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ECON6042
:':::;';,
emai I address
Office
: iosephwu(decon.hku. hk
hours:
6:15
- 6:45pm Thursdays
ECONOMICS 6042
M ATH EM
DR.
J.
WU
/ Jan/2010
This course aims to show the interconnection between mathematics and economics.
The cornerstone of modem economic theory is general equilibrium theory based on
optimization. Static and dynamic optimal models will be presented for studying
microeconomic and macroeconomic topics. In particular classical welfare economic
theorems will be covered within nonlinear programming framework in the Euclidean
space R". Such analysis will be extended to more abstract spaces as a lead-in to the
study of topological foundation for static and dynamic equilibrium and optimization
models. Rehrning to the Euclidean space, application of these abstact concepts in the
form of Ponfyagin optimal contol theory and recursive methods based on Bellman
stochastic dynamic programming will be used for analyzing the all-important macro
topics of economic growth and employmen! illustating the importance and relevance of
these advanced theories.
Textbook: Lecture notes for the whole course will be available at my WebCT, HKU
Portal
Reference textbooks:
Olq E.A., Real analysis with Economic Applications, Princeton Univ. Press , Princeton
2007
Stokey, N.L.
E conom ics,
Hoy, M., Livernois, J., McKenna, C., Rees, R., Stengos,T., Mathematics for Economics
2ed. Cambridge, Massachusetts. The
MT
Press 2001
Ljungqvist, L, and Sargent, T.J., Recursive Macroeconomic, MIT Press, Cambridge 2000
Romer, D.,Advanced Macroeconomics 2ed. , McGraw-Hill, New York 2000
Takayama, A-, Mathematical Economics 2ed, Cambridge U. Press, Cambridge 1985
Reference Bibliography:
Akerlof, G. "The Ivlarket for 'Lemons': Quality Uncertainty and the Market Mechanism" , Quarterly
Journal of Economics 1970
Arrow, K. J., "The Role of Securities in the Optimal Allocations of Risk-Bearing," Reiew of Economic
Studies
3l (April l96a)
Bellman,
kE,
Browning, M., I{ansen, L.P. & Heckman, J.J., "Micro Data and General Equilibrium Models"
& Woodford, M. (eds/ Handbook of Macroeconomics, Norlir Holland, Amsterdam 2000
in Tayloq
Capinski, N., Kopp, P.,Measurc,Integral & Probability 2ed Springer-Verlag London 2004
Cass, D., Optimum Growth in an Aggregative Model of Capital Accumulation, Reiew of Economic
Sndies 1965
Chiang, A., Wainwrigh\K, Fundamenal Methods ofMathematical Economics 4ed, McGraw Hill
International Edition 2005
Chow, G. C.,D)mamic fuonomics: Optimization by the Iagrange Merhd, Oxford U. Press, Oxford 1997
Debreu, G., Theory of Value,, Wiley, New York I 95 I
De La Croix, D., Mchel, P.A Theory of Economic Growth, Dynamics and Policy in Overlapping
Generations, Cambridge University Press, Cambridge 2002
Dixig
A K.,Optimimtion
Dreyfus, S.E., Law, A.M., The Art and Theory of Dynamic Programming,Academic Press, N.y. 1977
Farmer, R.E. A.,Macroeconomics, South-Westem College Publishing Cincinnati 1999
R E. Hall, "Tumover
Heathfiel4
to
Hoy, M., Livemois, J., McKenna, C., Rees, R., Stengos, T.,Mathematicsfor Economics 2ed. The MIT
Press, Cambridge, IMassachusetts 200 I
Huang, T., Ilallam., 4., Arazem, P., Patemo, E. "Empirical Tests of Efficiency Wage Models", Economica
vol.65, ppl25-43 1998
Intriligator, M.D., Mathematical Optimimtion & Economic Theory, Prentice Hall , New Jen ey
l97l
J.
Kamien,
and Schwartz, N., Dynamic Optimization 2ed Elsevier North Holland, Amsterdam 2003
l92l
Kubrusky , C., Measure Theory A First Course, Elsevier Academic Press lvfass, 2007
Kusuoka" S., and Maruyama, T. @ds.) Advances in Mathemqtical konomics, Springer, Tokyo 1999
Layard, R, Nickell, S., Jackman R,(Jnemployment Macroeconomic Performance and the Inbour Market,
2ed.,Oxford U. Press, Oxford 2005
Leslie,
D, Advwnced
22 (1988\
I\{ankiq
N .G.,
fuuilibium
Oh E.A., Real Analysis with Economic Applications, Princeton University Press, Princeton, 2007
Pissarides, C.A., Equilibrium Unemployment
Theory,2d MIT
Press 2000
Radner, R, Paths of Economic C'rowttr that are Optimal with regard only to Final States,.Review
Economic Sudies 196l
of
2d,
Romer, P.M., "Increasing Retums and Iong-Run Growth", Joumal of Political Economy 94 (Oct 1986)
Samuelson, P. A., Foundations of konomic Analysis, Harvard University Press, Cambridge, IVIass. 1947
W W. Norton
1994
Silbe6erg, E. & Suen, Wing,The Structure of Economics, AMa*tematical Analysis,, Irwin McGraw-Hill
Intemational Edition, Boston 2001
Stiglitz, J.E. & Weiss,
Review
l98l
merican
konomic
Stokey, N.L. & Lucas, RE. (with Prescotl E.C.), Recursive Methods in Dynamic konomics,I{arvard
University Press, Cambridge 1989
Takayama, 4., Analytical Methods in Economics,, University ofMichigan Press, Ann Arbor 1993
Takayama, 4., Mathematical honomics 2ed , cambridge univenity Press, cambridge 1985
Tobin, James, (selected by) Landmark Papers in Macroeconombs,E dward Edgar Publishing Ltd.
Northampton, Ndass. 2002
Tobin, James, "On the Efficiency of the Financial System", trloyds Bank Reiew July l9B4
Tinbergen, J. and Bos, H.C., ,Mathematical Models of Economic Growth,McGraw
Uz"awa,
1962
H., Optiimal Growth in a Two-sector Model of Capital Accumulation, Review of Economic Swdies
1964
Van, C.L., Dana, R, Dynamic Programming in Economics,Kluwer Academic Publishers, Dordrecht 2003
Vohrq
k,
*Model
Von Neumann, John, & Morgentstem,O., Theory of Games & Economic Behawor, Princeton, New York,
1955
Wan, F.Y.M. ,Introduction to the Calcalus ofYariations and its Applications,Chapman &
t995
Weinstock,
Whinston, A, Moore, J., Wu, J. 'Resource Allocation in a Non-Convex Economy'', Review of Economic
Sudies 1973
Chapter L A.
What is Economics?
Tvpical definitions:
./\
Study of resource allocation,
production and distribution.
-/
Actually want
most
efficient(Optimal)
IU
optimization,
constrained optimization:
l.
changes)
2.
Microeconomics:
Study of individual
Producers and consumers in markets
Macroeconomics:
study of the economy
as a whole
optimizing
macro
micro foundation of
Remark:
But optimization as the main principle to study economics went through stages of
opposition and refinement.
Karl Man
alleviate poverty.
J. M. Keynes wrote the General Theory because of unemployment during the Great
Depression in 1930s which ran contrary to the full employment predicted by
microeconomics theory. The attention shifted from optimnationto aggregate concepts in
the economy.
All the while, classical economics, especially the Ghicago School, went through
refinements and modification. In 1990s, the tide seems to shift back towards
optimization by rational (self-interest) economic agents and the resultant market
equilibrium (G.E. models). Macroeconomics also was swept towards this general
equilibrium framework.
3.
ECONOMIC
-.
A) i)
When
the
functions
t
"*
q*
In other words, there are optimal models underlying the equilibrium models.
ii)
B) i) Dynamic
,*))
equilibrium models:
J,
Pontryagin's Optimal Contol Theory
.,
--L/
II
certainty
with
risk
O..irion Theory
(dual contol)
risks can be J by
learning
(p d. fcn)
Since this is a gadmath econ course, we will also cover general analysis, topology
and set theory to provide a math foundation of such consfiained optimization as well as
most general cases for optimization and existence of solutions. This is typical coverage
of advanced grad math econ]
[C)
MATHEMATICS
- OPTIMIZATION
OR CONSTRAINED OPTIMIZATION
CONTINENT
Leibniz (1646
ENGLAND
- 1714)
of
t0)=o
of brachistochroneproblem
(minimum time of sliding object from 0
p under Savlty g
(which is a dyn opt problem)
,*?
I
P. Mauperfuis, Euler noticed that many phenomena in Nature occur in the most efficient
and most economical (no waste) way. Based on this metaphysical realization, Euler
established general principle to study all these simplifying, economizing phenomena in
Nature
developed into a branch of math in1744 called Calculus of Variations.
Principle
I
I
I
bubbles
Water droplets
Geodesics
Hamilton's Principle
Soap
calculus of variations is a
t
I
NATURE - OPTIMIZATION
INTERCONNECTED
MATH
ECON
Chapter L
'T*
16m
Century
-max Exportl
*"
Mercantilism
-min Import.[
-Classical Economics
Adam Smith
1776 nu rNeulRy tNTo rHE NATURE AND cAUSEs oF THE wEALTH oF NATIoNS
lffil*
l(nade)
social optimum
I
& growth
David Ricardo
1817 Principles of Political Econ
the
Rent
"{.'
& Taxation
",
\
mparative Advantage
@. Krugman 2008 trade pattems basod on econ of
scalg location. But still compamtive advantage?)
Thomas Malthus
John Stuart Mill (state as "civilizer", forerunner of macro),
Edgeworth, Pareto, Wicksell, Walras
Karl Marx
Das Kapital
-Neoclassical Econ
Alfred Marshall
1890 Principles of Economics
-Util max and profit fi max
/
A. C.
Pisou
,/\
tvt*uritd"ti"
of all i's
util
*l\
J. M. Keynes
Robbins
vs. L.
