Mathematical Economics I (ECO606) VU

Lesson 01
INTRODUCTION TO MATHEMATICAL ECONOMICS

TOPIC 001: DEMYSTIFYING MATHEMATICS AND MATHEMATICAL ECONOMICS

Who’s Afraid of Mathematics (The oldest friend)?
- Unity of Allah and His Book in „Kalma‟ teaches us Math.
- Inception of Life on Earth teaches us Math.
- Adam gave us 1st number.

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- Eve gave us addition.
- Their children gave us multiplication.
- Total number of Prophets give us idea of large numbers.

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Origin of Mathematics
From Latin „mathēmatica’ that stands for mathematics and „mathēmaticus’ stands for
mathematical.

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Age of Mathematics

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“Mathematics is as old as man.” (Stefan Banach)

Universality of Mathematics
Film is one of the three universal languages, the other two: mathematics and music. (Frank
Capra) bo
The study of mathematics, like the Nile, begins in minuteness but ends in magnificence.
(Charles Caleb Colton)
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“Pure mathematics is, in its way, the poetry of logical ideas.” (Albert Einstein)

Mathematics is the music of reason. (James Joseph Sylvester)

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God used beautiful mathematics in creating the world. (Paul Dirac)

All science requires mathematics. The knowledge of mathematical things is almost innate in us.
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This is the easiest of sciences, a fact which is obvious in that no one's brain rejects it; for
laymen and people who are utterly illiterate know how to count and reckon. (Roger Bacon)

"Without mathematics, there's nothing you can do. Everything around you is mathematics.
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„Everything‟ around you is numbers." (Shakuntala Devi)

Human beings have a certain number of eyes, ears, hands, arms, legs, feet. And there is also a
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certain number of skies i.e. seven skies.

Precision via Mathematics

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My belief is that nothing that can be expressed by mathematics cannot be expressed by careful
use of literary words. (Paul Samuelson)

Mathematics allows for no hypocrisy and no vagueness. (Stendhal)

I've always enjoyed mathematics. It is the most precise and concise way of expressing any idea.
(N. R. Narayana Murthy)

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“A problem well stated is a problem half solved.” (Charles Franklin Kettering)

Applicability of Mathematics
The true mathematician is not a juggler of numbers, but of concepts. (I. Stewart (1975))

Mathematics as a Subject
Despite, its primitive origin, students are usually afraid of mathematics.
Opinion of Shakuntala Devi (a.k.a. Human Computer), “Why do children dread mathematics?
Because of the wrong approach, because it is looked at as a subject.” (Shakuntala Devi)

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Good news for young people as they like adventures. “Mathematics is an adventurous and
satisfying route to doing things.” Every mathematical problem starts with uncertainty of not
having a definite solution but the solution, if obtained, gives a sense of fulfillment and the

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journey from the problem to the solution becomes an adventure.

A central figure in journey of scientific revolution is Galileo Galilei (a.k.a mathematical Platonist).
He says, “If I were again beginning my studies, I would follow the advice of Plato and start with

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mathematics.”

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“Don‟t worry about your difficulties in mathematics. I can assure you mine are still greater”.
(Albert Einstein)
I've always enjoyed mathematics. It is the most precise and concise way of expressing any idea.
(N. R. Narayana Murthy)
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I've always been interested in using mathematics to make the world work better. (Alvin E. Roth)
This sums the learning and inspiration from the elders.

Mathematics for Economics vs. Mathematical Economics

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No carving in the stone. However;
Former is about „Comprehension‟ of the mathematical tools applied to economic situations.
[Algebra, matrices, differential calculus etc.]
Whereas, latter deals with the „Application‟ of mathematical tools to comprehend and solve of
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economic situations [e.g. application of algebra on market equilibrium, application of matrices on

national income analysis, application of differentiation for marginal utility/cost/product etc].
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Mathematical Economics: An Approach to Economics rather than its Branch

Can include problems from microeconomics, macroeconomics, public finance, international
trade and other branches of economics.
e.g. Equilibrium for demand and supply curves, calculation of taxation revenue, local price
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elasticity of foreign demand of exports, among others.

TOPIC 002: MATHEMATICS VS. NON-MATHEMATICAL ECONOMICS

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Non-mathematical economics can also be termed as literary economics.

Both remain approaches and should not fundamentally differ from each other.
However, there are two noteworthy differences:
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- Former uses symbols/equations to denote assumptions and conclusions instead of

words/sentences.

An Assumption in Mathematical Economics

Rather stating an assumption that a consumer can consume whole of any increase in his
income, or a part of it or none of it is mentioned in mathematical fashion as follows:

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Marginal Propensity to Consume.

A Conclusion in Mathematical Economics

Rather stating a conclusion that an increase in private investment has brought about 3 times of
increase in national income can be expressed in mathematical expression as follows:

Investment multiplier

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= Change (increase) in national income.
= Change (increase) in private investment.

Theorems in Mathematical Economics

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Theorem: A rule in mathematics expressed in terms of symbols and formula.
Envelope Theorem: Applied to producer theory and auction theory.
Roy's Identity: Applied to Marshallian demand function.
Shephard Lemma: Used to explain relationship between expenditure (or cost) functions and

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Hicksian demand functions.

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Advantage(s) of Mathematical Economics
- Mathematical economics utilizes the symbols that are more convenient to use in
deductive reasoning.
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- The use of symbols also increases conciseness and preciseness of statement.
- Use of mathematical functions allow to incorporate more than two economic variables in
a situation without resorting to 3-dimensional or hyperspace graphs i.e. allows for
number of variables.
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Practical Importance of Mathematical Economics
- During current times, economics is said to be highly mathematized.
- Enables the comprehension of the professional articles one comes across in such
periodicals as the American Economic Review, Quarterly Journal of Economics, Journal
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of Political Economy, Review of Economics and Statistics, and Economic Journal.

TOPIC 003: MATHEMATICAL ECONOMICS VERSUS ECONOMETRICS

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Mathematical economics is often confused with econometrics.

- Etymology of Econometrics: A portmanteau of two words „Econo‟ from economics and
'metrics‟ which implies measurement.
- In Jargonized language: Econometrics is the study of empirical observations using
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statistical methods of estimation and hypothesis testing.

- Mathematical economics is, however, concerned with application of mathematical tools
on economic theory without much concern to measurement of variables and errors in it.
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- Thin line between a mathematical model and econometrics model:

- =𝜶+𝜷𝑿 is a mathematical model while adding error term (𝝐) in it makes it look like:
- =𝜶+𝜷𝑿+𝝐 which is regarded as econometric model.
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Difference with an Example
Consider law of demand and its mathematical and econometric models:

Mathematical Model
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𝜶 𝜷 is a mathematical model.
Regardless of fact that many variables play a significant role in determining quantity demanded
( ).
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These untapped variables are silenced using „ceteris paribus’ assumption. A caveat is that other
factors that can affect quantity demanded like income, price of related goods, tastes, weather,
location etc. are not included in equation.
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Econometric Model
While adding error term (𝝐) in it makes it look like:
𝜶 𝜷 𝝐 which is regarded as econometric model.
- Here the assumption of „ceteris paribus’ is relaxed which gives rise to error term ( ).
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- It makes a grab-bag of all other factors like income, price of related goods, tastes,
weather, location etc. and includes all of them in the equation as a residual.
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Lesson 02
INGREDIENTS OF A MATHEMATICAL MODEL

TOPIC 004: INGREDIENTS OF A MATHEMATICAL MODEL: VARIABLES AND ECONOMIC

VARIABLES
Mathematical economics resorts to models for economic analysis.
- Their building blocks are variables, constants/ coefficients and parameters.
- These building blocks are usually combined using algebra, trigonometry and other

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branches of mathematics to make a mathematical model.
- For example, law of demand uses algebra to connect building blocks:
𝜶 𝜷
- Solution of Price time path in dynamic analysis uses trigonometric ratios:

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( ) ( )
Variables
- Etymology: (Vary + Able = Variable)
- A phenomenon that has ability to vary (usually over time).

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- Life is full of specific variables: age, knowledge, weight, temperature, etc.

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- However, mathematical variables are general in nature conventionally denoted by
.

Economic Variables bo
Some instances of economic variables:
- Demand (D)
- Supply (S)
- Price (P)
- Individual Income (Y)
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- Consumption (C)
- Investment (I)
- Savings (S)
- Revenue (R)
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- Costs (C)
- Profit ( )
- Wage (W)
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- Gross Domestic Product (GDP)

- Government Expenditure (G)
- Taxes (T)
- Supply of Money (Ms)
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- Demand for Money (Md)

- Interest Rate (i)
- Inflation ( ̇ )
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- Exports (X)
- Imports (M)
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Freezing a Variable
Allotting a certain value to a variable is freezing a variable.

Microeconomic Examples
- Excess supply in real market
Qd = 250, Qs = 350, P = 50.
Excess Supply (ES) = Qs - Qd
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Excess Supply (ES) = 350 - 250

Excess Supply (ES) = 100 units

Profit of a Firm
R = 5,00,000, C = 3,00,000, and = R – C, then
= 5,00,000 - 3,00,000
= PKR 2,00,000.
Freezing a variable is useful in calculations of other economic variables.

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Macroeconomic Example
If C = 20m, I = 5m, G = 0.2m, X = 0.1m, M = 0.5m, then national income in 4-sector economy is
formulated as:

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GDP = C + I + G + (X-M)
GDP = 20m + 5m + 0.2m + (0.1m - 0.5m)
Gross Domestic Product (GDP) = PKR 24.8m

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Solution Values

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Properly constructed economic models give „solution values‟.
In superjacent examples. i.e.:
- Excess Supply (ES) = 100 units
- Profit ( ) = PKR 2,00,000.
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- Gross Domestic Product (GDP) = PKR 24.8m
In addition, equilibrium D=S in goods market is a classic example of an economic model that
gives solution values (q*, p*).
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Endogenous vs. Exogenous Variables

Endogenous Variables
- Etymology: {„Endo‟ (internal) + „genous‟ (generating)} = „Internally generated‟.
- Variables, solution values of which comes from the model.
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- e.g. Market equilibrium model uses Qd, Qs and P to give the values of P* and of Q*.

Exogenous Variables.
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- Etymology: {„Exo‟ (external) + „genous‟ (generating)} = „Externally generated‟.

- Variables, values of which come from outside the model.
- Their values are assumed to be given (not influenced by endogenous variables).
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- Exogenous variables shift the relationship curves of endogenous variables.

- e.g. Income can shift the demand curve either inwards or outwards.

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▪ At macroeconomic level, political-will and policy variables like supply of money (Ms), tax
rates (t) and government expenditure (G) are usually, but not always treated as
exogenous variables.

TOPIC 005: INGREDIENTS OF A MATHEMATICAL MODEL: CONSTANTS AND

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PARAMETERS

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Constants
- Etymology: Latin Origin (Con (with) + Stare (stand) = Constant)
- Lexically speaking; to stand or hold out against; resist or oppose, especially
successfully. bo
- It‟s an antithesis of a Variable.
- Daily life examples: total number of, God(s) = 1 and Prophets = 1,24,000.

Constants in Mathematical/Economic Analysis

- In economic analysis, constants can appear in either numerical or symbolic manner.
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- Range of numerical constants: ( ) e.g. 0.7, 7, -7000 etc.
- In symbolic manner, usually denoted by or or .
- Caveat: A constant in a product with a variable, is called „coefficient‟. e.g In
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and and are coefficients.

- Coefficients tend to amplify or compress the efficiency of variable - hence suitably called
„co-efficient‟.
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- is times larger than and is 10 times smaller than .

Parameters
- Lexical Meaning: ‫ احاطہ‬/ or a boundary of some activity.
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- Value of parameter can change but within a restriction. Therefore, it is also called
„parametric constant‟.
- Such restrictions can be called as „parametric restrictions‟.
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- e.g. value of MPC can vary but from 0 to 1.

- Mathematically, it is written as:
- ( )
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- Similarly, for Marginal Propensity to Save (MPS)

- ( )
- Summarily, we can say that „parameter is constant that is somewhat variable‟.

Exogenous Variables as Parameters

- For instance, in Keynes psychological law of consumption
( )
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and are endogenous

is exogenous
is parameter.
- Some writers consider exogenous variables as parameters.
- However, no carving in stone, rather a matter of convention.

TOPIC 006: A FEW ASPECTS OF LOGIC: PROPOSITIONS, IMPLICATIONS AND

NECESSARY AND SUFFICIENT CONDITIONS

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Logic
- Etymology: Late Latin origin (Logica = Art of reason)
- In mathematical reasoning Logic is to be developed.
- Two major ingredients of logical reasoning: propositions and implications.

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Propositions
- Etymology {Latin: proponere (propound/propose)}
- Assertions that are either true or false.

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- True Proposition: “All individuals who breathe are alive”.

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- False Proposition: “all individuals who breathe are healthy”.

Propositions
- Imprecise proposition hinders in developing logic.
- “67 is a large number”
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- Need for definition of “large number”.
- Mathematics gives precise results using algebra, matrices and calculus etc.
- Therefore, mathematical economics helps to develop clear propositions and hence
better logic.
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Implication(s)
- Concatenates the propositions in logical reasoning using „implication arrow‟ (⇒).
- Let A and B be propositions and whenever P is true, Q is necessarily true.
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- „Implication arrow‟ concisely expresses:

- P⇒Q
- “P implies Q”, or “if P, then Q”, or “Q is a consequence of P”.
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Implication(s)
More examples:
- ⇒
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- ⇒
- is a square ⇒ is a rectangle
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Logical Equivalence
- From last slide:
- ⇒
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- Reverse is also true, as:

- ⇒
- Such is logical equivalence and uses equivalence arrow ( ):
-
- Similarly, for logical equivalence between propositions A and B:
-

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- Read as A is equivalent to B.
Necessary and Sufficient Conditions
- Literary economics extensively uses necessary and sufficient conditions.
- In mathematical economics, we use logical equivalence to show these conditions in a
concise way.
- Logical equivalence means that is necessary and sufficient condition for .

Necessary and Sufficient Conditions

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- If MC cuts MR from below, then is maximum.
- ( )
- MC cuts MR means MC = MR bo
- From below means
- Hence logical equivalence explains concisely.

TOPIC 007: THE REAL-NUMBER SYSTEM

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Number System
- Economic variables adopt numerical values.
- Number system guides about types of numerical values.
- In this course, we deal with real numbers only.
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- However, there is another type as well as shown in figure.

Numbers
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Real Imaginary
Numbers Numbers

Rational Irrational
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Numbers Numbers

Integers Fractions
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Real vs. Imaginary Numbers

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Mostly, real number are used in economic analysis.

A Digression
- Differ from imaginary numbers: which include square root of (-1).
- This value is denoted by a Greek Letter iota ( ).
- √ , so
- In usual economic situations such values don‟t occur.

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- However, in some economic situations, we have to deal with imaginary numbers. (Which
is beyond the scope of this course).

Rational vs. Irrational Numbers

Rational Numbers
- Can be expressed in a ratio; ( ⁄ ) where, .
Where, and are integers ( )

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- ( ⁄ ) (undefined).
- Infinity is undefined and is hard to interpret just like timelessness.

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Examples
( ⁄ )
. ⁄ /

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⁄ ) same pattern repeats infinitely.

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Irrational Numbers
- Other than rational
- No repetitive pattern
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- Endless
e.g. ( )

Combining Rational & Irrational Numbers

- We get real numbers
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- Integers & fractions need some description.
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Integers vs Fractions
Integers
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- Combination of zero, natural numbers, and –ve values of natural numbers.

- ( )
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Fractions
- Not a whole number (0, 1, 2, 3, …).
⁄
⁄

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Lesson 03
USE OF SETS IN ECONOMICS

TOPIC 008: USE OF SETS IN ECONOMICS: SET NOTATION

Set Notation
- Collection of distinct objects.
- e.g. Numbers, labor, firms, countries etc.
- These objects are called „elements‟ of sets

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- Two ways to write sets: enumeration & description

Enumeration
B = {Al Baraka Bank Ltd., Barclays Bank PLC., Citibank, Deutsche Bank AG., Dubai Islamic

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Bank Ltd., Industrial and Commercial Bank of China Ltd., Standard Chartered Bank Ltd., The
Bank of Tokyo-Mitsubishi UFJ Ltd}

Description

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* +

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- Read as: "B is the set of all (banks in Pakistan) x, such that x is a foreign bank in
Pakistan."
- B is the set of all foreign banks in Pakistan.
- Membership of an element is denoted by ∈
- (Al Baraka Bank Ltd.) ∈ B

Range in Set Notation

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Ranges can also be defined in set notation:
* +
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Relationship using Set Notation
If A = {Pakistan, India, Afghanistan, Bangladesh, Bhutan, Maldives, Nepal, Sri Lanka}
B = {Pakistan, Bangladesh, Afghanistan}
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- B ⊂ A (B is contained in A) or A⊃B (A includes B)

- Or B is a „Subset‟ of A.
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TOPIC 009: USE OF SETS IN ECONOMICS: OPERATIONS OF SETS

Set Operations
Three major operations:
- Union
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- Intersection
- Complement
Union
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- Similar to addition (+).

- Write all elements of all sets once only, regardless of their multiple presences in sets.
- Denoted by „U‟
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Venn diagram of union

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Green shaded area depicts union of set A and B
A= {1, 2, 3, 4, 5} & B = {1, 3, 5, 7}
Union is denoted by .

