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CLASSICAL OPTIMIZATION An optimizing function is defined as a rational action chosen consistently to get the decision maker near to any

desired goal as circumstances permit. In dealing with optimization problems we start with what is called an objective function, in which the left-hand side is the object of optimization (for example, profits) while in the right-hand side we have a set of choice variables and a set of coefficients or constants. The choice variables (or decision variables) are the ones that the economic agent (consumer, firm, government etc) can vary (decide on) in its attempt to optimize the objective function. Well examine 2 types of optimization problems: Unconstrained and Constrained. Unconstrained Optimization Consider the function Y of variables Xi, and in the simplest case one variable, X1: Y = f(X1) This function could be linear or non-linear, monotonically increasing or decreasing or with various increasing and decreasing parts. In optimization we are looking for an extreme value, i.e.,

In the above graph on the left, suppose we are looking for a minimum, then point A represents the lowest point on the graph. Consequently, if point A remains the lowest value of Y for all non-negative values of X, then A is called an absolute or global minimum. On the other hand, point C is a relative or local minimum, since it is an extreme point only in the immediate neighborhood of point C only. When we search for an extreme point the first thing to look at is the first derivative of the function. In the graph below:

When the function has a max. (at X=X*) the slope of the function changes from positive to 0 and then to negative. This means that this one-variable function has a max when the derivative is 0. However, in the graph below the same condition holds:

The function has a minimum at point A where the first derivative is 0. This means that the first derivative test is a necessary condition for identifying both a max and a min. That is the first derivative identifies a stationary value (extreme point) of the function. At this point we notice that in the case of a max the first derivative changes sign from positive to negative as X increases, while in the case of a min the first derivative changes sign from negative to positive. Therefore, the distinction between a max and a min relies on the direction of change of the first derivative, which is measured by the second derivative. So, when the first derivative is decreasing as X increases, the second derivative is negative and the function has a max, while when the first derivative is increasing, the second derivative is positive and the function has a min. Summarizing, the condition f(x)=0 is necessary to establish a max or a min, but not sufficient. A relative max exists if f(x) < 0 and a relative min exists if f(x) > 0. This is the second order condition. Example: Y = -2x2 + 20x Then, f(x) = -4x + 20 and =0 when x=5. The second derivative is f(x)= -4 < 0, and the function has a max at x=5.

Another possible stationary point is a point of inflection. Consider a stationary value characterized by f(x)=0 and f(x)=0 at x=x*. This is neither a max nor a min.


X* f(x)

There is a stationary point at A (first derivative =0 in second diagram). The first derivative does not change sign, but remains positive as X increases. For x< x*, f(x) decreases (f(x) <0), while for x > x*, f(x) increases in value (f(x) > 0). At x = x*, f(x) is at min (f(x) = 0). This is a stationary point of inflection.



X* f(x)

Another possibility is a non-stationary point of inflection. Here, while f(x)=0 at C as in the previous case, the slope (f(x)) is not horizontal at point C. Therefore, f(x) does not have a stationary point of inflection at x = x*. So, f(x)=0 is not required for an inflection point. A necessary condition for a point of inflection is f(x) = 0.


Example of non-stationary point of inflection (i.e., think of the short-run production function): Y = -(2/3)x3 + 20x2


Graph the functions f(x), f(x), f(x) (restricting f(x) to the non-negative quadrant). Inflection point where f(x) = 0. f(x) = -2x2 + 40x f(x) = -4x + 20 = 0, when x = 5 f(x) = -4 < 0 (i) the non-stationary point of inflection is (5, 500/3). (ii) f(x) has a max at x = 5. (iii) For x < 5, f(x) > 0, f(x) > 0, so f(x) is convex to the x-axis. For x > 5, f(x) > 0, f(x) < 0 and f(x) is concave to the x-axis. (iv) Point (10, 1000/3) is a relative max.



Simple economic applications: 1. Profit maximization Choose the rate of output which maximizes profits: = R C, R = R(q), C = C(q) = R(q) - C(q) 1st order condition: (q) = R(q) C(q) = 0, and: R(q) < C (q) (2nd order condition) In economics this means that at the profit max output, the rate of change of MR must be less than the rate of change of MC (i.e., the MC function must cut MR from below). 2. Relationship between AP of L (APL) and MP of L (MPL) APL = Q/L = f(L)/L To find the max point of the APL curve: d(APL)/dL = d[f(L)/L]/dL = [Lf(L) f(L)]/L2 = 0, or f(L) = f(L)/L, or: MPL = APL then, d2(APL)/dL2 = { L2[Lf(L) + f(L) f(L)] [Lf(L) f(L)](2L)}/L4 = f(L)/L 2f(L)/L2 + 2f(L)/L3 Substituting the 1st order condition that Lf(L) = f(L):

d2(APL)/dL2 = f(L)/L 2f(L)/L2 + 2Lf(L)/L3 = f(L)/L < 0 for max AP of labour. So, given that L>0, the second order condition for max AP of labour requires: f(L) < 0, that is, d(MPL)/dL < 0 (diminishing MPL) At the max point of the AP of labour, the AP of labour equals the MP of labour, and at the same time the slope of the MP curve is negative (the MP curve cuts the AP curve from above). Practice exercise Q = -(2/3)L3 + 10L2, Derive the AP of labour function and show that where AP is at max, MP=AP. -------------------------------------APL = -(2/3)L2 + 10L APL/L = -(4/3)L + 10 = 0 L = 7.5 MPL = -2L2 + 20L At L=7.5: MPL = APL = 37.5 d2(APL)/dL2 = -(4/3) < 0

Unconstrained optimization with more than one variable Two-variable case Consider the function: z = f(x, y) The first-order condition can be expressed in a similar fashion to the one variable case. For z to obtain an extreme value at point A (top of a hill), the function must be stationary at this point. Momentarily, z neither increases nor decreases in value at this point: dz = f(x)dx + f(y)dy = 0 For any (non-zero) arbitrary variations dx and dy, it is necessary that: f(x) = f(y) = 0 This is the first-order condition for a relative extreme point.

From the graph, since A is a candidate max, this means that the tangent line through point A parallel to the xz plane has zero slope. Likewise, the tangent line drawn through point A // to the yz plane has a zero slope. The first-order condition does not tell us whether the extreme point is a max or a min. (because it also holds for minimum). We need a sufficient condition or a second-order condition. Given the function z = f(x, y), The partial derivatives are: z/x = f(x) = fx, z/y = f(y) = fy

The second partial derivatives with respect to x (while y is held constant) are: fxx = /x(z/x) = 2z/x2 , and fyy = /y(z/y) = 2z/y2 The above measure the rate of change of the first derivative with respect to x and y. The cross-partial derivatives fxy, fyx are defined as: fxy = /y(z/x) = 2z/yx, and fyx = /x(z/y) = 2z/xy Cross-partial derivatives measure the rate of change of a first partial derivative with respect to the other variable. Consider now the concept of the second-order differential.

Given the function: Z = f(x, y) The first order differential was: dz = fxdx + fydy The second order differential will be: d2z = d(dz) = (fxdx + fydy)/x(dx) + (fxdx + fydy)/y(dy) = (fxx dx + fyx dy)(dx) + (fxy dx + fyy dy)(dy) = fxx dx2 + fyx dydx + fxy dxdy + fyy dy2 = fxx dx2 + 2fxy dxdy + fyy dy2 < = > 0 Suppose we are looking for a max (at point A in the graph). It is going to be a max if a tiny movement away from A in any direction results in a decrease in the value of z (dz < 0) in the neighborhood of A, given that dz at A equals zero. In other words, we need dz to be decreasing (d2z < 0). So the second order (sufficient) condition for max is d2z < 0 for non-zero arbitrary values of dx and dy. Likewise, d2z > 0 is the sufficient condition for a minimum. The above condition, while sufficient, is not necessary because it is possible for d2z to be 0 at the max or min. The sufficient condition for max can be translated into a more convenient form: It can be shown that for any non-zero values of dx and dy, d 2z will be negative (for max) iff:

fxx <0, fyy <0 and fxxfyy > f2xy Likewise for min: fxx > 0, fyy > 0 and fxxfyy > f2xy The second part of the sufficient condition will ensure that the surface decreases for max. (increases for min.) as we go away from point A in any direction (not only in the two basic direction). The above sufficiency condition can be inconclusive. For example, if: fxxfyy = f2xy, this could be a max or a min but the test is inconclusive. Alternatively, if: fxxfyy < f2xy, which can occur when fxx and fyy are of different sign, the function will have a saddle point. That is the sign of d2z will be positive for some values of dx and dy and negative for others. Functions with more than 2 variables Consider the following function for optimization: Y = f(X1, X2,.Xn) The first order conditions for a stationary value are that all partial derivatives of Y must = 0 for all i = 1,n. For example, in the case of profit max the objective function is: = Pf(x1, X2,.Xn) wixi, where xi are the inputs, wi are the prices of inputs and P is the price of output. The first order conditions are: /Xi = P(f/Xi) - (wiXi)/Xi = 0 for all i.

Or, i = Pfi wi=0 (value of marginal products equal to input prices). In order to have a maximum, the second order conditions must be satisfied. In the 2 variables case, recall that these conditions required: fxx <0, fyy <0 and fxxfyy > f2xy, or f11 f21 f12 >0 f22

To extend the second-order conditions to the n-variable case we make use of our knowledge of determinants. Given some nth order determinant, we have called a principal minor of order k of this determinant, what remains when any n-k rows and the corresponding number of columns are eliminated from the determinant. With a 2x2 determinant, we can form 2 principal minors, a22 and a11. With a 3x3 determinant: a11 a12 a13 a21 a22 a23 a31 a32 a33 we can form 3 principal minors of order n-1 by eliminating the 1st row and 1st column, the 2nd row and column and the 3 rd row and column.

We can also for 3 principal minors of order n-2 by eliminating the 1 st and 2nd, the 1st and 3rd and the 2nd and 3rd rows and columns. The following theorem establishes the sufficiency condition: Theorem: Given a function y = f(X1, X2, .. Xn), which has a stationary value at X = X* (a vector of Xi), and given the Hessian matrix of crosspartial derivatives of f (fij) then, if all the principal minors of the determinant: det(fij) of order k have sign (-1)k for all k = 1,n at X = X*, then f(X1, X2, .. Xn) has a maximum at X = X*. If all the principal minors are positive for all k at X = X* the function has a minimum at X = X*. If the signs do not follow the pattern in any of the above cases, the function has a saddle point at X = X* Finally, if some or all of the principal minors are 0 and the rest have the appropriate sign, then it is not possible to determine whether there is a max or a min. Going back to the profit max problem: = Pf(X1, X2,.Xn) wiXi, (1)

The first order conditions (FOC) for max are: /Xi = P(f/Xi) wi = 0 for all i. In order to find the candidate values of vector X for max, we have to solve the system of equations (the First Order Condition equations (1)) for the Xs in terms of the parameters wi and P.


If the system is solvable (that is the Jacobian determinant J = det(i/Xj) is not zero, meaning that the FOC equations are independent) we can solve for the demand functions for inputs: Xi = Xi*(wi, P). The second order conditions require that the successive principal minors of ij = Pfij have sign (-1)k, for k = 1,n. Given that P > 0, we can express the matrix of second partial derivatives in terms of the production function. The (symmetric) Hessian determinant is: f11 f12 f1n f21 f22 f2n fn1 fn2 fnn and the successive principal minors are: f11 f12 H1 = f11, H2 = f21 f22 f11 f12 f13 H3 = f21 f22 f21 f31 f32 f33 Hn = H

These principal minors have to alternate in sign, starting with negative, i.e., f11 < 0. This in turn requires that all fij (diagonal elements) be < 0, which means diminishing marginal products. In addition the 2nd order determinant must be > 0, i.e., fiifjj f2ij > 0. The 3rd order must be < 0, etc. By requiring that the signs alternate in sign starting with negative amounts to requiring that d2y is negative definite. Furthermore, these conditions, if satisfied, make sure that the objective function is concave in the neighborhood of a maximum. The relevance of concavity and convexity in optimization Second order conditions test whether the stationary point is the top of a hill shaped function or the bottom of a valley shaped function. The former are called concave functions. The strict case of concavity is associated with a global maximum. In the weak case of concavity, the hill may contain somewhere a flat section. A unique, absolute maximum requires strict concavity. The second order conditions we examined earlier, as they apply to the 2nd order differential, d2z, can be distinguished in necessary conditions, i.e., when d2z is negative-semi-definite (when we have weak inequalities in the relevant principal minor test) and in sufficient conditions, when d2z is negative definite (strict inequalities). When we use d2z to test (or alternatively the principal minor test), the sign definiteness of the 2nd differential is evaluated only at the stationary point, that is we establish a relative maximum.

However, if the 2nd differential is everywhere negative semi-definite, the function is (strictly) concave and this implies an absolute maximum. This is a necessary and sufficient condition. The stronger property of everywhere negative semi-definiteness of d2z is sufficient but not necessary for strict concavity, because strict concavity of z is compatible with zero value of d2z. Summarizing: (1) (2) (3) Given a concave function, a stationary point can be identified as an absolute maximum (i.e., from the first order conditions). Establishing concavity and strict concavity can replace the 2 nd order conditions as a sufficient condition for maximum. Even if d2z happens to be zero at the stationary point, establishing concavity or strict concavity can take care of this.


Application 1 Consider the case of profit maximization by a multiproduct firm in perfect competition: 2 products, Q1, Q2 Products are technically interdependent (what does it mean?), i.e., C = c(Q1, Q2) MC1 = C/Q1 = c1(Q1, Q2) MC2 = C/Q2 = c2(Q1, Q2) Prices are fixed at P1 and P2 TR = P1Q1 + P2Q2 MR1 = TR1/Q1 = P1 MR2 = TR1/Q2 = P2 The profit function is: = TR C = P1Q1 + P2Q2 - c(Q1, Q2) = (Q1, Q2) Max = (Q1, Q2) 1 = /Q1 = P1 MC1(Q1, Q2) = 0 2 = /Q2 = P2 MC2(Q1, Q2) = 0 Assuming the 2nd order conditions are satisfied, we can solve for the optimal values of Q1 and Q2.


Example: TR = 4Q1 + 8Q2 C(Q1, Q2) = (Q1)2 + 2Q1Q2 + 3(Q2)2 + 2, then : = 4Q1 + 8Q2 - (Q1)2 - 2Q1Q2 - 3(Q2)2 - 2 1 = 2Q1 + 2Q2 = 4 2 = 2Q1 + 6Q2 = 8 Q1 = Q2 = 1, = 4 The 2nd order conditions are: 11 = -2, 22 = -6, 12 = 21 = -2. So, 11 <0 and the second order determinant = 8 (> 0). Therefore the second order differential is negative definite and we have a maximum. Application 2 Price discrimination A single product firm (monopolist or firm with significant market power) is selling output in more than one market. How much output should the firm sell in each market and what prices should it charge to each one to maximize profits? Q = Q1 + Q2 Total revenue: TR = TR1(Q1) + TR2(Q2) Total cost is: C = c(Q), (Q = Q1 + Q2) MC1 = [c(Q)]/Q1 = (dC/dQ)*(dQ/dQ1) = dC/dQ = c(Q) MC2 = [c(Q)]/Q2 = (dC/dQ)*(dQ/dQ2) = dC/dQ = c(Q), MC1 = MC2

= TR1(Q1) + TR2(Q2) c(Q) 1 = TR1/Q1 (C/Q)(Q/Q1) = (MR1) c(Q) = 0 2 = TR2/Q2 (C/Q)(Q/Q2) = (MR2) c(Q) = 0 These are the first-order conditions. From these we can find Q1*, Q2* and * = (Q1*, Q2*). The first-order conditions imply: MR1 = MR2 = MC. Also observe that, since TR1 = P1Q1, then: MR1 = dTR1/dQ1 = P1(dQ1/dQ1) + Q1(dP1/dQ1) = P1(dQ1/dQ1) + (Q1dP1/dQ1)(P1/P1) = P1 + (dP1/dQ1)(Q1P1/P1) = P1[1 + (dP1/dQ1)(Q1/P1) = P1(1 1/Ed1) Similarly, MR2 = P2(1 1/ Ed2) Then, from MR1 = MR2 = MC: P1(1 1/Ed1) = P2(1 1/ Ed2) We see that, P1 = P2 only if price elasticities are equal for the 2 demand curves. If Ed1 < Ed2 at (optimal) Q1* and Q2*, then P1 > P2.


