MATHEMATICS FOR

ECONOMICS AND FINANCE

MICHAEL HARRISON AND PATRICK WALDRON
Mathematics for
Economics and Finance

The aim of this book is to bring students of economics and finance who have only an
introductory background in mathematics up to a quite advanced level in the subject, thus
preparing them for the core mathematical demands of econometrics, economic theory, quan-
titative finance and mathematical economics, which they are likely to encounter in their
final-year courses and beyond. The level of the book will also be useful for those embarking
on the first year of their graduate studies in Business, Economics or Finance.
The book also serves as an introduction to quantitative economics and finance for math-
ematics students at undergraduate level and above. In recent years, mathematics graduates
have been increasingly expected to have skills in practical subjects such as economics and
finance, just as economics graduates have been expected to have an increasingly strong
grounding in mathematics.
The authors avoid the pitfalls of many texts that become too theoretical. The use of math-
ematical methods in the real world is never lost sight of and quantitative analysis is brought
to bear on a variety of topics including foreign exchange rates and other macro level issues.
This makes for a comprehensive volume which should be particularly useful for advanced
undergraduates, for postgraduates interested in quantitative economics and finance, and for
practitioners in these fields.
Michael Harrison is Emeritus Senior Lecturer and Fellow of Trinity College Dublin,
where he lectured from 1969 to 2009. He currently lectures in the School of Economics
at University College Dublin.
Patrick Waldron is a graduate of the Universities of Dublin and Pennsylvania and a
Research Associate in the Department of Economics at Trinity College Dublin.

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February 12, 2011 11:1 Pinched Crown A Page-ii HarrWald
Mathematics for
Economics and Finance

Michael Harrison and

Patrick Waldron

February 12, 2011 11:1 Pinched Crown A Page-iii HarrWald

First published 2011
by Routledge
2 Park Square, Milton Park, Abingdon, Oxon, OX14 4RN
Simultaneously published in the USA and Canada
by Routledge
711 Third Avenue, New York, NY 10017
Routledge is an imprint of the Taylor & Francis Group, an informa business

c 2011 Michael Harrison and Patrick Waldron
Typeset in Times New Roman by Sunrise Setting Ltd, Devon, United Kingdom
Printed and bound in Great Britain by TJ International Ltd, Padstow, Cornwall
All rights reserved. No part of this book may be reprinted or reproduced
or utilized in any form or by any electronic, mechanical, or other means,
now known or hereafter invented, including photocopying and recording,
or in any information storage or retrieval system, without permission in
writing from the publishers.
British Library Cataloguing in Publication Data
A catalogue record for this book is available from the British Library
Library of Congress Cataloging in Publication Data
A catalog record for this book has been requested
ISBN 978-0-415-57303-0 (hbk)
ISBN 978-0-415-57304-7 (pbk)
ISBN 978-0-203-82999-8 (ebk)

February 12, 2011 11:1 Pinched Crown A Page-iv HarrWald

Contents

List of figures ix
List of tables xi
Foreword xiii
Preface xv
Acknowledgements xvii
List of abbreviations xviii
Notation and preliminaries xix

Part I
MATHEMATICS

Introduction 3
1 Systems of linear equations and matrices 5
1.1 Introduction 5
1.2 Linear equations and examples 5
1.3 Matrix operations 11
1.4 Rules of matrix algebra 14
1.5 Some special types of matrix and associated rules 15

2 Determinants 30
2.1 Introduction 30
2.2 Preliminaries 30
2.3 Definition and properties 31
2.4 Co-factor expansions of determinants 34
2.5 Solution of systems of equations 39

3 Eigenvalues and eigenvectors 53

3.1 Introduction 53
3.2 Definitions and illustration 53
3.3 Computation 54
3.4 Unit eigenvalues 58
3.5 Similar matrices 59
3.6 Diagonalization 59

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vi Contents
4 Conic sections, quadratic forms and definite matrices 71
4.1 Introduction 71
4.2 Conic sections 71
4.3 Quadratic forms 76
4.4 Definite matrices 77

5 Vectors and vector spaces 88

5.1 Introduction 88
5.2 Vectors in 2-space and 3-space 88
5.3 n-Dimensional Euclidean vector spaces 100
5.4 General vector spaces 101

6 Linear transformations 128

6.1 Introduction 128
6.2 Definitions and illustrations 128
6.3 Properties of linear transformations 131
6.4 Linear transformations from Rn to Rm 137
6.5 Matrices of linear transformations 138

7 Foundations for vector calculus 143

7.1 Introduction 143
7.2 Affine combinations, sets, hulls and functions 143
7.3 Convex combinations, sets, hulls and functions 146
7.4 Subsets of n-dimensional spaces 148
7.5 Basic topology 154
7.6 Supporting and separating hyperplane theorems 157
7.7 Visualizing functions of several variables 158
7.8 Limits and continuity 159
7.9 Fundamental theorem of calculus 162