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A B = {1, 2, 3, 4, 5} U {1, 3, 5, 7}
A B = {1, 2, 3, 4, 5, 7}
In description, union of A and B:
A U B = {x | x ∈ A or x ∈ B}

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Intersection

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- Write common elements of all sets.
- Resembles „common factor‟ in factorization.
- Denoted by
- A B = {1, 3, 5} bo
- In Description, Intersection of A and B:
A ∩ B {x | x ∈ A and x ∈ B}

Venn Diagram of Intersection

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Green shaded area depicts intersection of set A and B

- Complement
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- Write uncommon elements of the universal set ( ) in comparison to set under process
( ).
- Resembles „subtraction‟.
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- Denoted by ̃ or
- Complement
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If U = {0, 1, 2, 3, 4, 5, 6, 7, 8, 9},
A = {1, 2, 3, 4, 5}, then
- ̃ or = U A
- ̃ or = {0, 6, 7, 8, 9}
- ̃ or = {x | x ∈ U and x A}

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Venn Diagram of Complement

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Green shaded area depicts complement of set A

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TOPIC 010: USE OF SETS IN ECONOMICS: LAWS OF OPERATIONS OF SETS
Laws of Operations
Three major Laws:
- Commutative Law

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- Associative Law

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- Distributive Law

Commutative Law of Union

- Order does not matter.
- Of union: A U B = B U A bo
A= {1, 2, 3, 4, 5} & B = {1, 3, 5, 7}
A B = {1, 2, 3, 4, 5} U {1, 3, 5, 7}
A B = {1, 2, 3, 4, 5, 7}
B A = {1, 3, 5, 7} U {1, 2, 3, 4, 5}
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B A = {1, 2, 3, 4, 5, 7}
Hence, A U B = B U A

Commutative Law of Intersection

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A B=B A
A= {1, 2, 3, 4, 5} & B = {1, 3, 5, 7}
A B = {1, 2, 3, 4, 5} {1, 3, 5, 7}
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A B = {1, 3, 5}
B A = {1, 3, 5, 7} {1, 2, 3, 4, 5}
B A = {1, 3, 5}
Hence, A B = B A
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Associative Law of Union

- Order of „selection‟ does not matter, while dealing with more than 2 sets.
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- Of union:
A U (BUC)= (AUB) U C
A= {1, 2, 3, 4, 5}, B = {1, 3, 5, 7} & C = {4, 6, 8, 10}
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- L.H.S
A U B = {1, 2, 3, 4, 5} U {1, 3, 5, 7}
A U B = {1, 2, 3, 4, 5, 7}
(A U B) U C = {1, 2, 3, 4, 5, 7} U {4, 6, 8, 10}
(A U B) U C = {1, 2, 3, 4, 5, 6, 7, 8, 10}

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- R.H.S
B U C = {1, 3, 5, 7} U {4, 6, 8, 10}
B U C = {1, 3, 4, 5, 6, 7, 8, 10}
A U (B U C) = {1, 2, 3, 4, 5} U {1, 3, 4, 5, 6, 7, 8, 10}
A U (B U C) = {1, 2, 3, 4, 5, 6, 7, 8, 10}
Hence, (A U B) U C = A U (B U C)

Associative Law of Intersection

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A (B C) = (A B) C
A= {1, 2, 3, 4, 5}, B = {1, 3, 5, 7} & C = {4, 6, 8, 10}
L.H.S

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B C = {1, 3, 5, 7} {4, 6, 8, 10}
B C = {}
A (B C) = {1, 2, 3, 4, 5} {}
A (B C) = {} = ∅ [theta]

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R.H.S

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A B = {1, 2, 3, 4, 5} {1, 3, 5, 7}
A B = {1, 3, 5}
(A B) C = {1, 3, 5} {4, 6, 8, 10}
(A B) C = {} = ∅ [theta]

Distributive Law of Union

A U (B C) = (AUB) (AUC)
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A= {1, 2, 3, 4, 5}, B = {1, 3, 5, 7} & C = {4, 6, 8, 10}
L.H.S
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(B C) = {}
A U (B C) = {1, 2, 3, 4, 5}
R.H.S
AUB = {1, 2, 3, 4, 5, 7}
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AUC = {1, 2, 3, 4, 5, 6, 8, 10}

(AUB) (AUC) = {1, 2, 3, 4, 5}
Hence, L.H.S = R.H.S
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Distributive Law of Intersection

A (BUC) = (A B) U (A C)
A= {1, 2, 3, 4, 5}, B = {1, 3, 5, 7} & C = {4, 6, 8, 10}
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L.H.S
(BUC) = {1, 2, 3, 4, 5, 6, 7, 8, 10}
A (BUC) = {1, 2, 3, 4, 5}
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R.H.S
A B = {1, 3, 5}
A C = {2, 4}
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(A B) U (A C) = {1, 2, 3, 4, 5}
Hence, L.H.S = R.H.S

TOPIC 011: CARTESIAN COORDINATES

- Named after descartes (French philosopher, mathematician, and scientist).
- Intersection of 2 numbers lines ( and ) horizontally and vertically,
respectively.
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- 4 slices called quadrants (quarters of a circle).
- Ordered pairs are two variables (X & Y), in order, within parentheses:
- 1st quadrant: (+ve, +ve)
- 2nd quadrant: (-ve, +ve)
- 3rd quadrant: (-ve, -ve)

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- 4th quadrant: (+ve, -ve)

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- Most of economic variables lie in 1st quadrant as they are usually non-negative ( ).

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- Order in the coordinates is not interchangeable( ) ( ).

- In quadrant – I, ( ) ( ), as they have different locations.
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- For 3-dimensional (3D) graphs, ordered triples are used ( ).

- Instead of lines, surfaces are generated.
- e.g. A cube is 3D.

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Lesson 04
USE OF FUNCTIONS IN ECONOMICS

TOPIC 012: WHAT ARE FUNCTIONS?

“Power to act in a specific way.”

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-
-
-
is dependent variable.
is independent variable.
bo
System to write the dependence of one variable ( ) on other ( ).
es

- In addition to f, F, G, the Greek letters (phi) and (psi), and their capitals, are used to
show functions.
lu

- Sometimes, the dependent variable is itself used instead of „f’.

y = y(x), z = z(x) etc.
- It is suitable to use different symbols for multiple functions with same independent
.C

variable.
y=f(x), z = g(x) etc.

Plotting a Function
w

Function (x=2) depicts a vertical line parallel to y-axis.

w
w

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m
co
- Function; y=f(x)=2 portrays a horizontal line parallel to x-axis.

.
ok
bo
es
- Functions; y=f(x)=2x, y=f(x)=x & y=f(x)=0.5x.
lu
.C
w
w

- Plotting a function gives a locus (route/way) of points – hence called mapping.

- Function also converts values of independent variable into that of dependent variable –
w

hence called transformation.

TOPIC 013: DOMAIN AND RANGE IN A FUNCTION

- All permissible values of are „Domain‟
- All permissible values of are „Range‟.

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m
- Numerically speaking:
*( ) ( ) ( ) ( )( )( )+
- Ordered pairs show the mapping of function.

. co
ok
Numerically speaking:
- Domain=* + bo
- Range=* +
es
lu

Economic Example
- Total cost/day 'C' of a firm depends on its daily output
.C

- Its functional form is:

C = 150 + 7Q.
- Capacity limit = 100 units/day.
* +
w

* +
- Extreme values ( ) don‟t necessarily occur, however.
w
w

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Daily Output Cost/Day

0 150
10 220
20 290
30 360
40 430

m
50 500
60 570

co
70 640
80 710
90 780

.
100 850

ok
TOPIC 014: DIFFERENCE BETWEEN FUNCTIONS AND RELATIONS
Slight but noteworthy difference.
Formation of ordered pairs

Function: (1,2),(2,4),(3,6)
Relation: (1,3),(2,5),(1,7).
bo
- One value of dependent variable (1) has multiple corresponding values of independent
variable (3, 7).
es
- Formerly a.k.a. single-valued function and multi-valued function, respectively.

Vertical Line Test

Function passes vertical line test while relation does not.
lu

- A vertical line cuts a function on one point only.

- While it cuts a relation on multiple points.
- Case no. 5 is classic example of relation.
.C
w
w
w

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Mapping of Function (Formerly)

m
Mapping of Relation

. co
ok
TOPIC 015: ECONOMIC EXAMPLE OF SCHULTZ DEMAND FUNCTION
- H. Schultz estimated US cotton demand for the period 1915–1919.
- ( ) bo
- If then
( ) ( )
( )
- If then
( ) ( )
es
( )
- If then
( ) ( )
( )
lu

- As expected, negatively sloped demand curve is generated.

.C

4.1
4
3.9
3.8
w

3.7
3.6
3.5
w

3.4
3.3
7.5 8 8.5 9 9.5 10 10.5
w

- Conversely, we can find price of cotton ( ), if quantity demanded ( ) is given:

-
- If then
( )

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TOPIC 016: ECONOMIC EXAMPLE OF COST FUNCTION OF CLEANING IMPURITIES

FROM A LAKE:
Cleaning cost of p% of impurities in a lake:
( )
- If then
( )
( )
( )

m
- If then
( )
( )
( )

co
- If then
( )
( )
( )

.
ok
- The increase in cleaning cost of lake impurities has an increasing trend.
- However, it does not grow as a straight line.

Cleaning Cost of Lake

250
bo Impurities

200
150
es
100
50
0
0 20 40 60 80 100
lu

Additional cost of additional cleaning (h%) above p% can be written as follows:

( )
( ) ( )
( )
.C

If then
( ) ( )
( ) ( )
w

Additional cost of cleaning above 50% is 22.09 Units.

w

TOPIC 017: ECONOMIC EXAMPLE OF FUNCTION: LAFFER CURVE

Laffer curve shows the theoretical relationship between rates of taxation and the corresponding
w

levels of government revenue.

- In functional form:

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( )

m
co
- Till the point of „revenue maximization‟, the relationship between tax rates and tax
revenue is positive/direct.

.
ok
- After this point, the relationship becomes negative/inverse.

-
theorem.
bo
The tax revenue maximizing point in the Laffer curve can be found using Rolle's

- It is a calculus-based theorem but is beyond the scope of this course.

es
lu
.C
w
w
w

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Lesson 05
CONSTANT FUNCTIONS AND LINEAR FUNCTIONS

TOPIC 018: TYPES OF FUNCTIONS: CONSTANT FUNCTIONS

Functions where the power of independent variable is zero (0).
e.g. ( )
( )
Where, „ can be any constant value.

m
- The graphs of such constant functions appear as horizontal lines.

- In constant function, , let a = 2.

- Then, ( ) .

co
- Its graph is a line parallel to x-axis.

.
ok
bo
es
Autonomous Consumption ( )
- Consumption at .
- ( ).
lu

- Consumption independent of disposable income.

.C
w
w
w

Autonomous Investment ( )
- Investment at .
- ( ).

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m
co
Autonomous Government Spending ( )
- Government spending is usually based on political will (independent of Y)
- ( ).

.
ok
bo
es
Autonomous Tax ( )
- Taxes independent of level of income (Y).
- e.g. Lump-sum taxes.
lu

- ( ).
.C
w
w
w

Supply of Money ( )
- In the short run, supply of money is usually independent of interest rate ( ).
- Determined by central monetary authority (e.g. SBP, FED etc.).
- ( ).

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m
co
TOPIC 019: TYPES OF FUNCTIONS: POLYNOMIAL FUNCTION: LINEAR FUNCTIONS
Polynomial Functions
Etymology: {(„poly‟ (many) + „nomial‟ (parts)}.

.
Linear Functions

ok
- Different values of give different types of functions.
- Linear function ( )
- Degree of linear equation = .
- If , then , which gives a y-intercept (vertical intercept).
bo
- It holds true for both positive and negative sloped linear function.
- If , +ve slope.
- If , -ve slope.
es
lu
.C
w
w
w

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m
. co
ok
bo
es
lu
.C

TOPIC 020: INTERPRETING LINEAR ECONOMIC FUNCTIONS

w

Estimated cost function for the US Steel Corp. (1917–1938).

Interpreting linear Function

w

Compare with slope intercept form of a straight line:

Where, & .
w

- Here, slope = 55.73,

- If production increases by 1 ton, then the cost increases by $55.73.
- Estimated annual demand function for rice in India for the period 1949–1964.

Interpretation
- Similar to last example.
- The slope is −0.15.
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- If price increases by one Indian rupee, then the quantity demanded decreases by 0.15
units.

Calculating Slope of a Straight Line

- Take two points e.g. ( )& ( ).
- Draw perpendicular from higher point and horizontal line from lower point to get a
triangle .
- ( )

m
. co
ok
bo
es
lu
.C

TOPIC 021: APPLICATIONS OF LINEAR FUNCTIONS: POPULATION AND CONSUMPTION

FUNCTIONS
Population Function
w

European population was 641 million in 1960, and 705 million in 1970.
- Let (in millions) & (in years).
- for 1960 & for 1961 and so on.
w

- Linear function:

- Given points:( ) ( ) and ( ) ( ).

w

- Using point-point formula of slope of straight line:

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- Back-cast and forecast

m
co
Consumption Function
Haavelmo estimated for US economy (1929–1941):
( )

.
is autonomous consumption.
- Geometrically, it shows the intercept of the linear function.

ok
.
- About 71.2% of increase in income was being spent in US.
- MPC also shows the slope of consumption function.
bo
es
lu
.C
w
w
w

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Lesson 06
QUADRATIC FUNCTIONS AND CUBIC FUNCTIONS

TOPIC 022: TYPES OF FUNCTIONS: POLYNOMIAL FUNCTION: QUADRATIC FUNCTIONS

Polynomial Functions

Quadratic Functions
( )

m
Or standard form of quadratic equation is:

- Degree of quadratic equation = .

co
- Gives a „parabola‟

.
ok
- Etymology: {para „beside‟ + bolē „a throw‟}.
- bo
Curve with a single bump or wiggle either in a valley or hill.
es
lu

- First graph shows a happy/U-shaped/open upwards parabola (valley), as ( ) .

- Whereas, second is sad/Inverted U-shaped/open downwards parabola (hill), as
( ) .
.C
w
w
w

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m
. co
ok
bo
es
lu
.C
w
w
w

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TOPIC 023: QUADRATIC COST FUNCTION AND PROFIT FUNCTION OF A MONOPOLY

m
. co
Quadratic Cost Function

ok
( ) bo
( ) ( )
es
Condition for maximization of quadratic function/at parabola
lu
.C

Quadratic Profit Function

w
w

Condition for maximization of quadratic function/at parabola

w

- Here, for quadratic formula:

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m
. co
TOPIC 024: QUADRATIC FUNCTION AND PRODUCTION POSSIBILITIES FRONTIER

ok
Where, and are two goods.
Let ; bo
Quadratic formula:
es

*( )( )+
lu

Now, let ;
( ) ( )
.C

*( )+
w

Combining the 3 intercepts;

*( )( )( )+
w

- Only intercepts cannot give a precise production possibilities frontier.

- Other points on curve are also required where both coordinates are non-zero.
w

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m
co
TOPIC 025: TYPES OF FUNCTIONS: POLYNOMIAL FUNCTION: CUBIC FUNCTIONS
Cubic Functions

.
ok
Cubic Functions
( )

bo
Or standard form of cubic equation is:

are constants
- , as is the requisite for a cubic function
es
- Degree of cubic equation = .
( )
lu
.C
w
w

- Curve with two bumps or wiggles.

w

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m
co
TOPIC 026: CUBIC COST FUNCTIONS
Cubic Cost Functions

.
ok
- Then

bo
es
lu
.C

Example
( )
- Then should hold.
w

- Here .
( )( ) ( )
w

Which is true.

Electric Power Generating Plant Cubic Cost Function

w

( )
Here 0.
- Testing the validity of .
( )( ) ( )
, Which is against the condition.

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m
co
Components of Cost Function (FC & VC)
( )
Here, .
( )

.
ok
bo
es
lu
.C
w
w
w

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Lesson 07
RATIONAL FUNCTIONS AND EXPONENTIAL FUNCTIONS

TOPIC 027: RATIONAL FUNCTIONS

Rational Functions
Ratio of two polynomial functions.
( )

m
- and are not necessarily same.
- It shows that it is not necessary to have same degree of equation in numerator and
denominator.

co
- , else the rational function will become undefined.

( )
, for ( ) to be defined.

.
- Here n = 1 and m = 2.

ok
- Ratio of a linear function to a quadratic function.

bo
es
lu

Asymptote is a line or curve that approaches a given curve arbitrarily closely.

.C

Vertical asymptote is at such value of x that turns y into infinity.

Horizontal asymptote is at such value of y that turns x into infinity.
w
w
w

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m
. co
ok
bo
es
TOPIC 028: OTHER TYPES: RECTANGULAR HYPERBOLIC FUNCTIONS
Rectangular Hyperbolic Functions
Hyperbola: Etymology: {Hyper (Beyond)+Bola (Throw)}.
- Similar to parabola but not the same.
lu

- Usually wider than parabola.

.C
w
w
w

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m
co
- Rectangular hyperbolic functions have x and y asymptotes.
- Economic examples include aggregate demand (AD) curve.

.
ok
bo
es
lu
.C
w
w
w

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TOPIC 029: OTHER TYPES: NON-ALGEBRAIC EXPONENTIAL FUNCTION

Etymology: Latin origin; Expōnēre. In english expound: explain in detail.
- Independent variable occurs as a root or power.
( ) where, >0 and .
- Non-linear graphs.