PROFIT MAXIMIZATION AND INPUT DECISIONS Consider a perfectly competitive firm using two inputs, K and L producing output Q: Q = f(K, L) Total cost is given by: C = c(K, L) = rK + wL Total revenue is: TR = PQ = Pf(K, L) Profit is: = TR- C = Pf(K, L) - rK - wL The first-order conditions for profit max. are: K = Pf/K r = PfK r = 0 L = Pf/L w = PfL w = 0 We can solve the FOC for the optimal values of K and L (K* and L*), and optimal profit *. The FOC state that: PfK (=VMPK)= r PfL (= VMPL)= w


Example: Q =6K1/3L1/2 P=2, r=4, w=3 Max = 12K1/3L1/2 4K 3L K = 4K-2/3L1/2 4 = 0 L = 6 K1/3L-1/2 3 = 0 Solving, K* = 8, L* = 16, Q* = 48 Check the Second Order Conditions: KK = -8/3L1/2K-5/3 < 0 LL = -3K1/3L-3/2 < 0 KL = 2K-2/3L-1/2 LK = 2K-2/3L-1/2

The Hessian determinant is: -8/3L1/2K-5/3 2K-2/3L-1/2 2K-2/3L-1/2 -3K1/3L-3/2

= 8(K-4/3L-1) - 4(K-4/3L-1) = 4(K-4/3L-1) = 4/(K4/3L) > 0, maximum, along with KK, LL < 0.


Comparative Statics Exercises Starting from profit maximization: = Pf(X1, X2) w1X1 + w2X2 (were X1, X2 are 2 inputs) FOCs: Pf1(X1, X2) - w1 = 0 (1) Pf2(X1, X2) w2 = 0 SOCs: f11 < 0, f22 < 0, and f11 f22 f212 > 0 Solving the FOCs (implicit functions) for the 2 unknowns, X1 and X2, in terms of the parameters P, w1 and w2 we get: X1 = X1*(w1, w2, P) (2) X2 = X2*(w1, w2, P) The above are the factor demand curves. Comparative statics results What happens to the optimal (profit maximizing) values of X1 and X2, as well as Q and the profit of the firm if there is a change in a factor price or the price of output? Establish the sign of the following derivatives: X1*/w1, X1*/w2, X1*/P, X2*/w1, X2*/w2, X2*/P [FOCs are Equilibrium conditions]


First substitute equations (2) into equations (1): Pf1{X1*(w1, w2, P), X2*(w1, w2, P)} w1 = 0 (3a) Pf2{X1*(w1, w2, P), X2*(w1, w2, P)} w2 = 0 (3b) That is, the firm must employ X1*, X2* amounts of the 2 inputs to keep the values of the marginal products for each factor exactly equal to the price of each factor. Now differentiate 3a and 3b partially with respect to w1 using the chain rule: P(f1/X1)(X1*/w1) + P(f1/X2)(X2*/w1) 1 = 0 P(f2/X1)(X1*/w1) + P(f2/X2)(X2*/w1) =0 Or, Pf11(X1*/w1) + Pf12(X2*/w1) = 1 Pf21(X1*/w1) + Pf22(X2*/w1) = 0 (4a) (4b)

We need to solve for X1*/w1 and X2*/w1. Suppose we multiply (4a) by f22 and (4b) by f12 and subtract (4b) from (4a) (and given that f12 = f21), then: P(f11 f22 f212) (X1*/w1) = f22, so: X1*/ w1 = f22/P( f11 f22 f212) (5a) Note that the denominator is > 0 because of the SOCs. X2*/ w1 = -f21/P( f11 f22 f212) Likewise, for a change in w2: X1*/ w2 = -f12/P( f11 f22 f212) X2*/ w2 = f11/P( f11 f22 f212) (5c) (5d)


Conclusion: The factor demand curves (5a, 5d) are downward sloping. However, we cannot determine the sign of the cross-effects (X1*/w 2 and X2*/w1), as the signs of f12 and f21 are not known in the general case. Changes in the price of the product Differentiate (3a), (3b): Pf1{X1*(w1, w2, P), X2*(w1, w2, P)} w1 = 0 (3a) Pf2{X1*(w1, w2, P), X2*(w1, w2, P)} w2 = 0 (3b) with respect to P: Pf11(X1*/P) + Pf12(X2*/P) = -f1 Pf21(X1*/P) + Pf22(X2*/P) = -f2 Multiply the first by f22 and the second by f12, then subtract second from first: P(f11 f22 f212) (X1*/P) = - f1 f22 + f2 f12 and, X1*/P = - f1 f22 + f2 f12 / P(f11 f22 f212) then, X2*/P = - f2 f11 + f1 f21 / P(f11 f22 f221) (6a) (6b)

As before, the signs of X1*/P and X2*/P cannot be established, as the sign of the cross-derivative f12 (= f21) is unknown in the general case. However, it can be shown that not both X1*/P and X2*/P can be negative. [dQ = (Q/X1)(X1/P) + (Q/X2)(X2/P) > 0 ]


Changes in Q The production function is Q = f(X1, X2) and optimal output is: Q* = f(X1*, X2*) Given: X1 = X1*(w1, w2, P) X2 = X2*(w1, w2, P) Then, Q* = f{X1*(w1, w2, P), X2*(w1, w2, P)} = Q*(w1, w2, P) This is the supply function of the firm. Differentiate with respect to P to find how output changes when P changes: Q*/P = (f/X1)(X1*/P) + (f/X2)(X2*/P) = f1(X1*/P) + f2/(X2*/P) Substituting the expressions for (X1*/P) and (X2*/P), Q*/P = - f21 f22 + 2f12 f1f2 f22f11/ P(f11 f22 f212) Although it is not immediately clear what sign the numerator has, it could be shown that the sufficient condition for concavity of a function can be written as: f22f11 - 2f12 f1f2 + f21 f22 < 0 then, the numerator is positive and Q*/P > 0. Conclusion: the sufficient condition for profit maximization (concavity of a function) also implies that the supply curve is upward-sloping. (7)


We could also show that: Q*/w1 = - X1*/P Q*/w2 = - X2*/P, and the signs of these expressions are indeterminate. Q* = f{X1*(w1, w2, P), X2*(w1, w2, P)} Q*/w1 = (f/X1)(X1/w1) + (f/X2)(X2/w1) = f1(X1/w1) + f2(X2/w1) X1*/w1 = f22/P( f11 f22 f212) X2*/w1 = -f21/P( f11 f22 f212) Then, Q*/w1 = f1f22/P(D) f2f21/P(D) = - X1/P [Since, X1*/P = - f1 f22 + f2 f12 / P(f11 f22 f212)] Similarly for Q*/w2


COMPARATIVE STATICS IN MACROECONOMICS We are going to study the economy at a given state and observe how it is affected by changes in various events. We tend to aggregate the economy in up to 4 markets, i.e., 1. 2. 3. 4. The output market The money market the bond market The labour market

Because these markets are interdependent, once equilibrium is determined in 3 of them, the 4th one will necessarily be in equilibrium. Therefore, we can eliminate one of them (the bond market). We are going to begin with the basic closed economy Macro model and subsequently build on it. The output market Equilibrium in the product market: Y = C + I + G (in real values) In the simplest possible case: C = c(Yd) 0 < c <1 Yd = Y-T I = I0 (exogenous) G = G0 (exogenous) So, Y = c(Y-T) + I0 + G0 (1)


For a richer model we replace the exogenous investment function with: I = I(r) Then, Y = c(Y-T) + I(r) + G (2) (3)

This model gives rise to the IS curve. To find the slope of the IS differentiate (3): dY = cdY + Idr, and dr/dY = (1 c)/I, which is negative because dI/dr is < 0. So, the IS curve is negatively sloped. The money market Money demand is a function of National Income, Y and the interest rate, r. Treating money supply, Ms, as exogenous, and money demand is: Md/P = L(Y, r), L1 = L/Y > 0 and L2 = L/r < 0. Equilibrium in the money market gives the LM curve: LM: Ms/P = L(Y, r). (4) From (4): L1 dY + L2 dr = 0 dr/dY = - L1/L2 = -L/Y/L/r, which is > 0. So, the LM curve is positively sloped. Now combine the IS and the LM curves:

The IS-LM model Y - c(Y-T) - I(r) - G = 0 M/P - L(Y, r) = 0 (IS) (5) (LM) Solve for the endogenous variables Y and r in terms of the exogenous variables, P, G, M, T. In particular, by allowing the price level to vary, the solution: Y = Y(P; G, M, T) Is the aggregate demand curve (AD). To find the slope of the AD curve, differentiate equations (5) with respect to P (which in the IS-LM model is taken as fixed): Y/P c(Y/P) I(r/P) = 0 -L1Y/P L2r/P = M/P2 Or, (1-c) (Y/P) - I(r/P) = 0 -L1(Y/P) L2(r/P) = M/P2 Or, (1-c) -L1 -I -L2 Y/P = r/P M/P2

0 Y/P =

-I IM/P2 (-ve) = -----------------------L2(1 c) L1I (+ve) <0

M/P2 -L2 ------------------(1-c) -I -L1 -L2

That is, the AD curve is downward sloping. Fiscal Policy An expansionary fiscal policy is characterized by an increase in G. This increase needs to be financed by: (1) (2) (3) Issuing bonds (debt financed increase) By raising taxes Printing money

Assume case (1) Supply of bonds increases in the bond market, price of bonds decreases the interest rate (bond yield) increases (with money supply fixed). The IS curve shifts to the right. The effect of the increase in G can be obtained by differentiating (5): Y - c(Y-T) - I(r) - G = 0 M/P - L(Y, r) = 0 with respect to G and solving for Y/G and r/G Y/G (C/Y)(Y/G) (I/r)(r/G) = G/G = 1 (L/Y)( Y/G) + (L/r)(r/G) =0

Or, Y/G c( Y/G) I(r/G) = 1 L1(Y/G) +L2(r/G) From the second, r/G = - (L1/ L2)(Y/G) Substituting in the first and solving for Y/G and given that I < 0, L 1 > 0, L2 < 0: 1 Y/G = ---------------------------- > 0 1-c + I (L1/ L2) (-) (-) Then, - L1/ L2 r/G = ---------------------------- > 0 1-c + I (L1/ L2) (6) =0


The increase in the interest rate as a result of the increase in G represents the partial crowding out effect. Y/G varies inversely with - L1/ L2 which is the slope of the LM curve.


Practice question: You can do the same for a change in T (taxes), in isolation or in combination with an increase in G (for combination see page 35). Monetary Policy Differentiate (5): Y - c(Y-T) - I(r) - G = 0 M/P - L(Y, r) = 0 with respect to M and derive Y/M and r/M Y/M (C/Y)(Y/M) - I/r(r/M) = 0 L/Y (Y/M) + L/r(r/M) Or, (1-c) (Y/M) I(r/M) L1(Y/M) + L2(r/M) Or, (1-c) L1 and, 0 -I 1/P L2 I/P I/PL2 Y/M = ------------------- = -------------------- = ------------------ > 0 (1-c) -I (1-c)L2 + IL1 (1-c) + IL1/L2 L1 L2

= 1/P

=0 = 1/P 0 = 1/P

-I L2

Y/M r/M

(1 c)PL2 r/M = . = --------------------- < 0 (1-c) + IL1/L2 As I 0 or L2 monetary policy becomes inefficient in influencing national income.

The relative effectiveness of fiscal and monetary policy is an empirical matter. Dividing Y/G by Y/M we can see the determinants of the relative effectiveness of the 2 policies: (Y/G)/(Y/M) = 1/(I/PL2) = PL2/I The relative effectiveness depends upon the interest responsiveness of the demand for money (L2) and investment demand (I).


The Balanced Budget Multiplier In this case dG = dT. Using equations (5) : Y - c(Y-T) - I(r) - G = 0 M/P - L(Y, r) = 0 Differentiate the model by allowing both G and T to change by the same amount. Y/G (C/Y)(Y/G) + (C/Y) (I/r)(r/G) = G/G = 1 [Why? Remember, consumption depends on Yd = (Y-T)] Or, Y/G c(Y/G) + c I(r/G) = 1 and, -L1(Y/G) L2(r/G) = 0, or: r/G = - (L1/ L2)(Y/G) Then, (1-c) (Y/G) + c I[- (L1/ L2)(Y/G)] = 1 [1 c +I(L1/ L2](Y/G) = 1 c (1 c) Y/G = ---------------------- < = 1 1 c +I(L1/ L2) The effect of the tax does not fully offset the effect of the increase in G. the BBM will be equal to 1 only if investment is completely inelastic to changes in the interest rate, or L2 (i.e, pure Keynesian case).


The Labour Market We have derived the IS, LM and AD curves. To be able to determine the price level, P, we need the aggregate supply curve (AS). This requires a labour market in the model. Assume a production function involving K and L. In the short-run K is fixed, so that: Y = f(K; L), f >0 , f < 0 Competitive firms maximize profit: Pf(L) = W W/P = f(L) [If on the other hand the firm has market power, it could be shown that the demand for labour is derived from: P(1 + 1/Ed)f(L) = W] In the general case, the demand for L will depend on the real wage rate. W/P = (L), with (L) < 0 (downward sloping demand for L). To determine the supply of labor, Ls, we need to perform maximization, in the context of the workers work-leisure choice. Assume a concave utility function which depends upon real income (Y) from work and leisure (T Ls), where T is the fixed hours available to workers (24 hours) and Ls is hours of labour supplied. Max U = u(Y, T-Ls) Subject to: Leisure = T Ls Y = (W/P)Ls Substitute into the utility function:

Max U = u[(W/P)Ls, (T Ls)] [(W/P)Ls] (T Ls) U/Ls = u1 ---------------------- + u2 ---------------- = u1 (W/P) - u2 = 0 Ls Ls and, W/P = u2 (Ls) / u1 (Ls) So the labour supply function can be expressed as: W/P = (Ls), > 0 This is a classical labour supply function, since the assumption is that workers care about their real wage rate. Equilibrium in the labour market requires: Ld = Ls = L, or W/P = (L) = (L) Add now the labour market functions into the model: (1) (2) (3) (4) (5) Y c(Y-T) I(r) - G = 0 M/P L(Y, r) =0 Y Y(L) =0 (L) = (L) W/P = (L)

This is a recursive model: We have 5 equations with 5 endogenous variables, Y, r, P, L, W. [Note that: Real variables are Y, L (and W/P), while nominal variables are: r, P, W]

However, this model leads to the so called classical dichotomy. Equation 4 alone determines employment and then Y and W/P are determined from equations 3 and 5. So L, Y and W/P (the real variables) are determined exclusively in the labour market and are independent from G and M. So real activity is independent of fiscal and monetary policy. 4 L (5 W/P) 3 Y 1 r 2 P (and W/P) W Fiscal Policy Totally differentiate the system of equations allowing G to change: (1-c)(Y/G) - I(r/G) L1(Y/G) + L2(r/G) + M/P2 (P/G) (Y/G) - Y(L/G) (-) (L/G) =1 =0 =0 =0

(L/G) (1/P)(W/G) + (W/P2)(P/G) = 0 then, (1-c) L1 1 0 0 - I L2 0 0 0 -Y 0 0 0 0 M/P2 0 0 Y/G r/G L/G W/G P/G = 1 0 0 0 0

0 (-) 0 0

-1/P W/P2


1 0 0 0

. . . .