8 Difference equations 167

8.1 Introduction 167
8.2 Definitions and classifications 167
8.3 Linear, first-order difference equations 172
8.4 Linear, autonomous, higher-order difference equations 181
8.5 Systems of linear difference equations 189

9 Vector calculus 202

9.1 Introduction 202
9.2 Partial and total derivatives 202
9.3 Chain rule and product rule 207
9.4 Elasticities 211
9.5 Directional derivatives and tangent hyperplanes 213
9.6 Taylor’s theorem: deterministic version 217
9.7 Multiple integration 224
9.8 Implicit function theorem 236

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 Contents vii
10 Convexity and optimization 244
10.1 Introduction 244
10.2 Convexity and concavity 244
10.3 Unconstrained optimization 257
10.4 Equality-constrained optimization 261
10.5 Inequality-constrained optimization 270
10.6 Duality 278

Part II
APPLICATIONS

Introduction 287
11 Macroeconomic applications 289
11.1 Introduction 289
11.2 Dynamic linear macroeconomic models 289
11.3 Input–output analysis 294

12 Single-period choice under certainty 299

12.1 Introduction 299
12.2 Definitions 299
12.3 Axioms 301
12.4 The consumer’s problem and its dual 307
12.5 General equilibrium theory 316
12.6 Welfare theorems 323

13 Probability theory 334

13.1 Introduction 334
13.2 Sample spaces and random variables 334
13.3 Applications 338
13.4 Vector spaces of random variables 343
13.5 Random vectors 345
13.6 Expectations and moments 347
13.7 Multivariate normal distribution 351
13.8 Estimation and forecasting 354
13.9 Taylor’s theorem: stochastic version 355
13.10 Jensen’s inequality 356

14 Quadratic programming and econometric applications 371

14.1 Introduction 371
14.2 Algebra and geometry of ordinary least squares 371
14.3 Canonical quadratic programming problem 377
14.4 Stochastic difference equations 382

15 Multi-period choice under certainty 394

15.1 Introduction 394
15.2 Measuring rates of return 394

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viii Contents
15.3 Multi-period general equilibrium 400
15.4 Term structure of interest rates 401

16 Single-period choice under uncertainty 415

16.1 Introduction 415
16.2 Motivation 415
16.3 Pricing state-contingent claims 416
16.4 The expected-utility paradigm 423
16.5 Risk aversion 429
16.6 Arbitrage, risk neutrality and the efficient markets hypothesis 434
16.7 Uncovered interest rate parity: Siegel’s paradox revisited 436
16.8 Mean–variance paradigm 440
16.9 Other non-expected-utility approaches 442
17 Portfolio theory 448
17.1 Introduction 448
17.2 Preliminaries 448
17.3 Single-period portfolio choice problem 450
17.4 Mathematics of the portfolio frontier 457
17.5 Market equilibrium and the capital asset pricing model 478
17.6 Multi-currency considerations 487

Notes 493
References 501
Index 505

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List of figures

4.1 Parabola with focus (a, 0) and directrix x = −a 72

4.2 Ellipse with foci (±a, 0) and directrices x = ±a/ 73
4.3 Hyperbola with foci (±a, 0) and directrices x = ±a/ 75
5.1 Vectors in 2-space 89
5.2 Addition of vectors 89
5.3 Multiplication of vectors by a constant and subtraction of vectors 90
5.4 Vector coordinates 91
5.5 Vector addition with coordinates 91
5.6 A translation 92
5.7 Another translation 92
5.8 A 3-vector 93
5.9 Distance between vectors 94
5.10 Angles between vectors 94
5.11 Orthogonal projection 97
5.12 Subspace of R2 103
5.13 Linearly dependent and linearly independent vectors 107
5.14 Orthogonal projection in R3 115
5.15 Gram–Schmidt process in R2 116
5.16 Gram–Schmidt process in R3 117
5.17 Change of basis using rectangular coordinates 118
5.18 Change of basis using non-rectangular coordinates 119
5.19 Orthogonal transformation 123
7.1 The hyperplane through x∗ with normal p 149
7.2 Unit or standard simplex in R2 150
7.3 Unit or standard simplex in R3 151
7.4 Upper and lower hemi-continuity of correspondences 163
7.5 Motivation for the fundamental theorem of calculus, part (a) 164
7.6 Motivation for the fundamental theorem of calculus, part (b) 164
8.1 Divergent time path of yt = 1 + 2yt−1 from y1 = 1 177
8.2 Divergent time path of yt = 1 − 2yt−1 from y1 = 1 178
8.3 Convergent time path of yt = 1 + 12 yt−1 from y1 = 1 to y ∗ = 2 178
8.4 Convergent time path of yt = 1 − 12 yt−1 from y1 = 1 to y ∗ = 23 179
9.1 Tangent hyperplane to the graph of a function of one variable 215
9.2 Indifference map and two cross-sections of the graph of the function
f : R2 → R: (x, y) → x 2 + y 2 216

