BULE HORA UNIVERSITY

FACULTY OF BUSINESS & ECONOMICS

DEPARTMENT OF ECONOMICS

Mathematical Economics (Econ2051)

PREPARED BY: -Mr. SOLOMON TESSEMA (MSc)

&

Mr. ABDELA AHMED (MA)

EDITED BY: - Mr. WOYEMA BERISO

MODULE FOR SUMMER EDUCATION PROGRAM, BULE HORA

UNIVERSITY

JUNE, 2017
 Bule Hora University

Table of contents
Table of contents…………………………………………………………………………………………………………………………………………... i

CHAPTER 1
1. Introduction……………………………………………………………………………………….1
1.1 Basic rules of differential calculus…………………………………………………………………………. 1
1.1.1. Differential Calculus –Differentiation------------------------------------------------------------------------1
1.2. Integration------------------------------------------------------------------------------------------------------------------6
1.2.1 Basic rules of integral calculus………………………………………………………………………...6
1.3. Differentials---------------------------------------------------------------------------------------------------------------11
1.3.1. Total Differentials---------------------------------------------------------------------------------------------------12
CHAPTER 2
2. Derivatives in Use……………………………………………………………………………………….14
2.1. E l a s t i c i t i e s : definition and as logarithmic derivatives……………………………………………………14
2.2. H i g h e r -Order Derivatives…………………………………………………………………………………...19
2.2.1. Concavity and convexity………………………………………………………………………………….20
2 . 2 . 2 . Linear approximations (the differential of a function; rules for differentials)…………………………22
2 . 2 . 3 . Polynomial Approximations (quadratic and higher order approximations)…………………………24
2.2.4. Estimation of functions (Maclaurin and Taylor series)…………………………………………………27
2.2.5. Intermediate value theorem, Newton method……………………………………………………………31
2.3. Multivariate Calculus……………………………………………………………………………………….37
2.3.1. Partial derivatives………………………………………………………………………………………..37
2 . 3 . 2 . Second partials and cross partial derivatives (Young's theorem)……………………………… ……..43
2 . 3 . 3 . The multivariate chain rule……………………………………………………………………………46
2 . 3 . 4 . Homogeneous functions and Euler's theorem…………………………………………………………...47
2.3.5. Total differentials and implicit differentiation……………………………………………….…………….50

CHAPTER 3
3. Unconstrained Optimization………………………………………………………………………………56
3.1. Functions of one variable……………………………………………………………………………………56
3.2. Function of several independent variables………………………………………………………………….65
3.3. Unconstrained envelope theory………………………………………………………………………………76

CHAPTER 4
4. Constrained Optimization…………………………………………………………………………………83
4.1. One variable constrained optimization with Non- negative constraint……………………………………...83
4.2. Two variables problems with equality constrains…………………………………………………………….86
4.3. Optimization of N- variable Case-----------------------------------------------------------------------------------------97
4.4. Inequality constraints and the theorem of Kuhn-Tucker……………………………………………………..101
4.5. Mixed constraint ………………………………………………………………….………………………115

CHAPTER 5

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5. Comparative Static Analysis…………………………………………………………………………………120
5.1. The nature of comparative static, Differentiation and it Application on Comparative Static Analysis………..121
5.1.1. Nature of comparative static………………………………………………………………………………..121
5.1.2. Differentiation and it Application on Comparative Static Analysis………………………………………..122
5.2. Jacobean and Hessian Determinants……………………………………………………………………….138
5.2. 1. Jacobean Determinants………………………………………………………………………………….139
5.2. 2. Hessian Determinants…………………………………………………………………………………….142
5.3. Comparative Static of General Function Models and Limitation of Comparative Static-------------------------151
5.3.1. Comparative Static of General Function Models…………………………………………………………151
5.3.2. Limitation of Comparative Static Analysis…………………………………………………………………157
CHAPTER 6
6. Dynamic Equilibrium Analysis --------------------------------------------------------------------162
6.1. Continuous Time Dynamic Analysis --------------------------------------------------------162
6.1.1. First Order Linear Differential Equations------------------------------------------------162
6.1.2. Second Order Linear Differential Equations--------------------------------------------- 167
6.2.Discrete Time Dynamic Analysis ----------------------------------------------------------------172
6.2.1. First Order Linear Difference Equations------------------------------------------------- 172
6.2.2. Second Order Linear Differential Equation--------------------------------------------- 175

CHAPTER 7

7. Linear Differential and Difference Equations………………………………………………………191

7.1. Definition and concepts…………………………………………………………………………………..191

7.1.1 First order linear differential Equations…………………………………………………………..194

7.1.2 First order linear Difference equations…………………………………………………………..197

7.2. Economic applications…………………………………………………………………………………...199

7.2.1. Uses of differential equations in economics………………………………………………………199

7.2.2 Uses of Difference Equations in Economics………………………………………………………201

References…………………………………………………………………………………………………….209

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CHAPTER ONE

INTRODUCTION
Unite Objective
Up on the completion of this unit, you should be able to
- Explain the meaning of differential calculus.
- Describe the rules of differentiation
- Explain the difference between differential calculus and integral calculus.
- Describe basin concepts of a matrix.
- Discuss the methods of solving simultaneous linear equations using matrix algebra.

1.1 Basic Concepts from Calculus

After completing this section, you are expected to

- Describe the meaning of differentiation.

- discuss the different rules of differentiation
- explain the meaning and methods of integration
- Describe the concept of differentials.
- apply the techniques of differentiation and integration for
solving economic problems.

1.1.1 Differential Calculus - Differentiation

Given a function y = ƒ(x), where x and y are independent and dependent variables
respectively, if x is an increment in the value of x and y is an increment in the value of y,

then
y is referred to as the average rate of change or the rate of change of y with respect to
x
the given change in x. This limiting value is also known as derivative which is the instantaneous
rate of change of y due to a very small change in x represented by
dy .
dx

This means f ( x  x )  f ( x )
Lim y x = Lim = dy dx
x
x 0 x 0

Thus, differentiation is the process of finding the rate of change of the dependent variable (y)
with respect to a given change in the independent variable (x). In other words, it is a process of
determining the slope of the function y= ƒ(x) at any point of x in the domain of the function.

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Given the function y= ƒ(x) and other functions such as g(x) and h(x) which are differentiable, the
following are the rules of differentiation.

1.Constant function Rule

Given a function y = ƒ(x) = k, where k is constant
dy dk
  0, That is the derivative of the constant function is zero.
dx dx
dy
Example If ƒ (x) = 4 = 4x 0 , = 0 (4x 01 ) = 0
dx

2.Linear function Rule

Given a function y = ax + b, where a and b are constants
dy
a
dx

Example If ƒ (x) = 3x + 5, then ƒ' (x) = 3

If f(x) = 5x, then ƒ' (x) = 5

3.Power function rule

Given a function ƒ(x) =x n where x  0 and n is any real number
ƒ '(x) = n x n 1
Example If ƒ(x) = 2x 5 , ƒ ' (x) = 5 (2x 51 ) = 10x 4
If ƒ(x) = 1 3  x 3 , ƒ' (x) = -3 (x 31 ) = -3x 4
x
ƒ '(x) = 3
x4
1 1
1 1 2
If ƒ (x) = xx ½, ƒ’
(x) = ½ x 2 = x
2
4.Sum and Difference Rule
When y = g(x)  h(x), then ƒ' (x) = g' (x)  h' (x)
Example If g (x) = 2x+3 and h (x) = 5x 2 + 2x, then
ƒ ' (x) =g'(x)  h' (x)
= 2  10x +2
g' (x) +h' (x) = 10x +4
g' (x)- h' ( x) = 2 - (10x+2)
= -10x

5.Product rule
This rule enables us to differentiate two functions which are multiplied together.
If ƒ' (x) =g' (x) h(x) + h' (x) g(x)
Example
1. If ƒ(x) = ( 7.5+ 0.2 x 2 ) ( 4+8x 1 ) , What is ƒ' (x) =
dy ?
dx
This function can be multiplied out and differentiated without using the product rule. But, let us
first use the product rule and then compare the answers obtained by the two methods.
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Let g (x) = 7.5 + 0.2x 2 and h(x) = 4+8x 1

Therefore, g' (x) = 0.4x and h' (x) = -1 (8x 2 ) = -8x 2
Using the product rule
ƒ' (x) = 0.4x ( 4+8x 1 ) + - 8x 2 ( 7.5 + 0.2x 2 )
= 1.6x + 3.2 - 60x 2 - 1.6
ƒ' (x) = - 60x 2 + 1.6x +1.6--------------------------------------------(1)

If we multiply the original function, we get

ƒ(x) = ( 7.5 + 0.2x 2 ) ( 4+8x 1 )
= 30+ 60x 1 + 0.8x 2 + 1.6 x
Therefore
ƒ' (x) = - 60x 2 + 1.6x +1.6---------------------------------------------(2)
These two derivatives, i.e. (1) and (2) are the same. But in some cases, it is not possible to
multiply out the different components of a function and then we must use the product rule to
differentiate.
Quotient rule

This rule allows as differentiating two functions where one function is divided by the other
function.
If ƒ'(x) = h(x).g' (x) – g(x).h' (x)
( h (x) )2
Example
4x2
1.Determine ƒ' (x) if f ( x) =
8  0 .2 x
Let g (x) = 4x 2 and h(x) = 8+0.2x,
g' (x) = 8x and h' ( x) = 0.2
According to the quotient rule,
ƒ'(x) = 8x(8+0.2x) – 0.2(4x2)
(8+0.2x) 2

= 64x + 1.6x2 – 0.8x2

(8+0.2x) 2
64 x  0.8 x 2
ƒ' (x) =
(8  0.2 x) 2

2. If a monopoly faces a non- linear demand function

252
p=
( 4  q ) 0 .5
Derive the marginal revenue function (the rate of change of TR with respect to output).
As we know, TR = p x q,
252q
TR =
( 4  q ) 0 .5
If u = 252q and v = (4+q) 0.5 , then

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du dv
 252 And  0.5 (4+q)-0.5
dq dq
Now we can find the marginal revenue function using the quotient rule as follows.
252(4  q ) 0.5  252q (0.5)(4  q ) 0.5
MR =
[(4  q ) 0.5 ] 2
= 252(4+q) 0.5 – 252q (0.5) (4+q) 0.5
(4+q)
(4  q )252  125q
=
(4  q )1.5
1,008  252q  126q
=
(4  q )1.5
1,008  126q
MR =
(4  q )1.5
6. Chain Rule
The chain rule enables us to differentiate' functions within functions ', for instance, given
a function y = ƒ (z) and z = g(x), then y= ƒ [g (x)].
dy dy dz

dx dz dx
To differentiate y with respect to x, we use chain rule which states that
Example
1. Given a non- linear demand function, p = (1500 -0.2q) 0.5 , find its slope.
Let z = 150 - 0.2q as a result p = z 0.5
dz dp dz 0.5
= = (0.5z ) (-0.2)
dq dz dq
= -0.1(150-0.2q) 0.5
= - 0.1
( 150 – 0.2q) 0.5
2. If the present value of a one birr due in 8 years time is given by the formula

1
PV =
(1  r )8

Where r is the given interest rate, find the rate of change of PV with respect to r.
Let (1+r) = z, then PV= 1 = z 8
z8
dPV
 -8z 9
dz
dz
This means = 1 and
dr
Thus, using the chain rule
dpv dpv dz
 ( ) = - 8 (1+r) 9 (1) = -8 (1+r) 9
dr dz dr

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8
=
(1  r )9
Dear colleague! As you know in your microeconomics course the marginal revenge productivity
theory of demand for labor states that profit is maximized when MRP L = MC L . Where MRP L
= marginal revenue product of labor
MC L = Marginal cost of labor.

dTR and DTC L

MRP L = MC L =
dL DL

Where TR is total revenue and TC L is total cost of labor.

3. A firm is a monopoly seller of good q and faces the demand schedule P = 200 - 2q, where p is
price in birr and the short run production function is given as q = 4L 0.5 Determine the marginal
revenue productivity of labor (MRP L ) function.

dTR dq
MRP L = ,
dq dL

Thus, first we need TR, given P = 200 - 2q

TR = (200 - 2q) q = 200q - 2q 2
Therefore,
dTR dq 0.5
= 200 - 4 q, = 2L
dq dL
As a result, MRP L = (200 - 4q) (2L 0.5 )
= [200-4(4L0.5)] 2L 0.5
= (200- 16 L 0.5 ) 2 L 0.5
MRPL = 400 – 32L 0.5
L 0.5
7.Implicit function Rule
Functions of the form y = ƒ(x) express the dependent variable y explicitly in terms of the
independent variable x and are called explicit functions. Where as functions of the form ƒ (x, y)
=0 do not express y in terms of x. These functions are referred to as implicit functions. If the
implicit function ƒ(x, y) = 0 exists, and the first order partial derivative of the function on with
respect to y is different from zero (ƒ y  0), then the total differential
f x dx  f y dy  d 0
f x dx   f y dy
Rearranging these terms,
dy  fx  ( f ( x, y )
= , where ƒx =
dx fy x

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f ( x, y )
ƒy =
y
Example
1. Given the function ƒ (x, y) = x 2 + y 2 - 9 = 0, find
dy we should partially differentiate the
dx
function with respect to x and with respect to y, and then determine
dy .
dx
f x  2 x and f y  2y
dy  2x  x
Thus, = =
dx 2y y

2. Given the implicit function ƒ (x, y) = x 3 - 2x 2 y + 3xy 2 - 22 = 0, find

dy .
dx
ƒ x = 3x 2 - 4xy + 3y 2 and ƒ y = - 2x 2 +6xy
dy
Therefore, = - (3x 2 – 4xy + 3y2)
dx
- (- 2x 2 +6xy)
9. Inverse function rule
Given the function y= ƒ(x), it has an inverse if and only if each value of y corresponds with one
and only one value of x. According to the inverse function rule, the derivative of the inverse
function is the reciprocal of the derivative of the original function. The derivative of the given
1

original function is
dy . Thus, the derivative of the inverse function x = ƒ 1 (y) which is dy =
dx dx
dx
dy
Example If Q = P 3 + 2P 2 +7p, find the derivative of P with respect to Q
dQ dp 1
= 3 P 2 + 4P + 7, Thus, =
dp dQ 3 p 2  4 P  7
1.2 Integration

Integration is the reverse of differentiation. Thus integrating a function means finding another
function when it is differentiated gives the primitive function.

1.2.1 Rules of Integration

As you know integration is the reverse of differentiation. As a result, the rules of integration are
the reverse of that of differentiation. They are explained as follows

1. The power rule

Given the derivative function ƒ'(x) = x n , according of the power function rule the primitive
function
ƒ( x) =  f ( x ) dx ax n 1
n
ƒ(x) =  ax dx = +C
n 1
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When a and n are parameters and n  -1

Example
3 x 4 1  C
1. If ƒ'(x) = 3x 4 , ƒ(x) =  3x 4 dx =
4 1
3x5
= C
5
5 x 0 1
2. If ƒ’(x) = 5, then ƒ(x) =  5dx = + C = 5x+C
0 1
2. Exponential Rule
Given the function ƒ'(x) = e x , the primitive function ƒ(x) is
ƒ( x) =  e x dx  e x  C
3. Logarithmic function Rule
1
Given the derivative of the function ƒ' (x) = , the original function
x
1
dx  n /x/ + c , x  0 .
ƒ(x) = 
x
4. The Integral of sum
The integral of sum of functions is the sum of the integral of those functions. Given the two
derivative functions ƒ' (x) and g '(x), then
ƒ(x) = [ ƒ'(x) + g'(x) ] dx =  ƒ' (x) dx +  g'(x) dx
= ƒ (x) + g(x) + C
Example
Find  (2 x 2 + 3x+2) dx
 (2 x 2 +3x+2) dx =  2 x 2 dx   3 xdx   2dx
2 x 3  c1 3 x 2  c2 ) 2 x  c3
= + +
3 2 1
2 3
= x3  x 2 2x  C
3 2
In the final answer the arbitrary constants of integration can always be combined in single
arbitrary constants.

5.The Integral of a multiple

The integral of the product of a constant and a function is equal to the product of the constant and
the integral of the function, that is

 ƒ' (x) dx = c  ƒ'(x) dx where c is constant.

3 x 4 1
 3x dx  3 x dx 
4 4
Example +C
4 1
3
 x5  C
5

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Economic Applications
You know that integration of marginal functions shall give us the corresponding total functions.
Thus let us discuss some applications of integration.
Total Costs
It is clear that the total cost is a summation of total fixed cost and total variable cost. Thus, the
integration of the marginal cost with zero constant of integration will give total variable cost.
Example
If a firm spends 650 Birr on fixed costs and its marginal cost is given as
MC= 82-16Q + 1.8Q 2 Where Q is quantity produced, determine the total cost
function of the firm.
Using the method of integration
TVC =  MC.dQ

TVC =  (82  16Q  1.8Q 2 ) dQ = 82Q - 16 Q 2 + 1 .8 Q 3

2 3
2 3
TVC = 82Q - 8Q +0.6Q
We know that TC = TVC + TFC. Therefore, TC = 0.6Q 3 - 8Q 2 + 82Q + 650

Total Revenue
Similarly we can determine total revenue function provided that we know the marginal revenue
functions.

Given the marginal revenue function MR = 520 - 3Q 0.5 , find the total revenue function and the
corresponding demand function.
TR =  MRdQ
=  [520  (3) Q ]dQ
TR = 520Q - 2Q 1.5
Dividing the total revenue (TR) function by the quantity Q gives us the corresponding demand
function. Thus,
520Q  2Q1.5
P=
Q
P = 520 - 2Q 0.5
What will be the total revenue if the firm charges a price of P= 120 Birr?
P = 520 - 2 Q 0.5
Rearranging this equation, 2Q 0.5 = 520 - P
520  P
Q 0.5 =
2

Q = [(520 – P)/2]2

Thus, Q = [(520 – P)/2] 2= (200)2=40,000 units.

But we know that Total Revenue (TR) = PQ, where P is price and Q is quantity sold. Thus,

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TR = 120x40, 000 = 4, 800,000 Birr

Consumption and Saving Functions

Dear colleague! Applying the same technique we can drive the consumption and saving functions
provided that marginal propensity to consume and autonomous consumption are given.

Example
Suppose the marginal propensity to consume (MPC) out of income for the economy as a whole is
given as 4 and it is known that when income is zero, consumption is equal to 12 billion Birr.
5
Find the function which relates aggregate consumption to national income. Find the aggregate
saving function of the economy.

Dear colleague! As you remember from your macroeconomics study

Income = consumption + saving
dc 4
Here MPC =  where MPC is Marginal Propensity to Consume C is consumption and y
dy 5
,
is income.
Integrating MPC With respect to income gives us the aggregate consumption function.
 MPC.dY   4
5
C= dy = 4 Y + K, where k is an arbitrary constant.
5
However, when income is zero, consumption is 12 billion birr.
C= 12, when y = 0,
4 (0)  K  K  12
This means, 12= 5
Therefore, the consumption function is

C= (4/5) Y +12

And the aggregate saving function is S = y- [(4/5) Y+12]

S= y- [(4/5) Y +12]
= y-(4/5) Y - 12

S = (1/5) Y -12

Definite Integrals
Until now we have discussed about indefinite integrals. However, there is also another form of
integral i.e. definite integral, which is specified with two values of the independent variables and
defined as the value of the integral at one value minus the value of the integral at another value .
Given the derivative function ƒ’(x),
b
a
f ( x)dx  f (b)  f (a )
From this difference we can get a specific numerical value which is free of x and the arbitrary
constant, C. This value is referred to as the definite integral of f(x) from x  a to x  b . In this
case, a is the lower limit of integration and b is the upper limit of integration.

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Example
6
1. Given 2
( 3x2 + 2x) dx , find the value of the primitive function from x = 2 to x = 6
First we ought to determine the original function ƒ(x),

 (3x
2
ƒ( x) =  2 x)dx

3x3 2x2
= +  c  x3  x 2  c
3 2
6
Therefore  2
(3 x 2  2 x)dx  f (6)  f (2)
= (6 3 + 6 2 + C) - (2 3 + 2 2 + C)
= 216 + 36 + C - 8 -4 - C
= 252 - 12 = 240
Economic Applications

An important feature of the definite integrals is that they are equal to the area between a function
and the horizontal axis, and between the two specified values of the independent variables. As a
result, we can calculate the consumer's surplus and producer's surplus using the method of
definite integrals.
Examples
1. Given the non - linear demand function P = 1, 800 - 0.6Q 2 and the corresponding marginal
revenue function MR = 1,800 -1.8Q 2
Using the technique of definite integral, find
a) Total revenue ( TR) when Q = 10
b) Change in total revenue when Q increases from 10 to 20,
c) Consumer's surplus when Q = 10.

Solution
a). When Q = 10 , TR shall be
10 10
0
MRdQ  
0
(1,800  1.8Q 2 )dQ

3
1.8Q 10
= [1,800Q - ]
3 0

= [1,800Q - 0.6 (10) 2 ] - [1,800(0) -0.6(0 3 )]

= 18,000 - 600
TR = 17,400 Birr

b).The change in total revenue when Q increases from 10 to 20 units is

20 20
10
( MR)dQ  10
(1,800  1.80Q 2 )dQ

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20
= [1,800Q - 0.6Q 3 ]
10

= [1,800(20) - 0.6(20 )] - [1,800(10) -0.6(10) 3 ]

3

= (36,000 - 4,800) - (18, 000 -600)

= 13, 800 Birr
c).The consumer's surplus when Q = 10 shall be the definite integral of the demand function
minus the total revenue actually spent.
10
Consumer's = 0
(1,800  0.6Q 2 )dQ  TR
Surplus
10 10


0
(1,800  0.6Q 2 )dQ  [1.800Q  0.2Q 3 ]  18,000  200  17,800birr
0
But we know that TR = PQ = (1,800 - 0.6Q2)Q
TR = 1,800 Q - 0.6Q3
When Q = 10, TR = 1,800(10) - 0.6(10) 3
= 18,000 -600 = 17,400 Birr
Therefore, consumer's surplus = 17,800 - 17,400= 400 Birr

2. Suppose a company whose annual sales are currently 500,000 Birr has been experiencing sales
increase by 20% per year. Assuming this rate of growth continues, what will be the total sales of
the company in five years time?
Here the rate of sales is
S' (t) = 500,000 e 0.2t
Thus, total sales (at the end of year)
5 5
= 0
S ' (t ) dt = 0
500,000e 0.2t dt
500,000 0.2t 5 500,000(e  1)
= e 
0 .2 0 0 .2
Total sales = 4,295, 694 Birr

3. The market demand and market supply functions under perfect competition are given as P= 16
- Q 2 and P = 2 Q 2 + 4 respectively. Find the producer's surplus.

Dear colleague! It is clear that in perfectly competitive market equilibrium price and quantities
are determined when market demand and market supply are equal. Thus,
16-Q 2 = 2Q 2 + 4  Q 2 = 4, Q = 2 as a result P=16 = 2 2 = 12

2
Thus, Producer’s surplus = PQ -  0
(2Q 2  4)dQ
2
= 12 (2) - [ 2 Q 3  4Q ]
3 0

= 24-[ 2 (2)  4(2)] 3

3
= 24 - 16 - 8 = 32 units
3 3

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1.3 Differentials
Given the function y = ƒ(x) if we know the rate at which x changes, we can find the change in y,
y y dy
y  ( )x . As x  0, 
x x dx
Denoting dy as small change in y and dx as small change in x,
dy dy
dy = ( )dx, where  f ( x)
dx dx

dy  f ( x)dx It is the differential.

Example
Given y = (5x3 + 2x2+ x) dy = (15x2 + 4x+1) dx
Suppose x changes from 2 to 2.01 (i.e. dx = 0.01), by what value does the dependent variable y
changes?
dy = (15 x2 + 4x +1)( 0.01)
= [15 (2 2 ) + 4 (2) + 1] (0.01)
= (60+ 8+1) (0.01)
dy = (69)0.01 = 0.69
From the original function, the actual change in y is
y = ƒ (2.01) - ƒ (2)
ƒ (2) = 5(2 3 ) + 2(2 2 ) +2
= 5 (8) + 2(4) +2
ƒ (2) = 40+8+2 = 50
ƒ(2.01) = 5(2.01) 3 + 2(2.01) 2 + 2.01
= 40.606020+8.0802+2.01
=50.696220
y  f (2.01)  f (20  50.696220  50  0.696220
y  dy  0.696220  0.69
= 0.006220
The value 0.006220 is the error of calculation.
As x changes from 2 to 3, that is x = 1, what is the change in y?
dy = [15 (2) 2+ 4(2) + 1] 1
= 60+8 +1 = 69
y  ƒ (3) - ƒ(2)
But we have determined that
ƒ ( 2)  50
ƒ (3) = 5 ( 33 ) + 2(32) + 3
= 5 (27) + 2(9) +3
ƒ (3) = 135 + 18 + 3 = 156
Thus,  y = 156 - 50 = 116. The error term is 116-69 = 47
Note. Dear colleague! By now we have realized that the smaller the change in x the smaller error
term and the greater the change in x the larger will be the error term.
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1.3.1 Total differentials

The concept of differential can be extended to a function of two or more independent variables.
Given the utility function U = U ( x1, x2)
Supposing U as continuous and differentiable
u
Ux1 = which is marginal utility of x1.
x1
u
Ux2 = which is marginal utility of x2.
x2
u
The change in total utility that results from small change in x 1 is given by .dx 1 and from
x1
u
small change in x2 is dx 2
x2

Then the total change in utility is

u u
du = dx1  dx2
x1 x2

Example Find the total differential, given

1. Z = 3x2 + x y- 2 y 3
z z
dz = dx  dy
x y
dz = (6x + y) dx + (x-6y2) dy
2 2
2. U = x  6 x1 x2  4 x
1 2
du = (4x1 + 6x2) dx1+ (6x1 + 8x2) dx2

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CHAPTER TWO
DERIVATIVE IN USE

2.1 Elasticity: Definition and as Logarithmic Derivative

Elasticity is a measure of a proportionate change in the dependent variable which results from a
proportionate change in the independent variable. Thus elasticity of demand is a measure of the
percentage change is quantity demanded due to a percentage change in the factors which
determine demand.

If there is change in quantity demanded from Q to (Q+ Q ) resulting from a given change in
price from P to (P + P ), the price elasticity of demand is

E p = Proportionate change in quantity demanded

Proportionate change in price
Q
Q
=
p
p
Q p Q p
= x = ( )
Q p p Q
It gives us the average, price elasticity of demand over the price range of P to (P+ p ) .It is
possible to use the method of derivative to get the price elasticity of demand at a particular point
P, i.e., as p approaches to zero.

p Q P Q
E p = lim ( ) = lim
Q p Q P
p  0 p  0
P dQ
= ( )
Q dp
Thus price elasticity of demand dQ p
E p= ( )
dp Q

Let us do the following examples.

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Example
1.Find the price elasticity of demand if the demand function for a product is
Q = P 2 - 6P + 36, where Q is quantity and P is price of a product. Using the above formula
dQ p dQ
E p= ( ), but  2p  6
dp Q dp

p
Therefore, E p = (2 p - 6) 2
P  6 P  36
2
2p  6p
Ep = 2
p  6 p  36
2 p2  6 p
Ep =
p 2  6 p  36
What is the elasticity of demand at P = 4?

2(42 )  64) 
Ep = 2
4  6(4)  36

32  24 8
= = < 1
16  24  36 28
As E p < 1 demand is said to be price inelastic at P = 4.

2. Find the price elasticity of demand in terms of quantity sold.

10
P= = 10 (Q+1) 2
(Q  1) 2

dQ P 1 dp Q
Ep = ( ), Therefore, = ( )
dp Q Ep dQ P
Differentiating the demand function with respect to Q gives as
dp  20
 -20 (Q+1) 3 =
dQ (Q  1)3
Q
1  20 10
Thus, =[ ]
Ep (Q  1)3 (Q  1) 2

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1  2Q
=
Ep (Q  1)

This means

Q 1
Ep 
 2Q

Elasticity as Logarithmic Derivative

In a function y = ƒ (t), when the dependent variable y is a function of time t, then the
instantaneous rate of growth is determined as
dy m arg inalfunction
Rate of growth = dt =
y totalfunction
This ratio exactly represents the derivative of n ƒ (t). This means, the instantaneous rate of
growth of the function is the derivative of natural logarithm of the function with respect to time.
That is
d ln f (t )
Rate of growth =
dt
By now, given the function y = f(x), let us observe the result provided that we carry out
differentiation of ln y with respect to ( ln x ). To start it, suppose u = ln y and v = ln x . Then the
chain of relationship relating u to y and v to x is that
u = n y , y = f(x), U = n x , x  ev
Finding the derivative of ln y with respect to ln x gives us
d (n y ) du dy dx
 ( ) ( )( )
d ( n x ) dy dx dv

Using the method of substitution

d ( n y ) d ( n y ) dy d (e v )
 [ ] ( )[ ]
d ( n x ) dy dx dv
1 dy
= ( ) ev
y dx
1 dy
= ( ) x as e v = x
y dx

d (n y ) dy x
 ( )
d (n x ) dx y 16
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As you remember this expression is the point elasticity of the function. Hence, one can
generalize that for a function y = f(x), the point elasticity of y with respect to x is
d (ny )
E x y=
d ( n x )
Example
1. Find the point elasticity of demand given Q = K/ P n where K and n are positive constants
Q = K p n
ln Q  ln K  n ln P
d (ln Q )
Ep  =-n
d (ln p )
/ EP / = / -n/ = n
2. Find the pointelasticity of demand provided that x = a p b where a and b are positive constants,
and x and p are quantity demanded and price of a product respectively. ln x = ln a + b ln P
d (ln x)
Thus, E p = =b
d (ln p )

Relationship between Marginal revenue, average revenue and elasticity of Demand

Given the total revenue function TR= PQ

Where P = price at which the product is sold
Q = quantity sold
Then marginal revenue that is the rate of change of total revenue with respect output is
d ( PxQ)
MR =
dQ
Using the product rule of differentiation
dQ dp
MR  p Q
dQ dQ
Q dp
MR = P +
dQ
dQ p 1 dp Q
We know form the above analysis that E p  which implies that  ( )
dp Q Ep dQ p
p dp Q
multiplying both sides by p gives us  ( )( ) p
Ep dQ p

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p dp
Q
Ep dQ
Substituting it the above marginal revenue function give us
P
MR  P 
Ep
However, we also know that p is equal to average revenue (AR), thus
AR
MR  AR 
Ep
1 1
MR = AR (1+ ) = AR ( 1  )
Ep / Ep /

1
MR  AR (1  )
/ Ep /

From this equation we realize that

When demand is unitary elastic, i.e. / Ep / = 1, MR = 0 this means, total revenue is maximized.

When demand in elastic, i.e., / Ep /> 1, MR > 0 which implies that total revenue is increasing.
However, as demand is inelastic, i.e., / Ep /< 1, MR < 0 which implies that total revenue in
decreasing.

By now you have completed the first section of this unit. Therefore, try to do the following
questions in to examine how you have understood this section.

Self - Test 2.1

Solve the following questions based on the analysis in this section.
1. Define price elasticity of demand.
2. Describe the relation ship between marginal revenue, average revenue and price elasticity of
demand briefly
27
3. Given the demand function of a product as Q = 2 where Q and P are quantity demanded and
p
price of a product respectively, the find the price elasticity of demand.-
100
4. If the demand function as Q = , then find the price elasticity of demand
p6
5. Given the demand function as P = 500 -2Q where P and Q are price and quantity demanded
respectively. Find Marginal revenue at P = 100. Whit happens to the total revenue at this point?

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Dear colleague! Have you answered these questions? If your answer is no, re-read this section
and try to answer them. If your answer is yes good. Go to the next section

2.2 Higher Order Derivatives

After completing this section, you are expected to

- describe what concavity and convexity is

- describe about linear approximation and polynomial approximation of
a function
- explain the Maclaurin and Taylor's series
- discuss about the intermediate value theorem and Newton method

So far we have discussed the first order derivative f (x) of the function Y = f(x). Now let us
turn our attention to the concept of second order derivative and higher order derivatives. Having
this knowledge enables us to have alternative criteria for determining the relative maximum or
minimum poin
t of a function.

We know that the first order derivative f (x) of a function y = f (x) is a function of x. As a result
we can determine the rate of change of f (x) with respect to x if f (x) is differentiable. The
result of this differentiation is referred to as second order derivative of the function y = f (x) . It
is represented by f (x) where the double prime shows that the primitive function has been
differentiated with respect to x twice. The expression (x) next to the double prime indicates that
the second order derivative in a function of x.
Alternatively this second order derivative can be represented by

d 2 y d dy
 ( )
dx 2 dx dx

We have seen that the second derivative is a function of x. Thus, it is possible to differentiate
this function with respect to x in order to get the third order derivative of the function f (x) or

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f 3 ( x) which in turn can be a source of fourth order derivative and so on provided that the
differentiable condition is satisfied.

Symbolically, these successive higher order derivatives are

f 3 (x), f 4 (x), f 5 (x) -----------, f n (x).
Or
d3y d4y d5y d n ( x)
, , , -----
dx 3 dx 4 dx 5 dx n
Example
1. Find the first through the fourth derivative of the following function.

f (x) = 5x3 + 2x2 + 3x + 4

These derivatives are f (x) = 15x2 + 4x + 3

f (x) = 30x + 4
f (x) = 30
f 4 ( x) = 0

We have seen that each successive derivative gives us a simpler expression than it's precedence
until we get the fourth derivative. However, it in not always true. The fourth order derivative is
equal to zero does not imply that it does not exist.

2. Find the first four derivatives of the function given as

2x
f (x) = , x  1
1 x
2(1  x)  (1)(2 x)
f (x) = , using the quotient rule
(1  x) 2
2(1  x)  (1)(2 x) 2
f (x) = 2
=
(1  x) (1  x) 2
f (x) = 2(-2) (1-x)-3 (-1)
f (x) = - 4(-1) (1-x)-3 using the chain rule
= 4 (1-x) -3
f 3 ( x) = (-3) (4) (1-x)-4 (-1)
f 3 ( x) = 12 (1-x)-4
f 4 ( x) = (-4) (12) (1-x)-4 (-1)
f 4 ( x) = 48 (1-x)-4

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2.2.1 Convexity and Concavity of a Function

Given the function y = f(x), it is clear that the derivative of the function f (x) indicates the rate
of change of the primitive function with respect to x. similarly, f (x) shows the rate of change
of f (x) with respect to x. Observing the sign of the first derivative of the original function at
any point of x, one can determine whether a function is increasing or decreasing. However, the
sign of the second derivative indicates whether the function is concave or convex at that
particular point. If the original function is y = f(x),
- f (a ) > 0 implies that the function is increasing at x = a and
- f (a ) < 0 implies that the function is decreasing at x = a
- f (a ) = 0, implies that the function is at its optimum point at x = a
Similarly
- If f (a ) > 0, then the function is convex at x = a
- If f (a ) < 0, then the function is concave at x = a
- If f (a ) = 0, x = a is the point at which the curvature of the function is
Changed.

In general, a positive first derivative coupled with a positive second derivative at x = a shows
that the function increases at an increasing rate at x = a . A positive first derivative coupled with a
negative second derivative at x = a , indicates that the original function is increasing at a
decreasing rate at this point.
A negative first derivative with a positive second derivative shows that the function is decreasing
at an increasing rate where as a negative first deteriorative with negative second divertive at
x= a , implies that the function decreases at a decreasing rate at x = a .

Example
 If f (x) = x 3 - 12x 2 + 36x + 8,

a) Is it increasing or decreasing at x = 3?
b) Is it convex or concave at x = 3?

Solution
First we should find the first and second derivative of this function at x = 3 to answer these
questions.

f (x) = 3x2 - 24x + 36

f (x) = 6x - 24
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Therefore, f (3) = 3(9) - 24(3) + 36

f (3) = 27 - 72+36 = 63- 72 = -9 <0
f (x) = 6(3) - 24 = 18 -24 = -6 <0
This implies that the function is decreasing at decreasing rate at x= 3 and it is concave at this
point.

2.2.2 Linear Approximation

As we know there are complicated functions in economics. In order to avoid this complexity,
we sometimes try to find a simpler function which approximates the original function. Given the
function y = f(x) , the equation of a straight line which passes through point ( x 1, y1) and having a
slope b is represented as
y  y1
b =
x  x1
b( x  x1 ) = ( y  y1 )
y  b( x  x1 )  y1
This means, the equation of the tangent line which passes through the graph of the function y =
f (x) at x = a provided that f(x) is continuous and smooth at x = a , is expressed as
y  f (a )  f (a )( x  a )

y  f (a )( x  a )  f (a )

When we approximate the graph of f (x) by its tangent line at x = a , then the resulting
approximation is referred to as linear approximation.

