MATHEMATICAL ECONOMICS

ECN5020
LECTURE 1
INTRODUCTION:
How important is Mathematics for
Economics?
The Nature of Mathematical Economics
Economics Model

1. How Important is Mathematics

for Economics?

You cannot avoid Maths in an Economics

degree!

Core elements: Pure Mathematics and

Statistics

continue

Mathematics is part of an economists

toolkit
Model economic relationships
Demonstrate well-known empirical
results
Solve for economic equilibrium

BUT an economist must also be able to

interpret results and evaluate conclusions

2. The Nature of Mathematical

Economics
an approach to economic analysis
use of mathematical symbols in the
statement of the problem and also draw
upon known mathematical theorems to
aid in reasoning.

Mathematical versus
Nonmathematical Economics

In mathematical economics, the

assumptions and conclusions are stated
in mathematical symbols rather than
words and in equation rather than
sentences.

Advantages of the Mathematical

Approaches

The analysis is more rigorous

It allows us to treat the general n-variable
case; and
The language used is more concise and
precise

Mathematical Economic versus

Econometrics

Econometrics is concerned mainly with the

measurement of economic data.
Study the empirical observations using
statistical methods of estimation and
hypothesis testing
Mathematical Economics is the application
of mathematics to the purely theoretical
aspects of economic analysis, with less
concern of statistical problems.

3. Economic Model

An economic model is merely a theoretical

framework
Mathematical model usually consists of a
set equations designed to describe the
structure of the model

Mathematics for Microeconomics

Consumer Theory
Indifference curves and budgetary
constrainsts maximise utility with
respect to a budget
Intertemporal consumption decisions
allocating consumption between time
periods

Continue

Producer Theory
Pricing and output decisions profit
maximisation
Constant, increasing & decreasing returns
to scale

Mathematics For Macroeconomics

Aggregate Supply & Demand

IS-LM framework solve for equilibrium
Intertemporal aggregate consumption
Fiscal Policy
Intertemporal government spending
decisions
Monetary Policy
Money demand and supply equilibrium

Using Maths in Economics

Using mathematics provides a convenient,

short-hand way for economists to develop
their models
implications of various economic
assumptions can be studied in a
simplified setting through the use of such
mathematical tools

3. Equilibrium Analysis in
Economics

The meaning of Economics Equilibrium

simply a state of the world where economic
forces are balanced and in the absence of
external influences the (equilibrium) values
of economic variables will not change.
Example: Market equilibrium - Dd = Ss

Partial Market Equilibrium

A Linear Model

In a static-equilibrium model, the standard

problem is that of finding the set of values of
the endogenous variables which will satisfy
the equilibrium conditions of the model

ontinue..

Three variables
Qd = the quantity demanded of the commodity
Qs = the quantity supplied of the commodity

P = the price of the commodity

The Equilibrium condition: Qd = Qs
The model is
Q d = Qs
Qd = a bP (a, b > 0)
Qs = -c + dP (c, d > 0)

Continue..
Qd, Qs
a

Qd=a-bP

Qs=-c+dP

(demand)

(supply)

Q*

0
-c

P*

The slope of Qd=-b, the vertical intercept = a

The slope of Qs=d, the vertical intercept = -c

Continue..

One way of finding the equilibrium is by

successive eliminate of variables and
equations through substitutions
From Qs = Qd, we have
a bP = -c + dP
(b + d)P = a + c
Since b + d 0, then the equilibrium price
is
P* = (a + c) / (b + d)
The equilibrium quantity can be obtained by
substituting P* into either Qs or Qd

Continue..

Q* = (ad bc) / (b + d)

Since the denominator (b+d) is positive, the

positivity of Q* requires that the numerator
(ad - bc) > 0. Thus, to be economically
meanful, the model should contain the
additional restriction that ad > bc.

Partial Market Equilibrium

A Nonlinear Model

The partial market model can be nonlinear.

Suppose a model is given by
Qd = Qs
Qd = 4 P2
Qs = 4P 1

Continue

This system of 3 equations can be

reduced to a single equation by
substitution
4 P2 = 4P 1 or
P2 + 4P 5 = 0
which is a quadratic equation.