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x List of figures
9.3 (a) Intermediate value theorem, (b) Rolle’s theorem and (c) mean value
theorem 218
9.4 Taylor approximation 220
10.1 Illustration of the proof that (10.12) is a necessary condition for concavity 249
10.2 Illustration of the proof that (10.12) is a sufficient condition for concavity 250
10.3 Constrained optimization with two variables and one constraint 265
10.4 Interpretation of Lagrange and Kuhn–Tucker multipliers 272
12.1 Continuous preferences when N = 2 302
12.2 Lexicographic preferences when N = 2 303
12.3 Signs in the Slutsky equation 315
12.4 Edgeworth box 324
13.1 Motivation for Jensen’s inequality 358
14.1 Geometry of ordinary least squares regression in R3 377
15.1 The relationship between clean and dirty bond prices and calendar time,
assuming a flat and stable yield curve 404
16.1 Concave expected utility function of a risk-averse individual 430
16.2 Edgeworth box diagram for Example 16.7 438
17.1 Portfolio frontier in R3 458
17.2 The portfolio decomposition 464
17.3 Portfolio frontier in mean–variance space: risky assets only 471
17.4 Portfolio frontier in mean–standard deviation space: risky assets only 472
17.5 Portfolio frontier in mean–standard deviation space: risk-free and
risky assets 476
17.6 Portfolio frontier in mean–variance space: risk-free and risky assets 478
17.7 Mean–standard deviation frontier with margin constraints on borrowing 479
17.8 Mean–standard deviation frontier with different borrowing and
lending rates 480
17.9 Capital market line 483
17.10 Security market line 483

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List of tables

2.1 Classification of permutations of the first three integers 31

10.1 Hierarchy of concave and related functions 252
10.2 Sign conditions for inequality-constrained optimization 273
12.1 The consumer’s problem and its dual 311
13.1 Probability of winning (π ) and size of jackpot (J ) for a Lotto-style draw
with n balls 339
14.1 Sample data for regressions 391
15.1 The effect of an interest rate of 10% per annum at different frequencies of
compounding 396
16.1 Payoffs for call options on aggregate consumption 422
17.1 Notation for the portfolio choice problem 449

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February 12, 2011 11:1 Pinched Crown A Page-xii HarrWald
Foreword

This book has two parts, the first labelled MATHEMATICS, the second APPLICATIONS.
Specifically, the applications are to economics and finance. In their Preface, the authors,
Michael Harrison and Patrick Waldron, advise that the book is written for “advanced under-
graduates of either mathematics or economics”. However, the advanced undergraduate in
economics who does not have a substantial exposure to mathematics will find Part I of this
book challenging. The advanced undergraduate in mathematics, on the other hand, should
find this book quite suitable for: reviewing branches of mathematics used in theoretical eco-
nomics and finance; learning some aspects of these branches of mathematics, perhaps not
covered in their mathematics courses, but useful in economic and financial applications; and
then being presented with a comprehensive survey of economic and financial theory that
draws upon this mathematics.
The advanced undergraduate in economics can use Part I as a checklist as to what mathe-
matical background is expected in the applications in Part II. If the student has enough
background to work through the presentation of the subject, then Part I is sufficient in that
area. But as the authors note, their “development is often rather rapid”. If the student finds
the material too compact in an area, he or she can seek a suitable alternative text, which
explains the subject less rapidly, then return to the Harrison and Waldron presentation.
In general, then, the two parts of this volume represent, first, an orderly and comprehensive
assemblage of the mathematics needed for a great deal of important economic and financial
theory; and, second, a presentation of the theory itself. The diligent student who makes his
or her way through this volume will have gained a great deal of mathematical power, and
knowledge of much economic and financial theory.
Any volume must have its inclusions and exclusions. One topic that has quite limited space
in this volume is optimization subject to inequality constraints, such as the problem of trac-
ing out mean–variance efficient sets subject to any system of linear equality, and/or (weak)
inequality constraints in which some or all variables may be required to be non-negative.
Markowitz and Todd (2000) is devoted to this topic. If the reader decides to read the latter
after reading the present book, he or she will find that the present book’s extensive cover-
age of vectors and matrices will be a big help. More generally, the mathematics background
presented here will allow the student to move comfortably in the area of “computational
finance” as well as financial theory.
Harry M. Markowitz
San Diego, California
October 2010