. . . .

. . . .

. . . .

0 . . . . Y/G= --------------------------------. . . . . . . . . . . . . . . . . . . .

Looking at the numerator first (the denominator = IM(-)/P3): You can verify that the numerator = 0. So, Y/G = 0, and fiscal policy is ineffective in the classical model.


Monetary Policy (1) (2) (3) (4) (5) Y c(Y-T) I(r) - G = 0 M/P L(Y, r) =0 Y Y(L) =0 (L) = (L) W/P = (L)

To determine the effect of monetary policy in the classical model, differentiate the 5 equation model, allowing for money supply to change: (1-c)(Y/M) - I(r/M) L1(Y/M) + L2(r/M) (Y/M) - Y(L/M) (-) (L/M) (L/M) or, (1-c) L1 1 0 0 -I L2 0 0 0 -Y 0 0 0 0 M/P2 0 0 Y/M r/M L/M W/M P/M = 0 1/P 0 0 0

=0 + M/P2 (P/M) = 1/P =0 =0 - (1/P)(W/M) + (W/ P2)(P/M) = 0

0 (-) 0 0

-1/P W/P2

Y/M = ------------------------

The numerator is again = 0, so again Y/M = 0. So, the real activity is independent of both fiscal and monetary policy. The effect of the increase in G is to raise interest rates and reduce investment by an amount which exactly offsets the increase in G (complete crowding out). With a higher r and fixed Y, money market equilibrium requires higher P. In order to preserve the real wage rate, money wages rise by the same proportion as the price level. Look at the aggregate supply curve (AS). Use the equations: Y Y(L) = 0 (L) (L) = 0 The slope of the AS curve is Y/P: Y/P = Y(L/P) (L/P) (L/P) = 0

then, L/P = (Y/P)/Y, and ( - ) (Y/P)/Y = 0 #0 #0 Y/P = 0.


An alternative Labour Supply curve While it is reasonable to assume that the demand for labour depends on the real wage rate, this is hardly the case with labour supply because of money illusion on the part of the workers (lack of information, incorrect expectations about inflation, etc). Consider the extreme case where labor supply depends exclusively on the money (nominal) wage rate: W = (Ls) (instead of W/P = (Ls)) The system of equations now becomes: (1) (2) (3) (4) (5) Y c(Y-T) I(r) - G = 0 M/P L(Y, r) =0 Y Y(L) =0 P(L) = (L) (Ld = Ls) W/P = (L) (demand for L)

[for 4, W/P = (L) and W = (L) equilibrium: P(L) = (L)] We can see that it is no longer true that the labour market alone determines L. Instead, the entire system is interrelated. This suggests that fiscal and monetary policies may now have an effect. Differentiate the system with respect to G and derive Y/G: [Differentiating (4): (L)*(dP/dG) + P*(dL/dG) = (L)] Numerator determinant: L2Y/P (verify). Denominator det: (1-c)L2Y/P + L1IY/P - IM(P )/P2 Dividing by the numerator:

1 Y/G = ----------------------------------------------------- > 0 (1-c) + I(L1/L2) - IM(P - )/L2YP2 [verify why it is indeed > 0] Comparing the above multiplier with the one derived earlier from the ISLM model (Y/G = 1/[(1-c) + I(L1/L2)], when prices were fixed, we see that the value of the multiplier is reduced. The reason is that one of the effects of the increase in G is to raise prices, thereby reducing real money supply (real money balances), thus raising the interest rate further. However, compared to the pure classical model examined earlier, the interest rate does not rise sufficiently to lead to an equal reduction in investment; so we get some increase in Y. The AS is upward sloping. Y/P Y(L/P) = 0 + P(L/P) (L/P) = 0 [i.e., differentiation of P(L) = (L)] then, (P ) (L/P) = , (L/P) = /(P ) and, Y/P = Y[ /(P )], which is > 0. Monetary policy Similarly, we can derive an expression for Y/M (>0).


Constrained Optimization We can introduce constrained optimization by considering the familiar utility maximization problem. In the 2 variables case: Max. U=f(X, Y) Subject to: PxX + PyY= M To deal with the above we can stick to the previous methodology by doing the following: Since in the constraint we have 2 arguments, X, Y, we could solve the constraint for, say, X and substitute into the objective function, which can then be optimized as usual. This could work nicely in this case but not in a case involving several choice variables and/or more than one constraint. Suppose we have: Max. Y = f(X1, X2, Xn) s. t : g = g(X1, X2, Xn) We confront this type of optimization problem using the Lagrangian method. It involves setting up the following function: L = f(X1, X2, Xn) + (g - g(X1, X2, Xn)) The constraint must hold as equality. Looking at the function, whatever the value of , when the constraint is satisfied, the second term on the right-hand side disappears and we are left with the objective function. We treat as an additional variable, so we have n+1variables to consider.

The L-function will have a stationary value when the objective function has a stationary value. The FOC require that: L/X1 = f/X1 (g/X1) = 0 . . L/Xn = f/Xn (g/Xn) = 0 L/ = g(X1, X2, Xn) =0 (n+1 equations in n+1 unknowns) Take the pair-wise ratios of the FOC: f1/f2 = g1/g2, ot fi/fj = gi/gj Going back to the utility maximization problem: Max. L=u(X, Y) + (M PxX PyY) L/X = u/X Px = 0 L/Y = u/Y Py = 0 L/ = M PxX PyY = 0 Then, (u/X)/(u/Y) = MUx/MUy = Px/Py Second Order conditions As in the case of optimization without constraints, the second order conditions require that the second order differential must be negative semi-definite for maximum and positive semi-definite for minimum (necessary conditions), or negative definite for maximum and positive definite for minimum (sufficient conditions).

The difference when there are constraints is that, while before we were considering all non-zero values of dX and dY, now we consider those non-zero values of dX and dY which satisfy the constraint (dg = 0). The sufficient conditions translate into certain sign requirements of a bordered Hessian determinant: L11 L12 L1n g1 H= L21 L22 L2n g2 .. g1 g1 gn 0 0 g1 g2 gn

g1 L11 L12 .... L1n or H = ................................ gn Ln1 Ln2 ... Lnn

Find its successive border-preserving principal minors: L11 L12 H2 = L21 L22 g1 g2 g1 g2 0 , H3 = L11 L12 L13 g1 L21 L22 L23 g2 L31 L32 L33 g3 g1 .... with the last one being H itself. d2y is negative definite subject to dg = 0 iff: H2 > 0, H3 < 0, H4 > 0 ... for maximum, and: d2y is positive definite subject to dg = 0 iff: H2 , H3, H4 < 0 ... for minimum.



In the 2 variable case of utility maximization the bordered Hessian is: u11 u12 -P1 H= u21 u22 -P1 -P2 -P2 0 and H2 = H

Therefore, H must be >0 for maximum. Case of more than one constraints L = f(X1, X2, Xn) + j[gj gj(X1, X2, Xn)] L11 L12 L1n g11 .. gr1 Ln1 H= Ln2 Lnn g1n .. grn

g11 ..................g1n 0 ......0 ............................................. gr1 .................. grn 0 .......0

The sufficient conditions here state that for maximum the border preserving principal minors of order k > r alternate in sign, beginning with (-1)r+1 , the second of opposite sign, etc. [Note that the order k is for rows and columns from 1 to n] For minimum, the border preserving principal minors of order k > r have sign (-1)r. The principal minors must be of order k > r because, by inspecting H we observe the r x r matrix of zeros in the lower right side of the determinant; a determinant involving fewer than r rows and columns from rows and columns 1 through n will be equal to 0.

Establishing quasi-concavity and quasi-convexity in the constrained maximization case. If we establish the shape of the function we can disregard the 2nd order conditions. For twice-differentiable functions, the test for quasi-concavity and quasiconvexity we are going to use is as follows: From the following bordered determinant: f11 f12 f1n f1 D= f21 f22 f2n f2 ................................ fn1 fn2 ... fnn fn f1 f2 .... fn 0 0 f1 f2 .... fn

f1 f11 f12 f1n , or ............................. fn ................. fnn

The above differs from the bordered Hessian because the border consists of the first derivatives of the function, not the constraint. Then, we examine the sign of the principal minors: 0 D1 = f1 0 D2 = f1 f11 f2 , D3, Dn. f1 or f1 0 f11 f1

f1 f11 f12 f2 f21 f22


For Y = f(X1, X2,Xn) to be quasi-concave, (with Xi >=0) it is necessary that: D1 <= 0, D2 >=0 The necessary condition for quasi-convexity is: D1 <=0, D2 <=0 The sufficient conditions are the above with strict inequalities. Note that the non-positivity of D1 is already satisfied because: D1 = -f21 Example: Z = -x2 y2 (x, y, >0) fx = -2x, fy = -2y, fxx = -2, fyy = -2, fxy = fyx = 0 -2 D= 0 0 -2 -2x -2y 0 or -2x -2y = -4x2 < 0 -2x -2 -2x -2y -2 0 0 -2

-2x -2y 0 0 D1 = -2x

D2 = .. = 8(x2 + y2) > 0 The function is quasi-concave.


Now, lets go back to consumers maximization of utility. L = U(X, Y) + (M PxX PyY) FOCs: Lx = Ux Px = 0 Ly = Uy Py = 0 L = M PxX PyY = 0 Solving the FOCs for X*, Y* and * yields the demand functions for the 2 inputs X and Y as functions of prices of inputs and income. Divide the first 2 condition through to get: Ux / Uy = Px / Py Solve for X as a function of Y (or vice-versa) and then use the budget constraint to solve for the other. Interpretation of The Lagrange multiplier provides a measure of the sensitivity of U* to changes in the consumers budget (i.e., a relaxation of the budget constraint): = U*/M Thus, it measures the change in maximum utility resulting from a change in money income. It can be considered as the gain (loss) in maximum utility resulting from a very small increase (decrease) in M, prices held constant. It can be interpreted as the Marginal Utility of Money (income) when the consumers utility is maximized.

Example: U = 2(ln X1) + ln X2 s.t. 2X1 + 4X2 = 36 L = 2(ln X1) + ln X2 + (36 - 2X1 - 4X2) LX1 = 2/X1 - 2 = 0 LX2 = 1/X2 - 4 = 0 L = 36 - 2X1 - 4X2 = 0 2X2/X1 = , and X1 = 4X2 Substituting into the budget constraint: X2* = 3, X1* = 12, * = 1/12, U* = ln(432) = 6.07 Checking the SOCs: L11 H = L21 g1 L12 L22 g2 g1 g2 0 0 -1/(X22) 4 2 4 0


-2/(X12) H2 = H = 0 2

-1/(X22) = -2/(X12) 4

4 -0 0 + 2

0 2

-1/(X22) 4

= -2/(X12) (-16) + 2(2/(X22) = 32/(X12) + 4/(X22) > 0 Alternatively, we can check the shape of the function: f11 D = f21 f12 f22 f1 f1 = -2/(X12) 0 0 -1/(X22) 1/X2 2/X1 1/X2 0

f1 f2 0 2/X1 which can also be written as: 0 D= 2/X1 1/X2 Then, 0 D1 = 2/X1 -2/(X12) 2/X1 D2 = -2/X1 1/X2 -1/(X2 )

2/X1 -2/(X12) 0 2/X1

1/X2 0 -1/(X22)

= -4/(X12) < 0

0 + 1/X2

2/X2 1/X2

-2/(X12) 0

= 4/(X12) (X22) + 2/(X12) (X22) > 0 The function is quasi-concave, therefore the FOCs represent a maximum.

Cost Minimization subject to an output constraint Q = f(K, L), fK, fL, > 0 C = rK + wL What quantities of K and L should the firm employ to produce a give output, Q*, at minimum cost? [To obtain the slope of an isoquant we use the property that the change in Q along an isoquant is 0. dQ = fK dK + fLdL = 0 MRTS = -dK/dL = fL/fK This means that to have convex isoquants, (which are derived from a concave production function), we require diminishing MRTS (i.e., d(MRTS)/dL < 0), all along the isoquant.] Now set up the Lagrangian function: L = rK + wL + (Q* - f(K, L)) Lets use an example: Q = 4K1/2L1/2, Q* = 32 C = 2K + 8L Then, L = 2K + 8L + (32 - 4K1/2L1/2) FOC: LK = 2 - 2 K-1/2L1/2 = 0

LL = 8 - 2 K1/2L-1/2 = 0 L = 32 - 4K1/2L1/2 = 0 L/K = , K = 4L and using the constraint: L* = 4, K* = 16, C* = 64, * = 2 SOCs: LKK H= LLK gK K-3/2L1/2 = - K-1/2L-1/2 - 2K-1/2L1/2 = . < 0 LKL LLL gL gK gL 0 =

-K-1/2L-1/2 - 2K-1/2L1/2 K1/2L-3/2 - 2L-1/2K1/2 -2L-1/2K1/2 0


Comparative statics Certain comparative statics results can be obtained from the constrained maximization of utility problem. L = U(Q1, Q2) + (I P1Q1 P2Q2) For purposes of demonstration consider an example of a utility function such as: U = Q1Q2. Then: L = Q1Q2 + (I P1Q1 P2Q2) FOCs: Q2 P1 = 0 Q1 P2 = 0 I P1Q1 P2Q2 = 0 Take the total differential: dQ2 P1d dQ1 -P1dQ1 P2dQ2 In matrix form: = dP1 P2d = dP2 = dI + Q1dP1 + Q2dP2


0 1 -P1

1 0 -P2

-P1 -P2 0

dQ1 dQ2 d

dP1 = dP2 dI + Q1dP1 + Q2dP2

Suppose we consider only a change in P1 (so dP1 0, dP2 = 0, dI = 0). Solve for dQ1: dP1 0 dQ1 = 1 0 -P1 -P2

Q1dP1 -P2 0 -(P2)2dP1 P2Q1dP1 ----------------------------- = -------------------------------0 1 -P1 2P1P2 1 -P1 0 -P2 -P2 0

Divide by dP1: dQ1/dP1 = (-P2) /2P1 Q1/2P1 Find the value of from the FOCs: Q2 = P1 Q1 = P2 I P1Q1 P2Q2 = 0 = I/(2P1P2) So,

Q1/P1 = -I/4(P1)2 Q1/2P1 i.e., if P1 = 1, P2 = 2 and I = 100 we can solve the FOCs for Q1* and Q2*: Q1* = 50, Q2* = 25, and Q1/P1 = -100/4 50/2 = -25 25 = -50 For every $ change in the price of good 1 the consumer will change his purchases of Q1 by 50 units in the opposite direction. Likewise we could derive Q2/P2, Q1/I, etc. Lets go back to the FOCs of the general model: U1(Q1, Q2) P1 = 0 U2(Q1, Q2) P2 = 0 I P1Q1 P2Q2 = 0 Suppose there is a change in consumer income, I. Differentiate the FOCs with respect to I: U11(Q1/I) + U12(Q2/I) P1(/I) = 0 U21(Q1/I) + U22(Q2/I) P2(/I) = 0 1 P1(Q1/I) P2(Q2/I) Or,

