Mathematical Economics

For MSC In Development Economics

Wollo University, Department of Economics

Amare Mitiku

Oct, 2016

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Content

Chapter 1. Introduction
Chapter 2. Linear Algebra
Chapter 3. Calculus
Chapter 4. Optimization
Chapter 5. Dynamics

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Chapter 1.

Introduction
Mathematical Economics
Economic Models
Equilibrium Analysis

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Cont…
 1.1.What is Mathematical Economics?

 Refers to economic principles and analyses formulated and developed

through mathematical symbols and methods.

 Not a separate school of thought, but rather a method. Paul Samuelson,

“By 1935, … [i]t became easier for a camel to pass through the eye of a

needle than for a nonmathematical genius to enter into the pantheon of

original theorists.”

 Mathematics is used in economics in two general ways: To derive and

state theories, and To test economic hypotheses or theories quantitatively.

 Econometrics combines these two types of mathematical economics.

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Cont…
Mathematics helps us describing human behaviour in
economics.
It helps us answer several questions: What does the
indifference curve look like?
Why?
How to get demand functions from the utility functions?
Is there a utility function?
Does the maximum exist?
Is it unique?
How to obtain the solution?
What properties does a well-behaved demand function
possess?
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Mathematical vs Non-mathematical Economics

The assumptions and conclusions are stated

in mathematical rather than words; and in
equations rather than sentences Symbols and
words are really equivalents,
so the choice of mathematical or literary
logic matters little
Mathematical approach has many advantages

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Cont…
Criticism: unrealistic?
Is there a realistic one?
Theory is by its very nature an abstraction
from the real world.
It is a device for singling out only the most
essential factors and relationships so that we
can study the crux of the problem at hand, free
from the many complications that do exist in
the actual world (economic model).

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Mathematical Economics vs. Econometrics
Econometrics: Measurement of economic
data. It deals with the study of empirical
observations using statistical methods of
estimation and hypothesis Testing
Mathematical economics: Refers to the
application of mathematics to purely
theoretical aspects of economic analysis.

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1.2.Economic Models
 Any economic theory is an abstraction from the real world
The immense complexity of the real economy makes it
impossible for us to understand all the
interrelationships at once;
Not all the interrelationships are of equal importance
for the understanding of the particular economic
phenomenon under study.
To pick out what appeal to our reason to be the
primary factors and relationships relevant to our
problem and to focus on these alone. Such a
deliberately simplified analytical framework is called
economic model----it is only a skeletal and rough
presentation of the actual economy.
Note: There is no inherent reason why an economic
model must be mathematical.
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Ingredients of a mathematical economics model

A set of equations: designed to describe the

structure of the model (Equations give
mathematical form to the set of analytical
assumptions adopted);
A number of variables: related to one another
in certain ways;
Then, through application of the relevant
mathematical operations to these equations,
we may seek to derive a set of conclusions
which logically follow from those assumptions.

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Cont…
Variables, constants, and parameters
A variable is something whose magnitude can
change, i.e., something that can take on
different values. (price, output, profits,
revenue, cost, national income, consumption,
investment, imports, exports)
Endogenous variables (originating from
within): solution values from the model.
Exogenous variables (originating from
without): variables that are determined by
forces external to the model, and whose
magnitudesAmare
are accepted as given data only. 11
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Cont.....
A constant is a magnitude that does not
change.
(0.5P)
When a constant is joined to a variable, it is
often referred to as the coefficient of that
variable.
Parameter (parametric constant): a constant,
yet, not assigned a specific number. (aP)

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Cont…
A definitional equation: sets up an identity
between two alternative expressions that have
exactly the same meaning.
∏ Ξ R-C (read: is identically equal to)
A behavioural equation: specifies the manner
in which a variable behaves in response to
changes in other variables.
C=5+10Q; C=5+10Q2; C=5+10Q1/2 ;
An equilibrium condition is an equation that
describes the
prerequisite for the attainment of equilibrium.
Qd = Qs ; S=I;
U(x, y) = x α
y
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1.3. Equilibrium Analysis

Equilibrium
Partial Market Equilibrium
General Equilibrium

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Cont…
Selected
Some variables are not selected to be in the model
Equilibrium is relevant only to the selected variables
and may no longer apply if different variables are
included (excluded)
Interrelated
Since the variables are interrelated, all the variables
must be in a state of rest if equilibrium is to be achieved
Inherent
The state of rest refers to the internal forces of the
model; external forces (exogenous variables) are
assumed fixed

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Cont…
An equilibrium for a specific model is a situation

that is characterized by a tendency not to change

Two types of equilibrium: Partial and general

Note that since equilibrium refers to a lack of

change, we often refer to equilibrium analysis as

static analysis or statics

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Partial Equilibrium
Partial equilibrium analysis is the process of
examining the equilibrium conditions in individual
markets, and for households and firms, separately.
It is an equilibrium attained by a market under given
supply and demand conditions Or a model of price
determination in an isolated market
Constructing the model
An equilibrium condition, behavioural equations, and
restrictions must be specified
Qd = Qs
Qd = a - bP (a, b > 0)
Qs = -c + dP (c, d > 0)

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Cont…
What is the solution? (Does it exist? Is it
unique? How to work out?)
What is the effect of changes in a or b on the
equilibrium price?

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 General Equilibrium Model
General equilibrium is the condition that
exists
when all markets in an economy are in
simultaneous equilibrium.
Our analysis can extend to n commodities
There will be an equilibrium condition for
each of the n markets
There will be behavioural equations for each
of the n markets

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Cont…
Behavioural equations
Qd1=a0+a1P1+a2P2
Qs1=b0+b1P1+b2P2
Qs1= Qd1
Qd2=a0+ a1P1+ a2P2
Qs2=b0+ b1P1+ b2P2
Qs2= Qd2
What is the solution? (Does it exist? Is it unique? How
to work out?)
What is the effect of changes in a or b on the
equilibrium price?
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Cont…
National Income Model
Y = C+I0+ G0
C = α +β(Y-T) α >0; 0< β <1
T = γ +δY γ>0; 0< δ <1
Exogenous and endogenous variables?
What is the solution? (Exist? Unique? How to
work out?)
What will happen to the equilibrium if I0
changes?
What will happen to the equilibrium if one of the
four parameters changes separately?
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For Example

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