UGC SWAYAM MOOCS - Mathematical Economics Content Writer: Sikha Ahmad

Matrix and Market Model

Introduction:
The market in any economy is a complex entity with a large number of forces that determine
the demand, supply and price of goods. Single equations that were discussed in the earlier
modules of this course have certain limitations and fail to show the real scenario.
So, can mathematics help to understand a complex market situation? How to solve problem
where a large number of variables interact and influence each other?
This module will try to explore the method of solving complex market models.

Objectives
The objectives of this module are:
1. Distinguish between single equation and simultaneous equations
2. Interpret the structure of simultaneous equations
3. Transform a system of simultaneous equations into a single equation in matrix form
4. Solve the market model using matrix algebra

Terminology
1. Identity: an equality equation where function on the LHS is the same as that on the RHS
and the equation is true for all values of the variables.
2. Conditional equation: an equation that is true only for particular values of the variables.
3. Simultaneous equation: a system of equations that describe joint dependence of
variables
4. Endogenous variable: a variable that may be behave as dependent and independent and
whose value is determined from the model
5. Exogenous variable: a variable that is purely an independent variable and whose value is
given from outside the model

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14.1 Equations, Single equation and Simultaneous Equations:

The term ‘equation’ is a mathematical expression of equality. It contains two or more variables.
An equation has two expressions connected by an “=” sign. The expression to the left of “=”
sign is called Left Hand Side (in short, LHS) and the expression to the right of “=” sign is called
Right Hand Side (in short, RHS). The “=” sign was invented by Robert Recorde, a physician and
mathematician.

Robert Recorde

[Source: https://en.wikipedia.org/wiki/Robert_Recorde#/media/File:Robert_recorde.jpg ]

Solving an equation means to find the values of the variables that makes the equation true. An
equation may be an identity or it may be conditional. An identity is true for all the values of the
variables, while a conditional equation is true for only particular values of the variables.

Example:

The equation is a conditional equation because this equation is true only for .
On the other hand, an equation ( ) is an identity because it is true for all
values of .

14.2. Equations and Models used in Economics:

The use of mathematics in solving economic problems dates back to the 17 th century. However
the importance of mathematics in economic analysis has gained ground since the 20 th century.
Also, in recent years, researchers have started using theories and methods originally developed
by physicists to solve economic problems.

Below is a list of few of the equations and models that are used in economics:

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Table 5.1: List of few equations and models used in Economics

S. No. Name of the equation Name of the scientist Application

1 Bernoulli equation/ Daniel Bernoulli/ Change of Gross Domestic

Differential equation Jacob Bernoulli Product (GDP) over time
2. Black-Scholes Equation Fisher Black and Mathematical Finance
Myron Scholes
3. Euler-Lagrange Leonhard Euler and Optimization problems
Equation Joseph Louis Lagrange
4. Fisher Equation Irving Fisher Financial mathematics
5. Kolmogorov Equations Andrey Kolmogorov Markov stochastic processes
6. Slutsky Equation Eugen Slutsky Consumer Theory
7. Gravity Model of Walter Isard Predicts bilateral trade flows
International Trade
8. Kinetic Exchange Model Meghnad Saha, B.N. Distribution of income and
Shrivastava and wealth in an economy
Bernoit Mandelbrot
9. Chaos Theory Edward Lorenz Inequality and chaotic behaviour
10. Game Theory Dov Monderer and Potential game
Lloyd Shapley

There are a large number of other equations and models that are used in Economics. The above
list was prepared to give the reader an idea of the use of mathematics and physics in solving
economic problems.

14.3. Simultaneous equations in Economics:

Two or more equations form a system of simultaneous equations. It is a system that describes
the joint dependence of variables. In single equations, there is a one-way cause and effect
relationship. The independent variables are the cause and dependent variable is the effect. In a
simultaneous equation system, there is a two-way cause and effect relationship. The
independent variable may act as a cause in one equation and may act as an effect in another.
Similarly, the dependent variable may act as the effect in one equation and may act as the
cause in another.

Example:

In the simple economic model for a consumer, the demand equation is expressed as function of
price. Mathematically, ( ), where D is quantity demanded (effect) of a good and P is the
price (cause) of the good. This mathematical expression tells that Quantity Demanded depends
on the Price, all other determinants remaining constant. However, there may be instances,

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where the price of the good is determined by the quantity demanded. In such a case, price
behaves as the dependent variable (effect) and quantity demanded (cause) behaves as the
independent variable. The mathematical expression may then be written as ( ).

Therefore, we have two equations in the above situation, or a simultaneous system where one
equation shows that quantity demanded is dependent and another shows that quantity
demanded is independent.

A. Basic terms in simultaneous equations:

i) Endogenous variable: an endogenous variable is a variable whose value is
determined from the model. In a simultaneous equation system, an endogenous
variable may be dependent or independent.
ii) Exogenous variable: an exogenous variable is a variable whose value is given. It is
determined from external sources. It behaves as a purely independent variable in
the equations of the system of simultaneous equations.

Example:

( )

( ) (A)

( )

(A) is a system of simultaneous equation with 3 equations and 6 variables. Out of the
variables, are endogenous variables, since they behave as both dependent
and independent variables and are exogenous variables, since they are
purely independent.

B. General Structure

The general structure of a simultaneous equation with equations and endogenous

variables may be written as follows:

……….. ………..

………… ………..

……………………………………………………………………………………………………………………………….. (B)

………………………………………………………………………………………………………………………………..