(U1 = U/Q1) (U2 = U/Q2)


U11 U12 P1 U21 U22 P2 P1 P2 0 0 0


(Q2/I) = 0 (/I) U12 U22 P1 P2 U12 P1 -1

-1 P2 0 U22 P2 (Q1/I) = ------------------------- = --------------------- > = < 0 U11 U12 P1 D (>0) U21 U22 P2 0

P1 P2 Similarly, U11 P1

U21 P2 (Q2/I) = ------------------- > = < 0 D (>0) U11 U21 U22 (/I) = ------------------------ > = < 0 D (>0) U12


So, there is a possibility of inferior goods. However, not both (Q1/I) and (Q2/I) can be negative (intuitively) and formally: From: P1Q1 + P2Q2 = I: P1(Q1/I) + P2(Q2/I) = 1 (>0) And since P1, P2, > 0 not both effects can be negative. Lets now differentiate the FOCs: U1(Q1, Q2) P1 = 0 (U1 = U/Q1) U2(Q1, Q2) P2 = 0 (U2 = U/Q2) I P1Q1 P2Q2 = 0 with respect to the price of one input, say P1: U11(Q1/P1) + U12(Q2/P1) P1(/P1) - (dP1/dP1) = 0 U21(Q1/P1) + U22(Q2/P1) P2(/P1) P1(Q1/P1) P2(Q2/P1) Or, U11 U12 P1 U21 U22 P2 P1 P2

=0 = Q1(dP1/dP1)

(Q1/P1) (Q2/P1) (/P1) =

0 Q1

U12 P1 U22 P2 U22 P2 U12 P1 (1)

Q1 P2 0 (Q1/P1) = --------------------- = D

P2 0 U22 P2 ------------------ + Q1 ------------------D D


U21 P2 U11 P1 (2)

P1 0 U21 P2 (Q2/P1) = . = - ------------------- - Q1 -----------------D D

U21 (/P1) = . =



U12 (3)

P1 -P2 U21 U22 ------------------- + Q1 --------------D D

All 3 are of indeterminate sign. We define goods as substitutes if an increase in the price of one good increases the demand for the other. And vice-versa for compliments. Thus above, Qi/Pj > 0 means Qi and Qj are gross substitutes. Lets attempt to interpret the results from (1) and (2): Consider the Q1/I, Q2/I results: U12 U22 P2 Q1/I = -------------------, D P1




U21 P2 Q2/I = ------------------D The above expressions are exactly the second terms of equations (1) and (2) multiplied by Q1 (income effect). On the other hand, the first parts in equations (1) and (2) are the pure substitution effects of a change in price (movement along the same indifference curve), i.e., Qu/P, so we can write equations (1) and (2) as:
(Q1/P1) =

Q1u/P1 Q1(Q1/I) (subst. effect) (income effect) Q2u/P1 Q1(Q2/I)

(3) (4)

(Q2/P1) =

In (3) the substitution effect is clearly negative while the income effect is of indeterminate sign because the sign of Q1/I is unknown. The above are known as Slutsky equations. Similarly: (Q1/P2) = Q1u/P2 Q2(Q1/I) (Q2/P2) = Q2u/P2 Q2(Q2/I) And in general, (Qi/Pj) = Qiu/Pj Qj(Qi/I)


The Slutsky equations show that the response of the consumer to the change in the price can be split-up into 2 parts: first, a pure substitution effect (or the response to a price change holding the consumer on the original indifference curve), and second, a pure income effect, where income is changed (purchasing power of a given money income) holding prices constant.


Comparative statics: Theory of the firm Max. Q = f(X1, X2) s. t. C = r1X1 + r2X2 Lagrangian function: L = f(X1, X2) + (C - r1X1 + r2X2) FOCs: L/X1 = f1 r1 = 0 L/X2 = f2 r2 = 0 L/ = C - r1X1 + r2X2 = 0 Then, f1 / f2 = r1/r2, = f1 /r1 = f2 /r2 r1 = f1 r1 = (1/) f1 and r2 = (1/) f2 By differentiating the constraint: dC = r1dX1 + r2dX2, or dC = 1/(f1dX1 + f2dX2) (1)

By taking the differential of the production function: dQ = f1dX1 + f2dX2 (2)


Dividing (2)/(1): f1dX1 + f2dX2 dQ/dC = ( ---------------------) = = 1/MC f1dX1 + f2dX2 The SOCs require that the bordered Hessian determinant is positive: f11 f21 -r1 f12 f22 -r2 -r1 -r2 0 >0

This requires that the production function is quasi-concave. Lets go back now at the equivalent unconstrained profit maximization problem: = Pf(X1, X2) r1X1 r2X2, and derive some comparative statics results. Comparative statics: Profit maximization Max: = Pf(X1, X2) r1X1 r2X2 Comparative statics results from the profit maximization problem can be derived by first deriving input demand functions using the FOCs: 1 = Pf1(X1, X2) r1 = 0 2 = Pf2(X1, X2) r2 = 0 As prices of inputs change, the producer will change the use of inputs so that the FOCs continue to be satisfied.

By totally differentiating these conditions: Pf11dX1 + Pf12dX2 = -f1dP + dr1 Pf21dX1 + Pf22dX2 = -f2dP + dr2 Or, Pf11 Pf21 Pf12 Pf22 dX1 = dX2 -f2dP + dr2 -f1dP + dr1

Letting dr2 = 0 and dP = 0, dr1 Pf12

0 Pf22 dr1Pf22 dX1 = ------------------ = -------------Pf11 Pf12 P2 |D| Pf21 and, dX1/dr1 = f22 /P |D| < 0 (|D| = f11f22 f212 > 0) Pf22

The response to the change of an input price (other things constant) is always negative. Similarly, with dr1=0, dP = 0, dX2/dr2 = f11 /P |D| < 0 On the other hand, with dr1=0, dP = 0,

dX1/dr2 = - f12 /P |D| If we assume that an increase in the use of one input increases the MP of the other, i.e., if f12 > 0, then: dX1/dr2 < 0 Finally, let dr1 = 0, dr2 = 0 and allow P to change: -f1dP Pf12

-f2dP Pf22 -Pf1f22dP + Pf2f12dP dX1 = ----------------------- = ----------------------------P2 |D| P2 |D| dP(f2f12 f1f22) = = ------------------------ , and: P |D| (f2f12 f1f22) dX1/dP = ---------------------P |D| Here too, if f12 > 0, dX1/dP > 0 and an increase in output price will result in an increase in input demand. Further question: Assume a Cobb-Douglas production function, Q = (X1)a(X2)b, with a and b > 0 and a + b <1 (decreasing returns to scale). Find the expression for dX1/dr1 and show that it is negative.


=PX1aX2b r1X1 r2X2 1 = PaX1a-1X2b r1 = 0 2 = PbX1aX2b-1 r2 = 0 Pa(a-1)X1a-2X2b(dX1) + Pab X1a-1X2b-1(dX2) = -aX1a-1X2b (dP) + dr1 PabX1a-1X2b-1(dX1) + Pb(b-1) X1aX2b-2(dX2) = -bX1aX2b-1 (dP) + dr2 1 Pab X1a-1X2b-1

0 Pb(b-1) X1aX2b-2 Pb(b-1) X1aX2b-2 dX1/dr1 = ----------------------------------- = -------------------------- < 0 P2 |D| P2 |D| Similarly: dX1/dr2 > 0 dX1/dP > 0

Can you find these expressions if a + b =1? (see page 70).


Homogeneous functions Given: f(x1, x2,xn), A function is homogeneous of degree r, if: f(jx1, jx2,jxn) = jr f(x1, x2,xn), where j>0. Linearly homogeneous functions These are homogeneous functions of the first degree, i.e., those exhibiting CRTS. Properties: (1) Given: Q = f(K, L): (1) the APPL and APPK, as well as the MPPL and MPPK can be expressed as functions of the capital/labor ratio, k=K/L alone. Multiply (1) by a factor j = 1/L. Because of linear homogeneity (CRTS), output will be multiplied by jQ = Q/L, So: f(K, L) = f(K/L, L/L) = f(K/L, 1) = f(k, 1) = f(k) APPL = Q/L = (k) [Q=L(k)] then: APPK = Q/K = (Q/L)(L/K) = (k)/k. The above imply that as a result of linear homogeneity, if K/L is kept constant, the average products will stay constant too (i.e., average product functions are homogeneous of degree 0). Similarly for MPPL and MPPK (se book for proof) Consider the Cobb-Douglas production function with constant returns to scale: Q = AKaLb = AKaL1-a MPPL = Q/L = A (1-a)KaL-a = A(1-a)Ka/La = A(1-a)(K/L)a, and MPPK = Q/K = = Aa(K/L)a-1

In economic terms, this means that the MP of labor and capital are constant whenever the capital to labor ratio is constant. That is the MP are independent of the scale of production, and depend only on capital intensity (K/L). A puzzle Use a production function exhibiting CRTS and perform comparative statics. Earlier we asked the question: Can you find the expressions dX1/dr1, dX2/dr2, dX1/dr2, etc, when if a + b =1? 1 Pab X1a-1X2b-1

0 Pb(b-1) X1aX2b-2 Pb(b-1) X1aX2b-2 dX1/dr1 = ----------------------------------- = -------------------------P2 |D| P2 |D| The determinant |D| is: Pa(a-1)X1a-2X2b PabX1a-1X2b-1 Pab X1a-1X2b-1 Pb(b-1) X1aX2b-2

= (P2ab(a-1)(b-1)X12a-2X22b-2) - (P2a2b2 X12a-1X22b-1) = (X12a-2X22b-2) [P2ab(a-1)(b-1) - P2a2b2] = (X12a-2X22b-2) [P2ab(-b)(-a) - P2a2b2] =0 So these effects are indeterminate under CRTS. Why?

Under CRTS, MC and AC are constant (independent of the scale of production). So with a horizontal long run average cost curve (instead of U-shaped), there is no unique combination of inputs for the firm; i.e., the firm is indifferent as long as the first order conditions are satisfied and the firm makes zero economic profits.

Eulers theorem Property (2) If Q= f(K, L) is linearly homogeneous: K(f/K) + L(f/L) Q (for proof see book). (1)

One should distinguish this identity which holds for any values of K and L (but only for constant return to scale production functions) from the total differential of Q: dQ = (Q/K)dK + (Q/L)dL, which holds for any function, not only CRTS functions. Eulers theorem says that under CRTS, if each input is paid according to its marginal product contribution, payments to inputs will exactly exhaust all output (product) i.e., the pure economic profit will be 0. Note that from the first order conditions: (f/K) = r/P and (f/L) = w/P Substituting into the Euler equation and multiplying both sides by P: rK + wL = PQ (2) (under CRTS payments to owners of inputs exhaust revenue). However, the above equation is subject to the adding up problem. If we consider increasing returns to scale the Euler theorem says:

K(f/K) + L(f/L) mQ, with mQ>Q, and form equation (2): rK + wL > PQ, That is total revenue will not be enough to reward factors of production at the existing market prices. So factors cannot receive rewards equal to their marginal products. Similarly, under decreasing returns to scale, total revenue is more than sufficient to reward factors according to their MP (there is a surplus). This leave unanswered the question: what should be done with the surplus. Because of the above issues, neoclassical economic theory tends to use the assumption of CRTS.


Non-linear optimization with inequality constraints Introduction It refers to the problem of finding the optimal value of a given function f(X1, X2,Xn) of n variables, usually restricted to be non-negative (Xj 0), subject to one or more constraints which are in general inequalities:, g(X1, X2, , Xn) { , =, or } bi. f and g are not both linear. i.e., Min f = (X1 4)2 + (X2 -3)2 s. t. 3X1 + 2X2 12 -2X1 + 2X2 3 2X1 X2 4 2X1 + 3X2 6 X1, X1, 0 (g1) (g2) (g3) (g4)

The optimal point is X1 = 34/13, X2 = 27/13, f =2.77. To find this point we utilize the fact that at the tangency point (see graph), the slopes are equal. The slope of g1 is -3/2. To find the slope of the objective function, we take the total differential: (X1 4)2 + (X2 -3)2 f = 0 2(X1- 4)dX1 + 2(X2 3)dX2 0 = 0 2(X1- 4) + 2(X2 3)dX2/dX1= 0 But at tangency between f and g1 the slope is -3/2. So, 2(X1- 4) + 2(X2 3)(-3/2) = 0 2X1 3X2 = -1

Solving along with 3X1 + 2X2 = 12, we get the solution given above.

One can show that the optimal can occur inside the Feasible Set. Example: Min Z = (X1 9/5)2 + X2 2)2 (same constraints)


Now the optimal value of Z occurs at an interior point (2, 9/5) and Z = 0 at minimum. We can also show that a local optimum is not always a global one, i.e.: Suppose we were looking for maximum instead of a minimum (same objective function and constraints). Point A will provide a local maximum (Z = 169/100), but point B would give global maximum, that is Z at B > Z at A. Finally, a further complication can result; example: X1X2 b1 X12 + X22 b2 X1, X2, 0


This results in a feasible set that is not convex (it is disjoint). Some N.L.O. problems have a solution, some do not. A solution may not exist if the constraints contain inconsistencies (as in the example above) or if the problem is unbounded. Necessary conditions for optimum. In handling classical optimization problems we used calculus techniques. A convenient approach there was the Lagrangian method. Can we extend this approach to N.L.O. problems (that is problems with inequality constraints)? Kuhn and Tucker have shown that: (1) There is a wide class of problems for which a Lagrangian approach can be followed; when the Lagrangian function is optimized, the same values that optimize the Lagrangian will also optimize the original function subject to the constraints.


Furthermore, suppose we have a maximization problem: We set up the L-function and treat the L-multipliers as variables (as we did earlier); then suppose we solve the problem. We say that it is an optimal solution only when we have found the values of the variables of the maximization problem (X1, X2,) that maximize the L-function and at the same time the values of the multipliers () which minimize the value of the L-function. This solution is called a saddle point.