Example
1. Find the linear approximation of the function f ( x)  4 x , about x = 1.

First we should determine the value of f (x) and f (x) at x = 1 to answer this question. Thus,
1 3
1 ( 1) = 1 ( 4 )
f (x) = x 4 x
4 4
3
 1
f (x) = 1 (1) 4
= 4
4
f (1) = 4 1  1

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Therefore, the linear approximation of the function is

1
f (x)  (x-1) + 1
4
1
If x = 1.02, f (x)  (1.02 - 1) + 1
4
1
 (0.02) +1
4
1
f (x)  +1 = 1.005
200

However, the actual value is f (1.02) = 4

1.02 =1.00496 which is very close to the approximate
value of the function, i.e., 1.005.

2. Determine the linear approximation of the function

1
3 1
f (x) = (1+ x + x2) 2 at x = 0
2 2
1 3 1 3
f (x) = (1+ x + x2) -½ ( + x )
2 2 2 2
3 3
This means f (0) = 1 (1+ (0) + 1 (0)]-½ ( 2  0)
2 2 2
1 3 1 3 3
f (0) = 1 (1) 2 ( ) = ( ) =
2 2 2 2 4
1
3 1
And f (0) = [1+ (0) + (0)] 2
2 2
1
f (0) = (1) 2
=1
Therefore, at x = 0 the linear approximation of the function is
f (x)  f (0) (x- 0) + f (0)
3
f (x)  (x - 0) + 1
4
3
f (x)  x +1
4

2. Identify an approximate value of (1.001) 50

Solution
In order to approximate it, initially we should convert the equation in to

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f ( x)  x 50 , when x is close to 1.Then we should evaluate the original function and

the first derivative of this function at x=1.
Then f (x) = 50 x 49
f (1) = 50 (1) 49
= 50
And f (1) = (1) 50 = 1
Thus, f (x))  f (1) + f (1) (x-1)
 1 + 50 (x-1) = 1+50x-50 = 50x -49
50
(1.001)  1+50 (1.001- 1)
 1+50 (0.001) = 1+0.05 = 1.05
However, the actual value is (1.001) 50 = 1.0512 which is very close to the approximate value
i.e., 1.05

2.2.3. Polynomial Approximation

Approximation using linear functions is not as such accurate. Therefore, it is necessary to use
quadrate approximation or higher order approximation minimizes this problem.

a) Quadratic Approximation
Given a function y = f(x), how can it be approximated by the second degree polynomial of the
form P ( a ) = A+ B (x - a ) + C (x- a ) 2 as x is close to a ?
In this function we have seen three unknown coefficients such as A, B and C. Therefore, we
ought to put the following three conditions in order to determine these three unknowns.

At x = a, it is assumed that
 f (a) = P (a)
 f  ( a ) = P ( a )
 f  ( a ) = P  ( a )
Given the polynomial function P (x) = A + B (x - a ) + C(x- a ),
P (x) = B+ 2 C (x - a )
P (x) = 2C
When x = a , P ( a ) = A + B ( a - a ) + C ( a - a ) 2
= A = f (a)
P  ( a ) = B+ 2C ( a - a )
P ( a ) = B = f  ( a )
1
P  ( a ) = 2C = f  ( a ), C = f  ( a )
2

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Substituting these values in the given quadratic function gives us the quadratic approximation of
the function which is represented by
1
f (x)  f ( a ) + f  ( a ) (x- a ) + f  ( a ) (x- a ) 2
2
as x is close to a .

Example
1 Determine the quadratic approximation to a function f(x) = 4 x about x= 1. In this case, first
we should find the value of f (x) , f (x) and f (x) at x = 1 . Thus,
1 1
4
f (x) = x 4
, f (1) = 1 =1
3 3
f (x) = 1 x 4 , f (1) = 1 (1) 4
=¼
4 4
 3 7 4 3
f (x) = 1 ( ) x , f (1) =
4 4 16
Thus,
1
f (X)  f (1) + f (1) (x-1) + f (1) (x-1)2
2
1 1 3
 1+
(x-1) + ( ) (x-1)2
4 2 16
1 3
f (X)  1+ (x-1) - (x-1)2
4 32
Dear learner! Compare the actual value and the approximate value of this function when x =
1.02.

2. Find the quadrate approximation to a function f (x) = (5x +3) 2 about x = 0.

Solution
1
f ( 0) =
9
f (x) = -2 (5x+3)-3 (5) = -10(5x + 3)-3
f (0) = -10 [5(0) +3]-3 = -10 (3)-3 =  10
27
f ( x)  30(5 x  3) (5)  150(5 x  3) 4
4

150
f (0) = 150 (5(0) +3) 4 = 150 (3) 4
=
81
There fore, the quadratic approximation of the function is
 1
f (x)  f (0) + f (0) (x-0) + f (0) (x-0)2
2
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1 10 1 150
 + (- )( x  0)  ( ) ( x  0) 2
9 27 2 81
1 10 75 2
f (x)   x x
9 27 81

B. Higher Order Approximation

 Dear learner! Do you understand that quadratic approximation is more accurate than
linear approximation of a function? However quadratic approximation is not as such
accurate. Therefore, functions with higher order derivatives can be better approximated
near one point by using polynomial function of higher degree.

Given a function y = f (x) , how can we approximate it around x = a by an n th degree

polynomial of the form
P (x) = A0 + A1 (x - a ) + A2 (x- a ) 2 + A3 (x - a ) 3 + ------ + An ( x- a ) n

Dear learner! As we have seen this function has (n+1) unknown coefficients. Therefore, we
should impose (n+1) conditions on the polynomial to determine the value of the unknown
coefficients. These are, at x = a, it is assumed that
f (a) = P (a)
f  ( a ) = P ( a )
f  ( a ) = P  ( a )
'
'
'
f n ( a )= P n ( a )
Given the above polynomial function,
P (x) = A1+ 2A2 ( x- a ) + 3A3 (x- a )2 + 4 A4 ( x- a )3 + ---- + n An ( x- a )n-1
P (x) = 2 A2 + 6 A3 (x- a ) + 12 A4 (x- a ) 2 +…+ n (n -1) An (x- a ) n-2
P (x) = 6 A3+ 24 A4 (x - a ) + ----- + n (n-1) (n-2) An (x- a ) n-3
'
'
'
P n (x) = n (n-1) (n-2) (n-3) ----------------------- (3) (2) An

Therefore, when x is close to a ,

P ( a ) = A0 = f ( a )
P  ( a ) = 1! A1 = f  ( a ), A1 = f  ( a ) /1!
P  ( a ) = 2! A2 = f  ( a ), A2 = f  ( a )/ 2!
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P 3 ( a ) = 3! A3 = f 3 ( a ), A3 = f 3 ( a )/ 3!

'
'
'
P n ( a ) = n! A = f n ( a ), A = f n ( a ) /n!
n n

Substituting these values of the unknown coefficients in the polynomial function gives us the
polynomial approximation of the function as x is close to a , which is represented by
.

f (a ) f (a ) 2 f 3 (a )( x  a ) 3
f (x)  f ( a ) + (x- a ) + (x- a ) + (x- a ) 3 +---- +
1! 2! 3!
n
f (a)
n!

x  a)n 

Example

Find the fourth order approximation of the function

f (x) = 1  x , about x = 0
f (0) f 3 ( 0) f 4 ( 0)
In this case f (x)  f (0) + f  (0) (x- 0) + (x- 0)2 + (x-0)3 + (x-0)4
2! 3! 4!
1
f (x) = 1 (1+x) 12 , f  (0) = 1 (1+0)  2 = 1
2 2 2
1 3
f (x) = (1+x) 2 , f  (0) =  1
4 4
3 3
f 3 ( x) = (1+x) 5 2 , f 3 ( 0) 
8 8
 15 7  15
f 4 (x) = (1+x) 2 , f 4 (0) =
16 16
Therefore,
1 3 1 1
1  x  1+ (x- 0) + (-¼) (½) (x- 0) 2 + ( ) (x-0)3 - 15/16 ( ) (x-0)4
2 8 3! 4!
1 1 3 3 15 4
1  x  1+ x - x 2 + x - x
2 8 48 384

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1 1 1 15 4
1  x  1+ x - x 2 + x3 - x
2 8 16 384

2.2.4 Estimation of Functions (Maclaurin and Taylor series)

A. Maclaurin series (Expansion of a function around x = 0)

It is an expansion of a function y = f(x) that is differentiable, around x = 0. In other words, it

represents the polynomial approximation of the function around x= 0. Therefore, given the
function

f (x) = A0 + A1x + A2x2 A3x3 + --- + An xn

Repeatedly differentiating this function gives us
f (x) =A + 2A + 3A x2 + ----+ n A xn-1
1 2 3 n

f (x) 2A2 + 6A3x + --- + n (n- 1) Anxn-2

=

f 3 (x) = 6A + 24 A x + ---- + n (n-1) (n-2) A xn-3

3 4 n
'
'

' f n (x) = n (n-1) (n-2) (n-3) --- ( 3) (2) (1) (A ), (n = Positive integer)
n

Dear learner! What do understand from these successive derivatives? We have understood that
the number of constant terms is decreased by one until the n th derivative is reached. We can
determine the value of each rate of change at various values of x. In this case, let us evaluate
these derivatives at x = 0. When we determine the value of the derivatives at x = 0, then all terms
containing x will be eliminated.
f  (0) = A1, f  (0) = 2A2, f 3 (0) = 3(2) A3, f 4 (0) = (4) (3) (2) A4 ---------,
f n (0) = n (n-1) (n-2) (n-3) ... (3)(2) (1) An
Using the symbol (n!) which can be read as n – factorial (n!), where n! = n (n-1) (n-2) (n-3).... (3)
(2) (1)
  f 3 ( 0) f n ( 0)
A1 = f (0) , A2 = f (0) , A3 = , --- An =
1! 2! 3! n!
Now the primitive function f(x) can be expressed as a new polynomial function by substituting
these terms in it as follows
f (0) f (0) f (0) 2 f 3 ( 0) 3 f n ( 0) x n
f (x) =  x x + x + ----- +
0! 1! 2! 3! n!
In this case, the unknown coefficients of the primitive function are replaced by the derivatives
evaluated at x = 0 or and 0! is equal to 1.

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This power series representation is known as Maclauin series of the primitive function
f (x) around x = 0

Example
1. Determine the Maclaurin series of the function
f(x) = 5x3 + 2x2 + 3x + 1
This function has the following derivatives
f (x) = 15 x2 + 4x +3
f  (x) = 30 x+ 4
f 3 (x) = 30
So that f (0) = 1
f  (0) = 15 (0)2 + 4 (0) + 3 = 3
f  (0) = 30 (0) + 4 = 4
f 3 (0) = 30

Therefore, the Maclauris series of this function is

f 0  f (0) f 3 ( 0)
f (x) = f (0) + (x-0) + (x- 0)2 + (x- 0)3
1! 2! 3!
4 30
= 1+ 3 (x- 0) + (x- 0) 2 + (x - 0) 3
2 6
2 3
f (x) = 1+3x + 2x + 5x
This result shows that the Maclaunin series really represents the given function f (x).

2. Find the Maclaurin series of the function

f (x) = 3x2 + 2x + 4
The derivatives from this function
f (x) = 6x +2
f  (x) = 6
So that f (0) = 4, f  (0) = 2, f  (0) = 6
f (0)
Thus, f (x) = f (0) + f  (0) (x- 0) + (x- 0) 2
2!
6
= 4 + 2 (x-0) + (x- 0) 2 = 4+ 2x + 3x2
2

B. Taylor's Series
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It deals about the expansion of the primitive function f (x) provided that the function is
continuous and smooth, around any point x  x0 . Thus given the function y = f(x), we will
explain it using a specific quadratic function for the sack of simplicity.

Dear colleague! Let us consider the expansion of this function at some point x = x 0
f (x) = A0 + A1 x + A2 x2 + A3 x 3 + A4 x4 + --- + A n xn
First let us write this function in terms of the power of (x-x0)
f (x) = A0 + A1(x- x0) + A2 (x- x0) 2 + A3 (x- x0)3 + --- + A n (x - x0) n
This function has the following successive derivatives
2 3 n-1
f (x) = A1 + 2 A2 ( x- x0 ) + 3A3 ( x- x0 ) + 4A4 ( x- x0 ) + ---- + n An ( x -x0)
f (x) = 2 (1) A2 + 3 (2) (1) A3 (x -x0) + ---- + n (n-1) A n (x -x0) n - 2
f 3 ( x) = 3(2) (1) A + 4(3) (2) (1) A (x- x + --- - + n (n -1) (n- 2) A (x- x -3
3 4 0) n 0) n

'
'
'

f (x) = n (n-1) (n-2) (n-3) - - - (3) (2) (1) An

n

So that
f ( x0 )
f ( x0 ) = 0! A 0, A 0=
0!
f ( x0 )
f ( x0 ) = 1! A 1, A1 =
1!
f ( x 0 )
f ( x0 ) = 2! A 2, A 2=
2!
'
'
f n ( x0 )
f n ( x 0 ) = n! A n, An =
n!
Therefore

f ( x0 ) f ( x 0 ) f ( x 0 ) f 3 ( x0 )( x  x0 ) 3
f (x) = + ( x  x0 ) + ( x  x0 ) 2 +  ... +
0! 1! 2! 3!
f n ( x0 )( x  x0 ) n
n!

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This power series representation is referred to as Taylor's series. If we consider 3 as a point of

expansion, then
f 2 (3) f n (3)
f (x) = f (3) + f (3) (x-3) + (x-3)2 + .......... + (x- 3) n
2! n!

Example
Find the Taylor's series of the function f (x) = 3 x 2 + 2x + 5, around x = x 0
The successive derivatives of this function are
f (x) = 6x + 2
f (x) = 6
So that f ( x0 ) = 3x 02 + 2 x0 +5
f ( x0 ) = 6 x0 + 2
f ( x0 ) = 6
6
Thus, f (x) = (3x 02 + 2x0 + 5) + (6x0+2) (x-x0) + (x-x0)2
2
=
(3x 0 + 2x0 + 5) + (6x0x-6x 0 ) + 2x-2x0 + 3 (x2 - 2xx0 + x 02 )
2 2

= 5 - 6x 02 + 2 x + 3x 2 + 6x 02
f (x) = 3 x2 + 2x +5

This realizes that the Taylor's series correctly represents the given function

2.2.5 Intermediate value theorem and Newton Method

A. Intermediate Value Theorem
Dear students! Do you know what the intermediate value theorem states? Please, discuss with
your friends and try to answer this question. Write your answer on a rough paper and try to relate
it with the following analysis.

Suppose that there is a function f(x) that is continuous for all values of x in the close interval [a,
b], and assume that the values of the function at x = a and at x = b are not equal to each other and
each value has opposite sign, i.e., f (a) and f (b) have different signs. The intermediate value
theorem states that there is at least one value of x say c in the interval [a, b] such that f(c) = 0.

Example
1. Prove that the equation x6 + 3x2 - 2x - 1 = 0 has at least one solution in between 0 and 1, i.e.
[0, 1]
Dear Colleague! You ought to follow the steps below to solve this Problem.

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 First put the equation in a polynomial form of f( x ) = x 6 + 3x2 - 2x - 1

 Second check whether the function is continuous in between 0 and 1 or not.
 Third determine the value of the function at x = 0 and x = 1
As we know the function f(x) is referred to as continuous in the interval (a, b) iff
i) f (x) is continuous at x = a [i.e., lim f(x) = f( a) ]
xa

ii) f(x) is continuous at x = b [ i.e. lim f(x) = f (b) ]

x  b-

iii) f( x is continuous at x = c[ i.e., a < c < b ]

As a given function in our example is a polynomial function, it is continuous in between 0 and 1.

f (0) = 06+ 3(0) 2 - 2 (0) - 1 = -1
f (1) = 16+ 3 (1)2 - 2(1) -1 = 1+3-2-1 = 4-3 =1

We have seen that f (0) and f (1) have different signs. Therefore, according to the intermediate
value theorem there is at least one number that is c  [0, 1] so that f (c) = 0. In other words, the
above equation has at least one solution in between 0 and 1.

2. Prove that the equation 2 x 2  3 x  2 has at least one solution in between 0 and 1, i.e. [ 0,
1]
First make it in to polynomial function by squaring both sides of the equation as
( 2 x 2  3 x ) 2 = 22
2x2 + 3x = 4
2x2 + 3x - 4 = 0, then f(x) = 2x2 + 3x - 4
As the function is polynomial it is continuous in between 0 and 1.

f (0) = 2(0)2 + 3 (0) - 4 = -4, f (1) = 2+3 - 4 = 1

The value of this function has different signs at x= 0 and x = 1 which implies that there is at least
one solution for the equation 2 x 2  3 x  2 has at least one solution in [0, 1].

3. Show that the equation x 2  1  3 x has at least one solution in between 0 and 1.

Solution
Initially change the equation in to polynomial function by squaring both sides as
( x 2  1) 2  (3 x) 2
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- 8x 2 +1 = 0 thus, f(x) = - 8x 2 + 1
As the function is a polynomial function, it is continuous in between 0 and 1.
f (0) = 1 and f (1) = - 8 (1)2 +1 = - 7
Dear colleague! We have observed that f (0) and f (1) have different signs. As a result, the
equation has at least one solution in between o and 1.

B. Newton's Method

Dear students! Do get information regarding the specific solution of the equation from the
intermediate value theorem? Discuss with your friends and answer this question. Write your
answer on a rough paper and relate with the following analysis.

The intermediate value theorem does not provide information concerning the location at which
the solution resides. Rather Newton's method leads to a better approximate solution of the
equation under consideration.

Given the function y = f(x) and assume f(x) = 0 at x = a. Estimate a. To carry out this activity,
let us begin with an initial estimate x0 of a .Constructing a tangent line which passes through
[ x0 , f ( x0 )] we get x1 near to a as shown in the following figure.

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Undertaking the same procedure we get the estimate x1 by drawing a tangent line at [ x1 , f ( x1 )] .
Continuing this process enables us to estimate the value of a. However, we can also easily find
the formula for x n derived by the Newton's method.

What is the equation of the tangent line which passes through [ x0 , f ( x0 )] and with slope
m?-----------------------------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------
Have you answered this question? Ok. Good. Try to relate your answer with the following
analysis. The slope of this line can be calculated as

y  y0 f ( x)  f ( x0 )
m= =
x  x0 x  x0
f ( x)  f ( x0 ) = m ( x  x0 )
f ( x)  f ( x0 ) = f ( x0 )( x  x0 )
When x  x1 , f ( x)  0 (for the tangent line passing through [ x0 , f ( x0 )]
Therefore, 0  f ( x0 ) = f ( x0 )( x1  x0 )
Rearranging this equation gives as
 f ( x0 )
= ( x1  x0 )
f ( x0 )
f ( x0 )
This implies that x1  x0 
f ( x0 )

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f ( x1 ) f ( x2 )
Similarly x 2  x1  , x3  x 2 
f ( x 1 ) f ( x 2 )

In general the points generated by the Newton method are obtained by

f ( xn )
x n 1  x n 
f ( x n )

Example
1. Find the approximate values of the equation f (x) = x6 + 3x2 - 2x-1 in the interval [0,1]
using the Newton's method once.

Solution
Dear colleague! In this case n = 0, and x0 = 1
f ( x0 )
We know that x1  x0 
f ( x0 )
f ( x0 ) = f (1) = 1+3 -2- 1 = 4-3 =1
f ( x0 ) = 6x 5 + 6x - 2  f ( x0 ) = f (1) = 6+6 -2 = 10
1
Therefore, x1  1   0 .9
10
If we check for f ( x1 ) = f (0.9)
(0.9)6 + 3 (0.9)2 - 2(0.9) -1
=
= 0.53441 + 2.43 - 1.8 -1
f (0.9) = 0.161441
Applying Newton's method twice
f ( x1 )
x 2 = x1 -
f ( x1 )

f ( 0 .9 )
= 0.9 -
f (0.9)

0.161441
= 0.9 -
6.94294

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x 2  0.877
Thus, f (0.877) = (0.877)6+ 3(0.877) 2 - 2 (0.877) - 1
= 0.0084 which is more approximate to zero.

2. Determine the approximate value of the equation x 2  3x  3x in the

interval [0, 1] using Newton's method once.

Solution
Squaring both sides of the equation gives us f (x) = - 8x2 + 1. In this case also n = 0, x0  1
f ( x0 )
x1  x0 
f ( x0 )
f ( x0 ) = (1) 2 (-8) + 1 = - 7
f ( x0 ) = f (1) = - 16 (1) = -16
Therefore
( 7 )
x1  1 
(16)
= 1- 0.4375
x1 = 0.5625  0.56

If we check the original function at this value of x, we get f (0.56)  8(0.56) 2 +1

= - 2.5088 +1
f (0.56) = - 1.5088

Applying the Newton method twice gives us

f ( x1 )
x 2  x1 
f ( x 1 )
f (.56)
x 2  0.56 
f (.56)
(1.5088)
x 2  0.56   0.392
(8.96)
Then f (0.392)  8(0.392) 2  1  0.2293 which is more approximate to the solution than the
earlier value. This shows that we can determine the most approximate value of the solution by
applying this procedure continuously.

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Dear colleague! By now you have completed the second section of this unit. Therefore, try to do
the following questions in order to examine how you have understood this section.

Self - Test 2.2

Do the following questions based on the information in this section.

1.Given the function f (x) = 2x4 + 3x2 + 2x2 + 3x, find the first five derivatives of the function
with respect to x
2. If the demand function of a monopolist is given by P = 60 - 4Q where P is price in Birr and Q
is quantity. Determine whether the total revenue function of the firm is concave or convex at Q
= 7.

3. If the total cost function of a product is given by

C (Q) = Q 3 - 315 Q2 + 27,000 Q + 20,000, where Q is quantity produced. Determine whether the
average cost function (AC) is convex or concave when the firm produces two units of output.
What happens to the AC at this point?
4. Find the linear approximation of the function f(x) = 3x 3 + 2x2 + x , about x =
5. Determine the quadratic approximation of the function given in question number four
6. Given the function f(x) = 2x 2 + 3x + 5, find its Maclaurin series
7. Find the Taylor's series of the function given in question 6 above around x  x0
8. Given the equation x5 + 2x4 + 3x2 + x - 3 = 0
- Show that the equation has at least one solution in [0, 1]
- Determine the approximate value of the equation in the interval [0, 1] using the
Newton's method once. -------------------------------------------------------------------------------------

2.3 Multivariate Calculus

Up on the completion of this section you are expected to

- describe what partial derivative is

- explain the Young's theorem states
- describe the multivariate chain rule
- describe homogenous functions and Euler’s theorem
- explain about total differential of a function

Dear learner! What are multivariate functions? Some functions involve one dependent
and more than one independent variable. These functions are said to be multivariate functions.

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For example, the production function Q = f (K, L) has one dependent and two independent
variables, labor L and capital K.

2.3.1 Partial Derivatives

Dear learner! What is partial differentiation? You should remember what you studied from
quantitative method for economists I to answer this question. Have you answered it? Ok, good.
Try to relate your answer with the following analysis.

Partial differentiation is a technique of deriving the rate of change of the function with respect to
change in one of the independent variable when all other variables in the function are held
constant. Thus, if the production function Q = f (K, L) is differentiated with respect to L, with K
being constant, we obtain the rate of change of total product with respect to labor, i.e., Marginal
product of labor ( MPL ) .

Partial differentiation follows the normal rules of differentiation apart from the fact that all
variables other than the one the function is being differentiated with respect to are assumed to be
constant.

Given the function, y  f ( x1 , x 2 ) the usual notation for the partial derivative of the function with
respect to x1 is
y y
= f x1 and that of with respect to x 2 is = f x2
x1 x 2

Example
1. If the function is given by y  4 x12 x 23  6 x12 x 2  x14  7 x 23 , find f x1 and f x2 .

f x1  8 x1 x 23  12 x1 x 2  4 x13 ( x 2 is assumed to be constant)

f x  12 x12 x 22  6 x12  21x 22 ( x1 is assumed to be constant )
2

Economic Applications

Partial differentiation is frequently applied in economic analysis as the economy is a complex

system to understand. Economists usually observe the effect of changes in one variable
supposing all other variables constant.

A. Elasticity

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As we know quantity demanded for a product depends on various factors such as price of the
good , ( p) consumer's income ( y ) , price of related goods, and population ( n) .
Qdd  f ( p, y, p c , p s , n) where p c is price of complement.
p s is price of substitutes.
And we also know that price elasticity of demand E p is
dQ p
Ep = ( )
dp Q
But with the existence of these determinants in the demand function
Q P
Ep  ( )
P Q
Example
Given the demand function as Q= 35-0.4P+ 0.15y- 0.25 Pc +0.12 Ps +0.003n, what is the price
elasticity of demand when price is 24?
Q P Q
Ep  ( ) , you are required to get .
P Q p
Q
 - 0.4 (all factors other than the price of the product are constant)
P
(0.4)(24)
Ep 
35  0.4(24)  0.15 y  0.25 Pc  0.12 Ps  0.003n
( 9 .6 )
Thus, Ep 
25.4  0.15 y  0.25 Pc  0.12 Ps  0.003n
The exact price elasticity of demand can be calculated if the values of the remaining variables are
given.

B. Utility Functions

Dear colleague! According to the Cardinality approach the consumer who consumes only two
products A and B will have the utility function
U = U (A, B)
We can determine the marginal utility of each good from this function using the technique of
partial differentiation.

Example
If the utility function of the consumer is given by
U = 2A0.4 B0.4 Where A and B represent the quantity of the two goods consumed; find marginal
utility of each good.
MUA = 2(0.4) A-0.6 B0.4

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0 . 8 B 0 .4
=
A 0 .6

MUB = 0.4(2) A0.4 B- 0.6

0 . 8 A 0 .4
=
B 0 .6
As the consumption of good A increases, MU A decrease and as the consumption of B increases
MUB decreases. As a result the law of diminishing marginal utility holds for both goods.

C) Production Function
When the firm produces a product using two or more variable inputs, then we can determine the
rate of change of total product with respect the change in each input using the method of partial
differentiation.

Example
If the production function for a product is given by Q = 20K 0.5 L 0.5 where K is capital and L is
labor, Find the marginal Product of each input.
Marginal product of labor (MP L) = 0.5 (20) K0.5 L-0.5
10 K 0.5
MPL =
L0.5

Marginal Product of capital (MP K) = 0.5 (20) K 0.5 L 0.5

10 L0.5
MP k =
K 0 .5
Dear colleague! We have seen that the law diminishing marginal productivity is satisfied for
each input.

D) Revenue and Cost Functions

It is clear that some cases firms may produce different products. If they use common production
facilities, the costs of each product will be related. Therefore, the marginal cost function of the
individual product can be determined by the method of partial differentiation.

Example
A firm produces two products Q 1 and Q 2 and it's total cost function is C ( Q1 ,Q2 ) = 20 (Q1+ Q2
), What are the relevant marginal cost functions.
C = 20Q1 + 20Q 2
C
Thus, Marginal cost of Q1 =
Q1

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MC 1 = 20
Marginal cost of Q2 (MC2) = 20

In other cases, the firm may produce different products which are complementary with each
other. This means, the price of one good will affect the quantity demanded of the other good.
Thus, the marginal revenue of one good is the partial derivative of total revenue with respect to
that good assuming the price of the other good constant.

Example
Suppose a firm produces two products A and B which are complements. The relevant demand
functions are
QA = 850 - 12.5 P A -3.8P 
QB = 936 - 4.8 P A + 24 P B

What are the marginal revenue functions of the two goods? -------------------------------------
---------------------------------------------------------------------------------------------------

Dear colleague! Marginal revenue is usually expressed in terms of quantity. Thus, we should
initially rewrite the demand functions in the form of price in terms of quantity.
For good A, QA = 850 - 12.5 P A - 3.8 P B

12.5 P A = 850-3.8 PB- QA

850  3.8 PB  Q A
PA 
12.5
850Q A  3.8 PB Q A  Q A2
TRA = P A Q A =
12.5

TRA
Therefore MRA =
Q A
= 850 - 3.8 PB- 2 QA
12.5

MR A = 68 - 0.304 P B -0.16 QA

For good B, Q B = 936- 4.8 P A - 24 P B

24 P B = 936 - 4.8 P A - Q B

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QB
P B = 39 - 0.2 P A -
24
QB2
But TR B = P B Q B = 39 Q B - 0.2 P A Q B -
24
TR B
MR B =
QB

1
MR B = 39 - 0.2 P A - QB
12

The marginal revenue functions of the above two goods show that when the demand for the two
goods are interrelated, the marginal revenue function for one good will depend on the price level
of the other good.

E) Keynesian Multiplier

If we incorporate the government sector and foreign trade, the basic Keynesian macroeconomic
model will be
Y= C+ I + G+ (X -M)
and the functional relationship with consumption is
C = c Yd
Where c is the marginal Propensity to consume, and imports
M = m Yd
Where m is marginal propensity to import,
Y d = (1-t) Y
is the disposable income c, m and t are parameters and Investment I, Government expenditure
G and export X are exogenously determined.
Therefore Y = c Y d + I + G + [X- (m Y d )]
Y = c (1-t) Y + I+ G+ X- m (1-t) Y
Y - c ( 1-t) Y + m ( 1-t) Y = I+ G+X
Y [1-c (1-t) + m (1-t)] = I+ G+ X

I G X I G x
Y= =
1  c(1  t )  m(1  t ) 1  (c  m)(1  t )

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Dear colleague! If we are interested to determine the government expenditure multiplier, we

should partially different income with respect to G, holding Investment L and export X constant
as shown below.
Y 1
=
G 1  (c  m)(1  t )
Y Y Y
However, = =
G X I
Example
In a Keynesian Macroeconomic model of an economy
Y = C+ I + G+(X-M) I = 820
C = 0.75 Y d G = 960
M = 0.25 Y d Y d = (1-t) Y
X = 650 t = 0.3
Determine the equilibrium level of national income. Using the export multiplier find out what
will happen to the balance of trade if export exogenously increases by 100.

Dear collogue! Initially, we should solve the relationship between income (Y) with consumption
and Import.
C= 0.75 Y d = 0.75 (1-t) Y = 0.75(1-0.3) Y
= 0.75 (0.7) Y
C = 0.525 Y
M = 0.25Y d = 0.25 (1- 0.3) Y
= 0.25 (0.7) Y
M = 0.175 Y

Therefore, the equilibrium level of national income is

Y = 0.525Y+ 820 + 960 + 650 - 0. 175Y
Y - 0.525Y + 0.175Y = 2430
0.65Y =2430
2430
Y= = 3,738.46
0.65
At this equilibrium level of income, import will be
M= 0.25 (0.7) (3,738.46)
M = 654.23
Thus, the balance of payment will be
X- M = 650 - 654.23
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= -4.23 which is negative trade balance.

However, as export increases by 100, then the equilibrium level of income will be increased by
change in export times export multiplier, i.e.,
Y 1
Y  X = 100 [ ]
X 1  (c  m)(1  t )

1
=100[ ]
1  (0.75  0.25)(1  0.3)

1
=100 [ ]
1  (0.5)(0.7)

1
= 100 [ ]
0.65
Y  153.85
As a result, equilibrium level of income increases from 3, 738. 46 to 3, 892.31 when export
increases from 650 to 750. At this new level of equilibrium income, import will be
M = 0.175 (3,892.31)
M = 681.15
And the new balance of trade will be
X - M = 750 - 681.15
= 68.85
Therefore, the balance of trade changes from 4.23 deficits to t8.85 surplus when export
exogenously increases by 100.

2.3.2 Second Partials and Young’s Theorem

Dear colleague! As you know, if the first order partial derivatives of the function are continuous
and differentiable, differentiating these functions will result in second order partial derivatives.
Given the function Z = ƒ (x, y), if it is differentiable, it has two first order partial derivatives such
z z
as Z x= and Zy = . In addition to these, this function has four second order partial
x y
derivatives (direct and cross partial derivatives). These are
2Z
Z xx =
x 2
2Z
Z yy =
y 2

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These two derivatives are referred to as direct second order partial derivatives where a as
z y Z x
Z xy = and Z yx = are said to be second order cross partial
x y
derivatives. According to the young's theorem, the mixed (cross) partial derivatives for a given
function are always equal if both cross partials exist and they are continuous. This means
z y Z x
Z xy  Z yx = =
x y
Example
1. Given the demand function for the two commodities Q 1 and Q2
Q1  P11.7 P20.8 And Q2  P10.5 P20.2
Find the first and second order partial derivatives of the function and determine whether the two
goods are complementary or substitute. Show that whether young's theorem is satisfied or not.
Q1 Q2
 1.7 P1 2.7 P20.8  0.5 P1 0.5 P2 0.2
P1 p1
Q1 Q2
 0.8 P11.7 P20.2  0.2 P10.5 P21.2
P2 p2

From these first order partial derivatives we have observed that an increase in the price of
commodity Q1 results in an increase in the quantity demanded of commodity Q 2. Therefore, Q1
and Q2 are substitute goods.

The second order direct partial derivatives are

 2 Q1
 (1.7)(2.7) P13.7 P20.8
P12
= 4.59 P13.7 P20.8
 2Q2
= 0.24 P 10.5 P 22.2
P22

The second cross partial derivatives are

 (Q1 p1 )
= (0.8) (-1.7) P 12.7 P 20.2
p2
=  1.36 P12.7 P20.2

 ( Q1 )
P2
 (1.7)(0.8) P1 2.7 P20.2
P1
=  1.36 P12.7 P20.2

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 (Q2 p 2 )
= (- 0.2) (0.5) P10.5 P21.2
P1
= - 0.1 P10.5 P21.2
 (Q2 p 1 )
= (-0.2) (0.5) P 10.5 p 21.2
P2
= - 0.1 P10.5 P21.2

2. Given the production function Q= 6K+ 0.3 K 2L + 1.2L2 derive the four second order partial
derivatives and interpret their meaning.

The two first order partial derivatives are

Q Q
= 6+ 0.6 KL and = 0.3 K2 + 2.4 L
K L
They represent the marginal product function of the two inputs.

The four second order partial derivatives are

 2Q
i)  0 .6 L
K 2
This represents the rate of change of marginal product of capital function with respect to capital.
It indicates that marginal product of capital increases as labor increases.
 2Q
ii)  2 .4
L2
It represents the slope of marginal product of labor function which is independent of capital.
 2Q
iii)  0 .6 K
LK
This tells us that MP L increases if K is increased, for any given value of L.
 2Q
iv)  0 .6 K
LK
This tells us that MP K increases if L is increased, for any given value of L.

2.3.3 Multivariate chain Rule

As we know many economic models involve composite functions. Thus differentiation of such
functions requires the application of chain rule.
- Chain rule for functions of one variable
dy dy dx
Given y = f(x) and x= g (t), then 
dt dx dt

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- Chain rule for multivariate function

Suppose z= ƒ (x, y), x = ƒ (t) and y = ƒ (t), in this case we should use the total derivative.
dz z dx z dy
 ( ) ( )
dt x dt y dt
Given the function y = ƒ (x, w) and x  g (w) to get this total derivative, let us initially
determine the total differential dy  f x dx  f w dw . If we divide both sides of this equation by dw ,
we obtain
dy dx dw
 fx  fw
dw dw dw
dy dx
 fx  fw
dw dw

dx
Where ƒ x measures the indirect effect of w on y and ƒ w shows the direct effect of w on y.
dw

Example
1. Suppose that the relationship between revenue R, output Q produced and sold each week is
given by
R = 400Q - Q2
In addition, suppose that Q is a function of t, i.e. time period, Q = ƒ (t)
dR dR dQ

Thus dt dQ dt

dQ
 (400  2Q)
dt
When Q = 30 and that the Management is considering to increase production by five units per
week,
dR
 400  2(30)5
dt

 (400  60)5
dR
 (340)5  1700
dt

Interpretation
The management decision to increase production by five units per week increases total revenue
by 1700 units.

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2. Given the utility function U = x 2+ x y + y2, x = t3 + 1 and y = t - t3

du u dx u dy
 ( ) ( )
dt x dt y dt
= (2x+y) (3t2) + (y+ 2y) (1-3 t2)

2.3.4 Homogenous Functions and Euler's Theorem

Dear students! Do you know what homogenous function is? Please discuss with your
friends and try to answer this question. Then write your answer on rough paper.---------------------
---------------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------
Have you answered it? Ok Good .Now try to relate your answer with the following analysis.