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February 12, 2011 11:1 Pinched Crown A Page-xiv HarrWald
Preface

This book provides a course in intermediate mathematics for students of economics and
finance. It originates from a series of lectures given to third-year undergraduates in the
Faculty of Business, Economic and Social Studies and the School of Mathematics at
the University of Dublin, Trinity College. The prime aim is to prepare students for some of
the mathematical demands of courses in econometrics, economic theory, quantitative finance
and mathematical economics, which they may encounter in their final-year programmes. The
presentation may also be useful to those embarking on the first year of their postgraduate
studies. In addition, it serves as an introduction to economics and finance for mathematics
students.
In recent decades, mathematics graduates have been increasingly expected to have skills
in practical subjects such as economics and finance, while economics graduates have been
expected to have an increasingly strong grounding in mathematics. The growing need for
those working in economics and finance to have a strong foundation in mathematics has been
highlighted by such layman’s texts as Ridley (1993), Kelly (1994), Davidson (1996), Bass
(1999), Poundstone (2005) and Bernstein (2007). The present book is, in part, a response
to these trends, offering advanced undergraduates of either mathematics or economics the
opportunity to branch into the other subject.
There are many good texts on mathematics for economists at the introductory and
advanced levels. However, there appears to be a lack of material at what we call the inter-
mediate level, a level that takes much for granted and is concerned with proofs as well as
rigorous applications, but that does not seek the abstraction and rigour of the sort of treat-
ments that may be found in pure mathematics textbooks. Indeed, we have been unable to
find a single book that covers the material herein at the level and in the way that our teaching
required. Hence the present volume.
The book does not aim to be comprehensive. Rather, it contains material that we feel is
particularly important to have covered before final-year work begins, and that can be covered
comfortably in a standard academic year of three terms or two semesters. Other more special-
ized topics can be covered later, perhaps as part of a student’s final year, as is possible in our
programme. Thus we focus in Part I on the mathematics of linear algebra, difference equa-
tions, vector calculus and optimization. The mathematical treatment of these topics is quite
detailed, but numerous worked examples are also provided. Part II of the book is devoted
to a selection of applications from economics and finance. These include deterministic and
stochastic dynamic macroeconomic models, input–output analysis, some probability, statis-
tics, quadratic programming and econometric methodology, single- and multi-period choice
under certainty, including general equilibrium and the term structure of interest rates, choice
under uncertainty, and topics from portfolio theory, such as the capital asset pricing model.

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xvi Preface
It is assumed that most readers will have already completed good introductory courses
in mathematics, economics and/or finance. The section on notation and preliminaries
(pp. xix–xxiii) lists many of the basic ideas from these areas with which it is assumed that
most readers will have some familiarity.
These are not rigid prerequisites, as the material presented is reasonably self-contained.
However, the development is often rather rapid and the discussion fairly advanced at times.
Therefore, most students, we feel, will find the book quite challenging but, we hope, cor-
respondingly rewarding as the contents are mastered. Those who have solid preparations in
mathematics, economics and finance should not be lulled into a false sense of security by
the familiarity of the early material in some of the chapters; and those who have not taken
such preliminary courses should be prepared for an amount of additional background reading
from time to time. The exercises at the end of each chapter provide additional insight into
some of the proofs, and practice in the application of the mathematical methods discussed.
A solution manual will be available.
Economics may be defined as the scientific study of optimal decision-making under
resource constraints and uncertainty. It is less about forecasting – however much that may
be the popular perception – than it is about reacting optimally to the best available fore-
casts. Macroeconomics is concerned with the study of the economy as a whole. It seeks to
explain such things as the determinants of the level of aggregate output (national income),
the rate of growth of aggregate output, the general level of prices, and inflation, i.e. the
rate of growth of prices. Microeconomics is fundamentally about the allocation of wealth
or expenditure among different goods or services, which via the interaction of consumers
and producers determines relative prices. Basic finance, or financial economics, is about the
allocation of expenditure across two or more time periods, which gives the term structure of
interest rates. A further problem in finance is the allocation of expenditure across (a finite
number or a continuum of) states of nature, which yields random variables called rates of
return on risky assets. Clearly, we might try to combine the concerns of microeconomics and
finance to produce a rather complex problem, the solution of which points up the crucial role
of mathematics.
It is probably fair to say that economics, particularly financial economics, has in recent
years become as important an application of mathematics as theoretical physics. Some
would say it is just another branch of applied mathematics. In mathematics departments that
have traditionally taught linear algebra courses with illustrations from physics but have also
followed the modern trend of offering joint programmes with economics or finance depart-
ments, the present work could be used as the basis for a general course in linear algebra for
all students. The successful application of techniques from both mathematics and physics
to the study of economics and finance has been outlined in the popular literature by authors
such as those listed at the start of this preface. It is hoped that this book goes some way to
providing students with the wherewithal to do successful mathematical work in economics
and finance.
Michael Harrison and Patrick Waldron
School of Economics, University College Dublin
Dublin 4, Ireland
and
Department of Economics, Trinity College Dublin
Dublin 2, Ireland