1936 General Theory of Employment,
I
(Pigou incorrect : as cannot'
Interest & Monev
have interpersonal util
comparison
MACRO _
Pareto Optimality
P.O.:
\
situation where no one can be made better off
without somebody else beingmade worse off.
Thus avoiding problem of interpersonal
utility comparison
MICRO _
view from each market and then add
up to whole economy.
I
I
Micro Development
I
MCrl\
r/\
Theory of Consumer
Given:
Theory of Firm
yrN)
yj vector
each consumer
tvlax
each producerj
tI, (xi )
Max
Vi
rc1
= Max
s.t. production
pnyjo
lonstaints Vj
s.t P**in(Incomei
constained optimization
I
j's
terms of given P
ri
[P*, x*,
y*]
Max
and
ri
s.t. production
P* clears nft
sst
market
Vj
V nft markets
Then [P*, x*, y*] is called a General Equilibrium GE under Perfect Competition
OR a Competitive Equilibrium C. E.
I
(:
Theorem of Invisible
t
t
1ra
1'6f-0
Policy implication: explains why laissez faire (each agent left to pursue
his own constrained maximization) leads to social optimality; why
decentalized (as opposed centralized planned economy) is "good"
because it is Pareto optimal.
|4ko20
(Welfare Economics)
if market
Coase
rrotp.reri
(1991)
G. Stigler (1982)
M. Friedman
A. Director, Coase
no perfect exchange no perfect information properfy rights to
:) Transaction cost in real life
clarifu 1) incentive to
:> information cos! use Price system
Coase Thm: if TC:0
CE t P.O.
search cost to set
(laissez faire &
Properfy rights to
information
decenfralized market)
clarifu externality problems
2) externality (Coase
Theorem)
F.Oshom (2009) common propty
Rb can be managed by group
O. Williamson (2009)firm as
structure to rcsolve conllicts
if no atomism
facing J sloping D
facing fsloping
sc
not P-taking
?
PX
,/
b.Aa..6
pncmg
non-pricing behavior
to compete
packaging
- sales promotion
u
Generalized Neoclassical Micro Model (incorporating real life features)
P.O.+C.E.
But calculus proof
I
I
C.E.
P. O. globally
General analysis & set theory in math used to extend results from Euclidean
o
space R to more general topological spaces & provide proof of solution
existence.
il
rtft.A.0
t4 6cQo
How about risks?
/_
Theory
Game
=_\_-*_
Decision Theory
(esp. B-School)
Von Neumann-
@ayesian, adaptive
Model )
Expected
Morgenstern VN-M
VonNeumann 1928
Zur Theorie der
Gesellschaflspiele
Utility
&
then
C.E. still + P. O.
even under risky situations.
Qualifications :
asymmetrical information
Stiglitz, Spence, Akerlof(all 2001)
Ttrring remains
hero to
By NATIIAN ilfYHR\rOtD
irtually all comPuterstodaY, from
WORLD WAR II
HtS COLOSSUS CRUNCHED NUMBERS FOR BRITAIN IN
.: a!.
'
ffiffi
j:
*'
:!E5
:l-\
'
theorv: The 1997 Nobel Prize in
to'
Economics was awarded
eame theorists, the seventh
iobel Prize that grew out of Von
Neumann'b ideas:.
:l**'d:'fllfJ',i:;f
*HT"'"",JI:
sruoY
BorntoprosperousJewishparentsincalcu|ations_donefirstbyhandand|aterby
primitive electronic computers-required to
vun N"u."ni w"i a
Budaoest in 1g03,
ittiiJiroaiey who could divide eight-digit design,the bombs'
After the war, he returned to the l^.s.
age iix,-lEarned'
nur"Ulri in'[,is f,eaa by
jndamuiea
became obsessed with computing' von
and
nis
;;i;;ilt-;; "LL "igt t
vision for the machines went
phone
Neumann's
at
a
parents' friends by glanclng
tasks for which
book and reciting wnote pales verbatim. beyond the rote arithmetic
d::g!:9:.L}t idealized
Mathematics quickly oecanie the {ocus of they were o1iginally
computer, thJsaml memory units that held
his studies, culminating in a Ph.D. from
104
1999
Strangelove.
MACRO
Agg concepts C,I, G, T
Samuelson
(1
970), Robinson
Stone (1984)
parallel development
GNP as measurement of
national income, measurement
of C, I, G, Y, L, M etc
ECONOMETRICS
(Econ + statistics)
Tinberger (19 69), R.Frisch( I 969)
Klein ( I 980),Kuznets( I 97 I )
Haavelmo(l 989 Identification Problem)
Samuelson' s Keynesian Crgss
lz +5U Lts+kl
ctt th
(,r,Q t
+*
1 ,EW
;
u-{4*r*(
Y.
Tac;{
letg:0 )equilibriumYe:C + I
t Y- C : I
defineS=Y-C butY-C:I
I I: S
get IS curve
ws
1950-60
IS-LMfremework
Aggregate D
i Aggregate S
{}
u
1960 Growth Theory (=tper capita Y &lor Yfrr".ploym*t by
technological advances and labour productivity increase education/fraining)
Inflation, unemployment issues (esp. Phillips Curve and later
Friedman-Phelps (2006) expectations-augmented Phillips Curve)
Friedman Permanent Income Hypothesis (expectation)
U
r970-94
1930-60
Dynamic l\dodels (with time dimension) for both macro (e.g. growth
models) and micro intertemporal models, mostly using difference &
differential equations and calculus of variations.
OPIMON
DECEMBER 3,2008
71u2009
Lia4
Page 2
of2
',,
.
argument often made is that these institutions had huge numbers of complicated ciaims, and that the
bankruptcy of any one of them would have 1ed to contagion and systemic failure, causing scores of further
banh-uptcies. 41G had to be saved, the argument goes, because it had rillions of dollars of credit default
swaps wrth J.p. Morgan. These credit default swaps acted as hedges for tillions of dollars of credit default
swaps ttrat J.p. Morgan had wi*r other parties. If AIG had gone bankrupt, J.P. Morgan would have found
itself unhedged, putting its sAbiliry and that of others at risk.
parties rather
This argument has some validity, but it suggests that the best way to proceed is to help third
than the disftessed company itself. In other words, instead of bailing out AIG and its creditors, it would
have been better for the goyernment to guarantee AIG's obligations to J.P. Morgan and those who bought
probably at much
insurance frorn AIG. Such an action would have nipped the contagion in the bud,
smaller cost to ta:cpayers than tire cost of bailing out the whole of AIG. It would also have saved ttre
govemment from having to tnke a position on AIG's viabiliW as a business, which could have been left to
i Uuot *prcy court Filally,'it would have minimized concerns about moral hazwd. AIG may be
responsible for its financial problems, but the culpabiliW of those who do business with AIG is less clear,
and so hetpile them out does not reward bad behavior.
prices
Similar principies apply !c the housing market. It appean that many people thought that house
premise.
The adjusunent tc the
would never fali nationaily, and made financial decisions based on this
new reality is painful. But past mistakes do not constitute a market failure. Thus it makes tro sense for the
govemment to support house prices, aS Some economists have suggested.
Where there is arguably a market tailure is in mortgage renegotiations. Many mortgages are secwitized,
and the lenders are dispersed and cannot easily alter ttre terms of the mortgage. It is unlikely ttrat the
prcsent situation was anticipated when the loan contacts were written. Government initiatives at
Mr. Hat is a professor of economics at Harvard. Mr. Zingales is a professo: of finance at tle Chicago
Booth School of Business.
Hanlon's Razor: Never attribute to nalice that which can be adequately explained by stupidity.
dscott,s corollary: The line between malice and stupidity is called depraved indifference'
?6J
'- ----4'
- /r ,^nnn
Dynamic econ
- optimize
1960- present
Remark: most analysis relies on function differentiability, hence opt are local results;
with present-day powerful computers, computational iterations &/or approximation
algorithms are employed to estimate functions, whether differentiable or not.
Pontryagin Optimal Confrol Theory
(for both continuous & discrete cases,
mostly m4thematical econ)
-l
under
ce@inty
Principle of optimality
tlll
recursive
models
stochastic models
just frnd steady state dynamic system (equilibrium) but theoretical models
with equil described by stochastic processes over different periods fiust like real life
economic behavior). But many times, such problems are analytically insoluble or
have no evident closed form solutions, or can only be solved by common sense, or no
standard solving procedure, &lor can only be approximated by some algorithm
So now not
sometimes.
Summarv:
Mercantilism
I
Marshall
Pigout
-Keyn"s
MICRO
Theory of Cons. D Theory of Firm
MACRO
GE model
-r
CE +
PO globally
PO locallv
Applied P Theory
esp. Chicago School
realJife features by relaxing
compet and perf mkt assumptions
Generalized Neoclassical Micro Model
RISKS???
Stochastic models
Game theory
Decision
+LM
(usual undergrad)
+AggS
Agg D
1
I
to*l
Rational Exp
Towards GE model (Op$
Dyna mic optimizationrnodels
Discrete time
,/\
case
RISKS???
Stochasticdynamicoptimization
Chapter I.