A function y  f ( x1 , x 2 ,....x n ) is referred to as homogenous of degree r if and

only if
f (tx1 , tx 2 ,....., tx n )  t r f ( x1 , x x ,..., x n ) , where t is any parameter.

Multiplying all the independent variables by a factor t will multiply the value of the function by
the factor t  .

Example
1. If ƒ(x, y) = 3 x 3  5 x 2 y  2 y 3 , then
ƒ (t x, t y) = 3 (t x)3+ 5 (t x)2(t y ) + 2(t y )3

=
3t3x3  5t2x2 y  2t3 y3
 3t3x3 5t3x2y2t3y3
 t3(3x3 5x2y 2y3)

Therefore, the function is homogenous of degree 3.

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2. Consider the Cobb- Douglas production function

Q  bL K 1
f ( Lt , kt )  b( Lt ) (kt )1
 b t  L k 1 t 1
 b t  1 L k 1
 b t L k 1
 t b L k 1
Thus, the production function is homogenous of degree 1.
Given the function f ( tx1 , tx2, tx3, ...txn )  t  f ( x1 x2 , x3, ....xn )
If r = 1, a function exhibits constant returns to scale.
If r > 1, a function exhibits increasing returns to scale.
If r < 1, a function exhibits decreasing rectums to scale.

Euler's Theorem 1.
If the function y = f ( x1 , x 2 , x3 ) is homogenous of degree r, then according to the Euler's theorem
f f f
x1 + x2 + x3 = r f ( x1 , x 2 , x3 )
x1 x 2 x3
Example
Find the degree of homogeneity of the function
f ( x, y )  x 4  x 2 y 2 Using Euler's theorem
f x x  f y y  r(x 4  x 2 y 2 )
(4 x 3  2 xy 2 ) x  (2 x 2 y ) y  r ( x 4  x 2 y 2 )
= 4x 4  2x 2 y 2  2x 2 y 2
4 2 2
= 4x  4x y

= 4( x 4  x 2 y 2 )
Thus, the function is homogenous of degree 4.

Euler's theorem 2
If a function y  f ( x1 , x 2 ,....x n ) is homogenous of degree r, then according to this theorem the
first partials f x1 , f x2 , f x3 are homogenous of degree (r  1) .
Example
1. Given the function f ( x, y )  x 4  x 2 y 2 ,
f  4 x 3  2 xy 2 f y  2x2 y
x

f x (tx, ty )  4(tx ) 3  2(tx )(ty ) 2

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= 4t 3 x 3  2t 3 xy 2
= t 3 (4 x 3  2 xy 2 )
Thus, the function f x is homogenous of degree 3.
f y (tx, ty )  2(tx) 2 (ty )
= 2t 2 x 2 ty
= 2t 3 x 2 y  t 3 (2 x 2 y )
This means, f y is homogenous of degree 3.

2. Given the Cobb - Douglas production function

3 1
f (L, K) = 60 L 4
K 4

Find the degree of homogeneity of f L and f k using Euler's theorem.

The first partial derivatives are
3 1 1 1 (60) L 3 3
f L = 60 ( ) L 4 K 4 f k=
4
K 4
4 4
1
3
45 K 4
15 L 4
fL = 1
fK = 3
L 4
K 4

1 1
Thus, f L (tL, tK )  45(tL) (tK ) 4 4

1 1 1 1
= 45 L t K t4 4 4 4

1 1 1 1
(  )
= 45(t ) 4 4
L K 4 4

1 1
0
= t (45 L K ) 4 4

3 3
And f K (tL, tK )  15(tL) 4 (tK ) 4

3 3 3 3
= 15 L4 t 4 K 4 t 4

3 3 3 /3
(  )
= 15(t ) 4 4
L4 K 4

3 3
= t 0 (15 L4 K 4
)
Dear colleague! What we have seen from this is both of f L and f k is homogenous of degree 0.
In other words, the original Cobb-Douglas production is homogenous of degree 1.

2.3.5. Total Differential and Implicit Differentiation

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Given the function y = f(x), the differential is dy  f ( x)dx .The concept of differential can be
extended to functions with two or more independent variables.

Given the utility function, U  f ( x1 , x 2 ) , assuming that U is continuous and differentiable

U
U x1  = Marginal utility of x1
x1
U
U x2  = Marginal utility of x 2
x 2
U
Change in U which is resulted from small change in x1 is dx1 and from small change in x 2 is
x1
U
dx 2 .
x 2
Thus the total change in utility is

u u
dU = dx1  dx2
x1 x2

Dear colleague! If the two variables x and y are related by the implicit function f(x, y) = 0, the
total differential of the function is
d 0  f x dx  f y dy
0  f x dx  f y dy
If we rearrange this equation, we get
0  f x dx  f y dy
dy  f x

dx fy
Dear learners! As you remember in your microeconomic studies, the theory of production states
that the slope of the isoquant represents the marginal rate of technical substitution (MRTS)
between two inputs. In this case, the use of total differential can help us to show the reality that
MRTS between the two inputs is equal to the ratio of the marginal products of the two inputs. If
dK
the producer use capital (K) and labor (L) in the production process, MRTS LK 
dL
Given the production function Q  f ( L, K ) , the total differential is
Q Q
dQ = dK  dL
K L

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Once the isoquant is determined, there is no change in output along the same isoquant. This
means change in Q is zero. Therefore,
Q Q
dK  dL  0
K L
Q  Q
dK  dL
K L
 Q
dK
 L =  MPL
dL Q MPK
K

 MPL
MRTS Lk =
MPk

Dear students! By now have completed the last section of this unit .Therefore; try to do the
following self- test question to examine how you have understood the section.

Self - Test 2.3

Do the following questions based on the information in this section.
1. What is partial differentiation? ---------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------
2. What does the young’s theorem state? -------------------------------------------------------------------
--------------------------------------------------------------------------------------------------
3. Given the demand function for a good as Q= 56.6-0.25 P - 0.03Y+ 0.45Ps + 0.6n
Where Q is quantity demanded per week, P is price per unit, Y is average weekly income, P s is
Price of competing good and n is population in million. Given values are P = 65, Y = 350 P s = 60
and n = 24. Find the price elasticity of demand. -----------------------------------------------------------
-----------------------------------------------------------------------

4. In the Keynesian Macroeconomic model, given the following attributes

Y = C+ I+ G+ x-M t = 0.2
C = 0.8 Yd G = 400
M = 0.2Yd I = 300
Yd= ( 1-t) Y X = 288
a. Determine the equilibrium level of income.
b. What increase in G would be necessary to increase Y to 2, 500?
c. Determine the balance of trade at the initial equilibrium level of income

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---------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------
5. Derive all the first order partial derivatives for the production function Q = 35KL +
1.4LK2 + 3.2L2 and interpret their meaning. ----------------------------------------------------------
---------------------------------------------------------------------------------------------------------------
--------------------------------------------------------------------------
6. What do the Euler's theorems state? -----------------------------------------------------------------
---------------------------------------------------------------------------------------------
7. Given the function F(x, y, z) = x 3 y2 z - xy5 + y3z3, determine whether the function is
homogenous or not. ---------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------

Dear students! Have you done these questions? The answer is found at the end of this unit
.Thus; try to check your answer with it.

Check List

Write √ inside the box which corresponds to the problem that you can solve easily.
1 What is elasticity? ------------------------------------------------------
2 Explain the relationship between marginal revenue, average
revenue and price elasticity of demand
3 Describe higher order derivatives of the function --------------------
4 Explain linear and polynomial approximation of a function------
5 What is the difference between concavity and convexity of a
function? -------------------------------------------------------------------
6 Describe the difference between Maclaunin series and Taylor's
series.----------------------------------------------------------------------
7 Describe what partial derivative is --------------------------------------
8 Can you explain the young's theorem states---------------------------
---
9 Discuss about the homogenous function and the Euler's theorem.

Dear students! Is there any box that you don't tick inside it? If your answer is yes, please reread
this unit. If your answer is no, go to the next unit.

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Unit Summary

Elasticity is a measure of proportionate change in the dependent variable resulting from a

proportionate change in the independent variable. Therefore, elasticity of demand is percentage
change in quantity demanded to percentage change in demand factors.

Given the function y =f(x), the sign of the first order derivative of the function enables us to
determine whether the function is increasing or decreasing where as that of the second order
derivative of the function indicates whether the function is concave or convex.

It is possible to expand the given function y = f(x) around x = 0 or x = x o if it is differentiable.

Maclaurin series represents expansion of the function around x= 0 whereas Taylors series
represents expansion of the function around x = x 0 where x0 is any value of x.

Given the function y = f(x), if it is continuous for all values of x in the close interval [a, b], the
intermediate value theorem states that there is at least one value of x that c 
[a, b] such that f(c) = 0.

Partial differentiation is a technique of deriving the rate of change of functions with respect to
change in one of the independent variable when all other variables are held constant. According
to the young's theorem, the mixed (cross) partial derivatives of a given function are always equal
if both cross partials exist and they are continuous.

A function y  f ( x1 , x 2 ,.x3 ) is referred to as homogenous of degree r if and only

if f ( x1t , x 2 t , x3 t )  t r f ( x1 , x 2 , x3 ) where t is an arbitrary parameter. If the function f ( x, y ) is
homogenous of degree r, then the Euler's theorem states that f x x  f y y  rf ( x, y ) .

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Important Points (for focus)

Elasticity Estimation of a
Marginal revenue function
Average revenue Newton method
Concavity Young’s Theorem
Convexity Keynesian multiplier
Linear approximation Homogenous function
Polynomial Euler’s theorem
approximation Returns to scale

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Answers for Self Test Questions

Self Test 2.1

3) e p  2 4) e p  6 6) MR  100, TR increases.

Self test 2.2

f ( x)  8 x 3  9 x 2  4 x  3
f ( x)  24 x 2  18 x  4
1) f ( x)  48 x  18
f 4 ( x)  48
f 5 ( x)  0
2) TR is concave at Q= 7.
d 2 AC dAC
3) 2
 10,001, at , Q  2 It is convex.  5,311
dQ dQ
Thus, AC decreases at an increasing rate at Q = 2.
4) f ( x)  12 x  6

5) f ( x )  10 x 2  8 x  4
6) f ( x )  2 x 2  3 x  5 7) f ( x )  2 x 2  3 x  5
8) f (0)  3, f (1)  4 Thus it at least one solution in between 0 and 1.
f (1) 4
x1  1   1  0.8
f (1) 20
Self Test 2.3
3) e p  0.228
4) a. Y  1,900 b. G  312 c. X  M  288  400  112
Q
MPL   35 K  1.4 K 2  6.4 L
L
5)
Q
MPK   35 L  2.8 LK
K
7) The function is homogenous of degree 6. It shows increasing return to scale.

Economics Department Mathematical Economics (Econ2051)

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UNIT THREE

3. UNCONSTRAINED OPTIMIZATION

INTRODUCTION

Dear students! As you know economics is a science of choice. If we want to undertaken

an economic project, say producing a certain product, there may be several possible ways
of doing it. However, one or more of them will be more important than others from the
point of view of some criteria. Thus, the main duty of optimization problem is choosing
the best alternative according to the specified criteria.

In economics we usually use the objective of profit maximization or cost minimization

as the most common criteria to select the best alternative to carry out the project. In
economics, optimization problem is a general heading which represents both
minimization and maximization problem. Optimization means ' the quest for the best".
To solve optimization problem, first we should formulate the objective function which
will be maximized or minimized. This function includes dependent and independent
variables. The independent variables are referred to as choice variables because the
economic unit chooses their magnitude to optimize the objective function.

In general, the nature of optimization process is to get the values of the choice variables
that will optimize the objective function.

Dear students! This unit is emphasized on unconstrained optimization, i.e. minimization

or maximization of objective function without constraint.

Unit Objective
After completing this unit, your are expected to
- define the term optimization
- describe the conditions that should be satisfied for optimizing unconstrained
functions
- solve optimization of unconstrained functions with one independent variable
- solve optimization problem of function of two or more independent variables
- describe the unconstrained envelope theory

3.1 Functions of One Independent Variable

Up on the completion of this section the student is expected to

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- describe the first order condition that

should be satisfied for optimization
- explain the second order condition for
optimization
- solve economic models

Dear students! What is unconstrained function? You ought to refer your Quantitative
Method for economist I material to answer this question. ---------------------------------------
------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------?
Have you answered it? Good. Try to relate your answer with the following analysis.

Some objective functions involve constraints and others do not.Fonctions which do not
involve constraints are referred to as unconstrained functions and the process of
optimization is said to be unconstrained or free optimization.

Given the function y = f(x) which is continuous and differentiable, it is said to have a
maximum value at a point where it changes from an increasing to decreasing function
where as it is said to have a minimum value at the point where it changes from decreasing
to increasing functions. The values of x at which the function is at its minimum or
maximum point are known as critical values. The given function should satisfy two
conditions in order to decide about maximum and minimum value at a particular point.
These conditions are called order conditions.

a) Conditions for minimum value

1. First order condition f ( x)  0
(Necessary condition)
2. Second order condition f ( x)  0
(Sufficient condition)

b) Conditions for Maximum value

1. First order condition f ( x)  0
(Necessary condition)
2. Second order condition f ( x)  0
(Sufficient Condition)

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However, the second derivative of the function may be equal to zero in some cases.
When f ( x)  0 , the second derivative test would be inconclusive. Thus, we should take
the successive derivative test to determine whether the function is at its extremum point
or the point of inflection. Evaluated at a critical point if the first non - zero value of a
higher order derivative is an odd numbered derivative, then the function is at the point of
inflection. If the first non - zero value of a higher order derivative is an even numbered
derivative, the function is at it's relative extremum with positive value the derivative
shows the relative minimum and with negative value the derivative indicates the relative
maximum point.

Example
Find the minimum and maximum values of the function f ( x)  3 x 4  10 x 3  6 x 2  5

Solution
The first order condition is f ( x)  0 .We can determine the critical values using this
condition. Thus, f ( x)  12 x 3  30 x 2  12 x  0
3 x(4 x 2  10 x  4)  0
3 x[2 x(2 x  1)  4(2 x  1)]  0
3 x[(2 x  4)(2 x  1)]  0
3x  0 or 2 x  4  0 or 2 x  1  0

1
Thus the critical values are x  0 or x  2 or x  .
2
We should test the second order condition at these points to know whether the function is
at its relative maximum or minimum point.
f ( x)  36 x 2  60 x  12
At x  0 , f ( x)  36(0) 2  60(0)  12  12  0 . Thus, the function is at its relative
minimum point at x = 0.
At x = 2, f ( x)  36(2) 2  60(2)  12
=144-120 +12
f ( x)  36  0 . Thus, the function is at its relative minimum point at x  2 .
1 1
At x = ½, f ( x)  36( )  60( )  12
2 2
1
= 36( )  30  12
4
= 9  30  12  9  0

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1
Therefore, the function is at its relative maximum point when x  .
2

Economic Applications

Revenue functions
Dear students! As you remember revenue represents the amount of money that the firm
generates either from the sale of the products or providing services. Therefore,

Total Revenue = Price x Quantity Sold

It can be written as
TR = P x Q
Where P is price and Q is quantity.
The firm can maximize its total revenue when
dTR
 0 or MR  0 (First order condition)
dQ
d 2TR d ( MR)
and 0 or  0 ( Second order condition )
dQ 2 dQ

Example

1. A farmer wants to send his perishable product to a city market as soon as possible. He
has estimated that he can send now 1.5 tones of the product per day and can get a price of
2,500 birr per tones. If he waits, he can get a price increase of 20 Birr per tones per day
but the quantity of the product to be supplied will be reduced by 0.01 tones per day. For
how many days should he wait so that his revenue becomes a maximum?

Solution
Let x be the number of days waiting
Total revenue (TR) = (2, 500 + 20x) (1.5-0.01x)
= 3,750 - 25x + 30x - 0.2x2
TR = 3,750 + 5x - 0.2x2

Revenue is maximized when

dTR d 2TR
0 and < 0
dx dx 2

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dTR
Thus,  5  0.4x = 0
dx
-0.4x = -5
x = 12.5
d 2TR
At x = 12.5,   0 .4  0
dx 2
Therefore, the farmer should wait for 12.5 days to maximize he's revenue.

2. Suppose a 200- room hotel in Addis Ababa will rent all its rooms when it charges 125
Birr per night per room. However from past experience, the manager knows that for each
5 birr increase in rate per night per room, 4 rooms remain unoccupied per night. What
rent per room will maximize total revenue per night?

Solution
Let x be increase in nightly rent per room.
TR = (200 – 4 x) (125+ 5x)
= 25,000 + 1,000 x – 500 x – 20 x2
TR = 25,000 + 500 x – 20 x2
dTR d 2TR
Total revenue is maximized when  MR  0 and <0
dx dx 2
MR = 500 - 40 x = 0
-40x = -500
x = 12.5
d 2TR
When x = 12.5,   40  0
dx 2
Thus, total revenue is maximized when x  12.5
The rent per room per night that should be charged to which maximizes revenue is
Rent = 125 + 5(12.5) = 125+ 6.5
= 187.5 Birr per room per night

Profit functions

Dear students! Do you remember the conditions that should be satisfied for profit
maximization? What are they? As we know that the main objective of every firm is
profit maximization; therefore, it wants to know the level of output which maximizes
profit.
Total profit = Total revenue - Total cost
 = TR – TC

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Where  represents total profit, TR is total revenue and TC is total cost.

We have discussed above that there are first orders and second order conditions for
maximizing profit. The first order condition that must be fulfilled for maximizing profit
is that the slope of total revenue (marginal revenue) has to be equal to the slope of total
cost (marginal cost). That is
d dTR dTC
0  0
dQ dQ dQ

MR - MC = 0
MR = MC

The second condition that has to be satisfied is that the slope of marginal revenue must
be less than the slope of marginal cost. In other words, the marginal cost curve has to
cross the marginal revenue curve from below. That is

d 2 d 2TR d 2TC
<0   <0
dQ 2 dQ 2 dQ 2
d ( MR) d ( MC )

dQ dQ

Slope of < Slope of

MR MC

Dear students! Let us do the following examples to make it clear.

Example
1. Suppose a monopolist has a demand curve Q = 106 - 2 P and average cost curve
Q
AC = 5+ , where P is price per unit and Q is the number of units of output. Determine
50
the profit maximizing level of output and price of this monopolist.

Solution

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Dear students! As we know, total profit (  ) = Total Revenue (TR) - Total Cost (TC)
but TR = PQ. Thus we should rewrite the demand function in the form of price expressed
in terms of quantity. That is
2P = 106 - Q
1
P = 53  Q
2
1
Thus, TR = (53 - Q) Q
2
1
TR = 53Q - Q2  MR = 53 - Q
2
And
TC = AC (Q)
Q
= (5+ ) Q
50
1 2  1
TC = 5Q + Q MC = 5 + 25 Q
50
Dear students! I think you remember that profit is maximized when
MR = MC
1
53 - Q = 5 + Q
25
1
53 - 5 = Q + Q
25
26
48 = Q
25
48(25)
Q=
26
Q = 46.15
However, this information is not sufficient enough to conclude that it is the profit
maximizing level of output. Thus it must fulfill the following condition at this point.
d 2TR d 2TC 1
When Q = 46.15, - = -1 -
dQ 2 dQ 2 25
 26
= <0
25
Now we are confident enough to conclude that Q = 46.15 is the profile maximizing level
of output of the monopolist as this level of output satisfies both of the above conditions.
The profit maximizing level of price is
1
P = 53 - (46.15)
2
= 53 = 23.075
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P = 29.93
Cost Functions

Dear students! Do you remember the analysis of cost in your Microeconomics I

study? Please try to re-read that material so that you will have a good understanding for
this of this topic. As you remember costs represent the amount of expenditures that
firm’s incurred in the production process. It includes both implicit and explicit cost.
Thus, firms want to minimize these costs.

Given Total Cost (TC) = f (Q), where Q is output, Firms can minimize total cost if and
only if
dTC
i)  0  MC  0
dQ
2
d TC d ( MC )
ii) 2
0 >0
dQ dQ
Example

1.Suppose the total cost of producing Q units of a certain product is described by the
function TC = 100,000 + 1, 500Q + 0.4 Q2 where TC is the total cost stated in Birr.
Determine the amount of output which minimizes average cost.

Solution
TC
Average cost (AC) =
Q
100,000
AC = + 1, 500+ 0.4 Q
Q
AC is minimized when
dAC d 2 ( AC )
 0 And 0
dQ dQ 2
dAC  100,000
  0 .4  0
dQ Q2
100,000
- = - 0 .4
Q2
100,000
 Q2
0 .4
Q 2 = 250,000
Q =  500 but output should be positive.

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Therefore, Q = 500. But we should check the second order condition at this point to
reach to our conclusion.
d 2 AC  2(100,000)
When Q= 500, 2
=
dQ Q3
200,00 200,000
= = >0
Q3 (500)3
Thus, the level of output which minimizes average cost is Q = 500 units.

2. Find the minimum point of the average cost function

Ac = 25 Q 1 + 0.1Q 2

Solution
Applying the same conditions
dAC
= - 25 Q 2 + 0.2Q = 0
dQ
-25Q 2 + 0.2Q = 0
-25Q 2 = - 0.2Q
25
= 0.2Q
Q2
Q 3 = 125
Therefore, Ac is at its stationary point when Q = 5. The rate of change of the slope of AC
d 2 AC
with respect to output is 2
 50 Q 3  0.2
dQ
d 2 AC 50
When Q = 5,  3  0 .2
dQ 2 5
50
=  0 .2
125
= 0.4+0.2 = 0.6 > 0
Thus, the second order condition for a minimum value of AC is satisfied when Q = 5.
The actual value of AC at its minimum point will be
25
25 Q 1 + 0.1Q 2 = + 0.1 (25) = 5+2.5 = 7.5
5
Dear students! By now you have completed the first section of this unit. Therefore, try to
do the following self test questions to examine how you have understood this section.

Self - Test 3.1

Solve the following questions based on the information given above.

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1.The owner of the orange grove must decide when to pick one variety of oranges. She
can sell them for 8 birr a bushel if she sells them now, with each tree yielding an average
of 5 bushels. The yield increases by one - half bushel per week for the next five weeks
but the price per bushel decreases by 0.5 birr per bushel each week. When should the
oranges be picked for maximum return? -----------------------------------------------------------
-------------------------------------------------------------------------------------
2.If a firm faces the demand schedule P = 90 - 0.3 Q how much does it has to sell to
maximize sales revenue? -----------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------
3.For the non - linear demand function P = 750 - 0.1Q 2 what output will maximize the
sales revenue? -----------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------

4. What is the maximum profit a firm can make if it faces a demand function p =
660 - 3Q and the total cost function TC = 25+240 Q- 72Q2 + 6Q 3 ---------------------------
------------------------------------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------------------------------

5.ABC Company is planning to market a new model of product X. The management

collects information from retailers that how many units of good X they would buy for
various prices. From this survey, it is determined that the unit demand function is
X = -1,500 p + 30,000

The fixed costs to the company for production of good X are found to be 28,000 birr and
the cost for material and labor to produce each unit of good X is estimated to be 8 birr per
unit. Determine the price that the company should charge to maximize its profit. ----------
------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------
6. Find the profit maximizing output for a firm with the total cost function
1
TC  Q 3  8.5Q 2  97Q  4 and total revenue TR  58Q  0.5Q 2 .
3

Dear students! Have you answered these questions? If your answer is no, please reread
this section and try to answer these questions. If your answer is yes, very good. Go to the
next section.

3.2 Functions of Several Independent Variables

After completing this section, you should be able to

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- describe conditions of optimization of these

functions
- solve optimization problem of multiproduct
firm
- explain optimal combination of various
Dear students! Until now weinput
different have discussed about the problem of optimization of an
objective function with only one choice variable. Now let us turn our attention to develop
away of finding the extreme values of an objective function which includes two or more
choice variables. Then we will have the ability to solve problems such as determining the
profit maximizing level of outputs for several commodities and the optimal combinations
of several different inputs.

Given the function z = f(x, y), the objective function z to be maximum or minimum, it
must satisfy both of the order conditions.
The first order conditions are
z z
= 0 and =0
x y
This means, the first order total differential of the function is zero
( dz  f x dx  f y dy  0 ).
However, there are two sets of second order conditions
2z 2z
a) To be maximum  0 , and < 0 -----------------------------------
x 2 y 2
(1)
2 z 2z
b) To be minimum >0, and 2 > 0
x 2 y
The other second order condition for both to be at maximum and minimum value is
2 z 2 z 2 z 2
( ) ( ) > ( )
x 2 y 2 xy
Alternatively we can determine the second order sufficient condition using the concept
of total differential of the differential of the function which is denoted by
 ( f x dx  f y dy )  ( f x dx  f y dy )
d 2 Z  d (dZ )  dx  dy
x y
d 2 Z  ( f xx dx  f xy dy )dx  ( f yx dx  f yy dy )dy ------------------------
d 2 Z  f xx dx 2  f xy dydy  f yx dxdy  f yy dy 2
(2)
But we know that f xy  f yx (Young’s Theorem)

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d 2 Z  f xx dx 2  2 f xy dxdy  f yy dy 2 ---------------------------------------------
(3)
Then the second order condition for any value of dx and dy not both zero
d 2 Z  0 indicates that the function is at its maximum whereas d 2 Z  0 shows that the
function at it minimum point. However, for any value of dx and dy ,
d 2 Z  0 if and only if f xx  0, f yy  0 and f xx f yy  ( f xy ) 2  0 .
d 2 Z  0 if and only if f xx  0, f yy  0 and f xx f yy  ( f xy ) 2  0 .

Dear students! Do you know the concept of discriminant of a quadratic function?

Discuss with your friends and try to answer this question. --------------------------------------
------------------------------------------------------------------------------------------------------------
-----------------------------
Have you answered it? Good. Relate your answer with the following analysis.
Given the quadratic function U  ax12  bx1 x 2  cx 22 , the discriminant, which is symmetric
determinant, is formed by putting the coefficient of the squared variable on the principal
diagonal and dividing the coefficient of the non squared term equally between the off-
diagonal positions as follows
b
a
D = 2
b
c
2
b2
Where D1  a the first principal minor of the discriminant and D2  ac  is the
4
second principal minor. The sign definiteness of the given function can be described in
terms of sign restriction on these principal minors.
U is positive definite iff D1  0 and D2  0 .
U is negative definite D1  0 and D2  0
For n-variable quadratic form of the function, the discriminant becomes

d11 d12. d13 ...... d1n

d d 22 d 23 ..... d 2n
D  21
d 31 d 32 d 33 ..... d 3n
d n1 d n2 d n 3 ...... d nn

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It has n- number of principal minors. The necessary and sufficient condition for sign
definiteness is that all principal minors must be greater than zero for positive definiteness
and they have to alternate in sign as D1 is negative for negative definiteness.

Dear colleague! The total differential expressed in equation (3) above is in a quadratic
form. As a result, the discriminant is a determinant that contains the second order partial
derivatives as it elements. This determinant is referred to as Hessian determinant.
f xx f xy
H 
f yx f yy
H 1  f xx And H 2  f xx f yy  f yx f xy are the first and second principal minors
respectively.
By now we can express the sign defiantness of d 2 Z using the sign of these principal
minors and there by we are able to identify the second order sufficient conditions for the
extremum of the function Z  f ( x, y ) as
d 2 Z is positive definite iff H 1  f xx  0 And H 2  f xx f yy  f yx f xy  0 . In this
case, the function achieves its minimum.
d 2 Z is negative definite iff H 1  f xx  0 And H 2  f xx f yy  f yx f xy  0 . This
indicates that the function is at its maximum.

Considering the function of n- choice variables

Z  f ( x1 , x 2 , x3 ,....x n )
The first order condition for the extremum of the function is
f 1  f 2  f 3  .........  0 which leads to the fact that
dZ  f 1 dx1  f 2 dx 2  f 3 dx3  ......  f n dx n  0
The second order sufficient conditions are identified using the Hessian determinant
f 11 f 12. ........ f 1n
H  . f 21 f 22 .......... f 2n
f n1 f n 2 .......... f nn
The sufficient condition for the maximum of the function is satisfied when
H 1  0; H 2  0; H 3  0,......(1) n H n  0 .where as for the minimum of the function all
of the Hessian principal minors must be positive.

Example
1.Given the function Z= 160x – 3x2 - 2xy - 2 y2 + 120 y - 18, find the maximum value of
the function.

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Solution
The first order conditions that should be satisfied for maximum are
Z Z
Zx   0 And Zy  0
x y
z
Zx = = 160 - 6x - 2y = 0
x
6x + 2y = 160 -------------------------------- (1)

Z
Zy  = -2x - 4y + 120 = 0
y
2x + 4y = 120 -------------------------------------- (2)

Taking equation (1) and (2) simultaneously, multiplying (1) by 2 and subtracting
equation (2) from this gives us
6x +2y = 160
2 x  4 y  120
12x +4y = 320
2 x  4 y  120

10 x + 0 =200
10 x = 200
x= 20

Substituting 20 in place of x in either of the two equation we will get y = 20

Taking the second partial derivatives,
Z xx = - 6 < 0, Z yy = - 4 < 0
And
( Z xx ) ( Z yy ) > ( Z xy ) 2
(-6) (- 4) > (-2)2
24 > 4
6 2
Alternatively, H  , H 1  6  0 and H 2  20  0
2 4
Thus, the function Z is maximized when x = 20 and y = 20
The maximum value of Z is
Z= 160(20) - 3(20)2 - 2(20) (20) - 2(20)2 + 120 (20) - 18
Z = 2,782

Economic Applications

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Example
1.A firm produces two products that are sold in two markets with the demand schedules
P1 = 600 - 0.3Q1 and P2 = 500 - 0.2Q2. Production costs are related and the firm faces the
total cost schedule TC = 16+1.2Q1 + 1.5Q2 + 0.2 Q1Q2
 Determine the profit maximizing level of output and price in each market.
 Determine the maximum profit of the firm

Solution

Total Revenue (TR) = TR 1 + TR 2

= P1Q1  P2 Q2
= (600  0.3Q1 )Q1  (500  0.2Q2 )Q2
TR = 600Q1 - 0.3Q 12 + 500Q2 - 0.2Q 22
Profit (  ) = TR -TC
= 600Q1  0.3Q12  500Q2  0.2Q22  (16  1.2Q1  1.5Q2  0.2Q1Q2 )
The first order conditions for maximum profit are


= 598.8 - 0.6 Q1 - 0.2Q 2 = 0
Q1
0.6Q1+ 0.2Q2 = 598.8------------------------------ (1)
And

= 498.5 - 0.4 Q2 - 0.2 Q1 = 0
Q2
0.2Q1  0.4Q2  498.5 ---------------------------------- (2)

Taking equation (1) and (2) simultaneously, multiplying equation (2) by 3 deducting it
from (1) gives us

0.6 Q1 + 0.2 Q2 = 598.8

Multiplying (2) by 3 0.2 Q1+ 0.4 Q2 = 498.5

0.6Q 1 + 0.2Q2 = 598.8

0.6Q1  1.2Q2  1,495.5
-Q2 = - 896.7
Q2 = 896.7 units

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Substituting this value for Q 2 in (1), we get

598.8 - 0.6Q 1 - 0.2 (896.7) = 0
598.8 - 179.34 = 0.6Q1
419.46 = 0.6 Q1
Q1 = 699.1
Dear colleague! To decide whether these output levels maximize the profit of the firm,
We must check the second order conditions at these levels of output. That is
( 2  ) ( 2  ) ( 2  )
( ) = -0.6 <0, = -04<0, = -0.2
Q12 2 Q1Q2
Q2

 2  2 ( 2  ) 2 2
Therefore, [ ][ ] > [ ]
Q12 Q22 Q1Q2

(-0.6) (-0.4) > (-0.2)2

0.24 > 0.04
The corresponding Hessian determinant is
 0 .6  0 .2
H  , H 1  0.6  0; H 2  (0.6)(0.4)  (0.2) 2  0.2  0
 0 .2  0 .4
Therefore, profit is maximized when Q 2 = 896.7 and Q 1 =699.1 and the profit
maximizing prices are
P1 = 600 - 0.3 (699.1) P2 = 500 - 0.2 (896.7)
= 600 - 209 .73 = 500 - 179.34
P1 = 390.27 P2 = 320.66
The maximum profit is
2 2
 = 16 + 598.8 (699.1) - 0.3(699.1) + 498.5(896.7) - 0.2(896.7) -
0.2(699.1)(896.7) = 432,797.02 Birr

2. A multiplant monopoly operates two plants whose total cost functions are given by
TC1 = 8.5 + 0.03 Q1 and TC2 = 5.2 + 0.04 Q 22
If the demand function is given by P = 60-0.04Q, where Q= Q1 + Q 2 .How much output
should the monopolist produce in each plant in order to maximize profit?

Solution
Total Revenue (TR) = PX Q = (60 - 0.04Q) (Q)
TR= 60 Q - 0.04 Q2
TR  60(Q1  Q2 )  0.04(Q1  Q2 ) 2

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TR = 60 (Q 1 + 60Q2 - 0.04 Q12 - 0.08Q1Q2 - 0.04Q22

Total Profit (  ) = TR - TC1 - TC1
2 2
 = -13.7 + 60 Q 1 + 60 Q2 - 0.07 Q1 - 0.08Q2 - 0.08Q1Q2
First order conditions for maximum profit are

= 60 - 0.14 Q 1 - 0.08 Q 2 = 0
Q1
0.14Q 1 + 0.08Q 2 = 60 ------------------- (1)
And

= 60 - 0.16Q 2 - 0.08Q 1 = 0
Q2
0.08Q 1 + 0.16 Q 2 = 60 ----------------------- (2)
Taking equation (1) and (2) simultaneously, multiplying (1) by 2 and reducing (2) from
it

0.14Q 1 + 0.08 Q 2 = 60
0.08Q 1 + 0.16Q2 = 60

0.28Q1 + 0.16 Q2 = 120

0. 08Q1 + 0.16 Q2 = 60
0.2Q1  0  60
Q1  300

Substituting this value in place of Q 1 in equation (1), we get

0.14(300)  0.08Q2  60
0.08Q2 = 60 – 42
0.08Q2 = 18
Q2  225
When we check the second order conditions at these levels of output
 2  2  2
= - 0.14 < 0, = - 0.16, < 0, = - 0.08
Q12 Q22 Q1Q2

Thus, (- 0.14) (- 0.16) > (-0.08)2

0.0224> 0.0064

This verifies that profit is maximized when Q 1 = 300 and Q2 = 225

The total amount of output that the firm should produce to maximize profit is
Q = Q1 + Q2 = 525 units.
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Therefore, P = 60 - 0.04 (525) = 60 - 21 = 39

3.Suppose a firm faces the production function Q = 0.8 K 0.4 L 0.3. It sells its output at a
fixed price of 450 Birr a unit and can buy K and L at 15 Birr per unit and 8 Birr per unit
respectively. What input mix will maximize profit?

Solution
Total revenue (TR) = PQ = 450 (0.8K 0.4 L)
TR = 360 K0.4 L0.3
Total cost (TC) = LPL + KP K
TC = 8 L + 15 K
Thus total profit (  ) = TR - TC
 = 360 K0.4 L 0.3 - 8 L - 15 K
The first order conditions for maximum output are

 108 K 0.4 L0.7  8  0
L
108 K 0.4 L0.7  8
K 0 .4 8
 0 .7
 -------------------------- (1)
L 108

 144 K 0.6 L0.3  15  0
K
144 K 0.6 L0.3  15
L0.3 15
0 .6
 ------------------------- (2)
K 144

Thus, we must have,

108 0.4
From (1) L0.7 = 8 K
10 4
(108) 7 7
L= [ ] K ------------------------------- (3)
8
144
From (2) K 0.6 = L 0.3 --------------------------------------- (4)
15
Substituting equation (3) in place of L in ( 4) , we get
10 4 3
0 .6 144
K  [(13.5) 7 K 7 ]10
15
3 6
0.6 144
K = (13.5) 7 K 35
15
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6 3
( 0 .6  ) 144
K 35
 (13.5) 7
15
3 3

K  (9.6)(13.5)
7 7

7
K = (9.6) 3 (13.5)
= (195.87) (13.5)
K = 2,644.25
Substituting the value of K in equation (3) enables us to determine the amount of labor
that should be employed in the production process.
10 4
L = (13.5) 7 (2, 644.25) 7
= (41.19) (90.282)
L = 3,718.72
Dear colleague! As you know it is necessary to check the second order conditions at these
values. Therefore,
 2
2
= -75.6 K 0.4 L 1.7 = - 75.6 (2,644.25) 0.4 (3,718.72) 1.7
L
= - 0.0015 < 0
 2
= - 86.4 k 1.6 L 0.3 = - 86.4 (2644.25) 0.6
(3781.72) 0.7
K 2
= 0.00121
    2
  2
2 2
( )( 2 )  ( )
2
L K LK
Therefore, (- 0.0015) (- 0.0034) > (0.00121) 2
The corresponding Hessian determinant is
 0.0015 0.00121
H  , H 1  0.0015  0; H 2  0 .
0.00121  0.0034

Now we are confident enough to conclude that the firm will maximize its profit when it
employs 2, 644.25 units of capital and 3, 718.72 units of labor in the production process.