Continue..

In general, given a quadratic equation in the

form
ax2 + bx + c = 0 (a 0)
Its two roots can be obtained from the
quadratic formula:

b b 2 4ac
x1 , x 2
2a
Where the + part of the sign yields x 1 , and
the - part yields x 2

Continue..

Thus, by applying the quadratic formulas to

P2 + 4P 5 = 0, we have
P1 = 1 and P2 = -5
but only the first is economically
admissible, as negative prices are ruled out

The Graphical Solution

Q
4

Qs= 4P - 1

(1,3)

2
Qd = 4 P2

-2

-1

0
-1

General Market Equilibrium

In the above, we have discussed methods of

an isolated market, where the Qd and Qs of a
commodity are functions of the price of that
commodity alone.

In the real world, there would normally

exist many substitutes and complementary
goods.

Continue..

Thus a more realistic model for the demand

and supply functions of a commodity
should take into account of the effects not
only of the price of the commodity itself,
but also of the prices of other commodities

As a result, the price and quantity variables

of multiple commodities must enter
endogenously into the model

General Market Equilibrium.

The equilibrium condition of an n-commodity

market model will involve n equations, one for
each commodity, in the form

Ei Qdi Qsi = 0

(i = 1,2,n)

where Qdi = Qdi(P1, P2,.,Pn), and Qsi =

Qsi(P1, P2,.,Pn).

Continue..

Thus, solving n equations for P:

Ei (P1, P2,,Pn) = 0

we obtain the n equilibrium prices Pi* - if a

solution does indeed exist. And then the Qi*
may be derived from the demand or supply
functions.

Two-Commodity Market Model

Consider a two-commodity market model with

linear demand and supply functions. In
parametric terms, such a model can be
written as
Qd1 Qs1 = 0
Qd1 = a0 + a1P1 + a2P2
Qs1 = b0 + b1P1 + b2P2
Qd2 Qs2 = 0
Qd2 = 0 + 1P1 + 2P2
Qs2 = 0 + 1P1 + 2P2

(1)
(2)
(3)
(4)
(5)
(6)

Continue..

By substituting the (2) and (3) equations into

the (1); and (5) and (6) equations into the (4),
the model is reduced to two equations in two
variables:
(a0 b0) + (a1 b1)P1 + (a2 b2)P2 = 0 (7)
(0 0) + (1 1)P1 + (2 2)P2 = 0 (8)
If we let ci = ai bi
i = i i

(i = 0,1,2)

Continue...

The above two linear equations (7) and (8)

can be written as
c1P1 + c2P2 = -c0

(9)

1P1 + 2P2 = - 0

(10)

which can be solved by further elimination of

variables

Continue

The solution are

P1*

c 2 0 c 0 2

c1 2 c 2 1

P2*

c 0 1 c1 1

c1 2 c 2 1

denominator c12 c21 0;

to ensure positivity, the numerator must have the
same sign as the denominator

Two-Commodity Market Model

Numerical Example

Suppose that the demand and supply functions are:

Qd1 = 10 2P1 + P2
Qs1 = -2 + 3P1
Qd2 = 15 + P1 P2
Qs2 = -1 + 2P2
By substitution, we have
5P1 P2 = 12
-P1 + 3P2 = 16
Which are two linear equations.
P1* = 52/14, P2* = 92/14, Q1* = 64/7 and Q2* = 85/7

General Market Equilibrium.

Similarly, for the n-commodity market model,

when demand and supply functions are linear in
prices, we can have n linear equations
In the above, we assume that an equal number
of equations and unknowns has a unique
solution
However, some very simple examples should
convince us that an equal number of equations
and unknowns does not necessarily guarantee
the existence of unique solution

Continue...

For example, for the two linear equations,

x+y=8
x+y=9
we can easily see there is no solution
2x + y = 12
4x + 2Y = 24
A system has an infinite number of solutions
These two equations are functionally dependent,
which means that one can be derived from the other

Continue..

Consequently, one equation is redundant

and may be dropped from the system. Any
pair (x, y) is the solution as long as (x, y)
satisfied y = 12 x.

Consider the case of more equations than

unknown. In general, there is no solution.

