Functions and Optimization

Daniel Halbheer
halbheer@hec.fr
 Session Outline
This session shows how mathematics can be
used to tackle business problems:
• Linking the business environment,
managerial decisions, and outcomes.
• Optimizing business outcomes to make
smart managerial decisions.
• Analyzing the impact of changes in the
business environment on decisions.
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 Climate and Business

Source: PwC Strategy and Business (2023): How climate adaptation can both protect
and grow your business. Link.
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 Pricing Example

Price Managerial decision

Mapping / function
Market potential
Consumer price sensitivity
Firm technology Sales
Competition Firm profit

Business environment Business outcomes

Questions: What drives the outcomes sales and firm profit? And
how?
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 A Changing Environment
Question: How would
a recession affect sales
and profit?
Specifically: How does
the recession affect the
purchase decisions of
the consumers? What is
the impact on the cost
structure of the firm?
Quantifying impact:
Need a mathematical
Link to podcast: https://on.wsj.com/2MnjAGP
model to gain insights.

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How can sales be described
mathematically?
Collect Survey Data

How much would you be

willing to pay for the 750ml
bottle of bling H2O?
State your WTP in EUR …

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 Deriving Demand
25 Based on Stated Willingness to Pay / Sample Size N = 69

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Price (€/unit)

15
The demand function tells the quantities consumers
will wish to purchase at various prices.
10
Note: When price falls, the quantity demanded
increases—the “law of demand.”
5

0
0 10 20 30 40 50 60 70 80
Quantity (units)

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 Demand and Profit
100
Based on Stated Willingness to Pay / Sample Size N = 69
Price (€/unit), Profit (€)

80

60

40
Profit
Demand
20

0
0 10 20 30 40 50 60 70 80

-20 Quantity (units)

-40 Note: The unit costs are constant and set at €1.

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 Bling Water Pricing in
La Grande Épicerie de Paris

More here: https://blingh2o.com/

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How is a function defined? What
are commonly used functions?
 Functions
Definition: A function 𝑓: 𝑋 → 𝑌 is a rule that
assigns, to each element 𝑥 of 𝑋, at most one
element of 𝑌. If an element is assigned to 𝑥 in
𝑋, it is denoted by 𝑓 𝑥 .

Example: The equation 𝑦 = 𝑥 + 2 defines 𝑦

as a function of 𝑥, the rule being “add 2 to 𝑥.”
Terminology: The independent variable is 𝑥
and the dependent variable is 𝑦.
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 Is Every Equation a Function?
Let 𝑦 2 = 𝑥. If 𝑥 is 9, then 𝑦 2 = 9, so 𝑦 = ±3.
Hence, to the input 9, there are assigned two
output numbers, −3 and +3, instead of one.
So 𝑦 is not a function of 𝑥.

Exercise 1: Graph the equation 𝑦 2 = 𝑥.

Exercise 2: Verify that 𝑦 = 1Τ𝑥 is a function
and graph it.

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 Graphing 𝑦 2 =𝑥

Note: The rule assigns to each value of 𝑥 two

values of 𝑦, as 𝑦 = ± 𝑥.
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 The Function 𝑦 = 1Τ𝑥

Note: The function is not defined for 𝑥 = 0.

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 Linear Functions
The demand function 𝐷 𝑝 = 𝑀 − 𝑏𝑝, with
𝑏 > 0, is linear in price 𝑝.
Note: The parameters 𝑀 and 𝑏 represent the
market potential and the reduction in sales
in response to a higher price, respectively.
Exercise 1: Graph the demand function.
Exercise 2: What happens if the market
potential decreases? What if 𝑏 goes up?
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 Debt Payments
Jeff has charged $9425 on his credit card. He
plans to pay them off at a rate of $325/month.

Exercise 1: Write an equation to represent

the amount he owes, excluding any charges,
after he has made 𝑥 payments.
Exercise 2: Graph the function and explain
the financial significance of the intercepts.

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 Quadratic Functions
Definition: A function 𝑓 is quadratic in 𝑥 if
and only if 𝑓 𝑥 = 𝑎𝑥 2 + 𝑏𝑥 + 𝑐, where 𝑎, 𝑏,
and 𝑐 are constants, with 𝑎 ≠ 0.
Exercise: A firm offers a service at zero unit
cost and faces demand 𝐷 𝑝 = 10 − 𝑝 for a
given price p. What is the profit-maximizing
price for the firm? Use a graphical argument.