4. suppose the monopolist sells a certain product in three separate markets and the
demand functions facing the firm are
P1  63  Q1
P2  105  5Q2 And the cost function is
P3  75  6Q3
C  20  15Q; Q  Q1  Q2  Q3

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Determine the amount of output that should be sold to maximize profit .Identify the
prices charged in each market to maximize profit.
First we should construct the total revenues for each market. These are
TR1  63Q1  Q12
TR2  105Q2  5Q22
TR3  75Q3  6Q32
Therefore, the total profit function is   TR2  TR2  TR3  C
  63Q1  Q12  15Q2  5Q22  75Q3  6Q32  (20  15Q1  15Q2  15Q3 )
  48Q1  4Q12  90Q2  5Q22  60Q3  6Q32  20 ---------------------------(1)
First order conditions


1   48  8Q1  0  Q1  6
Q1
 2  90  10Q2  0  Q2  9
 3  60  12Q3  0  Q3  5
P1  57, P2  60, P3  45
We can check the second order condition using the sign of the principal minors of the
Hessian determinant. The corresponding Hessian determinate is
 11  8,  12  0,  13  0
 21  0,  22  10,  23  0
 31  0,  32  0,  33  12

 11  12  13  8 0 0
H   21  22  23  0  10 0
 31  32  33 0 0  12

Evaluating the successive principal minors,

8 0
H 1  8  0, H 2   80  0, H 3  H  960  0
0  10
It indicates that d 2 is negative definite. Thus, the monopolist can maximize its profit
when it sells 20 units of out put out of which 6 units at a price of 57 birr per unit in
market 1, 9 units at a price of 60 birr per unit in market 2 and 5 units at a price of 45 birr
per unit in market 3.

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Dear colleague! By now you have completed the second section of this unit. Therefore,
try to do the following self - test questions to evaluate whether you understand the section
or not.

Self - Test 3.2

Do the following questions based on the above examples.
1.What are the conditions for the optimization of a function Y = f(x, z)? -------------------
------------------------------------------------------------------------------------------------------------
-----------------------------------------------
2. A firm produces two products which are sold in separate market with demand
functions
P1  180  15Q1
and the cost function is TC  150  120Q where Q  Q1  Q2
P2  380  20Q2
How much should the firm charge in each market to maximize profit? -----------------------
------------------------------------------------------------------------------------------------------------
--------------
3. A multipant monopoly operates two plants whose cost functions are
TC1 = 2.4 + 0.015 Q1 2 and TC2 = 3.5 + 0.012 Q2 2 and its demand function is
P = 32- 0.02 Q,
How much should it produce in each plant to maximize its profit? ----------------------------
------------------------------------------------------------------------------------------------------------
-----------------
4.A firm selling in a perfectly competitive market where the ruling price is 40 birr can
buy inputs K and L at prices per unit of 20 birr and 6 Birr respectively and operates with
production function Q = 21 K 0.4 L 0.2 , what is the maximum profit ? ------------------------
------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------
----------------------------------------------------.
Have you answered these questions? If your answer is no, please reread this section and
try to do them. If your answer is yes, very good, go to the next section.

3.3 Unconstrained Envelope Theorems

Up on the completion of this section, the student is expected to

Dear learner! Have you ever heard about envelope theorem? What does it state?
Try to discuss with your friends and answer this question. And write your answer on a
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rough paper.--------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------

Have you answered it? Good. Try to relate your answer with the following analysis. Until
now we have discussed about the way how the maximum or minimum value of the
function depends on the value of the independent variables under consideration.
However, in economic theory we are usually interested in how the optimal value of a
function depends on some parameters such as tax rates etc.

Although these parameters are assumed to be constant during the process of

optimization, they may vary according to the economic situation. Therefore, what
happens to the optimal value of the objective function when these parameters change?

Considering the firm which produces an output Q using L units of labor as input, and it's
production function is given by Q= f( L). Suppose the price of the product is p and that
of labor is w , the theory of the firm states that the firm chooses the amount of labor L
which maximizes profit. The profit function is

 [ L, ( w, p )]  pf ( L)  wL

Considering L ( w, P ) as the optimal amount of labor when the prices are w and P , then
the maximal profit of the firm is represented by
  ( w, p )  pf [ L ( w, p )]  wL ( w, p )
This function is known as the firms indirect profit function. According to the envelope
theory, the partial derivative of the profit function with respect to P , evaluated
at L  L ( w, P ) is  ( L ( w, p ))
In this case the derivative is positive which indicates that as the price of the product
increases, the profit of the firm increases.

Similarly, the envelope theorem states that the derivative of the firms profit function with
respect to w is  L ( w, p ) .But in this case the derivative is negative which shows that an
increase in the price of an input decreases the maximal profit of the firm.
Dear learner! The following graph shows how the indirect objective function envelopes
the direct objective function.

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Fig.3.1 Envelop Curve.

Each of the inverted U-shaped curves is the graph of direct profit function  ( L, ( w, p )) as
a function of w for a given value of L and p .Each of these graphs show how  changes
due to change in w for a given value of L and p .To get the solution of the maximization
problem for any given value of w , we should find the highest function for that value of
w . Thus the graph of the indirect profit function is the locus of these highest points.
Thus, the indirect objective function is the envelop curve of the direct objective function
at various values of w in our case.

Example
1. Suppose a firm is producing a certain product Q and wants to maximize its profit.
Suppose a tax rate t is imposed on a production of Q. What is the effect of change in the
tax rate on total profit?
Total Profit (  ) =TR-TC
TR  R (Q )
TC  C (Q )  tQ
Thus,  (Q, t )  R (Q )  C (Q )  tQ
The first order condition for maximum profit is
 (Q, t )  R (Q)  C (Q)  t  0
MR  MC  t  0
MR  MC  t -------------------------------- (1)
From equation (1) we can determine the critical value of the profit function and let’s say
Q  Q .
Second order condition for maximum profit is
 (Q, t )  R (Q)  C (Q)  0
Given the optimal output Q  Q  (t ) , the maximal profit is
 (Q  (t ))  R (Q  (t ))  C (Q  (t ))  tQ  (t )
The effect of change in the tax rate on total profit is determined by differentiating the
Profit function with respect to the tax rate. It is given as
d dQ  dQ  dQ 
 R (Q  (t ).  C (Q  (t )).  Q  t
dt dt dt dt
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dQ  dQ 
= [ R (Q  (t ))  C (Q  (t ))]  Q  t
dt dt
However, R (Q  (t ))  C (Q  (t ))  t
d dQ  dQ 
Therefore,  [C (Q  (t ))  t  C (Q  (t ))]  Q  t
dt dt dt
dQ  dQ 
=t  Q  t
dt dt
d
 Q 
dt
Dear learner! As you have seen the rate of change of total profit with respect to tax rate
is negative. It indicates that an increase in tax decreases the total profit of the firm.
2.Assume that the demand and the total cost functions of the monopolist are P=24-3x and
C= x2+8x respectively. Determine the rate of change of the profit function with respect to
the tax rate when a tax rate of 4 Birr per unit of production is imposed.
Total profit   (24  3 x) x  ( x 2  8 x  4 x)
 24 x  3 x 2  x 2  12 x
  4 x 2  12 x
Dear learner! Now let us determine the critical value applying the first order condition.
   8x  12 
 8 x  12
x   1.5units
Second order condition is
   8  0
Therefore, x  x   1.5 is the optimal amount of output.
Then  (t )  4 x 2  16 x  1.5t  4(1.5) 2  16(1.5)  1.5t
=  9  24  1.5t  15  1.5t
d
 1 .5   x 
dt

Dear learner! By now you have completed the third section of thin unit. Thus, to do the
following self - test questions
Dear colleague! Is there any box in which you didn't tick? If yes, please reread this
unit and try to do it. If no, very good Go to then next unit.

Unit Summary

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In economics we usually use profit maximization or cost Minimization as the most

common criteria to select the best alternative to under take a project. Optimization
problem is a general heading which represents both maximization and maximization
problems.

To solve the optimization problem first we should formulate the objective function.
Objective functions which do not involve constraints are called unconstrained functions
and their process of optimization is referred to as free optimization or unconstrained
optimization.

In the optimization process, the parameters are assumed to be constant even if they vary
according to the economic situation.

Envelope theorems are theorems that describe conditions under which the value of a
parameterized optimization problem is a differentiable function of the parameter.

The indirect objective function is the envelope curve of the direct objective function at
various values of the parameter.

Important Points(For Focus)

Optimization Critical points

Unconstrained function Unconstrained Envelop theorem
Choice variables Direct objective function
Minimization Indirect objective function
Maximization Parameters
Order conditions Free optimization
Hessian determinant

Answers for Self Test Questions

Self test 3.1

1) The orange must be picked at the 3rd week to maximize return.
(Hint. TR  (8  0.5 x)(5  0.5 x), where X represents number of weeks.)
2) Q = 150 units
3) Q = 50units
4) Max.  5,075 , when Q= 10.

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1) P  14 & Q  9,000units
2) Q= 13

Self Test 3.2

2) P1  150 & P2  250
3) Q1  266.67 & Q2  333.33units

4)   29,69.47, when, K  1,493.47 & L  2,489.12

Self Test 3.3
4) Before tax P  75 & Q  2500
After tax P  80 & Q  2000
d
 2500
dt

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UNIT FOUR
4. CONSTRAINED OPTIMIZATION

INTRODUCTION

Dear learner! In the previous unit we studied the optimization of functions with out the existence
of constraints. However, in business and economics studies there are many situations in which
complete freedom of action is impossible. For example, a firm can maximize output subject to
the constraint of a given budget for expenditures on inputs, or it may need to minimize cost
subject to a certain minimum out put being produced. Such functions which involve constraints
are called constrained functions and the process of optimization is referred as constrained
optimization. This unit explains the ways of solving constrained optimization problems with
equality and inequality constraints.

Unit Objective

Up on the completion of this unit, you are expected to

 describe what constrained function is
 describe the order condition for the optimization of constrained function
 explain the Lagrange multiplier
 describe how functions with inequality constraints are solved
 describe the Kuhn - Tucker theorem
 solve objective function subject to mixed constants

4.1 One Variable Constrained Optimization with Non - Negative Constraint

After completing this section, you should be able to

- describe optimization of the objective function at a given

point
- explain the first order conditions that must be met
- describe the second order condition that must be met for
optimization

i) With equality constraint

Maximize y = f(x), subject to x  x . In this case y   f (x )

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It simply involves determining the value of the objective function at the given point in the
domain.

ii) With non - negativity constraints

Maximize subject to x  0

(a)

At x  0, f ( x)  0
For the above function the unconstrained maximum attained when x < 0 at point b as shown in
the above figure where as y attains its constrained optimum at point a.

y   f ( 0)

(b)

In this case the constrained and unconstrained maximum value of the function lie at the same
point, i.e., they coincide at point a as shown above. y   f (x) .

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(c)

(c)

In this case, similar to that of b, the constrained and unconstrained maximum value of the
function reside on the same point,
y   f ( 0)
f ( x)  0
Dear colleague! Please try to minimize y  f (x) , subject to x  0 in a similar way.

Given the function y  f (x) subject to the x  0

For maximization,

f ( x)  0 if f ( x)  0, x 
if f ( x)  0, x  0

For minimization

f ( x)  0 if f ( x)  0, x 
if f ( x)  0, x  0

Example

Maximize the objective function y = - 3x2 - 7 x + 2 subject to x  0.

First order condition for maximization
f ( x)  6 x  7 = 0
6x= - 7
7
x=
6

Second order condition for maximization

f ( x)  6  0
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7
Thus, the unconstrained maximum value of the function locates at x= , i.e., x < 0 but the
6
constrained maximum, at x  0, f (0)  7  0 Thus the constrained maximum is the function is
y  2.

2. Minimize y = x2 + 2x+ 5, subject to X  0

First order condition
f ( x)  2 x  2  0
x  1  0
Second order condition
f ( x)  2  0
Thus the function actives it’s unconstrained minimum at x = -1, i.e., y = 4 However,
at x  0, f ( x)  2  0 . Therefore, the minimum value of the constrained function is y = f (0) = 5.

Dear colleague! By now you have completed the first section of this unit. Thus, try to do the
following self - test questions to examine your understanding of this section.

Self - Test 4.1

Solve the following questions based on the information in the above section.
1. Maximize y = -x 2 + 5x + 6, subject to
2. Maximize y = - 2 x2 + 3 x + 4, subject to x  0
3. Find the maximum value of the function y = -3x 2 + x + 7, subject to x  0
4. Minimize the function y = x 2 + 3 x + 4, subject to x  0
5. Find the minimum value of the function y = 2x 2 + x + 7 , subject to x  0
Dear learner! Have you answered these questions? If no, Please rereads this section and try to do
them. If yes, good go to the next section.

4. 2. Two Variable Problems with Equality Constraints

Up on the completion of this section, you should be able to

- describe the order condition for optimizing these functions

- explain the method of optimization by Substitution
- describe the Lagrange multiplier method
- interpret the Lagrange multiplier
- optimize multivariable functions

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Dear Colleague! In this section we will see two method of constrained optimization. These are.
 Constrained optimization by substitution
 Lagrange multiplier method

A. Constrained Optimization by Substitution

Dear learner! Where can we apply this method? Please discuss with your friends and try to
answer this question. And write your answer on a rough paper. Have you answered it? Ok good.
Try to relate your answer with the following analysis.

This method is mainly applicable for problems where the objective function with only two
variables is maximized or minimized subject to one constraint.

Consider a firm that wants to maximize output given the production function Q = f (K, L) and
suppose PK and PL prices of K and L respectively and a fixed budget B. Then, we can determine
the amount of K and L that optimize Q using the method of substitution.

Example
1. A firm faces the production function Q= 12K 0.4 L 0.4 and assume it can purchase K and L at
pries per unit of 40 birr and 5 Birr respectively and it has a budget of 800 Birr. Determine the
amount of K and L which maximizes output.

Solution
The problem is Maximize Q= 12K 0.4 L 0.4
Subject to 40K +5L = 800

According to the theory of production, the optimization condition is written in such away that the
ratio of marginal product of every input to its price must be the same. That is
MPK MPL

PK PL
The marginal products can be obtained by the method of partial differentiation as follows.

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MPK = 4.8 K -0.6 L 0.4....................................... (1)

MPL =4.8 K 0.4 L 0.6 ......................................... (2)
Substituting these marginal products and the given prices in the constraint function gives us

4.8 K 0.6 L0.4 4.8 K 0.4 L0.6


40 5

K -0.6 L 0.4 = 8 K 0.4 L -0.6

Multiplying both sides by K 0.6 L 0.6

L = 8k..................................................................... (3)
Substituting (3) in the budget constraint we get

40K + 5(8K) =800

40K+ 40K = 800
80k =800
K=10
Thus, L= 8(10) =80
There fore, this firm should employ 10 units of capital and 80 units of labor in the production
process to optimize its output.

2. Suppose the utility function of the consumer is given by U  4 xy  y 2 and the budget
constraint is 2x+y = 6. Determine the amount of x and y which will optimize total utility of the
consumer.

Solution
MU X MU y
Utility is maximized when 
Px Py
In our example, MU x = 4y, MU y = 4x-2y.Therefore, at the point of equilibrium
4 y 4x  2 y

2 1
4y = 8x-4y
4y + 4y = 8x
8y = 8x
x  y ---------------------------------------- (4)

Substituting (4) above in the budget constraint gives us

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2x +x= 6
3x=6
x=2=y
Therefore, this consumer can optimize his utility when it consumes 2 units of good x and 2 units
of good y.

B. Lagrange Multiplier Method

Dear learner! What is Lagrange Multiplier Method? What are the steps to use this method?
How do you interpret the Lagrange multiplier? Remember the concepts of your calculus for
economists and Microeconomics I ---------------------------------------------------------------------------
------------------------------------------------------------------Have you answered it? Ok, try to relate
your answer with the following analysis. The essence of this method is to change a constrained
optimization problem in to a form such that the first order condition of the unconstrained
optimization problem can still be applicable. This method can be used for most type of
constrained optimization problems. Given the function Z= f (x, y) subject to g (x, y) = P x X+
PYY =M, to determine the amount of x and y which maximize the objective function using the
Lagrange Multiplier Method, we should involve the following steps.

Step 1 Rewrite the constraint function in its implicit form as

M  xPx  yPy  0
Step 2 Multiply the constraint function by the Lagrange multiplier 
 (M- x P x- y P y) = 0

Step 3 Add the above constraint to the objective function and thereby we get the Lagrange
function that is a modified form of the objective function which includes the constraints as
follows:
L( x, y,  )  Z ( x, y )   ( M  xPx  yPy ) ------------------- (5)
Necessary condition, i.e. the first orders condition for maximization is that the first order partial
derivatives of the Lagrange function should be equal to zero.

Differentiating L with respect to x, y, and  and equating it with zero gives us.
L z
  Px  0 ----------------------- (6)
x x
L z
  Py  0 ----------------------- (7)
y y

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L
 M  xPx  yPy  0 ------------------------- (8)

From equation (6) and (7) we get
Z Zy
 = x and  =
Px Py
Zx Zy Z x Px
This means,   or 
Px Py Z y Py
Sufficient condition -To get the second order condition, we should partially differentiate
equations (6), (7) and (8). Representing the second direct partial derivatives by Z xx and Z yy and
the second cross partial derivatives by Z xy and Z yx, the border Hessian determinant bordered
with 0, g x and g y is
0 gx gy 0  Px  Py
H  gx L xx L xy   Px Z xx Z xy  o
gy L yx L yy  Py Z yx Z yy

d 2 Z is referred to as positive definite subject to dg = 0 iff H <0,

d 2Z is referred to as negative definite subject to dg = 0 iff H > 0 .

2
Negative definiteness of d Z implies that the function achieves its relative maximum point
where as a positive definite is a sufficient condition to satisfy the relative minimum of the
objective function.

Maximization

Example
Given the utility function of the consumer who consumes two goods x and y as
U (x, y) = (x+ 2) (y+1)
If the price of good x is P x = 4 birr, that of good y is P y = 6 Birr and the consumers has a fixed
budget of 130 birr. Determine the optimum values of x and y using the Lagrange multiplier
method,

Solution
Maximize U (x, y) = x y + x+ 2y + 2
Subject to 4x + 6y = 130

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Dear colleague! Now we should formulate the Lagrange function to solve this problem. That is
L( x, y,  ) = x y + x+ 2y + 2 +  (130 - 4x - 6y) --------------------------------- (9)
L L L
Necessary conditions for utility maximization are  0,  0, 0
x y 
L
 ( y  1)  4 = 0
x
y = -1 + 4  ------------------------------------- (10)
L
 ( x  2)  6  0
y
x  2  6 ---------------------------------- (11)
L
 4 x  6 y  130  0

4x+6y= 130----------------------------------- (12)
Substituting the value of x and y explained in equation (10) and (11) in to (12) enables us to
determine
4 (-2+ 6  ) + 6 (-1 +4  ) = 130
- 8 + 24  - 6 + 24  = 130
48  = 144
 =3
Therefore, x = -2+6(3)
x = -2 + 18 = 16
y = -1 + 4 (3)
y = 11
Second order sufficient condition for utility maximization is

0 gx gy
H  gx L xx L xy
gy L yx L yy

The second partial derivatives of the objective function and the first partial derivatives of the
constraint function are
2L
L xx = = 0, L yy = 0, L xy = L yx = 1
x 2
g g
ց x = = 4, and ց y = 6 =
x y
Therefore, the bordered Hessian determinant of this function is
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0 4 6
H  4 0 1 = - 4(0-6) + 6 (4- 0) = 48 > 0
6 1 0

The second order condition, i.e., H > 0 is satisfied for maximization. Thus, the consumer
maximizes utility when he consumes 11 units of good y and 16 units of good x. The maximum
utility is U = (16+2) (11+1) = (18) (12) = 216 units which is similar to the value of the Lagrange
function at these values of x , y and  . The value of the Lagrange multiplier  is 3. It indicates
that a one unites increase (decrease) in the budget of the consumer increases (decreases) his total
utility by 3 units.

2. Suppose the monopolist sells two products x and y and their respective demand is
P x = 100 - 2 x and P y = 80 - y
The total cost function is given as TC = 20x + 20y, when the maximum joint product of the two
outputs 60 unit. Determine the profit maximizing level of each output and their respective price.

Solution
Dear colleague! We know that total profit (  ) = TR - TC, where TR represents total revenue
and TC represents total cost.
TR= x P x + y P y = (100x - 2x2) + (80y - y2)
Thus  = 100x - 2x2 + 80 y - y2 - 20x - 20 y
 = 80 x + 60 y – 2x2- y2
But this monopolist can maximize its profit subject to the production quota. Thus,
Maximize  = 80x + 60 y- 2x2- y 2
Subject to x+ y = 60
To solve this problem, we should formulate the Lagrange function,
L (x, y,  ) = 80x + 60y - 2x2 - y 2 +  (x+ y - 60) --------------- (13)
First order conditions for maximum profit are
L x = 80 - 4x +  = 0
- 4x = - 80 - 
 = 20 + 1 4  ------------------------------------------------ ------- (14)
L y = 60 - 2y+  = 0
- 2y = - 60 - 

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1
y = 30 +  ----------------------------------------------------------- (15)
2
L  = x + y -60 = 0
X + y = 60------------------------------------------------------------ (16)
Substituting equation (14) and (15) in equation (16), we get
1 1
20 +  + 30+  = 60
4 2
3
50 +  = 60
4
3
 = 10
4
40

3
1 40 1 (40)
Thus, x = 20 + ( ) y = 30 +
4 3 2 3
= 20+ 3.33 = 30+6.67
x = 23.33 y = 36.67
Second order condition for maximum profit is
L xx = - 4, L y y = -2, L x y = L y x = 0
g x = 1, g y = 1
Therefore, the bordered Hessian determinant of the given function is
0 1 1
H = 1 -4 0 = -1 (-2 - 0) + 1 (0+4) = 6> 0
1 0 -2

The second order condition is satisfied for maximization of functions.

Px  100  2(23.33) Py  80  36.67
Px  53.34 Py  43.33
Therefore, the monopolist maximizes its profit when it sells 23.33 of good x at a price of 53.34
40
birr per unit and 36.67 units of good y at a price of 43.33 birr per unit.  = shows that a one
3
40
unit increase in total expenditure on inputs increases total profit of the monopolist by units.
3
In other words, if the constant of the constraint relaxes by one unit that is x  y  61 , then the
value of the objective function increases by the value the Lagrange multiplier .

Minimization
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Dear colleague! As we know, the firm can determine the least cost combination of inputs for the
production of a certain level of output Q. Given the production function Q= f (L, K) and the cost
function of the firm is C = LP L + KP k Where L = labor, K = capital, Q = output. Suppose the
price of both input to be exogenous, we can formulate the problem of minimizing the cost as
Minimizes C = PL L + P k k
Subject to Q = f (L, K)
To determine the amount of labor and capital that should be employed initially we should
formulate the Lagrange function. It is
L  LPL  KPK   (Q  f ( L, K ) --------------------------- ---- (17)
First order conditions for a minimum cost are
LL  PL  QL  0
PL P
  L ---------------------------------------------- (18)
QL MPL
LK  PK  Qk  0
PK P
  K ------------------------------------------- (19)
QK MPK
L  Q  f ( K , L)  0 --------------------------------------------- (20)
Where QL and Qk represents marginal product of labor and capital respectively.
From equation (17) and (18), we get
P P
  L  K -------------------------------------------------- (21)
MPL MPK

Equation (21) indicates that, at the point of optimal input combination the input - price ratio and
the marginal product ratio have to be the same for each input. This ratio shows the amount of
expenditure per unit of the marginal product of the input under consideration. Thus, the
interpretation the Lagrange multiplier is the marginal cost of product at the optimal condition. In
other words, it indicates the effect of change in output on the total costs of production, i.e., it
measures the comparative static - effect of the constraint constant on the optimal value of the
objective function.

The first order condition indicated in equation (21) can be analyzed in terms of isoquants and
isocosts as
P MPL
 = L = --------------------------------------------- (22)
Pk MPk

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MPL
The represents the negative of the slope of the isoquant, which measures the marginal rate
MPK
of technical substitution of labor to capital (MRTS Lk )
PL
The ratio shows the negative of the slope of the isocost. An isocost is a line which indicates
PK
the locus of input combinations which entail the same total cost. It is shown by the equation
C PL
C= PL L + P k K or K = - L
PL Pk
PL MPL
= indicates the fact that the isocost and isoquant lines are tangent to each other at the
Pk MPk
point of optimal input combination.

Second order condition for minimization of cost.

Dear colleague! As you know, a negative bordered Hessian determinant is sufficient to say the
cost is at its minimum value. That is

0 QL QK
H  QL LLL LLK
QK LKL LKK
Example

Suppose a firm produces an output Q using labor L and capital K with production
function Q  10 K 0.5 L0.5 . If the output is restricted to 200 units, price of labor is 10 birr per unit,
the price of labor is 10 birr per unit and Price of capital is 40Birr per unit, and then determines
the amount of L and K that should be employed at minimum cost. Find the minimum cost.

The problem is Minimize C = 10 L + 40K

Subject to 200  10 K 0.5 L0.5
Formulating the Lagrange function
L( L, K ,  )  10 L  40 K   (200  10 K 0.5 L0.5 ) ---------------------- (23)
First order conditions
LL  10  5K 0.5 L0.5  0
2 L0.5
 ------------------------------------------------------------- (24)
K 0 .5
LK  40  5K 0.5 L0.5  0

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8 K 0 .5
 ------------------------------------------------------------- (25)
L0.5
L  200  10 K 0.5 L0.5  0
10 K 0.5 L0.5  200 ----------------------------------------------------- (26)

From equation (24) and (25), we get

2 L0.5 8 k 0 .5
=
k 0 .5 L0.5
2L = 8K
L= 4K ------------------------------------------------------- (27)
Substituting equation (27) in to (26) gives us
K 0.5 (4 K ) 0.5  20 ------------------------------------------------ (28)
2K = 20
K = 10 and L = 4(10) = 40,  = 4

Second order condition

Dear colleague! Now we should check the second order condition to verify that cost is least at K
= 10 and L = 40.
For cost minimization the determinant of the bordered Hessian matrix must be less than zero.

0 QL QK
H  QL LLL LLK < 0
QK LKL LKK

At L = 40 and K = 10
K
QL = Q
10
= (5)  (5)  2 .5
L L 40
L
Q k = Q = (5)
40
 (5)  10
k K 10
LLL = 2.5 K 0.5 L1.5 = 2.5(4)(10) 0.5 (40) 1.5
= 0.125
L kk = 2.5 K 1.5 L0.5 = 2.5(4)(10) 1.5 (40) 0.5
=2
LKL  LLK  2.5K 0.5 L0.5  2.5(4)(10) 0.5 (40) 0.5

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Therefore, the determinant of the bordered Hessian matrix is

0 2 .5 10
H  2.5 0.125  0.5
10  0 .5 2

= - 2.5 (5+5) +10(-1.25 -1.25)

= - 2.5 (10) + 10 (-2.5)
H = -50 < 0

Thus, the firm can minimize its cost when it employs 10 units of capital and 40 units of labor in
the production process and the minimum cost is
C = 10 (40) + 40 (10)
Min. C = 400 + 400 = 800 birr
In this problem K, L and  are endogenous. The Lagrange multiplier  measures the
responsiveness of the objective function to a change in the constant of the constraint function.

Dear learner! What happens to the value of the Lagrangian function and the constrained
function when total output increases from 200 to 201? What about the amount of L and K?
Compare the value of the constrained function and that of the Lagrangian function at this point.
Interpret the value of 
Elasticity of Substitution

K P
Dear learner! What happens to the optimal input ratio when the input price L
L Pk
increases? Please discuss with your friends and try to answer this question.
Have you answered it? Good. Try to relate your answer with the following analysis.
P
Increase in the L shows the fact that capital is relatively cheaper so that it will be substituted
Pk

for labor and the optimal input ratio K will increase. The extent of this substitution is
L
measured by the elasticity of substitution which is represented by  (lower - case Greek letter
sigma).
k
relativechangein( )
= L
relativechangein( Pl Pk )

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K K
d( ) d( )
L L
K
( ) d ( PL )
 = L  PK
PL K
d( ) ( )
PK L
PL PL
( ) ( )
PK PK

The value of  lies in between 0 and +

When  = 0, the two inputs are used in a fixed proportion as complement to each other. When
 =  , the two inputs are perfect substitute to each other. As  increases, the substitutability
between the two inputs increases.

4.3 Optimization of n - variable case

Given the objective function

Optimize Z  f ( x1 , x 2 , x3 ...., x n )
Subject to g ( x1 , x 2 , x3 ,...., x n )  c
Dear colleague! Similar to our earlier discussion we ought to first formulate the Lagrange
function. That is
L  f ( x1 , x 2 , x3 ...., x n )   (c  g ( x1 , x 2 , x3 ,..., x n ))

The necessary condition for optimization of this function is that

L  L1  L2  L3  L4      Ln = 0
The second order condition for optimization of this function depends on the sign of d 2L subject
to dg  g1 dx1  g 2 dx 2  g 3 dx3  .....  g n dx n  0 similar to our earlier discussion.
The positive or negative definiteness of d 2 L involves the bordered Hessian determinate test.
However, in this case the conditions have to be expressed in terms of the bordered principal
minor of the Hessian. Given the bordered Hessian as

0 g1 g2 ---------- gn
g1 L11 L12 ---------- L1n
H g2 L21 L22 ----------- L2 n

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- - ------------------ L3 n

- - -------------------------

gn Ln1 Ln 2 -------- Lnn

The successive bordered principal minors are

0 g1 g2 0 g1 g2 g3
H 2  g1 L11 L12 H3  g1 L11 L12 L13
g2 L21 L22 g2 L21 L22 L23 etc.

g3 L31 L32 L33

However, H  H n . .

H 2 Shows the second principal minor of the Hessian bordered with 0, g1 and g 2 .

d 2 L is positive definite subject to dg  0 if and only if H 2 , H 3 ,-----, H n  0 .

d 2 L is negative definite subject to dg  0 if and only if H 2  0, H 3  0, H 4  0 ,---.

A positive definite d 2 L is a sufficient condition for minimum value and negative definite d 2 L is
sufficient condition for maximization of the objective function.
In our analysis above H 2 is the one which contains L22 as the last element of its principal

diagonal. H 3 is the one which includes L33 as the last element of it's principal diagonal etc.

Optimization when there is more than one equality constraint

Let us consider the optimization problem involves three variables and two constraints.
Optimize Z  f ( x1 , x 2 , x3 )
Subject to g 1 ( x1 , x 2 , x3 )  c 1
g 2 ( x1 , x 2 , x3 )  c 2
As usual we should construct the Lagrange function by using the Lagrange multiplier  .Since we
have two constraint functions, we are required to incorporate two  s, i.e., 1 and 2 in our
analysis.
The Lagrange function is
L  f ( x1 , x 2 , x3 )   (c 1  g 1 ( x1 , x 2 , x3 ))   (c 2  g 2 ( x1 , x 2 , x3 ))
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First order conditions for optimization

L1  f 1  1 g11   2 g12  0
L2  f 2  1 g 12   2 g 22  0
L3  f 3  1 g 31   2 g 32  0
L1  c 1  g 1 ( x1 , x 2 , x3 )  0
L 2  c 2  g 2 ( x1 , x 2 , x3 )  0
When there are n - variables and m - constraints, the Lagrange function becomes
m
L  f ( x1 , x 2 , x3 ,....., x n )   i (c j  g i ( x1 , x 2 , x3 ,..., x n ))
j 1

In this case we will have m+ n variables in the Lagrange function and we will have also m+ n
simultaneous equations.

First order conditions are

Li  f i   j g ij  , (i = 1, 2, 3, ---, n) and (j= 1, 2, 3, --- m)
Li  c j  g i ( x1 , x 2 , x3 ,..., x n )  0

Second order conditions for optimization of three variables and two constraints problem are

0 0 g11 g 12 g 31
0 0 g12 g 22 g 32
H = g11 g12 L 11 L12 L13
g 12 g 22 L 21 L 22 L 23

g 31 g 32 L31 L 32 L 33

In this case, H 3 = H . Thus for a maximum value,

H 2 > 0, H 3 < 0.
For a minimum,
H 2 < 0, H 3 < 0.
With the existence of n - variables and m - constraints, the second order condition is explained as

0 0 0 -------- 0 g11 g 12 g 31 -------- g 1n

0 0 0 -------0 g12 g 22 g 32 ----- -- g n2
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-- - - - - - - - - ----------------
m m
0 0 0 ------ - 0 g1 g2 g 3m ------ -- g nm
H =
g11 g 12 g 31 ----- - g 1n L11 L12 L13 ---------- L1n
g12 g 22 g 32 ------ g n2 L21 L22 L23 --------- L2 n
3 3 3
g13 g 2 g 3 ------ g n L31 L32 L33 ------ L3n
-- -- -- ------ -- -- - -- -------
m m m m
g1 g 2 g 3 - - - - g n Ln1 Ln 2 Ln 3 -------- Lnn

Now we have divided the bordered Hessian determinant in to four parts. The upper left area
includes zeros only and the lower right area is simply a plain Hessian. The remaining two areas
include the g ij derivatives. These derivatives have a mirror image relationship to each other
considering the principal diagonal of the bordered Hessian as a reference.

We can create several bordered principal minors from H .It is possible to check the second
order sufficient condition for optimization using the sing of the following bordered principal
minors:
H m 1 , H m  2 ,----------, H n
The objective function can sufficiently achieve its maximum value when the successive bordered
principal minors alternate in sign. However, the sign of H m 1 is (-1) m+1 where as for minimum
value the sufficient condition is that all bordered principal minors have the same sign, i.e., (-1) m.
This indicates that if we have an odd number of constraints, then sign of all bordered principal
minors will be negative and positive with even number of constraints.

Dear colleague! By now you have completed the second section of this unit. Thus, try to do the
following self test questions to examine your understanding of this section.

Self - Test 4.2

Solve the following questions based on the information above.
1. What is constrained function? -
2. Explain elasticity of substitution
3. What does the Lagrange multiplier indicate

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4. Suppose a firm faces the production function Q = 120 L + 200K - L2 - 2K 2 for positive
values of Q. If it can buy L at 5 birr per unit, K at 8 birr per unit and has a budget of 70 Birr,
determine the maximum output that it can produce using substitution method.
5.Suppose the prices of inputs K and L are 12 birr and 3 birr per unit respectively and the
production function of the firm is Q= 25K0.5 L 0.5 . Determine the minimum costs of producing
1,250 units of output using Lagrange multiplier method
6. Suppose a consumer has a utility function of U = 40x0.5 y0.5 .If the price of x is 20 birr per unit,
price of y is 5 birr unit and the consumer has a budget of 600 birr . Determine the amount of x
and y which maximize utility using the Lagrange multiplier method. Have you answered these
questions? If your answer is no, reread this section and try to answer them. If yes, good, Go to
the next section.

4.4 Inequality Constraints and Kuhn - tucker Theorems, and Mixed Constraints

Up on the completion of this section you are expected to

- describe what nonlinear programming is

- describe the Kuhn - Tucker conditions
- explain about the constraint qualification
- describe the Kuhn - Tucker sufficiency theorem
- describe the case of Mixed constraints
- show economic application of this theorem

Nonlinear programming

Dear learner! I think you know about the concept of linear programming in your
quantitative method for linear algebra studies. What is nonlinear programming? Discuss with
your friends and try to answer this question. Write the answer on a rough paper.
Have you answered this question? Ok, Good. Evaluate your answer with the following analysis.
The problem of optimization of an objective function subject to certain restrictions or constraints
is a usual phenomenon in economics. Mostly, the method of maximizing or minimizing a
function includes equality constraints. For instance, utility may be maximized subject to a fixed
income that the consumer has and the budget constraint is given in the form of equation. Such
type of optimization is referred to as classical optimization. But objective function subject to
inequality constraints can be optimized using the method of mathematical programming. If the
objective function as well as the inequality constraints is linear, we will use a method of linear
programming. However, if the objective function and the inequality constraints are nonlinear, we
will apply the technique of nonlinear programming to optimize the function.

