EPMP673

Mathematics & Statistics for

Policy

Lecture 1-2: FUNCTIONS AND APPLICATIONS TO

ECONOMIC PROBLEMS

Prof. Bernardin Senadza

Department of Economics
[email protected]

College of Education
School of Continuing and Distance Education
2014/2015 – 2016/2017
 Nature of Mathematical Economics
• Mathematical economics is not a distinct
branch of economics
• It is an approach to economic analysis
– It allows economists to use mathematical language to
analyze economic relationships
– It also draws on mathematical theorems to aid
reasoning
– It employs mathematical techniques such as matrix
algebra, differential and integral calculus, etc.

Prof. Senadza 2
 Mathematical vs. Nonmathematical
Economics
• There is no fundamental difference between
mathematical and non-mathematical economics
– mathematical economics uses symbols and equations
– but non-mathematical (literary) economics uses words
and sentences in the statement of economic
assumptions, relationships and conclusions
• Symbols are defined in words but they are more
convenient to use in deductive reasoning
• Equations are also more powerful for analyzing
situations involving three or more variables than
geometrical methods
Prof. Senadza 3
 Mathematical vs. Nonmathematical
Economics
• The mathematical approach has the following
strengths
– The language is more concise and precise
– Draws on a wealth of mathematical theorems
– Allows us to explicitly state all assumptions
– Allows generalization of analysis to the n -variable
case

Prof. Senadza 4
 Mathematical Economics vs. Econometrics
• The term “mathematical economics” is sometimes
confused with a related term called “econometrics”
– Econometrics deals mainly with the measurement of economic
relationships
– It uses empirical data and employs statistical methods of
estimation and hypothesis testing
• Mathematical economics on the other hand concerns itself
with the application of mathematics to theoretical aspects
of economic analysis
• The two are however complementary
– Econometrics depends on the mathematical formulation of
the economic relationship of concern
– Mathematical economics relies on econometrics for the
validation of the theoretical formulation
Prof. Senadza 5
 Economic Models
• An economic model is a simplified theoretical
framework of how the economy behaves
• If the model is mathematical it will consist of a set of
equations relating a number of variables
• A variable is something whose magnitude can change,
i.e., it can take on different values
– Economic examples of variables: price, profit, revenue, cost,
national income, etc.

Prof. Senadza 6
 Economic Models
• Endogenous Variables:
– those whose values are determined within the model
• Exogenous Variables
– those whose values are determined outside the model
• A variable that is endogenous to one model may be
exogenous in another model
• Example of economic model:
– Consumption function: C = a + bY
• C: endogenous
• Y: exogenous
Prof. Senadza 7
 Economic Models
• Because their magnitudes can change, variables are
often represented by symbols
– Example: P,  , R, C, Y, etc.
• But if we know the specific value then we freeze the
variable at that value
– Example: Y = 100 or P = 12
• An economic model can be solved to give the solution
values to a set of variables
– Example: equilibrium price or profit-maximizing level of output

Prof. Senadza 9
 Economic Models
• Variables often have some fixed numbers or constants written in
front of them;
– for example: 2P
• A constant is a magnitude that does not change
• When the constant is joined to a variable it is called the
coefficient of the variable
• Coefficients are sometimes represented by symbols rather than
numbers for generality;
– for example: αP
• The symbol represents a given constant but since it has not been
assigned to any specific number it can take virtually any number
• So it is a constant that is variable and we refer to it as parametric
constant or simply parameter
Prof. Senadza 10
 Economic Models
• We distinguish between 3 types of equations
– Definitional (identity) equations
– Behavioural equations
– Equilibrium conditions
• A definitional equation sets up an identity between 2
alternative expressions that have exactly the same
meaning
–  ≡ TR – TC