This saddle point is a consequence of duality. The duality concept specifies a primal-dual, or max-min relationship. Suppose we have a profit maximization problem. The dual will be a cost minimization problem. Let X* be the optimal set of the max. problem variables and Y* be the optimal set of the dual variables. Then, - The values of the primal variables X* which maximize the primal objective function, Z(X), will also maximize the L-function in which the L-multipliers take the dual optimal variable values, Y*. - Similarly, the value of the dual variables Y* that minimize the dual minimization problem will also minimize the L-function, L(Y*, X*) in which the multipliers are the primal optimal values, X*. Therefore, the Lagrangian multipliers in the primal problem are equal to the dual optimal variables, and the dual multipliers are equal to the primal optimal solution values (More about duality in Linear Programming). To set up the L-expression in the case of NLO problems we have to follow a similar but slightly different approach from the case of classical constrained optimization. Given the problem: Max. Z = f(X1, X2, Xn) s. t. g1(X1, X2, Xn) b1 . gm(X1, X2, Xn) bm


Then, L(X, ) = f(X1, X2, Xn) + 1[b1 - g1(X1, X2, Xn)] + + m[bm - gm(X1, X2, Xn)] The Kuhn-Tucker conditions are necessary (but not sufficient) for optimization. In other words, they are the First-Order-Conditions for NLO problems. Following are the K-T conditions side by side with the FOCs for classical constrained optimization: Classical optimization (Max.) L(X, )/Xj = 0 L(X, )/i = 0 Xj, i, 0 (for minimization the inequalities are reversed) Example: Max Z = X13 + X1X2 s. t. X1 + X25 10 X12 + 2X2 4 X1, X2, 0 Then, L(X, ) = X13 + X1X2 + 1(10 - X1 - X25) + 2(-4 + X12 + 2X2)

K-T Conditions for Max. L(X, )/Xj 0, and Xj[L(X, )/Xj] = 0 L(X, )/i 0, and i[L(X, )/i] = 0

We entered the constraints in such a way so that when we take the derivative of L with respect to 1 and 2 we get the result that the K-T conditions L/i 0 are equivalent to the constraints: L/1 = 10 - X1 - X25 0 (equivalent to X1 + X25 10) L/2 = -4 + X12 + 2X2 0 (equivalent to X12 + 2X2 4) Now the K-T conditions are: L/X1 = 3X12 + X2 1 + 22X1 0 L/X2 = X1 - 51X24 + 22 0 Along with, X1[3X12 + X2 1 + 22X1] = 0 X2[X1 - 51X24 + 22] = 0 and, L/1 = 10 - X1 - X25 0 L/2 = -4 + X12 + 2X2 0 Along with, 1[10 - X1 - X25 = 0] 2[-4 + X12 + 2X2 = 0] X1, X2, 1, 2 0

(1) (2)

(1a) (2a)

(3) (4)

(3a) (4a)

The K-T conditions are in fact generalizations of the FOCs in classical constrained optimization. Having inequality constraints amounts to allowing for the possibility that the optimum occurs at a point where one or more of the solution values are = 0 (Xj = 0), i.e., the possibility of a boundary or corner solution as opposed to an interior solution. The K-T conditions apply to both cases. In this respect, they describe a more general case and therefore contain the conditions for classical optimization. i.e., for y = f(x),

A max. can occur at a corner point as well as an interior point. If Y/X = 0 (point B), we may have a max. At C we have Y/X < 0 and X = 0. Can this represent a maximum? Yes, because the value of Y will decrease to the right of point C, which from the non-negativity constraints has to be at the positive orthand.

However, for max. we cannot have Y/X > 0 at X = 0, because then, we can increase the value of Y by increasing X. Putting the above together and generalizing for functions with more than one variables, for max. we have: Either Y/Xi = 0 and Xi > 0 (interior max.), or Y/Xi < 0 and Xi = 0 (corner max.) Y/Xi = 0 and Xi = 0 is also possible Which one applies? From the K-T conditions: Xj[L/Xj] = 0 This means that if Xj > 0 L/Xj = 0 If L/Xj 0 Xj = 0 That is, either Xj = 0 or L/Xj = 0 (or both) Similar conclusions are derived from i[L/] = 0. If we have minimization problem, the signs of the inequalities are reversed. L/Xj 0 L/i 0 (point A) (point C) (point B)

Intuitive explanation

Max. Z = f(X1, X2, Xn) s. t. g1(X1, X2, Xn) b1 . gm(X1, X2, Xn) bm Consider the Lagrangian expression: L(X, ) = f(X1, X2, Xn) + 1[b1 - g1(X1, X2, Xn)] + + m[bm - gm(X1, X2, Xn)] Condition L/i 0 for maximum means: L/i = bi - gi(X1, X2, Xn) 0, which is the ith constraint. That is, we know that the constraints are satisfied. Then, by the complimentary condition: i (L/i) = 0, or i [bi - gi(X1, X2, Xn)] = 0 for all i, these terms on the right hand side vanish and we are left with: L(X*, *) = f(X1, X2, Xn), which is the objective function. Therefore, a solution which satisfies the K-T conditions for the Lfunction must also: (1) (2) Satisfy the constraints. Will make the value of L equal to that of the objective function.

Sufficient conditions The candidate point will be a global max (min) if: (1) (2) For max (min), the set of constraints form a Feasible Region which is convex (concave) i.e., the constraint functions must be convex. For maximum the objective function must be concave. For a minimum it must be convex.

(3) The K-T conditions must be satisfied. [Notice that the classification for convex vs. concave can refer to a function or a region]

Non-strictly concave Strictly concave

Strictly convex


Note also that a linear function satisfies both convexity and concavity.


Computational aspects We are still looking for a method by which we can solve a NLO problem. We can approach this in an informal way, by examining the K-T conditions using examples. Consider the problem: Min. C = (X1 3)2 + (X2 4)2 s. t. X1 + X2 4 X1, X2, 0 Then, L = (X1 3)2 + (X2 4)2 + (4 - X1 - X2) (1) L/X1 = 2(X1 3) 0 (1) X1[2(X1 3) ] = 0 (2) L/X2 = 2(X2 4) 0 (2) X2[2(X2 4) ] = 0 (3) L/ = 4 - X1 - X2 0 (3) (4 - X1 - X2) = 0 We have 4 cases to consider: 1. 2. 3. 4. X1 = 0, X2 = 0 X1 = 0, X2 > 0 X1 > 0, X2 = 0 X1 > 0, X2 > 0 (immediately rejected) (=0 if X1 > 0) (=0 if X2 > 0) (=0 if > 0)


Case 2: If X1 = 0, X2 > 0, From (1): -6 0, or 6 + 0 < 0 If is also restricted to be non-negative, we already have a violation. Furthermore: From (2), with < 0: 2X2 8 = 0 2X2 8 = (< 0) X2 < 4. Then from (3): 4 X2 < 0 (contradiction/violation). Case 3: If X1 > 0, X2 = 0, From (1): 2X1 6 = 0 (since X1 > 0). From (2): -8 0 8 + 0 < 0. From (1), with < 0, 2X1 6 < 0 X1 < 3. From (3): 4 X1 < 0 (contradiction/violation) Case 4: If X1 > 0, X2 > 0, >0 2(X1 3) = 0 2X1 6 = 2(X2 4) = 0 2X2 8 = And the constraint is equality, therefore: X1 + X2 = 4 Solve the 3 equations to get: X1 = 3/2, X2 = 5/2, C=4.5. This solution satisfies the K-T conditions and the constraint; however, this is not the optimal solution. Case 5: X1 > 0, X2 > 0, = 0 The point which minimizes the objective function and satisfies the K-T conditions and the constraint is: X1 = 3, X2 = 4, = 0. [2X1-6 = 0 X1 = 3, and 2X2 8 = 0 X2 = 4]

(1) (2) (3)

The optimal value of the objective function is: C = 0. The constraint is satisfied as a strict inequality. Example 2 Max. -3e-2X1 4e-5X2 s. t. X1 + X2 1 X1, X2, 0

L = -3e-2X1 4e-5X2 + (1 X1 X2) L/X1 = 6e-2X1 0 L/X2 = 20e-5X2 0 L/ = 1 X1 X2 0 Examine the 4 cases: (1) (2) X1 = 0, X2 = 0 (rejected: it implies >0 1- X1-X2 = 0) X1 = 0, X2 > 0, then: (=0 if X1 > 0) (=0 if X2 > 0) (=0 if > 0)

60 Furthermore, 20e-5X2 = (since X2 > 0) > 0 Thus, 1 X2 = 0 X2 = 1 Then, 20e-5 = 0.134 which violates 6 0. (3) X1 > 0, X2 = 0, then:

6e-2X1 = 0 20 - 0 > 0, and:


1 X1 = 0 X1 = 1 So, 6e-2 = 0.81 = , which violates 20 0. (4) X1 > 0, X2 > 0, then: 6e-2X1 = 20e-5X2 = >0 Hence, 1 X1 X2 = 0 X2 = 1 X1. Substitute: 20e-5(1-X1) = 6e-2X1 (20/6) e-5(1 X1) = e-2X1 (20/6) = e-2X1 + 5(1-X1) Or, 3.33 = e-7X1 + 5 Or, ln(3.33) = -7X1 + 5 = 1.2 X1 = 0.54, X2 = 0.46


Example: Maximization of Utility The model of a consumer maximizing utility, U(X1, X2), subject to a budget constraint can be given a treatment using K-T analysis. The qualifying difference here, compared to the usual treatment, is that now the consumer is not necessarily spending all his income and doesnt need to consume positive amounts of both goods. Max: U(X1, X2) s. t: P1X1 + P2X2 I X1, X2, 0 L = U(X1, X2) + (I - P1X1 - P2X2) K-T conditions: L/X1 = U1 P1 0 L/X2 = U2 P2 0 L/ = I - P1X1 - P2X2 0 (=0 if X1 > 0) (=0 if X2 > 0) (=0 if > 0)

Recall that the Lagrange multiplier, , has been interpreted as the MU of money income, I. Consider as a first case: X1, X2, > 0, then: U1 = P1 U2 = P2 (MU of money income) = U1 / P1 = U2 / P2 This represents the MU per $ spent on X1 and X2.

In this case (interior point maximization), the consumer equates the MU per $ spent on each good to the MU of money income. In this case, L/ = I - P1X1 - P2X2 = 0 (consumer exhausts all income). Going to the alternative case (if consumer not necessarily spends all incime): L/ = I - P1X1 - P2X2 0, this can be written as: P1X1 P2X2 I. If the constraint is not binding (i.e., the consumer does not exhaust income), then, U1/P1 = U2/P2 = = 0, that is MU of income is 0 (utility from spending one more $ of income = 0). This means that the consumer is satiated in all goods. To see this: U1 = P1 = 0 U2 = P2 = 0, That is the consumer will not consume more of the 2 goods even if they are free. The remaining possibility is that the consumer is maximizing at a corner:

Since X1 = 0, U1 - P1 < 0, or U1 < P1 > U1 / P1 That is, his MU of money exceeds the MU of consuming X1 per $ spent.

At the same time, since X2 > 0, U2 - P2 = 0, or U2 = P2 = U2 / P2, i.e., the consumer is consuming X2 so that he equates the MU per $ spent on X2 to the MU of money income.


DYNAMIC SYSTEMS In dynamics, we are concerned with growth (change of key economic variables, such as Y, P, etc) and stability over time. A system is dynamical, if its behaviour over time is determined by functional equations, in which variables at different points in time are related in an essential way. What is a functional equation: It is an equation in which the unknown is a function. To solve an equation in the usual sense is to find the value (or values) of the unknown which satisfies the equation. To solve a functional equation means to find an unknown function which satisfies the functional equation identically. Example: Consider the functional equation: y(x) y(x) = 0. It is easy to confirm that the function we are looking for is: y(x) = Ae x, since y(x) = Aex for any x. Now consider the function: y = ax + b, which gives y = a. If we put x = (a-b)/a, we have also y = a, i.e., y y = 0. However, for any other value of x, the value of the function will be different from a, therefore, the function y = ax + b does not satisfy out functional equation identically. Now if we suppose that the symbol x stands for time, we are ready to understand the definition of dynamic systems: y(t) y(t) = 0 [example]


In fact, y(t) = y(t) can be considered as a relation which involves the value of y at any point in time and the value it takes at an arbitrarily close point determined by y(t). Use of integration in dynamics (continuous time) Consider a relation such as the one given above. Suppose that a variable (for example, population) is known to grow over time at the rate: dy/dt = 1/t ( or t-1/2) (1)

We want to find the time path of this population given that this population is growing at the rate given by (1). We are looking for the function y = y(t), given that we know its derivative. We need to find the primitive function corresponding to the derivative (1). This is the essence of integration. The function whose derivative is t-1/2 is 2t1/2, i.e., y(t) = 2t1/2 + c, where c is an arbitrary constant. In order to be able to solve for the constant, we need additional information. Indeed, in most cases we have such information; in particular we know the value of the function at some point in time, usually at time 0. This is called an initial condition. If, for example, we know that y(0) = 10, then: y(0) = 2(0)1/2 + c = 10 c = 10, and: y(t) = 2t1/2 + 10. In general, y(t) = 2t1/2 + y(0). Before we proceed with more examples, we can refresh the rules of integration:

Rules of integration Notation: f(x)dx The outcome of integration is: f(x)dx = F(x) + c, which implies: F(x) = f(x) Rules: (1) (2) (3) (4) Integral of a constant: kdx = kx + c Integral of a power function: xndx = xn+1/n+1 + c (n -1) Integral of 1/x: (1/x)dx = ln(x) + c (n > 0) (also a sub-case of (2)) Integral of a natural exponential function: ekxdx = ekx/k + c (special case: exdx = ex + c) Integral of a constant times a function: kf(x)dx = kf(x)dx Integral of a sum of 2 or more functions: [f(x) g(x)]dx = f(x)dx g(x)dx Integral of the negative of a function: -f(x)dx = - f(x)dx

(5) (6) (7)

Examples 1. 9dx = 9x + c 2. x4dx = x4+1/4+1 = x5/5 + c 3. 2x2 x + 1)dx = 2x2 - xdx + dx = 2(x3/3) - (x)2 + x + c = 2/3(x)3 - (x)2 + x + c 4. 12x-1dx = 12(1/x)dx = 12 ln|x| + c 5. 20e-4x = 20[(-1/4)e-4x ] = -5e-4x + c Integration by substitution Its use becomes clear in cases where it is difficult or impossible to use the simple rules. Example (here we could still have used the simple rules): 20x4(x5 + 7)dx Let another function, u, equal (x5 + 7) Differentiate u: du/dx = 5x4 Solve for dx: dx = du/5x4 Substitute u for (x5 + 7) and du/5x4 for dx:

- 20x4(x5 + 7)dx = 20x4u(du/5x4) = 4udu = 4udu Integrate with respect to u: 4udu = 4(1/2)u2 = 2u2 + c

Convert back in terms of the original problem: 20x4(x5 + 7)dx = 2(x5 + 7)2 + c Now consider the following example: 3x(x + 6)2 dx Let u=x +6, then du/dx = 1 dx = du 3x(x + 6)2 dx = 3xu2du = 3xu2du, And we stop there because integration by substitution will not work. However, another method will work. Integration by parts It is derived by reversing the process of differentiation of a product: d/dx[f(x)g(x)] = f(x)g(x) + f(x) g(x) take the integral of the derivative: f(x)g(x) = f(x)g(x)dx + f(x)g(x)dx then solve algebraically for the first integral on the right hand side: f(x)g(x)dx = f(x)g(x) - f(x)g(x)dx Now, lets go back to the example: 3x(x + 6)2 dx


- Separate the integrand (i.e., what is to be integrated) into 2 parts as in the formula. Usually we consider first the simpler function for f(x) and the more complex for g(X). Let f(x) = 3x, g(x) = (x + 6)2, then: f(x) = 3, g(x) = (x + 6)2dx = 1/3(x + 6)3 + c1 - Substitute the values for f(x), f(x) and g(x) in the formula (note that g(x) is not used): 3x(x + 6)2 dx = f(x)g(x) - f(x)g(x)dx = 3x[1/3(x + 6)3 + c1] 3[1/3(x + 6)3 + c1]dx = x(x + 6)3 + 3xc1 - [(x + 6)3 + 3c1]dx = x(x + 6)3 + 3xc1 1/4(x + 6)4 3xc1 + c = x(x + 6)3 - 1/4(x + 6)4 + c So: 3x(x + 6)2 dx = x(x + 6)3 - 1/4(x + 6)4 + c Note that c1 does not appear in the final solution. We can always assume that c1 is always = 0. - Check the answer by differentiating Another example: 5xex-9dx Let f(x) = 5x and g(x) = ex-9, then: f(x) = 5, g(x) = ex-9dx = ex-9


