cost. If this condition is met, average costs decline whether marginal
costs are falling, rising or constant.
E. =alse. 2arginal profit e&uals marginal revenue minus marginal cost, and e&uals
!ero at the profit maimi!ing activity level.
P2.2 Revenue Mai!i"a#i$n% Ta&les. +arketing director (eter (etrelli has derived the
following price-demand information from a market e$periment for a new closet2
space organizer product called +a$ 3eadroom4
Pri'e
Pr$(u'#
De!an(
5677 7
896 :
867 ;
8;6 <
877 8
<96 6
<67 =
<;6 9
<77 >
;96 ?
;67 :7
;;6 ::
;77 :;
:96 :<
:67 :8
:;6 :6
A. @se a spreadsheet to calculate total and marginal revenue at each level of
product demand.
B. At what price level is total revenue ma$imizedA WhyA
P2.2 SOLUTION
A. Total and marginal revenue at each level of product demand are as follows"
Price
P
Pr)&ct
Dema!)
.
Ttal
Re*e!&e
TR/P .
Mar%i!al
Re*e!&e
MR/ TR> .
?@$$ $ 111 111
%3@ 1 ?%3@ ?%3@
%@$ ' 8$$ %'@
%'@ 4 1,'3@ 43@
%$$ % 1,#$$ 4'@
Price
P
Pr)&ct
Dema!)
.
Ttal
Re*e!&e
TR/P .
Mar%i!al
Re*e!&e
MR/ TR> .
43@ @ 1,73@ '3@
4@$ # ',1$$ ''@
4'@ 3 ','3@ 13@
4$$ 7 ',%$$ 1'@
'3@ 8 ',%3@ 3@
'@$ 1$ ',@$$ '@
''@ 11 ',%3@ -'@/
'$$ 1' ',%$$ -3@/
13@ 14 ','3@ -1'@/
1@$ 1% ',1$$ -13@/
1'@ 1@ 1,73@ -''@/
-. At a price level of ?'@$ and product demand of 1$ units, total revenue is
maimi!ed at a level of ?',@$$. (rior to that point, the added sales from a
decrease in price more than compensate for the loss in revenue from charging
current customers a lower price. At prices lower than ?'@$, the loss in revenue
from charging current customers a lesser price is greater than the gain in
revenues from new customers, and total revenue declines. As seen in the
marginal revenue column, total revenue increases so long as marginal revenue is
positive, but declines when marginal revenue is negative.
P2.0 A*era%e Cst Mi!imi$ati!" Ta1les. 2ende! 2achine Tools, )td., has been as*ed
to submit a bid on the projected cost of sophisticated production machinery. To help
in the bid development process, Isaac 2ende!, head of product &uality control, has
prepared the following schedule of projected volume and production costs"
Ou#)u#
T$#al
C$s#
7 567,777
: 6:,967
; 68,777
< 6=,967
8 =7,777
6 =<,967
= =>,777
9 9<,;67
> 9?,677
? >=,;67
:7 ?<,677
:: :7;,;67
:; :::,677
:< :;;,;67
:8 :<8,677
:6 :67,777
A. @se a spreadsheet to calculate the marginal and average cost at each level of
production.
B. At what level of production is average cost minimizedA WhyA
P2.* SOLUTION
A. 2arginal and average cost at each level of production appears as follows"
O&tp&t
Ttal
Cst
Mar%i!al
Cst
A*era%e
Cst
$ ?@$,$$$ 111 111
1 @1,3@$ ?1,3@$ ?@1,3@$.$$
' @%,$$$ ','@$ '3,$$$.$$
4 @#,3@$ ',3@$ 17,81#.#3
% #$,$$$ 4,'@$ 1@,$$$.$$
@ #4,3@$ 4,3@$ 1',3@$.$$
# #7,$$$ %,'@$ 11,444.44
3 34,'@$ @,'@$ 1$,%#%.'8
7 38,@$$ #,'@$ 8,843.@$
8 7#,'@$ #,3@$ 8,@74.44
1$ 84,@$$ 3,'@$ 8,4@$.$$
11 1$','@$ 7,3@$ 8,'8@.%@
1' 111,@$$ 8,'@$ 8,'81.#3
14 1'','@$ 1$,3@$ 8,%$4.7@
1% 14%,@$$ 1','@$ 8,#$3.1%
1@ 1@$,$$$ 1@,@$$ 1$,$$$.$$
-. 2inimum average costs of ?8,'81.#3 are reali!ed at an activity level of 1' units
of output. Aotice from the marginal cost column that average cost falls so long
as marginal cost is less than average cost. Average cost rises so long as
marginal cost is greater than average cost. Average cost reaches a minimum
when marginal cost switches from being lower than average cost to being
greater than average cost.