Prof. Senadza 12
 Economic Models
• A behavioural equation specifies the manner in
which a variable behaves in response to changes in
other variables
– Y = a + bX
• Y: endogenuos variable
• X: exogenous variable
• a: constant
• b: parameter & coefficient of exogenous variable X
• Equilibrium conditions are for cases where the model
involves the notion of equilibrium
– Qd = Q s
– S=I
Prof. Senadza 13
 Functions
• Functions are very important in economics because of the
functional relationships that exist between and among many
(economic) variables.
• For example, in simple demand and supply functions, quantity
demanded/supplied depends on price; in a production
function output depends on the quantity of labour and capital
inputs used; cost and revenue functions depend on quantity
produced/ sold; consumption depend on disposable income;
etc.
• These are referred to as economic functions.
• One variable is a function of another if the first variable
depends upon the second.
Prof. Senadza Slide 12
 Functions
• Suppose that the average weekly household expenditure on food
(C) depends on the average net household weekly income (Y).
• This functional relationship symbolically may be written as:
C = f(Y)
• Or more explicitly (assuming a linear relationship) as:
C = a + bY
– Where a and b are parameters
– If the values of the parameters a and b are known, then for any given value
of Y, we can find the value of C.
– Any value of Y chosen will produce one unique corresponding value C.
– In the above function, Y is called the independent (exogenous) variable and C
is called the dependent (endogenous) variable.
– There are several other examples of the functional dependence of variables
that we shall examine.
Prof. Senadza Slide 13
 Figure 1. A Coordinate System
• Recall that a rectangular (or a
Cartesian) coordinate system is
obtained by first drawing two
perpendicular lines, called
coordinate axes.
• The two axes are respectively
the x-axis (or the horizontal axis)
and the y-axis (or the vertical
axis).
• The intersection point O is called
the origin.
• The coordinate system in Figure
1 is also called xy-plane.
• The coordinate axes separate
the plane into four quadrants,
which are numbered in Figure 1.
Prof. Senadza Slide 14
 Figure 2. A Coordinate System
• Any point in the
coordinate plane
constitute an ordered
pair, written as (x, y); i.e.
x comes first and y comes
second.
• This implies that a y value
is associated with an x
value as shown in Figure
2.
• In Figure 2, we illustrate
two ordered pairs; P(3,4)
and Q(-5,-2).

Prof. Senadza Slide 15

 Relations and Functions
• Any collection of ordered pairs constitutes a relation
between y and x.
• Consider 3 ordered pairs: (1, 2), (0, 0), (-1,-2).
• These pairs constitute a relation and its graphical
depiction will correspond to the set of points lying on the
straight line y = 2x. [We will shortly demonstrate how to
determine the equation of a straight line from given
ordered pairs]

Prof. Senadza Slide 16

 Relations and Functions
• It is possible that in a relation, a given x value will be
associated with several values of y.
• This happens with inequalities: for example, y ≤ x
• Which is satisfied by the following ordered pairs: (1, 0),
(1, 1), (1,-4)
• However in a relation where for each x value there exists
only one corresponding y value, we say y is a function of
x, an is written: y = f(x)
• Note then that function implies a relation but relation
does not imply a function.
Prof. Senadza Slide 17
 Some Basic Definitions
• Relation: a relation is a set (or collection) of ordered
pairs (or a subset of the Cartesian product).
Given x={1, 2} and y={3, 4} => four ordered pairs (1, 3), (1, 4), (2, 3)
and (2, 4).
• Function: a function is a set of ordered pairs with the
property that any x value uniquely maps unto a y value.
• If f is a function, we sometimes let y denote the value of f
at x, so that y =f(x)
– In the above function, x is the independent variable (or the
argument) while the y value is the dependent variable.
– In economics x is often called the exogenous variable while y is
referred to as the endogenous variable.
Prof. Senadza Slide 18
 Basic Definitions
• Functions can be represented by several letters or symbols so we
don’t necessarily have to write the function in the form: y =f(x)
– Other possible forms are: y=g(x); y=h(x); y=y(x); z=g(x); etc.
• Domain: refers to the set of all permissible values that x can take in
a given context.
– Example: define x as a positive integer => x = 1, 2, 3, …
• The y value into which an x value is mapped is called the image of
that x value.
– Example: y=2x. If x=1, its image is y=2.
• Range: refers to the set of all values that the y variable will take as
x varies.
• In economic models, behavioural equations (which describe how
an economic variable behaves in response to another or others),
usually enter as functions.