November 2010

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Acknowledgements

We would each like to acknowledge our mathematics and quantitative economics and finance
teachers at (for Harrison) the University of Lancaster, particularly Alan Airth, Anna Kout-
soyiannis and Tin Nguyen, and (for Waldron) Trinity College Dublin and the University of
Pennsylvania, particularly Adrian Raftery, David Simms, John Woods, Angel de la Fuente,
Bob Litzenberger and Krishna Ramaswamy.
Our thanks are also due to several cohorts of undergraduate students at Trinity College
Dublin, some of whom drew attention to various typographical errors in previous versions
of parts of the book used as course notes (they know who they are); and to Vahagn Galstyan
for a number of useful comments on some of the linear algebra chapters.
We are grateful to three anonymous reviewers who read an earlier version of our
manuscript and provided many helpful comments and suggestions; in particular to the
reviewer whose detailed observations have greatly improved our treatment of Stein’s lemma
(Theorem 13.7.1) and Siegel’s paradox (Theorem 13.10.2). We remain entirely responsible
for the current version of the book, of course.
For biographical notes not otherwise attributed we have drawn on the official website
of the Nobel Prize (http://nobelprize.org/nobel_prizes/economics/laureates); the MacTutor
History of Mathematics archive at the University of St. Andrews (http://www-history.mcs.st-
andrews.ac.uk/); the Earliest Known Uses of Some of the Words of Mathematics web-
site (http://jeff560.tripod.com/mathword.html) and the Mathematics Genealogy Project
(http://genealogy.math.ndsu.nodak.edu/).
We thank those at Routledge who have helped to bring this project to fruition, especially
Simon Holt, Robert Langham, Lisa Salonen, Emily Senior and Thomas Sutton. We also
thank Geoff Amor, our copyeditor, Gareth Toye, our cover designer, and Jessica Stock and
her team at Sunrise Setting Ltd.
We are indebted to Donald Knuth for the TEX typesetting system and to other members
of the worldwide TEX and LATEX community, especially to Leslie Lamport for LATEX, to Till
Tantau for the TikZ and PGF packages, and to Christian Feuersänger for PGFPLOTS.
We are especially grateful to Professor Harry M. Markowitz, Nobel laureate, for kindly
contributing the Foreword.
Last, but not least, thanks to June Harrison for all the dinners.

February 12, 2011 11:1 Pinched Crown A Page-xvii HarrWald

List of abbreviations

AR autoregressive
BLUE best linear unbiased estimator
CAPM capital asset pricing model
CARA constant absolute risk aversion
cdf cumulative distribution function
CES constant elasticity of substitution
CRRA constant relative risk aversion
DARA decreasing absolute risk aversion
DCF discounted cash flow
DRRA decreasing relative risk aversion
EMH efficient markets hypothesis
EU European Union
EUR euro
GBP pound sterling
GLS generalized least squares
HARA hyperbolic absolute risk aversion
I(0) integrated to order zero
IARA increasing absolute risk aversion
iff if and only if
iid independent and identically distributed
IRR internal rate of return
IRRA increasing relative risk aversion
IS investment and saving equilibrium
ISO International Organization for Standardization
LM liquidity preference and money supply equilibrium
m million
MVN multivariate normal
NPV net present value
OLS ordinary least squares
pdf probability density function
RLS restricted least squares
rv random variable or random vector
s.t. so that or subject to or such that
UK United Kingdom
US(A) United States (of America)
VAR vector autoregressive
VNM von Neumann–Morgenstern
WLS weighted least squares

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Notation and preliminaries

We assume familiarity with basic mathematics from Pythagoras of Samos (c.569–c.475BC)