P2.2 Pr'it Ma#imi$ati!" Sprea)sheet A!al3sis. )incoln Burrows, a writing instrument
design specialist at =o 6iver Btate (en, Inc., has been as*ed to project the profit1
maimi!ing activity level for a given design during the coming period. 6elevant
demand and cost information are as follows"
+ P TC
7 5:,77
7
5677
: ?=7 987
; ?;7 ?>7
< >>7 :,;;7
8 >87 :,8=7
6 >77 :,977
= 9=7 :,?87
9 9;7 ;,:>7
> =>7 ;,8;7
? =87 ;,==7
:7 =77 ;,?77
:: 6=7 <,:87
:; 6;7 <,<>7
:< 8>7 <,=;7
:8 887 <,>=7
:6 877 8,:77
A. Construct a table Bor spreadsheetC showing total revenue, marginal revenue,
marginal cost, average cost, total profit, marginal profit, and average profit
for this product at the various activity levels indicated previously.
B. #dentify the profit2ma$imizing activity level.
C. #s the profit2ma$imizing activity level the same activity level as that at which
minimum average costs are e$periencedA WhyA or Why notA
P2., SOLUTION
A. A table -or spreadsheet/ showing total revenue, marginal revenue, marginal cost, average cost,
total profit, marginal profit, and average profit for this product at the various activity levels is
as follows"
. P
TR /
P .
MR /
 TR4 . TC
MC /
 TC4 .
AC /
TC4.
5 /
TR6TC
M5 /
 54 .
A5 /
54.
$ ?1,$$$ ?$ 111 ?@$$ 111 111 -?@$$/ 111 111
1 8#$ 8#$ ?8#$ 3%$ ?'%$ ?3%$.$$ ''$ ?3'$ ?''$.$$
' 8'$ 1,7%$ 77$ 87$ '%$ %8$.$$ 7#$ #%$ %4$.$$
4 77$ ',#%$ 7$$ 1,''$ '%$ %$#.#3 1,%'$ @#$ %34.44
% 7%$ 4,4#$ 3'$ 1,%#$ '%$ 4#@.$$ 1,8$$ %7$ %3@.$$
@ 7$$ %,$$$ #%$ 1,3$$ '%$ 4%$.$$ ',4$$ %$$ %#$.$$
# 3#$ %,@#$ @#$ 1,8%$ '%$ 4'4.44 ',#'$ 4'$ %4#.#3
3 3'$ @,$%$ %7$ ',17$ '%$ 411.%4 ',7#$ '%$ %$7.@3
7 #7$ @,%%$ %$$ ',%'$ '%$ 4$'.@$ 4,$'$ 1#$ 433.@$
8 #%$ @,3#$ 4'$ ',##$ '%$ '8@.@# 4,1$$ 7$ 4%%.%%
1$ #$$ #,$$$ '%$ ',8$$ '%$ '8$.$$ 4,1$$ $ 41$.$$
11 @#$ #,1#$ 1#$ 4,1%$ '%$ '7@.%@ 4,$'$ -7$/ '3%.@@
1' @'$ #,'%$ 7$ 4,47$ '%$ '71.#3 ',7#$ -1#$/ '47.44
14 %7$ #,'%$ $ 4,#'$ '%$ '37.%# ',#'$ -'%$/ '$1.@%
1% %%$ #,1#$ -7$/ 4,7#$ '%$ '3@.31 ',4$$ -4'$/ 1#%.'8
1@ %$$ #,$$$ -1#$/ %,1$$ '%$ '34.44 1,8$$ -%$$/ 1'#.#3
-. (roduction and sale of 1$ units at a price of ?#$$ -or 8 units and a price of
?#%$/ is the profit1maimi!ing activity level. (rofits are maimi!ed at a level of
?4,1$$. (rior to this point, the marginal revenue associated with additional
sales eceeds their associated marginal cost, marginal profit is positive, and total
profit rises with an epansion in output. Bubse&uent to this point, the marginal
revenue associated with additional sales is less than their associated marginal
cost, marginal profit is negative, and total profit falls with an epansion in
output.