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 Exponential Functions
Definition: The function 𝑓 𝑥 = 𝑏 𝑥 , where
𝑏 > 0, 𝑏 ≠ 1, and the exponent is any real
number, is called exponential function with
base 𝑏.
Exercise: Show that the compound amount
𝑆(𝑡) of the principal 𝑃 at the end of 𝑡 years at
the rate of 𝑟 compounded annually is given by
𝑆(𝑡) = 𝑃(1 + 𝑟)𝑡 .

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 Project Evaluation
Suppose you need to evaluate two projects.
The company’s internal hurdle rate is 10%.
Project A: Invest $1,000 and earn $430 each
year, over three years.
Project B: Invest $10,000 and earn $2,700
each year, over five years.
Question: Which project is “better,” and why?
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 Quantifying Performance

Note: The Net Present Value (NPV) is the value of the project to the firm and
discounts future cash flows back to time 0. The Internal Rate of Return (IRR)
measures the future rate of return and solves NPV = 0.

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 Natural Exponential Function
Definition: The function 𝑓 𝑥 = 𝑒 𝑥 , where 𝑒
is a mathematical constant, is called the
natural exponential function.
Note: 𝑒 is approximately equal to 2.71828.
Geeky fact: If interest is compounded 𝑛 times
per year, then 𝑆(𝑡) = 𝑃(1 + 𝑟Τ𝑛)𝑛𝑡 . If 𝑛 → ∞,
known as “continuous compounding,” then
𝑆 𝑡 = 𝑃𝑒 𝑟𝑡 , as 𝑒 ≡ lim 1 + 1Τ𝑛 𝑛 .
𝑛→∞
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 The Function 𝑦 = 𝑒 𝑥

Note: The function takes value one for 𝑥 = 0.

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 Population Growth
The projected population 𝑃 of a city is given
by 𝑃(𝑡) = 100,000𝑒 0.05𝑡 , where 𝑡 denotes the
number of years after 2015.
Exercise 1: Predict the population for the
year 2035.
Exercise 2: Due to migration, the population
is expected to decline at the rate of 2% from
2031 on. How will this affect 𝑃?
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 Natural Logarithm Function
Definition: The natural logarithm function
ln 𝑥 is the power to which one must raise 𝑒
to get 𝑥: ln 𝑥 = 𝑦 if and only if 𝑒 𝑦 = 𝑥.
Note: This definition can also be summarized
by 𝑒 ln(𝑥) = 𝑥 and ln 𝑒 𝑥 = 𝑥.
Exercise: Calculate the number of years that
it takes to double a principal 𝑃 if the interest
is compounded continuously.
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 The Function 𝑦 = ln(𝑥)

Note: The function is only defined for 𝑥 > 0

and takes value zero if 𝑥 = 1. What is ln(𝑒)?
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 Logarithms and Percent
Fact: For 𝑟 close to zero, ln 1 + 𝑟 ≅ 𝑟.
Note: Small changes
in the log of a variable
(that is, the log of the
growth rates) can be
interpreted as
percentage changes.

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What is a derivative? What can it
be used for?
 Business Analysis
• A key question often is how a change in the
business environment affects decisions and
outcomes—a what-if analysis.
• When the mapping between outcome and
environment is linear, such a change is
captured by the “slope” of the function.
• For nonlinear mappings, such a change is
captured by the “derivative” of the function.

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 The Slope of a Line
Definition: Let (𝑥0 , 𝑦0 ) and (𝑥1 , 𝑦1 ) be points
on a line 𝐿. The ratio
𝑦1 − 𝑦0
𝑚=
𝑥1 − 𝑥0
is called the slope of the line 𝐿.
Exercise: Graph a linear function 𝑦 = 𝑎𝑥 + 𝑏
in the 𝑥, 𝑦 -space and illustrate the slope.

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 Nonlinear Functions
Definition: Let 𝑥0 , 𝑓 𝑥0 be a point on the
graph of 𝑦 = 𝑓 𝑥 . The derivative of 𝑓 at 𝑥0 ,
written
𝑑𝑓 𝑑𝑦
′
𝑓 𝑥0 or (𝑥0 ) or 𝑥0 ,
𝑑𝑥 𝑑𝑥

is the slope of the tangent line to the graph of

𝑓 at 𝑥0 , 𝑓 𝑥0 .
Note: If 𝑓 ′ 𝑥0 exists, 𝑓 is “differentiable.”
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 Basic Differentiation Rules

Sources: https://www.dummies.com/education/math/calculus/the-basic-differentiation-rules/ and

https://en.wikipedia.org/wiki/Differentiation_rules
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 Linear Approximations
A tangent line very closely approximates the
graph of 𝑓 around 𝑥0 , 𝑓 𝑥0 , which implies
that 𝑓(𝑥) itself can be approximated by
𝑓 𝑥 ≅ 𝑓 𝑥0 + 𝑓 ′ 𝑥0 𝑥 − 𝑥0 .

