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Original Title: Economic Applications of Implicit Differentiation

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1. Substitution of Inputs

Let Q = F(L , K ) be the production function in terms of labor and capital. Consider the isoquant

Q 0 = F(L , K ) of equal production. (This is the level curve of the function.) Thinking of K as a function

of L along the isoquant and using the chain rule, we get

0=

Q K

Q

+

.

L

K L

K

measures the rate of substitution of capital for labor needed to keep the output constant.

L

For the Cobb-Douglas production function Q = cL a K b . If the quantity produced Q is fixed and K is

considered a function of L, then differentiating

The derivative

0=

cbL a K b

L

= acL a1 K b + bcL a K b1

K

acL a1 K b

=

L

bcL a K b1

a K

.

=

b L

K

,

L

so

Thus, the marginal rate of technical substitution of capital for labor is a constant multiple of the average of

capital to labor.

2. Comparative-Static Analysis of Balancing Supply and Demand

Assume the supply and demand functions for a single commodity are

Q = S(P, T )

Q = D(P, Y )

(supply) and

(demand),

where Y is the income, T is the tax on the commodity, and P is the price. We do not assume a particular form

of the supply and demand functions, but we do assume that the supply increases with price and decreases

with tax while the demand decreases with price and increases with income: Assume that

S

> 0,

P

D

DP =

< 0,

P

S

< 0,

T

D

DY =

> 0.

Y

SP =

ST =

0 = S(P, T ) D(P, Y ).

The partial derivative of the right hand side with respect to P is S P D P > 0, so this equation determines

the price P as a function of income Y and tax T while the system stays in an equilibrium state. Taking the

1

P

P

DP

DY

Y

Y

P

P

0 = SP

+ ST D P

,

T

T

0 = SP

and

so

P

= DY

Y

P

(S P D P )

= ST ,

T

(S P D P )

and

and

P

DY

=

>0

Y

SP D P

P

ST

=

> 0.

T

SP D P

and

Thus, the price increases with both an increase in income and tax.

3. General Method of Implicit Differentiation

Following the books treatment of the general implicit function theorem, assume that there are m > 0

equations in n + m variables with n > 0,

F1 (x1 , . . . , xn , y1 , . . . , ym ) = C1

F2 (x1 , . . . , xn , y1 , . . . , ym ) = C2

..

..

.

.

Fm (x1 , . . . , xn , y1 , . . . , ym ) = Cm

such that at p = (a, b)

F1

F1

y (p) y (p)

m

..

..

det

6= 0.

.

.

Fm

Fm

(p)

(p)

y1

ym

By the implicit function theorem, there is a implicitly defined function y = h(x) such that C = F(x, h(x))

for all x near a. Thus, the (y1 , . . . , ym ) are the dependent variables and (x1 , . . . , xn ) are the independent

variables. Let H (x) = (x, h(x)), so C = F(H (x)). Differentiating this equation with respect to x and using

the chain rule, we get the matrix equation

I

0 = D F(p)D H (a) = Dx F(p), Dy F(p)

Dh(a)

= Dx F(p) + Dy F(p)Dh(a)

or

F1

F1

F1

y1

F1

y1

x (p) x (p) y (p) y (p) x (p) x (p)

0

m

1

1

1

n

n

..

..

..

..

..

.. .

(1) ... =

+

.

.

.

.

.

.

Fm

0

Fm Fm

Fm ym

ym

(p)

(p)

(p)

(p)

(p)

(p)

x1

xn

y1

ym

x1

xn

Solving for the partial derivatives of the dependent variables and taking the inverse of the square matrix

involving the partial derivatives of the Fi , we get

y1

x (p)

1

..

.

ym

(p)

x1

(2)

F1

y1

(p)

(p)

xn

y1

.. =

..

.

.

Fm

ym

(p)

(p)

xn

y1

1

F1

F1

(p)

(p)

ym

x1

..

..

.

.

Fm Fm

(p)

(p)

ym

x1

F1

(p)

xn

..

.

.

Fm

(p)

xn

In a given problem, we just write down the matrix equation (1) and solve them rather than use equation

(2). The reason is that it is easier to remember the correct form for the matrix equation (1): The rows

are determined by the coordinate functions (or equations) of the problem; the first matrix has the derivatives

with respect to the independent variables; the second matrix has the derivatives with respect to the dependent

variables and is multiplied by the unknown matrix of partial derivatives of the dependent variables with

yj

Fi

is multiplied by

as the

respect to the independent variables. Notice in the matrix product the term

yj

x`

chain rules says it must be.