C. Ao, the profit1maimi!ing activity level is not the same activity level as that at
which minimum average costs are eperienced. In this problem, marginal costs
are a constant ?'%$ per unit. 5ith fied costs of ?@$$, average costs continue
to fall as output epands: they approach ?'%$ as a lower limit. Although
average costs continue to diminish as output epands, ever lower prices must be
offered to generate these added sales. Total profits fall as output epands
beyond 1$ units because marginal revenues are less than marginal costs beyond
that point. It is important to recogni!e that profit maimi!ation re&uires a
comparison of marginal revenues and marginal costs: average cost minimi!ation
involves a comparison of marginal cost and average cost relations only -revenue
effects are not considered/.
P2.- Marginal Analysis% Ta&les. +ichael Dcofield, a student at +innesota Dtate
@niversity, is preparing for final e$ams and has decided to devote five hours to the
study of managerial economics and finance. DcofieldEs goal is to ma$imize the
average grade earned in the two courses, and must decide how much time to spend
on each e$am. Dcofield realizes that ma$imizing the average grade in the two
courses is e%uivalent to ma$imizing the sum of the grades. According to DcofieldFs
best estimates, the grades achieved will vary according to the schedule shown below.
Managerial
E'$n$!i's
.inan'e
/$urs $0
S#u(y 1ra(e
/$urs $0
S#u(y 1ra(e
7 ;6 7 67
: 86 : =;
; =6 ; 9;
< 96 < >:
8 >< 8 >>
6 ?7 6 ?<
A. Gescribe the manner in which Dcofield could make use of the marginal concept
in managerial economics to assist in determining the optimal allocation of five
hours between the two courses.
B. 3ow much time should Dcofield spend studying each subectA
C. #n addition to managerial economics and finance, Dcofield is also taking a
marketing course. Dcofield estimates that each hour spent studying marketing
will result in an eight point increase on the marketing e$amination score.
Dcofield has tentatively decided to spend three hours preparing for the
marketing e$am. #s DcofieldFs attempt to ma$imize the average grade in all
three courses with three hours devoted to marketing and five hours devoted to
managerial economics and finance Ballocated as in part HC an optimal
decisionA WhyA or Why notA
P2.- SOLUTION
A. An optimal allocation of study time is one that will permit Bcofield to maimi!e
the average grade earned in the managerial economics and finance courses. This
maimi!ation will occur when Bcofield allocates each hour of study time to that
course where the marginal grade value of study time is greatest.
-. To determine how much time Bcofield should spend studying each subject a
table illustrating the marginal grade value of each hour of study time must be
constructed. This table reads as follows"
Ma!a%erial Ec!mics (i!a!ce
H&rs '
St&)3 7ra)e
Mar%i!al
7ra)e Val&e
H&rs '
St&)3 7ra)e
Mar%i!al
7ra)e Val&e
$ '@ 11 $ @$ 11
1 %@ '$ 1 #' 1'
' #@ '$ ' 3' 1$
4 3@ 1$ 4 71 8
% 74 7 % 77 3
@ 8$ 3 @ 84 @
5ith only five hours to study, Bcofield should spend three hours on managerial
economics and two hours on finance.