Prof. Senadza Slide 19

 Types of Functions
• The expression y = f(x) is a general statement about the
relation between x and y but this relation is not explicit.
• Constant Functions
• A constant function is one whose range consists of only one
element.
• Example: y = f(x) = 7; This implies that y=7 irrespective of the
value x takes.
• In the coordinate plane, this function is a horizontal line (to
the x-axis).
• In national income models, for example, when I (investment)
is exogenously determined, we write it as I =100 or I = I0
• Another constant function in economics is TFC (total fixed
cost).
Prof. Senadza Slide 20
 Types of Functions
• Polynomial Functions (Multi-term functions)
• They take the following general form:
y  a0  a1 x  a2 x  ...  an x
2 n

• Each term (variable) has a coefficient: a0, a1, a2,…an and

also a non-negative integer power: 0, 1, 2……n.
• So the first term is actually: a0x0 but we know that any
number (except zero) raised to the power zero equals 1.
• Also for the second term, we usually don’t write the
value 1 in the power.
• The value of n specifies the highest power of x.
Prof. Senadza Slide 21
 Types of Functions
• Thus, depending on the value of n, we can have several sub-
classes of polynomial functions.
• When:
• n  0  y  a0 Constant function
• n  1  y  a0  a1 x Linear function

• n  2  y  a0  a1  a2 x 2 Quadratic function

• n  3  y  a0  a1 x  a2 x  a3 x
2 3
Cubic function

• The superscript indicators of the powers of x are called

exponents.
Prof. Senadza Slide 22
 Types of Functions
• Note that the order in which the exponents appear does not
change anything. So when n=3, the cubic function can be
written as:
y  a3 x3  a2 x 2  a1 x  a0
• The highest power (i.e. value of n) for a given polynomial is
called the degree of the polynomial function.
• So that a quadratic function is a second degree polynomial
function, while a cubic function is a third degree polynomial
function.

Prof. Senadza Slide 23

 Types of Functions
• Rational Functions
• A function expressed in the form
• f ( x) or x 1
y y 2
g ( x) x  2x  4
• That is, as a ratio of two polynomials in x, is called a rational
(ratio-nal) function.
• A special rational function that has relevance in economics is
the function
a
y or xy  a
x
• where a is constant, plots as a rectangular hyperbola.
Prof. Senadza Slide 24
 Figure 3. A Rectangular Hyperbola

• The rectangular hyperbola approaches both axes asymptotically,

i.e., as x and y become large, the curve gets closer and closer to
the axes without touching them.
Prof. Senadza Slide 25
 Two Economic Examples of Rational
Functions
1. The AFC Curve
TFC
AFC 
Q

2. Constant Elasticity Demand Curve

• Total expenditure is TR=PQ and is constant at all price levels (i.e.,
the elasticity of demand is 1 at each point of the demand curve)
TR=PQ
Let TR=a, where a is a constant
Then Q  a
P
Prof. Senadza Slide 26
 Linear Functions
• Linear functions occur very often in economics (or rather it is
convenient for economists to assume linear relationships
between variables).
• Generally, we define a linear function as:
y  ax  b
where a and b are constants; a = slope and b = y intercept.
– The slope measures the change in the value of the function when x
changes by 1 unit.
– The shape of the straight line defined by the function depends on the
value of a.
– A special case when a = 0, implies y = b, and we have a constant
function.
Prof. Senadza Slide 27
 Linear Functions

Prof. Senadza Slide 28

 Finding the Slope
• To calculate the slope of a line, pick two different points on
the line such as:
• P   x1 , y1  and Q   x2 , y2 
• Calculate the slope as: y2  y1
a
x2  x1
• where x1  x2
• Example: Determine the slope of the line passing through the
points: P(2, 2) and Q(4, 3).
y2  y1 3  2 1
• Solution: a   
x2  x1 4  2 2
Prof. Senadza Slide 29
 EXERCISE 1
• Find the slopes of the straight line passing through
the following pairs of points:
• a) (1,2); (3,4)
• b) (1,2); (4,1)
• c) (1,2); (5,2)