C. Unconstained
Unconstrained
functionwith I
indep variable
-/
\-'-{
multivariate function
_/\ -/\
y: (x)
n indep
vbles
y : f(x1. x2,
2 indep
vbles
Y: (xI, x2)
I
max
Optimization
y:
f(x)
max
II
y : (xr, x2)
y:
f(x1, x2,
max
(without matrix)
(with mahix)
consfrained
,1,
----4\
equality
constaint
2 indep vbles
max
f(x1, xz)
s.t. g(x1, x2): k
y:
(without matrix)
(with mafrix)
m inequalify
constramts
vbles
max y (xt, x2,
s.t. g(x1, x2, "', xo)
'.. , xn)
:k
(with mafix)
max y
S.t.
xi20
i:1,2,
j:1,2,
(The most general case
programming section)
will
i)
Unconstained optimization
Optimizef(x) x
with
1 independent variable
solution x*
[r-21
In case f " 1x*; : 0 at critical point x*, then we need to have successive derivative test,
We must keep taking derivative at x* until we get a nonzero higher-order derivative.
lf
t'\
--\
odd-numbered
... .)
g*, ...)
then
I
I
x* is an inflection point.
and
ll
>0
x*isa
x*isa
relative max
relative min
RMK: For a rigorous derivation of the l't and 2od order condition using Taylor's
please see Silberberg & Suen or Takayama [985].
series,
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A firm wishes to max profit n(Q) defined as Revenue R(O - Cost C(0, & given
R(Q) : 407Q - Q' ; C(Q) :Q' -lQ'- 50 where Q: outputquantrtyofthe firm.
-Qt - (Qt-3Q2-s0)
Maxn(Q):407Q
:
1o order
4o7Q +2Q2
-Q' + 5o)
dn(Q/dQ:407 +4Q-3Q' :
3Q'- 4Q-407
Q*
or -
'.'
da(Q)
/ d Q :407
2od order
Tt"
+4 Q-3Q'
407 +
4(37/3)-3(378)2
:0
condition at Q*:
(Q):4*6Q- 4-6(3713):-70<0 )
localmaximum
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set
zx
:3*-36x+81 :0 t *-tzx+27:0
t
zy:3t'+l2y-36:0
t
23
4 critical
x*:3
points (3,2)
(3,
l2(l)
or9
y'+4y-12:0
+'{Wnt
: {12+ 6} 12: 3 or 9l
[x:{+12
-6) (9,2)
[y:{-4+{
16
{-4+ 8\ /
2:
4(rX-12)| t2(1)
2 or -61
(9, -6)
zw :
z,u<:6x-36
*y:
y* :
z*"
(3,-6)<0
zr,
points
6y+12
("
*)' :
relative maximum
for (9,2)
relative minimum
for (3, 2)
z*"(3,2)<A
zo (3,2)> 0 (different
signs)
&2"*zw:(-1SX24)
-432<0 :
("*)'
@)
saddle point
for ( 9, -6)
z *" (9,-6) >
w:
(18X-24)
-432
( 0 : (r r)'
saddle point
Afirm's
revenue function depends on its two products a and b and is given as:
za :32-2a+2b :0
26 :2a -4b+16:0
a*:40
b*:24
zaa :
zab :
-2
26 : 2 t
("ua )' :4
zM zbb:G2)(-4): 8 > 4:
Hence revenue is maximized at a*
revenue z
(40,24):
32(40)
(zuo )'
40
*:
24 and
n:2
p2
independent variables,
independent variables case):
Assumption: below multivariate function f has continuous partial derivatives to any order.
ls
fi
2nd
: 0
Vi
order condition: (using Taylor series and sign definiteness of quadratic forms)
IlfiitFl:o
r-r
t-r
dxi
d":
da
da
if [F] < 0 then negative definite (f stictly concave) and we obtain local maximum.
and ltr] > 0 then positive definite (f strictly convex) and we obtain local minimum.
We can see with the many combinations of i, j when n gets large, the terms becomes very
unwieldy. One way to overcome this is to use linear (matrix) algebra.
Remark: A formal derivation of the l" and 2d order condition can be found in Silberbere &
Suen [2001] and Chiang & Wainwright [2005].
n independent variables.
optimize
f(xr,xr,...,xn) )
atsolution
f* =(x,,*1,...*l)
1$ order condition:
vector
x' = (xi,*!,...*l)
i=1,2,...,n
.f,(7')=0
2od order
is such that
critical point x.
condition:
matix
H:
a'f a'f
ax? &r&,
azf
azf
&,&o
a2f
*,7'
&r.&"
a2f
a2f
..--;
&n&,
Ax;
2oo order
with
Chapter I. C.
We mentioned at the start of the course that resources in the economy are scarce. We also
cannot do anything that is technologically impossible &lor we are bound by existing sociefy's
property right structure. So when we optimize we will be constrained by resource scarcity &/or
tecbnology &/or some other conditions (like private property rights consfaints whereby you
cannot just take other people's resources without making proper payment).
In particular, if optimize linear functions subject to (s.t.) linear constaints, the math
programming is oalled Linear Programming (LP). The most general case is Nonlinear
Programming where both objective and consfaint ftinctions are nonlinear.
zc(y)
Rn
Rn
ft n
s.t. technological level and inputs/labor availability.
Max f(x, y)
s.t. g(x, y) :
equality constraint:
h(x, y) so we will
(x, y,
rl:
(r,lv)
constraint
(k-
* t t k - Jf*, ,ll
t
g)
IAA) tk - Bl :0
[k - g] :0 so optimizing Lagrangian = opt original
BB) The Lagrangian is unconsfained
we can apply the unconstained
CC)
Max O (x, y,
I) : (x, y) + l,
Ik
g(x, y)]
@r
:0 (= k-g(t,y):.0
whichisjusttheconstraint laftersolvingforx,y,l,fromthese
Interpretation of the Lagrangian multiplier l. : at the optimal level, l.* shows the approximate
change in the objective function when the constraint is changed by I unit.
We can derive the 2"d order condition for oonsfained optimization but this again involves many
different combinations of partiats and cross derivatives like (Dii , (Dtj as well as solving for
simultaneous equations in the 1$ order optimization condition, all of which can be handled more
easily with mafix algebra.
Usual econ examples:
s.t, prx+pzy: t
x , y commodities
1o order
Q*:2x+5y-21,:0
@r
: 5x + 2y - l" -0
@l -100-Zx-y:0
(rfiiohisjusttheoonstraintlaftersolvingforx,y, l,fromthesimultaneousl$order
condition equations, the constraint is automatically satisfied at the critical point)
atthecriticalpoint(x*,y*):(10,80)
{J*:(10)2 +
see
constraint
y:
x+ y
191
8x
101
:10x
10,500)
:211.05 = 210 :
,F
Optimal Lagrangian multiplier /' x tells us if we relax the consffaint by one unit, the optimal value
of the objective function will change by L x units.
For programming (constained optimization) problems, we often times use a value function V (x, o)
where x is the endogenous variable and o the parameter. Value firnction is defined as the optimal
value of the objective function given the parameter. Hence in the above example, O is the
objective function, x,y are the endogenous variables and consfiaint amount 100 is the parameter.
Then
:
V(x*, Y*, 101) :
V(xn, Y*, 100)
10,500
10,7I1.05
In this context, the Lagrangian multiplier 2 * is the imputed value of the consfiaint.
It is the maximum amount that the optimizsr is willing to pay to change one unit of constraint (i.e.
the shadowprice of the consfaint).
ln the above example, we used equality consfraints (in the budget conshaint case, flris means
the consumer will use up all his income). We will extend the case to inequality consfraints.
Alternatively,
Constrained optimization
in terms of linear algebra.
Optimize
I equality constaint,
f(x,,xr)
s,t. $(xr,xr) =
k:
constant
- gix,, xr;)
note = 0
ls
order condition:
-)
set Or=0
0
@r=0
Oz =
(xi,x])
fNote:O^=0 )
+g("rr,xr)-k=0
=+ constraint is satisfied when solving simultaneous
equations]
2n
order condition:
setupborderedHessian
1o1=13,,
andcheckat
(xi,xi)
if
llt-rJ=1"-l
\
if
"
is a locat min.
=+(xi,xi)
is alocatmax.
t )l
\
\ J() /
.-o
dH
oo
6.o
adl
o6
Ec
.eI
6E
3
&;- bo
'D
e'
_b6
.*oo
,>,
trEq
o=
r0
.9
R
#E
r tx
h,
i
EE
6==
e
6
e
-6d
EH
Eg
n.:-^ 9!
nS!';E
"lp
EF
E
h
;XF EE
8E
JJ;
^
>
6lio
r*
'-'??Al qtgF
r{
;Y-; & ,$,
?
p:
\\rl
e--,^
e
t s$e T
rR*s
'-lt ra
:
:3
=F'6
aa
E ed"edd ;;;
:,S
H;
'Et
'e*
rtsi
R
.H;ti
EE
tr .9 " E: o
#3E
rEf
5H#.E.EF
g
g H5
j s iEs I
E Eg i:
E!gH:E
P
0
"
;E*H,q {
EgEEEi : ^g
sflsse-$ * (}E
JS
9lPPFoo:
;
EE$TsE rg
.8.6;PE ,: !
s.EE*,a'f , 3.-E
FFi{: { SrE
*$qf!" s*: $E
E EE;#:*
E#
E'q.eiE .R
E E6;EEB
"E R
'H 5
H
i gcEsF E iE
-
ls
&
m\
> -Jl
tr
3
60
bo\\
^
:*-qe,e
ry
< d ,. ,. bo v
{a
dd dd
|t'lJ"
::
ge
\:t
lJ
Ag
''
^"
J<
dll
6a
t
Ix
,Og
;d"
+
e*
ll
c.5E
bo,Og
.:
'st
s 6 s..
-d
u- A a.'...]t/
c>6So
tl
rf
;
II
1i
x
.ta
..9
'F
x6
o5
.o=
E=
tr:r
o..
6$o
n rl
'rj:?
EF s'o T
k:
xo
-12
l3::
Bordered HessianlHi=
orn
9r
or=
lo"t
lt,
8z
o-
g
9n
o
|'n
ls,
ls,
l'tolon
))
8r
lo
8z
constant
Ez
8n
@,,
Q^
@rt
orn
Ort
":
@rn
o*
lo order condition:
set O,
2"o order
if
lH-,1,1H,1,...1tr,1<0
x.