C. Ao, BcofieldCs decision to spend three hours studying for the mar*eting eam is
incorrect if the objective is to maimi!e the average grade received in
managerial economics, finance and mar*eting. Dnly two hours should be
allocated to studying mar*eting because an additional hour spent on finance
would increase the total grade achieved by nine points: one point more than the
eight point gain associated with the third hour spent preparing for the mar*eting
eam, and will lead to a maimum average grade.
P2.8 Mar%i!al A!al3sis" Ta1les. 2onica +eller is a regional media consultant for
=riendly Images, Inc., a Aew Eor*1based media consultant. +eller has gathered the
following data on wee*ly advertising media ependitures and gross sales for a major
client, +reenwich 0illage=s 9entral (er* 9offeehouse.
A(ver#ising
E)en(i#ure
1r$ss Sales .$ll$2ing Pr$!$#i$n in #3e .$ll$2ing Me(ia%
Ne2s)a)er Ra(i$ Televisi$n
57 5:7,777 5:7,777 5:7,777
:77 :;,777 :8,777 :<,777
;77 :<,>77 :9,=77 :6,=77
<77 :6,877 ;7,;77 :>,777
877 :=,=77 ;;,777 :>,=77
677 :9,;77 ;;,877 :>,>77
A. Construct a table Bor spreadsheetC showing marginal sales following promotion
in each media. BAssume here and throughout the problem that there are no
synergistic effects across different media.C
B. #f the Central (erk Coffeehouse has an advertising budget of 5677 per week,
how should it be spentA WhyA
C. Calculate the profit ma$imizing advertising budget and media allocation
assuming the Central (erk Coffeehouse enoys an average profit contribution
before media e$penditures of =I on store2 wide sales. 3ow much are
ma$imum weekly profits Bbefore ta$esCA
P2.4 SOLUTION
A. A table showing marginal sales generated by promotion in each media appears
as follows"
A)*ertisi!%
E#pe!)it&re
Mar%i!al Sales (ll9i!% Prmti! i! the
(ll9i!% Me)ia"
Ne9spaper Ra)i Tele*isi!
?$ 111 111 111
1$$ ?',$$$ ?%,$$$ ?4,$$$
'$$ 1,7$$ 4,#$$ ',#$$
4$$ 1,#$$ ',#$$ ',%$$
%$$ 1,'$$ 1,7$$ #$$
@$$ #$$ %$$ '$$
-. Fsing the data in part A, and given a ?@$$ advertising budget, gross sales and
profit contribution are maimi!ed by allocating ?4$$ to radio and ?'$$ to
television advertising. Irrespective of whether the 9entral (er* 9offeehouse
see*s to maimi!e revenues or profit, this ependiture allocation is optimal.
C. +iven an average profit contribution before media ependitures of #G on
store1wide sales, an additional dollar of advertising will be profitable so long as
it returns more than ?1#.#3 in additional revenues. That is, the profit
contribution on additional revenues of ?1#.#3 is just sufficient to cover media
costs of ?1 -, ?1#.#3  $.$#/. The profit maimi!ing advertising budget is ?8$$
per wee* allocated as" ?'$$ on newspaper, ?%$$ on radio, and ?4$$ on
television.
2aimum wee*ly profits are"
Base sales ?1$,$$$
H Aewspaper sales 4,7$$
H 6adio sales 1',$$$
H Television sales 7,$$$
?44,7$$
 +ross margin $.$#
+ross profit ',$'7
1 2edia costs 8$$
Aet profit ? 1,1'7
-before ta/
P2.5 Marginal Analysis% E6ua#i$ns. American #dol (roducts, #nc., has developed a new
pocket2sized wireless communications device. This productFs reliability level,
measured by its failure rate, is a function of the amount of on2site preventive
maintenance and warranty work4
Jailure &ate ' 7.: 2 7.7:t K 7.77:t
;
,
+arginal Jailure &ate '  J- t ' 2 7.7: K 7.77;t,
where t represents the amount of time devoted to on2site preventive maintenance and
warranty work4
A. Det the marginal failure rate e%ual to zero to determine the failure rate2
minimizing level of on2site preventive maintenance and warranty work.