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Maximization problem of non - linear programming

Maximize  = f ( x1 , x 2 , x3 ,....., x n )
Subject to g 1 ( x1 , x 2 , x3 ,..., x n )  k1
g 2 ( x1 , x 2 , x3 ,..., x n )  k 2
g 3 ( x1 , x 2 , x3 ,..., x n )  k 3
: : :
g m ( x1 , x 2 , x3 ,..., x n )  k m and xj  0 , ( j  1,2,3....., n)
The minimization Problem can be expressed in the form of
Minimize C = f ( x1 , x 2 , x3 ,....., x n ) )
Subject to g 1 ( x1 , x 2 , x3 ,..., x n )  k1
g 2 ( x1 , x 2 , x3 ,..., x n )  k 2
g 3 ( x1 , x 2 , x3 ,..., x n )  k 3
: : : :
g m ( x1 , x 2 , x3 ,..., x n )  k m , x j  0 ( j  1,2,3....., n)

Where C- represents total cost which is the objective function.

x j - is the amount of output produced
k i - is the constant of the constraint function
-
gi is the constraint function.

We have observed from the above expression that the nonlinear programming also includes three
ingredients. These are
- the objective function
- a set of constraints ( inequality )
- non - negativity restrictions on the choice variable

The objective function as well as the inequality constraints is assumed to be differentiable with
respect to each of the choice variables. Like linear programming we apply on  constraints for
maximization and minimization problem involves only  constraints.

Example1
1. Find the values of x and y of the following function graphically.
a) Minimize C  x 2  y 2
Subject to x y  25

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x, y  0
Dear colleague! First we should convert the inequality constraint in to equality as xy  25 and
draw the graph of this constraint function on the xy plane.

x 1 2 3 4 5 6 7 ...............................25
y 25 12.5 8.3 8.3 5 4.6 3.57 ..........................1

Fig.(a)

The shaded region in the above figure represents the feasible region. Let us evaluate the
objective function C at points A, B, C, D and E on the graph.

At point a (1, 25), C=12+ 252 = 1+ 625 = 626

At point B (4, 6.3), C = 42 + (6.3) 2 = 16+ 39.69 = 55.69
At point c (5, 5), C = 52 + 52 = 25 + 25 = 50
At point d (6, 4.6) C = 62 + (4.6) 2 = 36 + 21.16 = 57.16
At point E (25, 1) , C = ( 25) 2 + 12 = 625 + 1 = 626

Therefore, the value of x and y which minimizes the objective function are 5 and 5 respectively.
The minimum value is C = 50.

b) Maximize  = x2 + (y - 2) 2

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Subject to 5x + 3y  15
And x, y  0

Solution
Similar to that of problem a, we should convert the inequality constraint in to equality constraint
and draw its graph in the x y plane. It is 5x + 3y = 15

X 0 1 2 3
Y 5 3.3 1.67 0

Fig.(b)

The shaded region of the above figure represents the feasible region as every point in this
feasible region satisfies the inequality constraint 5 x + 3y  15.

Evaluating the objective function at points A, B, C and D of the above graph (fig. b),
At point A (0, 5),  = 02 + (5 - 2)2 = 0 + 9 = 9
At point B (1, 3.3),  = 12+ (3.3 - 2) 2 = 1+ 1.69 = 2.69
At point C (2, 1.67),  = 22 + (1.67 - 2)2 = 4 + 0.1089 = 4.1089
At Point D (3, 0),  = 32 + 9 (0 - 2)2 = 9+ 4 = 13
Therefore, the objective function is maximized when x = 3 and
y = 0. The maximum profit is  = 13

In general, we can distinguish the nonlinear programming from that of linear one based on the
following points.
1.In nonlinear programming the field of choice not necessarily locates at its extreme points.
2. The number of constraints may not be the same with the choice variables.
3. Following the same direction in a movement may not lead to a continually increasing or
(decreasing) value of the objective function.

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4. The feasible region may not be a convex set.

5. A local optimum may not be a global optimum.

Kuhn - Tucker Conditions

Dear colleague! In the previous sections of this unit, we have discussed about optimization
problems of the objective function with equality constraints and without explicitly restricting the
sing of the choice variables. In this case, the first order condition is satisfied provided that the
first order partial derivative of the Lagrange function with respect of each choice variable and
with respect to the Lagrange multiplier is zero. For instance, in the problem

Maximize  = f ( x, y )
Subject to g ( x, y )  k
The Lagrange function is
L  f ( x, y )   (k  g ( x, y ))
The first order condition states that
L x  L y  L  0

In non-linear programming, there is a similar first order condition which is referred to as Kuhn -
Tucker conditions. As we discussed previously, in classical optimization process, the first order
condition is a necessary condition. However, a certain condition should be fulfilled for the Kuhn
- Tucker conditions to be necessary conditions.

Dear colleague! Now let us discuss Kuhn - Tucker conditions in two steps for the purpose of
making the explanation easy to understand.

Step 1
In the first step, let us take a problem of optimizing the objective function with non negativity
restrictions and with no other constraints. In economics, the most common inequality constraint
is non negativity constraint.
Maximize  = f(x)
Subject to x  0
provided that the function is supposed to be continuous and smooth. Based on the restriction x
 0, we may have three possible results. As shown in the following figures.

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When the local maximum resides in side the shaded feasible region as shown above at point B of
fig (i), then we have an interior solution. In this case, the first order condition is similar to that of
d
the classical optimization process, i.e., = 0.
dx

Diagram (ii) shows that the local maximum is located on the vertical axis indicated by point C.
d
At this point, the choice variable is 0 and the first order derivative is zero, i.e. = 0, at point
dx
C we have a boundary solution.

Diagram (iii) indicates that the local maximum may locate at point D or point E with in the
d
feasible region. In this case, the maximum point is characterized by the inequality <0
dx
because the curves are at their decreasing portion at these points.

Therefore, from the above discussion it is clear that the following three conditions have to be
met so as to determine the value of the choice variable which gives the local maximum of the
objective function.

f ( x)  0 , and x > 0 (point B)

f ( x)  0 , and x = 0 (point C)
f ( x)  0 , and x = 0 (point D and E)
Combining these three condition in to one statement given us
f ( x)  0 x0 and xf ( x)  0

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d
The first inequality indicates the information concerning . The second inequality shows the
dx
non negativity restriction of the problem. The third part indicates the product of the two
quantities x and f (x) .The above statement which is a combination of the three conditions
represents the first order necessary condition for the objective function to achieve its local
maximum provided that the choice variable has to be non negative.

If the problem involves n - choice variables like

Maximize   f ( x1 , x 2 , x3 ,...x n )
Subject to xi  0
The first order condition in classical optimization process is
f1 = f 2 = f 3 = -------= f n = 0
The first order condition that should be satisfied to determine the value of the choice variable
which maximizes the objective function is
fi  0 xi  0 and xi f i = 0 (i =1, 2, 3, -------, n)
Where f i is the partial derivative of the objective function with respect to xi , i.e.,

fi  .
xi
Step 2
Dear colleague! Now we continue to the second step. To do this, let us attempt to incorporate
inequality constraints in the problem. In order to simplify our analysis, let us first discuss about
maximization problem with three choice variables and two constraints as shown below.
Maximize  = f ( x1 , x 2 , x3 )
Subject to g 1 ( x1 , x 2 , x3 )  k1
g 2 ( x1 , x 2 , x3 )  k2
And x1, x2, x3  0

Using the dummy variables s1 and s2 we can change the above problem in to
Maximize  = f ( x1 , x 2 , x3 )
Subject to g 1 ( x1 , x 2 , x3 )  s1  k1
g 2 ( x1 , x 2 , x3 )  s 2  k 2
And x1, x2, x 3  0 and s1, s2  0

We can formulate the Lagrange function using the classical method provided that the non
negativity constraints of the choice variables are not existed as

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L  f ( x1 , x 2 , x3 )  1 [k1  g 1 ( x1 , x 2 , x3 )  s1 ]   2 [k 2  g 2 ( x1 , x 2 , x3 )  s 2 ]

It is possible to derive the Kuhn Tucker conditions directly from the Lagrange function.
Considering the above 3-variable 2-constraints problem
The first order condition is

L L L L L L L
= = = = = = =0
x1 x 2 x3 s1 s 2  2 1

However, x j and s i variable are restricted to be non negative. As a result, the first order
conditions on these variables ought to be modified as follows.
L L
0 xj  0 and x j =0
x j x j
L
0 si  0 and si L = 0
si si
L = 0 Where (i = 1, 2 and j= 1, 2, 3)
i
However, we can combine the last two lines and thereby avoid the dummy variables in the
L
above first order condition as shown below. As  i , the second line shows that
si
 i  0, , S i  0 and – S i  i = 0
or
i  0, S i  0 and S i i = 0

But, we know that si  k i  g i ( x1 , x 2 , x3 ) . By substituting it in place of si , we can get

k i  g i ( x1 , x 2 , x3 )  0 , i  0 and i [ k i  g i ( x1 , x 2 , x3 ) ] =0

Therefore, the first order condition without dummy variables in expressed as

L L
 0 xj  0 and x j =0
x j x j
L
= k i  g i ( x1 , x 2 , x3 )  0 i  0 and i [ k i  g i ( x1 , x 2 , x3 ) ] =0
i
These are the Kuhn - tucker conditions for the given maximization problem.

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Dear students! How can we solve minimization problem? Discuss with your friends and
try to answer this question.
Have you answered this question? Ok good. Read the upcoming discussion and evaluate your
answer with reference to it. One of the methods to solve this problem is changing it in to
maximization problem and then applies the same procedure with maximization.
Minimizing C is similar to maximizing (  C ). However, keep in mined the fact that we have to
multiply each constraint inequalities by (  1 ).We can directly apply the Lagrange multiplier
method and determine the minimization version of Kuhn - Tucker condition instead of
converting the inequality constraints into equality constraints using dummy variables as
L L
0 x j  0 and x j =0
x j x j
L L
0  i 0 and i = 0 (minimization)
i i

Example
2. Let us check whether the solutions of our example 1 satisfy the Kuhn - Tucker conditions or
not

a) Minimize C= x2+ y2
Subject to x y  25
and x, y  0

The Lagrange function for this problem is

L = x2 + y2 +  (25 – x y)
It is a minimization problem. Therefore, the appropriate conditions are
L L
= 2x -  y  0 , x  0 and x =0
x x
L L
= 2 y - x  0 , y  0 and y =0
y y
L L
= 25 – x y  0,   0 and  =0
 
Dear learner! Can we determine the non negative value  which will satisfy all the above
conditions together with the optimal solution x and y? The optimal solutions in our earlier
L
discussion are x = 5 and y = 5, which are nonzero. Thus, the complementary slackness ( x =
x
L L L
0, y = 0) shows that  0. and = 0.
y x y
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Thus, we can determine the value of  by substituting the optimal values of the choice variables
in either of these marginal conditions as
L
= 2x - y = 0
x
2(5) -  (5) = 0
10 - 5  = 0
 =2>0
L L L
This value  = 2, x = 5 & y = 5 imply that = 0, = 0, = 0 which fulfils the marginal
x y 
conditions and the complementary slackness conditions. In other words, all the Kuhn - Tucker
conditions are satisfied.

3. Maximize Z  10 x  x 2  180 y  y 2
x  y  80
Subject to
x, y  0

Solution

Dear colleague! First we should formulate the Lagrange function assuming the equality
constraint and ignoring the non negativity constraints.
L  10 x  x 2  180 y  y 2   (80  x  y )
The first order conditions are
L
 10  2 x    0    10  2 x              (1)
x
L
 180  2 y    0    180  2 y            (2)
y
L
 80  x  y  0  x  y  80                (3)

Taking equation (1) and (2) simultaneously
10  2 x  180  2 y
2 y  2 x  170
2 y  170  2 x
y  85  x                                (4)
If we substitute equation (4) in to (3), we get
x  85  x  80
2 x  5  x  2 .5
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However, the value of the choice variables is restricted to be non negative. x   2.5 is
infeasible. We must set x= 0 since it has to be non negative. Now we can determine the value of
y by substituting zero in place of x in equation (3) .
0  y  80
y   80
Therefore,   180  2(80)  20
The possible solutions are x   0, y   80,   20
However, we must check the inequality constraints and the complementary slackness conditions
to decide whether these values are solutions or not.
1) Inequality constraints
i) The non negativity restrictions are satisfied since x  0, y  80,   20  0
ii) Inequality constraints
x  y  80
0  80  80
2) Complementary Slackness conditions
L L
i) x  0, x  0   0 as the problem is maximization.
x x
L
 10  0
x
L L
ii) y  0, y  80  0  0
y y
L
 180  2(80)  20  0
y
L L
  0,   20  0  0
 
iii)
L
 80  0  80  0

All the Kuhn Tucker conditions are satisfied. Thus, the objective function is maximized when
x   0, y   80,   20 .

Constraint Qualification

We have studied that the Kuhn Tucker conditions are necessary conditions if and only if a
particular precondition is fulfilled. This precondition is referred to as constraint qualification and
it imposes some restriction on the constraint function of nonlinear programming so as to avoid
some irregularities on the boundary of the feasible region that would affect the fulfillment of the
Kuhn-Tucker condition at the optimal solution.
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There will be not a boundary irregularity provided that a certain constraint qualification is met.
In order to describe it, let us say x  ( x1 , x 2 , x3 ,...., x n ) be boundary points on the feasible region
and suppose dx  (dx1 , dx 2 , dx3 ,..., dx n ) indicates a specific direction of movement from the
boundary point. Thus, we have a vector dx . By now let us put two requirements on vector dx .
1. dx j  0 if x j  0
2. dg i ( x )  g1i dx1  g 2i dx 2  ....  g ni dx n  0 for maximization if g i ( x )  k i .
 0 for minimization if g i ( x )  k i .
If the vector dx fulfils these two conditions, it is referred to as the test vector. When there is a
differentiable arc which
 originates from x
 included in the feasible region
 is tangent to the given test vector , it is known as a qualifying arc for the given test
vector.
The existence of this qualifying arc for each test vector dx at any point x on the boundary of the
feasible region satisfies constraint qualification.

Kuhn Tucker Sufficiency Theorem

Dear colleague! As we have discussed in the classical approach the sign of the second order
derivative of the function provides the sufficient condition for maximum and minimum of a
function. These conditions have intimacy with the concept of convexity and concavity of a
function. In nonlinear programming, we can express the sufficient condition for the optimum of
the function in terms of convexity and concavity of a function.

Given the problem

Maximize   f (x)
Subject to g i ( x)  k i (i=1, 2, 3… n) and x 0
The Kuhn - Tucker sufficient conditions are satisfied provided that

1) the objective function is differentiable and concave in non negative orthant.

2) each constrain function is differentiable and convex in the negative orthant
3) the point x satisfies the Kuhn -Tucker maximum condition

For minimization problem you can easily add the Kuhn - Tucker minimum condition on
condition (1) and ( 2) above to determine whether the Kuhn - Tucker sufficient condition is
satisfied or not.
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Proof
Given the problems
Maximize   f (x)
Subject to g i ( x)  k i
and x  0
The Lagrange function is shown as
m
L= f(x) +   [k
i 1
i i  g i ( x)]

If we give specific value for the Lagrange multiplier i , L will be a function of x. According to
condition (1) and (2) above, assume f(x) as concave and g i (x) as convex when we multiply it by
(-1) gives us  g i (x) ) that is concave. Therefore, The L functions will be concave function (sum
of two concave functions) in x.
The Lagrange function L is concave means that
n
L
L( x)  L( x )   (x j  x j )
j 1 x j

L
When x represents some particular point in the domain refers to the partial
x j
L
derivative examined at x . Now let’s choose the value of the choice variable x and the value
x j
of the Lagrange multiplier in line with condition (3) above, i.e. which satisfy the Kuhn tucker
maximum condition. If we decompose terms in the summation we get
n
L n
L n
L
j 1 x j
( x j  x j )  
j 1 x j
x j  
j 1 x j
xj

By the application of complementary slackness at point x j , this expression is reduced to

n
L
 x
j 1
xj
j

L
From this expression we know that  0 (marginal condition) and x j  0 as it is a choice
x j
variable. As a result the reduced expression is non positive. Thus we can conclude
that L( x)  L( x ) . This indicates that x is the optimal solution.

Economic Application

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Example
4. Given the revenue and cost conditions of a firm as R  32 x  x 2 and C  x 2  8 x  4 , where
x output is. Suppose the minimum profit is  0  18 .Determine the amount of the out put which
maximizes revenue with the given minimum profit. In this case, the revenue function is concave
and the cost function is convex.

The Problem is
Maximize R  32 x  x 2
Subject to x 2  8 x  4  32 x  x 2  18
And x  0

Under these situations the Kuhn - Tuck en conditions are necessary and sufficient conditions as
all of the above three conditions, i.e., (1), (2), 4(3), are satisfied.

The Lagrange function of this problem is

L  32 x  x 2   (22  2 x 2  24 x)                (1)
Thus,
L
 32  2 x  4x  24  0                  (2)
x
L
 22  2 x 2  24 x  0                    (3)

 22  2 x 2  24 x  0
From equation (3)
2 x 2  24 x  22  0                      (4)
3 1
Solving (4) we get, x  1 or x  11 .   0r  
2 2
However, we must check the inequality constraints and the complementary slackness conditions
to decide whether these values are the solutions or not
L L
 0, x0 and x  0, -----------------------------(5)
x x
L L
 0, 0 and   0, -----------------------------(6)
 
At X=1
L L 3
At this point x  0 this implies that  0, Thus  30  20  0    .It does not
x x 2
satisfy equation (6).

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L L 1
At X=11, x  0 this implies that  0, Thus  10  20  0    . It satisfies both
x x 2
equation (5) and (6). This means, the Kuhn Tucker conditions are fulfilled at x  11 .Therefore,
revenue is maximized when x  11 .

4.5 Mixed constraints

Dear colleague! An optimization problem with mixed constraints can be reformulated either as
maximization or minimization problem. This procedure incorporates the following conditions.
i) Maximizing the objective function Z (x) is equivalent to the problem of Minimizing
 Z (x) or vice versa-
ii) The constraint g ( x)  c can be presented as  g ( x)  c .
iii) The constraint g ( x)  c is equivalent to the double constraint g ( x)  c and  g ( x)  c
iv) The non negativity constraint x  o can be denoted by a new constraint g ( x)   x  0 .

Dear colleague! By now you have completed this section. Therefore, try to do the following
questions.

Self - Test 4.3

Solve the following questions based on the information above.
1. Describe non linear programming
2. Explain the difference between linear programming and non lines one
3. What are the ingredients of non linear programming problems?
4. Write the Kuhn - Tucker condition of the problem
Maximize U  U ( x1 , x 2 , x3 ,...., x n )
Subject to p1 x1  p 2 x 2  p3 x3  ..... p n x  B
And x1 , x 2 , x3 ,.....x n  0
When xi represents goods consumed and pi represent the respective price of these goods.
5. Check whether the Kuhn - Tucker conditions are satisfied or not for the problem given in
example 1 (b) at the optimal values of x and y.
6. Minimize C = x2 + y2
Subject to x+ y  2
And x, y  0
Write out the Kuhn - Tucker conditions and use them to find the optimal solution by trial and
error, what are the values of x and y?

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7. Given the demand function of the firm is given as

1
P  12  x And the cost function is C  x 2 when the minimum profit is   24 , then
2
Maximize R  f (x)
Subject to C ( x)  R ( x)  24
And x  0
 Is the Kuhn - Tucker condition satisfied or not?
 Determine the value of x using trial and error.

Dear learner! Have you answered these questions? If no, please reread this section and try to do
them. If yes, go to the next section.

Check List

Write √ inside the box which corresponds to the problem that you can solve easily.
1. Can you explain constrained function? ------------------------------------------------------- -----
2. Describe what constrained optimization is ----------- ---------------------------------------------
3. Describe the order condition for the optimization of constrained function. -------------------
4. Explain the Lagrange multiplier----------------------------------------------------------------- ----
5. Describe how functions with inequality constraints are solved----------------------------------
6. Describe the Kuhn - Tucker theorem----------------------------------------------------------------
7. Solve objective function subject to mixed constants----------------------------------------------
8. Describe bordered Hessian determinant--------------------------------------------------------------
9. Explain nonlinear programming problem-----------------------------------------------------------

Dear learner! Is there any box in which you didn't tick? If yes, please reread this unit and try to
do it. If no, very good Go to then next unit

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Unit Summary

In business and economics studies there are many situations in which complete freedom of action
is impossible. For example, a firm can maximize output subject to the constraint of a given
budget for expenditures on inputs, or it may need to minimize cost subject to a certain minimum
out put being produced. Such functions which involve constraints are called constrained
functions and the process of optimization is referred to as constrained functions and the process
of optimization is referred to as constrained optimization.

The problem of optimization of an objective function subject to certain restrictions or constraints

is a usual phenomenon in economics. Mostly, the method of maximizing or minimizing a
function includes equality constraints. For instance, utility may be maximized subject to a fixed
income that the consumer has and the budget constraint is given in the form of equation. Such
type of optimization is referred to as classical optimization. But objective function subject to
inequality constraints can be optimized using the method of mathematical programming. If the
objective function as well as the inequality constraints is linear, we will use a method of linear
programming. However, if the objective function and the inequality constraints are nonlinear, we
will apply the technique of nonlinear programming to optimize the function.

In non-linear programming, there is a similar first order condition which is referred to as Kuhn -
Tucker conditions. As we discussed previously, in classical optimization process, the first order
condition is a necessary condition. However, a certain condition should be fulfilled for the Kuhn
- Tucker conditions to be necessary conditions

Important points(for focus)

Constrained function Minimization

Constrained optimization Maximization
Constraints Non linear Programming
Lagrange Multiplier Kuhn Tucker theorem
Bordered Hessian determinant Non negativity constraint
Positive definite Constraint Qualification
Negative definite

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Answers for Self Test Questions

Self Test 4.1

1. The constrained maximum of the function is y  2 at x=2.
3
2. The function is maximized at x  .
4
27 1
3. y  At x 
4 6
4. y  4 At x  0
5. y  7 At x0

Self Test 4.2

4) L  4.47, K  5.79;&Q  1,637.28

5) K  12.6 & L  21
6) TC  600birr
7) x  15 & y  60

Self Test 4.3

6) x  1 & y  1 7) x  4

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UNIT FIVE

5. COMPARATIVE STATICS ANALYSIS

Introduction

Dear learner! The change in equilibrium states in response to a change in exogenous

variables leads to a type of analysis known as comparative static (equilibrium) analysis
where as the question of attainability and stability of equilibrium lies on the field of
dynamic analysis. But this unit will be emphasized on the nature of comparative static
(equilibrium) and its application on economic models (particularly on market and
national income models) and its limitations.

Dear learner! First of all you should have good understanding about the meaning of
equilibrium in order to know the concept of comparative static analysis.

What is equilibrium? Discuss with your friends and try to answer this question.
Write your answer on rough paper.
Dear colleague! Have you answered this question? Ok, good. Try to relate your answer
with the following analysis.

Equilibrium is “a constellation of selected interrelated variables so adjusted one another

that no inherent tendency to change prevails in the model which they constitute.” 1
In this definition there are some words, which require particular consideration. These
are,
The word “selected” gives emphasis to the reality that there are other variables that have
not been incorporated in the model. It is clear that the equilibrium which we are dealing
with can be functional based on certain assumptions such as other things being equal
(cetrius paribus). The reason is that, if other variables are included in the model, the
existing equilibrium state will not persist.
The word “interrelated” indicates that all variables in the model have to be in a state of
rest at the same time for achieving equilibrium condition.

1
Fritz Machlup, “ Equilibrium and Disequilibrium : Misplaced concreteness and Disguised politics,”
Economic Journal, March 1958, P.9 Quoted in Chaing A. C., Fundamental Methods of Mathematical
Economies, 3rd ed, p. 35.

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The word “inherent” shows that this state of rest considered should depend only on the
balancing of internal forces of the model. It is supposed that there are no changes in
external factors, for a change in these factors will result in a new equilibrium

Objective of the Unit

After completing this unit, a student is expected to
- describe the meaning of comparative static
- explain how the new equilibrium can be compared with the old one.
- analyze the application of differentiation on comparative static analysis.
- describe the Jacobian and Hessian determinants.
- explain the limitations of comparative static analysis
5.1 Nature of Comparative Static, Differentiation and its Application on
Comparative Static Analysis

Having studied this section, you should be able to

- define what comparative static is

- describe how can the new equilibrium be compared with the old
one
- explain rules of differentiation
- explain how can we use the technique of differentiation on
comparative static analysis

5.1.1 Nature of Comparative Static

Dear colleague! What is comparative static analysis?

Dear colleague! Have you answered this question? Ok good try to relate your answer
with the following analysis.

As its name indicates the term comparative static is emphasized on the comparison of
different equilibrium states, which are related, with different set of values of parameters
and exogenous variables. First of all, it is usual to suppose a given initial equilibrium
state so as to carry out this comparison. For instance, this initial equilibrium will be
indicated by a define price P and its corresponding quantity Q in a closed–market
model.
In the simple national income model a determinate income Y and a corresponding
consumption C will represent the initial equilibrium. This initial equilibrium will be

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disturbed provided that there is a change in exogenous variable or certain parameters in

the model. Consequently, several endogenous variables have to be subjected to some
adjustment. Supposing that some of the new equilibrium state can be defined and
attained, the problem faced by comparative static analysis is comparing the new
equilibrium with the old one.

We don't pay attention for the process of adjustments in comparative static analysis rather
we compare the old equilibrium with the new equilibrium state. In this analysis, we
assume that the new equilibrium has to be attainable as we did for the old one.

The nature of comparative static may be either qualitative or quantitative. The analysis
will be qualitative provided that our emphasis is only to determine the direction of the
change. On the other hand, quantitative analysis is concerned on determining the
magnitude of the change in the endogenous variables resulting from a given change in
some parameters or exogenous variables to the model. However, it is clear that we can
get the direction of the change from the algebraic sign of the quantitative solution. This
means quantitative analysis often incorporate qualitative analysis.

Dear colleague! How can we determine the rate by which the endogenous variable is
changed due to a change in the exogenous variable, i.e. the rate of change?
Have you answered this question? Ok, good. Try to relate your answer with the following
analysis.

5.1.2 Differentiation and its Application to Comparative Static Analysis

Dear colleague! As we know the main problem in comparative static analysis is finding
the rate of change of the dependent variable with respect to a small change in the
independent variables. For instance, in a function
y  f (x)
Where y is dependent variable
x is an independent variable
The rate of change of ' y' with respect to 'x' is denoted by
dy
dx
Dear colleague! I think you have learnt about the concept of differentiation and its rules
in quantitative method for economists I and in the first unit of this course. Therefore, go
to these sources and check what you have studied and discuss with your friends in order
to avoid the redundancy.

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Have you checked and grasp the concept of differentiation and its rules? Ok. Good. By
now, therefore, we have the ability to solve certain problems we face in comparative
static analysis such as determining the equilibrium values of the endogenous variables
when there is a change in any of the exogenous variables or parameters. Let us apply the
mathematical method of derivative on the following economic models.
Market Model
Let us take a simple-one commodity market model to observe the application of
techniques of derivative to determine equilibrium quantity and equilibrium price. There
are three variables in this model as it is a one commodity model. These are:
 quantity demanded of a good ( Qd )
 quantity supplied of a good ( Qs )
 price of a good ( P)
Dear colleague! It is clear that we should put assumptions considering the working of the
market.

Assumptions
 It is assumed that market equilibrium will be achieved when quantity demanded is
equal to quantity supplied, i.e. when the market is cleared.
 Quantity demanded is supposed to be a decreasing linear function of price. This
means, as price decreases, quantity demanded of a good increase, citrus paribus
and vice versa.
 Quantity supplied is assumed to be an increasing function of price, other things
being equal. In this case no quantity will be supplied if the price is not greater
than a certain positive value.
The model includes:-
 One equilibrium condition.
 Two behavioral equations.
Algebraically, the model can be expressed as
Qd  Q s
Qd   1   1 P (  1,  1  0) ---------------------------- (1)
Qs   2   2 P (  2 ,  2 >0)

All of the four parameters  1,  2, 1 , and  2 are supposed to be positive.

Equating Qd and Qs results in
Qd = Q s = Q
And the model can be written as a reduced form of two equations in two variables:

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Q   1  1 P
----------------------------------------------- (2)
Q   2   2 P
The model can be further reduced to a single equation in a single variable as
 1  1 P   2   2 P
Rearranging this equation gives us
 1   2  1 P   2 P
 1   2  P( 1   2 )
Dividing both sides of the equation by (  1 +  2) gives us the solution value of P, i.e. P .
 2
P 1 ,  1   2  0 -------------------------------- (3)
1   2

Equation 3 indicates the fact that the determinate value, i.e., equilibrium price, is
expressed in terms of the parameters. P is positive because we put the restriction that all
the four parameters are positive.
To get the equilibrium quantity of the market which corresponds to P we should
substitute equation (3) in to one of the equations of equation (2). Substituting it in the
supply equation gives us
 2
Q =  2  2 ( 1 )
1   2
1 2   2  2
Q = 2+
1   2
  2 (  1   2 )  ( 1  2   2  2 )
Q=
1   2
  2 1   2  2   1  2   2  2
=
1   2
 1  2   2 1
Q = ,  1   2  0 ------------------------ (4)
1   2
Similarly in equation (4) we have observed that equilibrium quantity is expressed in
terms of the parameters. We know that quantity never be negative. Thus, this situation
requires that the numerator (  1  2   2 1 ) should be positive. This means  1  2   2 1 .

Dear colleague! Now we can observe the effect of a small change in one of the
parameters either on P or Q . To do this, we must partially differentiate each variable
with respect to each of the parameters. Through observing the sign of the partial
derivative of the variables, for example P , with respect to the parameters, we can point
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out the direction in which P will move when the parameter changes. If the magnitude is
known, it will constitute quantitative analysis. Let us see the effect of change in the
parameters on P ,
P 1
=
 1 (  1   2 )
P 0(  1   2 )  1( 1   2 )
=
 1 ( 1   2 ) 2
 ( 1   2 )
= ----------------------Quotient rule)
( 1   2 ) 2
P 1

 2  1   2
P P  ( 1   2 )
= =
 2  1 ( 1   2 ) 2
We have put a restriction that all parameters are positive in this model. As a result, we
have the ability to conclude that
P P
= 0
 1  2
It indicates that as the parameter  1 increases, there will be an upward shift in the
demand curve which leads to an increase in equilibrium price, i.e. p , given the supply
P
curve. However, the slope of the demand curve is the same. Similarly,  0 shows
 2
that an increase in the parameter  2 leads to a parallel downward shift in the supply
curve which in turn results in an increase in equilibrium price, i.e. p given the demand
curve. In this case the slope of the supply curve is constant.

P P
In addition to this = < 0.
 1  2
P
< 0 reflects the fact that as 1 increases, the slope of the demand curve will be
 1
steeper and it will rotate to the left (inward) at the point of the intercept. Therefore, the
P
equilibrium price decreases given the supply curve. Similarly, <0 shows that as the
 2
slope of the supply curve increases, the original supply curve will be rotated to the left

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about the point of it's intercept which decreases the equilibrium prices given the original
demand curve. It is in line with the negative sign of the above derivative.

Show the effect of change in these parameters on equilibrium quantity and

interpreter the result. --------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------
Dear colleague! Have you done the above exercise? Ok that is good .Now try to relate
your answer with the following analysis. We know that
    2 1
Q = 1 2
1   2
From this equation one can see the effect of change in each of the parameters using the
technique of partial differentiation as follows.
Q 2
 >0
 1  1   2

Q   2 (  1   2 )  1( 1  2   2  1 )
 ------------- (Quotient rule)
 1 ( 1   2 ) 2
  2 1   2  2   1  2   2 1
=
( 1   2 ) 2
Q  ( 2  2   1  2 )
 <0
 1 ( 1   2 ) 2

Q  1
 <0
 2  1   2
Q  1 (  1   2 )  1( 1  2   2  1 )

 2 ( 1   2 ) 2
 1 1   1  2   1  2   2 1
=
( 1   2 ) 2
Q  1  1   2  1
 >0
 2 ( 1   2 ) 2

Try to interpreter the above result. ----------------------------------------------------------

------------------------------------------------------------------------------------------------------------
Example

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Given the demand function Qd = 24 -2p

The supply function Qs = - 5 + 7 P
Find the equilibrium price and equilibrium quantity of the commodity. In our example  1
= 24,  2  5, 1  2 and  2  7 . Equilibrium is achieved where quantity demanded is
equal to quantity supplied of a commodity, i.e.
Q d = Qs = Q
Therefore, at the point of equilibrium
24- 2p= -5 + 7p
24+5 = 7p+2p
29=9p
29
p
9
P represents the equilibrium price (market price) of the commodity. Substituting the
value of equilibrium price either in the demand or the supply equation gives us the
equilibrium quantity. When we substitute it in the demand equation
29
Q = 24- 2( )
9
58
Q  24 
9
216  58
Q
9
158
Q
9
What happens to the equilibrium price P when  1 increases from 24 to 25 other things
being equal?
It becomes 25-2p = -5+7p
25+5 = 9p
30= 9p
30
p =
9
29 30
The equilibrium price increases from to when the parameter  1 increases from
9 9
24 to 25 units.
What happens to the equilibrium price, P when the parameter  2 increases from 7 to 8?
Dear colleague! Please, try to observe the effect of change in the remaining parameters
on equilibrium price and equilibrium quantity of the commodity.

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Given
Qd = 51 - 3 P
Qs  6P - 10

Find equilibrium price and quantity of the commodity

National Income Model
Now let us consider a national income model with three endogenous variables namely
 national in come ( Y)
 consumption ( C)
 taxes ( T)
The model becomes Y  C  I 0  G0
C  a  b(Y  T ) , Where a >0; 0<b<1 ----------------- (5)
T  c  dY , where c > 0, 0<d<1

As it is shown above, the equilibrium condition of the national income is reflected in the
first equation. But the second and the third equations indicate the way to determine
consumption (C) and taxes (T) respectively.

In this model, a , b, c and d are parameters. Their values are restricted and they are
described as follows.
The parameter a represents autonomous consumption, i.e. consumption without income.
It is positive. It indicates that the consumer may consume from past saving, family
remittance or borrowing with zero income.
b shows marginal propensity to consume (MPC). It is the rate at which consumption
changes when disposable income changes by one.
C
Algebraically, MPC = b =
 (Y  T )
Its value lies in between zero and one. MPC = b= 0.6 means that as disposable income
increases (decreases) by one unit consumption increases (decreases) by 0.6 units.
The parameter c represents tax revenue without income. It is clear that government can
have positive tax revenue from the tax base other than income. As a result c is positive.
The exogenous variables in the model namely investment (I 0 ) and government
expenditure ( G0 ) are supposed to be nonnegative. Similar to the parameters, these
exogenous variables are assumed to be independent of one another.
In this model, it is possible to solve the equilibrium income  in such a way that
substituting the third equation of the model in to the second one and then substituting the
resulting equation in to the first equation.
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The second equation of the mode is

C  a  b(Y  T )
Substituting the third equation it gives us
C  a  b[Y  (c  dY )]
C  a  bY  bc  bdY
Substituting this resulting equation in the first equation of the model, we get
Y  a  bY  bc  bdY  I 0  G0
Rearranging this equation,
Y  bY  bdY  a  bc  I 0  G0
Y (1  b  bd )  a  bc  I 0  G0

Thus, the solution value of Y (the equilibrium national income, Y ) in reduced form is

a  bc  I 0  G0
Y =
1  b  bd
--------------------- (6)

Dear colleague! From this equation we can get six comparative static derivatives.
What are they? Please, partially differentiate Y with respect to a, b, c ,d, I 0 and G 0 , and
thereby answer this question .------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------
Have you answered this question? Ok, good. Now try to relate your answer with the
following analysis and correct it if there you have done a mistake.
 1
=
a 1  b  bd
 2(1  d )  c(1  b  bd )
=
b (1  b  bd ) 2
 b
=
c 1  b  bd
   b(a  bc  I 0  G0 )  bY
= =
d 1  b  bd ) 2
1  b  bd
Y 1
 (Investment multiplier)
I 0 1  b  bd
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Y 1
 (Government expenditure multiplier)
G0 1  b  bd
From these partial derivatives, the following three are very crucial from policy point of
view.2

 b
= <0 -------------------------------------------- (7)
c 1  b  bd

Y  b(a  bc  I 0  G0 )  bY
   0 ------------------- (8)
d (1  b  bd ) 2
1  b  bd
 1
= > 0 ----------------------------------------------- (9)
G0 1  b  bd
The partial derivative shown in equation (7) above indicates the non- income tax
multiplier. This equation explains how the change in government revenue from non-
income tax sources affects equilibrium income. It is negative in the model as the
denominator is positive and the numerator is negative as shown above.
.
The partial derivative indicated in equation (8) represents an income-tax rate multiplier
which is negative for any positive equilibrium income. As tax rate increases, then
equilibrium income decreases.