Continue

However, when the number of unknowns equals the

number of functional independent equations, the
solution exists and is unique.
Example
2x + 3y = 58
y = 18
x + y = 20
Thus, for simultaneous-equation model, we need
systematic methods of testing the existence of a
unique (or determine) solution (following chapters)

Equilibrium in National-Income
Analysis

The equilibrium analysis can be also applied to other

areas of economics
Keynesian national-income model
Y = C + I0 + G0
(equilibrium condition)
C = a + bY
(consumption function)
Y = national income
C = consumption expenditure
I0 = investment
G0 = government expenditure

Continue..

Solving these two linear equations, we obtain

the equilibrium national income and
consumption function:

a I0 G 0
Y
1- b

a b(I0 G 0 )
C
1- b

Graphical Interpretation

Candidates are given graphs and asked to

identify/describe the economic relationship
Explain or show how an economic
relationship can be modeled with
mathematics
Draw the graph of a mathematical function

Partial Market Equilibrium A Linear

Model..
Qd, Qs
a

Qd=a-bP

Qs=-c+dP

(demand)

(supply)

Q*

0
-c

P*

The slope of Qd=-b, the vertical intercept = a

The slope of Qs=d, the vertical intercept = -c

The Graphical Solution

Q
4

Qs= 4P - 1

(1,3)

2
Qd = 4 P2

-2

-1

0
-1

Total Revenue Curve

Graphical Interpretation
Question: Describe the relationship
between total revenue and sales
(output)?
What mathematical function would
you use to model this relationship?

Continue..

Solution : This is a quadratic function

Revenue is an increasing function up to
output q and decreasing thereafter
Graph is an inverted parabola we know
that the quadratic term must be negative
The general form is:

TR(q) = a + bq - cq2

Calculus Review

Derivatives are often used in economics

because economists are interested in
how marginal changes in one variable
affect another
partial derivatives incorporate the ceteris
paribus assumption used in most economic
models

Calculus Review

Rules for Finding Derivatives

db
1. If b is a constant,then
0
dx
d [bf ( x )]
2. If b is a constant,then
bf ' ( x )
dx
dx b
b 1
3. If b is constant, then
bx
dx
d ln x 1
4.

dx
x

Calculus Review..

Rules for Finding Derivatives

da x
x
5.
a ln a for any constant a
dx
a special case of this rule is dex/dx = ex

Calculus Review..

Rules for Finding Derivatives

Suppose that f(x) and g(x) are two
functions of x and f(x) and g(x) exist
Then
d [f ( x ) g ( x )]
6.
f '(x) g'(x)
dx
d [f ( x ) g ( x )]
7.
f ( x )g ' ( x ) f ' ( x )g ( x )
dx

Calculus Review..

Rules for Finding Derivatives

f (x)
d

g ( x ) f ' ( x )g ( x ) f ( x )g ' ( x )

8.

dx
[g ( x )] 2
provided that g ( x ) 0

Calculus Review..

Rules for Finding Derivatives

If y = f(x) and x = g(z) and if both f(x) and
g(x) exist, then:
dy dy dx df dg
9.

dz dx dz dx dz

This is called the chain rule. The chain rule

allows us to study how one variable (z)
affects another variable (y) through its
influence on some intermediate variable (x)

Partial Derivatives

The partial derivative of y with respect

to x1 is denoted by
y
f
or
or fx or f1
x1
x1
1

It is understood that in calculating the

partial derivative, all of the other xs are
held constant

Partial Derivatives.

Calculating Partial Derivatives

1. If y f ( x1, x 2 ) ax12 bx1 x 2 cx22 , then
f
f1 2ax1 bx2
x1
f
f2 bx1 2cx2
x 2

and

Partial Derivatives.
3. If y f (x1, x2 ) a ln x1 b ln x2 , then
f
a
f
b
f1
and
f2
x1
x1
x2
x2

Partial Derivatives.

We must be concerned with how variables

are measured
if q represents the quantity of gasoline
demanded (measured in billions of gallons)
and p represents the price in dollars per
gallon, then q/p will measure the change
in demand (in billiions of gallons per year)
for a dollar per gallon change in price