B. What is the optimal failure rateA
P2.5 SOLUTION
A. Bet 2= , $ to find the failure rate1minimi!ing level of on1site preventive
maintenance and warranty wor*"
2= , 1$.$1 H $.$$'t
$ , 1$.$1 H $.$$'t
$.$$'t , $.$1
t , @ hours
=or this to be a failure1rate minimi!ing, rather than maimi!ing, level of on1site
preventive maintenance and warranty wor*, the failure rate must be increasing
beyond this point. This is indeed the case, as can be illustrated with a simple
numerical eample -see part B/.
-. At t , @, note that"
= , $.1 1 $.$1t H $.$$1t
'
, $.1 1 $.$1-@/ H $.$$1-@
'
/
, $.$3@ -or 3.@G/
To confirm that this is failure1rate minimi!ing level of t, notice that = is
increasing for t I @, e.g., = , $.$3# or 3.#G when t , #.
P2.7 Pr$0i# Mai!i"a#i$n% E6ua#i$ns. 1regory 3ouses, #nc. operates with the following
revenue and cost functions4
T& ' 5:77* 2 57.6*
;
BTotal &evenueC
+& '  T&- * ' 5:77 2 5:* B+arginal &evenueC
TC ' 5:,677 2 5:7* K 57.6*
;
BTotal CostC
+C '  TC- * ' 2 5:7 K 5:* B+arginal CostC
where * represents the %uantity of output produced and sold as measured by
thousands of hours of temporary accounting services B777C.
A. Det +/ ' +& 2 +C ' 7 to determine the profit2ma$imizing price-output
combination for AT#.
B. Dhow that marginal revenue e%uals marginal cost at this profit2ma$imizing
output level.
P2.7 SOLUTION
A. Bet 2J , 26 1 29 , $ to maimi!e profits, where"
2J , 26 1 29
$ , ?1$$ 1 ?1. H ?1$ 1 ?1.
'. , 11$
. , @@ -$$$/
And,
( , T6>.
, -?1$$. 1 ?$.@.
'
/>.
, ?1$$ 1 ?$.@.
, ?1$$ 1 ?$.$@-@@/
, ?3'.@$
-. At . , @@ -$$$/, note that"
26 , ?1$$ 1 ?1. , ?1$$ 1 ?@@ , ?%@
29 , 1?1$ H ?1. , 1?1$ H ?@@ , ?%@
This numerical finding illustrates the general result that if 2J , 26 1 29 , $,
then 26 , 29 will always be true.
P2.8 Pr$0i# 9ersus Revenue Mai!i"a#i$n. West Wing (roducts, #nc., based in Gurham,
Lew 3ampshire, produces and sells a wide variety of replacement parts and
e%uipment for light aircraft. Meo +c1arry, a product line specialist for the
company, is reviewing the company=s #nternet marketing strategy for a popular
flight manual. Gemand and cost relations for the guidebook are given by the
e%uations4
( ' 5:66 2 57.76* BGemandC
+& '  T&- * ' 5:66 2 57.:* B+arginal &evenueC
TC ' 596,777 K 56* K 57.7:;6*
;
BTotal CostC
+C '  TC- * ' 56 K 57.7;6* B+arginal CostC
where * is the %uantity produced and sold per week.
A. Calculate the revenue2ma$imizing price-output combination.
B. Calculate the profit2ma$imizing price-output combination.
C. Are the differences in your answers to parts A and H typical or atypicalA
"$plain.
P2.8 SOLUTION
A. Bet 26 , $ to find the revenue1maimi!ing output level"
26 , ?1@@ 1 ?$.1.
$ , ?1@@ 1 ?$.1.