=lHi
nositivedefinite
+ tocatmin
if ltrrl t
O,lFrl
alternating in
sign+ lHl
local max
if
negative definite
c)
*{
wl
u4, f(*,rfIr-'-'r-i)
(;l', iX C*, ,*r, "', x.) e ft't
l.r\
*n
f,{r,,-*, -- ,y^}+
({
Lxl
i=t
+g
(x,,
--,*"))
ral :
gp
't,'to"*-"'1,^
'8, *0, - -- '$"
(3
o1
,tl
lt+
b o '-o iE'*f,"---.$n
-'g,"X, --ry, ![,, [,o fl,.
'?"
',-'1
'x^ 'e^
9" '_':
{o^
?ffr
h;4*t
l-r
t:T
I
tu I
l"-"tr4' Lt,**t I .,It-,^+"\ -- -
>d ur{t-
tia*t{
\ f,l"tn^*r \ gr-*.
\\
\
(r'.t*-g *3
Gl,"s a.I*at<--
6"^'. I
tS b*oi=4 'f
"
frl
5*- *
k, f *
,t,i-u'&6rt
4;
#'{lc."r&
-- 1"
Kt*
Lrs-{'af
Econornic application
fu\A.
l,[I-(p1x + pzy)]
O":5y -Ipr :0
l,:5ylpt:Sxlpz
@v:5x -l"pr:6
@r:I-(pr" +pzy):O
t I-prx -pzx(prlpz):0
(tlrisisjusttheconstaint)
) x: I / 2pt -
* y: x(p1lp2)
\
I -2prX
l4,l:lu-l: lorr en er | : lo r
0
l@r, Qzz Ez
I
15 pz
o
| *' Ez I lp'
I r = pr , s: = p: )
o,
pz
o
|u" u"
dzt urrl
: 0
ua
I
at'
dtt ullll+
lu,t
( -1) arz
5Pt
Cl)5
+Pr
Pr0
zzz
dtz
50
Pr
Pz
ll
- PtPz
:5prpz
+ 5prpz
: l0 prpz >0
5Pz
'.'
prices
Pr>o
pz>o
local maximum.
Chapter I. C.
iii)
So far we used equaliry in the constraint. For example in the budget constraint case, equality
means consumer will use up all his income. How about the case when he doesn't spend all his
income and save some of it? Then we need to look at inequality constraints. How can we handle
inequality constraints? Answer: convert the inequality constraint into an equality constaint
('.' we know howto solve opt s.t. equality constraint):
Max
f(x)
4-
x>0
s.t.
inequality consfaint
equalitv constraint
tr
x:
X,
x>0case
whens * 0
0 case
when
Noteifs#0
w)
s:0
: s' > 0 *
u!\Ny {b0
{e>
X-
*x7O
:
:
Noteifs:0) x st 0 t corner solution and constraint is bindine.
Subcase I
)turtv.&*)
4 u4 Arfr:afr'^
ah
subcase 2
te)
r
\
MM fC*>
(!,
>(..7_9
xtso
:
Max Lagrangian O
l't
Max f +
?,
[r - r'
........n u
.........12.21
ol,: x-s2 -o
[3.3.]
(interiorsolution.
Casel) if s l0 from 12.2) + t : 0 I
@:f+1,[x-s2]
:f+0[x_s,]:f
: lo
?: ?: %'l
f**
-2 ?,,
-2s
+l
must > 0
(if we want
maximum)
tf *(0-4r')-o+1(2 r)
-4
s2
fx*+27,
>o
.. ..
t4.41
: 0 ) corner solution x* : 0
('.' from [3.3])
and , 2?,, >0 ('.' from[a.a])
) l. >0 t f'< 0 ('.'fromll.l] f'--1.)
Case 2)
if
(Nwd4,.f(*) #xAo
-rr
x*
;c(:o
:+
max
(x)
s.t. x )
generalized,l'1 order
Note above principle was derived using the 2nd order condition
ws are saying if we want
(i.e.
the max
set (H)t o ) then the principle is hue, but this does not tell us how to find the max.
Similarly for
min
f(x) s.t.
x>0
generalized l'tordercondition:
f'(x) Z 0; if
max
f(x,,...,xo)
s.t.
1)
x,
not restricted
to
>0
*fi=0
(-)
Analogously, c&r add slack variables and do the same derivation to get optimum
max f(xl,
X2 ,. . ., X1
)
s.t. tg(*,,'"x,,)>0
of
any n, m
jg(*,,".,Xn)=fi.rnctions
'g(xr,...x")>0
I,(*,,'"x")>o
xi
>0
i=l,"',n
r( )+ir,,ie
j=l
1$ order condition:
(also known
as
*t
O, = fi
f, j g' s 0
j=t
KUHN-TUCKER
and
if
(D,
<0,
Xi:0
condition)
(D^ =jg 2 0
andif
*r,t0, =
For min
f(
1$ order
fu,=0
j=l
and
if
>0, then
x;:
0r, =rg 2 o
and
if *r, t O,then I: = 0
Remark: again these conditions only describe max/min but cannot be used to find the
max/mn.
Show Kuhn-Tucker K-T condition for constained maximization can be rewritten as:
(B) :[Qi:
fi+ I I: jg, . 0
(Bl):[@rj:'g]
Pf:
l.i
0 ;
as
and x'
@i1
Or:0]
:ol
and second part
(Al) below:
K-Tconditionfirstpart: (A)[@1:f1+
Hence
(A)
+ (B)
or
(A)
(B)
And
(A1)
(81)
(B) + (Bl)
x*
L*
Min
C:
Pu
a +
Pu
s.t. his
>K
price ofbread b
a,b
C =
Max
-C
Max-Pua - Pub
becomes
s.t.U(a,b)-K>
]">
and
and a* (-Pu
[K-T-l]
L*(AU*/db)):0
[K-T-2]
u*_K> 0
If we assume
from
I*> 0
[K_T_3]
[K-T-l]
(-Pu
?u*
(AF*/d a) :9
I*(U*_K):O
l.* > 0
'U*:K
Economic interpretation: to min cost, John is at the same time "maximizing" his utility level
by consuming up to his constraint level K.
il4
Max f
(x1, x2,X3,
jg(x1.
s.t.
... Xn)
xz,x...
.. "") ) 0
I :(xr,
xz,
j --1,2,...
,J
We notice
1)
Our analysis so far are characterization of optimum using calculus, there is no known
algorithm for finding the optimum (except in Linear Programming LP - we have the
simplex algorithm based on extreme point theorem.)
Usual method for nonlinear case is to find feasible points (points that satisfy the
constraints) and check Af when A x i ; and keep changing x 1 to hopefully max/min f
There are many approximation algorithms using computers but these are not closed
form solutions. This brings up the question of
Existence ofa feasible point that is optimal? and
Can we characterize constrained optimum for general firnction case?
2)
3)
f, .
jg
of
f(x )
jg(x) > 0 V j ( constraints)
s.t.
Max
Remark: f
and
jg
We show we can characterize the optimality of this concave programming with saddle point
and tle optimal result is global.
Defn: in particular if
xl ,x2
of
-cr)x2 e C
[hence relationship: convex functions requires convex set for its domain]
My teacher the late Prof. Takayama used the Chinese character for convex
a set is convex
if A
(protruding) everywhere
<
I
f(ct x1 + (1 -cr)xr) > a f(x1 ) + (1 - c.) (x, )
[Geometrically, line joining any 2 points on f
lies on/below the function f l
cr
also concave
(but not strictly
concave) finction
If strict inequaiity
{e;
*,
:"
o,,!,{-{)xt
'(a,.'
if - f
is (shictly) concave.
convex function
/r
L'l
f(cr1
x1
6s2
x2 +
f is concave over
a convex set
f(x1
cra,Xn
)>
cr1
L,U
and
0j
Defii: Given a function O(x,l.) = f G) + Itrg(x)1, (x *, l*; is a saddle point Sp of O (x, ),)
if@ (x,l"t) S @(x *,2,*) S @(x *,2,) V_x
V& in the domain.
[Remark: SP means if viewed fiom one cross section, the fiinction
if viewed from another cross section, it's a relative minimuml
If i'g ,Vj:1,2,...
Max
(i.e. x
iff
3
o(x,D:f(x
> 0 s.t. (*
*,
[Tfus tleorem actually points out the important primal-dual result in Linear Programming. For
proof, please see Takayama [985]1.
Before proceeding to more general concave programming theorems, we will look at KuhnTucker Theorem. As a simple illustration, we will only prove the theorem for the case of 2variable differentiable concave functions and one inequality constraint. We will also state the
more general case theorem for n-variable concave firnctions (not necessarily differentiable) and
j inequality constraints and its proofcan be found in Takayama [1985].
Lemma:
For concave firnctions f (x1. x2) and g(xl, x2) with
xl.
xz
2 0; (xr. x2 ) e C c R2
(A)
If /
(x1#, x2#) e C s.t. f(x1#. x2#) > 0 and g(x1#. x2#) > 0
(i.e. no points in the domain for f and g to be simultaneously positive),
then 3 nonnegative weights po.
pr- )
@) firthermore if I
(xrO, x20)
e C s.t.g(x10. x20)
>0
[Slater's condition]
('.'
po. > 0)
(x1.
x2)e C gR2
g(*r,
*r) . 0
(x1,
x2)e C
-cRz
Theorem: (Kuhn-Tucker)
Given f (x1. x2) and g(xr, x2) are real-valued differentiable concave functions defined over a
convex set C c Fi and
If f
>0
[ Slater's condition]
x2)) 0 xr,xzZ0
iff
Lagrangian multipliers
(x1. x2, l")
f(xr.
x2
+ l" I g (xr.
xz
0@/0x;_
f i(xl*, x2*)
xi+ (d@/dx-i-)
xr*. x2*
>
=Q i:1,2
A@/A),.: g(xr*.xz*) 2 0
l"*>0
l,* (ao/a).) -0
Proof: If(x1*, x2*
f (x1*. x2*)
I /
any (xr,
f (x1.
x2)e C
f(x1*. x2*)<f(x1,
x2)
with g(x1.
s.t.
meaning
any (x1,
x2)e C
It,
(concave
numoer,
sl
concave
s.t.