Prof. Senadza Slide 30

 Finding the Equation of a Straight Line
• The Point-Slope Formula
• To find the equation of the straight line passing through the
point P   x1 , y1  with slope a.
• Let Q   x, y  be any other point on the line.
• The slope of the line is given by the formula:
y  y1
a
x  x1
• Multiplying each side by x  x1, we get y  y1  a  x  x1 
• Hence the equation of the line passing through P   x1 , y1 
with slope a is: y  y1  a  x  x1 
Prof. Senadza Slide 31
 Finding the Equation of a Straight Line
• Example: Find the equation of the line passing through the
point (2, 2) and with slope a = ½.
• Solution: Let (x, y) be another point on the line. Then
y2 1 1 1 1
  y  2   x  2  y  2  x  1  y  x  1
x2 2 2 2 2

Prof. Senadza Slide 32

 Exercise 2
• For each of the following, find the equation of the
line with the given slope and passing through the
given point:
• a) Slope 3 and point (3, 1)
• b) slope -2 and point (-1, 4)
• c) slope 4 and point (4, 2)

Prof. Senadza Slide 33

 Finding the Equation of a Straight Line
• The Point-Point Formula
• To find the equation of the straight line passing through the
points P   x1 , y1  and Q   x2 , y2 
• First find the slope as
y2  y1
a
x2  x1
• Substitute for the slope in the point-slope formula as
y2  y1
y  y1  a  x  x1   y  y1   x  x1 
x2  x1
• and then solve for y in terms of x.
Prof. Senadza Slide 34
 Finding the Equation of a Straight Line
• Example: Find the equation of the line passing through the
points: P(2, 2) and Q(4, 3).
y2  y1 3  2 1
• Solution: Slope is a   
x2  x1 4  2 2
• Substitute value of slope into point-slope formula
y  y1  a  x  x1   y  y1  1
2
x  x1 
• Using the x and y coordinates of any of the 2 points to
represent x1 and y1 gives
y  y1  1
2  x  x1   y  3  1 ( x  4)  y  1 x  1
2 2
Prof. Senadza Slide 35
 Exercise 3
• For each of the following, find the equation of the
line through the given points:
• a) (1, 3) and (2, 5)
• b)(-1, 3) and (2, 5)
• c) (-3, 5) and (2, 6)

Prof. Senadza Slide 36

 Algebraic Solution of Simultaneous
Linear Equations
Two equations in two unknowns
• Consider the two linear equations: 4 x  3 y  11............(1)
2 x  y  5................(2)
• Finding the solution of two equations with two unknowns
means solving for the values of x and y that satisfy the two
equations simultaneously.
• It is important to realize that not all simultaneous equations
have solutions.
• The general rule is that the number of unknowns should be
equal to the number of equations for there to be a unique
solution.
• There are different methods of solving simultaneous
equations.
Prof. Senadza Slide 37
 Graphical Method
• Solution is at point of intersection of the two lines when
graphed.
• At this point the solution values are x=2 and y=1.

Prof. Senadza Slide 38

 Elimination Method
Here, we seek to do away with one of the variables in the
system of equations in order to find the other.
4 x  3 y  11..................(1)
2 x  y  5.....................(2)
(2)  2  4 x  2 y  10..............(3)
(1)  (3)  y  1
Substitute y=1 into (1) or (2), Using (1)
4 x  3(1)  11
4 x  3  11
4x  8
x2
Prof. Senadza Slide 39
 Substitution Method
• Make one variable the subject in one equation and substitute
in the second equation to eliminate one of the unknowns.
4 x  3 y  11..................(1)
2 x  y  5.....................(2)
• From equation (2)
y  5  2 x..............(3)
• Substitute the RHS of equation (3) for y in equation(1)
4 x  3(5  2 x)  11  4 x  15  6 x  11
 2x  4  x  2
• To find y substitute the value of x into equation (1) or (2).
4(2)  3 y  11  8  3 y  11  3 y  3  y  1
Prof. Senadza Slide 40
 Exercise 4
• Solve the following systems of linear equations