- For ,
( )

m
( )
- Exponential function reduces to a constant function if .
- Caveat: unlike power functions which have variables in base instead of exponent.
e.g. ( )

co
- Exponential function can either have growth or decay.

Case of Exponential Growth

.
ok
bo
es
lu
.C
w
w

Case of Exponential Decay

w

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m
. co
ok
bo
es
TOPIC 030: POPULATION GROWTH USING GENERAL EXPONENTIAL FUNCTIONS
Europe population function function: ( ) ( )
- is population in millions,
- is time in years
lu

700
Time (t) Population (P)
.C

0 641 690

1 645.6152 680
2 650.2636 670
3 654.9455
w

660
4 659.6611
650
5 664.4107
w

6 669.1945 640
7 674.0127 630
8 678.8655
w

620
9 683.7534
610
0 1 2 3 4 5 6 7 8 9 10
10 688.6764

For , ⇒ year 2000

( ) million
- Whereas, ( ) million.
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- Overestimation of 126 million could be due to poor projection.

- Time required for certain level of population ( )
( )
years.
- Detailed steps

m
. co
ok
bo
es
lu

TOPIC 031: OTHER TYPES: NON-ALGEBRAIC NATURAL EXPONENTIAL FUNCTIONS

Special type of exponential functions
- Represented by using in the base of the exponent.
.C

- exponential
- It has a constant value: 2.718.
- Also known as „magical number‟.
w
w
w

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m
. co
ok
bo
TOPIC 032: POPULATION GROWTH USING NATURAL EXPONENTIAL FUNCTIONS
Population growth of a region
- ( ) ( )
⇒ in year 2000 ( )
es
-
- ⇒ in year 2005 ( )
- Substituting:
( ) ( )
- 2.02%
lu
.C
w
w
w

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Detailed solution

m
. co
ok
bo
es

Forecast for Population Growth after 10 years

lu

- t = 10 ⇒ year 2010.
( )
- ( ) ( )
( )
- ( ) ( )
.C

- ( )

Time needed for doubling of Population

Let be that time.
w

- Double population =
( )
( )
w

( )
- ( ) ( )
( )
- ( )
- 657 years
w

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m
. co
ok
bo
es
lu
.C
w
w
w

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Lesson 08
LOGARITHMIC FUNCTIONS AND INVERSE FUNCTIONS

TOPIC 033: OTHER TYPES: NON-ALGEBRAIC LOGARITHMIC FUNCTIONS

“Exponents in disguise”.
- Output is an exponent.
- If is index/exponent form then
- is its logarithmic form.

m
- Numerically:
, Where, , and .
- Then, .

. co
ok
bo
es
lu
.C
w
w
w

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m
. co
ok
bo
es
lu
.C
w
w
w

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TOPIC 034: OTHER TYPES: NON-ALGEBRAIC NATURAL LOGARITHMIC FUNCTIONS

“A logarithm to the base e (2.71828 …).”.
- Represented using instead of .
- Base of natural log is omitted as it is understood.
- Laws of natural logarithm are similar to that of common logarithm.

m
. co
ok
bo
es
lu

TOPIC 035: RATE OF GROWTH OF GNP USING LOGARITHMIC FUNCTIONS

-
- Rate of growth of GNP of China ( )
.C

-
- Rate of growth of GNP of U ( )
- If the GNP of each country continued to grow exponentially, when would the GNP of the
two nations be the same?
w
w
w

TOPIC 036: INVERSE FUNCTIONS

A reciprocal of a function.
- If original function is:
( ),
Then ( )
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Or ( )
- Economic applications of inverse function include „Inverse demand function‟

m
. co
ok
bo
TOPIC 037: FUNCTIONS WITH TWO OR MORE INDEPENDENT VARIABLES
( )
es
- A given pair of x and y give value of z.
- e.g. Linear specification:
- e.g. Quadratic specification:
lu

- Ordered triples ( ).
.C
w
w
w

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m
. co
ok
bo
es
lu
.C
w

- More than two independent variables can also exist.

( )
w

- e.g. Utility function:

( )
w

- Ordered quadruples ( ).
- Hypersurface – non-graphable.

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m
co
- Generally speaking, number of independent variables.

.
( )

ok
- e.g. Utility function:
( ).

TOPIC 038: SURFACES AND DISTANCE IN GRAPHS OF TWO OR MORE INDEPENDENT

VARIABLES bo
Surfaces
- ( ) makes a point in graph.
- ( ) makes a surface in graph.
es
lu
.C
w
w
w

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m
. co
ok
bo
es
lu
.C
w
w
w

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Lesson 09
EQUATIONS AND TYPES OF EQUATIONS

TOPIC 039: EQUATIONS AND IDENTITIES

Equations
Mathematical expression with equality. e.g.

m
- True for certain values of .
- is true only for .
- Not for other values.

co
Economic Examples of Equations
- Demand function

- Production function

.
ok
- Cost function

- Optimization condition

-
bo
Market equilibrium condition

Identities
Etymology: Latin: Idem (same).
es
- Mathematical equalities that are true for all values of .
- e.g.

- is used to represent an identity.

lu

* +

Economic Example of Identity

.C

Equation of profit:

- Deducting cost from revenue will always give profit, therefore:

w

TOPIC 040: TYPES OF EQUATIONS IN ECONOMICS: DEFINITIONAL EQUATIONS

w

Reflection of a definition in an equation.

- An Identity having exactly same meaning.
w

Economic Examples
Revenue Function:

- Is read as, “Revenue is identically equal to the difference of revenue and cost”.
- However, ( ) is also used.

- Here
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- Regardless of the positivity/negatively of answer.

- Identity of profit function remains intact even if answer is negative (loss) or zero
(breakeven).

National Income Accounting Identity

( )

m
- Is read as: “Sum of expenditures by consumers, investors & government, and net
exports is equation to national income”, under expenditure approach.

TOPIC 041: FISCAL SURPLUS AND FISCAL DEFICIT USING EQUATIONS

co
Fiscal Deficit/Surplus
Fiscal Deficit

- Is read as: “Fiscal deficit is identically equal to the difference of government revenue and

.
government expenditure”, while former is smaller than latter.

ok
- e.g.
- Government is suffering from 50M of fiscal deficit.

Fiscal Surplus

-
bo
Is read as: “Fiscal Surplus is identically equal to the difference of government revenue
and government expenditure”, while former is greater than latter.
es
- e.g.
- Government is 50M of fiscal surplus.
lu

Neither Fiscal Deficit nor Surplus

- Is read as: “Neither fiscal deficit nor surplus exist when there is no difference b/w
.C

government revenue and government expenditure”.

- e.g.
w

- Government is neither having any fiscal deficit nor fiscal surplus.

- Fiscal deficit/surplus using tax revenue function.

w

( )
w

If
( )

If ,

Budget surplus = 80.

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- If G⭡ by 60, T⭡ due to ⭡in government spending multiplier ( ).

- New G= Old .
- ( )
- New Y= Old .
- New T= ( ) .
- New budget surplus (compared with 80).

TOPIC 042: TYPES OF EQUATIONS IN ECONOMICS: BEHAVIORAL EQUATIONS

m
Specifies the manner in which dependent variables behaves in response to changes in
independent variable(s).
- Can include technological and legal aspects.

co
- Such behavior can be either human or non-human.

- Human behavior: Aggregate consumption in relation to national income.

- Non-human behavior: Total Cost in relation to output.

.
ok
- Consider two cost functions:

- Fixed cost(FC) = ( )
bo
- FC are 75 and 110, respectively.
- First function has linear relationship.
es
- While second has quadratic.

- Consider two cost functions:

lu

- Fixed cost(FC) = ( )
- FC are 75 and 110, respectively.
First function has linear relationship.
.C

-
- While second has quadratic.
w
w
w

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C=75+10Q
C = 75+10(Q)
Q C
0 75 200
1 85 180
2 95 160
3 105 140
4 115 120

m
5 125 100
6 135 80
7 145 60

co
8 155 40
9 165 20
10 175 0
0 2 4 6 8 10 12

.
ok
C=110+Q2
Q C C = 110+Q2
0 110
250 bo
1 111
2 114
3 119 200
4 126
5 135 150
es
6 146
7 159 100
8 174
9 191 50
lu

10 210
0
0 2 4 6 8 10 12
.C

TOPIC 043: TYPES OF EQUATIONS IN ECONOMICS: CONDITIONAL EQUATIONS

w

Specifies a requirement to be satisfied.

- To specify equilibrium, an equilibrium condition should be specified.
- Two famous equilibrium conditions are:
w

Quantity demanded = Quantity supplied ( ).

Desired savings = Desired investment ( ).
w

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m
. co
ok
bo
- Optimization conditions is also an example:
- Marginal cost = Marginal revenue ( ).
es
lu
.C
w

TOPIC 044: STRUCTURAL AND REDUCED FORM EQUATIONS

w

Assume following equations:

̅ …………………(1)
………………(2)
w

National income
Consumption
̅ Autonomous investment
and are parameters.
Equation (1) & (2) are structural form equations.

- Putting value of C in eq. (1).

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̅
̅
( ) ̅
̅
( )
{ }̅
( ) ( )
- Value of Y (endogenous variable) in terms of exogenous variable ( )̅ and parameters

m
( ).
- Reduced form equation

co
- Value of other endogenous variable ( ):

{ } ̅

.
( ) ( )

ok
[ { } ]̅
( ) ( )
{ } { } ̅
bo ( ) ( )
( ) ̅
8 9
( )
̅ ̅
2 ( )
3=2( )
3
es
Numerical results:
- If ̅ , and , then
{ } ̅
( ) ( )
lu

{ }( )
( ) ( )
3000
.C

̅
8 9
( )
( )( )
{ }
w

( )
w
w

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Mathematical Economics I (ECO606) VU

Lesson 10
PARTIAL LINEAR MARKET EQUILIBRIUM

TOPIC 045: CONSTRUCTING A PARTIAL LINEAR MARKET EQUILIBRIUM

- Three variables; , and :
- Specify conditional equation for equilibrium:
……..(1)
Or

m
- Excess demand is equal to zero.

- Behavioral equations of and .

co
……………(2)
..…………(3)
Where ( )

.
- Where, is the intercept of . is the slope of which is negative.

ok
- is the intercept of . is the slope of which is positive.

- has horizontal intercept at which is reservation price – lowest price at which a

seller is willing to sell.
bo
- Contrary to convention where is plotted on y-axis and , on x-axis.
- Convention is based on inverse demand function.
- Mathematically justified.
es
lu
.C
w
w
w

TOPIC 046: SOLVING PLMM USING ELIMINATION OF VARIABLE METHOD

Equate behavioral equations of and by assuming
.
……………(2‟)
..…………(3‟)
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( )

( )
Equilibrium price
;( )

m
- Substitute in (or ).
( )

co
( )

( ) ( )

.
ok
,( )
OR ( ) for
- In set notation bo *( ) +
*( ) +
( )

TOPIC 047: SHIFTS IN DEMAND IN MARKET EQUILIBRIUM

es
Assume demand & supply functions:
&
lu
.C

- Equilibrium price and equilibrium output are 30 and 70, respectively.

w

- Any exogenous factor (e.g. increased income) increases the demand shifting its curve to
the right side:
w
w

- New equilibrium price and equilibrium output are 33.3 and 76.7, respectively.

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m
co
TOPIC 048: SHIFTS IN SUPPLY IN MARKET EQUILIBRIUM
Assume demand & supply functions:

.
&

ok
bo
- Equilibrium price and equilibrium output are 30 and 70, respectively.
es
- Any exogenous factor (e.g. improved technology) increases the supply shifting its curve
to the right side:
̃
̃
lu
.C

- Equilibrium price and equilibrium output are 28 and 72, respectively.

w
w
w

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TOPIC 049: EFFECT OF TAX ON PRODUCER ON PARTIAL MARKET EQUILIBRIUM

Assume demand & supply functions:
&

m
( )

co
- Rs. 2 per unit tax on producer:
- Let the tax be „ ‟
( )

.
( )

ok
bo ( )
es
- Revenue of producer before tax ( ) and after tax ( ):
lu
.C

- Change in producer revenue =

TOPIC 050: EFFECT OF TAX ON CONSUMER ON PARTIAL MARKET EQUILIBRIUM

w

Assume demand & supply functions:

&
w
w

( )

- Rs. 2 per unit tax on consumer:

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( )

( )

( )

( )

m
. co
ok
bo
es
lu
.C
w
w
w

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Mathematical Economics I (ECO606) VU

Lesson 11
GENERAL EQUILIBRIUM AND NATIONAL INCOME EQUILIBRIUM

TOPIC 051: PARTIAL MARKET EQUILIBRIUM-A NON-LINEAR MODEL

Assume demand & supply functions:
&

m
( ) ( )

co
( )( )
Either ( )
Or ( )

.
ok
bo
es
lu
.C

- is the standard form of quadratic (non-linear) function.

- It can also be solved using quadratic formula:
-
√
w

- Here, , , and .
w

√ ( )( )
( )
w

√ ( )( )
( )
√

,
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,
- Other nonlinear models may be cubic, quartile etc.

TOPIC 052: GENERAL MARKET EQUILIBRIUM: GENERAL FORM OF TWO GOOD CASE
Assume demand & supply functions:

m
Good – 1

OR

co
(No excess demand of Good 1)

Good – 2
𝜶 𝜶 𝜶

.
𝜷 𝜷 𝜷

ok
OR
(No excess demand of Good 2)

bo
es
lu
.C
w
w
w

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m
. co
ok
- The equilibrium outputs of Good -1 ( )and Good -2 ( ) can be found by putting
equilibrium values of their prices i.e and .

TOPIC 053: GENERAL MARKET EQUILIBRIUM: NUMERICAL SOLUTION OF TWO GOOD

bo
CASE
Assume demand & supply functions:
Good – 1
es

Good – 2
lu

- Solving for Good – 1:

.C

- Solving for Good – 2:

w
w

Solving underlined equations, simultaneously:

w

⁄ & ⁄
Put in for :

. ⁄ /

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⁄
Put in for :

( ⁄ ) ⁄
*( ), ( )+ *( ⁄ ⁄ ), . ⁄ ⁄ /+

TOPIC 054: GENERAL MARKET EQUILIBRIUM: N-GOOD CASE

m
Transition from partial equilibrium analysis to general-equilibrium analysis.
- Two goods case can be generalized to -number of goods.
- ( )

co
& ( )

Where, ( ).
- Excess demands ( ) for - goods (complete market).

.
- ( ) ( )

ok
- Let ( )
- Then ( )
- Solved simultaneously, these equations can determine the equilibrium prices .

TOPIC 055: NATIONAL INCOME EQUILIBRIUM

Application of algebra to macroeconomic analysis.
bo
- Simple Keynesian model.
es
( )

- Endogenous variables: and represent national Income & consumption respectively.

lu

- Exogenous variables: and represent autonomous investment & government

expenditure respectively.
- Second equation is a behavioral equation showing the behavior of consumption with
.C

respect to income.

- Substituting consumption function in national income equation.

w

( )
w

( )

( )
w

- Solution is in terms of exogenous variables and parameters.

, for to be defined.
- Equilibrium level of the other endogenous variable (consumption).
- Substitute in consumption function.

( )
( )
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( ) ( )
( )

( )
( )
( )
- , for to be defined.

m
TOPIC 056: NATIONAL INCOME EQUILIBRIUM WITH INDUCED AND AUTONOMOUS TAX
- Macroeconomic analysis with autonomous tax ( ) & induced tax ( ).
- Keynesian model.

co
( )
( )
( )
( )

.
ok
- Endogenous variables: and represent national income, consumption & taxes
respectively.
- Exogenous variables: and represent autonomous investment & government
expenditure respectively.
- 2nd and 3rd equations are behavioral equations showing the behavior of consumption and
bo
taxes with respect to income.

- Substituting consumption function and tax function in national income equation.

es
* ( )+
, * ( )+-
lu

( )
.C

( )
w

- Equilibrium level of taxes.

{ }
w

( )
* ( )+ ( )
( )
w

)
( )
( ) ( )
( )
- Equilibrium level of consumption.

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{ }
( )
( ) * ( )+ * ( )+
( )
( ) ( )
( )

( )

m
( )
( )

co
( )
* ( ) ( )+
( )
( )( )

.
( )

ok
TOPIC 057: NATIONAL INCOME EQUILIBRIUM WITH PROPORTION OF GOVERNMENT
EXPENDITURE
Macroeconomic analysis with proportion of government expenditure.
bo
- Keynesian model.

( )

( )
es
- Endogenous variables: , and represent national income, consumption and
government expenditure, respectively.
- Exogenous variables: and represent autonomous investment & autonomous tax
lu

respectively.
- 2nd and 3rd equations are behavioral equations showing the behavior of consumption and
government expenditure w.r.t income.
.C

⇒
- It implies the government expenditure is a ratio of national income.
- Substituting consumption function and government expenditure function in national
w

income equation.

( )
w

* ( )+
( )
w

( )

( )

- Parametric restriction for avoiding undefined value of national income.

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( )

m
. co
ok
bo
es
lu
.C
w
w
w

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Mathematical Economics I (ECO606) VU

Lesson 12
USE OF MATRICES IN ECONOMICS

TOPIC 058: MATRICES AND VECTORS

Matrix is a rectangular array of numbers considered as one mathematical object.
- Bold capital letters such as A, B, … etc. are used to represent a matrix.
- When there are rows and columns in the matrix, it is a matrix (written
as ).

m
- A matrix is of the form:

co
- are the elements/entries of the row of matrix.
- are the elements/entries of the row of matrix.