>0 with
concave
xr) >0
3 nonnegative weights
s.t. p0.[f(x1,
ps- f (x1.
po-
po.,
pr. i
0, notboth zero.
xz)-
f("r. x2)+
<
get
*r*) s 0
po,
and
[I-L-9]
po. f (xr,
x2)+
tl-L-gj
g(xr
*, x2*)
> 0 [-L-11]
p1- g(xl,
[-L-10]
[-L-10]
from
x2) S
po-
O, g(x1*.
x2*)
/,=o
f(xr*. x2*)
/r=o
into [I-L-9]
V (xr. x2)e
x2*)
f(x1*,
but pr-
[I-L-l1]
p6. f(x1*. x2*) * p1* g(xr*. x2* ) < p6- f(x1*. xz*
)
.z>o
pz g(x1*, x2*
) [I-L-13]
f (xr,x2)+pr" g(xr.xz)
po. f(x1*,x2*
)rpy. g(x,*,
xr*f
pn.
f(x1*,x2*)+prg(x,*.x2*) [Sp]
(x1,
and
(x1.
x2)+ l"tg(x1,
x2
and given
l.* :pr.
+.
/po- >
0 tsplj
becomes
[SP2] means (x1i. x2*) maxim izes Lagrangian (D (x1. x2, L) while l+ mifimizes the same
Lagrangian (D. And since f and g are differentiable functions then l't and 2nd order condition
for max and min are the same as those depicted by the Kuhn-Tucker conditions (i.e. thev both
I (*r \
\7
Conversely,
[SP2]
i) ifl"* >0
Case
:0
[r-L-15]
g(x1*, x2+)
< f(x1*,
x2*) +
Ir
g(x1*,x2*) Vxr.xz
0 tI-L_141
[-L-l4l
+
t
l"t )
But
) 0<
f(xr
f(x1*,
=
=
*,
xz*)- f(xr,xz)
x2*)2 f(xl,x2)
g(xl, x2)>0&Vx1,x2)
s.t. constraint
s.t. constraint
& vxr.x:)
& vxr,xz
Case
[-L-14]
(xr*,
xz*)
>
g(xi *,
x2*):0
0 V g (x1. x2)
t ],* -0
There are two more general and useful theorems covering conoave programmmg.
i f
)+
s.t.
jg(x)
.. *prspo- ({*)
*pr. ig(d):0
Proof of this theorem uses Minkowski separation Theorem and the details can be found in
Takayama [985].
x0 e
Theorem: if
convex set C
[Slater's condition]
c R.'
iff
)"*> 0
s.t. (x *,
.l.i):
l)
Vxe
V),>
Proof of the above treorem follows from the above Kuhn-Tucker-Uzawa Theorem and can be
found in Takayama [1985]
The above theorems form the basis for showing existence of competitive equilibrium, pareto
optimality and other issues in welfare economic theory which occupied thJ main part of math
eoon development in 1950-1980.
Above analysis is also extended to more absfact level using fourdations of math (set Theory
and math logic, general analysis) to provide foundation of math econ.
We
will
Chapter II.
Math Framework
Microeconomics: principal theory is price Theory and main theme is Adam Smith's
Invisible Hand Theorem (= Qlassical Welfare Theorems)
Adam Smith's Invisible Hand rheorem Iinks equiribrium and efficiencv concepts.
Competitive Equil C E.
i)
efficient in
Equilibriun
Given: scarce resources (if resources are not scarce, no need to study economics)
)
A1.
-.---
resource allocation
A 2. income/wealth disaibution
we
need
Planned
(: s6p6-6;
econ I
allocation by
decenfr alized price system
(Micro hice Theory)
A&
\
m slmplest sense
ifS>Dforsomething
* supplier will supply
pJ
will
demand more
if D>
tleme
ii)
propensity to work
Classical Welfare Econ Thms within NLp framework in Euclidean Spare R":
Economists for the next 200 years formulated his concepts oflaissez faire, invisible hands,
sooial optimality etc., culminating in the classical welfare Theorems with two imDortant
modern day concepts:
AND
\]v
Pareto Optimality P.O.: an economic state (equilibrium or allocation) is p.O. if no one can
be made better off without somebody else being made worse off. (This is to avoid
interpersonal utility comparison which is impossible)
Remarks on P. O.:
1
P. O. is a static efficiency conoept for question A1. Welfare Econ looks at the
equilibrium to see whether it is socially desirable in terms of efficiency.
2.
P. O. is not concerned with the (other) question 42. of income/wealth distribution
(which depends on subjective value judgment). e.g. a dictator may own 98% of the
wealth of his country while the people only own 2%, this situation may still be p.O.
because any re-distribution will make the dictator worse off -- objection to this
42.
income/wealth distribution
party
fiL
\,
47,
optimizing
no incentive to use price system.
333. Also no incentive to preserve resources
without private property rights
i-I)
Then use Edgeworth box of two persons' jndifference curve to prove P.O.
D functions from 1$ order conditions of utility maximization subject to budget constraint.
iII)
i-III)
textbook [1997] )
We will cover the above subjects ftom the viewpoint of the Classical Welfare theorems
n
n
the Euclidean space R (R is a vector space)
Assume perfect competition
1
2.
(l
in
i-I)
Theory of consumer
D:
L li S Wi. :
budget constraint:
utilif'
fti) s.t.
his incorne * endowment
U;
[we assume his utility depends on his consumption ofgoods bundle represented by
vectorl i: (xir, xi:, xi:, ...,xiv) : say (apples, ioranges, 1clothes, 1watch,.....,ipen)
vector p
market price vector (p1, p2. ...,pv),assumeditakesthisgivengandput
into his budget constraint when he is optimizing;
in our example (price of apples, price of oranges, price of clothes, ... , price ofpen).
Since i can only afford bundles x I within his budget, we call these feasible bundles.l
each individual
Max
(D
and from this consfained maximization problem we can get demand function of the
individual, in terms ofprice vector.
}t-ftt,
x
pr,
...,pu)-
i's demand depends on tle given prices and his optimization behavior; and
feasible (i.e. within his budget constraint)
x* will
be
x >i y
x -i y
ifbodr
r -i )L if & only if
x li y if&onlyif
(x) : U, (y)
UrG) >U,(y)
U,
irl'ilrii[
!i
it
rIftil
'
t: t;i+
ai
t- l" t-
li
ti
iiifi!i
ili r
iiiiir
,
r!
tn
al
i!l
;t
II
i'
il
irt
.F
ii!l
I
?fl$ I
:iis
rl
IT
I
!
I
I
a;
t'
rf rl
tt
i i
,r,
5rl
a;iF
:T
i;i:
tl
:f
I
f
I
I
I
I
i f
I
f
t I
$Er
iF
EE
5$ i$
f
!
i{
!BX{
I
t
.;l
i
I
I f t r
r9;
;r
f {t
iti
llr
lI
i ii
iFF
After i solved the above constrained maximization problem given price p the solution
bundle x* (feasible) will be preferred over all other feasible bundles x (i.e. x* L; x
)
i-II)
yi:
stands for his ouQu(s), negative entry stands for his input(s) and
6 ,
i-trI)
We combine the above Theory of consumer D and Theory of fum by first confining
total consumption by all i in good m must be < total production by all j + initial
endowment of all i and j in that good rn, for all goods m 1,2, ...,M.
i.e. feasible consumption s.t. x < y+xo, where x u = initial endowment goods vector.
m:
. .,xir) i:1,2,...,1
j:1,2, ...,J
..yjM),
letx
=i=lLxi
U1 (x11, xi2 , xB
y= IJi
j-l
xl
or
.x
\a
x$,
nf
) continuous and real-valued fimction
"o= Ixoi+di
i.j
,g(x)
vector X* e
if
rult;, ..
is called a vector
maximum ofU(a)
e consumption set
RM
Definition: Feasible {
1 *}
is
.} s.t.
feasible {
for all i, widr strict inequality for at least one i
Pmeto Optimal if
Remark:
U(x):[rU(x),zU($.,rU(x)]
2nd person
consfaint g(l) =
,v
feasible 1
X*
yi
util firnctiol
,v
feasible
$ )0
I y
IT
)0)
2)
hu (ro)
ru(xr),
.*U
2)
1t
y# s.t.
LU(x),rUG#r. ...U(xu)l
(x#) I
with sbict inequality
for at last one i
hu(x.),zu(r"). ..xu(x')l
i.e.
atleastsoms,uftl
/\
[ru(x').zU(x-), .ru(x-)]
| \
,.".
",,*"tsode
I x+ y*] is P.O.
means when feasible
x*
sav
:1r,2,3,41
y."
.g
xt
1*r';1
s.t.
11,
2,
3.01,
4l
lr,
2,
3,
4)
i',
Vi
Econ interpretation:
(CEl) means each i will max his utility at x* according to p* s.t. his budget consfaint.
(CE2) means eachj will max his profit at y* according to p* s.t. his proJuction
set
(CE3) means feasibility ofconsumption and market clearing for each market.
e)
....rU(x);
f x' s.t.
such that (
!*)
see Takayama
(a) >
19
S O( x*
l")
for all
1e X and i" ]
QJ
[1985].
C.E. globally
l)PO
I 2;
equivalant definition
::)
vector rnax
* 8t*n slat"t"
"-a
Q>8but+ 0; l,*>0
"*T-.,_,*^:*)*_l
l
Max Q U(a)
3)SP
1*r
sr"t
',si
s.t.