and his famous theorem onwards. Basic knowledge of probability and statistics, as well
as micro- and macroeconomics and especially financial economics, would also be advan-
tageous. The material on probability and statistics in Chapter 13 aims to be completely
self-contained, but will represent quite a steep learning curve for readers who do not have
some preliminary training in these areas. Similarly, some prior exposure to economics
and finance will enable readers to proceed more rapidly through the other applications
chapters.
For the sake of clarity, we gather together in these preliminary pages some of the more
important mathematical and statistical concepts with which we assume prior familiarity, con-
centrating especially on those for which notational conventions unfortunately vary from one
textbook to another.
Mathematical and technical terms appear in boldface where they are first introduced or
defined; the corresponding page number in the index is also in boldface.
Economics students who are new to formal mathematics should be aware of common pit-
falls of flawed logic, in particular with the importance of presenting the parts of a definition
in the correct order and with the process of proving a theorem by arguing from the assump-
tions to the conclusions. Familiarity with various approaches to proofs is assumed, though
the principles of proof by contradiction, proof by contrapositive and proof by induction are
described when these methods are first used.1 Similarly, mathematics students, who may
be familiar with many of the mathematics topics covered, should think about the nature,
subject matter and scientific methodology of economics before starting to work through the
book.
Readers should be familiar with the expressions “such that” and “subject to” (both often
abbreviated “s.t.”) and “if and only if” (abbreviated as “iff”), and also with their meanings
and use. The symbol ∀ is mathematical shorthand for “for all” and ∃ is mathematical short-
hand for “there exists”. The expression iff signifies a necessary and sufficient condition, or
equivalence. Briefly, Q is necessary for P if P implies Q; and similarly P is sufficient for
Q if P implies Q. Furthermore, P implies Q if and only if the contrapositive, “not Q”
implies “not P”, is true. We shall sometimes use an alternative symbol for a necessary and
sufficient condition, namely ⇔, which signifies that the truth of the left-hand side implies
the truth of the right-hand side and vice versa, and also that the falsity of the left-hand side
implies the falsity of the right-hand side and vice versa. Other logical symbols used are ⇒,
which means “implies”, and ⇐, which means “is implied by” or “follows from”.

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xx Notation and preliminaries
We will make frequent use of the identity symbol, n ≡, particularly
 in definitions; of ≈,
which denotes “approximately equal”; and of i=1 xi and nj=1 x j to denote the sum of,
and the product of, n numbers x1 , x2 , . . . , xn , respectively; i.e.


n
xi = x1 + x2 + · · · + xn
i=1

and


n
x j = x1 × x2 × · · · × xn
j=1

When
 the upper and lower limits are clear from the context, we occasionally just write

i or j.
The sum of the first n terms of a geometric series or geometric progression with first
term a and common ratio φ is
⎧
⎨ a(1 − φ ) = a(φ − 1)
n n

n
if φ = 1
aφ i−1
= a + aφ + aφ + · · · + aφ
2 n−1
= 1−φ φ −1
⎩
i=1 n×a if φ = 1

If −1 < φ < 1, then the sum to infinity of the series is a/(1 − φ). If φ ≤ −1 (and a = 0),
then the sum oscillates without converging as n → ∞. If φ ≥ 1, then the sum goes to ±∞ as
n → ∞, depending on the sign of a.
The expression n!, referred to as n factorial, denotes n the product of the integers from 1
to n, inclusive, and 0! is defined to be unity; i.e. n! ≡ i=1 i = 1 × 2 × · · · × n and 0! ≡ 1.
Readers are assumed to be familiar with basic set notation and Venn diagrams.2 If X is the
universal set and B ⊆ X , i.e. B is a subset of X , then X \ B denotes the complement of B
or X \ B ≡ {x ∈ X : x ∈ / B}. We say that sets B and C are disjoint if B ∩ C = { }, i.e. if the
intersection of B and C is the null set or empty set. The Cartesian product of the n sets
X 1 , X 2 , . . . , X n is the set of ordered n-tuples, (x1 , x2 , . . . , xn ), where the ith component, xi ,
of each n-tuple is an element of the ith set, X i .
We assume knowledge of the sets and use of natural numbers, N, integers, Z, and real and
complex numbers, R and C. Throughout the book, italic letters such as x denote specific
numbers in R. The Cartesian product R × R × · · · × R, denoted by Rn = {(x1 , x2 , . . . , xn ) |
x1 , x2 , . . . , xn ∈ R}, is called (Euclidean) n-space. Points in Rn (and sometimes in an arbi-
trary vector or metric space X ) are denoted by lower-case boldface letters, such as x, while an
upper-case boldface letter, such as X, will generally denote a matrix. Any x ∈ Rn can also be
written as the n-tuple (x1 , x2 , . . . , xn ), where x1 , x2 , . . . , xn are referred to as the (Cartesian)
coordinates3 of x. A tilde over a symbol will be used to denote a random variable (e.g. x̃)
or a random vector (e.g. x̃). The notation Rn+ ≡ {x ∈ Rn : xi ≥ 0, i = 1, 2, . . . , n} denotes the
non-negative orthant of Rn , and Rn++ ≡ {x ∈ Rn : xi > 0, i = 1, . . . , n} denotes the positive
orthant.
The interval [a, b] ≡ {x ∈ R: a ≤ x ≤ b} is called a closed interval and (a, b) ≡ {x ∈ R: a <
x < b} is called an open interval. The context will generally allow readers to distinguish
between the 2-tuple (a, b) ∈ R2 and the open interval (a, b) ⊂ R.