5xex-9dx = f(x)g(x) - f(x)g(x)dx = 5xex-9 - ex-9 5dx = 5xex-9 - 5ex-9 dx, So, 5xex-9dx = 5xex-9 - 5ex-9 + c Definite integrals The definite integral is a number which can be evaluated using the following: The numerical value of a definite integral of a continuous function f(x) over the interval [a to b]: b f(x)dx a is given by the primitive function F(x) + c, evaluated at the upper limit b, minus the same primitive evaluated at the lower limit, a: b b f(x)dx = [F(x)] = F(b) F(a) a a 3 3 2 3 Example: (6x + 5)dx = [2x + 5x] 1 1 = [2(3)3 + 5(3)] - [2(1)3 + 5(1)] = 69 7 = 62


Properties of definite integrals b a 1. f(x)dx = - f(x)dx a b a 2. f(x)dx = 0 a c b c 3. f(x)dx = f(x)dx + f(x)dx a a b A few simple applications Suppose we are given the slope of a cost function of a firm, which is at any point equal to (1/2)q and the total cost curve passes through the point (2,7). Find the equation of the total cost curve. You are essentially given the marginal cost (MC) curve. Then, TC= (1/2)qdq = (1/2)[q2/2] = q2/4 + c We can definitize the constant, c, if we utilize the additional information. Given that when q =2, TC = 7, TC = (2)2/4 + c = 7 c = 6, and: TC = 6 + q2/4 (=TFC + TVC) (a <b < c)


Calculation of capital stock This is done on the basis of a known pattern of change of investment. If we are given that investment at time t is given by the function: I(t) = 12t1/2 and K(0) = 25 (this is an example from Chiang and Wainwright), we have: K(t) = 12t1/2 dt = 12(t3/2/3/2) + c = 8t3/2 + c K(0) = 25 = 8(0) + c c = 25, and K(t) = 8t3/2 + 25, which is the time path of capital stock. On the other hand, if you are asked to find the amount of capital accumulated over a particular time interval, say (1, 3) in years: 3 3 1/2 3/2 K(3) K(1) = 12t dt = 8[t ] 1 1 Present value of a cash flow Another application is finding the P.V. of a cash flow (a series of revenues or costs receivable at various times in the future). Suppose an amount, I, is invested at the rate of interest, i; we know that the total amount expected t years later is: R(t) = Ioeit We can rearrange to get: Io = R(t)/eit = Re-it (how much to invest now, to receive R, t years later)

This is the continuous case counterpart of: I = R/(1 + i)t , where I is the present value of R. This refers to a single future value, R. But if a person expects to earn R at the end of the first period and subsequent periods, then he has to invest: t I = Re-itdt 1 where I is the present value of a series of annuities given by the return expected from an investment outlay for a unit of a particular asset; i.e., if i = 0.04, compounded annually and the investor wishes to receive $100 for 10 years, he has to invest: 10 I = 100e-itdt = (100/0.04)e-0.04 - (100/0.04)e-0.4 = $726 1


Economic dynamics We may introduce economic dynamics by considering pre-Keynesian and Keynesian notions of equilibrium. Before Keynes, the question asked was whether the equilibrium exists and if it is unique and stable. The explanation stopped there. Keynesian analysis is different. If the achievement of full employment equilibrium requires a certain amount of new investment to be undertaken to bring total effective demand to the level of full capacity utilization, the very fact new investment is undertaken, will change the objective situation on which the current equilibrium is based. Investment will increase productive capacity at the same time it increases total effective demand (aggregate demand). So, investment plays a special role in Keynesian economic dynamics and acts trough 2 different channels: 1. Change in effective demand through the multiplier: dy/dt = m(dI/dt) = 1/s(dI/dt) 2. Total new investment is an addition to existing productive capacity. Application: Domars growth model The model assumes a rather rigid production function which involves only capital: k = K (1)

where k is capacity output (full employment output), taken to be a multiple of capital. As a result, = k/K.

One implication here is that, since labour is indispensable, K and L are combined in fixed proportion, because only then we can consider capital alone. By differentiating (1): (full employment output over time): dk/dt = (dK/dt) = I along with: (from the demand side): dY/dt = 1/s(dI/dt) There is no reason why these two effects should necessarily be compatible with the maintenance of full capacity utilization. We can explore, however, the conditions to be satisfied in order that effective demand and productive capacity may expand in a compatible way over time. First of all, total effective demand must be equal to productive capacity to begin with: Y(0) = k(0) Secondly, dk/dt = dY/dt must always hold over time, i.e., 1/s(dI/dt) = I, or: dI/I = sdt (1/I)dI = sdt ln(I) = st + c, or eln(I) = e(st + c) It = estec,then: It = Aest So: (I(0) = Ae0 = A) It = I0est


The above says that, in order to maintain equilibrium in the long-run, new investment must expand over time according to the above exponential function (i.e., expand at a rate g= *s over time). An economy might satisfy or not satisfy this condition. We could arrive at the same condition for I t using definite integrals instead [take this as a practice question] The above discussion of Domars growth model and the application of integration will take us to the concept and use of a differential equation in economic dynamics.


Differential equations Basic concepts and definitions Equations in which the unknowns are functions and which contain not only the unknown function but also their derivatives, are called differential equations. The form of the function is not given; it is to be found by solving the equation. The general expressions of an ordinary differential equation in a function y of an independent variable x, can be written as: F(y, x, dy/dx, d2y/dx2, ..., dny/dxn) = 0 (1)

The order of the equation is that of the highest derivative of it. An equation relating the independent variable x, the unknown function y and its first derivative, is called a differential equation of the first order. If in addition, the equation contains a second derivative of the function we are looking for, then such an equation is of the second order. Accordingly we can define deferential equations of higher order. The differential equation is linear with constant coefficients, if the coefficients of y, dy/dt, ... are all constants not involving x. So, the general form of a linear differential equation with constant coefficients and order n is: a0(dny/dxn) + a1(dn-1y/dxn-1) + ...+ an-1(dy/dx) + any = f(x) where f(x) is an function of x.


In the case where in place of f(x) on the right hand side we have a constant instead, the equation is called linear with constant coefficients and a constant term. The first-order case is written as: dy/dx + a1y = f(x) The second order: (d2y/dx2) + a1(dy/dx) + a2y = f(x) The particular case where f(x) is absent altogether is called the homogeneous form, i.e., a0(dny/dxn) + a1(dn-1y/dxn-1) + ...+ an-1(dy/dx) + any = 0 Summarizing: Differential equations Linear (1 or higher order)

No linear (1 ort higher order)


Constant coefficients

Variable coefficients

Homogenous Non-homogeneous

Homogeneous Non-homog.

In discussing differential equations, emphasis will be given to linear equations of the 1st and 2nd order. Now suppose we have an equation like the following: (d2y/dt2) + a1(dy/dt) + a2y = 0 If we take y to be an economic variable and t stands for time, then, since dy/dt describes how y changes over time, and since d2y/dt2 describes how dy/dt is changing over time, it is clear that the equation tells us something about the behaviour of y over time, so, it is about economic dynamics. Solving linear differential equations By solution we mean an expression (formula) giving y at all points in time such that it satisfies the equation. The number e (2.718...) The number e plays a role in our analysis using differential equations (continuous time). In particular, it will enter the solution of the differential equations. Say that we invest X$ at a rate of interest i, compounded annually. At the end of the year the principal will be: P = X(1 + i) If instead the interest is compounded semi-annually: P = X(1 + i/2)2

Generalizing: P = X(1 + i/n)n If interest was compounded continuously, we would have a principal given by the value approached by P as n . In particular, if X=$1 and the rate of interest i = 100% ( i = 1): P = (1 + 1/n)n The limit approached by P as n is equal to e (the principal of one dollar compounded continuously for 1 year at 100% interest); e 2.718. Of course, money is not compounded continuously, but one could think of events which behave very much like a sum on which interest is compounded continuously. Solution of Linear Differential Equations of the 1st order These can be written in the general form: dy/dt + ay = f(t) if f(t) = 0 (homogeneous form): dy/dt + ay = 0 Since the above equation is separable, the solution can be found as follows: dy/dt = - ay dy/y = -adt, then:

dy/y = -adt ln(y) + c1 = -at + c2 ln(y) = -at + c, then: elny = e(-at + c) y(t) = e-atec = Ae-at Verify by substituting into the differential equation: dy/dt = -a Ae-at and: -a Ae-at + a(Ae-at) = 0 Alternatively, we can find the solution in a slightly different (and more general) way: Given: dy/dt + ay = 0 Assume that y(t) = cet, then: dy/dt = cet, and: cet + acet = 0 cet ( + a) = 0 = -a This is a general way of solving the homogeneous equation and there is an arbitrary constant, c, appearing. To remove the unknown constant requires additional information i.e., an initial condition. From the general solution: y(t) = ce-at. For t=0: y(0) = ce0 = c = y(0), so: y(t) = y(0)e-at. Besides the solution to the homogenous equation there is also a particular solution; we need to take into account the non-homogeneous

part, f(t). The particular solution will be any particular solution to the complete equation. The general solution will be the solution to the homogeneous form (call it complimentary solution, yc), plus the particular solution, yp. One way to find the particular solution is by setting the solution to be a general expression of the same form as f(t); i.e., if f(t) is a constant k (such as f(t) = 3), try yp = k. If f(t) = e3t, try yp = ekt and so on. Example 1: Solve, dy/dt 3y = -3, y(0) = 2.

Using the general way of solving the homogeneous form: yc =ce3t To find the particular solution: let yp = k. Then: dy/dt = 0 and we have: 0 3k = -3 k = 1. The complete solution is: yt = ce3t + 1 Using the initial condition, y(0)= c + 1 = 2 c =1, and yt = e3t + 1 Example 2: y 2(dy/dt) + 2t = 6, y(0) = 1

Using the standard solution, we first need to re-write the equation: 2(dy/dt) y = 2t 6, or dy/dt y = t 3. Then:

yc = ce-(-1/2)t = ce0.5t (check solution) To find the particular solution, set yp = ko + k1t, then: dy/dt = k1 and: k1 ( ko + k1t) = t 3 re-write as: k1 1/2 k1t 1/2 ko = t 3 (-k1/2)t (ko /2 - k1) = t 3 Then: -k1/2 = 1 and - (ko /2 - k1) = -3 (ko /2 - k1) = 3 Solving, we get k1 = -2 and ko = 2, and: yp = 2 2t, so: yt = ce0.5t + 2 2t Using the initial condition, y(0) = 1: y(0)= c + 2 = 1 c = -1 Then: yt = -e0.5t + 2 2t (definate solution) Check by substituting into y 2(dy/dt) + 2t = 6, given that: dy/dt = -2 0.5e0.5t: -e0.5t + 2 2t 2(-2 0.5e0.5t) + 2t = 2 2t + 2t + e0.5t + -e0.5t + 4 = 6


Economic Applications Consider the following case: A communitys savings (= investment at equilibrium) at any point in time t, is a constant proportion, s, of income at time t:

St = sYt Investment is proportional to the rate of change of income over time: (1)

It = g(dy/dt)

Given the equilibrium condition, I = S: sYt = g(dy/dt), or: dy/dt (s/g)Y = 0 (1st order homogeneous equation, with constant coefficient, s/g). Solution: Yt = Y(0)e(s/g)t = Y0e(s/g)t Implications: Given that s is positive, our solution will converge to infinity as t if g > 0, that is, growth of output accelerates the expansion of productive capacity and investment. On the other hand, of g < 0 the solution converges to 0 (!!), since: lim{ e(s/g)t } = 0 which suggests that if output does not grow enough, with investment falling and unused capacity appearing, output will finally decline to 0. This is an unreasonable implication. However, when we introduce a slight modification to the above model, we derive a non-homogeneous differential equation:

Harrods growth model I1t = g(dY/dt) (induced investment)

I0t: autonomous investment, and: It = I1t + I0t From the definition of National Income: Yt = Ct + It , Ct = aYt , a = dC/dY (MPC)

St = sYt , s = dS/dY (MPS); a + s = 1, or s = 1 a. The simple multiplier is: k = 1/s. The accelerator expresses planned investment as: I1t = g(dY/dt) Putting everything together: Yt = aYt + g(dY/dt) + I0t autonomous investment). (= consumption + induced investment +

g(dY/dt) = [(1-a)/g]Yt - I0t/g dY/dt (s/g) Yt = - I0t/g The solution to the homogeneous equation is: Yc = Y0e(s/g)t To find the particular solution:

Yp = k and: -(s/g)Y = - I0t/g Yp = I0t/s, then: Yt = Y0e(s/g)t + I0t/s Since I0t/s is a constant, income grows at a steady exponential rate s/g, which may either converge or diverge from the equilibrium value of I0t/s, depending on the sign of s/g. If s/g < 0, equilibrium income will finally reach I 0t/s; but if (as one would expect) s/g > 0, income would rise exponentially. So, for convergence we need: s/g < = so that lim{ e(s/g)t} = 0 as t .


Dynamic models of market price Stability of equilibrium In a perfectly competitive market, equilibrium is determined at the intersection of D and S. Starting from the simple case in which D and S of a commodity are assumed to depend only on price (other things unchanged), our objective is to see what happens when the system is not in equilibrium. In particular, the question is whether the system will tend to equilibrium or not. When the question is simply whether the economic forces will finally bring the system to equilibrium without being concerned about the time path of price, then the question concerns the static stability of the system. But even if economic forces push the system towards equilibrium, we cannot exclude the case where equilibrium is overtaken. This would give rise to oscillations before approaching equilibrium, if we ever reach it. So the question is that of dynamic stability. The first thing we have to do is adopt an assumption about the behaviour of the variables in the system. Stability conditions will depend on this assumption. In the case of dynamic models of market price, the usual behavioural assumption is the Walrasian assumption: According to it, if there is excess demand price tends to rise; if there is excess supply price tends to fall.


An alternative assumption is the Marshalian assumption according to which, quantity tends to increase if excess demand price is positive. Excess demand price is the difference between the price that buyers are willing to pay for any given quantity and the price that is required by suppliers. It is measured by the vertical distance between D and S for any disequilibrium quantity. We are going to consider the Walrasian assumption only. Walrasian assumption: Equilibrium is (statically) stable if a P increase caused by positive excess demand will decrease excess demand: dE(P)/dP = d[D(P) S(P)]/dP < 0 or, dD/dP dS/dP < 0 (slope of supply > slope of demand)

In analysing dynamic stability we express the behavioural assumption in the form of a function, which is then solved to derive the time path of the variable: dP/dt = P = c[D(P) S(P)], from which we can solve for Pt. In the case of linear demand and supply: D = a + bP, S = a1 + b1P, dP/dt = P = c[a + bP a1 b1P] = c(b - b1)P + c(a a1) Equilibrium price is derived by setting P = 0: Pe = - (a a1)/(b b1) To find the time path of price:

dP/dt = c(b - b1)P + c(a a1), or P - c(b - b1)P = c(a a1), The solution of the homogeneous equation (complimentary solution) is: Pc = Aec(b b1)t (complimentary solution) For the particular solution we let: Pp = k -c(b b1)k = c(a a1) k = - (a a1)/(b b1) = Pe, so: Pt = Aec(b b1)t + Pe Looking at the exponent in the solution, we need: c(b b1) to be negative for stability (since c >0). So, the stability condition is: b b1 < 0 or b < b1 i.e., the slope of the supply must exceed that of the demand. This is the dynamic stability condition; however, note that this condition is the same as: dD/dP dS/dP < 0, so in this case the static and dynamic stability conditions are the same. This is not always the case though. When they are different, we are more interested in the dynamic stability condition. Example: Static stability D = 80 4P, S = -10 + 2P, P0 = 18

Find the equilibrium point and examine static stability. At equilibrium: 80 4P = -10 + 2P Pe = 15, Qe = 20

Using the Walrasian stability assumption; E(P) = 80 4P (-10 + 2P) = 90 6P dE/dP = -6 < 0, i.e., static stability. Example: Dynamic stability dP/dt = P = c[80 4P (-10 + 2P)] = c(90 6P) = -6cP + 90c which has the solution: Pt = Ae-6ct + 15 (Pp = k, 6ck = 90c k = 15) Given that P0 = 18 A = P0 Pe = 18 15 = 3 Given c> 0, the term 3e-6ct 0 and equilibrium is dynamically stable.