U(1) +l,g(x)
[by NLP theorem in Chapter I. L. which states given concave functions over a
convex set and Slater's condition, SP ( x* ,l,*) of Lagrangian O(
is
global max for conoave prograrnming problem]
l,l,)
4) If
5)
[16-A]
concave prog problem:
[Conprog 16-16]
d,l is NOT &e global max I : i ..t. U1i 1t U(!*) s.t. feasibility.
Butg>g,q+0 t CU(i) > 0 UG1) s.t feasibility + contradicting [16-A']
i d, y! is the global Irra\imrn for [CorProg 16-16]l
[Pf
Assume
6) By Kuhn-Tucker-Uzawa
concave programming
I,
theorem in Chapter
x*,
y!
..
is a solution of the
.,py* ) >0
s.t.
po*
x'))0
7) from[17-17]
pe*
a zero temr
(A-1)
lSUefs conaftionl
(A-2) Y
117-17)
x#
C.E]
convex set
(A-3)
(A-4)
*,
*> p*x3 # , V
[Cheaper Point Assumption] given 41 p*: 1 4_; # a X; s.t. p*Li
[without this assumption, i may only be minimizing his expenditure but not
necessarily maximizing his utility s.t. budget constraint].
Theorem [P.O.
if
[{rli*},
(A-4)
>0 and{yr*}s.t.[p*,{t*},{yi*}]
isaC.E.
and
BB)
(CE3)
letx:*
1,2, ... , J
tp1(vi)<p1(vi1)
similarly we let
x: xi &V:C
vj
t(cE2)
becomes
vxr',e
Xi anvi=1,2,...,r
[19-191
2 cases:
ifpq*>0,
Uu(xrJ) >UlGr.)
ifps*:0,
)plxl*
If I
* then
p*
Vx-.; e X;
+
Proof: assumep*:0 then from [19-19] p6* Q(d < ps* Ui (Xt)
i is satiated
[C.E.
at x_;
@eductio ad absurdum
proof by contradiction)_
I{
x_,
*}, {g*}l
x o; Ui (x i *
ll
now if [{
)3
) >:
1*}, {1i*}]
iii)
U1(3_1
[{
x-;
*}, {;vi*}]
with
feasibility
Vi
120-201
notp.O.
feasiblefu')s.t. U, (X,')>IJi
is p.O.
o.;
(a_1*)
Ui(1 * )
must be P.o.
p.O.
[193040 Hicks, Samuelson, studying C.E.
(Ref: Econ of Control Ny MacMillan 1944) were
studying the converse P.O.
p* s.t. C.E.l
and Oskar Lange and A. Lerner
) f
03
is
i's
:p*
share of
profit from
01i
(A"5)
Z:
{(xr.
xz.
,xr,y): x
y*+
x0
y_e
4ie X;
Vi}
<
11
iscompact {in
real spaoe = closed (including all boundary points) and bounded (does not go to infinite))
l3
X;
[{
(48) Suwival: 3
0eYi
x1m e
X1
I }, y] e Z
Vi
Vj (togerp)0)
s.t. &oo. *,0 Vr
(^
[Existence of C.E.]
Theorem Ee: Under assumptions (A-1)
(A-8)
Proof
Point Thm.)
In the above analysis, we are concentrating on the theory and making all kinds of
assurnptions necessary for the theory to work. e.g.. we assume I utility function; swvival
and semi-continuiry in above theorem etc.
In order to explain the rationale behind all these assumptions, go into details of some of
our proofs and extend our results, we need proper math econ foundation. Ald we also
need various FP theorems. The next section on general math analysis and topology is
typical grad school coverage for such purpose.
lRemark: For students who want to see a preview of the next section
A) Brouwer's FP Thm
s nonemp4" convex, compact c R" and continuous
s
S
- fixed point xx S s.t. f(x*) : x*.
f: )
)R
Since budget constaints remain unchanged when price vector p is scaled by any constanl
we can normalize p by scaling to get p A ".
Construot use excess demand funotion E(p) to construct a mapping f (p)
p + E(p) .
Such that
and satisfying all Brouwer's Thm assumptions
f: A' ) A'
i by Brouwer FP Thm 3 fixed point p* s.t. f (p*): p* but f(p*) ulro: p*+E(p*)
I p* : p* + E(p*)
) I p* s.t. E(p*) = 0 [i.e. p* will make aggregate excess demand function:01
I - p* s.t. supply = demand resulting in C.E.
B) Kakutani's
FP Thm
X nonempty compact, convex set
R.'
and conespondence
valued, then
(x) is convex_
Chapter II. B. Generalization of math econ concepts using general math analysis
i)
ofreal analysis
For undergrad math econ courses we mainly do problems in Euclidean space R.'. @lease
see footnote below). But not all econ problems are Euclidean. Something as
fundamental as preference is not really Euclidean. Hence in grad level math econ, we
move up to a more abstact and more basic level to work in general topological spaces (of
which R' is a special case) and theory of functions in general (not just real-valued
functions). For instance, we work in a space of bundles of goods (not real numbers) in
which cons'rmers will have a preference ordering (psychological, emotional rather than
real numbers).
Topological spaces .ne math structues drat allow the formalization of concepts such as
convergence, connectedness and continuity. The three main structures we are interested
in are
1. order structure (ordering things so we can talk about finding higher/highest (or
lower/lowest) order for maximization (or minimization)).
metic struohre (concept of "distance" for measurement purpose, i.e. how much
higher or how much lower, how near. We also need metric spaces with arbitrary set X
to show preference ordering can be represented by real-valued functions).
3. linear structure (to add vectors and do scalar multiplication. This is necessary to have
proper consumption and production sets consisting of vectors.)
2.
And of course, when we move from our abstract level back down to the Euclidean level,
we get the usual undergrad defrnition of convergence, continuity of real sequences/series
and real analysis.
6ncttt^l
Footnote:
e.g.
RP space
br'C--,a / E
In advanced undergrad and grad courses, we use vector maximum in R:'space for PO. [x*, y*], CE [x*, y+,
p*] concept.
In proper grad coursies, we can start widl any space like a commodities space - not Rl- and preference
ordering. Then modi$ the space (make it compact etc) so that preference can be represented by utility
function etc., making the analysis both realistic and general.
(;-'
''-'
.....}
1)VxX,3yeYs.t.xE/
y,z Y, xS and xfz )
2)V
Notation: f
y:"
X
domail
codomaio
ffi
Notation:
yx:1f :X ) y)
={Y
Y is a set}, 3 a function g: Y
uY s.t. g(Yl
VY
we just rely on this axiom that we can pick one element from each of the
inffnitely rnany sets in the Cartesian product. This is equivalent to :
1. every n-nary relation conteins a function.
2. Zorn's Lemma which we will cover after introducing order structurel
[ntuitively:
Given set X
The list(X,
if
+,.
on
X ; x, y,
zX.
x+y:y+x ; x.y:y.x
2) associative: (x+y)+z:x+(y+z) ; (x. y) .z:x.(y.z)
3) distributive: x(y+z):x.y * x.z
1) commutative:
i)
1-/T
Vu,v,wV;
veotor addition v +
x,yF
w: Vx !-+V
xv:
---+
2.
commutative: v + w=w + v.
4.
inverse elements
L>l
A,
l.
3. 3 identity element
w):
(u + v) + w.
zero vector
.t1o
V: v+0:v
-v Vwith v+-y:$.
5. Distributive: x (v + w) :
1v
to.
6. Distributive: (x + y) v : x v + y v.
7. x (y
8.
v):
(xy) v.
flntuitively: Vector space is a set of objeots called vectors that can be scaled (scalar
multiplication) and added (vector addition)
Examples: real vector spaces R ' , R ', ... ; in particular R n is n-dim real vector space]
a'l
U,
lvls: : I
:l
a.l
.J
Coorcmate
1!
E : X) X
as:
(Vx,y,zX)
1. Transitive
(T)
2. Reflexive (R) if
xE
E y and y E x
4. Symmetical (S) if x E y I y E *
5. Antisymmetrical (A) if xE y& yE xl x=y
3.
Complete (C)
if
either
called preorder
ifTR
if TRA
if TRAC and
E called poset
)
E ) cailed loset
If
if 3 b Ps.t.
pE
Vp
if
p s.t. a P p Vp p;
and
p.
(X, P ) is just a generalization of (X, >). From tlere we can extend to utility function
expressing such preference ordering.
[krtuitively: we
EI
if it is TRS
::
{y X ; y = x} denoted by [x]=
Application to Theory of Choice in Eoon: [x]= is just a generalization of indifference
curve going though the point x.
[f we move back down to the Euclidean space R.', we get the familiar indifference curve]
),
+Y
y>
y*
y* E-minimalifiyYs.t. y* >
Y*
E-maximalif/yYs.t.
Ey V ye Y I
if yEy* V yY )
ify*
and
y* Y
y* called E-maximum of Y.
y* called E-minimum of Y
Gven
x
x*
a poset
VxX
VxX
The supremum of X, denoted by sup(X), is the least upper bound. i.e. sup(X) is the Eminimum of {upper bounds xi of X}
lnfimum of X, inf(X), is the geatest lower bound: the biggest of all lower bounds of X.
(xt,xz, ....
{x.},
,x.,....) x. X
So basically it's a function f: N) Xwithf(m):x. mN
Given seq(x1
, x-, ... .), take the seq m1 (rrlz (m:
{x * "} is a subsequence of {x,n}
,x2,....
<..
< m.
<....
ofX,
Z!
[Example: a Cauchy sequence in metric space - its elements becomes closer and closer
together as it progresses. i.e. after n terms of the sequence, the maxirnum ilistance
between any two elements becomes smaller than an arbitrary e > 0.
{xJ = 0, v,, 1/3,....1&, 1/m,...) and l1& - l/ml < l1&l + l1/ml ;
as k, m ) co Iim l1&l + ll/ml = 0l tlistance between l/k & l/m squeezed
) no "holes". But since we are talking about distance, we can do this only in metric
spaces which we will cover.
e.g.
