ECONOMIC OPTIMIZATION PROCESS

Optimal decisionChoice alternative that produces a result most consistent with managerial objectives

Maximizing the Value of the Firm

Maximizing Equation is a complex task that involves consideration of future revenues, costs, and discount rates.

Total revenues are directly determined by the quantity sold and the prices received.

Factors that affect prices and the quantity sold include the choice of products made available for sale, marketing strategies, pricing and distribution policies, competition, and the general state of the economy.

Cost analysis includes a detailed examination of the prices and availability of various input factors, alternative production schedules, production methods, and so on.

Present discounted value (PDV), or present value (PV) The present discounting value of R dollars to be paid t years in the future is the amount you need to pay today, at current interest rates, to ensure that you end up with R dollars t years from now. It is the current market value of receiving R dollars in t years.

tr

RPV

)1(

• PRESENT VALUE

TABLE 11A.2 Calculation of Total Present Value of a Hypothetical Investment Project (Assuming r = 10 Percent)

END OF… $(r)DIVIDED BY

(1 + r)t =PRESENTVALUE ($)

Year 1 100 (1.1) 90.91

Year 2 100 (1.1)2 82.65

Year 3 400 (1.1)3 300.53

Year 4 500 (1.1)4 341.51

Year 5 500 (1.1)5 310.46

Total Present Value

1,126.06

If the present value of the income stream associated with an investment is less than the full cost of the investment project, the investment should not be undertaken.

LOWER INTEREST RATES, HIGHER PRESENT VALUES

TABLE 11A.3 Calculation of Total Present Value of a Hypothetical Investment Project (Assuming r = 5 Percent)

END OF… $DIVIDED BY

(1 + r)t =PRESENTVALUE ($)

Year 1 100 (1.05) 95.24

Year 2 100 (1.05)2 90.70

Year 3 400 (1.05)3 345.54

Year 4 500 (1.05)4 411.35

Year 5 500 (1.05)5 391.76

Total Present Value

1,334.59

Investment Project: Go or No? A Thinking Map

Total Revenue

“Total revenue is a function of output.”

The value of the dependent variable (total revenue) is determined by the independent variable (output).

The variable to the left of the equal sign is called the dependent variable. Its value depends on the size of the variable or variables to the right of the equal sign.

Variables on the right-hand side of the equal sign are called independent variables. Their values are determined independently of the functional relation expressed by the equation.

If price is constant at $1.50 regardless of the quantity sold, the relation between quantity sold and total revenue is

TR = $1.50 Q

Total, Average, and Marginal Relations

Marginal

Change in the dependent variable caused by a one-unit change in an independent variable

Marginal revenueChange in total revenue associated with a one unit change in output

Marginal costChange in total cost following a one-unit change in output

Total, Average, and Marginal Relations

Marginal

Change in the dependent variable caused by a one-unit change in an independent variable

Marginal revenueChange in total revenue associated with a one unit change in output

Marginal costChange in total cost following a one-unit change in output

Total, Average, and Marginal Relations

Marginal profitChange in total profit due to a one-unit change in output

MARGINAL ANALYSIS IN DECISION MAKING

Alokasi biaya untuk iklan $5,000 per minggu

Biaya iklan sebesar $1,000 per tayang

Gross profit 8% dari sales

Pada “Bay area market” sampai advertising ke 4 menghasilkan marginal revenue $20,000

Pada “Sacramento market” sampai advertising ke 1 menghasilkan marginal revenue $20,000

Setelah itu maka akan terjadi penurunan marginal revenue

Biaya advertising sebesar $5,000 ($4,000 dan $1,000)Total Revenue sebesar $225,000 ($200,000 dan $25,000)

Apabila gross profit 8% sebelum advertising, maka gross profit sebesar $18,000 (0.8 dari $225,000)

Net profit sebesar $13,000 ($18,000 - $5,000)Apakah penambahan iklan akan lebih baik atau tidak?