Some abnormal cases 1. b> 0, b1 > 0 b1 > b, stable


b> 0, b1 > 0 b1 < b, unstable


b < 0, b1 < 0 |b1| > |b|, unstable


b < 0, b1 < 0 |b1| < |b|, stable


A dynamic model of market price Stability in a single market Assume small shocks in market price. Consider the following demand and supply for a product (and assuming the market clears at any point in time): D = D(P, dP/dt) S = S(P) Assuming linear functions: QD = a1 + a2P + a3(dP/dt) QS = b1 + b2P Q = a1 + a2P + a3(dP/dt) = b1 + b2P a1 + a2P + a3(dP/dt) = b1 + b2P a3(dP/dt) + (a2 b2)P = b1 a1 dP/dt + [(a2 b2)/a3]P = (b1 a1)/a3, and the time path of P: Pt = Ae-[(a2 b2)/a3]t + P*, or Pt = Ae[(b2 a2)/a3]t + P* = (P0 P*)e[(b2 a2)/a3]t + P* (P0 = A + P* A = P0 P*) (1)

For price to converge to P* (stability) we need: [(b2 a2)/a3] < 0, then as t : lim (e[(b2 a2)/a3]t) = 0


We can highlight 4 cases, assuming a3<0: 1. 2. 3. 4. (+ - (-))/ - = -ve (stable) (+ - (+))/ - = (), stability if b2 > a2 (- - (+))/ - = + ve (unstable) (- - (-))/ - = (), stable if |a2| > |b2|


Second-order differential equations with constant coefficients In the general case a 2nd order differential equation can be written in the following general form: F(x; y, y, y) = 0 (1)

where y=y(x) is the unknown function we are looking for, and y = y(x), y=y(x) are its 1st and 2nd derivatives. The function (x) will be called a solution of (1) if it has derivatives (x), (x) such that for any x the following equality holds: F(x; (x), (x), (x)) = 0 It can be shown that for any two initial conditions: y0 = y(x0), y0 = y(x0) (3)

there exists only one solution, y = y(x) of equation (2) which satisfies condition (3). This constitutes the basic contents of Cauchys theorem. Linear equations with constant coefficients y + by + cy = k (2nd order with a constant term, k) if k = 0, y + by + cy = 0 (homogeneous) Example 1 y y = 0 It is easy to verify that the function: y = ex is a solution.

We can show that for any two constants c1, c2, the function: y = c1ex + c2e-x is also a solution to (1), since: y = c1ex - c2e-x y = c1ex + c2e-x = y so, y y = 0 From Cauchys theorem there is no other solution to the homogeneous equation. Example 2 y 4y = 0 (1)

We can find the solution in the form: y = e x, where is an unknown number. Substitute this into (1) and since: y = 2ex - 4 ex = 0 (2 4) ex therefore, a function of the form ex satisfied equation (1) if an only if: (2 4) = 0 The roots that satisfy the equation are 1=2 and 2=-2. Therefore the solution is: y = c1e2x + c2e-2x


Characteristic equation The above examples suggest an idea to use a solution of the form e x in the general case as well. Given a homogeneous linear equation with constant coefficients: y + by + cy = 0 (1)

substitute ex as well as its first and second derivatives into (1): y + by + cy = 0 2 ex + bex + c ex = 0 ex(2 + b + c) = 0 the function ex will be a solution of (1) if satisfies: (2 + b + c) = 0 (2)

Equation (2) is called the characteristic equation of (1). Consider first the case of 2 distinct real roots (solutions) for the characteristic equation, 1 2, then: y = c1e1*x + c2e2*x Proposition: If 1 and 2 are both solutions of (1), then so is the function = c11 + c22, which is the general solution. Consider now an example where in addition to the equation we are given initial conditions. Also use time as the independent variable (t instead of x).

Example 1: y + 4y + 3y = 0 The characteristic equation is: 2 + 4 + 3 = 0, and: 1 = -1, 2 = -3, then: y = c1e-x + c2e-3x Example 2 (with initial conditions): d2y/dy2 3(dy/dt) + 2y = 0, dy0/dt = 6, y0 = 4 or: y 3y + 2y = 0, y(0) = 6, y(0) = 4.

The characteristic equation is: 2 - 3 + 2 = 0, and: 12 = 2, 1. The general solution to the homogeneous equation (complementary solution) is: yt = c1e2t + c2et Then, to satisfy the initial conditions: y(0) = c1e0 + c2e0 = c1 + c2 = 4 y(0) = 2c1e2t + c2et = 2c1e0 + c2e0 = 2c1 + c2 = 6


solving, c1 = 2, c2 = 2 and the solution of the homogeneous equation (definite solution) is: yt = 2e2t + 2et (definite solution) Case of multiple roots y + by + cy = 0 Characteristic equation: 2 + b + c root, = [-b 0]/2 = -b/2 and 2 = -b, also, b = -2, c = b2/4 = 2 , and since, b2 4c = 0 b2 = 4c Solution: et is a solution to equation (1). We can show that in this case (case of multiple /repeated) root, tet is also a solution. (1)


We have: y = tet , y = et + tet, y = et + et + 2tet = 2et + 2tet so, y + by + cy = 2et + 2tet + bet + btet + ctet = et (2 + b) + tet (2 + b + c) = et (2 - 2) + tet (2 - 22 + 2) = 0 Therefore, the solution is: yt = c1et + c2tet Example: y 2y + y = 0 12 = -1 (repeated root)

solution: yt = c1e-t + c2te-t


Case of complex roots y + by + cy = 0 2 + b + c (1) (2)

When b2 4c < 0, the roots are complex. If we find the conjugate complex roots: 1,2 = h iv, then it can be shown (using the theory of complex numbers) that the general solution will be: yt = c1e(h + iv)t + c2e(h - iv)t which can be written as: yt = eht(c1eivt + c2e-ivt) (more later) Particular solution (for any case of roots) Suppose the right hand side is a constant. y + by + cy = d (1)

Consider a particular solution of the form: yp = k, then: y = 0, y = 0, and k = d/c = yp Example (real roots): y 2y 3y = 10, y(0) = 6, y(0) = 4. 12 = 3, -1

yp = k 0 0 3k = 10 k = -10/3 then: yt = c1e3t + c2e-t 10/3 y(0) = c1e0 + c2e0 10/3 = c1 + c2 10/3 = 4 y(0) = 3c1 c2 = 6, and c1 = 10/3, c2 = 4 The solution is: yt = (10/3)e3t + 4e-t 10/3 Stability of equilibrium 1. First-order differential equations

The solution is of the form: cet, or c(et). Since e > 1, et will grow at an ever-increasing rate if >0. Thus, if > 0, the solution is unstable (explosive solution). If = 0, then et = 1 and the solution remains constant over time. If < 0 so that = - is > 0, then (e t) = 1/(et), and since the denominator will grow at ever-increasing rates 1/(et) will approach 0. The solution is convergent. Since c can be positive or negative, we identify 6 possibilities for the time path of y:



Second-order differential equations

We have 2 terms in the solution: yt = c1e1*t + c2e2*t + yp If the largest root is i, eventually the solution will approximate: yt = ci(ei*t), since the other term becomes relatively negligible. The time path is unstable when there is at least one positive root.


But eventually may be a long time and we may be more interested what happens before that (i.e, immediately). We can answer this if the roots are of the same sort, i.e., both positive or negative. When this is not the case, what will happen in the immediate time horizon will depend on the relative values of the constants, c1 and c2. Stability in the case of complex roots. When we have a pair of complex roots there will be a term in the solution of the form: yt = eht(c1eivt + c2e-ivt) The expression in parenthesis will repeat itself (trigonometric fluctuations). The amplitude of fluctuations will depend largely on the magnitude of eht where h is the real part of the complex root. Stability requires h < 0. The distinction between + ve and ve real parts is of particular importance because it determines whether, whatever fluctuations may occur, these will be damped (convergent) or explosive. There is an easy way to determine whether, if the roots are complex, the real part is + ve or ve, by inspecting the equation itself. 2 + b + c = 0 The roots are: -b/2 b2 4c = -b/2 i4c - b2 Hence, the real part of the complex root is b/2 which is ve if b is + ve and vice versa.


Economic applications Consider a market model where the market behaviour of individuals is affected by expectations about the future price. The derivative dP/dt relates to whether price is rising or falling over time. On the other hand, the second derivative d2P/dt2 indicates whether price increases at an increasing rate (or decreasing at a decreasing rate). If Qd and Qs depend on d2P/dt2 in addition to dP/dt then: Qd = D[P(t), dP/dt, d2P/dt2] Qs = S[P(t), dP/dt, d2P/dt2] Using linear D and S equations and the alternative notation: Qd = P + mP + nP Qs = - + P + uP + wP (, > 0) (, > 0)

Equating D to S (that is assuming that the market always clears): P + bP + cP = d Where b, c, d are related to the original coefficients. The particular solution is found by setting yp = k, then: k = d/c The solution in the case of 2 roots is: Pt = c1e1t +c2e2t + d/c


Example (from textbook) Qd = 3P + P P + 9 Qs = 5P P + 4P 1 P(0) = 4, P(0) = 4 Equating Qd and Qs and simplifying: P P -2.5P = -5 Particular solution: Pp = 2 ( -2.5P = -5 P =2) The characteristic equations is: 2 5/2 = 0 and has complex roots: (3/2)i, with h = and v = 3/2. The general solution will be: Pt = e1/2t( )

The path is non-convergent and the fluctuations in price are explosive (b = -1, so b/2 is positive).


An example from Macroeconomics The dynamic Philips curve Original Phillips Relation w = f(U) (f(U) < 0) Using a linear function: w = U. Then: p = w T (w is the rate of change of nominal wage, p is rate of change in price level; T is labour productivity (induced by technology). So: p = T U (, > 0)

Introducing expectations w = f(U) + g (0 < g < 1) ( is the expected inflation rate) p = T U + g (1)

Assuming adaptive expectations, then the rate of change of expected inflation over time is: d/dt = j(p ) (0 < j < 1) (2)

If individuals under-predict the rate of inflation, they revise their expectations up, i.e., d/dt > 0. Now we add one more equation for unemployment. Assume that the only government policy that matters is monetary policy, and denoting the rate of growth of nominal money supply by m: dU/dt = -k(m-p) (3) (where k>0 and m-p is the growth of real money supply) According to (3), the change in the unemployment rate over time is determined by the rate of growth or real money supply.


The time path of Equations (1) (3) constitute a model with 3 variables, , p and U. We can choose to collapse the model into one equation; for example if we choose , putting (1) into (2): d/dt = j( T U) j(1-g) (4)

To create a dU/dt term, differentiate (4) with respect to time: d2/dt2 = -j(dU/dt) j(1-g) (d/dt) Put (3) into (5): d2/dt2 = jkm jkp j(1-g) (d/dt) We still need to eliminate p. From (2): p = (1/j)(d/dt) + Substituting into (5): d2/dt2 + [k + j(1-g)] d/dt + (jk) = jkm The particular solution is: p = (jkm)/ (jk) = m Which means that the inter-temporal equilibrium value (equilibrium over time) of expected inflation depends only on the rate of change of money supply [This result is independent of the value of coefficient g]. For the complimentary solution (which will tell us whether or not well reach this new equilibrium and if yes in what manner) we have two roots, and depending on the type of roots well know the time path (convergent or divergent, monotonic or oscillatory).



Similarly (and assuming that inflationary expectations are passed on fully to actual inflation), we can derive the time path of P and find that the particular solution (inter-temporal equilibrium price) is again: m. That is in the long-run (give it enough time), the rate of change of the price level (inflation) will equal to the rate of growth of nominal money supply. On the other hand, if we derive the time path of the unemployment rate, the particular solution (where the unemployment rate converges in the long-run) will be a number independent of the policy variable m (rate of growth of money supply) and regardless of the equilibrium rate of inflation, highlighting the result that in the long-run Philips curve is vertical [under the assumption that g=1]


Difference equations (discrete time) General principles Consider the function y = f(t). Then, its first difference is defined as the difference between the value of the function when the argument takes the value t + h and the value of the function at time t, i.e., yt = f(t + 1) f(t) Consider unit increments of the independent variable, t: yt = f(t + 1) f(t) = yt+1 yt yt+1 = f(t + 2) f(t+1) = yt+2 yt+1 Likewise we can compute second differences: 2yt = yt+1 - yt = (yt+2 yt+1) (yt+1 yt) = yt+2 2yt+1 + yt 2yt+1 = yt+2 - yt+1 = yt+3 2yt+2 + yt+1 We define an ordinary difference equation as a functional equation involving one or more of the differences, yt, 2yt, etc, of an unknown function of time. The order of the difference equation is that of the highest difference appearing.


Since the differences of any order can be expressed, as we have seen above, in terms of various values of the function, a difference equation may also be defined as a functional equation involving two or more of the values yt, yt+1 etc, of an unknown function of time, i.e., the difference equation: ayt + byt = 0 can be transformed into: a (yt+1 yt) + byt = 0, or: ayt+1 + (b-a)yt = 0 It makes no difference whether the equally spaced values of t are computed forwards or backwards, so long as the structure of the lags remains the same. i.e., the equation: ayt+1 + (b-a)yt = 0 is identical to: ayt + (b-a)yt-1 = 0 Example: Consumption function: Ct = 100 + 0.7Yt-1 implies, Ct-1 = 100 + 0.7Yt-2 First-order difference equations The general form is: c1yt + c0yt-1 = g(t) The homogeneous form is: c1yt + c0yt-1 = 0 or: yt + byt-1 = 0 where b = c0/c1. Looking for a solution: Suppose that in the initial period, t = 0, the arbitrary value A. Then, from (3): y1 = -by0 = -bA y2 = -by1 = -b2A .

(1) (2) (3) function y takes on an

The solution appears to be: yt = A(-b)t Check: A(-b)t + b A(-b)t-1 = A(-b)t (-) b A(-b)t-1 = A(-b)t (-) b A(-b)t(-b)-1 = A(-b)t A(-b)t = 0 Determining the arbitrary constant (A). We need to use an initial condition. This need derives from the fact that the solution yt = A(-b)t gives only the form of the function. Linear difference equations with constant coefficients The general nth order form is: cnyt+n + cn-1yt+n-1 + + c1yy+1 + c0yt = g(t) where the ci are constants and g(t) is a known function. Both cn and c0 must be 0 if the equation is of order n. when g(t)= 0 we have a homogeneous equation. When looking for a solution, the following theorem will be used: 1. If y1(t) is a solution of a homogeneous equation, then Ay 1(t), where a is an arbitrary constant, is also a solution. [Proof: If y1(t) satisfies the equation, substituting into the equation: cnAy1(t+n) + cn-1 Ay1(t+n-1) + + c1 Ay1(y+1) + c0y1(t) = 0,

therefore: A[ brackets vanishes.] 2.

] = 0. Since y1(t) is a solution, the expression in

If y1(t), y2(t) are 2 distinct solutions of the homogeneous equation (with n > 1), then A1y1(t) + A2y2(t) is also a solution, for any 2 constants A1 and A2. [Proof similar] 3. If yp(t) is any particular solution of the non-homogeneous equation, the general solution is obtained by adding the particular solution to the general solution of the homogeneous equation.