A firm uses two inputs, q1 and q2 to produce a single output Q determined by a production function. Let

p1 be the price of q1 , and p2 be the price of q2 ; let 1 be the price of the output Q. (Either the price of Q

is taken as the unit of money or we are looking at the ratios of the prices p j to the price of Q.) The profit

is given by = Q p1 q1 p2 q2 . We will see in the section on maximization later in the quarter that the

= 0 and

= 0. Calculating these partial derivatives, we get

inputs that maximize profits satisfy

q1

q2

Q

=

p1 and

q1

q1

Q

0=

=

p2 .

q2

q2

0=

For the Cobb-Douglas production function Q = q13 q22 , these equations become

(3)

1 23 12

q q p1

3 1 2

1 1 1

0 = q13 q2 2 p2 .

2

0=

We have two equations and four variables p1 , p2 , q1 , and q2 . If we specified values for the prices, then we

would have two equations for the variables q1 and q2 which could determine their values.

To see that these two equations in (3) determine the amounts of inputs q1 and q2 that optimize profit in

terms of the prices p1 and p2 , we check the determinant of the matrix of partial derivatives with respect to

q1 and q2 :

-2 - 35 12 1 - 32 - 21

9 q1 q2 6 q1 q2

2

1

1 - 34 -1

- 43 -1

det

=

q

q

=

q1 q2 6= 0.

2

1

1

-3

2

1

1 - 3 - 2 -1 3 2

36

36

36

q q

q q

6 1 2

4 1 2

Therefore, the partial derivatives of q1 and q2 with respect to p1 and p2 satisfy the following matrix equation:

-2 - 53 12 1 - 23 - 21

q1 q1

q

q

q

q

9 1 2 6 1 2 p1 p2

0

-1 0

=

+

1 - 23 - 12 -1 13 -32 q2 q2

0

0 -1

q q

q q

p1 p2

6 1 2

4 1 2

q1

p1

q2

p1

-2 - 53 21 1 - 23 - 21 -1

q1

q1 q2

q1 q2

p2

= 9 2 1 6 1 -3

q2 1 - 3 - 2 -1 3 2

q q

q q

p2

6 1 2

4 1 2

-1 31 -32 -1 - 32 - 12

q

q

q

q

4

4 1 2

6 1 2

= 36 q13 q2

2

1

-1 - 3 - 2 -2 - 53 12

q q

q q

6 1 2

9 1 2

5

2

-1

1

3

3

2

2

-9

q

q

-6

q

q

1 2

1 2

,

=

2

-1

1

3

3

3

2

2

-6 q1 q2 -8 q1 q2

qi

are negative.

pj

Because the sum of the exponents in the production function is less than one, 31 + 12 < 1, the production

has decreasing return to scale. Although it is not obvious from the above treatment, this property caused the

partial derivatives to be negative and has the effect that the amounts of the inputs decreases with an increase

in either price.

The details of this example are complicated. However, the outline of the method is not complicated.

(a) First, some equations are derived (or given) relating several variables. In our example, (3) has two

equations with four variables. (b) Second, thinking of these equations as defining some variables in terms of

the others, we take partial derivatives. In our case, we take the partial derivatives with respect to p1 and p2 .

and all the partial derivatives

A firm uses two inputs to produce an output. Assume the amounts of the inputs are x and y with p the

price of x and q the price of y. The amount produced Q is determined by the Cobb-Douglas production

function Q = x a y b , where the technology determines the exponents a and b. The firm can vary the

exponent b while keeping a fixed by changing the technology. It wants to keep the amount produced

fixed, Q 0 , and the cost of the inputs fixed px + qy = 125. What is the rate of change of the amounts at

x = 5, y = 50, p = 5, q = 2, a = 1/3, and b = 2/3?

Rather than use the equation Q 0 = x a y b , we take its logarithm and obtain the two equations

125 = px + qy

and

ln(Q 0 ) = a ln(x) + b ln(y).