.
- are the elements/entries of the column of matrix.

ok
- are the elements/entries of the column of matrix.

- Alternative ways of writing a matrix are:

- [ ] or ( ) bo
- In more simpler notation:
- [ ] or ( )
es
lu

- Zero Matrices: Four examples w.r.t matrix order

.C
w

- If matrix appears with either a single row or column, it is known as vector.

- If and then it is a row vector.
- If and then it is a column vector.
w
w

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m
TOPIC 059: MATRICES OPERATIONS

co
Like algebraic expressions, matrices can also be operated upon using arithmetic operators
( ).
Caveat – I: Matrices can‟t be divided ( ).
Caveat – II: Matrices can only be solved in linear algebra.

.
ok
bo
es
lu
.C
w
w
w

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m
. co
ok
bo
es

TOPIC 060: USING PRODUCT OF MATRICES TO CALCULATE TOTAL COST

lu

There are three coffee shops in a small college town.

Each coffee shop sells four blends of coffee: „Espresso‟, „Cappuccino‟, „Classic‟ and „French‟.
The cost of coffee for a cup of each blend is:
.C

Cost of Coffee per cup [Cost (C)]

Expresso $1.50
w

Cappuccino $0.75
Classic $0.50
French $1.00
w
w

Number of Cups of Coffee Sold Per Week [Quantity Produced (Q)]

Expresso Cappuccino Classic French
Coffee Shop 1 112 100 80 35
Coffee Shop 2 182 160 110 58
Coffee Shop 3 206 192 130 76

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m
. co
ok
bo
es

TOPIC 061: USING PRODUCT OF MATRICES TO CALCULATE TOTAL REVENUE AND

PROFIT
lu

There are three coffee shops in a small college town.

Each coffee shop sells four blends of coffee: „Espresso‟, „Cappuccino‟, „Classic‟ and „French‟.
The cost of coffee for a cup of each blend is:
.C

Cost of Coffee per cup [Cost (C)]

Expresso $1.50
w

Cappuccino $0.75
Classic $0.50
French $1.00
w

Number of Cups of Coffee Sold Per Week [Quantity Sold (Q)]

Expresso Cappuccino Classic French
w

Coffee Shop 1 112 100 80 35

Coffee Shop 2 182 160 110 58
Coffee Shop 3 206 192 130 76

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Retail Price ($) of Each Blend at Each Shop [Price (P)]

Expresso Cappuccino Classic French
Coffee Shop 1 8 4 3 6
Coffee Shop 2 6 2 2 5
Coffee Shop 3 5 3 1 3

m
. co
ok
bo
es
lu
.C
w
w
w

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m
. co
TOPIC 062: QUESTION OF MATRIX DIVISION

ok
Subject to the conformability conditions, matrices, like numbers, can undergo the operations of
addition, subtraction, and multiplication.
- However, division of two matrices is not possible i.e. is not possible
- For two numbers is defined when
bo .
- Alternative representations are or .
- where shows the reciprocal of .
- If is defined then there is no assurance if also defined (due to multiplication
conformity condition).
es
- Even if and are both defined, still they may not be necessarily equal.
- and are two distinct products.
- It is necessary to distinguish between them while specifying.
lu
.C
w
w
w

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m
. co
ok
bo
es
lu
.C
w
w
w

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Mathematical Economics I (ECO606) VU

Lesson 13
LAWS OF OPERATIONS OF MATRICES

TOPIC 063: COMMUTATIVE, ASSOCIATIVE, AND DISTRIBUTIVE LAWS

Commutative Law in case of addition holds but not in case of multiplication of matrices:
-
-

m
. co
Associative Law holds both in case of addition and multiplication of matrices:

ok
( ) ( )
( ) ( )

bo
es
lu

Distributive Law holds in case of Matrices operation:

( )
.C
w
w
w

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TOPIC 064: VECTOR OPERATIONS

m
. co
ok
bo
es
lu
.C
w
w
w

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m
. co
ok
TOPIC 065: TRANSPOSE OF A MATRIX

bo
es
lu
.C
w
w
w

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TOPIC 066: COFACTORS OF A MATRIX

m
. co
ok
bo
es
lu
.C
w
w
w

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TOPIC 067: ADJOINT OF A MATRIX

m
. co
ok
bo
es
lu
.C
w
w
w

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m
. co
ok
bo
es
lu
.C
w
w
w

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Lesson 14
DETERMINANT AND INVERSE OF MATRICES

TOPIC 068: DETERMINANT OF A MATRIX

m
. co
ok
bo
es
lu
.C
w
w
w

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TOPIC 069: SARRUS'S RULE FOR 3X3 ORDER DETERMINANT OF A MATRIX

m
. co
ok
bo
es
lu
.C
w
w
w

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TOPIC 070: INVERSE OF A MATRIX

m
. co
ok
bo
es
lu
.C
w
w
w

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. co
ok
bo
es
lu
.C
w
w
w

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m
. co
ok
bo
es
lu
.C
w
w

TOPIC 071: CONDITION(S) FOR NON-SINGULARITY

Assuming a system of equation.
w

Writing in matrix form

0 10 1 0 1

0 1, 0 1 0 1

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| | (A is non-singular matrix & )

Solving equations simultaneously

[Consistent, Independent]

m
. co
ok
Assume bo
0 1, 0 1 0 1
es
| | (A is a singular matrix & )

Solving equations simultaneously

( ) ⁄ ( ) (Undefined: Consistent & Dependent)
lu

No solution for x and y.

.C
w
w
w

Assume

Matrix form

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0 10 1 0 1

0 1, 0 1 0 1

| | (A is a Singular matrix & )

Solving equations simultaneously
[Inconsistent, Independent]

m
No solution for x and y.

. co
ok
bo
es
Summarizing conditions:
o Necessary condition: Coefficients matrix should be square [Rows= Columns].
o Sufficient condition: Determinant of coefficients matrix 0. Equations should
be intersecting. Neither coincident nor parallel.
lu

TOPIC 072: EXPRESSION OF NATIONAL INCOME USING MATRIX FORM

Simple national income model in two endogenous variables Y and C is:
.C

Re-arranging:
w

Writing in the equation in matrix form.

( ) 0 1,
w

𝑿( ) 0 1
0 1
w

( )
Following that:
𝑿
0 10 1 0 1
( ) ( )( )
[ ] 0 1
( )( ) ( )

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0 1 0 1

Corresponding elements are equal which is equivalent to original equations.

TOPIC 073: MINORS AND COFACTORS

m
. co
ok
bo
es
lu
.C
w
w
w

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Lesson 15
MATRIX INVERSION METHOD

TOPIC 074: MARKET MODEL ANALYSIS USING MATRIX INVERSION METHOD

m
. co
ok
bo
es
lu
.C
w
w
w

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TOPIC 075: NATIONAL INCOME ANALYSIS USING MATRIX INVERSION METHOD

m
. co
ok
bo
es
lu
.C
w
w
w

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TOPIC 076: EQUILIBRIUM PRICES USING MATRIX INVERSION METHOD

m
. co
ok
bo
es
lu
.C
w
w
w

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Mathematical Economics I (ECO606) VU

Lesson 16
CRAMER'S RULE IN MATRICES

TOPIC 077: SOLVING MARKET MODEL USING CRAMER'S RULE

Consider a linear partial market model:

m
. co
ok
bo
es
lu
.C
w
w
w

TOPIC 078: EQUILIBRIUM PRICES USING CRAMER'S RULE

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m
. co
ok
bo
TOPIC 79: NATIONAL INCOME DETERMINATION USING CRAMER'S RULE
2-sector national income model:
es
lu
.C
w
w
w

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m
. co
ok
bo
es
lu
.C
w
w
w

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Lesson 17
INPUT OUTPUT ANALYSIS USING MATRICES

TOPIC 080: INPUT COEFFICIENT MATRIX

Attributed to Wassely Leontief (1951)
- Static version: “What level of output should each of the industries in an economy
produce, in order that it will just be sufficient to satisfy the total demand for that product?”
- Input-Output: output of one industry is needed as input in another industry & vice versa –

m
Inter-industry dependence.
- Input-output analysis can be of great use economic planning.
- Need for „correct‟ level of output based on technical input-output, rather than market
equilibrium conditions.

co
- Mathematically speaking, it‟s the solution of simultaneous equations.
- Normally has large number of industries.

Assumptions

.
- Each industry has homogeneous output or jointly product in fixed proportions.

ok
- Each industry has fixed input ratio for output.
- CRS in each industry: k-fold ↑ in inputs ⇒ k-fold ↑ in output.
- Input coefficient matrix contains input coefficient.
bo
es
0.35 PKR input ‘3’ (2nd input) is needed in producing 1 PKR of ‘2’ (2nd output).

Output
lu

Input . . . N
I II III
I 11 12 13 . . . 1
.C

II 21 22 23 . . . 2
III 31 32 33 . . . 3
. . . . . . . .
. . . . . . . .
w

. . . . . . . .
N 1 2 3 . . .
w

- Number of input coefficients in input coefficient matrix are:

w

-
- Zero elements in principal diagonal:

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Output
Input . . . N
I II III
I 11 12 13 . . . 1
II 21 22 23 . . . 2
III 31 32 33 . . . 3
. . . . . . . .
. . . . . . . .
. . . . . . . .

m
N 1 2 3 . . .

. co
ok
bo
es

TOPIC 081: ECONOMIC MEANING OF HAWKINS-SIMON CONDITION

Attributed to David Hawkins and Herbert A. Simon,
lu

- Guarantees the existence of a non-negative output vector.

- Assume a 2-sector economy:
0 1
.C

( ) [ ]
- Two conditions
w

- First condition
w

implies that amount of first commodity used in production of 1st commodity is less than
w

PKR 1.
- Second condition
| |

( )( )

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( )
( )

( ) can be omitted without affecting the inequality.

⏟ ⏟

m
- Practicability and viability in production via Hawkins-Simon condition.

co
TOPIC 082: INPUT-OUTPUT ANALYSIS IN CASE OF OPEN ECONOMY
Assume a 3-sector economy (Agriculture, Industry & Services).
Its input coefficient matrix is:

.
ok
Agri Indu Serv
Agri
Indu [ ]
bo Serv
- Agriculture uses PKR 0.2 of agricultural output in producing PKR 1.
- Agriculture uses PKR 0.4 & PKR 0.1 of industrial & services outputs, respectively, in
producing PKR 1.
- In addition to mutual demand, consumer demand also exists.
es
- Demands (in billion PKR) are in demand vector.

< = [ ]
lu

- Forming a system of equations:

- Total demand = Mutual demand + Consumer demand

.C

⏟ ⏟

⏟ ⏟
w
w

⏟ ⏟
w

6 7 [ ]6 7 [ ]

( )
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( )

[ ] [ ]

( ) [ ] (Leontief Matrix)

m
co
( ) | |

( )
( )

.
ok
( ) [ ]

bo ( )

[ ][ ]
es

6 7 [ ]
lu

Interpretation: To suffice for mutual and consumer demand.

- Agricultural output = 24.84 billion PKR.
.C

- Industrial output = 20.68 billion PKR.

- Services output = 18.36 billion PKR.

TOPIC 083: INPUT-OUTPUT ANALYSIS IN CASE OF CLOSED ECONOMY

Assume a 3-sector economy (Agriculture, Industry & Services).
w

Its input coefficient matrix is:

w

Agri Indu Serv

Agri
Indu [ ]
w

Serv

- No consumer demand:

< = [ ]

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- All outputs are consumed in process of production.

- All columns sum to 1.
Total demand = Inter-industry demand
⏟

m
⏟

co
Writing in matrix form:

6 7 [ ]6 7

.
ok
However, the homogeneous system of equations can be solved simultaneously:

In ratio form (in terms of z):

bo
es
Converting to whole numbers:

For the closed model of 3 industries, we get a guiding ratio.

lu

TOPIC 084: THE NEED AND NATURE OF COMPARATIVE STATICS

If all variables are at rest, an equilibrium is often called a static.
Comparing equilibria is, therefore, called comparative statics.
.C

How would be the new equilibrium compared with the old?

Qualitative (in which direction) and quantitative (by how much) aspects.
w
w
w

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. co
ok
bo
es
lu
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w
w

Two Assumptions
w

- System returns to equilibrium instantaneously – merely compare the initial (pre-

change) equilibrium ( ) with the final (post-change) equilibrium ( ).
- Stable equilibrium.
- “Rate of change of the equilibrium value of an endogenous variable w.r.t the change in a
particular parameter or exogenous variable – Need for derivatives.”
- Functionally speaking:
( )
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= Equilibrium value of endogenous variable

= parameter/exogenous variable.

Difference Quotient
- Let, = change in from to .
- Then, .
= old value of
= new value of

m
- Then function ( ) changes from ( ) to ( ).
- Change in per unit of change in :

co
( ) ( )

Numerical
( )

.
( ) ( )
( ) ( ) ( )

ok
( )

If , and
bo
exists. Expression . / is derivative of the function.

. / ( )
es
. / ( )
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Mathematical Economics I (ECO606) VU

Lesson 18
CONCEPT OF DERIVATIVE AND RULES OF DIFFERENTIATION

TOPIC 085: CONCEPT OF LIMIT AND CONTINUITY

Limit: “A point or level beyond which something does not or may not extend or pass.”
Let

m
. co
ok
Clearly, at . i.e. ( ) .
Before and after 2, is defined.

x 1.9
bo1.99 1.999 2 2.001 2.01 2.1

f(x) 3.9 3.99 3.999 ∞ 4.001 4.01 4.1

es
Observe: x approaches to 2, f(x) approaches close to 4. i.e. , ( ) .
lu
.C
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. co
ok
4 5

bo
es
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m
. co
ok
bo
es
Let ( )

, denominator=0, ( )
lu

- For or
- Function ( ) is discontinuous at and .
.C
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w
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m
co
TOPIC 086: RATE OF CHANGE, SLOPE & DERIVATIVE
For any continuous function * ( )+, rate of change can be calculated using differentiation.

.
- Differentiation is process of calculating derivatives.
- Derivative is also the slope of the function.

ok
- Derivative of function = ( ) a.k.a Leibniz's notation of derivative
represents the change „Δ‟.
Rate of change is function
bo ( ) is .
Therefore;
i.e. Derivative of function represents the rate of change.
- Slope also shows the rate of change.
es
lu
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m
. co
ok
bo
Therefore, derivative, rate of change and slope can be used synonymously.
( )
es
- In economics, taking derivative is equal to calculating the marginal function of the
original function.
e.g. Derivative of total cost function gives marginal cost (rate of change of total cost).
lu
.C
w
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Mathematical Economics I (ECO606) VU

Lesson 19

PRODUCT RULE AND QUOTIENT RULE OF DIFFERENTIATION

TOPIC 087: DIFFERENTIATION RULES FOR SINGLE VARIABLE FUNCTIONS: CONSTANT

FUNCTION RULE AND POWER FUNCTION RULE
Rules of differentiation are necessary for calculating derivatives.
- Most commonly used are:
o Constant function rule

m
o Power rule
o Sum-difference rule
o Product rule

co
o Quotient rule

.
ok
bo
es
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TOPIC 088: SUM-DIFFERENCE RULE OF DIFFERENTIATION

m
. co
ok
bo
TOPIC 089: SUM-DIFFERENCE RULE: NUMERICAL ANALYSIS OF COST FUNCTION
es
- Is a cost function in cubic form.
- To calculate marginal cost, we can take its derivate with respect to .
( ) ( )
lu
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( ) ( ) ( ) ( ) ( )

( ) ( )
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w
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Slope of Cost Curve, Rate of Change in Cost Function, Marginal Cost

Q MC
0 10
MC
1 5
250
2 6
3 13 200

m
4 26
5 45 150

6 70

co
100
7 101
8 138 50
9 181

.
10 230 0

ok
0 2 4 6 8 10 12

TOPIC 090: UNDERSTANDING GRAPHS OF FUNCTION AND THEIR DERIVATIVES

bo
es
lu
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w
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Mathematical Economics I (ECO606) VU

Lesson 20
COST AND REVENUE ANALYSIS USING DIFFERENTIATION

TOPIC 091: PRODUCT RULE OF DIFFERENTIATION

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TOPIC 092: RELATIONSHIP BETWEEN AVERAGE REVENUE AND MARGINAL REVENUE

USING PRODUCT RULE
Given an average revenue function:

To find marginal revenue function, one needs to find total revenue first.
⇒
( )

m
Differentiating the total revenue function w.r.t Q, we get marginal revenue.

co
( )

( )

.
ok
Symbolic treatment of revenue function:

( ) [as AR depends on quantity sold]

bo
Differentiating w.r.t Q using product rule
es
( ) ( ) ( )+ ( ) ( )
Here ( ) ( ) and ( )
* ( )+
( )( ) 6 7
lu

( )( ) * ( )+
( ) ( )
.C

TOPIC 093: QUOTIENT RULE OF DIFFERENTIATION

w
w
w

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m
. co
ok
bo
TOPIC 094: MARGINAL PROPENSITY TO CONSUME VIA DIFFERENTIATION WITH AND
es
WITHOUT TAX
Given a consumption function:

Numerically speaking
lu

( )
Differentiating consumption function w.r.t. Y.
( ) ( )
.C

( )
Which is marginal propensity to consume.