Finally, equation (9) shows the partial derivative of equilibrium income with respect to
government expenditure. It is referred to as government expenditure multiplier. The value
is positive which indicates that increase (decrease) in government expenditure increases
(decreases) equilibrium national income.

Example
Given the following national income model,
Y = C+ I 0 + G 0
C = 50 + 0.6 (Y-T) --------------------------------- (10)
T = 30 + 0.3Y
I 0 = 20
G 0 = 15
Find  , C and T

2
Chiang A.C., fundamental Methods of Mathematical Economics, 3rd ed. P.182
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Solution
From the given model, substituting the third equation in to the second equation given
C = 50+ 0. 6 [Y- (30 + 0.3Y)]
= 50 + 0.6 (Y-30-0.3Y)
= 50+ 0.6 (0.7Y -30)
= 50-18+0.42Y
C = 32 + 0.42Y------------------------------------------------- (11)
Substituting equation (11) in to the first equation of equation 10, and the value of I 0 and
G 0 in this equation, we get
Y= 32 +0.42Y+20+15
Y = 67 + 0.42 Y
Y-0.42Y = 67
0.58Y = 67
67
Y 
0.58
Y  115.5 Equilibrium national income

Therefore,
C = 32 + 0.42 (115.5)
= 32+48.51
C = 80.51 or
We can get the value of C by using its reduced form
a  bc  b(1  d (1  d )( I 0  G0 )
C =
1  b  bd
In our example a = 50, b = 0.6, c = 30, d = 0.3
I 0 = 20, G 0 = 15
50  0.6(30)  0.6(1  0.3)(20  15)
Thus, C =
1  0.6  (0.6)(0.3)
50  18  (0.42)(35)
=
0.4  0.18
C  80.52

Similarly,
T = 30 + 0.3 Y
= 30+0.3(115.5)
= 30+34.65

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T = 64.65
Or
(c  bc)  d (a  I 0  G0 )
T=
1  b  bd
30  (0.6)(30)  0.3(50  20  15)
=
1  0.6  (0.6)(0.3)
30  18  0.3(85)
=
0.58
12  25.5
=
0.58
T = 64.65
What happens to equilibrium national income when government expenditure increases by
5 units? What about consumption and taxes at this point?
1 5
Y  G ( )  8.62
0.58 0.58
Y  115.5  8.62  124.12
It shows that an increase in government increases equilibrium national income.
Dear colleague! Try to determine C and T at this new level of equilibrium income.

Input - Output Model

Dear Colleague! I think you have studied about the concept of input - output model in
your Quantitative method for economists II course. Therefore, please try to revise what
you studied from these sources in order to understand the forthcoming discussion
properly.

As you know the solution of the open input - output model is described in the form of
matrix equation as follows.
X  ( I  A) 1 d
Where X represents the output vector in the model
I - is an identity Matrix
A- Technical coefficient Matrix
(I-A) – is Leontief Matrix (technology Matrix)
d- is the final demand vector
1
Representing the inverse of the technology Matrix (I - A) by C= [ C ij ], the solution of
the a simple three industry economy can be described as
X =Cd
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or in matrix form

X1 C11 C12 C13 d1

X2 = C 21 C 22 C 23 d2
X3 C 31 C 32 C 33 d3

Based on the above matrix we can determine the rate at which the solution value (the
output of each industry) X j changes with respect to change in the exogenous final
demand, d 1 ,d 2 ,d 3
X j
= C jk , where (j, k=1, 2, 3)
d k
To understand this fact, let us multiply the technology matrix with the final demand, and
show the solution as
X1 C 11 d 1 + C12 d 2 + C13 d 3
X = C 21 d + C 22 d + C 23 d
2 1 2 3

X3 C 31 d 1 + C 32 d 2 + C 33 d 3

Partially differentiating this system of three equations gives us a total of nine

comparative- static derivatives. These derivatives are
X 1 X 1 X 1
= C11 = C12 = C13
d1 d 2 d 3
X 2 X 2 X 2 C 23
= C 21 = C 22 =
d1 d 2 d 3
X 3 X 3 X 3
= C 31 = C 32 = C 33
d1 d 2 d 3
These nine derivatives can be summarized in matrix form as shown below.

C11 C12 C13

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X
 C 21 C 22 C 23
d
C 31 C 32 C 33

It is a compact way of representing all of the comparative static derivatives of our open
input - output model.
It is clear that comparative static derivatives of the input – output model are beneficial for
economic planning as they offer a means of solving the problem of changing the output
target of the industries due to a change in the final demand of consumers.

Numerical Example

Suppose a simple economy has three inter - industrial sector such as agriculture,
Manufacturing, and service, and one final demand sector, i.e., Household sector. It is
given that a birr wroth of agricultural product requires 20 cents worth of agriculture,
manufacturing and service sectors product each respectively as an input, a birr worth of
manufacturing product needs 5 cents, 20 cents and 10 cents worth of agriculture,
manufacturing and service sector's output respectively as input and that of a birr worth of
service sector's product requires 10 cents, 20 cents and 40 cents worth of agricultural,
manufacturing and service sector's output respectively as inputs.

Based on the given above determine the technical coefficient matrix in the order of
agriculture, manufacturing and service sector.

0.2 0.05 0.1

A= 0.2 0. 2 0.2
0.2 0.1 0.4

Determine the technology matrix

1 0 0 0.2 0.05 0.1

(I - A) = 0 1 0 - 0.2 0.2 0.2
0 0 1 0.2 0.1 0.4

0.8 - 0.05 -0.1

(I - A) = -0.2 0.8 -0.2
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-0.2 -0.1 0.6

With this technology matrix, the open input - out put system can be expressed in the form
(I- A) X = d as follows

0.8 - 0.05 -0.1 X1 d1

-0.2 0.8 -0.2 X2 = d2
-0.2 -0.1 0.6 X3 d3

By inverting the 3x3 technology matrix (I - A), the solution of the above system can be
determined as
X = (I - A) 1 d
To put it in matrix form, we ought to find the determinant of the technical coefficient
matrix and the inverse of the technology matrix, i.e., (I -A) 1 .
1
(I -A) 1 = adj.( I  A)
/ I  A/

/I-A/ = 0.8 0. 8 - 0 .2 + 0.05 -0.2 -0.2 -0.1 -0.2 0.8

-0.1 0.6 -0.2 0.6 -0.2 -0.1

= 0.8 (0.48-0.02) + 0.05(-0.12-0.04) -0.1 (0.02+0.16)

= 0.8 (0.46) +0.05 (-0.16)-0.1(0.18)
= 0.368-0.008-0.018
I  A = 0.342
To get the adj. (I- A), first we should construct the cofactor matrix of (I - A).
The cofactor matrix C of (I - A) is

C 11 C 12 C 13
C= C 21 C 22 C 23
C 31 C 32 C 33

Therefore,
C 11 = (-1) 2 0.8 - 0.2 , C 12 ( -1 ) 3 - 0.2 0.2
- 0.1 0.6 -0.2 0.6

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= 0.48 -0.02, = (- 1) (-0.2 - 0.04)

C 11 = 0.46 C 12 = 0.16

C 13 = (-1) 4 - 0.2 0.8

- 0.2 -0.1 = 0.02 + 0.16 0.18

C 21 = (- 1) 3 - 0.05 - 0.1 C 22 = (-1) 4 0.8 - 0.1 , C 23 = ( -1) 5 0.8 -

0.05
- 0.1 0.6 - 0.2 0.6 - 0.2
- 0.1

= -1 (-0.03 - 0.01) = 0.48 - 0.02 = -1 (-0.08 -

0.01)

C 21 = 0.04 C 22 = 0.46 C 23 = 0.09

C 31 = (- 1) 4 - 0.05 - 0.1 , C 32 = (-1) 5 0.8 - 0.1 ,C 33 (-1) 6 0.8 -

0.05
0.8 -0.2 - 0.2 -0.2 -0.2
0.8

= 0.01+0.08 = -1 (- 0.16 - 0.02) =

0.64 - 0.01
C 31 = 0.09 C 32 = 0.18 , C 33 =
0.65

Thus, the cofactor matrix of the technology matrix is

0.46 0.16 0.18

C= 0.04 0.46 0.09
0.09 0.18 0.63

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And the ad joint matrix is the transpose of the cofactor matrix. As a result, the ad joint
matrix of the technology matrix is

0.46 0.04 0.09

1
Adj (I-A) = C = 0.16 0.46 0.18
0.18 0.09 0.63

We know that
1 1
(I - A) = .adj ( I  A)
( I  A)
1 1
Therefore, (I - A) = 0.46 0.04 0.09
0.342
0.16 0.46 0.18
0.18 0.09 0.63

1.35 0.12 0.26

0.42 1.35 0.53
1
(I-A) = 0.53 0.26 1.83

Consequently, X1 1.35 0.12 0.26 d1

X2 = 0.42 1.35 0.53 d2
X3 0.53 0.26 1.83 d3

X 1 = 1.35d 1 + 0.12 d 2 + 0.26 d 3

X 2 = 0.42d 1 + 1.35 d 2 + 0.53 d 3
X 3 = 0.53 d 1 + 0.26d 2 + 1.83 d 3

Dear colleague! Determine the nine comparative static derivatives based on the
above system of equations ---------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------
If the final demand for agriculture, manufacturing and service sector's output of this
simple economy is valued 40 Birr, 80 Birr and 140 Birr respectively, find the gross
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output (equilibrium output level) of each sector for the given final demand. Putting it in
matrix form

X1 1.35 0.12 0.26 40

X2 = 0.42 1.35 0.53 80
X3 0.53 0.26 1.83 140

Then, the equilibrium levels of output are

X 1 = 1.35 (40) + 0.12(80) + 0.26 (140)

= 54 + 9.6 + 36 .4
X1 = 100 Birr
X 2 = 0.42 (40) + 1.35 (80) + 0.53 (140)
= 16.8 + 108 = 74.2
= 199 Birr
X 2 = 0.53 (40) + 0.26 (80) + 1.83 (140)
X 3 = 21. 2 + 20.8 + 256.2
X 3 = 298.2
By now you have completed the first section of this unit. Therefore, try to do the
following self - test questions in order to examine how you have understood this section.

Self - Test 5.1

Try to do the following questions based on the above analysis.

1. What is comparative static analysis
2. Comparative static analysis may be either qualitative or quantitative in nature. Explain
their difference
3. Discuss the different rules of differentiation.
4. Given the total cost function C= Q 3 -5Q 2 + 14 Q+75, write out the variable cost
function. Find the derivative of the variable cost function and interpret the economic
meaning of that derivative
5. Given the demand function Q d = 30 - 2 p

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the supply function Q s = - 6+5P

Find equilibrium price P and quantity
6. Given the national income model
Y= C+ I 0 + G 0
C  25  0.6Y
I 0 = 16
G 0 = 14
Find the equilibrium national income Y and consumption C
Dear colleague! Have you answered these questions? If your answer is yes, go to the
next section. If no, please re-read this section and try to answer these questions.

5.2 Jacobian and Hessian Determinants

After completing this section, you are expected to

- describe what Jacobian determinant is

- explain the way of determining whether a function is functionally
independent or not
- define what Hessian determinant is
- describe positive definiteness and negative definiteness
- explain
5.2.1 Jacobian how the Hessian determinant is used for identifying the
Determinant
extremum of the objective function with more than two independent
Dear colleague! Do you remember what you have studied about the determinant of
variables
a square matrix and its benefits in determining the existence of unique solution or linear
dependency of functions? How can we decide whether there exists a unique solution for a
system of linear equations or not?
Have you answered this question? If your answer is no, re-read what you have learnt in
Quantitative method for economists II and try to answer this question. If yes, very good.
Go to the next analysis and try to relate your answer with it.
A system of equations can have unique solution if there is the same number of equations
as unknowns. However, it is not a sufficient condition .In addition to this; the equations
are to be consistent and functionally independent. There exists a systematic method for
testing whether there is a unique solution or not for a system.

Simultaneous Equation Models

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For simultaneous linear equation models, we can use the concept of determinant of a
matrix.
Given a linear equation system BX  d where B is an n x n coefficient matrix the
determinant of the coefficient matrix B, i.e. B  0 , implies that
 there is row ( column ) independence in matrix B.
 B 1 exists and
 a unique solution x = B 1 d exists

This means, the determinant of the matrix enables us to decide whether there is unique
solution in a system or not. If the determinant of a matrix vanishes, i.e. zero, a system of
the equation does not have a unique solution. If the determinant of a matrix is different
from zero, these systems of the equations can have a unique solution. However, the
determinant criterion does not give the algebraic sign of the solution value although we
know that there is unique solution.
Dear colleague! Let us see the following example in order to make this the analysis
clear.
Example
Given the systems of sum ' tenuous linear equations
7x 1 - 3x 2 -3x 3 = 7
2x 1 + 4x 2 + x 3 = 0
0 x 1 -2x 2 -x 3 = 2
Determine whether there is a unique solution or not. To do this, we should use the
determinant of the coefficient matrix of the system.

7 -3 - 3
A= 2 4 1 = - 8 0
0 -2 1

Therefore, the equation system possesses unique solution because the determinate does
not vanish.

However, the technique of partial derivative and a special type of determinant known as
Jacobian determinant is needed in order to identify the existence of a unique solution
provided that the system of equations are non - linear models. This means, this type of
determinant enables us to determine whether there is functional dependency among a set
of n - functions in n- variables or not.

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If the value of the Jacobian determinant is zero, for all values of x 1 ..... x n , then the
functions are (linearly or non - linearly) dependent of one another. In this case, there is no
unique solution. On the other hand, the functions are said to independent and there exists
a unique solution if the value of the Jacobian determinant is different from zero.

Dear colleague, for the sake of understanding this concept, let us consider the following
examples.
Example
Given the functions
y 1 = 3x 12  2x 22
y 2 = 5x 1 +1
Partially differentiating these two functions gives us
y1 y1
 6x1 ,  4x 2
x1 x 2
y 2 y 2
 5, 0
x1 x 2
If we arrange these partial derivatives in to a square matrix in a prescribed order we can
get the Jacobian matrix, which is represented by J.

 y1 y1 
 x x 2 
J=  1 
 y 2 y 2 
 x1 x 2 

Its determinant is denoted by J .

y1 y1
J 
x1 x 2
y 2 y 2
x1 x 2

6x 1 4 x2
J = 5 0

= 6x 1 (0) - 5 (4x 2 )
= 0 - 20 x 2

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J  20 x 2  0
Therefore, the above two functions are functionally independent of each others.
Consequently, there is unique solution for this system of equations.

2. Given
y1  3 x12  x 2
y 2  9 x14  6 x12 ( x 2  4)  x 2 ( x 2  8)  12
If we partially differentiate these two functions, we get
y1 y1
 6x 1 , 1
x1 x 2
y 2 y 2
 36 x13  12 x1 x 2  48 x1 ,  6 x12  2 x 2  8
x1 x 2
Putting these partial derivatives in the form of Jacobian matrix

 6 x1 1 
J=  3
36 x1  12 x1 x 2  48 x1 6 x  2 x 2  8
2
1

And its determinant is

6x 1 1
J = 36x 13 + 12x 1 x 2 +48x 1 6x 12 + 2x 2 + 8

= 36x 13 + 12x 1 x 2 +48x 1 - (36x 13 + 12x 1 x 2 +48x 1 )

J =0

Therefore, these two functions are dependent of each other. As a result, there is no
unique solution for the system of equations.

Test the existence of functional dependence between these two functions and the
existence of unique solution using the Jacobian determinant.
y 1 = 2x 1 + 3x 2
y 2 = 4x 12 +12x 1 x 2 + 9x 22
5.2.2 Hessian Determinant

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Dear colleague! Do you remember the necessary and sufficient conditions of a

function with two or more independent variables to achieve its optimum value?
What are these conditions for a function? Z = ƒ (x, y)?
Have you answered this question? Ok, Good. Try to relate your answer with the
following analysis.
Given the objective function with two independent variables Z = ƒ (x, y), to get a
maximum or minimum of Z, it is necessary that the total differential of this function to be
zero ( dZ  0 ) for an arbitrary values of dx and dy where both are different from zero
dZ  f x dx  f y dy
Since dx and dy are a very small change in the independent variables ( dx  0 and dy  0 ),
the only situation which leads to a zero dZ is that
ƒx = ƒy = 0
This means, the necessary condition for a function to achieve its minimum or maximum
value is that both of the first order partial derivatives of the function must be equal to
zero.

The sufficient condition to have the extremum value of the function is related with the
positive and negative definiteness of the second - order differential of the given function,
d 2 z.
If d 2 Z is positive definite, it is a sufficient condition for a stationary value to be a
minimum value of a function where as the negative definiteness of d 2 Z suffice a
stationary value to be a maximum value of the given function. The second order total
differential of the above function is
d 2 Z  f xx dx 2  2 f xy dxdy  f yy dy 2 It is in a quadratic form.
d 2 Z is positive definite iff ƒ xx > 0 and ƒ xx ƒ xy
ƒ yx ƒ yy >0

d 2 Z is negative definite iff ƒ xx < 0 and ƒ xx ƒ xy

ƒ yx ƒ yy > 0

The determinantof
ƒ xx ƒ xy

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ƒ yx ƒ yy
is referred to as the second order Hessian determinant, H 2 or simply Hessian.
And f xx is the first order Hessian determinant, H 1 . According to the young's theories
ƒ xx = f yx
Example
Find the extremism value of the function
Z  x 2  xy  2 y 2  3  x 2 y 2
Dear colleague! To solve this problem let us first find the first order partial derivatives
and the second order partial derivatives of the function. These are
z z
 f x  2x  y ,  f y  x  4y
x y
ƒ xx = 2 , ƒ yy = 4 , ƒ xy = ƒ yx = 1
Setting the first order partial derivates equal to zero gives us
2x + y = 0------------------------------------------ (12)
x+4y = 0------------------------------------------ (13)
Taking these two equations simultaneously, multiplying equation (13) by 2 and deduct it
from equation (12) enables us to find the value of x and y.
2x + y = 0
2 x+4y = 0
2x  y  0
2x  8 y  0
0-7y = 0
y=0
Substituting zero in place of y in either of the two equations, we can find the value of x
2x+0=0
x=0
Thus, the critical points are at x = 0 and y = 0 .Now let us see the second order partial
derivates at the critical point. ƒ xx = 2, ƒ yy = 4, ƒ xy = ƒ yx = 1. They are independent of
the critical points. Arranging the second order partial derivates in the Hessian matrix

ƒ xx ƒ xy 2 1

H= =
ƒ yx ƒ yy 1 4

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The determinant of this matrix is

H = 2 1
1 4 = 2 x 4 - (1) 2 = 7 > 0

At x = 0 and y = 0, ƒ xx = 2 > 0 and (ƒ xx ) (ƒ yy ) > (ƒ yx ) 2 = 7 > 0 which implies that

d 2 Z is positive definite. Thus, the function achieves its minimum at x = 0 and y = 0 and
the minimum value is
Z = (0) 2 + 0 (0) + 2 (0) 2 + 3
Z=3
If the given function is with three independent (choice) variables,
Z = ƒ (x 1 , x 2 , x 3 )
The necessary and sufficient conditions that should be satisfied to achieve it's extremum
value are similar to that of a function with two choice variables. That is
The necessary condition is which
ƒ1 = ƒ2 = ƒ3 = 0
The sufficient condition is related with the positive and negative definiteness of the
second order total differential of the function.
 (dz )  (dz )  (dz )
d 2z = dx1 + dx 2 + dx3 =
x1 x 2 x3

  
( f 1 dx1  f 2 dx 2  f 3 dx3 )dx1  ( f 1 dx1  f 2 dx 2  f 3 dx3 )dx 2  ( f 1 dx1  f 2 dx 2  f 3 dx3 )dx3
x1 x 2 x3

2
= ƒ 11 dx1  f 12 dx1 dx 2  f 13 dx1 dx3  f 21 dx1 dx 2  f 22 dx 22  f 23 dx 2 dx3 
f 31 dx3 dx1  f 32 dx3 dx 2  f 33 dx32
In order to determine the positive and / or negative definiteness of d 2 Z we should
construct the Hessian matrix and then its determinant based on the second order partial
derivatives of the function as follows.

f11 f12 f13

H= f21 f22 f23
f31 f32 f33

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Then, the Hessian determinant is

f11 f 12 f 13
H  f 21 f 22 f 23
f 31 f 32 f 33
The successive principal minors of this determinant are

H 1  f11 H2  f11 f 12 f11 f 12 f 13

f 21 f 22 , and H 3  f 21 f 22 f 23  H
f 31 f 32 f 33

The second - order sufficient condition for an extremum of the given function can be
described as
 Z is at its maximum point if and only if H 1  0, H 2  0, H 3  0 (in this case
d 2 Z is negative definite).
 Z is at its minimum if and only if H 1  0, H 2  0, H 3  0 ( d 2 Z is positive
definite).
Example
Find the extremum values of
Z = x 12 3 x 22  3 x1 x 2  4 x 2 x3  6 x32
The first order condition for extremum constitutes
f 1  2 x1  3 x 2  0              (14)
f 2  3 x1  6 x 2  4 x3  0          (15)
f 3  4 x 2  12 x3  0              (16)
The determinant of the coefficient of these three linear equations is

2 -3 0

-3 6 4 = 2(36-16) + 3(-36) =  68  0

0 4 12

It is different from zero which implies that all of the equations are independent to each
other. As a result, there exists a single solution
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x1  x 2  x3  0
From equation (14), we got
2x 1 = 3x 2

3
x1  x2
2

From equation (16), we get

4x 2 + 12x 3 = 0
4x 2 = - 12x 3

1
x3  x2
3

Substituting these two results in equation (15) gives us

3 1
(  3( x 2 )  6 x 2  4( x 2 )  0
2 3
9 4
x2  6 x2  x2  0
2 3

 27 x 2  36 x 2  8 x 2
0
6
 35 x 2  36 x 2  0
6
 35 x 2  36 x 2  0
x2  0
3
x1  ( 0)  0
2
This means,
1
x3  ( 0)  0
3
Thus the critical values are x1  x 2  x3  0 .
Dear colleague! As you know the sufficient condition is determined by using the Hessian
determinant.

Thus, the Hessian determinant of this function is

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ƒ 11 f 12 f 13 2 -3 0
H = ƒ 21 ƒ 22 ƒ 23 = -3 6 4
ƒ 31 ƒ 32 ƒ 33 0 4 12

The successive principal minors are

H 1 = 2, H2 = 2 -3 = 12 - 9 = 3
-3 6

H 3  H  2 (72 -16) + 3 (-36) = 4

Dear colleague! As we have seen all of the principal minors are greater than zero. This
implies that d 2 Z is positive definite. Thus, the function achieves its minimum value at
x 1 = x 2 = x 3 = 0 and the minimum value is
Z = 0 2 3(0) 2  3(0)(0)  4(0)(0)  6(0) 2
Z=0
For functions of n-choice variables such as
Z  f ( x1 , x 2 , x3 , x 4 ,..x n )
The necessary condition for the extremum of this function is that all of the n-first order
partial derivatives must be equal to zero.
The second order condition can be described by using the sign of Hessian determinant. as
we have discussed in unit three.

Bordered Hessian Determinant, H

Dear colleague! We have discussed the use of the Hessian determinant in order to
expresses the second order sufficient condition of achieving free extremum. We can also
use a determinant form of expressing this condition for the problem of constrained
optimization. In this case, we will apply what is known as the bordered Hessian
determinant, H rather than the Hessian determinant, H .The bar on the top of the
bordered Hessian indicates the border.
Given the function

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Z  f ( x, y ) Subject to g ( x, y )  c , the bordered Hessian determinant is

0 gx gy
H = gx Z xx Z xy
gy Z yx Z yy

We can determine the sign definiteness of d 2 Z using H as follows:

d 2 Z is positive definite subject to dg  0 iff H < 0 (Z is minimized).

d 2 Z is negative definite subject to dg  0 iff H >0.(Z is maximized).

Given the stationary values of Z= ƒ(x, y) +  [c- g (x, y)], if d 2 Z is positive definite, it is
sufficient for a function Z to achieve its relative minimum where as a negative definite
d 2 Z is a sufficient condition to satisfy the relative maximum of the objective function.

Example

Suppose a consumer uses two goods with utility function U  xy  x subject to the
budget constraint 6x +2y =110. Determine the amount of x and y with maximize utility
and check the second order condition using the bordered Hessian determinant.

Solution
Formulating the Lagrange function
L  xy  x   110  6 x  2 y .....................................................................(1)

The first order conditions are

Lx  y  1  6  0.....................................................................................( 2)
Ly  x  2  0...........................................................................................(3)
L  110  6 x  2 y  0................................................................................(4)
The matrix form is

0 1  6 x 1
1 0 2 y = 0
 6  2 0   110

Using Cramer's rule

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The determinant of the coefficient matrix, i.e., A is 24.

1 1 6 0 1 6
A1  0 0  2 =224, A2  1 0  2 =648
 110  2 0  6  110 0

0 1 1
A3  1 0 0 =112
 6  2  110

A1 224 A2 648
Therefore, x  , y   27
A 24 A 24
A3 112
 
A 24

Taking the second partial of L with respect to x and y and the first order partial derivative
of the constraint function with respect to x and y, we can form Hessian bordered as
follows.
L xx  0, L yy  0, L xy  L yx  1 (Young's theorem)
g x  6, gy  2

0 6 2
Thus, H  6 0 1  6(2)  2(6)  24  0
2 1 0
Thus d 2L is negative definite and total utility is maximized when
224
x and y  27
4
Dear colleague! By now you have completed the second section of this unit. Therefore,
try to do the following questions to examine whether you understand this section or not.

Self -Test 5.2

Do the following questions based on the information given above.

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1. Describe what the Jacobian determinant is -----------------------------------------------------

-----------------------------------------------------------------------------------------------------------
2. Given the following functions determine whether there is functional dependence or
not using Jacobian determinant.
a) Y1  2 x1  6 x 2
Y2   x1  5x 2

b) Y1  5 x1  3 x 2
Y2  2 x1  4 x 2
------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------
3. If the total cost function of the firm is C  5Q12  2Q1Q2  3Q22  800 and a
production quota represented by Q1  Q2  39 is imposed on a firm.
Minimize C  5Q12  2Q1Q2  3Q22  800
Subject to Q1  Q2  39
Check the second order sufficient condition using the bordered Hessian determinant.
------------------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------------------
4. Suppose the demand functions of the product sold in two separate markets are given as
Q1  24  0.2 P1 ; Q2  10  0.05 P2
C  35  40Q, where, Q  Q1  Q2
Find the out put levels which maximize profit and check the second order sufficient
condition using the Hessian determinant-----------------------------------------------------------
------------------------------------------------------------------------------------------------------------
---------------------------
Dear colleague! Have you done these questions? If your answer in no reread this section
and try to do them. If yes, go to the next section..

5.3. Comparative Static of General Function Models, and Limitation of

Comparative Static
Up on the completion of this section, you should be able to

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- describe the use of implicit function rule.

- explain how change in income disturbs market equilibrium
- explain the effect of change in government expenditure on equilibrium
national income.
- describe the effect of change in income and tax on equilibrium price in the
market model.
- explain the limitation of comparative static analysis.
5.3.1. Comparative Static of General Function Models
Dear colleague! You remember that we have expressed the equilibrium values of the
endogenous variables of the model explicitly in terms of exogenous variables and
parameters when we discuss section 1 of this unit. In that case, we have applied a simple
method of partial derivative to get comparative static information. However, when the
model incorporates functions which are expressed in general form; explicit reduced form
solution cannot be obtained. In this case, we must find the comparative static derivatives
directly from the general function model using the concepts of total differentials, total
derivatives and implicit function rule. Now let us first discuss the market model.
Market Model
Let us take a one commodity market in which the quantity demanded for a product
dependent on the price of a product and consumer’s income which is determined
exogenously. But quantity supplied of a product depends only on price of a product.
Therefore, at the point of market equilibrium,
Qd  Q s
 Q Qd 
Where Qd  f d P, y 0   d  0,  0 ........................(1)
 P y 0 
 Qs 
Qs  f s ( P )   0 
 p 
Assuming that the demand function as well as the supply function is differentiable, the
restriction Qd P  0 shows that the demand function is a decreasing function of price
which meets the law of demand and Qd Y0  0 indicates that demand is an increasing
function of consumer’s income. In this case the good is normal good. Similarly,
Qs P  0 shows that the supply function is an increasing function of price which
satisfies the law of supply.

Dear colleague! As you know market equilibrium is determined by the interaction of

market demand and market supply, other things being equal. But a change in income
shifts the market demand which affects the equilibrium condition. The same will happen
in our case. This means, change in Y0 will disturb the equilibrium through the demand

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function. Therefore, let us see how a change in Y0 will affect the equilibrium condition of
the model as Y0 is the only exogenous variable.

Equilibrium is achieved when Qd  Qs . this implies that f d P, y 0   f s  p 

Rearranging these terms gives us
f d ( P, Y0 )  f s ( P)  0..............................................................(2)
It is difficult to solve this equation explicitly to determine equilibrium price. But let us
assume that there exists a static equilibrium whose price is P which is dependent
on the exogenous variable Y0
P  f (Y0 )..............................................................................(3)
Since equation (2) is expressed in the form of F ( P, Y0 )  0, the fulfillment of conditions
to apply implicit function theorem will enable us to say that every value of Y0 shall give a
unique value of P near an initial or old equilibrium solution. In this case, we are able to
dP
put the implicit function P  f Y0  and we can determine its derivative which is the
dY0
comparative static derivative we need. Let us observe the conditions.

1. As f d ( p, y 0 ) and f s ( p ) are differentiable by assumption, the implicit function

F ( p, y 0 ) is differentiable.
2. The partial derivatives of the implicit function with respects P i.e.,
Q
F  d  Qs , is negative but nonzero evaluated at every where.
P P P

Therefore we can apply the implicit function theorem given these conditions and thus,
P  f (Y0 ).
Now an equilibrium situation explained in equation (2) can be considered as an identity
near the equilibrium solution. As a result the equilibrium identity is expressed as
  
f d P, Y0  f s P  0.......................................................(4)

Now we can determine the comparative static derivative of d P using implicit

dY0
function rule as follows.
F Q
dp  d
Y0 Y0
    0................................(5) ,
 dY  F Qd
 0  dQs / d p
p p

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Where Qd /  p represents Qd p evaluated at the initial equilibrium. The same
interpretation is applied on Qs  p .

Qd y 0 has also to be evaluated at the point of equilibrium. d p dy 0 is positive shows 
that an increase in consumers income increases equilibrium price and a decrease in
income decreases equilibrium price.

Dear Colleague! Until now we have discussed the effect of change in consumer’s income,
Y0 on equilibrium price. Do you think that we can determine its effect on equilibrium
quantity Q ? ---------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------------------
The answer is yes because at the point of equilibrium
Q  fs p and p  f  y 0 , therefore, using the chain rule of differentiation,
dQ  dQs  d P  dQs
     0 as is positive ………………………(6)
 dY0 d P  dY0  dP
Thus, change in consumer’s income affects equilibrium quantity Q, directly.
Equations (5) and (6) show the fact that a right ward shift of the demand curve (an
increase in the demand for a product) increases both equilibrium price and quantity of a
product.
Simultaneous equation Approach

Dear colleague! In the above discussion we have determined the effect of change in
consumer’s income on equilibrium price and equilibrium quantity separately. Can we
find them at the same time? --------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------
The answer is yes. To see it, let us formulate a two equation system since the endogenous
variables are two. At the point of equilibrium, we know that
Q  Qd  Qs Our market model can be formulated as
F 1 P, Q, y 0   f d P, Y0   Q  0
F 2 P, Q, y 0   f s P   Q  0.......................................................(7)

Conditions for applying implicit function theorem are:

1) F 1 and F 2 Should be differentiable as both the demand and supply functions are
differentiable.
2) The endogenous variable Jacobian should be different from zero, i.e,

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F 1 F 1 Qd
1
P Q P dQs Qd
J      0...............................(8)
F 2
F 2
d Qs dP P
1
P Q dP

 
Supposing that P, Q exists, according to the implicit function theorem.
P  f Y0  and Q  f Y0 ...................................................................(9)
These two functions are differentiable with respect to Y0 . We will have the following
identities near the equilibrium state.
 
f d P, Y0  Q  0..................................................................................(10)
f P   Q  0
s

Now we can determine  d P  and  d Q 

 at the same time. Applying the implicit
dY  dY
 0  0

function rule on equation (10), we get by rearrangement.

Qd Qd
d P  dQ  dY0
P Y0
dQs
d P  dQ  0
dP
It is a linear equation system as d P and d Q appears in the first degree. d P and d Q are
considered as variables. Dividing both sides of the equation by an arbitrary change in the
exogenous variable, i.e. (dY0 ), we the following matrix form.
 Qd 
 Qd dP   Y 
 P   1   0 
dY
 0 
  
 Qs  dQ 
 1  

0 

 d P  
 dY0   
Now we can apply the Cramer’s rule and there by can determine the solution as follows.

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Qd
1
 dP  Y0 Qd
  ........................................................(11)
 dY   0 1

y 0
 0
J J

Qd Qd
 dQ  P Y0 dS Qd
 
 dY   dS 
d P Y0
 0 0
dP J
J
Where all the derivatives of demand and supply functions are evaluated at the initial
equilibrium. This result is similar to that of equation (5) and (6).

National Income Model

Dear Colleague! As you remember we have discussed a specific national income model
which includes consumption, government expenditure and investment in the first section
of this unit. Now let us reduce government expenditures and taxes for the purpose of
variety and add the foreign sector in to the model. In addition to this, let us incorporate
the money market with the goods market.

Goods market

In particular; it is supposed that the goods market has the following functions.
Investment is a function of interest rate,
I  f (i ) , dI di  0 
Saving s is a function of national income Y, and interest rate i,
S  f (Y , i ) (0  S y  1, S i  0)

Where S y  S and S i  S
Y i
Import (M) is also a function of national income Y,
 dM 
M  f (Y ), 0   1
 dY 
Export X 0 is an exogenous variable.
X  X0

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Money market

In the money market it is supposed that

1. The quantity demanded for money depends on national income and interest rate, i.e.,
M d M d
M d =f(Y, i),   0, 0
Y i
2. Money supply is an exogenous variable, which is determined by monetary policy
Ms  M so .

Dear colleague! All of the above functions are supposed to be differentiable. In this
model equilibrium is achieved when the goods market and the money market are in
equilibrium at the same time as shown below.
f (i )  X 0  f S Y , i   f Y                 (12)
f L Y , i   M so

Where f S represent the saving function f L represents money demand function.

Equation (12) can be rearranged and written as
F 1 Y , i, X o , Ms o   f (i )  X o  f S Y , i   f Y   0.          .12
F 2 Y , i, X o , Ms o   f L Y , i   M so  0
In this equation we have two endogenous variables namely Y and i and two exogenous
variables, X 0 and M so ,

In this system the conditions for the implicitly function theorem are fulfilled. These are
1. F1 and F2 are differentiable as all ingredients functions are differentiable
2. The endogenous - variable Jacobian is different from zero, evaluated every where.