Later on, we will look at comptrete metric space M (where all such Cauchy sequences
converge to a limit, i.e. evely Cauchy seq of points in M has limit also il M). And we can
always complete the space by fflling in all the "holes". E.g. given Q which is incomplete
because there are "holes" of irrational numbers like .f,2 and z ..., we can make it
complete by filling in all the irrational numbers.
Metric space l1{ js sorn.pact ifr M is complete and totally bdd (versus S C R " is compact
iff S is closed and bdd so we see compactness in metric spaces works like the abstract
generalization of finiteness due to the bdilness.l
Zorn's Lemma: If all loset in a given poset has an upper bound
elgment-
s.t.x
. , 2)
2 y) x+z2y+"aod if z2 0thenxz2yz
Notation: X. = {x
} 0l
X ={x <0}
X--: {x<0}
llx+vll s llxlr -
X*n: {x > 0}
. , ]),
#;+#
..n>
R has a sup@)
a real number
thl
r*.
Q has "holes"
ii)
Topological spaces
Deft:
let r
1.
a collection
of sets Oi
c X s.t.
@er, Xer
i: 1,2, ..., m )
Ooer aeA )
2. Oi
3.
fli=r Oie
Uo66 Ooe
ln addition, if the topological space (X, r) has a distance (= metric) frrnction d for its
points, then it's called metric space, denoted by (X, d).
Defn: (X, dx) is a metric space if X is any nonempty set and has a distance firnction
d: XxX) Rs.t.
l) d1 (x,Y)=A |ff1:t x,Y e X
2) dx (x,y) + d(v, z) > d(z,x) tiangular inequality
3) d;(x,y) Z 0
a) d1 (x,y): d(y,x) slmmetry
flntuitively, with the distance firncfion, we can talk about how near (the distance
between) any point xo is to another point x in the space; hence we can have notions of
length between 2 points - used to define open/closed intervals ; and
l.
t\
.'.?Lo
, ''-n-lt,
2.
if f
The real line R is a topological space @, t), associated with the metric space (R,
real number system with a distance function (called Euclidean mefic) d(x1, x)
:lxr*xzl(i.e.
,x2))
If
d) of
eR
interval does not include endpoints x and y, then it's an open interval.
includes the endpoints x and y, then it's a closed intenal.
If
interval
CIASt+ tilfe&,A,
o?6t l'^je*lh|-.
P.
On the real line, neighborhood is in terms ofopen intervals, namely,
given any xs,r e R" r>0,the set B"(x6) = {x eR:d(xs,x)< r}
{open intervals around about xo with radius r}.
Open sets in this metric space can then be characterized as a union of open intervals.
fl
I
p.ta',co
tu -+F
tu
nedr*il^;L
We can extend to Cartesian products
6"-(xn)
@ , r) topological
space:
i=1
Example:
(*,y):{G:;:Gfl
K';'l--" *ut,v\
,rc
l'''"
6.tx'\={tt f:a{'";)arJ
(.
3-dim
(R',
d) metric space
u&,>4."t
R-
ebbrc)<ltJ
[We note in the (Rl, d) space, points can be expressed in terms ofvectors.
x.= (x1,x2,....,xi,
a vector, denoted
by
Analogously, in a general metric space (X, d), an Open BalI around a point x
B,(xo): { xeX: d(x,xs) <r} and xois called the cenfe and r the radius.
any x
S,
e (X, d) :
[example: all open balls are open sets, collection of all open sets in X is open. Note open
ball are nonempty because it at least contains the oenhe]
[Intuitively, since we have d in metic space (X, dx), we can define open balls and hence
define open sets. We let t be the collection of open sets defrned in terms of open balls,
then we get a topological space (X, t )l
Since a metric space have these open (and closed set) set properties, we can leverage on
these to move to even more abstract topological spaces. @lease see below)
In addition, in metic
Vne
N++
We write
If
lim
n*
) dx(x6,xsr)<e
{x-}: x o or {x-})
S, then
x6
seq {xo'} is a convergent sequence in
{x.}convergestoxoiffor
'Y
Defir: Given topological
spaoe
sets.
(a,
bl
(X,
),S
Xis
a closed set
if its complement
S " is an
in R,
.), (-*,
a] are closed
x'o in the
1 t
sup
seq
{x.
:m
N}
<
co
B]
Sisbddinxif I
sequences in S convergent in
X converges to a
{y X: fi(x,y)< e
) (!
< .
flntuitively, continuity means for points x close to x6, (x) will be close to f(x6) in the
space.l
f:
Areal function f;
XqR) YcRis
continuous at a e X
R, I V ) R;
(x), then f is
Third way is to define continuity by open sets. This approach is most general and easiest
to gxtend to more abstract sDacs:
-. .- ^-1^:*
f is continuous rn X
ifff -'(W) is open in X whenever W is open in Y
continuity definition is extended to topological spaces as:
f: (X, Tx
To extend this local into a global concept, we need to extend continuif based on
uniformity:
) (l
X with dx(
x, xo)< 6,
s9
Note:
Uniformly continuous functions are continuous but not conversely. (e.g. (x) : 1 I x, x
0, changes in f(x) become unbounded, hence not
uniformly continuous).
2. A function f that is continuous on a closed bdd interval is also uniformlv continuous
l.
on that interval.
[f
we move back to real space R2 with Euclidean distance function ll . ll , then denr of
uniformly continuity becomes the familiar: if for any e > 0, f 6 > 0 such that for all x, xo
Rwith llx- xo) ll l< O
ll (") -("o) ll< t
[Concept of uniformly
continuif
'
x|
Z-dense in X.
2 y, then S
is
>)
(TR). If
Vx,y Xwithx>y,
!z
Ss,!
kr particular, let
---
indifference relation
on X.
Vx,y
Defir: Given
preordered set
U.(x):{yeX:y)x}
Analogous defo for stict upper )-contour sets U, (x) ofx:
U,(x):{yX: y>x}
reln.
Vx
L.(x):{yX: x)y}
I-,(x):{yX:x>y}
In order, to do utility theory in Econ, we need to find the class of preference relations that
can be described by a utility function and then maximize the utility function.
* Sc
Defir: Given 0
Function u:
x.y
S)
itr
R represents
u(x)
on X.
onSif
- u(y) Vx,yS.
If I
is
Note such a utility function is not 1! As any strictly increasing self-map f(u): u(X)
R
can also be a utility function.
.Hence this is an ordinal (order only, noi for calculations,
not cardinal utility function) utility concept.
U
^r-p^.-t--*
Hg) -t'l/'7L
ithei x > y or
T\nt: 0 #
y>x
representable.
BirkhoffTlvn:0
countable
X is a set and
l-dense S c X, then
I )
is
x>y
u(x)
>u(y) AND
x=y i
u(x) = u(y)
range R is
fRichter-Peleg utility firnction: domain X is not completely ordered
completely ordered. Hence there will be cases of indecisiveness or agent cannot compare
the altematives.
Shortcoming: (information contained in Richter-Peleg u) is < (information contained in
>\
Because uG)
us
SetU: X
R represents
[e.g.: givenR",n
) iff
>
itr
2.
Thus
u(x)
ui(x) 2
ui(v) i:1,2,,....,n
=xi
V x R"
if
altemative
x is preferred
Seq{y''}inX)y t:BR
closue of
Defu: (X,dx)andS
x).
s.t.
x)y.VmZB.
through semicontinuity.l
[Intuitively, S is dense in X
f. if any point in X can be "approximated" by points in S,
2. any nghd ofx N .,x(*) contains at least l point from S.l
4
{y X: dx(x,y)<.
space
if X contails
We wish to have metric spaces which are "nice". Separability is .hice". (please see
below Rader's Thn.). Also all open sets can be described as countable sets oi open sets
know all open subsets of (X, dx)
know all its closed &/or connected set
know
all seq convergent in that space
know about upper and lower semicon and continuity.
other properties making a metric space "nice" are compaotness and connectednes;.
@lease see below after Rader's Thm).
is upper semicontinuous
it can
be represented by a
utility firnction u: X
tO,ll
Before covering compact sets in topological spaces, we need to remark on class of sets.
Gven a set X, its power set denoted by 2x :{S: S c X} ('.' if I n elements in
f 2'
elements in 2x e.g.-X: {a, b, c} with 3 elts, then 2x has lA, fu\, lb}, {c},
b},
{a,
{a, c},
cardinality of2x > cardinalig, of X. S
{b, c}, {a, b, c}} 23 8 elts.
Xt
X:
[Cantor's Paradox]:
{S: S isa set} cannotbe a set.
Assume @: {S: S is a set} is a set
[VeltSin2@:> S g @ andisasett S@jmeans2@c @
cardinality
2@ < cardinality of contradicting
So @ = {S: s is a set} cannot
be considered as a set. we can just call it a (proper) class which is a collection
oi
)
I
of
s.
sets.
Defu: (X, d1) is compact if every open cover of X has a finite subset also coverins X.
S e X is a compact subset of X if every open cover of S has a finite subit atso
covering S.
[Lrtuitively, compactness provides a finite strucf,re for the infinite concepts we are
dealing with.
compactness helps to extend-results {iom metric spaces into more general topological
space settings Examples are function spaces that are not metric spaoe;. For
ourpurfose,
it is very important for optimization.l
In oase of R
following thm.
We
will
C(ry
+O
case
lyFwithy
2) if F is Nor
AND )
x* s.t. feasibilitv.
and it is compact.
findthex*Fs.t.
* Z
show that
Fc
If C(F)
subset
>
of)
x ) C(g +
x and
is upper semicontinuous:
is upper semioontinuous
L,
(x):{ y X: x )
cover of F
At the same time we know C(F)
is an open cover
ofF.