Now, assume imposition of tax.

w

( )
w

( )
( )
( )
w

*( ) +
( )

0.8 is the marginal propensity to consume in presence of tax

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TOPIC 095: RELATIONSHIP BETWEEN MARGINAL-COST AND AVERAGE-COST

FUNCTIONS USING QUOTIENT RULE

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Mathematical Economics I (ECO606) VU

Lesson 21

CHAIN RULE AND INVERSE FUNCTION RULE OF DIFFERENTIATION

TOPIC 096: VARIABLE AND FIXED COST COMPONENTS IN TOTAL COST FUNCTION
In short run, some costs do not change (cost of land, equipment and rent) – Fixed costs (FC)
- However, in long run all costs become variables.
- Other costs vary with output (cost of raw material, components, energy and unskilled
labor) – Variable costs (VC).

m
Total variable costs: =( ).

Total Costs

co
( )
Average Costs

.
ok
( )

( )
+
+
If FC = 1000, VC = 4, then:
bo
( )
es
- Average Cost

( )
+
lu

+
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m
co
TOPIC 097: OBTAINING MARGINAL COST FUNCTION FROM AVERAGE COST FUNCTION

.
Given average cost function:

ok
Total cost function

bo
( )
es
Marginal cost function
( )

( )
lu

Long run or Short run?

.C

Consider the total cost function.

Since all term involve (variable).

All components can vary, which is possible in long run – Long run cost function.
w

TOPIC 098: MARGINAL COST ANALYSIS

Given total cost function:
w

Marginal cost function

( )
w

( )

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Average cost function

m
500
400

co
300
200
100

.
0

ok
0 1 2 3 4 5 6 7 8 9 10

TC MC AC

TOPIC 099: MARGINAL REVENUE ANALYSIS

bo
Given total revenue function:

Marginal revenue function

( )
es
( )
lu

Average revenue function

.C
w

30
w

20

10
w

0
0 1 2 3 4 5 6 7 8 9 10
-10

-20

MR AR TR

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TOPIC 100: MARGINAL PRODUCT ANALYSIS

Given total product function:

Where,
Marginal product (of labor) function
( )

( )

m
co
Average product function

.
ok
bo
es
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Mathematical Economics I (ECO606) VU

Lesson 22

USE OF PARTIAL DIFFERENTIATION IN ECONOMICS

TOPIC 101: RULES OF DIFFERENTIATION FUNCTIONS WITH DIFFERENT VARIABLES

CHAIN RULE
Possibility of indirect dependence of one variable on other.
( ) where ( )
* ( )+

m
- Dependence of on via .
( )

co
← ←
- Hence chain reaction.

.
ok
Possibility of more than 2 functions.
( ) Where, ( )& ( )
, * ( )-
Dependence of on via and , respectively.
( ) bo
← ← ←
3-variables & 4-functions in a chain rule.
es
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TOPIC 102: MARGINAL REVENUE PRODUCT OF LABOR (MRPL) ANALYSIS

Given total revenue function of a firm:
( )
Where, output Q is further a function of labor input ( ), or ( )

* ( )+
( )
Dependence of on via .

m
Situation of chain rule.

co
← ←

.
Revenue due to labor = Marginal revenue Product due to labor

ok
( ) ( ) ( )

Marginal revenue product of labor = Marginal revenue Marginal physical product of labor
bo
TOPIC 103: MARGINAL ANALYSIS OF FISHERY PRODUCTION FUNCTION
Estimated production function for a certain lobster fishery:
22
Where S = Stock of lobsters,
es
E = Effort, and ( ) the catch.

Marginal Product w.r.t Stock of lobsters.

+
(2 2 )
lu
.C

Marginal product w.r.t effort.

+
(2 2 )
w

Knowledge of values of and can give rise to numerical values of and that will be
more interpretable.
w

TOPIC 104: INVERSE FUNCTION RULE

Given a function:
w

( )
It can be reciprocal can be written as:
( )
Read as: “x is an inverse function of y”.
( ) is function related to original function ( ) similar to ( ).
Numerical example
( )
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( )

: ⁄ ;

m
( )

co
Numerical example
( )
Finding is tricky.

.
( )

ok
⁄

bo : ⁄ ;
es
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Mathematical Economics I (ECO606) VU

Lesson 23
MARKET MODEL ANALYSIS USING PARTIAL DERIVATIVES

TOPIC 105: PARTIAL DIFFERENTIATION: THE CONCEPT

There can be more than one independent variables in a function.
For example, number of independent variable case.
( )
Partial differentiation is suitable in such situation.

m
Delta 𝜹 is used to represent change.

𝜹
( ⁄𝜹 ) is partial derivative of function w.r.t. independent variable .

co
𝜹 𝜹 𝜹
Further derivatives will be ( ⁄𝜹 ) ( ⁄𝜹 ), …, ( ⁄𝜹 ).

.
So, the number of partial derivatives shall be equal to the number of independent variables.

ok
bo
es
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m
. co
TOPIC 106: MARGINAL PHYSICAL PRODUCT OF LABOR AND CAPITAL USING PARTIAL

ok
DERIVATIVES
Specific Cobb-Douglas production function:

Where, K = Stock of capital,

bo
L = Labor, and Q(K,L) the output.

Marginal physical product w.r.t stock of capital.

+
( )
es
( )

( )
Specific Cobb-Douglas production function:
lu

Where,

Where, K = Stock of capital,

.C

L = Labor, and Q(K,L) the output.

Marginal product w.r.t of labor.
+
( )
w

( )

( )
w

Marginal physical products of capital and labor:

( )
w

( )
Knowledge of values of and can give rise to numerical values of and that will
be more interpretable.

TOPIC 107: MARGINAL UTILITY FUNCTIONS USING PARTIAL DERIVATIVES

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Specific utility function:

( ) ( )
where = 1st Good,
nd
= 2 Good, and is the total utility.

Marginal utility w.r.t 1st good.

+
{( ) ( ) }

m
( )( )

Marginal utility w.r.t 2nd good.

+

co
{( ) ( ) }
( ) ( )
Marginal utilities w.r.t. 1st and 2nd Goods, respectively:

.
( )( )

ok
( ) ( )

* ( )+( ) ; knowledge of values of and gave rise to numerical value of

which is more interpretable.
* ( )+( )
bo
TOPIC 108: OUTPUT ELASTICITY OF LABOR AND CAPITAL USING PARTIAL
DERIVATIVES
General, Cobb-Douglas production function:
es
𝜶 𝜷

Where, K = Stock of capital,

L = Labor, and Q(K, L) the output.
While, 𝜶 = Output elasticity of capital (𝝐 ) and 𝜷 = Output elasticity of labor (𝝐 ).
lu

𝝐 ( )⁄( )
Numerator
.C

+ 𝜶 𝜷
( )
𝜶 𝜷
𝜶
w

𝜶 𝜷 𝜶 𝜷
𝜶 𝜶
𝜶
𝜷
𝜶
w

𝜶 𝜷
𝜶
w

As
𝝐 ( )⁄( )
𝜶 𝜷 𝜶 𝜷
4𝜶 5⁄4 5
𝜶 𝜷
4𝜶 5( 𝜶 𝜷
)

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𝝐 𝜶
D.I.Y for 𝝐

TOPIC 109: MONEY MARKET ANALYSIS USING PARTIAL DERIVATIVES

Money supply ( ) has two components: cash holdings ( ) and bank deposits ( ) .
Assume a constant ratio . / Where, ( ).
High-powered money ( ) is the sum of cash holdings ( ) held by the public and the reserves
( ) held by the banks.

m
Bank reserves are a fraction of bank deposits, determined by the reserve ratio. . /
Where ( ).

co
Using given information following tasks can be done:
o Money supply expressed in terms of high-powered money.
o Impact of reserve ratio and money supply
o Impact of cash-deposit ratio and money supply.

.
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es
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Mathematical Economics I (ECO606) VU

Lesson 24
SECOND AND HIGHER ORDER DERIVATIVES

TOPIC 110: PARTIAL MARKET MODEL USING PARTIAL DIFFERENTIATION

Money supply ( ) has two components: Cash holdings ( ) and bank deposits ( ) .
Assume a constant ratio . / Where, ( ).
High-powered money ( ) is the sum of cash holdings ( ) held by the public and the reserves
( ) held by the banks.

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. co
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TOPIC 111: NATIONAL-INCOME MODEL USING PARTIAL DIFFERENTIATION

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TOPIC 112: SECOND AND HIGHER ORDER DERIVATIVES

w

Let, first derivative be ( ) of a function ( ).

Higher-order derivatives can also be calculated.
They are also called higher derivatives.
w

e.g. Second order derivative ( ) is twice differentiation of ( ).

Also denoted by .
w

Further, (higher than second) derivatives can be expressed as follows:

( ) ( )( ) ( )
( )
Or by using notation:

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Numerical example

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TOPIC 113: ECONOMIC APPLICATIONS OF SECOND DERIVATIVE: PROFIT

MAXIMIZATION CONDITION

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TOPIC 114: NUMERICAL EXAMPLE OF PROFIT MAXIMIZATION CONDITION USING

SECOND DERIVATIVE

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Mathematical Economics I (ECO606) VU

Lesson 25

PARTIAL DERIVATIVES APPLICATION ON ELASTICITY AND PRODUCTION FUNCTIONS

TOPIC 115: YOUNG'S THEOREM

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TOPIC 116: DEMAND FOR MONEY FUNCTION ANALYSIS USING PARTIAL DERIVATIVES

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m
co
TOPIC 117: INCOME ELASTICITY OF DEMAND USING PARTIAL DERIVATIVES

.
Income elasticity of demand ( ) shows the percentage change in demand of a good ( )

ok
w.r.t percentage change in income ( ).
(𝝐 )
bo ⁄
⁄
⁄
es
⁄

Where, = Marginal demand function w.r.t income and = Average demand function w.r.t
lu

income.
.C
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w
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TOPIC 118: CROSS PRICE ELASTICITY OF DEMAND USING PARTIAL DERIVATIVES

Cross price elasticity of demand ( ) shows the percentage change in demand of one good
w

( ) w.r.t percentage change in price of other ( ).

(𝝐 )
w

⁄
w

⁄
( )

( )

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Where, ( ) = Marginal demand function of Good-1 w.r.t price of Good-2. ( )= Average

demand function of Good-1 w.r.t price of Good-2.

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TOPIC 119: PARTIAL DERIVATIVES APPLICATION ON HERRING PRODUCTION

FUNCTION

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Mathematical Economics I (ECO606) VU

TOPIC 120: PARTIAL DERIVATIVES APPLICATION ON THREE INPUT PRODUCTION

FUNCTION

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Mathematical Economics I (ECO606) VU

Lesson 26

PARTIAL DERIVATIVES APPLICATION ON CONSUMER AND PRODUCER THEORIES

TOPIC 121: ENVELOPE THEOREM

A mathematical theorem based on calculus.
Multiple applications in economics including producer theory.
Here, consumer theory is being subjected.

m
Objective function
( )
Constraint function

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Lagrangian function
( ) ( )

.
Optimized utility function:

ok
( )
Where, ( ) ( ) are the Marshallian demand functions.
Detailed optimized utility function: ( ) { ( ) ( )}

are variables and

Variables in (
bo are parameters.
) is now parametrized by .
If marginal utility of money is to be found, (a total derivative) needs to be found at optimum
points.
es
| . /|
( ) ( )

Which can be a tedious calculation.

lu

( )

However, Envelope theorem suggests that a partial derivative can be found instead.
.C

Therefore;
|
( )
w

Envelope Theorem: Partial derivative of Lagrangian w.r.t a given parameter of variables equals
the total derivative of objective function evaluated at its variables‟ optimum points.
w

Numerical Exercise: Choose a utility function and a budget constraint and evaluate.

TOPIC 122: ROY’S IDENTITY

w

Attributed to for French economist René Roy.

One of the two ways to calculate Marshallian demand functions.
(Other being constrained optimization of utility function & budget constraint).i.e.

Objective function
( )
Constraint function

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Uses ratio of partial derivatives of indirect utility function with respect to price of good (under
consideration) and income, respectively.
( )

( )

For 2 Goods case:

( ) ( )

and

m
( ) ( )

( ) ( ) ( )
, are needed.

co
e.g.:
( )
( ) √

.
( )

ok
( ) ( )

( ) ( )
√ √

(
)

)
bo
es
( )
√

( )

( )
√
lu

( ) ( )
.C

( ) ( )

D.I.Y, similarly for ( ) ( )

w

TOPIC 123: HOTELLING’S LEMMA

Attributed to Harold Hotelling.
w

Mathematical result used to related supply of a good with producer‟s profit.

The change in profits from a change in price is equal to the quantity produced.
( )
w

( )

Specifically speaking for a maximized profit function:

( )

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Numerically speaking.
Assume( ̅ )
Profit
Price of output
Quantity of output produced
Price of capital input

m
Quantity of capital input employed
Let , , , .
( )( ) ( )( )

co
After change ( )
, , , .
( )( ) ( )( )

.
ok
in profits due to
bo
in price is 20 equals output produced.

TOPIC 124: SHEPHARD LEMMA

Attributed to Ronald Shephard
es
Mathematical result used in consumer & producer theory.
Demand for a particular good for a given level of utility and prices , equals the derivative of
the expenditure function with respect to the price of the relevant good:
lu

Consumers’ point of view

( )
( )
.C

( ) is the Hicksian demand function for good .

( ) is the expenditure function.

Producers’ point of view

w

( )
( )
( ) is the conditional factor demand function for input .
w

( ) is the cost function.

Consumer Theory
w

( )
( )
If maximized expenditure function:
( ̅) ̅
Hicksian demand function for and are:

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( ̅) ̅

( ̅) ̅

Similarly, producer theory also uses Shephard‟s Lemma.

D.I.Y by using a cost objective function and an output constraint.

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Mathematical Economics I (ECO606) VU

Lesson 27
USE OF DIFFERENTIALS IN ECONOMICS

TOPIC 125: DIFFERENTIALS VERSUS DERIVATIVES

Derivative . / of ( ): a single entity.
Ratio of two quantities, and – differentials.
Derivative as the ratio of differential of function by the differential of variable.
If ( ) is the derivative of ( ), then rearranging:

m
* ( )+
Differential of function.

co
Differentiation ⇒ Differentials ( ).
Differentiation w.r.t. ⇒ Derivatives . /.

.
Rules of Differentials

ok
- Sum-Difference Rule(s)
* ( ) ( )+ * ( )+ * ( )+
- Product Rule
* ( ) ( )+ * ( )+ ( ) * ( )+ ( )
- Quotient Rule bo
( ) , * ( )+ ( ) * ( )+ ( )-
2 ( )
3 * ( )+
Where ( )
es
Examples
( )
( )
Since, * ( )+
{ }
lu

( )
( )
Since, * ( )+
.C

{ }
( )
w
w
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TOPIC 126: POINT ELASTICITY USING DIFFERENTIALS

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Mathematical Economics I (ECO606) VU

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TOPIC 127: ELASTICITY OF RECTANGULAR HYPERBOLIC DEMAND CURVE
es
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Mathematical Economics I (ECO606) VU

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TOPIC 128: INCOME AND PRICE ELASTICITY OF DEMAND USING DIFFERENTIALS

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Mathematical Economics I (ECO606) VU

TOPIC 129: INCOME ELASTICITY OF CONSUMPTION USING DIFFERENTIALS

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TOPIC 130: INCOME AND PRICE ELASTICITY OF IMPORT FUNCTION USING
DIFFERENTIALS
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Mathematical Economics I (ECO606) VU

TOPIC 131: OUTPUT ELASTICITY OF COST

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Mathematical Economics I (ECO606) VU

Lesson 28
USE OF TOTAL DIFFERENTIALS IN ECONOMICS

TOPIC 132: CONCEPT OF TOTAL DIFFERENTIALS

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TOPIC 133: SAVINGS FUNCTION AND TOTAL DIFFERENTIALS

If ( )
Savings, National income, Interest rate.
Synonymous to:
( ̅) (̅ )

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* ( )+ * ( )+

* ( )+
Where,
( )̅ (̅ )

Total Differential: Sum of partial differentials of the function w.r.t to each independent variable.

m
Example
If ( )

co
. /
. /

.
ok
: Change in savings due to change in income is half of it.
: Change in savings due to change in interest rate is thrice of it.
bo
TOPIC 134: GENERAL UTILITY FUNCTION AND TOTAL DIFFERENTIALS
In real world, utility depends on multiple goods instead of 2.
Case of n-goods utility function.
( )
es
Total differential :
. / . / . /
lu

Total differential is composed of partial differentials.

.C

In case of -goods utility function ( ), there will be -partial differentials:

. / . / . /
w

Borrowing the partial derivative expressions.

, ,…, .
Multiple partial elasticities can be developed from these:
w

𝜺 . /. /
𝜺 . /. /
w

………………………………………
𝜺 . /. /

General form of partial elasticities of utility functions:

𝜺 . /. /

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TOPIC 135: SPECIFIC UTILITY FUNCTION AND TOTAL DIFFERENTIALS

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Mathematical Economics I (ECO606) VU

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TOPIC 136: PRICE AND RAIN ELASTICITY OF SUPPLY USING TOTAL DIFFERENTIALS

bo
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Mathematical Economics I (ECO606) VU

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TOPIC 137: LOCAL PRICE ELASTICITY OF FOREIGN DEMAND OF EXPORTS USING
bo
TOTAL DIFFERENTIALS
es
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Mathematical Economics I (ECO606) VU

Lesson 29
CONCEPT OF TOTAL DERIVATIVES

TOPIC 138: CONCEPT OF TOTAL DERIVATIVE

Assume ( ) Where, ( ).
Channel map.
⇐ ⇐

m
⇐
Combining the two functions
* ( ) +
: Ultimate source of change.

co
* ( ) +
Two channels: Direct & Indirect.
 Indirect: via function .