……….. ………..

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(B) is the general structure of a system of simultaneous equations with equations and
endogenous variables.

are the endogenous variables whose values are to be determined from the
model.

are the exogenous variables that is given from external sources.

C. Condition for solving a system of simultaneous equations:

Number of Equations = Number of Endogenous Variables

D. Application of simultaneous equations:

The real world is complex. Therefore, a single equation model is generally considered to be
unrealistic. Simultaneous equations help to understand the complex economy in a much better
way. Below are few examples where simultaneous equations may be used:

a) Market Model
b) National Income Model
c) Input-Output Analysis
d) Optimization problems (with equality constraint and inequality constraint)

14.4. Transforming a system of simultaneous equation to matrix form

A simultaneous equation is a system of two or more equations. Solving a system of

simultaneous equations by the elimination and substitution method becomes a tedious job. In
such cases, matrix algebra may be used to transform a system of simultaneous equations into a
single equation to obtain unique solutions.

Example:

Given a system of simultaneous equations

-------------------- (1)

-------------------- (2)

-------------------- (3)

Here, , and are variables

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are parameters

, and are constants

The system of three equations may be transformed into the matrix form as follows:

Step 1: Construct a matrix of all the co-efficient in the system

Arrange all the co-efficient in the system of equations in a particular order, Name the matrix as
A.

Thus,

[ ]

A is a matrix of order 3 x 3

Step 2: Construct a column vector of the variables.

Name the column vector of variables as X. Thus,

X = [ ], X is a column vector of order 3 x 1

Note: A column vector is constructed so that it can fulfill the condition required for matrix
multiplication. The condition says that the number of columns in the first matrix must be equal
to the number of rows in the second matrix.

Step 3: Multiply the co-efficient matrix and the column vector of variables.

Thus,

AX = [ ][ ]

Step 4: Construct a column vector of constants

Name the constant vector as Z. Thus

Z = [ ], Z is a column vector of order 3 x 1

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Step 5: Equate the product to the constant vector

Thus AX =Z ----------(4)

[ ][ ] [ ]

Step 6: Multiply both sides of equation (4) by A-1 (Inverse of A)

Therefore,

We know by property of inverse f a matrix, where is an Identity matrix

Therefore, ------------(5)

Thus it is seen that the system of three equations has been transformed into a single equation.

14.4. Solving the Market Model using matrix algebra

Solving a system of simultaneous equations means finding the value of the variables
(unknowns) that will satisfy all the equations simultaneously (at the same time).

Sometimes, when there are a large number of equations, solving the system of equations by
using the most common substitution and elimination method may become very difficult. In
such cases, matrix algebra can be used to solve a system of simultaneous equations.

The procedure for solving a simultaneous equation system is explained for the market model.

The market model comprises of three equations

Where D is the quantity demanded,

S is the quantity supplied

P is the price

a,b,c and d are the parameters

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The main task of solving the model is to find the values of the equilibrium price and quantity, i.e
the values of D, S and P.

In order to solve this model by using the matrix method, it has to be first transformed into the
matrix form.

Thus, re-arranging the model by putting the variables on the left hand side and the constants
on the right hand side, we get,

Further, to construct the matrix of co-efficients, we write,

Now, transforming the equations into matrix form we get,

[ ][ ] =[ ]

Naming the co-efficient matrix as A, variable matrix as X and constant matrix as Z, we get

Finding the Inverse of matrix A

The inverse of matrix A is given by

𝑨𝒅𝒋 𝑨
A-1 =
|𝑨|
Adj A is the Adjoint of A and |A| is the determinant of A

For a solution to exist, |A| ≠ 0

In the example of the market model,

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|A| = | | = 1 (-d) -0 +b(-1) = -d-b = -(b+d)

Adj A is calculated by finding out the transpose of the co-factor matrix.

Co-factor of an element is obtained by the following formula,

Cij = (-1)i+j Mij

Cij is the co-factor of the element in the i-th row and j-th column
Mij is the minor of the element in the i-th row and j-th column

Minor of an element is found out by striking of the row and column in which the element is
placed and taking the determinant of the remaining elements.

Thus, in the above example of the market model,

Minor of element 1 in the first row and first column is given by,

M11 = | | after striking out the first row and first column.

Thus M11 = - d

Now, co-factor of the element 1, C11 = (-1) 1+1 M11 , or C11 = - d

Similarly, co-factors of the remaining elements of matrix A is obtained by using the same
formula.

Thus Co-factor of element 0 in first row and second column is given by

C12 = (-1)1+2 M12 = (-1)3 | | or C12 = - d

C13 = (-1)1+3M13 = (-1) 4 | | or C13 = -1

C21 = (-1)2+1M21 = (-1)3 | | or C21 = -b

C22 = (-1)2+2M22 = (-1)4 | | or C22 = -b

C23 = (-1)2+3M23 = (-1)5 | | or C23 = 1

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C31 = (-1)3+1M31 = (-1)4 | | or C31 = b

C32 = (-1)3+2M32 = (-1)5 | | or C32 = d

C33 = (-1)3+3M33 = (-1)4 | | or C33 = 1

The co-factor matrix is given by

[ ]

And Adj A = [ ]

Therefore,

A-1 = [ ]
( )

Further,

X = A-1Z = [ ] [ ]= [ ]
( ) ( )

Or [ ]= [ ]
( )

Thus,

Equilibrium quantity

Equilibrium supplied and

Equilibrium Price

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