These two equations define x and y as functions of a, b, p, and q since

"

#

p q

pb qa

pbx qay

5 2 5 2 1 50

-1

=

=

=

6= 0.

det a b =

y

x

xy

3 5 50

15

x y

Considering x and y as functions of a, b, p, and q, and differentiating the two equations with respect to

the four independent variables gives the following matrix equation:

# x x x x

"

p q a b p q

0

0

0

x y

=

+ a b

y y y y

0

ln(x) ln(y) 0 0

x y

a b p q

x

a

y

a

x

b

y

b

x

p

y

p

x

b -q

y

xy

q

0

0

x y

ln(x) ln(y) 0 0

y

p

pbx qay -a

x

q

#

"

xy

b

-q ln(x) -q ln(y) bx

y

=

qay pbx p ln(x) p ln(y) -a -ay

x

2

-x yq ln(y)

qay pbx

x yp ln(y)

qay pbx

-x yq ln(x)

qay pbx

=

x yp ln(x)

qay pbx

10050

3

50

3

3(25)(50) ln(5)

y

=

a

50

= 75 ln(5)

bx

qay pbx

-ax y

qay pbx

bx y

qay pbx

.

-ay 2 ln(y)

qay pbx

and

y

3(25)(50) ln(50)

=

b

50

= 75 ln(50).

6. Nonlinear Keynesian Model

This is a nonlinear Keynesian IS-LM model for national income. The details of solving for partial derivatives in terms of other is more complicated than the other ones we considered since it involve more variables

and two equations that the system must satisfy. However, it does uses the general ideas of implicit differentiation as well as the chain rule.

The variables are as follows:

Y

C

I

G

T

r

M

Consumption

Investment expenditure

Government spending

Taxes

Interest rate

Money supply

The GDP is assume to be the sum of the consumption, investment, and government spending, Y = C +I +G.

The consumption is a function of after taxes income or the difference Y T , C = C(Y T ); the investment

is a function of the interest rate, I = I (r ); and the money supply is a function (called the liquidity function)

of GDP and the interest rate, M = L(Y, r ). The assumptions on the partial derivatives are that

L

> 0,

and

Y

C

Note that the partial derivative of C with respect to Y and T are

= C 0 and

Y

0 < C 0 (x) < 1,

I 0 (r ) < 0,

L

< 0.

r

C

= -C 0 .

T

We have obtained the following two functional relationships between the five variables:

(4)

0 = Y + C(Y T ) + I (r ) + G

0 = L(Y, r ) M

and

We consider G, M, and T as the independent variables which can be controlled; C and I are intermediate

variables (or functions); Y and r are dependent variables determined by G, M, and T through the variables

C and I .

Taking the partial derivatives of the two equations with respect to Y and r is an invertible matrix,

1 + C 0 I 0

= (C 0 1)L r I 0 L y > 0 :

1 = det

LY

Lr

The sign of 1 is positive because (C 0 1) < 0, L r < 0, (C 0 1) L r > 0, I 0 < 0, L Y > 0, and I 0 L Y > 0.

Therefore, these two equations define Y and r as functions of G, T , and M.

Taking the partial derivatives of the two equations with respect to G, T , and M (in that order), and

considering Y and r as functions of these variables, we get the following matrix equation:

Y

Y Y

0

0

0

0

1 -C 0

1 + C I G T M

=

+

0

0 0 -1

LY

L r r

r

r

.

G T M

Y Y

Y

1 Lr

-I 0

-1 C 0 0

G T M

=

r

r

r

1 -L Y C 0 1 0 0 1

.

G T M

1 -L r L r C 0

-I 0

=

.

1 L Y -L Y C 0 C 0 1

The partial derivatives of Y and r with respect to G are positive:

Y

-L r

r

LY

=

>0

and

=

> 0.

G

1

G

1

Thus, both the GDP, Y , and the interest rate, r , increase if government spending is increased while holding

the money supply and taxes fixed. The partial derivatives of Y and r with respect to T are negative, and both

Y and r decrease with increased taxes:

Y

Lr C 0

r

-L Y C 0

=

<0

and

=

< 0,

T

1

T

1

Finally,

Y

-I 0

r

C0 1

=

>0

and

=

< 0,

M

1

M

1

and Y increases and r decreases with an increased money supply.

This is the type of qualitative information that this type of analysis can give without knowing the particular

form of the functional dependence but only the signs of the rates of change.

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