.
 Direct: via function .

ok
 Indirect: * ( )+ ⇒ , * ( )+- ⇒
 Direct: ( ) ⇒

Total (Direct +Indirect): * ( )

bo +

⏟ ⏟ ⏟
es
Total Differentiation of w.r.t. .
Caveat:
lu

⏟ ⏟
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Example
( )
( )
w
w

( )
( )
w

( )
( ) ( )

Verification
( )
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Mathematical Economics I (ECO606) VU

( )
Substituting:
( ) ( )
( )
Differentiating w.r.t.
* ( )+ * +
(Same as that in Total Derivative formula).

m
TOPIC 139: COMPLEMENTARITY BETWEEN COFFEE AND SUGAR USING TOTAL
DERIVATIVE
Assume ( )

co
Where and are coffee and sugar, respectively.
Furthermore; ( ).
This implies complementarity between sugar and coffee (Financial Times newspaper).
* ( )+

.
Channel map:

ok
⇐ ⇐

Main variable causing change is : bo * ( )+

es
Example
* +
( )
lu

* ( )+

* ( )+
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* ( )+
w
w

( )
w

Verify using substitution.

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TOPIC 140: GENERAL PRODUCTION FUNCTION WITH TIME-DEPENDENT LABOR AND

CAPITAL

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TOPIC 141: SPECIFIC PRODUCTION FUNCTION WITH TIME-DEPENDENT LABOR AND

CAPITAL

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Mathematical Economics I (ECO606) VU

Lesson 30

CONCEPT OF IMPLICIT DIFFERENTIATION AND THEIR ECONOMIC APPLICATIONS

TOPIC 142: CONCEPT OF IMPLICIT DIFFERENTIATION

Deals with implicit functions:
o
o

m
o
To find of implicit function:
o Differentiate each side of the equation w.r.t. x, considering y as a function of x.

co
o Solve the resulting equation for .

Example

.
⁄ ( ) ⁄ ( )

ok
( ) ( ) ( )

( )bo { ( ) ( )}

{ }

{ }
es
lu

( )
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Implicit derivative of the given implicit function.

w

TOPIC 143: PRODUCTION FUNCTION ANALYSIS USING IMPLICIT DIFFERENTIATION

Assume
( )
w

Implicit function version.

( )
Marginal physical products of labor & capital ( ).
w

&
These are partial derivatives ( & ).
* ( ̅ )+ * + * ( ( ) ̅ )+
Resorting to implicit differentiation: * ( ( ) ̅ )+

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. /
4 5
. /

4 5
Marginal physical product of capital ( ) expressed in relation to the function ( ).
Similarly, * ( ̅ )+ * +

m
* ( ( ) ̅ )+

co
. /
( )
. /

( )

.
ok
Marginal physical product of labor ( ) expressed in relation to the function ( ).

Also ( ) can be found using implicit differentiation.

* (̅ ( ) )+ * + bo
. /
. /
. /
es
( ) . /
Marginal rate of technical substitution ( ) expressed in relation to the function ( ).

TOPIC 144: MARGINAL RATE OF TECHNICAL SUBSTITUTION USING IMPLICIT

lu

DIFFERENTIATION
Assume
( )
.C

An implicit function that can yield a production function:

( )
Marginal rate of technical substitution, ( )
w
w
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Mathematical Economics I (ECO606) VU

( ): Implicit Differentiation
* (̅ ( ) )+ * +

. /
. /
. /

( ) | . /

m
Marginal rate of technical substitution ( ) expressed in relation to the function ( ).

TOPIC 145: MARGINAL UTILITIES AND MARGINAL RATE OF SUBSTITUTION USING

co
IMPLICIT DIFFERENTIATION
Assume an implicit equation:
( )
Utility function can be extracted:
( )

.
ok
For , assume ( ) ( ) ⇒ * ( )+ ceteris paribus ( ̅ ̅ ).
* ( )+

Re-arranging
bo
( )
es
. /

For , assume
lu

( ) ( )⇒ * ( )+, ceteris paribus ( ̅ ̅ )

* ( ̅ ̅ )+
.C

. /

. /
w

Marginal utility due to an additional unit of ( good).

w

For , assume ( ) ( ) ⇒ * ( )+, ceteris paribus ( ̅ ̅ ̅ )

* (̅ ̅ ̅ )+
w

( )

( )

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( )
( )
( )

For , Assume

( ) ( )⇒ * ( )+, ceteris paribus ( ̅ ̅ ̅ ̅ )

m
* (̅ ̅ ̅ ̅ )+

co
. /

( )

.
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. /
( )
( )

TOPIC 146: NERLOVE-RINGSTAD PRODUCTION bo FUNCTION USING IMPLICIT

DIFFERENTIATION
Attributed to Nerlove (1963) and Ringstad (1967).
𝜶 𝜷

Where, ,𝜶 and 𝜷 .
es
𝜶 𝜷
| | | |
𝜶 𝜷
| | | |
𝜶 𝜷
( )( ) | |
lu

is not in explicit function form.

.C

Implicit differentiation w.r.t.

*( ( ̅ ) )( ( ̅ ) )+ ( 𝜶
| 𝜷
|)
{( ( ̅ ) )}( ( ̅) ) *( ( ̅ ) )+( ( ̅) ) ( 𝜶 )
w

* ( ̅ )+ * ( ̅ )+ ( 𝜶)
6 7( ( ̅) ) 6 7( ( ̅) ) 𝜶
w

( ̅) ( ( ̅) ) 𝜶 𝜶
* ( ̅ )+ 0 1 [ ] * ( ̅ )+ 𝜶
w

( ̅) ( ( ̅) )
* ( ̅ )+ [ ] 𝜶

Writing in simpler notation.

( ) 𝜶
( ) 0 1

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𝜶
0 1
𝜶
0 1
𝜶
( )

Implicit differentiation w.r.t. .

m
*( (̅ ) )( (̅ ) )+ ( 𝜶
| 𝜷
|)
{( (̅ ) )}( (̅ )) *( (̅ ) )+( (̅ )) ( | 𝜷
|)
* ( ̅ )+ * ( ̅ )+ 𝜷)

co
(
6 7( (̅ )) 6 7( (̅ )) 𝜷

(̅ ) ( (̅ ) ) 𝜷 𝜷
* (̅ )+ 0 1 [ ] * (̅ )+ 𝜷

.
(̅ ) ( (̅ ) )

ok
* (̅ )+ [ ] 𝜷

Writing in simpler notation.

( ) 0
(

𝜷
)
1
𝜷
bo
0 1
𝜷
0 1
es
𝜷
( )

TOPIC 147: MARGINAL PRODUCTS OF THREE INPUT LOGARITHMIC PRODUCTION

lu

FUNCTION
Assume an endogenous growth model:
𝜶 𝜷 𝜸
.C

: Human capital
Becker (1964): Skills and adequate motivation to apply them.

Logarithmically, linearizing the production function.

w

𝜶 𝜷 𝜸

For , & , partially differentiation w.r.t logarithms of , ,& .

w

* + * 𝜶 𝜷 𝜸 +
w

(𝜶 ) (𝜷 ) (𝜸 )

( ) ( ) ( )
𝜶 𝜷 𝜸

( ) ( ) ( )
𝜶 𝜷 𝜸
𝜶( ) 𝜷( ) 𝜸( )
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* + 𝜶 (Labor elasticity of output)

For :
* + * 𝜶 𝜷 𝜸 +

m
(𝜶 ) (𝜷 ) (𝜸 )

( ) ( ) ( )
𝜶 𝜷 𝜸 𝜷

co
(Capital elasticity of output)
* +

.
(𝜶 ) (𝜷 ) (𝜸 )

ok
( ) ( ) ( )
𝜶 𝜷 𝜸

* +
𝜶( ) 𝜷( ) 𝜸( ) 𝜸 bo (Human capital elasticity of output)
es
lu
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w
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Mathematical Economics I (ECO606) VU

Lesson 31
EXPONENTIAL FUNCTIONS AND GROWTH

TOPIC 148: EXPONENTIAL FUNCTIONS AND GROWTH

A quantity that increases (or decreases) by a fixed factor per unit of time is said to increase (or
decrease) exponentially.

( ) Where, is a factor by which increases when increases by 1.

m
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bo
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w
w
w

Each base gives a different value of ( ) . E.g. etc.

In calculus, most of exponential functions appear with base

An irrational number.
Represented by .
Its function is ( ) a.k.a. Natural exponential function.

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m
co
Exemplifies growth of a sum of money capital over time.
Can also represent growth of population, wealth, or real capital etc.

.
ok
TOPIC 149: INSTANTANEOUS RATE OF GROWTH
Given a value function of continuous interest compounding

:Points in time, : Principal amount, Natural base, : Interest rate, : Value at point in time.

{ ( )}= { ( )}= ( )
bo ( )
* ( )+ ( )

Instantaneous Rate of Change

es
For Instantaneous Growth Rate.
o We find the rate of change of value in relative (%age) terms:
* ( )+ ( )
o
lu

o Instantaneous Rate of Growth

Time dependent.
Constant (simplicity sake).
.C

Numerical Example
o ( )
Instantaneous Rate of Growth of is – a constant.
w
w
w

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. co
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TOPIC 150: NUMERICAL EXAMPLES OF INSTANTANEOUS RATE OF GROWTH
Given:
( )
Interest compounding:

: Principal amount = 1
bo
: Instantaneous growth rate
* ( )+
es
* ( )+ ( ) ( )
( )
lu
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w
w
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Mathematical Economics I (ECO606) VU

Given:
( )
Interest compounding:

: Principal amount = 0.03,

: Instantaneous growth rate
* ( )+

m
* ( )+ ( ) ( ) ( )
( )

. co
ok
bo
es

TOPIC 151: CONTINUOUS VS DISCRETE GROWTH

lu

Usually in economic situations, growth does not always take place on a continuous basis.
Not even in interest compounding.
However, for discrete growth, where changes occur only once per period rather than from
.C

instant to instant, the assumption of continuous exponential growth function can be justified.
( ) ( ) ( ) ( )
Exponents are time periods covered in compounding, : Principal amount, : Interest rate.
Series can be considered an exponential expression as .
w

That is . even for as (%age terms).

To convert base to natural exponent, compare with standard form of natural exponential
function :
w

( )
w

( )
( )
( )
( )
That's why natural exponential functions are extensively applied in economic analysis despite
not all growth patterns may actually be (purely) continuous.

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Mathematical Economics I (ECO606) VU

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TOPIC 152: DISCOUNTING AND NEGATIVE GROWTH
From interest compounding to discounting.
Compound-interest problem: future value V (Principal + Interest) from a given present value A
bo
(Initial principal).
Discounting problem: Present value A of a given sum V which will be available after t years.
 Discrete case:
( )
Cross-multiplying:
es
( )

( )
( )
lu

Reversed roles (as in intro.) of A and V.

 Continuous Case:
Principal A grows into after t years of continuous compounding at the rate r .
.C

Cross multiplying:
w
w

is also referred as discounting factor.

Reversed roles (like in discrete case) of A and V.
w

From growth to negative-growth.

TOPIC: 153: APPLICATIONS OF CONTINUOUS COMPOUNDING

Suppose, the sum of PKR 5000 is invested in an account earning interest at an annual rate of
9%. What will be the balance after 8 years if interest is compounded continuously?

Formula for continuous compounding:

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Here, , , .
Substituting values:
( )

Interpretation: Principal will increase from PKR 5000 to PKR 10272.17 during after 8 years, if
the annual interest is 9%, and there is continuous compounding of interest.

m
. co
ok
bo
es
lu
.C
w
w
w

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Mathematical Economics I (ECO606) VU

Lesson 32
USE OF LOGARITHMS IN ECONOMICS

TOPIC 154: LOGARITHMS MEANING AND TYPES

Attributed to a Scottish mathematician John Napier (1550-1617)
Etymology: Greek „logos‟ ratio + „arithmos’ number.
Inverse of exponentiation.
Helps to find the power of a number result of which is known.
⇒

m
⇒
Can have base different than 10:
,

co
Also 2.718 (Euler‟s number).

is the natural Logarithm of .

Contrary to natural exponential function

.
and are inverse functions of each other.

ok
Order independence in inverse.

bo ( )
es
lu
.C
w
w
w

TOPIC 155: LAWS OF LOGARITHMS

1 - Logarithm of a Product
( ) ( ) ( )
Or
( ) ( ) ( )

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Example
( ) ( ) ( )
( ) ( ) ( )
Using calculator

Economic Instance
( ) ( ) ( ) ( )

m
2 - Logarithm of a Quotient
. / ( ) ( )

co
OR
. / ( ) ( )

Example

.
. / ( ) ( )

ok
( ) ( ) ( )
Using calculator

Economic Instance
( ) . / ( )
bo
( )
es
3 - Logarithm of a Power

( ) ( )
OR
( ) ( )
lu

Example
( ) ( )
.C

( ) * ( )+
Using calculator
* +
w

Economic Instance
( ) 𝜶 𝜷
( )
𝜶)
( ) ( ( 𝜷)
w

( ) 𝜶 ( ) 𝜷 ( )

Log-linearized form of Cobb-Douglas production function.

w

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TOPIC 156: LAWS OF LOGARITHMS FOR TRANSFORMATION OF CES PRODUCTION

FUNCTION

m
. co
ok
bo
es
lu
.C
w
w
w

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Mathematical Economics I (ECO606) VU

Lesson 33

RULES OF DIFFERENTIATION OF EXPONENTIAL AND LOGARITHMIC FUNCTIONS

TOPIC 157: RULES OF DIFFERENTIATION OF EXPONENTIAL AND LOGARITHMIC

FUNCTIONS
Possibility of exponential functions in differentiation.
( )

m
( )
( )
Example:
Here, ( )

co
( )
Deploying the rule:
( )
* + ( )
( )

.
ok
Possibility of logarithmic functions in differentiation.
( ) Where ( ) 0 bo * ( )+ ( )
( )
Example:
Here ( )
es
( )
Deploying the rule:
* ( )+ ( )
( )
lu

* +

TOPIC 158: OPTIMAL TIMING: A PROBLEM OF WINE STORAGE

.C

Sell wine today ( ) for $ K or store and sell at higher price.

Higher value (V):.
( ) √ (√ ) ( )
w

Sell now, ( ) implies:

( ) ( ) ( )= ( )
w

Assumptions
o Storage costs = 0 (container)
o Sunk costs as wine is possessed in prior and not being produced currently.
w

Therefore:
reduces to as
As ( ) , value of is known.
( ) √

( ) √

( ) √ [ ( ) : ]
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( ) √
( )
( √ )
( )
( ) (√ ) ( )

( )
( ) (√ ) ( )

m
( )
√
( )
( )

co
√
( )
F.o.C implies:

( )
√

.
ok
OR
√
If ,
Then ( )
Storage should be done for 25 years before selling.
bo ( ) √
For Rate of Growth of V
* ( )+ √
es
√
√
√
√
lu

( )
√

( )
.C

√
Second Order Condition
{ ( )}
√
w

( ( )) implies ( )
w
w

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Mathematical Economics I (ECO606) VU

m
co
TOPIC 159: OPTIMAL TIMING: A PROBLEM OF TIMBER CUTTING
Value of timber already planted in $1000.

.
( ) √

ok
Harvest now, ( ) implies:
( ) ( )

( ):

Assumptions
o Upkeep costs = 0
bo
o Sunk costs as plants are already grown not being grown currently.
es
Therefore:
reduces to as
As ( ) , value of is known.
( ) √
lu

( ) √

| √|
.C

√ ( )
√
First Order Condition
. ⁄ /
w

√
( )
w

√
( )
√
w

√
Or . /
√
Optimum number of years of growth.
Greater the discount rate, earlier should the timber be cut.
Numerically: if
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,
. /
√

Or . /
√
Present value at ( )
( ) √

m
( ) √ ( )

( ) (thousands)

co
( )
( ) (√ ) ( )
( )
√

.
( )
( )

ok
√
( )

bo ( )
√
Or
√
If ,
Then ( )
es
Storage should be done for 25 years before selling.

( ) √
lu

For Rate of Growth of V

* ( )+ √
.C

√
√
√
√
w

( )
√

( )
w

√
Second Order Condition
{ ( )}
w

√
( ( )) implies maximum

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TOPIC 160: OPTIMAL TIMING: LAND PURCHASE FOR SPECULATION

Land purchased for speculation.
Value is increasing:
( ) 1000 √
Sell now, ( ) implies:
( ) ( )

( ):

m
Assumptions
o Upkeep Costs = 0
o Sunk Costs as plants are already grown not being grown currently.

co
As ( ) , value of is known.
( ) √

( ) √ √

.
| √ |

ok
√
Given that
bo √

. ⁄ /
⁄
es
( ⁄
)

First Order Condition

4 5
lu

4 5
⁄
.C

⁄
⇒
w

⁄
⁄
⁄
⇒ ( )
w

Optimum number of years.

w

Land should be held for 7.127 years before sale.