• a) 5 x  2 y  4
x  2y  8

• b) 4 x  3 y  1
2x  9 y  4

Prof. Senadza Slide 41

 Three Equations Three Unknowns
• Given the three equations in three unknowns.
x  3 y  z  4..............(1)
2 x  y  2 z  10..........(2)
3 x  y  z  4..............(3)
• Use any 2 pairs of the three equations to eliminate one
variable so as to obtain two equations in two unknowns.
• Assume we want to eliminate x, then using (1) and (2)
(1)  2  2 x  6 y  2 z  8.......... .( 4)
2 x  y  2 z  10.......... .......... .......( 2)
(4)  (2)  5 y  4 z  2.......... ....( 5)
Prof. Senadza Slide 42
 Three Equations Three Unknowns
• Now using (1) and (3)
(1)  3  3x  9 y  3z  12.........6
3x  y  z  4.......... .......... .......... 3
(6)  (3)  10 y  4 z  8.......... ....7 
• We solve equations (5) and (7) simultaneously; these are
two equations in two unknowns (y and z)
5 y  4 z  2..............(5)
10 y  4 z  8..............  7 
• Gives y=2 and z=3. Substitute for y and z in (1) gives x=1.

Prof. Senadza Slide 43

 Exercise 5
• Solve the following for x, y and z.
• a) x  3y  4z  5
2x  y  z  3
4x  3 y  5z  1
• b) 3 x  2 y  2 z  5
4 x  3 y  3 z  17
2 x  y  z  1

Prof. Senadza Slide 44

 Quadratic Functions
• Economists often find that linear functions are too limited to
allow some important phenomena to be described
sufficiently accurately.
• Many economic models involve functions that either
decrease down to some minimum value and then increase,
or increase to some maximum value and then decrease.
• Quadratic functions can be used to represent such
phenomena.
• Quadratic functions take the form;
• f ( x)  ax  bx  c , where a, b, c are constants; a  0
2

Prof. Senadza Slide 45

 Quadratic Functions
• Alternatively, we can write the quadratic function as
y  ax 2  bx  c
• where y = f(x)
• When graphed, it is called a parabola (U-shaped).
• When a < 0 the function has a maximum point and when a > 0 it
has a minimum point.

Prof. Senadza Slide 46

 Quadratic Functions

Prof. Senadza Slide 47

 Quadratic Functions
• When the function is of the form
f ( x)  ax  bx  c
2

• it means an infinite number of ordered pairs satisfy the

function.
• But if we assign f(x) = 0 or y = 0,  ax 2  bx  c  0
• Then only a selected number of x values can satisfy the
function and we call it a quadratic equation.
• The x values that give us a solution to the equation are
called the roots of the quadratic equation.
• Graphically, we get the solution values by finding the x-
values where the curve crosses the x-axis.
Prof. Senadza Slide 48
 Quadratic Functions
• Graphically, we get the solution values by finding the x-
values where the curve crosses the x-axis.

Prof. Senadza Slide 49

 Quadratic Functions
• To find the values of x that satisfy the quadratic equation
ax 2  bx  c  0
• we use the formula  b  b 2  4ac
x
2a
• Example: Find the solution value of 2 x 2  9 x  5  0
• Using the formula,

