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Arkansas Tech University

MATH 2924: Calculus II


Dr. Marcel B. Finan
14 Applications to Economics
In this section we consider some applications of denite integrals used in eco-
nomics such as the present and future values of a continuous income stream
and the consumers and producers surplus.
Discrete Present and Future Value
Many business deals involve payments in the future. For example, when a
car or a home is bought on credits, payments are made over a period of time.
The future value, FV, of a payment P is the amount to which P would have
grown if deposited today in an interest bearing bank account. The present
value, PV, of a future payment FV, is the amount that would have to be
deposited in a bank account today to produce exactly FV in the account at
the relevant time future.
If interest is compounded n times a year at an annual rate r for t years, then
the relationship between FV and PV is given by the formula
FV = PV (1 +
r
n
)
nt
.
In the case of continuous compound interest, the formula is given by
FV = PV e
rt
.
Example 14.1
You need $10,000 in your account 3 years from now and the interest rate is
8% per year, compounded continuously. How much should you deposit now?
Solution.
We have FV = $10, 000, r = 0.08, t = 3 and we want to nd PV. Solving the
formula FV = PV e
rt
for PV we nd PV = FV e
rt
. Substituting to obtain,
PV = 10, 000e
0.24
$7, 866.28.
Present and Future Value of a Continuous Income Stream
In the above discussion we introduced the present and future value of a sin-
gle payment. Next, we want to calculate the present and future value of a
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continuous stream of payments.
The revenues earned by a huge corporation (such as an electricity company),
for example, come in essentially all the time, and therefore they can be rep-
resented by a continuous income stream.
Since the rate at which revenue is earned may vary from time to time, the
income stream is described by a function S(t) which represents the ow rate
in dollars per year. Note that the rate depends on time , t, usually measured
in years from the present.
To nd the present value of a continuous income stream over a period of M
years we divide the interval [0, M] into n equal subintervals each of length
t =
M
n
and with division points 0 = t
0
< t
1
< < t
n
= M. That is, over
each time interval we are assuming a single payment is made. Assuming inter-
est r is compounded continuously, the present value of the money deposited
between the time t
i1
and t
i
is approximated by S(t
i
)te
rt
i
. Summing over
all intervals, the total present value is approximated by the following Rie-
mann sum:
PV S(t
1
)e
rt
1
t + S(t
2
)e
rt
2
t + S(t
n
)e
rtn
t =
n

i=1
S(t
i
)e
rt
i
t.
Letting t 0, i.e. n , we obtain
PV =

M
0
S(t)e
rt
dt.
The future value is given by
FV = e
rM

M
0
S(t)e
rt
dt.
Example 14.2
An investor is investing $3.3 million a year in an account returning 9.4%
APR. Assuming a continuous income stream and continuous compounding
of interest, how much will these investments be worth 10 years from now?
Solution.
Using the formula for the future value dened above we nd
FV = e
.94

10
0
3.3e
0.094t
dt $54.8million.
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Example 14.3
At what constant, continuous rate must money be deposited into an account
if the account contain $20,000 in 5 years? The account earns 6% interest
compounded continuously.
Solution.
Given FV = $20, 000, M = 5, r = 0.06. Since S is assumed to be constant,
we have
20, 000 = S

5
0
e
0.06t
dt.
Solving for S we nd
S =
20, 000

5
0
e
0.06t
dt
$4, 630 per year.
Supply and Demand Curves
The quantity q manufactured and sold depends on the unit price p. In gen-
eral, when the price goes up then manufacturers are willing to supply more
of the product whereas consumers are going to reduce their buyings. Since
consumers and manufacturers react dierently to changes in price, there are
two curves relating p and q.
Demand tells us the price that consumers would be willing to pay for
each dierent quantity. According to the law of demand, when the price
increases the demand decreases and when the price decreases the demand
increases. The graphical representation of the relationship between the quan-
tity demanded of a good and the price of the good is known as the demand
curve.
Supply tells us the price that producers would be willing to charge in order
to sell the dierent quantities. The law of supply asserts that as the price
of a good rises, the quantity supplied rises, and as the price of a good falls
the quantity supplied falls. The graphical representation of the relationship
between the quantity supplied of a good and the price of the good is known
as the supply curve.
Even though quantity is a function of price, it is the tradition to use the verti-
cal yaxis for the variable p and the horizontal xaxis for the variable q. The
demand and supply curve intersects at the point of equilibrium (q

, p

).
We call p

the equilibrium price and the q

the equilibrium quantity.


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See Figure 14.1.
Figure 14.1
Example 14.4
Find the equilibrium point for the supply function p = S(q) =
q
3
+
50
3
and
the demand function p = D(q) =
q
2
+ 50.
Solution.
Setting the equation S(q

) = D(q

) to obtain
q

3
+
50
3
=
q

2
+ 50. Multiply
through by 6 to obtain 2q

+100 = 3q

+300. By adding 3q

100 to both
sides we obtain 5q

= 200. Solving for q

we nd q

= 40. Substituting this


value in S(q) we nd p

= 30.
Consumer and Producer Surplus
Consumers Surplus
At the equilibrium level, a number of consumers have bought the item at a
lower price that they would have been willing to pay. (For example, there are
some consumers who would have been willing to pay prices up to p
1
.) Simi-
larly, there are some suppliers who would have been willing to produce the
item at a lower price, for example, down to p
0
. We dene the following terms:
At the equilibrium level, the consumers surplus is the dierence be-
tween what consumers are willing to pay and their actual expenditure: It
therefore represents the total amount saved by consumers who were willing
to pay more than p

dollars per unit.


To calculate the consumers surplus, we rst calculate the consumers total
expenditure. Divide the interval [0, q

] into n equal pieces each of length q.


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According to Figure 14.2, the consumers total expenditure is given by the
sum
D(q
1
)q + D(q
2
)q + + D(q
n
)q =
n

i=1
D(q
i
)q.
Letting q 0 to obtain (See Figure 53.2(a))
Total Expenditure =

0
D(q)dq.
This is the consumer expenditure if all consumers are willing to pay more
than p

.
Figure 14.2
Now, if all the goods are sold at the equilibrium price, the consumers actual
expenditure is only p

. Thus,
Consumers

Surplus =

0
(D(q) p

)dq.
Graphically, it is the area between demand curve and the horizontal line at
p

. See Figure 14.2(b).


The producers surplus is the extra amount earned by producers who were
willing to charge less than the selling price of p

dollars per unit, and is given


by
Producers

Surplus =

0
(p

S(q))dq.
Graphically, it is the area between suuply curve and the horizontal line at
p

. See Figure 14.3.


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Figure 14.3
Example 14.5
The demand and supply equations are given by D(q) = 60
q
2
10
and S(q) =
30+
q
2
5
. Find the consumers and producers surplus at the equilibrium price.
Solution.
To nd the consumers and producers surplus under equilibrium we rst
need to nd the equilibrium point by setting S(q) = D(q) and solving for q :
30 +
q
2
5
= 60
q
2
10
implies q

= 10.
Substituting this into the supply (or demand) equation we nd the equilib-
rium price p

= 50. Now we use formulas of the consumers and producers


surplus:
Consumers

Surplus :

10
0

60
q
2
10

50

dq = 10q
q
3
30

10
0
$66.67
Producers

Surplus :

10
0

50

30 +
q
2
5

dq = 20q
q
3
15

10
0
$133.33
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