Logarithms and percent: Consider 𝑦 = ln(𝑥)

and verify that a linear approximation of the
function at 𝑥0 = 1 yields ln 1 + 𝑟 ≅ 𝑟.

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 Approximating 𝑦 = ln(𝑥)

Note: The linear approximation of ln(𝑥) is

indeed pretty good for 𝑥’s around 𝑥 = 1.
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 Elasticities
Definition: The function

𝑓′ 𝑥 𝑥
𝐸 𝑥 =
𝑓(𝑥)
is called the elasticity of the function 𝑓(𝑥).
Note: The elasticty 𝐸 𝑥 captures the percent
change of the output 𝑓 relative to the percent
change of the input 𝑥.
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 Price Elasticity
Assume that demand can be described by the
linear function 𝐷 𝑝 = 𝑀 − 𝑏𝑝, with 𝑏 > 0.
Exercise 1: Show that the price elasticity of
demand is given by
𝑏𝑝
𝐸 𝑝 = .
𝑀−𝑏𝑝

Exercise 2: Explain how the market potential

𝑀 and the slope coefficient 𝑏 affect 𝐸 𝑝 .
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What is optimization? Why is it
relevant for managers?
 Minima and Maxima
To make optimal decisions, managers must
identify (constrained) minima or maxima of
functions that represent business outcomes.
In practice: Minimize cost, maximize profit.
Definition: The function 𝑓 has a global or
absolute maximum at 𝑥0 if 𝑓(𝑥) ≤ 𝑓(𝑥0 ) for
all 𝑥 in the domain of 𝑓.

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 Avoiding Pitfalls

Exercise: Suppose that 𝑓 is defined on the

interval [0,3]. Identify maxima and minima.
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 Concave Functions
Fact: If 𝑓 ′ 𝑥0 = 0 and 𝑓 ′′ 𝑥 < 0 for all 𝑥,
then 𝑓 has a global maximum at 𝑥0 .
Illustration:

Note: Minimization
of convex functions
works analogously.
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 Optimal Pricing
• Consider a monopoly firm—a firm that
does not face a “competitive constraint.”
• The constant unit costs for the product or
service are given by 𝑐, where 𝑐 ∈ [0,1).
• Demand is given by 𝐷 𝑝 = 1 − 𝑝.
Exercise: Derive the profit as a function of
price and determine the profit-maximizing
price. How does the price vary with 𝑐?
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Numerical Optimization
Note: Excel Solver is
helpful to determine
numerical solutions.
If needed, constraints
can be added to find
the constrained
solution.

Example: Consider a
price ceiling of 0.4 set
by a regulator.

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Back to NPV and IRR
Exercise: Use Excel
Solver to determine
the IRR of the project.

Recall: The Internal

Rate of Return (IRR)
solves NPV = 0.

Note: The problem

could also be solved
by maximizing NPV
subject to NPV = 0.

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 Conclusions
This session showed how mathematics can
be used to tackle business problems:
• Linking the business environment,
managerial decisions, and outcomes.
• Optimizing business outcomes to make
smart managerial decisions.
• Analyzing the impact of changes in the
business environment on decisions.
44
 Extra materials:
Inverse elasticity pricing
 Monopoly Pricing
Technology and demand:
• Consider a monopoly firm with unit cost 𝑐.
• Demand is given by 𝐷 𝑝 , with 𝐷 ′ (𝑝) < 0.
Profit function: The profit function can be
written as 𝜋 𝑝 = (𝑝 − 𝑐)𝐷 𝑝 .
Optimal pricing: The optimal price solves
𝜋′ 𝑝 = 0, that is, 𝐷 𝑝 + 𝑝 − 𝑐 𝐷 ′ 𝑝 = 0.

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The Inverse Elasticity Rule

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 Managerial Implications
1. Costs and consumer price sensitivity
jointly determine the optimal price.
2. Higher unit costs lead to a higher price.
3. Higher consumer price sensitivity reduces
the pricing power of the firm.
Note: Consumer price sensitivity affects “cost
pass-through”—the extent to which higher
costs are passed on to consumers.
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