The particular solution will depend on the form of g(t), as in the case of differential equations. The approach is to find the particular solution by trying a function having the same form as g(t), but with undetermined coefficients. Particular solution Case 1: g(t) = constant c1yt + c0yt-1 = a try yt = yt-1 = , then: (c1 + c0) = a = a/(c1 + c0), So, yp = a/(c1 + c0), with (c1 + c0) 0 If (c1 + c0) = 0, try yt = yt-1 = t Substituting into (1): c1t + c0(t-1) = a, with c1 = -c0. = c ct - c(t-1) = a t t + = a/c


= a/c, so: yp = (a/c)t this suggests the following generalization: If the function you try as the particular solution does not work, try the same multiplied by t. Case 2: g(t) is a polynomial of degree n, i.e., g(t) = 0 + 1t, then: c1( + t) + c0[ + (t-1)] = 0 + 1t therefore, (c1 + c0) c0 + (c1 + c0)t = 0 + 1t (c1 + c0) c0 = 0 (c1 + c0) = 1 solve for , Example: yt-1 - 5yt = 1 (y0 = 7/4)

The complimentary solution (solution to the homogeneous equation) is: yc = A[(5)t] = A(5)t yt = yt-1 = k k 5k = 1 k = -1/4 Solution: yt = A(5)t , y(0) = A = 7/4 A = 2, and: yt = 2(5)t

Applications The Cobweb model This is a dynamic demand-supply model. Assume that supply reacts to price with a lag of one period, while demand depends only on current price. Dt = a + bPt St = a1 + b1Pt-1 This model could apply to goods whose production is not instantaneous or continuous, but requires a period of time (i.e., agricultural products, raising pigs, etc). At the end of each period, the output started at the beginning of the period reaches the market. Producers think (assumption) that this price will hold also in the next period, so the quantity of their new production is based on current price. When market clears: Dt = St or, bPt - b1Pt-1 = a1 a Pt (b1/b) Pt-1 = (a1 a)/b And the solution (time path of price) is: Pt = A(b1/b)t + Pe, or Pt = (P0 Pe)(b1/b)t + Pe (since, P0 = A(b1/b)0 + Pe = A + Pe) Pe is the static equilibrium price. That is, it is the same price obtained from the solution of the static model: D = a + bP S = a1 + b1P D=S

Usually, D has a negative slope (b < 0), while b1 > 0. Then, b1/b < 0, and price will exhibit an oscillatory movement around the equilibrium price. These oscillations are explosive if |b1| > |b|, i.e., if the slope of the supply > slope of the demand; on the other hand, they will converge to the equilibrium price if |b1| < |b|.



Two abnormal cases Positively sloped demand curve and |b1| < |b|. In this case, the movement is monotonically stable, because the sign of b1/b is positive and |b1/b| < 1.


Positively sloped demand curve and |b1| > |b|. This case leads to monotonic divergence (unstable solution).


The cobweb model can be considered as a special case of a more general model: Dt = a + bPt St = a1 + b1Pet Dt = St where Pe is an expected price, i.e., the price that producers, at the time production begins, think will prevail when the output reaches the market. In the Cobweb model the assumption is that P e = Pt-1, which is a rather naive assumption. We can consider the case where producers have a price in mind (call it normal price) that they think is going to prevail sooner or later. If current price is different from the normal price, they expect that the former will change towards the latter, i.e., Pet = Pt-1 + c(PN - Pt-1) (0 < c < 1) [if c = 0, cobweb case]

But how we determine what the normal price is? One way is to assume that PN is a constant and equals Pe, the static equilibrium price. This would be realistic if the system was in equilibrium for a long time before the shock. Substitute Pet into the model: a + bPt = a1 + b1[Pt-1 + c(PN - Pt-1)] = a1 + b1Pt-1 + b1cPe b1c Pt-1 bPt - (b1 + b1c) Pt-1 = a1 a + c Pe Pt - [(b1 + b1c)/b] Pt-1 = a1 a + c Pe


And the homogeneous equation is: Pt - [b1(1 c)/b] Pt-1 = 0 Solution: Pt = A[b1(1 c)/b]t + Pe (Pe is the particular solution) The stability condition is: | b1(1 c)| < |b| If we compare the new model with the original Cobweb model we obtain the following observations: 1. A price movement which was convergent before converges faster now. 2. A constant oscillation before becomes a convergent oscillation. 3. A divergent movement may become convergent if the parameter c is sufficiently close to 1. So, the introduction of expectations based on the above assumption makes the model more stable.


Dynamic multipliers The simple Keynesian static multiplier in macroeconomics is: m = Y/I = [1/(1-b)] expenditure) (where I represents any autonomous

This reveals nothing about the transition from the old to the new equilibrium. To make the model dynamic we must introduce lags: Ct = a + bYt-1 It = I(0) + I Yt = Ct + It Then: Yt - bYt-1 = a + I(0) + I Solution (time path): Yt = A(b)t + (a + I(0) + I)/(1-b) [Note that: Yp = k k bk = a + I(0) + I k= (a + I(0) + I)/(1-b)] Since |b| < 1 (and positive , hence no fluctuations), the term A(b)t 0 and income moves monotonically towards its equilibrium value (a + I(0) + I)/(1-b).


Example: In a certain period income is in equilibrium at level Y(0) = 100; C(0) = 60; I(0) = 40. The consumption function is: Ct = 0.6Yt-1 and investment is autonomous. Assume investment increases from 40 to 50. Compute the new equilibrium income. Is equilibrium stable? The total increment in income is given from the static multiplier: (1-0.6) = 2.5 Y = 25. The new equilibrium is 125. Concerning stability: Yt = Ct + It Yt = 0.6Yt-1 + 50 Yt - 0.6Yt-1 = 50 Solution: Yt = A(0.6)t + 125 A = Y(0) 125 = -25, so


Yt = -25(0.6)t + 125 Since (0.6)t monotonically to 0, Yt tends to 125 and the equilibrium is stable. Now suppose that investment is not entirely autonomous: It = I(0) + hYt-1 Then: Ct = a + bYt-1 It = I(0) + hYt-1 + I and: Yt - (b + h) Yt-1 = a + I(0) + I The time path of income is: Yt = A(b + h)t + (a + I(0) + I)/(1-b-h) Stability requires: b + h < 1 or h < 1 b.


Harrods growth model Assume, St = sYt-1 It = k(yt yt-1) In equilibrium: sYt-1 = k(yt yt-1) kyt (k + s) yt-1 = 0 yt - [(k + s)/k] yt-1 = 0 Solution: yt = A[(k + s)/k]t = A[1 + s/k]t (1)

Equation (1) tells us that income increases over time at a constant rate of growth s/k. This is called the warranted rate of growth. It is a rate such that when income grows according to it, there is a continuous equality between savings and investment (i.e., dynamic equilibrium). The warranted rate of growth has the peculiarity of being unstable. This means that, if for any reason income deviates from the equilibrium path (given by the solution), it will go on deviating further and further away from the path. To confirm this, suppose that in period t income is not A[(k + s)/k] t but say, A[(k + s)/k]t + B, with B > 0. Then: St = sYt-1 = s A[(k + s)/k]t-1 And, It = k(yt yt-1) = k[A((k + s)/k)t + B - A((k + s)/k)t-1], So, It > St which will give an additional impact to income.


Second-order difference equations General form: c2yt + c1yt-1 + c0yt-2 = g(t) (c2, c0 0)

Consider the homogeneous equation written as: yt + a1yt-1 + a2yt-2 = 0 (a1 = c1/c2, a2 = c0/c2)

The general solution will involve a function of the form: t where is determined by means of the coefficients of the model. We can substitute yt = t to obtain: t + a1t-1 + a2t-2 = 0, or t-2 (2 + a1 + a2) = 0, where, 2 + a1 + a2 is the characteristic equation with roots 1,2. Case of 2 distinct real roots Solution: yt = A1(1)t + A2(2)t The kind of movement of y over time depends on the sign as well as the values of 1 and 2. The movement will be convergent if and only if both roots are in absolute value < 1. As t , the movement of y over time will be dominated by the root which is numerically larger (dominant root). Furthermore, when one or both roots are negative there will be stepped fluctuations. Case of multiple (repeated) roots yt + a1yt-1 + a2yt-2 = 0 1 = 2 = = -(1/2)a1,

Solution involves t. As shown in the case of differential equations, we can show that tt is also a solution. Substitute: tt + a1(t-1) tt-1 + a2(t-2)t-2 = 0 t-2 [t2 +a1(t-1) + a2(t-2)] = 0 from which: [(-1/2)a1)t-2 [t(1/4)a12 - t(1/2)a12 + (1/2)a12 + a2t 2a2] = [(-1/2)a1)t-2 [t(-1/4)a12 + (1/2)a12 + a2t 2a2] = 0 [since a12 4a2 = 0 a2 = ()a12] Which proves that tt is also a solution. The general solution is: yt = A1()t + A2t()t = (A1 + A2t)t when || < 1 the solution is convergent, since the conversing effect due to t dominates the diverging effect of the multiplicative t. Case of complex roots Two complex conjugate roots, h iv. The solution is: yt = A1(h + iv)t + A2(h iv)t

Mathematical Note Any complex number h iv can be written in its equivalent trigonometric form: r(cosw isinw) by transformation from the Cartesian to Polar coordinates, i.e., r(cosw) = h, r(sinw) = v, with: r2 = h2 + v2 The positive number r = h2 + v2 is called the modulus or absolute value of the complex number. Now, after manipulations, the solution can be written in a more suitable form: yt = A1[r(cosw + isinw)]t + A2[r(cosw - isinw)]t = rt[A1(cosw + isinw)t + A2(cosw - isinw)t] Although this can be manipulated further, lets leave it at this. The expression in the brackets produces trigonometric oscillations (stepped oscillations). Whether they are explosive or damped, depends on the magnitude of r. There is a simple formula connecting r to the coefficients of the characteristic equation: r = a2 (given without proof)

where the square root is taken with positive sign (because r is the absolute value of the complex number h iv).

Since a2 > = < 1 as a2 > = < 1, it follows that the oscillations will have an increasing, constant, or decreasing amplitude according to whether a2 > = < 1. The stability condition is r < 1 (a2 < 1). Example: Consider the equation: yt + 1.8yt-1 + 0.8yt-2 = 0, y1 = -2, y0 = 0

One could compute the successive values of y recursively, by writing the equation in the form: yt = -1.8yt-1 - 0.8yt-2 then: y2 = -1.8y1 - 0.8y0 = 3.6 y3 = -1.8(3.6) - 0.8(-2) = -4.88 y4 = ................. = 5.9 y5 = ................. = -6.7 etc.

We might be tempted to conclude that the movement is oscillatory and divergent. Lets check this by solving the equation. 2 + 1.8 + 0.8 = 0 1,2 = -1, -0.8, then:

yt = A1(-1)t + A2(-0.8)t y0 = A1(-1)0 + A2(-0.8)0 = A1 + A1 = 0 y1 = A1(-1)1 + A2(-0.8)1 = -A1 0.8A2 = 2 A1 = 10, A2 = -10, so: yt = 10(-1)t + -10(-0.8)t from which we can see that, given enough time, the term -10(-0.8) t will approach 0, so we are left with long-term oscillations of constant amplitude. The oscillations are actually of increasing amplitude, but they do not diverge, but tend to a limit cycle of constant amplitude.


The inference we were tempted to make on the basis of the recursive solution, therefore, is wrong. Economic application - 2nd order difference equations: Samuelsons multiplier-accelerator model Ct = bYt-1 It = It + It (0< b < 1) (autonomous + induced investment)

It = I0 (constant) It = k(Ct Ct-1) Yt = Ct + It Substitute: Yt b(1 + k) Yt-1 + bk Yt-2 = I0 Particular solution: Yp = I0/(1-b) Characteristic equation: 2 b(1 + k) + bk = 0 Example: In a certain period an economic system is in equilibrium with (for the sake of simplicity), Y(0) = 0, C(0) = 0, I(0) = 0, and assume that in period 1 autonomous investment increases to 100, afterwards remaining at the same level. Given: Ct = 0.8Yt-1, It = 3(Ct Ct-1), examine the behaviour of Y over time.

Yt = 0.8Yt-1 + 3(Ct Ct-1) + 100 Yt 3.2Yt-1 + 2.4 Yt-2 = 100

(1) (2)

If we want to compute the values of Y recursively, we use equation (1) because it allows for better economic understanding of the process. t 0 1 2 3 4 etc I 0 100 100 100 100 Ct = 0.8Yt-1 0 0 80 336 963 Ct Ct-1 0 0 80 256 627 3(Ct Ct-1) Yt = Ct + It + I 0 0 0 100 240 420 768 1204 1882 2945

which exhibits a tendency for Y to increase exponentially. This is confirmed by solving the difference equation: 2 3.4 + 2.4 = 0 1,2 = 1.2, 2 Yp = 100/(1 3.2 + 2.4) = 500, and: Yt = A1(1.2)t + A2(2)t + 500 Y0 = ... = A1 + A2 + 500 = 0 Y1 = ... = 1.2A1 + 2A2 + 500 = 100 A1 = -750, A2 = 250, so: Yt = -750(1.2)t + 250(2)t + 500 which confirms the monotonically explosive pattern of Y.

The Cobweb model with expectations We have seen earlier that the expectations assumption underlying the Cobweb model is unrealistic. Suppose that expectations are assumed to be formed according to the relation: Pet = Pt-1 + c(Pt-1 - Pt-2), with c positive (negative) according the weather price is expected to continue moving in the same direction (or to reverse direction). Dt = a + bPt St = a1 + b1Pet = a1 + b1[Pt-1 + c(Pt-1 - Pt-2)] Dt = St Then, bPt b1(1+c)Pt-1 + b1cPt-2 = a1 a Pt [b1(1+c)]/bPt-1 + (b1c/b)Pt-2 = (a1 a)/b 2 [b1(1+c)/b] + (b1c)/b = 0 Pp = Pe = (a1 a)/(b b1) Example 1: Dt = 80 - 4Pt St = -10 + Pet

Pet = Pt-1 + c(Pt-1 - Pt-2), c = 1 In period 0 price is in equilibrium, while in period 1, because of a disturbance, price rises to 20. Check if price converges to the equilibrium value or not and how. 80 - 4Pt = -10 + Pt-1 + Pt-1 - Pt-2 Pt + 0.5Pt-1 0.25Pt-2 = 22.5 Pp = Pe = 22.5/(1 + 0.5 0.25) = 18, 2 +0.5 - 0.25 = 0 1,2 = 0.2, -0.8, so: Pt = A1(0.3)t + A2(-0.8)t + 18 P0 = A1 + A2 + 18 = 18 A1 = -A2 P1 = 0.3A1 0.8(-A1) + 18 = 20 A1 = 1.82, A2 = -1,82, and: Pt = 1.82(0.3)t 1.82(-0.8)t + 18 Because the 2 roots are < 1 in absolute value the solution is convergent and price tends to the equilibrium value of 18, given enough time. Because of the negative second root, the time path is oscillatory.


Example 2: Same but with c = -1 80 - 4Pt = -10 + [Pt-1 (Pt-1 - Pt-2)] Pt + 0.25Pt-2 = 22.5 2 + 0.25 = 0, 1, 2 = 0 0.5i (purely imaginary roots, no real part) Pt = rt( )

r = h2 + v2 = 0.25 = 0.5, so: Pt = 0.5t( )

We have convergence since 0.5 < 1. Alternatively, since r = a2 = 0.25 = 0.5. The stability condition is: a2 < 1or a2 < 1.