$.1. , 1@@
. , 1,@@$
Because total revenue is declining beyond this point, . , 1,@@$ is a point of
maimum revenues. And,
( , ?1@@ 1 ?$.$@-1,@@$/
, ?33.@$
-. Bet 2J , 26 1 29 , $ to find the profit1maimi!ing output level"
2J , 26 1 29
$ , ?1@@ 1 ?$.1. 1 ?@ 1 ?$.$'@.
$.1'@. , 1@$
. , 1,'$$
Because total profit is declining for . I 1,'$$, . , 1,'$$ is a point of maimum
profits. And,
( , ?1@@ 1 ?$.$@-1,'$$/
, ?8@
C. This is a typical result: so long as the product demand curve slopes downward
and marginal cost eceeds !ero, revenue maimi!ation results in greater output
-here, 1,@@$ versus 1,'$$/ and lower prices -here, ?33.@$ versus ?8@/ than is
true with profit maimi!ation.
P2.1: Pr$0i# Mai!i"a#i$n 9ersus Average C$s# Mini!i"a#i$n. #mmensely popular
mystery writer Dtan +arsh has ust published a new book titled NDouth (ark,
Colorado.@ &elevant monthly demand and cost relations for this hard cover title
are4
( ' 5<6 2 57.77796* BGemandC
+& '  T&- * ' 5<6 2 57.77:6* B+arginal &evenueC
TC ' 567,777 K 56* K 57.7776*
;
BTotal CostC
+C '  TC- * ' 56 K 57.77:* B+arginal CostC
where * is the number of books produced and sold per month.
A. Calculate the profit2ma$imizing price-output combination and profit level.
B. Calculate the average cost2minimizing price-output combination and profit
level.
C. Contrast your answers to parts A and H.
P2.1: SOLUTION
A. To find the profit1maimi!ing activity level, set 2J , 26 1 29 , $"
2J , 26 1 29
$ , ?4@ 1 ?$.$$1@. 1 ?@ 1 ?$.$$1.
$.$$'@. , 4$
. , 1',$$$.
( , ?4@ 1 ?$.$$$3@-1',$$$/
, ?'#.
J , T61T9
, ?4@. 1 ?$.$$$3@.
'
1 ?@$,$$$ 1 ?@. 1 ?$.$$$@.
'
, 1?@$,$$$ H ?4$. 1 ?$.$$1'@.
'
, 1?@$,$$$ H ?4$-1',$$$/ 1 ?$.$$1'@-1',$$$
'
/
, ?14$,$$$
Because total profit is declining for . I 1',$$$, . , 1',$$$ is a point of
maimum profits per month. -Lote" A publisherCs price of ?'# is consistent with
a boo*store price of roughly ?4@./
-. To find the average cost1minimi!ing activity level, set 29 , A9"
29 , A9 , T9>.
?@ H ?$.$$1. , -?@$,$$$ H ?@. H ?$.$$$@.
'
/>.
?@ H ?$.$$1. , ?@$,$$$>. H ?@ H ?$.$$$@.
$.$$$@. , @$,$$$>.
.
'
, 1$$,$$$,$$$
. , 1$,$$$
( , ?4@ 1 ?$.$$$3@-1$,$$$/
, ?'3.@$
J , 1?@$,$$$ H ?4$-1$,$$$/ 1 ?$.$$1'@-1$,$$$
'
/
, ?1'@,$$$
Because average cost is rising for . I 1$,$$$, . , 1$,$$$ is a point of
minimum average costs per month.
C. (rofit maimi!ation involves a comparison of the marginal revenues and
marginal costs of production. Average1cost minimi!ation involves a
consideration of cost relations only. Therefore, it is not surprising that these
two approaches often yield different price>output combinations. In this instance,
the added revenues associated with an additional ',$$$ units beyond the average
cost1minimi!ing level of 1$,$$$ is so great as to overcome the disadvantage of
somewhat higher average costs at the 1',$$$ units versus 1$,$$$ units activity
level.