F 1 F 1  S dM dI S
Y i  
Y dY di i
J  2 2 =  0.      (13)
F F M d M d
Y i Y i

Therefore, according to the implicit function theorem,

Y  f  X 0, M so andi  f  X 0 , M so .......................14 

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 
Although it is difficult to solve Y and i explicitly, equation 121 can be expressed as a
pair of identities near the equilibrium state as
f (i )  X 0  f s (Y , i )  f (Y )  0..........................15
f L (Y , i )  M so  0

We can obtain four comparative static derivatives from equation (15). Two of them are
resulted from change in X 0 and the remaining is emanated from change in money supply
( M S 0 ) .Now let us determine the comparative static derivatives resulted from change in
export holding money supply constant. In this case dX o is a disequilibrating factor.
Taking the total differential of each identity in equation 15 with respect to X o , and
dividing through by dX o , we get the matrix equation
S dM dI S   1
     
Y dY di i    
  =   …………………..(16)
smd md   Y   
 
 X 0   
 
y i   0 
  
 i 
 X 
 o
Using the Cramer's rule the solutions are

dI S
1 
 Y  di i
  
 X o  M d
0 M d
i  0
i
J J ----------------17)
S dM
 1
 i  Y dY M d
    0
 X o  M d i
0
Y
J J
Where all of the above derivatives are evaluated at Y  Y and i  i .
Equation (17) shows that an increase in export increases both equilibrium interest rate
and equilibrium income.

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Dear colleague! By now you should determine the comparative static derivatives resulted
from change in money supply, i.e. dM so , using the same procedure.

5.3.2. Limitation of comparative static Analysis

We have discussed that it is concerned with the analysis of different equilibrium points.
Comparative static's is helpful in finding how the disequilibrating change in a parameter
or exogenous variable will affect the equilibrium state of the model. However,
comparative static's has the following shortcomings.
 It neglects the process of adjustment from the old equilibrium to the new
equilibrium.
 It ignores the time element contained in the adjustment process.
 It assumes that the new equilibrium can be defined and attained after a
disequilibrating change in the exogenous variable or a parameter.

Dear collogue! By now you have completed that last section of this Unit. Therefore, try
to do the following question to evaluate how you have understood the main point in this
section.

Self - Test 5.3

Do the following questions based on the information above
1. Explain the effect of change in consumer's income on equilibrium price and quantity --
-----------------------------------------------------------------------------------------------------------
2.Describe the effect of change in export on equilibrium national income and interest in
the national income model----------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------------------
3. What happens to equilibrium national income and interest rate when money supply
increases? Explain briefly based on the above national income model.

4. Describe the limitations of comparative static analysis.

5. What are the conditions that should be satisfied to differentiate the given function
f  x, y   0, in the form of? dy
dx,

Check List

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Write '' in side the box which corresponds to the question that you can solve easily

1. What is equilibrium? ………………………………………………

2. Explain comparative static analysis ………………………………..
3. Describe the difference between endogenous variable and exogenous variable
……………………………………………….....
4. Discuss Leontief input-output model. ………………………………..
5. Explain the Jacobian determinant ………………………………….
6. Describe positive and negative definiteness………………………….
7. Explain the difference between Hessian determinant and the bordered Hessian
determinate…………………………………………………
8. Describe the effect of change in income on equilibrium price and quantity for a good
…………………………………………………..
8. Describe the effect of change in export and money supply equilibrium national income
and interest rate ……………………..
9. What are the limitations of comparative static analysis? -------

Dear colleague! Is there any box in which you don't tick? If your answer is yes, please,
reread this unit and try to answer that question. If your answer is no, go to the next unit.

Unit summary
The change in equilibrium state in response to a change in exogenous variables or
parameters leads us to a type of analysis which is refereed to as comparative static
analysis. Comparative static analysis is emphasized on comparison of different
equilibrium states. Comparative static analysis may be either quantitative or qualitative
in nature.

Jacobian determinant is a special type of determinate which enables us to determine

whether there is functional dependence among a set of n-functions in n-variables or not.
We can also identify the existence of unique solutions of the system of linear equations
based on this determinant. The zero value of this determinant shows that there is
functional dependence among functions in a system and there is no unique solution.

A Hessian determinant is a type of determinant composed of all the second order partial
derivatives with the second order direct partials lie on the principal diagonal. Observing
the sign of this determinant, we can check the second -order sufficient conditions of a
function to achieve it's free optimum value. However, the bordered Hessian determinant
is used to determine second order sufficient condition of the problem of constrained
optimization.

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When the equilibrium value of the endogenous variable is expressed in terms of the
exogenous variable and a parameter, we can apply a simple method of partial derivative
to get comparative static information where as if the functions are presented in a general
form, we have to find the comparative static derivatives directly from the general
function models using the method total differential, total derivatives and implicit function
rule.

Important Points(for focus)

Equilibrium Jacobian determinant

Comparative Static analysis Hessian determinant
Parameters Total differential
Market model Implicit differentiation
National income model Bordered Hessian
Input out put model

Answers for Self Test Questions

Self Test 5.1

dTVC
4) TVC  Q 3  5Q 2  14Q,  3Q 2  10Q  14
dQ
36 138
5) P  ,Q 
7 7
6) Y  137.5  C  107. 5

Self Test 5.2

2) a. J  16  0 b. J  14  0 Thus, the functions are linearly independent in both
cases.
0 1 1
3) Q1  13, Q2  26,   182 H  1 10 2 , H 2  56  0; H 3  H  12  0
1 2 6
 10 0
4) Q1  8, Q2  4 H   400  0, H 1  10  0 The second order condition
0  40
is satisfied.

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CHAPTER SIX

6. DYNAMIC EQUILIBRIUM ANALYSIS

Introduction
Dear learner! So far we have discussed about comparative static analysis which is
emphasized on comparison of different equilibrium situations. For instance, in the theory of
supply and demand analysis, an increase in demand for a product increases equilibrium price
and quantity, other things being equal. However, nothing is said about the process by which
price and quantity are being adjusted to the new equilibrium values. The study of the process
of adjustment over time is the concern of dynamic analysis. In this unit you will deal about
discrete time and continuous time dynamic analysis and their economic application. In the
former case there will be a change in variable only once with in a period of time where as in
the later case there may be a change in variables at each point of time.

Unit Objective
After completing this unit, you should be able to
- discuss the difference between dynamic equilibrium analysis and comparative static
analysis
- describe dynamic analysis over continuous time period
- explain dynamic analysis over discrete time period
- describe differential equations and difference equations
- explain the cobweb model and the Keynesian macro economic model, and Harrods
Domar growth models and others

6.1 Continuous Time Dynamic Analysis

Up on the completion of this section, you are expected to

- describe differential equations

- explain general solution and definite
solution of a differential equation
- apply differential equations on
economic functions to determine
dynamic stability of equilibrium

Dear learner! What is differential equation? You studied concerning this concept in
Quantitative Method for economists I. Thus, try to remember it and answer this question. ----
-----------------------------------------------------------------------------------------------------------------
Have you answered this question? Ok, good, try to relate your answer with the following
analysis.
Differential equation is an equation that shows an implicit or explicit relationship between
the function y  f (t ) and one or more of its derivatives. For instance,
dy
= 6t + 10, where t represents time
dt
dy d2y dy
= 15 y, -2 + 19 = 0
dt dt 2
dt
The highest power attained by the derivative in the equation is known as degree of the
differential equation where as the order of a differential equation is the order of the highest
derivative in the equation.
Example
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dy
a) = 3x + 7 (first degree, first order)
dt
d3y dy 4
b) +( ) + 2x2 = 0 (third order, first degree)
dt 3
dt
6.1.1. First - Order Linear Differential Equations

dy
In this case, if the derivative, and y have to be is first degree and if no product of
dt
dy
y( ) exist, then the equation is referred to as first order linear differential equation. This
dt
equation will generally take a form
dy dy
+ V y = Z or + V (t) y = Z (t) ---------------- (1)
dt dt
Where V and Z are constants or functions of time, t, like y
When V and Z are constants and Z is zero, then equation (1) will be
dy
 y = 0 ------------------------------------- (2)
dt
Where  is constant which represents V. Such type of differential equation is referred to as
dy
homogenous as each term in the equation is in first degree in terms of y and .
dt
Rearranging equation (2), we get
1 dy
  ---------------------------------------- (3)
y dt
Now we can obtain the solution of equation (3) by integrating both sides of the equation with
respect to t.
By substitution rule and log rule, the left side of the equation gives us
1 dy dy
 y dt dt   y
 ln y  c1 , (y  0

The right side gives us

  dt  t  c 2 , (as -  is constant)
By equating the above two integrals and combining the two constants, we get
n y  t + C
Using the method of antilogarithm
(  t  C )
n y
e = e
y = e (  t e c

y (t )  Ae t , where A  e c ----------------------- (4)

There is an arbitrary constant A in equation (4). Therefore, it is a general solution.
If we substitute a particular value for A, then it will be a definite solution. We have seen two
situations in the solution of differential equation. These are.
 The solution is given in function form, not in number.
 The solution is free of any derivative. As result, we can determine the value of y if a
specific value is assigned for t.
When we put a nonzero constant  in equation (2) in place of Z, we get the equation,
dy
+ y =  , where  is constant ---------------------------- (5)
dt
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Such type of equation is known as non homogenous linear differential equation. Here, the
problem is how can we determine the solution? The solution of this equation will contain two
different terms. One is complementary function represented by y c and the other is particular
integral represented by y p as we will see it later.

Let us observe the solution of the homogenous equation even if we are dealing about the way
to solve non homogenous equation. For convenient let us consider the homogenous equation
as reduced equation and the non homogenous one as complete equation. Thus, the solution of
the reduced equation represents y c and y p represents particular solution of the complete
equation. This means,
y c  Ae t , from equation (4)
We have said that y p denotes a particular solution of the complete function. Thus, let us first
dy
try to obtain the simplest type of solution taking y as some constant k . Then,  0 when y
dt
is constant. As a result equation (5)
0  y  

yp  ,  0

Then the general solution of the complete function is

y (t )  y c  y p  Ae t  , (  0)            (6)


y (0)  Ae  ( 0 ) 


When t = 0, y (0)  A 


A  y (0) 

 
Thus, y (t )  [ y (0)  ]e t  , ( definite solution,   0 ) ------------ ( 7)
 
Example
dy
1. Find the definite solution of the equation + 4y = 12, y (0) = 0. In this
dt
case,   4,   12 , thus
y (t )  [0  3]e 4t  3
y (t )  3e 4t  3
dy
2. Determine the general solution of the equation 3 + 6y = 5
dt
Dividing both sides by 3, we get the equation
dy 5
+ 2y =
dt 3
5
y (t )  Ae  2t 
6

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Economic Applications
Dear learner! Differential equations are beneficial to determine the dynamic stability
condition of the market equilibrium. When the rate of growth of a function is given,
differential equation enables us to get the function whose growth is explained.

Example
1. Assume that the demand and supply functions of a particular product are given as
Qd  a  bP, (a, b,  0)                    (8)
Qs  c  dP, (c, d  0)
As we remember from comparative static analysis, equilibrium Price, P is
ac
P = ------------------------------------------------------------- (9)
bd
dP
Assuming that the rate of change of price in the market, is a positive linear function of
dt
excess demand, Qd  QS ,
dP
 k (Qd  Qs ) , k is constant, k > 0 ------------- (10)
dt

Given sufficient time for adjustment process, under what condition P (t ) converges to
the equilibrium price P as t   ---------------------------------------------------------------------
-------------------------------------------------------------------------------------------------------------?
dp
We know that = 0 if and only if Qd  QS
dt
Substituting the given parameters for Qd and Qs in equation (10)
dP
 k[(a  bP )  (c  dP )]  k (a  c)  k (b  d ) P
dt
dP
 k (b  d ) P  k (a  c)                (11)
dt
We have seen that equation (11) is expressed in the form of differential equation. As the
coefficient P is different form zero, it is possible to apply the solution formula and present
the solution as
( a  c )  k ( b  d ) t ( a  b)
P (t )  [ P (0)  ]e 
(b  d ) (b  d )
P (t )  [ P (0)  P ]e  k (b  d )t  P                (12)
As P (0) and P are constants whether P (t)  P as t   or not depends on the
exponential expression e  k ( b  d ) t . If k (b+ d) > 0, the exponential expression approaches to
zero as t approaches to infinity. As a result, the time path will really direct the price towards
equilibrium position on the assumption of our model. In this case, the equilibrium is refereed
to as dynamically stable.

2. If Cˆ , IˆandYˆ are deviations of consumption, investment and income from their respective
equilibrium values C , I and Y , determine the dynamic stability conditions for the two sector
income determination model.

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Cˆ  C (t )  C , Yˆ  Y (t )  Y and Iˆ  I (t )  I
In come changes at a rate proportional to excess demand
dYˆ (t )
(C  I  Y ) and Cˆ  gYˆ (t ) , Iˆ(t )  bYˆ (t ) ,  a (Cˆ  Iˆ  Yˆ ) , 0  a, b, g  1
dt
dY
Using substitution,  a ( gYˆ  bYˆ  Yˆ )  a ( g  b  1)Yˆ
dt
dYˆ
 a ( g  b  1)dt                (13)
Yˆ
When we integrate this function, we get
ln Yˆ  a ( g  b  1)t  C                (14)
Using the method of antilogarithm
a ( g  b 1) t  c
e n ŷ = e
Yˆ  e c e a ( g b 1)t
Yˆ  ke a ( g b 1)t , if , k  e c
As t = 0, ŷ = y (0) - ŷ = k
As a result, Yˆ  [Y (0)  Y )]e a ( g b 1) t . However, Yˆ  Y (t )  Y , Y (t )  Yˆ  Y
Thus, Y (t )  [Y (0)  Y ]e a ( g b 1)t  Y              (15)
This solution shows that as t  , Y (t )  Y if and only if g  b  1 .

3. It is clear that a change in the rate of investment will affect both aggregate demand and
productive capacity of the economy. The Domar model wants to determine the time path
along which an economy can grow while maintaining full utilization of its productive
capacity. Given the marginal propensity to save s and the marginal capital- output ratio k as
constant, determine the desired investment function for the growth to be needed.

Dear colleague! As we know change in aggregate demand is equal to change in investment

1
multiplied by the multiplier .
s
dy dI 1
= --------------------------------------------- (16)
dt dt s
Change in productive capacity is equal to the change in capital stock multiplied by the
reciprocal of marginal capital- output ratio,
dQ 1 dK 1 dK
= = I, as = I ---------------------- (17)
dt k dt k dt
Equating equation (16) and (17), gives us
1 dI 1
= I
s dt k
1 1
dI  Idt --------------------------------------------------- (18)
s k
Rearranging this equation, we get
dI s
 dt  0 -------------------------------------------------- (19)
I k
Applying the method of integration on equation (19), it becomes

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s
ln I  t  C
k
s
ln I  t  C
k
Using antilogarithm
s
[( ) t  c ]
ln I
e e k

s
( )t
c
I (t )  e e k

s
( )t
I (t )  Ae k
, if , A  e c                (20)

Equation (20) is the desired investment function for the growth to be needed which indicates
s
that investment has to grow at a constant rate determined by (saving rate divided by capital
k
output ratio).

6.1.2 Second - Order Linear Differential Equations

d2y dy
Functions of the form + a1 + a 2 y = b where a 1 , a 2 , and b are constants is
dt 2
dt
referred to as second - order linear differential equations. ------------------------------ (21)
If the tem b is zero, the given function is homogenous. However, if b is different from zero,
the equation is known as non homogenous equation.

The solution of the given equation has two components. These are complementary function
( y c ) and particular integral ( y p ).
y (t )  y c  y p
Similar to the previous analysis y c represents the deviation of y (t) from equilibrium for
every point of time path where as y p denotes the equilibrium value of the variable y in
intertemporal sense.

Particular integral ( y p )
Dear colleague! Let us try the simplest possible way, i.e., setting y = a, constant, to find the
particular integral y p .
 If y = a which is constant, then the above second order linear differential equation
dy d 2y d2y dy
becomes   0, As a result, the equation + a1 + a 2 y = b , will be
dt dt 2
dt 2
dt
b
reduced to a 2 y = b which gives us y  .
a2
b
Thus, the particular integral is y p  , (a 2  0)            (22)
a2
 If a 2  0, we have to find some non constant form of a solution. Setting y = k t
which is the simplest possibility, the second order differential equation (21) is
reduced to

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b
a1 k  b .This gives us the value of k  which is the particular integral .Then the
a1
particular integral is
b
yp  t , a1  0, a 2  0 , ---------------------------------- (23)
a1

 If a1  0 , the solution with a form y  kt fails since it is undefined. consequently,

we have to find other solution of the form y  kt 2 when a1  a 2  0 , then equation
d2y
( 21) is reduced to = b ------------------------------- ( 24)
dt 2
dy d2y
y = kt 2 implies that,  2kt , 2  2k . Then the differential equation (24) can be
dt dt
b
presented as 2k = b which implies that k  and then the particular integral is
2
b 2
y p  t , (a1  a 2  0)                  (25)
2
Example
Find the particular integral of the equation
d2y dy
- 2 + 5y = 2
dt
2
dt
2
Solution: y p 
5
2 2
If a 2  0 , y p  t  t (using equation (23)).But, if a1  0, y p  t 2  t 2 .
2 2

The complementary function ( y c )

The complementary function of equation (21) denotes the general solution of the equation
d2y dy a y = 0 ---------------------------------------- (26)
2
+ a1 + 2
dt dt
dy
As we have discussed in equation (4), y  e rt .. Adopting this solution,  rAe rt and
dt
d2y
 r 2 Ae rt
dt 2
Substituting these terms in equation (26) , we get
r 2 Ae rt  a1 rAe rt  a 2 Ae rt  0
Ae rt (r 2  a1 r  a 2 )  0                  (27)
Equation (27) shows that A e rt = 0 or (r 2  a1 r  a 2 )  0
We know that the value of A is determined by the use of the initial condition of the problem.
Consequently, we cannot set A e rt = 0. Thus, it is necessary to observe the value of r which
satisfies the equation (r 2  a1 r  a 2 )  0 . This equation is referred to as characteristic
equation of the homogenous function expressed in equation (26). This characteristic equation
has a form of quadratic equation which will result in two solutions (roots). These roots are
known as characteristic roots. Using quadratic formula,

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2
 a1  a1  4a 2
r1 , r2                 (28)
2
r1 and r2 are the only values we can put for r in the solution y = A e rt . Since there are two
roots, r1 and r2 , then we will have two solutions. These are,
y1  A1e r1t and y 2  A2 e r2t , where A1 and A2 are constants and r1 and r2 are
characteristic roots. The general solution is the summation of the above two solutions. This
means,
y c  y1  y 2                          (29)

Dear Colleague! The characteristic equation may have three different types of roots, namely
distinct real roots, reaped real roots and complex roots.
Case 1 When a12  4a 2 , the square root in equation (28) will be a real number and the two
roots r1 and r2 will be distinct real numbers. In this case
r1t r2t
y c  y1  y 2  A1e + A2 e , ( r1  r2 ) ------------------------------- (30)
Case 2 When a12  4a 2 , the term in the square root of equation (28) becomes zero. As a
result the two roots will be equal. The complementary function will be
y c  ( A1  A2 )e rt
Case 3 When a12  4a 2 the term in the square root of equation (28) becomes negative
number which is referred to as imaginary number. For the time being let us ignored this case.
For the first two cases it is possible to determine the dynamic stability of equilibrium
condition based on the sign of the characteristic roots. The condition (i.e., y c  0 as t  
) is fulfilled iff both r1 and r2 have negative sign.
Example
Find y c , y p , the general solution and the definite solution of the equation
y (t )  9 y (t )  14 y  7            (32)
1
Since the value of a 2 is different from zero, y p 
2
To determine the complementary function y c , we should first find the value of r1 and r2
 9  81  56 95
r1 , r2 =  , r1 =  2 , r2 =  7
2 2
We know that y c  y1  y 2  A1e r1t + A2 e r2t ------------------------------ (33)
Subsisting the value of r1 and r2 in equation (33) gives us
y c  A1e 2t  A2 e 7 t
Therefore, the general solution of the equation is
1
y (t )  A1e  2t  A2 e 7 t                 (34)
2
5
When y (0) = and y  (0) = 6, then the definite solution becomes,
2
1 5
y (0)  A1  A2  
When t = 0, 2 2
A1  A2  2                        (35)

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y (0)  2 A1e 2t  7 A2 e 7 t  2 A1  7 A2

y (0)  2 A1  7 A2  6
2 A1  7 A2  6                        (36)
Taking equation (35) and (36) simultaneously, multiplying (35) by 2 deduct it from equation
(36) gives A2 = - 2.
Substituting the value of A2 in equation (35), we get
A1 - 2 = 2
A1 = 4
1 5
Therefore, y (t )  4e  2t  (2)e 7 t  is the definite solution when y (0) = and y (0)
2 2
=6

Economic Applications

Dear colleague! It is clear that future price expectation affects supply and demand decisions.
dP
The price tread existing at the moment in continuous time context can be found in and
dt
d 2P
.Therefore, we ought to incorporate these two derivatives in the demand and supply
dt 2
functions as additional components to consider the price trend in our analysis.

Example
1.Suppose the demand and supply functions of a product are given as
dP d 2 P
Qd  42  4 P  4  2
dt dt
Qs  6  8 P                          (37)
With initial condition P (0)  6 and P (0)  4 . Assuming market clearance at every point of
time, find the time path P (t ).

Dear colleague! As we know market equilibrium is achieved when Qd  Qs . Thus, at the

point of equilibrium
dP d 2 P
42  4 P  4  2  6  8 P                (38)
dt dt
Rearranging this equation, we get
d 2P dP
-4 - 12P = - 48 which is second order differential equation in form.
dt 2
dt
Thus, P (t )  Pp  Pc where Pp represents the particular integral and Pc denotes the
complementary function. Thus, to determine the general solution P (t ), we should find
Pp and Pc .In this equation, a1  4, a 2  12, b  48 , since a 2  0, then
 48
Pp   4.
 12
To determine, we should find r1 and r2 . Using the formula presented in equation (28 ),
4  16  48 48
r1 , r2 = =
2 2

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r1 , r2 = 6,2 , i.e., r1 = 6 and r2 = - 2

This means Pc  A1e 6t  A2 e 2t
Therefore, the general solution is
P (t )  A1e 6t  A2 e 2t  4                  (39)
Considering the initial conditions p (0) = 6 and P  (0) = 4,
P (0)  A1  A2  4  6
A1  A2  2                      (40)
P (0)  6 A1e 0  (2) A2 e 0  4
6 A1  2 A2  4                      (41)
Taking equation (40) and (41) simultaneously, multiplying equation (40) by 2 and adding it
on (41), we get A1  1 and A2  1 . Therefore, the definite solution is
P (t )  e 6t  e 2t  4
Since r1  6 , P (t ) cannot converge to the intertemporal equilibrium. It is dynamically
unstable.

Dear colleague! By now you have completed the first section of this unit. Therefore, try to do
the following self - test questions to examine how you understand this section.

Self - Test 6.1

Do the following questions based on the information given above.
1. Describe dynamic equilibrium analysis---------------------------------------------------------------
----------------------------------------------------------------------------------------------
2. What is differential equation explain it briefly. ----------------------------------------------------
-------------------------------------------------------------------------------------------------
3. Describe the difference between homogenous and non homogenous differential equation. --
-----------------------------------------------------------------------------------------------------------------
-------------------------------------------------------------------------------
4. Explain the difference between general solution and definite solution of an equation --------
-----------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------
5. Given demand and supply functions of a product as
Qd  125  2 P
Qs  45  8 P
Determine whether the equilibrium price , P is dynamically stable over time or not as there is
sufficient time for adjustment using the formula presented in equation ( 12) ---------------------
-----------------------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------------------------
-

6. Suppose the demand and supply functions of a product are given as:
d 2P dP
Qd  3  2 P  10
dt 2
dt
Qs  2 P  30
With P (0) = 4 and P (0)  9 , determine the price path, assuming market clearance at every
point of time. Is the time path convergent? -------------------------------------------------------------
-----------------------------------------------------------------------------------------------------------------

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Dear colleague! Have you answered these questions? If your answer is no, please reread this
section and answer them. If your answer is yes, go to the next section.

6.2 Discrete Time Dynamic Analysis

Up on the completion of this section, you should be able to

- describe what a difference equation is

- explain the difference between first- order linear difference equation
and second-order difference equation
-explain the dynamic adjustment process in a cobweb model and in ----
Keynesian macroeconomic model
-explain the Harrod model of growth in the economy

Dear learner! In the previous section we have discussed the continuous time dynamic
analysis. In that case, the magnitude of change in time is very small. As result, the change in
y which is emanated from this change in time is expressed in the form of derivative.
However, this section is emphasized on discrete time dynamic analysis. In this case, time is
considered as discrete variable and the dynamic adjustment process between equilibriums is
observed as a step-by-step process rather than that of continual adjustment. Thus the change
in y has to be explained by "differences" rather than derivatives or differentials. Accordingly,
we can calculate the different values of the variables which are adjusting to new equilibrium
levels using
 The mathematical concept of difference equation and
 Spreadsheet

Dear learner! What is difference equation?

Have you answered this question? Good. Try to relate it with the following analysis.

Difference equation is an equation which expresses the relation ship between the dependent
variable and a lagged independent variable that changes at discrete intervals of time. The
largest number of periods lagged represents the order of difference equation.

6.2.1 First Order Linear Difference Equations

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First order difference equation represents a time lag of one period. The change in y which is
resulted from change in time t from t  to t  1 is referred to as the first difference of y
which is represented by
y t  y  y t 1  y t .........................(1)
This equation is first-order linear difference equation. Given the first-order linear difference
equation
y  3  y t 1  y t
y t 1  y t  3.............................................(2)

Let us find the solution of this equation by using iterative method first and then the general
method.

A. Iterative Method

Given equation (2), it is not difficult to find the value of y1 provided that the initial value of
y, i, e, y 0 is given. We can also find the value of y 2 once we have determined the value of y1

EXAMPLE
1. Find the solution of the difference equation y t 1  y t  3 provided that y 0  20 using
iteration method.
y1  y o  3
y 2  y1  3   y o  3  3  Y0  23
y 3  y 2 3   y1  3  3   y o  33  3  y 0  3(3)
y 4  y 3  3  y 0  4(3)

Yt  y 0  t (3)
For any period t, the solution of equation (2) with y 0  20 is
...........................................................(3)
y t  20  3t

2. Find the solution of the difference equation y t 1  2 y1  0 . In this case, the initial value is
unspecified simply represented by y 0 . using the method of iteration,
y1  2 y 0
y 2  2 y1  22 y 0   2  y 0
2

y 3  2 y 2  2  y 0
3

y t  2  y 0
t

The solution of y t 1  2 y 0  0 at any period t is

.............................................................(4)
y t  ( 2) t y 0

B) General method

Given the first order linear difference equation

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y t 1  by t  a......................................................................(5)
Where a and b are constants, the general solution s a combination of the particular integral
y p and the complementary function y c . y p denotes the intertemporal equilibrium level of y
where as y c represents the deviation of the time path from this equilibrium. Incorporating the
initial condition we can determine the definite solution.

Dear learner! Let us first determine the complementary function which is the solution of the
reduced equation y t 1  by t  0 . Based on equation (4) above,
y t  (b) t y 0 ..............................................................................(6)
Putting the constant A in place of y 0 , we get
y t  A(b) t
Thus, the complementary function is
y c  A(b) t .............................................................................(7)

Now let us find the particular integral y p

Taking the simplest form y t  k where k is constant, we have to have y t 1  k . If we
substitute these n to equation (5), we will get k+ b k= a
a
k 1  b   a  k  , b  1
1 b
Then the particular integral becomes,
a
yp  k  , b  1....................................................(8)
1 b
Therefore, the general solution of the equation is
yt  yc  y p
a
y t  A(b) t  , b  1..........................................................(9)
1 b
If b=-1 the general solution will be
y t  A  at
Setting the initial condition that y t  y 0 when t =0,
a a
y 0  A(b) 0   A , b  1,
1 b 1 b
a
A  y0 
1 b
Are a result, the definite solution is

 a  t a b  1.............................................(10)
yt   y0  (b) 
 1 b  1  b,

Example

Solve the first order difference equation

y t 1  3 y t  8  0  y t 1  3 y t  8, when y 0  16
y t 1  3 y t  8

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Using the formula in equation (10) , a =-8 , b 3, y 0  16

   8  t 8
y t  16     3
 1 3  1 3
y t  16  2   3  2  18 3  2
t t

The given equation s referred to as dynamically stable or convergent provided that the
complementary function approaches to zero as t approaches to infinity. The convergence of
the term b t depend the absolute value of b. If b  1 , the time path will move away from
equilibrium. If b  1 , the time path will move towards to equilibrium, i.e., convergent.
In our example above, b=-3, b   3  1. Therefore, the equilibrium is dynamically
unstable. In other words, the time path is divergent.

6.2.2 Second order Linear Difference Equations

Given the second order difference equation

y t  2  a1 y t 1  a 2 y t  C.............................................................(11) , the general
solution is composed of that of particular integral and complementary function. We know
that the particular integral is any solution of the complete equation. Thus, setting the simplest
solution
y t  k , equation (11) becomes
c
k , a1  a 2  1
1  a1  a 2

c
Therefore, yp  k 
1  a1  a 2
, a1  a 2  1............................(13)

If a1  a 2  1, equation (13) will be undefined. Thus, we have to set another value for
y t . .Let y t  kt , then equation (11) becomes,
k t  2   a1 k 1  t   a 2 kt  c................................(14)
Rearranging this equation,
k t  a1t  a 2  a1  2  c,
k t 1  a1  a 2   a1  2  c, as a1  a 2  1
This equation becomes
c
k a1  2   c k  , a1  2
a1  2

Thus,
yp 
c
t
, a1  a 2  1, a1  2....................(15)
a1  2

When a1  a 2  1 and a1  2 then equation (15) will be undefined. Therefore, we

should set another value for y t . Let y t  kt 2 , then equation (11) becomes,

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k t  2   a1 k t  1  a 2 k t   c...........................(16)
2 2 2

 
k t 2  4t  4  a1 t 2  2t  1  a 2 t 2  c 
k t 2
1  a1  a 2   t 4  2a   4  a   c, as
1 1 a1  a 2  1 and a1  2
This equation becomes,

k t 2 0   t o   4  2  c 
c .
k 2   c  k  , a1  a 2  1 and a1  2
2

Therefore, yp 
c 2
t , a1  a 2  1 and a1  2......................(17)
2

Dear learner! As complementary function is the solution of the reduced equation, we should
emphasize on the equation
y 2t  a1 y t 1  a 2 y t  0...................(18) to determine the complementary
function of the given equation we know that y t  Ab t . Thus the above reduced equation
becomes
Ab 2t   a1 Ab t 1  a 2 Ab t  0...................................(19)

Ab t b 2  a1b  a 2  0 
Ignoring the nonzero common factory gives us,
b 2  a1b  a 2  0..................................................(20)
This equation is referred to as characteristic equation of equation (18)
The solution of this equation using the quadratic formula
 a1  a12  4a 2
b1 , b2  ....................................(21)
2
We face three possible phenomenon based on the term in the square root of equation (21)

case1, When a, 2  4a 2, the characteristic equation will have two distinct roots,
b1 and b2, In this case, the complementary solution will be
y c  A1b1t  A2 b2t ................................................( 22)

Case 2 when a, 2  4a 2, the characteristic equation will have only one root, this means,
 a1
b1  b2  b 
2
The complementary function becomes

y c  A1b t  A2 b t   A1  A2 b t  A3 b t
y c  A3 b t  A4 tb t .................................................(23)
Case 3.when a12  4a 2, the term in the square root will be negative which an imaginary
number is. There is no characteristic root for the equation provided that we restrict our
domain to the real number system. Thus, we are forced to include numbers outside the real
number system. Ideally, we can define i   1 which a square root of negative one is. It is

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not real number rather it is known as imaginary number. Therefore, we can write
 25   25   1  5i,  10  10  1  10i
Given the diagrams

Imaginary
axis

R
v

h Real axis

v h
sin   , cos  
R R
v  R sin  , h  R cos  R  h2  v2
Then the conjugate complex number
h  vi   R cos   RiSin
According to De movers theorem h  vi   R n  R n cos n  Ri sin n ......(24)
n

If a, 2 4a 2  0 in equation (21), ten the roots will tae the form

a1 a12  4a 2
b1 , b2  h  vi, where h  ,v  ,i  1
2 2
2
2 2
a  4a 2  a
R= 1
 a21

4
The complementary function becomes

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y c  A1b1t  A2 b2t
 A1 h  vi   A2 h  vi 
t t

 A1 R t cos t  i sin t   A2 R t cos t  i sin t 

y c  R t  A1  A2  cos t   A1  A2 i sin t  
IfA1  A2  A5 and A1  A2 i  A6 , then
yc  R t  A5 cos t  A6 sin t ..............................................(25)
In al of the above three cases, the equilibrium will be dynamically stable provided that the
absolute value of every root is less than one whatever the initial condition may be

Table 6 1. Values of sin  and cos 

 1  3    3 
0   2 6 4 3 4
2 2
sin  0 1 0 1 0 1 1 3 1
cos  1 0 1 0 1 2 2 2 2
32 1 2 1 1 2
2

Example
Given the equation y t  2  4 y t  15, y 0  12, y1  11,
a. Determine the general and definite solution of the equation
b. Is the time path convergent or not?

Solution
15
a1  0, a 2  4, C  15 yp 
3
5
 a1 o
R  4  2, cos    0
2 a 2 22 
a12
sin   1 
4a 2
0
 1  1
16
sin  1

Sin  1 and cos   0 .Thus, as it is shown in table 1,    when we substitute this

2
value in equation (25), the complementary function will be
     
y c  2 t  A5 cos t   A6 sin  t 
 2   2 
Then the general solution becomes
    
y t  2 t  A 5 cos t   A 6 sin  t   3.....................................(26)
 2  2 
When t  0, y 0  2 A5 cos 0  A6 sin 0  3  12
0

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A5 (1)  A6 (0)  3  12

A5  3  12
A5  12  3  9
When t=1, 
y1  21 A5 cos 
2
 A6 sin   3  11
2

2A5 (0)  A6 (1)  3  11
2 A6  3  11
2 A6  8
A6  4
Therefore, the definite solution be comes
   
y t  2 t 9 cos t  4 sin t   3......................................................(27)
 2 2 

Economic Applications

Dear learner! In this sub topic you will learn about the application of first order and second
order linear difference equations on economic models.

A. Application of First Order Linear Difference Equation

Cobweb Model
Dear learner! In certain markets particularly agricultural markets, if demand for a product
increase, supply cannot immediately increase to satisfy the prevailing demand. Crops must be
planted and growth and livestock takes time to raise. Some manufactured products may also
take certain time when customers order that products suddenly. The Cobweb model considers
this lagged in supply side of the market by supposing that the present quantity supplied is
based on the ruling price in the previous time period. That is,
Qts  f Pt 1 
But the consumers demand for the same product depends on the prevailing price that is
Qtd  f Pt 
This is a logical situation of several agricultural markets. The quantity supplied this year is
based on the price of that product in last year. The Cobweb model assume that
 The market is perfectly competitive.
 The demand and supply functions are linear.
Given these assumptions, the Cobweb model can still give a fair idea of how price and
quantity adjust in many markets with a lagged supply. Based on the above assumptions, the
demand and supply functions of a product can be expressed in the form
Qtd  a  b Pt (demand function)...........
s
Q  c  d Pt 1
t (sup ly function)
Dear learner! As you know, the market achieves its equilibrium when quantity demanded is
equal to quantity supplied.
In other words, Qtd  Qts
a  bPt  c  dPt 1
bPt  c  a  dPt 1

.................................................................( 28)
ca d
Pt   Pt 1
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This equation is the Cobweb difference equation.

Thus, solving the Cobweb difference equation means setting it in the format Pt  f (t ). As a
result; we can calculate the value of Pt at any time period.
The solution of the Cobweb difference equation includes two parts. There are:
a) Long run equilibrium price
b) a complementary function which indicates how much price diverges from this
equilibrium level at different points in time.
Dear colleague! Now let us first find the long run equilibrium price P . In the log run,
Pt  Pt 1  P . Therefore
ca d
Pt   Pt 1
b b
cb d ac
Become P  PP , b  d .............................................(29)
b b d b
To determine the complementary function, we can rewrite equation (28) as
d ca
Pt 1  Pt  ..............................................................................(30)
b b
Using the method of determining the complementary function described in equation (7)
above,
Pc  P0 d  b t

If we substitute, A, a Constance in place of P0 , we get

t
d 
Pc  A  ......................................................................................(31)
b
In this case the value of A can be determined if a certain value of Pt is known for specific
value of t.
The complete solution of the Cobweb difference equation, therefore, becomes
t
 ac d 
Pt     A 
d b b

t ........................................................(32)
d 
Pt  P  A 
b

From this equation

t
d
1. If d  1, approaches to zero when t approach to infinity. In this case the
b b
market is stable. Price converges to the long run equilibrium price P .
t
d d
2. If  1, then   when t  . In this case the market is unstable. Price
b b
diverges from the equilibrium level.