Gross profit 8%, secara keseluruhan advertising menambah lebih dari $12,5000 dalam pendapatan

Apabila ditambah iklan di Sancramento, maka akan menghasilkan marginal revenue $15,000, gross profit sebesar $1,200 (0.8 * $15,000)

• Net profit sebesar $200 ($1,200 - $1,000) per tambahan iklan

Biaya iklan keseluruhan menjadi $6,000 ($4,000 dan $2,000)

• Total Revenue $240,000, • Gross profit naik menjadi $19,200 (0.8 * $240,000)• Net profit menjadi $13,200 ($19,200 - $6,000)• Tambahan iklan masih meningkatkan profit, tetapi

sampai tambahan iklan ke berapa?

• Comparing R(q) and C(q)– Output levels: 0- q0:

• C(q)> R(q)– Negative profit

• FC + VC > R(q)

• MR > MC– Indicates higher profit

at higher output

0

Cost,Revenue,

Profit($s per year)

Output (units per year)

R(q)

C(q)

A

B

q0 q*

)(q

Marginal Revenue, Marginal Cost,and Profit Maximization

• Comparing R(q) and C(q)– Question: Why is profit

negative when output is zero?

Marginal Revenue, Marginal Cost,and Profit Maximization

R(q)

0

Cost,Revenue,

Profit$ (per year)

Output (units per year)

C(q)

A

B

q0 q*

)(q

• Comparing R(q) and C(q)– Output levels: q0 - q*

• R(q)> C(q)

• MR > MC– Indicates higher profit

at higher output– Profit is increasing

R(q)

0

Cost,Revenue,

Profit$ (per year)

Output (units per year)

C(q)

A

B

q0 q*

)(q

Marginal Revenue, Marginal Cost,and Profit Maximization

• Comparing R(q) and C(q)– Output level: q*

• R(q)= C(q)

• MR = MC

• Profit is maximized

R(q)

0

Cost,Revenue,

Profit$ (per year)

Output (units per year)

C(q)

A

B

q0 q*

)(q

Marginal Revenue, Marginal Cost,and Profit Maximization

• Comparing R(q) and C(q)– Output levels beyond q*:

• R(q)> C(q)

• MC > MR

• Profit is decreasing

Marginal Revenue, Marginal Cost,and Profit Maximization

R(q)

0

Cost,Revenue,

Profit$ (per year)

Output (units per year)

C(q)

A

B

q0 q*

)(q

• Therefore, it can be said:

– Profits are maximized when MC = MR.

Marginal Revenue, Marginal Cost,and Profit Maximization

R(q)

0

Cost,Revenue,

Profit$ (per year)

Output (units per year)

C(q)

A

B

q0 q*

)(q

C - R

Marginal Revenue, Marginal Cost,and Profit Maximization

q

R MR

q

CMC

orq

C

q

R 0

q

: whenmaximized are Profits

MC(q)MR(q)

MCMR

thatso0

Marginal Revenue, Marginal Cost,and Profit Maximization

MR = MC$7,500 – $7.5Q = $1,500 + $2.5Q

$10Q = $6,000Q = 600 units

Price, Total Revenue and Profit

Revenue Maximization

Revenue maximization

Activity level that generates the highest revenue, MR = 0

Average Cost MinimizationAverage cost minimizationActivity level that generates the lowest average cost, MC = AC

The price/output combination at which total profit is maximized is P = $35 and Q = 5,000 units. At that point, MR = MC and total profit is maximized at $37,500.

The price/output combination at which total revenue is maximized is P = $30 and Q = 6,000 units. At that point, MR = 0 and total revenue is maximized at $180,000.

A. A table or spreadsheet for Pharmed Caplets output (Q), price (P), total revenue (TR), marginal revenue (MR), total cost (TC), marginal cost (MC), average cost (AC), total profit (π), and marginal profit (Mπ) appears as follows:

The price/output combination at which total profit is maximized is P = $830 and Q= 700 units. At that point, MR = MC and total profit is maximized at $209,000.

The price/output combination at which average cost is minimized is P = $870 and Q= 300 units. At that point, MC = AC = $440.