x
 b  b 2  4ac  9 

9  4(2)(5)
2

2a 2(2)
 9  41
• x => x  0.649,3.851
4
Prof. Senadza Slide 50
 Applications to Linear models in
Economics
Partial Market Equilibrium Analysis (Demand and Supply)
• We specify the relationship between quantity demanded and
price as
Qd  f ( P)
• Assume the relationship is linear then we have
Qd  a  bP a, b  0
• Similarly, we specify the relationship between quantity
supplied and price as
Qs  f ( P )  Qs  c  dP c, d  0
• a, b, c and d are constants.
Prof. Senadza Slide 51
 Partial Market Equilibrium Analysis
(Demand and Supply)
• Note that the demand equation could be written with price
as the subject, so that
a 1
Q  a  bP  P   Q  P     Q  P  f (Q)
b b
where   a   1
b and b
• Similarly, for the supply function
P  h(Q )  P     Q
  c d ,  1d
• Thus Q=f(P) and P=f(Q) are inverses of each other.
Prof. Senadza Slide 52
 Finding Equilibrium Quantity and Price
Algebraically
• Equilibrium graphically is where demand and supply curves
intersect.
• Equilibrium algebraically means Qd = Qs, thus, equating the
demand function to the supply function,
Qd  a  bP
Qs  c  dP
 a  bP  c  dP  P (b  d )  a  c
ac
P e

bd
bd  0
Prof. Senadza Slide 53
 Finding Equilibrium Quantity and Price
Algebraically
• Equilibrium quantity is obtained by substituting P in
demand or supply equation.
• Using demand,
ac
Q  a  b
e

bd 
a(b  d )  b(a  c)
Q 
e

bd
ad  bc
Q  e
b  d  0; ad  bc
bd
Prof. Senadza Slide 54
 Finding Equilibrium Quantity and Price
Algebraically
• Note that we could have used the technique for solving
simultaneous equations to determine the values of P and Q.
Q  a  bP..................(1)
Q  c  dP................(2)
(1)  (2)  0  ( a  bP)  (c  dP)
 0  ( a  c)  P(b  d )  P(b  d )  a  c
ac
P
bd
• Then substitute P into (1) or (2) to obtain Q.
Prof. Senadza Slide 55
 Solving for equilibrium Quantity and
Price algebraically
• Example: Given the following demand and supply functions,
find the equilibrium price and quantity.
Qd  25  1 P
2
Qs  50  2 P
• Solution: In equilibrium, Qd = Qs.
 25  1 P  50  2 P  5 P  75  P  30
2 2
• Substitute P=30 in Demand (or supply) equation.

 Q  25  1 P  Q  25  1 (30)  Q  10
2 2

Prof. Senadza Slide 56

 Solving for equilibrium Quantity and
Price algebraically
• Alternatively, we could use the method of simultaneous
equations or substituted the values of the parameters a, b, c
and d into the formulas we obtained earlier for P and Q.
• Using the latter, and from demand and supply equations,
a=25, b=1/2=0.5, c=50, d=2.
• Therefore
a  c 25  50 75
P 
e
   30
b  d 0.5  2 2.5
• And ad  bc 25(2)  0.5(50) 50  25 25
Q 
e
    10
bd 0.5  2 2.5 2.5
Prof. Senadza Slide 57
 Solving for equilibrium Quantity and
Price algebraically
• The demand and supply could be written with P as the
subject as below.
P  50  2Qd
P  25  1 Qs
2
• We can easily solve for Q and then substitute its value to
obtain P.
• Since in equilibrium there is a unique price, just equate the
RHS of both equations and solve for Q.
• Or you can drop the subscripts d and s and use the method
of simultaneous equations to solve the two equations for P
and Q. Try it!
Prof. Senadza Slide 58
 Analysis of Taxation on Market
Equilibrium
• Governments often impose taxes on goods and services
which necessarily alters the level of equilibrium in the
market, i.e. equilibrium quantity and price.
• The tax could be:
• (1) Specific (fixed monetary amount per unit of the good)
• (2) Ad valorem (imposed as a percentage of the value (price)
of the good.
• We analyse the effect of tax on equilibrium price and
quantity.
• We know from microeconomics that a (specific) tax shifts the
supply curve to the left.