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t
d d
3. If  1, then  1, as t  . In this case, price neither return to its equilibrium
b b
nor 'explode'.

Example
1. Given the demand and supply for the Cobweb model as
Qtd  400  20 Pt ................................................................(33)
Qts  50  10 Pt 1


Determine the long run (intertemporal) equilibrium price P , the complementary function
and the complete solution.
Determine whether the equilibrium is stable or not.

Solution

a =400, b =-20, c =-50, d=10

a  c 400  50 450
P  
d  b 10  20 30
P  15 (inter temporal equilibrium).
The complementary function is
t
 10 
Pc  A 
  20 
Therefore, the complete solution is
Pt  A 0.5  15.........................................................(34)
t

d
Since   1  1  1, the equilibrium is dynamically stable.
b 2 2

Dear learner! What happens to the market if quantity supplied suddenly changes
to 160? ______________________________________________________________
___________________________________________________________________
The initial stock output level is Q0  160 so that price will adjust until all output is sold.
Then P0 can be calculated from the demand function by substituting Q0  160.
Therefore, 160  400  20 P0 .
P0  12
By now we can determine the value of A.
P0  A0 .5   15  12
0

A  15  12
A  3

Thus, the definite solution is

Pt  3 0.5  15........................................35
t

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Using thin equation we can calculate the price of the product at any time period and there by
we can check whether the price converges to the equilibrium level or not.
2. In a market where the assumptions of the cobweb model hold,
Qtd  200  8 Pt

Qts  43  8.2 Pt 1 .......................................................36 

The long run equilibrium is disturbed when quantity suddenly changes to 90.
What happens to price in the following time period?
Solution
 
In the long run equilibrium , Q  Qtd  Qts and p  pt  pt 1 Thus,

200  8 P  43  8.2 P

16.2 P  243
P  15
t
 8 .2 
  A 1.025 ..................................(37)
t
The complementary function is p c  A
 8
Thus, the general solution is
Pt  A 1.025  15............................................38
t

Q0  90,
90  200  8 P0
When
8 P0  110
Po  13.75

If Po  13.75, the value of A will be,

13.75  A 1.025  15
0

13.75  A  15
A  1.25
Thus, the definite solution is
pt   1.25 1.025  15.......................................(39)
t

The Keynesian Macroeconomic Model

In the Keynesian model of national income determination, if foreign trade and government
expenditure and tax are not included, the model becomes,
Y  C  I ...................................(40)
And
C  a  bY ..................................(41)

Where Y is national income, C is consumption, I is investments a is autonomous

consumption and b is marginal propensity to consume. Then equilibrium level of national
income is

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Y  a  bY  I
Y  bY  a  I
Y 1  b   a  I
 aI
Y  b  1..................................(42)
1 b
, Y  Y at equilibrim

This equation shows that this national equilibrium income Y can be evaluated fro a given
values of a, b and I .
When there is a disturbance from this equilibrium, there will not be an immediate adjustment
to the new equilibrium. As the consumer expenditure may not adjust immediately to the new
level of income, a lagged effect may be introduced in the consumption function, as follows,
C t  a  bYt 1 ..............................................(43)

This means, consumer's expenditure at present depends on the income of the previous year.
But national income is still determined by the sum all current expenditure
Thus, Yt  C t  I t ........................................(44)

Substituting (43) in to (44) gives us

Yt  a  bYt 1  I t
Yt  bYt 1  a  I t .............................................(45)
Equation (45) is a first order linear difference equation,

The general solution of this equation includes two parts, namely intertemporal equilibrium
and complementary function Yc  , At the point of equilibrium,
Y  Yt  Yt 1
Thus,
Y  bY  a  I t
Y  bY  a  I t
a  It
Y (int ertemporal equilibrium)...........(46)
1 b
The complementary function as referred to equation ()7
Yc  Ab t .......................................( 47)
Thus, the general solution becomes
a  It
Yt  Ab t  ......................................( 48)
1 b
b  1.
This equation shows that the equilibrium will be dynamically stable provided that

Example

Given the Keynesian model

yt  C t  I t
Ct  650  0.5Yt 1
And I t  300
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Then it suddenly increases to 420

Dear learner! What will be the actual level of Y six time periods after this change?

Solution

a  650, b  0.5, I t  300

The initial equilibrium level of income is
650  300
Y   1,900
1  0 .5
Thus, consumption C o is
C 0  650  0.51.900   1,600
Thus, the value of Y immediately after the shock is
Yo  C 0  I 0
Yo  1600  420  2,020
The new equilibrium level is
650  420
Yˆ   2,140
1  0 .5
Substituting this value in general solution above, we will get
 
Yt  Yˆ  Yo  Yˆ b t
Yt  2,140  2,020  2,140 0.5
t

 2,140  1200.5
t

Y6  2,140  1200.5
6

 2,140  1.875
Y6  2,138.125

Dear learner! How much time period will it take y to reach 2,130? ------------------------
-----------------------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------------------------
----------
2,130  2,140  1200.5
t

 10  1200.5
t

10
 0.5
t

120
Putting this equation in it's logarithm form

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10
log  log 0.5 t
120
10
log  t log 0.5
120
10
log
t 120  3.585
log 0.5
t  3.585
The equilibrium national income will reach 2,130units after 3.585 time period.
SAMUEL SON'S MULTIPLIER-ACCELERATION INTERACTION MODEL

Dear learner! To observe the application of second order difference equations in

economies, let us consider Samuel son's classics interaction model. This model
examines the dynamic process of income determination if the acceleration principle
works with the Keynesian multiplier. The model describes the situation that the
interaction of, the multiplier and the accelerator results in cyclical fluctuation
endogenously.

Assume that national income Yt is a combination of consumption C t investment I t and

government expenditure G t . It is also assumed that current consumption is a function
of last years income Yt 1 , Investment I t is function of difference in consumption
C t 1 C t C t 1 . suppose I t is s fixed proportion of C t 1 . Gt is assumed to be
exogenous. Thus, the model becomes
Yt  C t  I t  G0
C t  bYt 1 , o  b  1................................(49)
I t  aC t  C t 1 , a  0
,Where b is marginal propensity to consume and a is accelerator coefficient. Now we can
express I t in terms of income as
I t  abYt  2 
I t  abYt 1  Yt  2 .................................(50)
If we substitute (50) and C t in equation (49), we get
Yt  bYt 1  abYt 1  Yt  2   G0
I t  b1  a Yt 1  abYt  2  G0
This means
Yt  2  b1  a Yt 1  aby t G 0 .................................(51)
This equation is a second order linear difference equation. As a result, we can solve it using
the method discussed in equation (11).

Solution
The general solution will include the particular integral Y p and the complementary function
yc 
The particular integral Y p is

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G0 G
Yp   0
1  b1  a   ab 1  b

Complementary function

As far as the complementary function is concerned, we are faced with three possible
phenomena
4a
Case .1 If b 2 1  a   4ab
2
or b  ,
1  a 2
Equation (51) with characteristic equation
r 2  b1  a r  ab  0 will have two roots,
b(1  a )  b 2 1  a   4ab
2

r1 , r2  .................................(52)
2
As we know whether the equilibrium is dynamically stable or not depends on r1 and r2 which
in turn are based on the value of a and b, we can express the dynamic stability in terms of
a and b.
Case. 2 If b 2 1  a  =4ab, we will have only one root,
2

b1  a 
r
2
Case. 3. If b 1  a   4ab, then we should use the method explained in equation (25)
2 2

b1  a  b 2 1  a   4ab
2

r1 , r2  h  vi, Where h  ,v 
2 2
i  1 , R  ab
Then the complementary function becomes

Yc  A1 r1t  A2 r2t
 A1 h  vi   A2 h  vi 
t t

Yc  R t  A1  A2  cos t   A1 A2 i sin t 

IfA1  A2  5 and  A1  A2 i  A6 ,
Yc  R t  A5 Cost  A6 sin t ..........................................................(53)
Then the general solution in case 3 becomes,
Go
Yt  R t  A5 Cost  A6 sin t   ..........................................(54)
1 b

Dear learner! Now try to determine the general solution of the equation in case 1 and case 2.
In all of the three cases, the equilibrium will be dynamically stable iff a b < 1, that is, the
product of the accelerator and marginal propensity to consume muse be less than one.

Dear colleague! By now you have completed the second section of this limit. Thus, try to do
the following question to evaluate how you understand this section.

Self Test 6.2

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Solve the following questions based on the information above.

1. What is difference equation? __________________________________________

_________________________________________________________________
2. What is the difference between discrete and continuous variable _____________
__________________________________________________________________

3. Solve the difference equation 5 y t 1  2 y t  140, y 0  30 _____________ ______

________________________________________________________________
4. Given the second order linear difference equation
y t  2  7 y t 1  6 y t  42 Find the general solution _________________________
_______________________________________________________________
5. assuming the usual Cobweb assumption, derive the difference equation which will calculate
price in the time periods following the unexpected decrease in equilibrium quantity to 75
given
Qtd  160  20 Pt
Qts  80  40 Pt 1
____________________________________________________________________
______________________________________________________________
__
6. A Keynesian macroeconomic model with a single time period lag on the consumption
function described below is initially in equilibrium with the level of I t  500.
Yt  C t  I t
C t  750  0.5Yt 1
If it is increased to 650, find the value of y in the fourth time period after this
disturbance. _______________________________________________________
_________________________________________________________________
7. If the accelerator is 0.5 and the marginal propensity to consume is 0.6, what will happen to
the time path? Answer this question using equation (51)
___________________________________________________________________________
_________________________________________________________
Dear colleagues! Have you answered these questions? If your answer is no, re read
this section and try to do them. If your answer is yes, good. Go to the following
check list.

Important Points

Dynamic analysis General solution

Continuous time Definite solution
Discrete time Particular integral
Adjustment Complementary function
Differential equation Imaginary number
Difference equations Characteristic roots
Cobweb model Accelerator
Keynesian macro-economic model Time Lagged

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Answers for Self-Test Questions

Self Test 6.1

5) P (t )  [ P (0)  17]e 10 kt  17 it is dynamically stable.

33  3  4t
6) P (t )  e t  e  10 ,As r1  1 & r2  4 P(t) cannot converge to Pp as
5 5
t  .

Self test 6.2

3) y t  10(0.4) t  20
4) y t  A1 (1) t  A2 (6) t  3
5) P (t )  4  0.25(2) t
6) 2,790.79
7) (0.5)(0.6)  0.3  1 .Thus, the time path is convergent or dynamically stable.

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Exercise
1. A form produces two types of products X and Y passing through to two machines M 1
and M 2 . Each unit of X requires 2 hours of time in M 1 and 8 hours of time in M 2
where as each unit of Y requires 12 hours of time in M 1 and 4 hrs of time in M 2
.The total time available in M 1 is 40 hours and M 2 is 28 hours. Determine the
amount of X and Y produced using gauss - Jordan elimination method.

2. Find the price elasticity of demand if the demand function is

Q = 40 - 5P + 3P 2

3. Find the point elasticity of demand if the demand function is given as

50
Q= where k is constant
pk

1
4. Prove that x  1  1+ x as x is close to zero
2

5. Find the Taylor's seines of the function f( x) = 4x2 + 6x+ 3 around x0 = 2

6. Given the Cobb - Douglas production function Q= A K  L  Where Q represents total
product, K is capital and L is labor. Find the marginal product of each input and determine
whether the law of diminishing marginal productivity holds for eachinput as far as   0 & 
<1.
7. Given the production function Q = 32K 0.5 L 0.25 R 0.4, derive the nine second - order partial
derivatives and show that the two cross partial derivatives with respect to each possible pair
of independent variables will be equal to each other.

8. Suppose the total cost faction of the monopolist is given by TC = 2Q2 + 10 Q + 15 and the
demand function is given by P = 10 - 3Q. Find
i) The level of output which maximize profit
ii) Determine the elasticity of demand at the point of equilibrium.
9. Discuss the difference between comparative static analysis and dynamic analysis briefly.

10. Go to section 5.1.2 observe the effect of change in all the parameters on equilibrium
quantity and interpret the result.

11. Explain the limitation of comparative static analysis.

12. Considering the following national- income model with tax ignored
Y  C (Y )  I (i )  G0  0, (0  C   1; I   0)
kY  L(i )  M s 0  0
(Where k is positive constant; L   0 )
Analyze the comparative static effect of the model when money supplies changes and
government expenditure changes.

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13. Suppose that the monopolistic firm has the following average revenue functions in three
separated markets
P1  63  4Q1
P2  105  5Q2 P and the cost function is C  20  15Q
P3  75  6Q3
Determine the price that should be charged in each market to maximize profit. Check the
second order sufficient conditions using the Hessian determinant.

14. Given the demand and supply functions be

Qd  9  P  P   3P 
with P (0)  4 & P (0)  4
Qs  1  4 P  P   5P 
Find the price path assuming market clearance at every point of time.
Is the time path convergent or not?

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Chapter 7
7. Linear differential and difference equations
So far we have seen the concept of differentiation and integration and their
application to economic problems. Now we are going to learn about the concepts
of linear differential and difference equations of the first order level, and their
economic applications as well.
Objectives:
At the end of this chapter you will be able to:
 Understand the difference between differential and difference concepts
 Apply the concepts of differential and difference to economic problems.
 Solve problems of the type of differential and difference equations.
 Identify the orders and degrees of the equations

7.1 Definition and concepts

A differential equation is an equation which involves derivatives. It is an implicit
functional relationship between variables and their differentials. The order of
differential equation is of the highest order of any of the derivatives contained in
it. A differential equation is order n if the nth derivative is the highest order
derivative in it. The highest power to which the derivative of the highest order
occurs is the degree of a differential equation.
dy
Example 1) y  x 2  x is the differential equation of order one, and degree one.
dx
4 2
d 2 y   dy 
2)  2   8   xy is of order two, and degree three
 dx   dx 
5
 dy 
3)   - 6 x = 0 is of order one, and degree five
7

 dx 
7 3
d 2 y  d 4 y 
4)  2    4   80 y of order four, and degree three.
 dx   dx 

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A different equation is said to be linear if the dependent variable is of the first

d nY d n 1Y
degree a 0  a1  , , ,  anY  f ( x ) is a linear differential equation of
dx n dx n 1
order n.

If a0, a1, …, an are constants and f(x) = 0 in the above equation we have a linear
homogeneous differential equation of order n with constant coefficients. Ordinary
differential equations involve only one independent variable and its derivatives.
When there are several independent variables we may have when there are several
independent variables we may have partial differential equations. To solve a
differential equation means to find all its solutions and incase it has no solution, to
show it is so. A solution of a differential equation in any function which satisfies
the equation i.e. reduce it to identify when substituted in to the equation. A
differential equation of order n has a general solution containing n arbitrary
independent constants. A particular solution may be obtained form the general
solution by assigning to the arbitrary constants certain specific values which are
obtained from any given information or the initial conditions given in the
problem.
To solve differential equations we recognize their different types and follow
certain standard procedures some of which are considered below.

I. direct integration
dy
To solve the differential equations of the type  f (x ) we can resort to
dx
integration because, if f(x) is the derivative of F(x), we can write the above
equation dy=f(x)dx

 dy   f ( x)dx
 y  F ( x)  c

dy dy
Example 1)  ky may be written  dy
dx ay

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1 dy 1
a y a
 ln y  x  c

ln y  x  c ln y  ax  c
ye
ax  ac

 e ac e ax
Or y= ex+c
We may write y=c1ex, where c1=ec

ii. Separable differential equation

If M is a function of X and N is a function of y and we have a first order
differential equation.
d
M(x) +N(y) 0
dx
This may be written
M(x)dx +N(y)dy =0
The solution is obtained by writing

 m( x)dx   N ( y )dy  0
dy y
Example equation  , find the general and particular solution, if y=1, when
dx x
x=1, then c=1
dy dx dy dx
 The above equation may be written
y
 , so that
x  y

x
 LnY=LnX+LnC, where LnC is an arbitrary constant.
The solution is there fore,
Y=Cx is general solution
Y= x is a particular solution
i) Exact Differential Equations
dy
An equation of the form M(x, y) +N(x, y) 0
dx

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dm dN dm dN
where  is called an exact differential equation  is a necessary
dy dx dy dx
and sufficient condition for a differential equation to be exact.
The solution of the exact differential equation can be shown to be:

d 
F(x, y) =  Mdx   Ndy     Mdx dy
 dy 

Example: Given ( xy 2  y )dx

d
 ( xy  y )dx   ( x 2 y  x)dy   [ 
2
F(x, y) = ( xy 2  y )dx]dy
dy

x2 y2 x2 y2 d x2 y2
=  xy   xy   [ (  xy)]dy
2 2 dy 2

x2 y2 x2 y2 x2 y2
=  xy   xy   (  xy )dy
2 2 2
x2 y2 x2 y2 x2 y2
=  xy   xy   xy  c
2 2 2
x2 y2
=  xy +c
2

7.1.1 First order linear differential Equations

d
 yp ( x )  Q ( x ) is linear homogeneous of order one. If Q(x) = 0, it
dx
dy
becomes homogeneous, i.e.  yp ( x )  0 whose solution is obtained by
dx
dy
expressing   p ( x)dx hence lny=   p ( x ) dx
y
 p  x dx
:. Y =C e 

dy
If Q(x)  0 we can show that the solution of  yp ( x )  Q ( x ) is given by
dx

y=e  (  Q ( x )e 
 p ( x ) dx p ( x ) dx
 c)

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dy
Example: 1) The solution of  yx  x can be written
dx
x2 x2
y=e  (  xe   c) = e
 p ( x ) dx xdx 
2
(  xe dx  c )
2

 x2 x  x2

=e 2
[e 2
 c]  1  ce 2

dy
General form:  vy  z , where, v and z are constants.
dt
dy
General solution:  vdt  zdt  ln y  vt  zt  c
y
lny = -vt + zt + c
z
y (t) = =Ae-vt + , where A is arbitrary constant.
v
Ae-vt =Yc  complementary solution, which represents the derivation of the
function from the equilibrium value.
If an initial condition or boundary value is given, “A”, can be specified, in which
case we get a definite solution.
z z z
i.e at t=0, y(0) = Ae-v (0) +  y(0) A +  A = y(0) - .
v v v
z -vt z
Definite solution: y(t) = [y(o) - ]e + .
v v
dy
Example 1) Given  2 y  4, find the general solution.
dx
a) Using the general formula
b) By separating the variables
z
Solution: a) y(t) = Ae-vt +
v
4
= Ae-2x +
2
 y(x) = Ae-2x +2
b) Separating the variables.

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dy
 4  2y
dx
dy

4  2y 
 dx ; let u = 4-2y

du = -2dy
du
dy =
2
du
( )
 2 xc
1
u
1
 - ln u  x  c1  ln u  2  2c1
2
 ln(4-2y) = -2x-2c1
 4-2y = e 2 x c2 // c2 = -2c1
 4-2y = ce 2 x // e c 2 =c 
c 2 x
Y=  e 2
2
 y(x) = A e 2 x  2

Domar Economic Growth Model

Investment has a dual character. It affects aggregate demand and promotes full
employment. It also leads expansion of capital stock and hence of supply of out
put.
Domar tries to determine as to how rapidly must investment grow to maintain full
capacity out put. Let b stand for marginal propensity to consume, S for marginal
propensity to save and  for the capital coefficient which represents average and
marginal productivity of capital. If I, Y, S, and K stands for investment, income,
1 1
savings and capital respectively, the multiplier K=  and the production
1 b S
function is of the form y=  K, then we have increment to total demand equals to

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dy dI 1 dI
total supply. Since increment to total demand: k  , and
dt dt 1  b dt
dy dk
increment to total supply:   I
dt dt

1 dI dI
 Sdt , Solving we get I =I0 e
St
  I or
1  b dt I
This is the time path of the investment level required to maintain full capacity out
put and suggests that investment must grow exponentially the rate S , if  and S
are large, investment will require a correspondingly high rate of growth. It follows
a I o st
that since y= C+I, C= a + by, we have y =  e . If a =0, i.e., if
s s

consumption is proportional to income, we have y=y0 eSt

Example;
In stead of constant S and  , let us have variable S (t) and  (t ), then the
differential equation can be written;
dI
 S (t ) (t ) dt , Show that the solution is
I
I = Ioe  s ( t ) ( t ) dt
 ln I   S (t ) (t ) dt

I = e  s ( t ) ( t ) dt

7.1.2 First order linear Difference equations

A difference equation expresses a relation ship between a dependent variable and
a lagged independent variables which changes at discrete interval of time.

Difference functions
Let y be the value of this variable at a time t. suppose we know that the value of
this variable at a previous time t-1 is yt-1. The equation expressing the relation
between the values of the variable at times t and t-1is called a difference equation.
If a, b, and c are constants then yt= ayt-1 + b is a linear first order non-

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homogeneous difference equation. There is a separate constant term independent

of y. The time log is one.
Yt = ayt-1 + byt-2 is a linear second order homogeneous difference equation. The
time lag is two. Yt = ayt-1 + byt-k +c is a liner kth order non- homogenous
difference equation. The time lag is k. In economics we often come across
situations where variables occur with discrete time lags. We now consider the
calculus of finite differences which deals with this subject. The use of this
differences as variables amounts to using lagged variables corresponding to
previous time periods.

Differences
The difference yt  yt 1  yt is called the first difference of Yt and provides

the rule for computing y t . It may be noted that y is a function of t but that it takes
only integral values. Thus y can be evaluated at intervals not continuously.The
second difference is written:
2 Yt =  (  Yt) =  Yt+1 - Yt
= (Yt+2 – Yt+1) – (Yt+1 – Yt)
= Yt+2 – 2Yt+1 + Yt
The third difference is:
 3Yt =  2Yt+1 -  2Yt
= (Yt+3 – 2Yt+2 + Yt+1) – (Yt+2 – 2Yt+1 + Yt)
= Yt+3 – 3Yt+2 + 3Yt+1 - Yt , and so on.
An ordinary difference equation is an equation involving difference like  Yt, 2
Yt, etc.
The order of difference equation is the highest difference in the equation.
The degree of a difference equation is the degree of the term of the highest order.
A difference equation of degree one is said to be linear. A difference equation
may be written with or without explicit presence of difference terms.

Examples:

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1) yt+1 – yt = 5 or y t  5 are equivalent forms of a difference equation of degree

one. The subscript t may be taken arbitrarily. Thus t may be replaced by t-1 or t+1
throughout and this equation can be written in the alternative forms:
Yt –yt-1 =5 or yt+2 – yt+1 = 5
2) Determine the order and the degree level of the following difference equations:
i) y t3 2  3 y t  2 it is second order, third degree.

First order linear difference equations

A difference equation expresses a relation ship between a dependent variable and
a lagged independent variables which changes at discrete intervals of time.
Example: Ct = f (yt-1)
General form of difference equation: yt+1 – byt = c or yt = byt-1 +c, where b and c
are constants.
c
General solution: yt = Abt+ , where b  1, but for b = 1, then yt = A +ct
1 b
c c
Definite solution:yt= [y0 - ]b t  , b  1 , for b = 1, then yt = y0 + ct
1 b 1 b
Example 1) Solve the following first order linear difference equation.
Yt+1 -2yt = 3, y0 = 5

t

Definite solution: y   y 
 t
c  t
b 
1 b
c 
  5 
1 b 
3 

1  2 
2  1 32
t

y t
8 2  3
t

7.2. Economic applications

7.2.1. Uses of differential equations in economics

Differential equations find wide applications in all branches of economics. It is

more applicable to derive cost function whose growth rate is given; it helps for
utility and demand analyses, market equilibrium analyses, macro- growth
economic analyses, etc.

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Example 1) Given the demand function Qd= c + bp, b<0, and supply function
Qs= g+hp, g<0
Determine the conditions for price stability in the market. (i.e. under what
conditions p(t) change to p as t   ?)

Solution: first find equilibrium price ( p )

Qd=Qs
C+bp = g+hp
C-g = hp – bp
cg
 p=
hb
dp
Assuming that the rate of change of price in the market ( ) is a positive linear
dt
function of excess demand, (Qd – Qs), we have:
dp
= m (Qd – Qs), where m is the adjustment coefficient, and m>0
dt
dp
= m[c+bP – (g + hP)]
dt
= m(c + bP – g – hP)
= m [(c-g) – (h-b)P]
dp
 m(h  b) p = m(c-g) general form
dt
Since V = m (h-b), and z = m(c-g)
m(c  g )
Pt = A e
 m ( h b ) t
+  general solution.
m(h  b)
Definite solution:
cg
At t = 0, P(0) = A +
hb
c  g -m(h-b)t c  g
Pt = [P0 - ]e +
hb hb
Pt = (P0 - P ) e-m(h-b)t + P

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Let K = m (h-b) t, where K>0, (since h-(-b) =positive)

Pt = (P- P ) e-Kt+ P
Whether, pt tends to p as t   , depends on whether the exponential expression
1

e
 kt
(e kt
 0 as t  ) .Since =e kt ,
, e  kt tends to 0 as t  ) .

As a result the time path will lead the price towards the equilibrium position.
Depending on the relative magnitude of p o- p , the above solution yields three
positive time paths.
Case -1 If P0 = p , pt = p price adjustment is immediate.

Case -2 If P0 > p , P0 - p >0  Pt > p and Pt approaches p from above as t  

Case -3 If Pt < p , Pt< p and Pt approaches the equilibrium price from below as t

2) Find the demand function (Q = f (p)), if the point elasticity, e = -1.
Solution:
dQ p
e= .  1
dp Q
dQ  dp
  
Q p
dQ dp
 Q
 
p
Ln Q = -lnP+c1
lnQ + lnP =c1
ln(QP) = c1

Qp = ec 1

e c1
Q=
p

kp ,[ ec1  k ]
1
Q=

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7.2.2 Uses of Difference Equations in Economics

The change from continuous time to discrete time produces no effect on the
fundamental nature of dynamic analysis.

The cobweb model

For many products (such as agricultural products) which are planted a year before
marketing, current supply deepens on last year’s price.
Qst-1 = f (Pt), or Qst = f(Pt-1)
When such a supply function interacts with the demand function of the form:
Qdt = f (Pt ), interacting dynamic price patterns are observed.
Using the linear versions of the lagged SS and the un-lagged DD functions, we
develop a market model as follows:
Qdt = c + bPt, (c > 0 and b < 0)
Qst = g + hPt-1, (g < 0 and h > 0).
Find first order linear difference equation. At equilibrium c + bP t = g + hPt-1
h g c h g c
 Pt = Pt 1  , where b  and c =
b b b b
Definite solution:-
t

g c h g c
p =  p  b  h     b  h
b
t 0

t
  h 
 

pt   p 0  p    p
  b 

Self – check exercise

Chapter Seven
I. Solve the following separable differential equations
dy dy
1)  3 xy 2)  e x y
dx dx

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II. Solve the exact differential equation

1) 2y3dx + 3xy2dy = 0
III. solve the following
a. using the general formula
dy
 2y  4
dx
b. using separating the variable
dy
 4  2y
dx
IV. solve the following (find the complementary function)
d2y dy
1) 2  3  2 y  0
dx dx
V. find the particular solution
d2y dy
1)  2  y  xe x  0
dx 2
dx
VI. Write the following equations
1) write respective expression of difference
yt - yt + 1 + yt - 1 = 0
2) without expressions of difference
2 y t  y t  1 y t  1  0

Answer key to self – check exercise

Chapter Seven
dy
I. 1)  3 xy
dx
dy
  3xdx
y

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3 2
ln y  x c
2
dy dy dy
2.   e x y   e x ey   e x dx
dx dx ey
In ey = ex + c
II. 1) 2y3 dx + 3xy2dy = 0
dy
  2 y 3 dx   3 xy 2 dy   [
dy 
( 2 y 3 dx)dy

d
= 2xy3+xy3-  2 xy 3 dy
dy

= 2xy3 + xy3 -  Gxy 2 dy

= xy3 +c = 0
dy
III. 1)  2y  4
dx
z
 y ( t )  A e  vt 
v
4
= A e 2 x   y ( t ) = A e 2t  2
2
dy
2)  4  2y
dx
dy

4  2y 
du  2 dy
 dx, let u = 4-2y , du
dy  
2

du
( )
  2  dx   1 in u = x+c
u  2
1

in = -2x – 2c1

Ln (4-2y) = -2x – 2c,

4-2y = e-2x + c2  C 2  2c1 ,

4-2y = c e-2x ec2=c

-2y = c-2x-4

Economics Department 204 Mathematical Economics (Econ2051)

 Bule Hora University

c
y   e 2 x  2
2
 y ( x )  A e- 2x + 2

d2y dy
IV 1)  3  2y  0
dx 2
dx

m
2
The characteristic equation is  3m  2  0 ,(m-1) (m-2) = 0  or m = 2

Since m has two distinct roots (real) in which case the complementary function

y  c em  c 2 em 2 ,  y c  c1 e  c 2 e
x x x 2x
1

c 1

d2y dy
V) 1) 2  y  xe x  0
x dx
2
d

 m 2  2m  1  0  (m  1)(m  1)  0  m1  m 2  1

 y c
 c1 e x  c 2 xe x

Here p(x) = ex, Q(x) = xex, f(x) = xex

 xe x .xe x x 2e 2x 1 3
P1(x) =  e x (1  x)ex  xe x .e x dx    e 2 x (1  x  x)dx   3 x  c3
e x .xe x xe 2 x 1 2
Q1(x) =  e x (1  x)e x  xe x .e x  e xe dx  2 x  c4
dx 

1 1
 yp  p1 p  Q1 Q  (  x3  c3)ex  ( x 2  c 4) xe x
3 2
x3 x3
ex  c3 e x  c4 x e  (  c3  xc 4 )e x
x

= 6 6

VI) 1) yt - yt+1 +yt+2 = 0

 (yt+2-yt-1) - (yt+1-yt) + (yt+1-yt) + yt = 0
 y t 1
_ y   y  y
t t t
0

(y t )  y t  y t  0

Economics Department 205 Mathematical Economics (Econ2051)

 Bule Hora University

2 y  y  y
t t t
0

2) 2 y t
 y t 1  y t
1 0

 (y t 1  y t )  y t 1  y t  0
yt+2 – yt+1-yt+1+yt-yt+1+yt=1
yt+2-3yt+1+2yt=1
1) yt+1-2yt= 3, y0 = 5
 Definite Solution:
c c
Yt = (yt - )b t 
1 b 1 b
3 3
= [5 - ](2) t 
(1  (2)) (1  (2))
Yt= 8  2t – 3  yt = 2t+3-3
2) yt+5 + 2yt+4 + 57 = 0, y0 = 1
 In general form:
yt+5 = -2yt+4 – 57
 yt+1 = -2yt – 57, y0 = 11
Definite Solution:
c c
Yt = (y0 + )b t 
1 b 1 b
 57  57
= (11 - )(2) t 
1  (2) 1  (2)
Yt = 30(-2)t – 19
At t = 0, y0 = -19
At t = 1, y1 = -79
At t = 2, y2 = 101
Then the time path diverges and oscillatory.
dQ p  (5 p  2 p 2 )
VIII) . 
dp Q Q

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 Bule Hora University

dQ (5 p  2 p 2 ) Q
   (5  2 p)
dp Q p

 dQ    (5  2 p )dp
Q = - (5p +p2) +c
At p = 10, = 500=-50-100+c
650 = c
Qd = 650 – 5p – p2
IX) Assuming market model
Dd = Sp
 20 – 2 p t
= -5 + 3 p t 1

-2pt = -25 + 3 p t 1

p = 25 2  3 2 p
t t
, where b =  3
2
and c = 25
2
25 25
() ( )
2  3 2
Definite Solution: p = [4 -
3
]( ) t 
t
1  ( ) 2 1  ( 3 )
2 2
3 t
p t
= -1(
2
) 5

Substituting this expression in the demand function

Qt = 20 – 2pt  20  2[1( 3 ) t  5]  20  2( 3 ) t  10

2 2

Qt = 2(- 3 ) t  10 the time path for quantity.

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Economics Department 207 Mathematical Economics (Econ2051)

 Bule Hora University

References
1. Chang, A.C.: Fundamental methods of mathematical economics, Mc
Graw-Hill,Inc,1984
2. Dowling , E.T.: Mathematics for economists, Schaum’s outline series,
McGraw-Hill, Inc , 1980
3. Barnet, R.A.: Applied calculus for Business economics, Life science and
Social science,4th edition, Dellen publishing co. 1991
4. Allen, R.G.D.: Mathematical economics 2nd edition, Macmillon,
Newyork,1963
5. Yamane, T.: Mathematical for economists: An elementary survey,2 nd
edition,prentice-Hall,1978
6. Black, J.: Essential Mathematics for economists, 2 nd edition, John willy &
sons, Inc. 1980
7. Henderson, J.M.: Microeconomics theory: A mathematical approach, 3 rd
edition, McGraw-Hill, Dic. 1980
8. Varian, H.R.: Intermediate microeconomics: A modern approach,4 th
edition, W.W.Norton,1996
9. Madnani, G.M.K.: Mathematics for economists, 8 th edition, Sultan chand
& Sons, New delhi,2001
10. Piskunov, N.: Differential & Integral calculus , peace publishers,
Moscow,1988
11. Shipachev, V.S: Highter Mathematics, Mir publishers, Moscow,1988
12. Maron, L.A.: Problems in calculus of one variable, Mir publishers,
Moscow,1988
13. Monga, G.S.: Mathematics & Statistics for economists, Vikas publishing
House PVT LTD,1996

Economics Department 208 Mathematical Economics (Econ2051)

 Bule Hora University

Bule Hora University

Faculty of Business and Economics

Department of Economics

Assignment of mathematical Economics (Econ2051) for Summer Students

Give short and precise answer for the following questions by showing
necessary steps for each. (40% maximum load)
1. Differentiate the following functions …………………………………………………………………………..(6 points)
a) ƒ(x) = 3x3 + 4x2 + 6x+2
b) ƒ(x) = x4e3x
c) f ( x)  3( x 3  7 x 2  5x)12
2. Solve the following integrals………………………………………………………………………………...……..(6 points)
3
 4e dx
2x
a)
0

 (120x  60 x )dx
4 3
b)

 (42  18x )dx

2
c)
3. If the marginal cost function of a firm is given as MC = 40 - 18 Q+4.5Q2
a) What would be the increase in total cost if output were increased from 30 to 40 units?
........................................................................................................................... (2 points)

4. Given the non - linear demand function P= 600 – 6Q0.5 and the corresponding marginal revenue
function MR= 600 – 9Q0.5. Using the definite integral find the following questions.

a) The total revenue (TR ) when Q = 2, 500 units………………………………………………….……(2 points)

b) The change in total revenue when q increases from 2, 025 to 2,500………………...….(2 points)
5. If the demand function of a monopolist is given by P = 60 - 4Q where P is price in Birr and Q is
quantity.
a) Determine whether the total revenue function of the firm is concave or convex at Q =7…

............................................................................................................................................ (3 points)

6. Given the function f(x) = 2x2 + 3x + 5,

a) Find its Maclaurin series. …………………………………………………………………………………. (2 points)
xx
b) Find the Taylor's series of the function given in question 6 above around 0

……………………….…………………………………………………………………………………………………..(2 points)

1
Economics Department Mathematical Economics (Econ2051) assignment
 Bule Hora University

7. Given the demand function for a good as Q= 56.6-0.25 P - 0.03Y+ 0.45Ps + 0.6n

Where

Q = quantity demanded per week

P = price per unit Ps = Price of competing good
Y = average weekly income n = population in million
Given values are P = 65, Y = 350 Ps = 60 and n = 24.

a) Find the price elasticity of demand. ……………………………………….……………………………… (2 points)

8. Suppose the prices of inputs K and L are 12 birr and 3 birr per unit respectively and the production
function of the firm is Q= 25K0.5 L 0.5 .
a) Determine the minimum costs of producing 1,250 units of output using Lagrange multiplier
method………………………………………………………………………………………………………………………… (5 points)
9. Suppose the demand functions of the product sold in two separate markets are given as

Q1  24  0.2 P1 ; Q2  10  0.05P2
C  35  40Q, where, Q  Q1  Q2

a) Find the output levels which maximize profit and check the second order sufficient condition
using the Hessian determinant……………………………………………………………………………………..(5 points)

10. A Keynesian macroeconomic model with a single time period lag on the consumption function
described below is initially in equilibrium with the level of I t  500. …………………………….... (3 points)

Yt  Ct  I t
Ct  750  0.5Yt 1

a) If it is increased to 650, find the value of y in the fourth time period after this disturbance.

2
Economics Department Mathematical Economics (Econ2051) assignment