February 12, 2011 11:1 Pinched Crown A Page-xx HarrWald

 Notation and preliminaries xxi
The most important result on complex numbers relied on is de Moivre’s theorem,4
which allows us to write √ (cos θ + i sin θ )t as cos tθ + i sin tθ and (cos θ − i sin θ )t as
cos tθ − i sin tθ , where i ≡ −1.
Recall also that the conjugate of the complex number z = a + ib is z̄ = a − ib, and that the
conjugate of a sum is the sum of the conjugates and the conjugate of a product
√ is the product
√
of the conjugates. Also, the modulus of z is the positive square root |z| = a 2 + b2 = z z̄.
The fundamental theorem of algebra states that a polynomial of degree n with real (or
complex) coefficients has exactly n, possibly complex, roots, with the complex roots coming
in conjugate pairs and allowing for the possibility of several roots having the same value.
The following definitions relating to functions and relations are important.

D EFINITION 0.0.1 A function (or map or mapping) f : X → Y : x → f (x) from a domain

X to a co-domain Y is a rule that assigns to each element of the set X a unique element f (x)
of the set Y called the image of x.

D EFINITION 0.0.2 If f : X → Y and g: Y → Z , then the composition of functions or

composite function or function of a function g ◦ f : X → Z is defined by g ◦ f (x) =
g( f (x)).

D EFINITION 0.0.3 A correspondence f : X → Y from a domain X to a co-domain Y is a

rule that assigns to each element of X a non-empty subset of Y .

D EFINITION 0.0.4 The range of the function f : X → Y is the set f (X ) = { f (x) ∈ Y : x ∈ X }.

D EFINITION 0.0.5 The function f : X → Y is injective (one-to-one) if and only if f (x) =

f (x  ) ⇒ x = x  .

D EFINITION 0.0.6 The function f : X → Y is surjective (onto) if and only if f (X ) = Y.

D EFINITION 0.0.7 The function f : X → Y is bijective (or invertible) if and only if it is

both injective and surjective.
An invertible function f : X → Y has a well-defined inverse function f −1 : Y → X with
f ( f −1 (y)) = y for all y ∈ Y and f −1 ( f (x)) = x for all x ∈ X.
For any function f : X → Y , if A ⊆ X , then

f (A) ≡ { f (x): x ∈ A} ⊆ Y

and if B ⊆ Y , the notation f −1 is also used to denote

f −1 (B) ≡ {x ∈ X : f (x) ∈ B} ⊆ X

If f is invertible and y ∈ Y , then f −1 ({y}) = { f −1 (y)}. If f is not invertible, then

f −1 ({y}) can be empty or have more than one element, but f −1 : f (X ) → X still defines
a correspondence.

D EFINITION 0.0.8 If f : X → Y is a differentiable function (X, Y ⊆ R), then f  : X → R

denotes the derivative of f , i.e. f  (x) is the derivative of f at x, also occasionally denoted
df
d x (x) or dy/d x if it is known that y = f (x).

February 12, 2011 11:1 Pinched Crown A Page-xxi HarrWald

 xxii Notation and preliminaries
D EFINITION 0.0.9 The function f : X → Y is homogeneous of degree k (k ∈ R) if and only
if f (θ x) = θ k f (x) for all θ ∈ R.
When k = 1 and f is homogeneous of degree one, the function is sometimes called
linearly homogeneous.

D EFINITION 0.0.10 A binary relation R on the set X is a subset R of X × X or a collection

of pairs (x, y) where x ∈ X and y ∈ X .

If (x, y) ∈ R, we usually write x Ry.5

D EFINITION 0.0.11 The following properties of a binary relation R on a set X are often of
interest:

(a) A relation R is reflexive if and only if x Rx for all x ∈ X.

(b) A relation R is symmetric if and only if x Ry ⇒ y Rx.
(c) A relation R is transitive if and only if x Ry and y Rz ⇒ x Rz.
(d) A relation R is complete if and only if, for all x, y ∈ X , either x Ry or y Rx (or both); in
other words, a complete relation orders the whole set.
(e) An equivalence relation is a relation that is reflexive, symmetric and transitive. An
equivalence relation partitions X in a natural way into disjoint equivalence classes.