Prof. Senadza Slide 59

 Analysis of Taxation on Market
Equilibrium
• Assume a per unit tax of t. The tax shifts supply to left. What
it also means is that it reduces the price received by the
seller by t.
• The seller now receives P-t, so we must replace P in the
original supply with P-t to obtain the new supply after tax.
• Given our original supply as
Qs  50  2 P
• Then the new supply is
Qst  50  2( P  t )  Qst  50  2( P  5)
 Qst  60  2 P
Prof. Senadza Slide 60
 Analysis of Taxation on Market
Equilibrium
• The post-tax equilibrium is obtained at the intersection of
the demand and new supply curve.
• Thus we must solve the demand and new supply equations
simultaneously
Qd  25  1 P
2
Qst  60  2 P
 25  1 P  60  2 P  P  34
2
 Q  25  1 (34)  8
2
• Note that you either substitute P=34 into the demand or the
new supply (not the old supply) equation.
Prof. Senadza Slide 61
 Analysis of Taxation on Market
Equilibrium
• Note: If supply is of the form P=f(Q), so that in our example
the supply function is
P  25  1 Qs
2
• Since the tax reduces the price received by the seller by the
amount of the tax, the post-tax supply function will be
P  t  25  1 Q  P  25  1 Q  t
2 2
 P  25  1 Q  5  P  30  1 Q
2 2
• The demand function is P  50  2Q so solve the demand
and the post-tax supply to obtain new equilibrium Q=8 and
P=34 as previously.
Prof. Senadza Slide 62
 Analysis of Taxation on Market
Equilibrium
• For a percentage tax, let t=5%, we first multiply P by t before
incorporating it in the supply equation.
• Thus, the seller now receives (P-tP)=P(1-t) of the market
price, where t is expressed in hundredths, i.e. t=0.05, which
gives (P-0.05P) or P(1-0.05).
• So with our original supply function Qs  50  2 P , a tax of 5%
means the post-tax supply equation is given as
Qst  50  2 P(1  t )  Qst  50  2 P(1  0.05)  Qst  50  1.9 P
• We then proceed to solve for the new (post-tax) equilibrium.
• If P=f(Q), a 5% tax gives P-0.05P=25+0.5Q => 0.85P=25+0.5Q

Prof. Senadza Slide 63

 Application of Linear Models: National
Income
• Consider the Keynesian national income model
Y  C  I o  Go .......... .......... .....(1)
C  a  bY .......... .......... .......... ....( 2)

• Two equations in two unknowns; two endogenous (Y and C),

and two exogenous (I0 and G0 ).
• We can solve for equilibrium Y and C, and using substitution
method.

Prof. Senadza Slide 64

 Application of Linear Models: National
Income
• Substitute (2) in (1)
Y  a  bY  I o  Go
Y (1  b)  a  I o  Go
_
a  I o  Go
Y
1 b
• Substitute for Y in (2) to obtain equilibrium C.

 a  I o  Go 
C  a  b 
 1  b 
 a  b( I o  Go )
C
1 b
Prof. Senadza Slide 65
 Application of Linear Models: National
Income
• For example, given
Y C  I G
C  70  0.8Y
I  35
G  20
• Find the equilibrium income and consumption.
• Using the formulas,
 a  I o  Go 70  35  20
Y   625
1 b 1  0.8
 a  b( I o  Go ) 70  0.8(35  20)
C   570
1 b 1  0.8
Prof. Senadza Slide 66
 Application of Non-Linear Models:
Demand and Supply
• Find the equilibrium price and quantity given the demand
and supply as follows. Qd  4  P 2
Qs  4 P  1
• Solution: Equilibrium => Qd = Qs
4  P2  4P 1
P2  4P  5  0
• Thus, a=1, b=4, c=-5

• P  e
4  4 2
 4(1)(5)  => P 
e 46
=> P e
 1,5
2(1) 2

• But P > 0 so  P e  1 and Q e  3 (substitute P in DD or SS)

Prof. Senadza Slide 67
 Application of Non-Linear Models:
Demand and Supply
• Another example: Solve for equilibrium, given
• Demand: P  Qd2  10Qd  150
• Supply: P  Qs2  14Qs  22
• In equilibrium, Qd = Qs, and removing the subscripts,
•  Q 2  10Q  150  Q 2  14Q  22
2Q 2  24Q  128  0
Q 2  12Q  64  0
 12  122  41 64
Q
2(1)
Prof. Senadza Slide 68
 Application of Non-Linear Models:
Demand and Supply
 12  20
• => Q  => Q  4 or Q  16
2