Second Order Condition

. / {( ⁄
) }
⁄
= 2. / 3
⁄ ⁄
2. / 3 2. / 3
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( ( )) implies maximum

TOPIC 161: OPTIMAL TIMING: ART COLLECTION

Estimated value of art collection of a deceased painter:
( ) 200000( )√
Sell now, ( ) implies:

m
( ) ( ) 200000( )√
( ):

co
As ( ) , value of is known.
( ) ( )√
( ) ( )√

.
( ) ( )

ok
| |

Given that
bo
. ⁄ /
⁄
. /
es
First Order Condition
⁄
⁄ { . / }
lu

⁄
⁄ { . / }
⁄
. /
.C

⁄
. /

⁄ ( ) ( )
⇒ { }
w

2 ( )
3 years
w

Art collection should be sold after 15.24 years.

w

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TOPIC 162: OPTIMAL TIMING: DIAMOND PURCHASE

Estimated value of diamond, bought for investment purpose, is:
( ) 250000( )√
Sell now, ( ) implies:
( ) ( ) 250000( )√
( ):

As ( ) , value of is known.

m
( ) ( )√
( ) ( )√

co
( ) ( )
| |

.
Given that

ok
. ⁄ / ⁄
. /

First Order Condition

⁄
bo
⁄ 2 . / 3
⁄
⁄ 2 . / 3
es
⁄
. /
⁄
. /
lu

( ) ( ) ⁄
⁄
⇒ 2 3
⁄
.C

2 ( )
3 years
Diamond should be sold after 2.52 years.
w
w
w

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Mathematical Economics I (ECO606) VU

Lesson 34

FINDING THE RATE OF GROWTH USING EXPONENTIAL AND LOGARITHMIC

FUNCTIONS

TOPIC 163: FINDING THE RATE OF GROWTH USING EXPONENTIAL AND LOGARITHMIC
FUNCTIONS
Assume ( )

m
depends on (time).
Instantaneous Growth Rate:
. / ( )
* ( )+

co
( )
Example:

Growth Rate of .

.
ok
Taking derivative w.r.t .
bo * +
* + * + (Rate of growth of V is r)

TOPIC 164: GROWTH OF EXPORTS OF A COUNTRY

es
A country export both goods ( ) and services ( ).
Both depend on time i.e. ( ) and ( ).
Total exports: 𝑿( ) ( ) ( ).
𝑿( )
Rate of growth of exports 𝑿
lu

𝑿( ) *𝑿( )+
.C

* ( ) ( )+

* ( )+ * ( )+
𝑿( ) ( ) ( )
w

𝑿( )
Substituting in 𝑿 𝑿
( ) ( )
w

𝑿
𝑿
( ) ( )
𝑿 +
𝑿 𝑿
w

( ) ( )
+
𝑿 𝑿
( ) ( )
𝑿
+𝑿

𝑿 𝑿
+𝑿 …………(A)

Given and

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Equation (A) becomes:

𝑿 𝑿
. /+𝑿 . /

𝑿
𝑿

TOPIC 165: FINDING THE POINT ELASTICITY

Using the usual formula of price elasticity of demand:

m
𝝐 ( ) ⁄( )

𝝐 ( )( )

co
𝝐 ( )( )

. /
𝝐

.
. /

ok
( )
𝝐
( )

Assuming a specific demand function:bo ⁄

Logarithmically differentiating w.r.t .

( ) ( ) ( )
es
( ) ( ) ( )

𝝐
𝝐 (Unitary elastic demand curve)
lu

TOPIC 166: RATES OF GROWTH OF POPULATION, CONSUMPTION, AND PER CAPITA

.C

CONSUMPTION
Growth rate of consumption ( ) is 𝜶.
Growth rate of population ( ) is 𝜷.
Consumption per capita ( ).
w

. /
| |
w

=
( ) ( ) ( )
w

( ) ( ) ( )
( ) ( ) ( )

Given 𝜶 and 𝜷
𝜶 𝜷
Rate of growth of a quotient variable is equal to difference of individual growth rates.

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TOPIC 167: RATE OF GROWTH OF PER CAPITA EMPLOYMENT

Growth rate of employment opportunities ( ) is .
Growth rate of population ( ) is .
Employment per capita ( ).
. /
| |

m
=
( ) ( ) ( )

co
( ) ( ) ( )
( ) ( ) ( )

.
Given and

ok
If and

Growth rate of a per capita employment is equal to difference of growth rate of employment and
population, respectively.
bo
TOPIC 168: RATE OF GROWTH OF EXPORT EARNINGS OF A COUNTRY
Two exports of a country C and B.
( ) , and ( ) .
es
grows at 10% and grows at 20%.

Differentiate w.r.t.
lu

( ) ( )

( ) ( )
.C

( ) ( )
and
Imply:
w

( )and ( )
( ) ( )
w

. / +. /

Given and .
w

. / +. /

TOPIC 169: RATE OF GROWTH OF SALES

Sales function is:
( ) √

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( ) √

( ) √

√
. / ( )
√

m
√

co
Sales function is:

.
Assuming ,

ok
Sales shall grow at 12.5% if 4 years are allowed.
bo
TOPIC 170: RATE OF GROWTH OF PROFIT
In addition to maximization of profit, rate of growth of profit can also be of interest for a firm.
Profit function is:
( ) √
es
( )
( )
lu

( )

⇒
.C

( )
. /
w

Growth rate of profit function is:

w

Assuming ,
w

Profit shall grow at 10% if 8 years are allowed.

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Mathematical Economics I (ECO606) VU

Lesson 35
CONCEPT OF OPTIMIZATION

TOPIC 171: CONCEPT OF OPTIMIZATION

Etymology optimum: Latin ‘Optimus’ „best‟
Process of maximizing favorable variables and minimizing unfavorable variables.
Assume a function:
( )

m
In cubic specification:
( )
Two wiggles.
One upwards and other downwards.

. co
ok
bo
es
lu
.C
w
w
w

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Mathematical Economics I (ECO606) VU

m
. co
ok
bo
es
Extremum vs Extrema
Maximum vs Maxima
Minimum vs Minima

TOPIC 172: CALCULUS APPROACH TO OPTIMIZATION: 1ST ORDER TEST

lu

Considering a function ( ).
Which is continuous and can have extremum/extrema.
Finding the critical value at which function is optimized.
.C
w
w
w

Since slope at maximum or a minimum is zero.

Slope = ( ) .
a.k.a First order condition (F.o.C).
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a.k.a Necessary condition for optimization.

m
. co
ok
bo
es

Instance:
lu
.C
w
w
w

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m
. co
ok
bo
es
lu
.C

TOPIC 173: AVERAGE COST ANALYSIS

w
w
w

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Mathematical Economics I (ECO606) VU

m
. co
ok
bo
es

TOPIC 174: CALCULUS APPROACH TO OPTIMIZATION: 2ND ORDER TEST

Considering a function ( ).
lu

Which is continuous and can have extremum/extrema.

Having found the critical value(s) at which function is optimized, one needs to confirm if function
is actually maximized or minimized or just a „bend in curve‟ (inflection).
.C
w
w
w

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m
. co
ok
Rate of change of slope.
. /
Rate of change of Slope = ( ) .
a.k.a Second order condition (S.o.C)
bo
a.k.a Sufficient condition for optimization

Instance:
es
( )
( )
For
( ) ( )
lu

( ) ( ) ( ) (maximum at )
For
( ) ( )
.C

( ) ( ) ( ) (minimum at )
For , ( ) , ( ) (inflection)
w
w
w

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TOPIC 175: MATRIX APPROACH TO OPTIMIZATION: 2ND ORDER TEST – HESSIAN

Hessian is a determinant with all the second-order partial derivatives.
2nd order direct partials on the principal diagonal
2nd order cross partials off the principal diagonal.
| |
Where, (Young‟s theorem)
Principal minors = 2

m
1st Principal minor:

2nd Principal minor:

co
| |

If both and are positive then minimum will be evident.

.
⇒ Minimum

ok
If and have alternative signs then minimum will be evident.
, ⇒ Maximum

If ( )
bo ( )

( ) ( )
,
( )
es
( ) ( )
,

| | | |
lu

| | | |
.C

Since both and are positive, there exists a minimum.

, Evaluate 2nd order condition using Hessian Determinant.

w

If ( )

For ( )
w

| |
w

implies a maximum.
implies a minimum.

N-number of variables can be dealt with using Hessian determinant.

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Lesson 36
PROFIT MAXIMIZATION ANALYSIS

TOPIC 176: PROFIT MAXIMIZATION ANALYSIS

m
. co
ok
bo
es
lu
.C
w
w
w

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m
. co
ok
bo
es
lu
.C
w
w
w

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TOPIC 177: NUMERICAL EXAMPLE OF PROFIT MAXIMIZATION

m
. co
ok
bo
es
lu
.C
w
w
w

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m
. co
ok
bo
es
lu
.C
w
w
w

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Mathematical Economics I (ECO606) VU

TOPIC 178: PROFIT MAXIMIZATION OF TECHNICALLY RELATED GOODS

m
. co
ok
bo
es
lu
.C
w
w
w

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m
. co
ok
bo
es
lu
.C
w
w
w

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TOPIC 179: PROFIT MAXIMIZATION OF MONOPOLISTIC FIRM PRODUCING RELATED

GOODS

m
. co
ok
bo
es
lu
.C
w
w
w

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m
. co
ok
bo
es
lu
.C
w
w
w

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Mathematical Economics I (ECO606) VU

TOPIC 180: PROFIT MAXIMIZATION OF FIRM PRODUCING SUBSTITUTE GOODS

m
. co
ok
bo
es
lu
.C
w
w
w

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m
. co
ok
bo
es
lu
.C
w
w
w

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Mathematical Economics I (ECO606) VU

Lesson 37
PROFIT MAXIMIZATION ANALYSIS (CONTINUED 1)

TOPIC 181: MARGINAL AND AVERAGE REVENUE ANALYSIS

m
. co
ok
bo
es
lu
.C
w
w
w

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m
. co
ok
bo
es
lu
.C
w
w
w

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Mathematical Economics I (ECO606) VU

m
. co
ok
bo
es
lu

TOPIC 182: SHORT RUN PRODUCTION FUNCTION ANALYSIS

.C
w
w
w

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m
. co
ok
bo
es
lu
.C
w
w
w

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Mathematical Economics I (ECO606) VU

m
co
TOPIC 183: TOTAL COST, TOTAL REVENUE AND PROFIT MAXIMIZATION

.
ok
bo
es
lu
.C
w
w
w

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m
. co
ok
bo
es
lu
.C
w
w
w

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Mathematical Economics I (ECO606) VU

Lesson 38
PROFIT MAXIMIZATION ANALYSIS (CONTINUED 2)

TOPIC 184: QUADRATIC PROFIT FUNCTION ANALYSIS

m
. co
ok
bo
es
lu
.C
w
w
w

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m
. co
ok
bo
es
lu
.C
w
w
w

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Mathematical Economics I (ECO606) VU

TOPIC 185: OPTIMIZATION OF EXPONENTIAL REVENUE FUNCTION

m
. co
ok
bo
es
lu
.C
w
w
w

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Mathematical Economics I (ECO606) VU

m
. co
ok
bo
es
TOPIC 186: OPTIMIZATION OF MORE THAN ONE CHOICE VARIABLE
Two (or more) independent variables can exist.
For instance, ( )
lu

Surface (or hypersurface).

Peaks of domes & bottoms bowls can exist.
.C
w
w
w

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m
. co
ok
bo
es
lu
.C
w
w
w

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Mathematical Economics I (ECO606) VU

Conditions for Relative Extremum: ( )

Condition Maximum Minimum

1st Order (Necessary)

2nd Order(Necessary)

2nd Order (Sufficient)

m
( ) ( )

Conditions for Inflection and Saddle Points:

co
Inflection Point Saddle Point

2nd Order(Necessary) OR

.
2nd Order (Sufficient) ( ) ( )

ok
Conditions for Inconclusiveness of the Test:

2nd Order (Sufficient) ( ) N.A.

Note: By Young‟s Theorem:

bo ⇒ ( )

 Numerical Example
es
( )
1st order conditions:

⇒
lu

⇒
Critical Points:( ) ⇒ *( )( )( )( )+
.C

A. ( ) ( )
B. ( ) ( )
w

C. ( ) ( )
D. ( ) ( )
w

POINT - I: ( ) ( )
( )
w

Different signs of & ⇒ Saddle pt.

POINT - II: ( ) ( )
( )
& ⇒ Maximum/inflection
( ) ⇒( )( )
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At ( ) Maximum is confirmed.
POINT - III: ( ) ( )
( )
& :Minimum/inflection
( ) ⇒( )( )
At ( ) Minimum is confirmed.

m
POINT - IV: ( ) ( )
( )
Different signs of & ⇒ Saddle pt.

co
D.I.Y
1.
2.

.
ok
TOPIC 187: ECONOMIC APPLICATION ON MULTI-PRODUCT FIRM

bo
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TOPIC 188: ECONOMIC APPLICATION ON MULTI-PLANT FIRM

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Mathematical Economics I (ECO606) VU

Lesson 39
PROFIT MAXIMIZATION ANALYSIS (CONTINUED 3)

TOPIC 189: PRICE DISCRIMINATION BY MONOPOLY

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TOPIC 190: PRICE DISCRIMINATION BY MONOPSONY

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TOPIC 191: INPUT DECISION OF A FIRM

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TOPIC 192: PROFIT MAXIMIZATION OF TWO-PRODUCT FIRM

Given that:
, , , ,
,
( )

( )

m
( ) +( )

. co
ok
( )
= bo
. / ( ). / . /. / . / . / . /
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Mathematical Economics I (ECO606) VU

Lesson 40
CONSTRAINED OPTIMIZATION ANALYSIS

TOPIC 193: COMPARATIVE-STATIC ASPECTS OF OPTIMIZATION

Example # 1 Reduced form Solutions

m
⇒
⇒

Need for comparative static analysis.

co
Partial differentiation of w.r.t. & .

( ) . /

.
ok
( ) . /
( ) . /
( ) . / bo
⇒ ⇒
⇒ ⇒
es
⇒ ⇒
⇒ ⇒
 Technical relation in production
lu

TOPIC 194: RATIONALE FOR CONSTRAINED OPTIMIZATION

Constraints can be considered as old as scarcity.
a.k.a. Restraint, side relation, or subsidiary condition.
.C

Narrows the domain ( ) and hence range ( ) of objective function (say ( )).
w
w
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bo
Free optimum is higher than constrained optimum.
es
Sometimes both can be the same.
However, constrained optimum can‟t be higher than free optimum.

TOPIC 195: FINDING STATIONARY VALUES USING SUBSTITUTION/ELIMINATION

METHOD
lu

Assume an objective function:

( )
A constraint function is:
.C

Use constraint:

Substitute in objective function.

w

( ) ( )
( )
First order condition
w

( )

( )
w

Critical values: and

Substitute and in objective function:
( )
( ) ( )( ) ( )
( )

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TOPIC 196: FINDING STATIONARY VALUES USING METHOD OF LAGRANGE

MULTIPLIER
Assume an objective function:
( )
A constraint function is:

Forming Lagrange function

( ) ( )

m
First of conditions:
* ( )+

* ( )+

co
* ( )+

Rewriting:

.
ok
Solving first two equation for .
& equation we get:

Substituting in 3rd F.o.C.

bo ⇒

( )
⇒
es
⇒

Critical values: and

Substitute and in objective function:
lu

( )
( ) ( )( ) ( )
( )
.C

TOPIC 197: INTERPRETATION OF THE LAGRANGE MULTIPLIER

w
w

Introduced by Joseph-Louis Lagrange.

w

What if we want to predict the impact of per unit change in constraint on objective function.
Answer: Value of Lagrange multiplier.
a.k.a Shadow prices.
Considering example:
4 3x Subject to:

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1-unit increase (decrease) in the constant of the constraint (56) would cause z to increase
(decrease) by approximately 348 units.
- 4x 3x
- 4x 3x
4( ) 3( )( ) ( )
-
Increasing the constant of constraint by 1 unit.
4 3x Subject to:

m
- 4x 3x

co
4( ) 3( )( ) ( )
-
( - - ) close to as predicted by - .

.
Economics Instances:

ok
In utility maximization subject to a budget constraint: ( ) sb. to , will estimate
the marginal utility of an extra PKR of income.
In output maximization subject to a cost constraint: ( ) sb. to , will estimate
the marginal product of an extra PKR of cost.
bo
TOPIC 198: SECOND ORDER CONDITION: THE BORDERED HESSIAN
es
lu
.C

Attributed to German mathematician, Ludwig Otto Hesse.

In addition to algebra, determinant of matrices can also be used for 2nd order condition in
constrained optimization.
), is tested with 2nd order condition:
w

( ) sb. to (

̅ | |
w

The standard form.

Order of a bordered principal minor equals the order of the principal minor being bordered (here,
w

).
̅ represents a second bordered principal minor ̅ | |
In algebraic form:

( ) | | ( ) | | ( ) | |

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( )( ) ( ) ( )
( ) ( )
( ) ( )
( ) ( )
For a function with variables ( ), subject to ( ):

m
. co
Where ̅ ̅ , because of the principal minor being bordered.

ok
For maximum: ̅ ̅ ̅ ( ) ̅
For maximum: ̅ ̅ ̅ ( ) ̅
( ) : Explained.
For even value of ( ), final bordered principal minor:
bo
( ) ̅ ̅
For odd value of ( ), final bordered principal minor:
( ) ̅ ̅
( ) helps to retain alternative signs.
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| |

̅ | | | |

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̅ | | ̅ ̅ | |

̅ ̅ ̅

Since, same signs of bordered principal minors occur, a minimum is evident.