In consumer theory, we will consider the weak preference relation , where x  y means
that either the consumption bundle x is preferred to y or the consumer is indifferent between
the two, i.e. that x is at least as good as y.
We expect readers to have a sound knowledge of basic calculus, including the taking
of limits and single-variable differentiation and integration. We assume familiarity with the
definition of a derivative in terms of a limit, and with the single-variable versions of the chain
rule and the product rule. We also assume knowledge of l’Hôpital’s rule,6 which states that,
if the limits of the numerator and denominator in a fraction are both zero or both infinite, then
the limit of the original ratio equals the limit of the ratio of the derivative of the numerator
to the derivative of the denominator.
Familiarity with integration by substitution and integration by parts and with the standard
rules for differentiation and integration of scalar-valued functions, in particular polynomial
and trigonometric functions, is assumed.7
Among the trigonometric identities used later are

• the cosine rule

a 2 = b2 + c2 − 2bc cos A

• the double-angle formula

cos 2A = 2 cos2 A − 1

• the fundamental identity

cos2 A + sin2 A = 1

February 12, 2011 11:1 Pinched Crown A Page-xxii HarrWald

 Notation and preliminaries xxiii
An ordered arrangement of r objects from a set of n objects is called a permutation, and
the number of different permutations of r objects that can be chosen from a set of n objects,
denoted n Pr , is given by

n!
n
Pr =
(n − r )!

A selection of r objects from a set of n objects without regard for their order is called a
combination, and the number of different combinations of r objects that can be chosen from
a set of n objects, denoted n Cr , is given by
nP n!
r
n
Cr = =
r! (n − r )! r !

We expect students to be comfortable with the properties of the exponential function

e: R → R++ : x → e x , where e ≈ 2.7182 . . .; and with its inverse, the natural logarithm func-
tion ln: R++ → R: x → ln x; and also with the use of logarithms to any base. In particular,
we rely on the fact that

r n
lim 1+ = er
n→∞ n

This is sometimes used as the definition of e, but others8 prefer to start with

rj ∞
r2 r3
er ≡ 1 + r + + +···=
2! 3! j!
j=0

The notation |X | denotes the number of elements in the set X , or the cardinality of X ,
while |z| denotes the modulus of the (complex) number z and |X| denotes the determinant
of the matrix X, more often denoted det(X). The modulus is just the absolute value when
z is real rather than complex. There is obviously some potential for confusion from use of
the same symbol for three different concepts, but the context and notation within the symbol
will almost always make the distinctions clear.
The collection of all possible subsets of the set X , or the power set of X , is denoted by 2 X .
Note that |2 X | = 2|X | .
The least upper bound or supremum of a set, X , of real numbers, denoted sup(X ), is the
smallest real number that is greater than or equal to every number in the set. For example,
sup{1, 2, 3, 4} = 4 and sup{x ∈ Rn : 0 < x < 1} = 1. The second of these examples indicates
that the supremum is not necessarily the maximum real number in the set.
The greatest lower bound or infimum of a set, X , of real numbers, denoted inf(X ), is
the largest real number that is less than or equal to every number in the set. For example,
inf{1, 2, 3, 4} = 1, inf{x ∈ Rn : 0 ≤ x ≤ 1} = 0 and inf{x ∈ Rn : x 3 > 2} = 21/3 . The infimum is
not necessarily the minimum real number in a set.

February 12, 2011 11:1 Pinched Crown A Page-xxiii HarrWald

February 12, 2011 11:1 Pinched Crown A Page-xxiv HarrWald
Part I
MATHEMATICS

February 12, 2011 11:1 Pinched Crown A Page-1 HarrWald

February 12, 2011 11:1 Pinched Crown A Page-2 HarrWald
Introduction

Part I of the book is devoted to mathematics. It begins with a quite extensive treatment
of linear algebra, dealing in Chapters 1 to 4 with matrices, determinants, eigenvalues and
eigenvectors, and quadratic forms and definiteness, before going on to the somewhat more
theoretical topics of vector spaces and linear transformations in Chapters 5 and 6. Chapter 7
provides the foundations for vector calculus, including such things as affine and convex com-
binations, sets and functions, basic topology, and limits and continuity. Some of this material
(on limits) is referred to in the following quite lengthy Chapter 8 on dynamic modelling
using difference equations, but most is intended as preparation for Chapter 9, which covers
important subjects in vector differentiation and multiple integration. Finally, Chapter 10 dis-
cusses the topics of convexity and concavity, unconstrained and constrained optimization,
and duality.
As mentioned in the Preface, the discussion of topics is reasonably self-contained but it
progresses quite rapidly and is rather advanced at times. Moreover, the order in which chap-
ters are read is important, as much of the material in earlier chapters is essential for a proper
understanding of the mathematics covered in the later chapters. Proofs are given for the vast
majority of the theorems introduced. In the few cases in which no proof is provided, a suit-
able reference to a proof is given. There are many worked numerical examples to help with
the understanding of concepts, methods and results, as well as a few economic examples and
illustrations intended, primarily, to motivate the mathematics covered, but also to introduce
issues for generalization and further study in Part II.

February 12, 2011 11:1 Pinched Crown A Page-3 HarrWald

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