• Substitute Q=4 in supply equation =>

P  4  14(4)  22  94
2

Prof. Senadza Slide 69

 Functions of Two or More
Independent Variables
• We discussed functions of one variable, where y =f(x).
• But we can extend the concept to the case of two or more
independent variables.
• Given the function
y  f ( x1 , x 2 )
• means a given pair of x1 and x2 values will uniquely
determine the value of y.
• Such a function may be written as:
• y  a0  a1 x1  a2 x2 Linear

• y  a 0  a1 x1  a 2 x12  b1 x 2  b2 x 22 Quadratic
Prof. Senadza Slide 70
 Functions of Two or More
Independent Variables
• For example, we know that the demand for a good depends
not only on the price of the good in question but on the
price of a related good, so that we can write
Qd 1  f ( P1 , P2 )  Qd 1  a 0  a1 P1  a 2 P2
• which is a linear function.
• It is possible to have quadratic or other forms of functions of
two or more variables.
• Similarly, output is usually written as a function of two
variables, capital and labour
 
• Q = f (K, L) = A L
K

Prof. Senadza Slide 71

 Application: General Market
Equilibrium
• Our earlier partial equilibrium analysis expressed quantity
demanded and supplied as functions of the price of the
commodity only.
• Realistically, there are influences of other factors such as the
price of a related product or the consumer’s income.
• Related products are either substitutes or complements.
• Also the market equilibrium condition was
 Q d  Q s  Qd  Q s  0
• For the n-commodity case, where i = 1, 2…,n equilibrium
 Qdi  Qsi
Prof. Senadza Slide 72
 Application: General Market
Equilibrium
• Consider two commodity case (two markets)
Qd 1  a0  a1 P1  a 2 P2
Qs1  bo  b1 P1  b2 P2
Qd 2   o   1 P1   2 P2
Qs 2   o  1 P1   2 P2
• Equilibrium  Qd 1  Qs1 and Qd 2  Qs 2

Prof. Senadza Slide 73

 Application: General Market
Equilibrium
• In market 1,
 a o  a1 P1  a 2 P2  bo  b1 P1  b2 P2
 (ao  bo )  (a1  b1 ) P1  (a 2  b2 ) P2  0.......... .......... ...(1)

• In market 2,
  o   1 P1   2 P2   o  1 P1   2 P2
 ( o   o )  ( 1  1 ) P1   2   2 P2  0.......... .......... .( 2)

• We have two equations in two unknowns, which we must

solve simultaneously for equilibrium prices and quantities
P1e , P2e , Q1e , Q2e
Prof. Senadza Slide 74
 Application: General Market
Equilibrium
• Example: Find the equilibrium prices and quantities, given
Qd 1  10  2 P1  P2
Qs1  2  3P1
Qd 2  15  P1  P2
Qs 2  1  2 P2
• Solution: Equilibrium  Qd 1  Qs1 and Qd 2  Qs 2
 10  2 P1  P2  2  3P1  5 P1  P2  12
 15  P1  P2  1  2 P2  P1  3P2  16
• Solving by elimination P1e  3.71
P2e  6.57
Prof. Senadza Slide 75
 Application: General Market
Equilibrium
• Equilibrium quantities are
• Q1e  9.15  substitute P1e , P2e in Qd 1 or Qs1

• Q2e  12.14  substitute P1e , P2e in Qd 2 or Qs 2

• The solution can be generalized to the n-commodity case.

Prof. Senadza Slide 76

 Exercise
• The demand and supply in two interdependent markets are
Qd 1  10  2 P1  P2
Qs1  3  2 P1
Qd 2  5  2 P1  2 P2
Qs 2  2  3P2

• Find the equilibrium prices and quantities.

Prof. Senadza Slide 77

 Taxation
• Note that the implication of a tax imposed on a product
for the supply function remains unchanged from earlier
discussed.
• The only difference here is that the tax might be on only
one commodity.
• In that case, it only affects the supply function (and of
course the price) of the commodity in question. If it is
imposed on both, each tax must affect their respective
supply function.

Prof. Senadza Slide 78