Economic Instance: Two period model of utility.

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Mathematical Economics I (ECO606) VU

Lesson 41
UTILITY MAXIMIZATION ANALYSIS

TOPIC 199: TWO PERIOD MODEL OF UTILITY

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m
co
TOPIC 200: CONVEXITY AND CONCAVITY USING SECOND ORDER DERIVATIVE

.
Convexity/concavity are closely related to minimum/maximum.

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m
is continuous in the interval and twice differentiable:

co
is convex on ( ) for all in
is concave on ( ) for all in

Numerical: ( )

.
( ) ;
( )

ok
⇒

bo
es
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w

Single input production function:

( )
w

( )
8
( )

Case – I: ( )
( ) ( ) ⇒ ( )
(Concave production function)

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Case – II:
( ) ( ) ⇒ ( )
(Convex production function)

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es
TOPIC 201: UTILITY MAXIMIZATION AND CONSUMER DEMAND: FIRST ORDER
CONDITION
Hypothetical consumer with 2 goods ( ), with continuous, +ve marginal utility ( ).
Market-determined prices ( ) - exogenous
lu

Budget constraint:

Utility (objective) function:

.C

( )
Lagrangian function:
( ) ( )
w

First order conditions:

⇒
w

⇒
w

Extracting value of from 1st & 2nd F.o.C and equating:

Interpretation:
is actually law of equi-marginal utility.

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Marginal utility of money spend on each goods is equal.

can be termed as the marginal utility of (budget) money when utility is maximized.

Alternatively, ( ) & ( ):

4 5 ( )

m
* ( )+
⇒ (IC has –ve slope)

co
( )

.
⇒ ( )

ok
( ) ( )

bo
es
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TOPIC 202: UTILITY MAXIMIZATION AND CONSUMER DEMAND: SECOND ORDER

CONDITION
.C

After developing and analyzing the 1st order condition, we develop 2nd order condition.
( ) ( )
;
w

̅ | |
w
w

Diagrammatically the shape of IC should be convex to origin.

Algebraically:

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( ) . /
⏟

( ) ( ( ))
⇒

m
Similarly,

co
( ) ( ( ))

.
ok
⏟

[F.o.C.]

;
bo
es
4 ( ) ( )5

( )
lu

⇒
.C

( )

( )
w

( )
w

( )

( )
w

Interpretation: Since, both, ̅ and are positive , fulfilling the condition for
convexity (to origin).
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Both S.o.C (Bordered Hessian ̅ ) & convexity condition . / are verified and inter-
related.

TOPIC 203: NUMERICAL EXAMPLE OF UTILITY MAXIMIZATION

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TOPIC 204: LAW OF EQUI-MARGINAL UTILITY USING LAGRANGIAN MULTIPLIER

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Mathematical Economics I (ECO606) VU

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Mathematical Economics I (ECO606) VU

Lesson 42
HOMOGENOUS PRODUCTION FUNCTION

TOPIC 205: ECONOMIC APPLICATION OF PRODUCTION FUNCTION MAXIMIZATION

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TOPIC 206: ECONOMIC APPLICATION ON LOGARITHMICALLY TRANSFORMED

PRODUCTION FUNCTION

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TOPIC 207: HOMOGENEOUS FUNCTIONS

Etymology: Greek homogenēs: homos „same‟ + genos „race, kind‟.
Here, genos refers to degree of term.
A function ( ) is considered homogenous if each term involved has same degree.

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Polynomial of degree :
( )
Each term has degree .

Example: ( )
To check, introduce scalar (say ) on both side.
( ) ( ) ( ) ( )
( )( ) ( )

m
( )( ) ( )
( )( ) ( )( )
( ){ ( ) ( )}

co
( ){ }
( )* +

Homogenous of degree 3 in variables and

.
D.I.Y.: Check, if functions are homogenous or not.

ok
If yes, then of what degree.

bo
TOPIC 208: HOMOGENEOUS PRODUCTION FUNCTION, AVERAGE PRODUCTS AND
CAPITAL-LABOR RATIO
𝜶 𝜷
Consider Cobb-Douglas production function: ( )
es
Testing homogeneity:
( ) ( )𝜶 ( )𝜷
𝜶 𝜶 𝜷 𝜷 𝜶 𝜷 𝜶 𝜷
⇒
𝜶 𝜷 𝜶 𝜷
⇒ 𝜶 𝜷( 𝜶 𝜷
)
lu

( ) 𝜶 𝜷* ( )+
Degree of homogeneity is 𝜶 𝜷.
.C

For a Cobb-Douglas production function 𝜶 𝜷 : Linearly homogeneous or shows linear

homogeneity.
Caveat: Misleading terms (linear homogeneous, linear and homogeneous)
Economic implication: Linear homogeneity implies that if all independent variables (inputs) are
w

increased by same proportion( ), the dependent variable (output) shall increase by same
proportion⇒ Constant returns to scale.
( ⇒ ⇒ )⇒ ⇒
w

Average product of labor ( ):

( ) 𝜶 𝜷
w

Since, 𝜶 𝜷 ⇒𝜷 𝜶
𝜶 𝜶 𝜶 𝜶
𝜶 𝜶 𝜶
⇒ ⇒ 𝜶
⇒ ( ) ⇒
Relationship between average product of labor and capital-labor ratio.
Degree of homogeneity of average product of labor ( ):

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𝜶
𝜶
. /
𝜶
( ) . /
𝜶
( ) . /
𝜶 𝜶 𝜶
. / . / ⇒ ( )𝜶 . /
𝜶
* 𝜶+
2 . / 3

m
( ) ( )

co
Average Product of Labor ( ):
( ) 𝜶 𝜶

𝜶 𝜶
𝜶 ⇒ . 𝜶 /

.
𝜶 𝜶

ok
. / ⇒ . /
𝜶
⇒ ( )

Relationship between average product of capital and capital-labor ratio.

Degree of homogeneity of
𝜶
𝜶
bo:
. /
𝜶
( ) . /
es
𝜶
( ) . /
𝜶 𝜶 𝜶
. / . / ⇒ ( )𝜶 . /
lu

𝜶
𝜶
{ . / } { }
( ) ( )
.C

Interpretation of degree of homogeneity & : both are homogeneous of degree zero in

w

the variables and ,

Since equal proportionate changes in and (maintaining a constant will not change the
magnitudes of the average products.
w

TOPIC 209: HOMOGENEOUS PRODUCTION FUNCTION, MARGINAL PRODUCTS AND

CAPITAL-LABOR RATIO
w

Marginal product of capital ( ):

* ( )+ ( 𝜶 𝜶)
𝜶 𝜶
⇒ ( 𝜶)
𝜶 𝜶
( 𝜶) 𝜶 ⇒ ( 𝜶) . /
( ) ( 𝜶) 𝜶
Relationship between marginal product of labor and capital-labor ratio.

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Degree of homogeneity of :
𝜶
𝜶
𝜶 𝜶. /
𝜶
( ) 𝜶. /
𝜶
( ) 𝜶. /
𝜶 𝜶
𝜶. / . /

m
𝜶
𝜶( )𝜶 . /
𝜶
𝜶
{ 𝜶. / } { 𝜶 }

co
( ) ( )

Marginal product of labor ( ):

.
𝜶 𝜷)
* ( )+ (

ok
Since 𝜶 𝜷 ⇒𝜷 𝜶
( 𝜶 𝜶) 𝜶 𝜶
𝜶 𝜶
⇒ 𝜶 ⇒ 𝜶 𝜶 ⇒ 𝜶. /
( ) 𝜶 bo
𝜶

Marginal product of capital and capital-labor ratio are related

Degree of homogeneity of :
es
𝜶
𝜶
𝜶 𝜶. /
𝜶
( ) 𝜶. /
𝜶
lu

( ) 𝜶. /
𝜶 𝜶
𝜶. / . /
.C

𝜶
𝜶( )𝜶 . /
𝜶
𝜶
{ 𝜶. / } { 𝜶 }
w

( ) ( )
w

Interpretation of degree of homogeneity & : both are homogeneous of degree zero in

the variables and ,
w

Since equal proportionate changes in and (maintaining a constant will not change the
magnitudes of the marginal products.

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TOPIC 210: HOMOGENEOUS PRODUCTION FUNCTION AND EULER'S THEOREM

Euler‟s theorem: Leonhard Euler, a Swiss mathematician

m
. co
A property of ( ) with degree of homogeneous:

ok
( ) ( ) ( )
In production context:
( ) ( ) ( )
In another notation:
( ) ( ) bo
2 3 2 3 ( )
. / . /
For linearly homogeneous production function ( ):
es
( ) ( )
. / . /
lu

𝜶 * ( 𝜶+ 𝜶 𝜶
{ 𝜶 } 𝜶) 𝜶 ( 𝜶)
𝜶 𝜶 𝜶
𝜶 𝜶
Restoring
.C

𝜶 𝜶 𝜶
𝜶 . / . / 𝜶 . /
𝜶 𝜶 𝜶
𝜶 𝜶 𝜶 𝜶 𝜶
𝜶
w

𝜶 𝜶
𝜶
⇒
w

Interpretation: Under CRS, if input factor is paid the amount of its MP, the TP will be exhausted
by the distributive shares for all the input factors.
Or, pure economic profit will be zero.
w

Caveat: Euler‟s theorem holds if perfect competition holds in factors market.

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Lesson 43
COBB DOUGLAS PRODUCTION FUNCTION

TOPIC 211: COBB-DOUGLAS PRODUCTION FUNCTION AND RETURNS TO SCALE

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Mathematical Economics I (ECO606) VU

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ok
bo
TOPIC 212: HOMOGENEITY AND RETURNS TO SCALE OF THREE INPUT PRODUCTION
FUNCTION
3 input production function.
( )
es
Where,
= Capital, = Labor, = Material

a+b+c is the degree of homogeneity.

lu

Introducing on both sides.

And Euler Theorem requires:
( ) ( ) ( ) ( )
.C

( ) ( ) ( ) ( ) ( ) ( )
( ) ( ) ( ) ( ) ( ) ( )
( ) ( ) ( ) ( )
* +
w

* ( )+

is completely factored out – Homogenous production function

w

( ) is the exponent showing degree of homogeneity.

If ( ) , then CRS prevails.
w

If ( ) , then IRS and if ( ) , then DRS, respectively.

TOPIC 213: LEAST-COST COMBINATION IN COBB-DOUGLAS PRODUCTION FUNCTION

CES production function.
( ) 𝜶 𝜷

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Forming Lagrangian function:

( ) 𝜶 𝜷
( )
* ( )+ 𝜶 𝜷
𝜶
* ( )+ 𝜶 𝜷
𝜶
* ( )+

m
Solving for in 1st and 2nd F.O.C‟s and equating.
𝜶 𝜶 𝜷

co
𝜶 𝜷
𝜶

𝜶 𝜷 𝜶 𝜷
𝜶 𝜷

.
Digressing to marginal products.

ok
* ( )+ 𝜶 𝜷
𝜶
* ( )+ 𝜶 𝜷
𝜷
Reverting to previous equation.
OR
bo
(Least cost input ratio).

𝜶 𝜶 𝜷 𝜶 𝜶
=
es
𝜷 𝜶 𝜷 𝜷 𝜷

TOPIC 214: EXPANSION PATH USING FIRST ORDER CONDITION

lu
.C
w
w
w

Comparative-static aspect of producer equilibrium.

̅̅̅̅̅̅
With fixed ratio of and i.e. . /, postulate successive increases of (ascent to higher
and higher isoquants.
Trace the effect on the least-cost combination .
Each shift of the isoquant, gives new point of tangency, with a higher Iso-cost.

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Locus of such points of tangency is expansion path of the firm, serves to describe the least-cost
combinations required to produce varying levels of

1st order Condition

𝜶 𝜷
As

m
𝜶 𝜷 𝜶 𝜷
( ) 𝜶
( 𝜶 𝜷) 𝜷 𝜶 𝜷

Substituting in condition.

co
𝜶 𝜶 𝜷 𝜶 𝜶
𝜷 𝜶 𝜷 𝜷 𝜷
𝜶 𝜶
𝜷
⇒ 𝜷

.
𝜶
At equilibrium: 𝜷

ok
Answer will be numerical as 𝜶 𝜷 are all constants.
Therefore, all points on expansion path shall show a fixed input ratio.
Or, expansion path shall be a straight line starting from origin.
bo
A homogeneous production function gives rise to a straight line of expansion path.

TOPIC 215: HOMOTHETIC FUNCTIONS

Etymology: Ancient Greek (homo-, “same”) + (thésis, “setting, placement, arrangement”).
es
Attributed Shepard (1953).
Diagrammatically speaking, homothetic functions generate radial expansions, preserving both
angles and ratios of distances.
lu
.C
w
w
w

Consider a production function :

( )
Its monotonic transformation generates a new production (composite) function :
* ( )+
Homogeneity may disappear:
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( )
* ( )+ .
( ) has a homogeneous of degree , however, * ( )+ is not homogeneous.
Dependence of monotone function on original function:
( )
Expansion path of ( ) is linear like that ( ).
As observed in diagram slope of Isoquants ( ) will remain the same, at given ( ):
( ) ( )

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* ( )+ [ { ( ̅)}]
( )
* ( )+ , * (̅ )+-

co
TOPIC 216: HOMOTHETICITY OF COBB-DOUGLAS PRODUCTION FUNCTION
Consider Cobb-Douglas production function :

.
𝜶 𝜷
( )

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Its homogeneous.
Monotonic transformation (squaring) generates a new production (composite) function :
( )

Slope of Isoquant =
bo ( 𝜶 𝜷
) 𝜶 𝜷

{ 𝜶 𝜷} 𝜷( 𝜶 𝜷( 𝜶 𝜷( 𝜷
𝜶 ) 𝜶 ) 𝜶 ) 𝜶
𝜶( 𝜷 𝜷 𝜶( 𝜷 𝜶( 𝜶
es
{ 𝜶 𝜷} ) 𝜷 ) 𝜷 ) 𝜷

With given ( ), slope of * ( )+ will be constant.

( ) is homogeneous of degree (𝜶 𝜷).
* ( )+ is also homogeneous, but of degree (𝜶 𝜷)
lu

However, a homothetic function is not necessarily homogeneous.

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Mathematical Economics I (ECO606) VU

Lesson 44
CES PRODUCTION FUNCTION

TOPIC 217: INTRODUCING CES PRODUCTION FUNCTION

Relatively new.
Attributed to Solow, Minhas, Arrow and Chenery.
a.k.a SMAC production function
A more general form of production functions, while Cobb-Douglas can be a specific case of it.

m
Standard form.
,𝜹 ( 𝜹) - ⁄
Where,
𝜹

co
𝜹 Distribution parameter
Efficiency parameter
Substitution parameter
Degree of homogeneity

.
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Generates a constant (not variable) value of elasticity of substitution ( ) between capital and
labor.
Hence called constant elasticity of substitution (CES) production function.
Elasticity of substitution. bo
⁄
[ ( ) ]
es
𝜹 .
1-𝜹 .
.
.
lu

⇒ CRS.
As
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= 0.71 1 ⇒ less elastic – lower substitution between capital and labor.

TOPIC 218: HOMOGENEITY OF CES PRODUCTION FUNCTION

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CES production function.

,𝜹 ( 𝜹) - ⁄
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For simplicity, let

,𝜹 ( 𝜹) - ⁄
( ) ,𝜹 ( 𝜹) - ⁄
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Introducing on both sides.

( ) ,𝜹( ) ( 𝜹)( ) - ⁄
,𝜹( ) ( ) ( 𝜹)( ) ( ) - ⁄
,( ) ,𝜹( ) ( 𝜹) ( ) -- ⁄
,( ) - ⁄ ,𝜹( ) ( 𝜹) ( ) - ⁄
( ) ,𝜹( ) ( 𝜹) ( ) - ⁄
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As is degree of homogeneity. CES production function is homogenous of degree .

However, the value of can be any positive number. i.e.

If , it implies decreasing returns to scale.

⁄
[ ( ) ]
If , it implies constant returns to scale.
⁄
[ ( ) ]

m
If , it implies increasing returns to scale.
⁄
[ ( ) ]

co
TOPIC 219: MARGINAL PRODUCTS OF CES PRODUCTION FUNCTION
CES production function.
⁄
[ ( ) ]

.
Where,

ok
𝜹
Marginal product of capital . /.
Marginal product of labor. /.
bo
es
lu
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. co
ok
bo
es
lu
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Mathematical Economics I (ECO606) VU

Lesson 45
CES PRODUCTION FUNCTION (CONTINUED)

TOPIC 220: SHARE OF LABOR AND CAPITAL IN CES PRODUCTION FUNCTION

CES production function.
,𝜹 ( 𝜹) - ⁄
Where,
𝜹

m
Let
,𝜹 ( 𝜹) - ⁄
( ) . /
Capital share of output 4 5.

co
( ) . /
Labor share of output 4 5

.
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bo
es
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Mathematical Economics I (ECO606) VU

m
. co
ok
TOPIC 221: CES PRODUCTION FUNCTION AND EULER'S THEOREM
CES production function. bo
, - ⁄
Where,
is the degree of homogeneity.
And Euler theorem requires:
es
+
Where:
lu
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. co
ok
bo
es
lu
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Mathematical Economics I (ECO606) VU

TOPIC 222: NUMERICAL CES PRODUCTION FUNCTION CALCULATION

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bo
es
lu
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