Since F compact
FF) C(D+ o
To show C(ry + A
with
x+
is compact:
Deft: A Cauchy
sequence is a sequence in a
)B
mefic
lBRs.t.
d"
[Intuitively:
Thm. A
Thm. If
X
it is Cauchy.
S of complete
completeness but converse not true (e.g. R is complete but not compact
Sc
CK, dx)
> 0, I fuite T
T}
hfrnite
is
discrete
space
bdd
but
not
totally]
[e.g.
s.t.
Sc u {neighborhood N .,;(x): x
Defii:
map
d: X)
K
.1,--
d[e),4@)
rd'"t)
sn..,e
X_
| -- -aQ&)
t,@,4611
--
-cg,
\8'7
Gven
a self-map
&
f :X
4()
i.|
EO
1{
In a complete (X, dv) a contraction mapping has a Mxed point. such a fixed point is
the limit of the convergent (cauchy) sequence defined by the recursive equation x
,*,
6(xJ, n=0, 1,2, ....... This is formulated in the thm below:
x*ex.
) X' l1!
fixed
point d(x*)=**
4en
4@t't)
dtrorlD))
+r,ft
l*t{
t) Qk)
r.
x-1
[The Banach FP Thm does not hold for a metic space that is not complete. The Thm can
also be used to prove existence ofordinary differantial equation solutions]
d: X)
point
(x*): **,
d'
"*
21d 6n+r=
) is a contaction
".
[Intuitively, if the iteration results in a smaller and smaller interval (confaction), then it
flteration is the starting point of recursive methods, difference equation and its phase
diagrams.l
Derivation ofgenera.l solution formula for l$-order linear autonomous difference equation:
xt = bxt.r *
We
a, b constants
xr= bxo + a
x:= bxr + a = b(bxo + d + a
=b2xo+ba+a
[2
1s+a(b+f)
a:
a,
bsx
= bixo
a( bz +
a(bfr
b+
1)
1-bt
1-
(bt.r +bt.s
ifb l1
+ ... + b+ t) {
ifb=l
)
{xo - [a/(1-b)]]b'+
xr
ia /(1
= {t
b* 1
-b)]
l,-
xo + at
Ifinitial condition is specified
tt
+-*tt
[6-6]
1r
(y
t_r)2
of solutions
If
.)
d: X)
t
)
t
on
(x)
E.g.
endowment Wi :
we define an excess demand function
'.'
demand :
f(p)
: ),
i's
@, (p) - W;
(when f(p)
0 means
supply).
we define o (p) = (p) + p and impose some conditions (like some continuity conditions
on f(p) and on concave utility functions, compact convex feasible set) to ensure bv
Brouwer's EP Thm I a fxed point p* (: price vector) where d(p*): p*
+ d (p*) = f(p*) + p* = p*
t f(p*) = 0
This is the FP part ofthe proof of Thm
2. For
if
game theory,
S_
I is
Es
Define
(S):
O,
(S_r)x O2(S_2)t
...,
d"(S_")
to itself
= Nash equilibrium
[It is said that when in 1949 Johr Nash presented his (-Nobel-prize-winning) theory to
von Neumann. Von Neumann's response: "That's trivial, you know. Thafs just a fixed
point theorem".]
3.
an:tio1;
If f is a contraction, then we
g(y): (y)
+c
In general, any topologioal space in which any continuous self-mapping must have
fixed point to said to possess a fixed point property. Note not all topological spaces have
point property, e.g. a continuous self-map rotating the annulus of dougbnut
this
_!xed
(or disc) has no fixed point. If annulus is filled in, then the centre will be the fixed point.
since Banach FP
Tlm
Programming DP, we
theorems.
will
ffi'#ifi;3,Hf*i"ffffi.i,
I
B(S)
and
0<5<l
s.t.
oeaosf
meansfext f+aX
r'
,gXandf
-g)
@(f+a) <O(f)+6a
is a contaction
(("):
max
(x, y) + 6 f(v)}
o<x,y <
0<6<1
with d (x, y) being any continuous mappilg: [0,1] x [0,1]) [0,1J x [0,1]
Note:
1) d
2) 0
{[0,1] x [0,1]]
\set of continuous
(D
O(D
>
(D
(g)
Furthermore
) l ll
=f
fixedpoint
O(f*)=f*
fC[0,1]
max{ g (x, y) +
f(y)} with
<x, y< I
0<6<1
X:, X:c
s.t.
We shall return to our discussion on Bellman Dynamic Programming later. First let us go
through the other fixed point FP theorems so that we can wrap up our discussion on
classical welfare tleorems and game theory.
a:
{all intervals
on
R}.
Lemma: Given metric spaces (X, d,.), (Y, dy) and continuous function
Xconnected
X)
Y.
fOO cormected c Y.
f:
) -
,, . ^-t-^,
^.
Smllarly 1'-'(O2)
nonempty open
cX.
nonempty open f 't(Or) , f -t(Or) must be disjoint (if they are not disjoint
Or anp 02 with
(x) Or and (x) 02 contradicting Or and 02 are disjoint,
-'(Oz)
-'(O1)
hence f
must be disjoint.)
,f
Moreover f -1(O1) U f -t(Or):f -r(Or U Or):X, contradicring X connected
must be connected.
These
) !
) ffi
Actually the simplest FP thm is the lntermediate Value Thm IVT. (= l-dimensional
Brouwer's FP Thm)
Version I of Intermediate Value Thm IVT
(K, d") connected and continuous function f:
R.
(x) <c < (y) anyx,y
latleastonez X s.t.
X)
X)
f(z):c.
Pf: From
tf
,Tl
JI
)l
sl
z X.
llol
f cont & X, f(X) connected
) no break in fgraph and [x, y]
) f going from f(x) to (y) must
go tlrough e : (z) and cannot skip
over it.
fq-)
fG)="
!e>
v
x-
c*__
*3-o^
IVT Corollary
Case 3) f(0) > 0,
ftt<
x*,
f(i) < 1
fcont
J&*)
Real life example inciudes: continuous water evaporation over time, temperature change
or fever over time:
Or lost 30 lbs weight over 15 day
sometime
-w
l.a*
3olh l--
lo t+
l0
t5 )4
Corollary: f continuous
[0,1])
Pl
Case
1)
(0):0 )
Case 2) f(1): I )
s.t.
[0,1]
(x*) = y*.
done.
done.
3) f(0) +
3x*
0t
f(x*)-x*
I (x*;:t*
frxed point.
llx
I.
Any a, b
Above corollary is a special case of a more general FP thm called Brouwer's FP Thm.
Where cont f: S ) S and S no longer: [0, 1].
retract of
[Intuitively, every point of the codomain is a fixed point of the function f. Note R can be
condensed continuously by the foliowing cont f into [0,1] in a way to leave each point in
gr"
[0,1] intact (x) 0 for all x < 0 and f(x) = 1 for all x > 1; for 0 < x < 1, f (x)
"
identify map.
Note [0,1] cannot be condensed into (0,1).1
Metric space (X, dJ has FP property (every continuous self-map f on X has a fxed
point) does not guarantee its mekic subspace also has FP property. E.g. [0,1] has FP
property but (0,1) does not.
If
Lemma @orsuk)
(S, ds) is a retract of iX, d"). (X, dJ has FP property
also has FP properly.
Rn aad continuous
f: S )
(S, ds)
1*.
a0
Pf:
in combinatorial topology).
V:
V:
Brouwer's FP Thm: Every continuous function f from closed unit ball B "
B n has at
least one fxed point.
Lemma @orsuk) fl any retraction fiom B n onto S n't n = 1,2,3, .....
[Intuitively, there is no oontinuous mapping from all the interior poinls of a disk onto the circle
forming the boundary ofthe disk.l
I
Take any x in B and f(x) #x
caa draw a straight line
-r
joining x
f(x) and extend the straight line to cut S " (at the boundary) at g(x). g is a
continuous function: B o
S'-1 and is a retraction, violating above Lemma @orsuk)
must 3 FP x* f(x*). l
Suppose X FP
x*
--
f(x*).
fNotes:
1. Generalization of Brouwer's FP Thm into infinite dimension by extending unit ball in
a Euclidean space to one in a Hilbert space is not true '.' uait ball in infrnite-dim Hilbert
space is not compact. So such generalization require additional compactless and many
li-nres convexity assumptions on the space.
2. Above Thm does not hold for open balls.
Brouwer's FP Thm is used to show existence of solution to differential =.tions,
existence of CE and existence of equilibrium in Game Theory.]
3.
a C.E.
in an exchange economy
i:
1,2,
.....,I
commodities
=(
x1 , xiz,
1,2, ..., J
...,x;:)
xi
rt'* n
. . .. c.ts)
x3, . . ., x1)
pricevectorp: (pr, pz, p:, . . ., pr)
allocation x
(x1, x2,
Ary
neighborhood of x;
.s.t.
u ;(y;)
in
> u i(x1)
[f
prove.l
For a function
2. lxi *: Ii
ci
Define function
difu):
<pc;(budget)&0<x<Q(feasibility)Vi}
Vx R.'* )
This is the most preferred bundle in the feasible budget set : demand by i (analogous to
derivation of demand function ftom the l'r order condition in utility max).
Since u(x) continuous, stictly concave ) d 1(p) well defrned and single-valued V p.
(feasibility)
ITerminology:
the standard (=
6it)
N:
n-simplex denoted by
{(r,, Xz, X:, .. ., *t)
Ii xt-1) ( Intuitively it is the n-dimension analogue of a triangle)
0-simplex is a point
1-simplex is a line segment plus all interior points.
2-simplex is a triangle plus all interior points.
R.':
x1
} 6 66
3-simplex is a py'ramid tetrahedron plus all interior points. (viewed from above X )
4-simplex
Given a regular (n-1)-simplex, pick a new vertex and join it to all original vertices by a
common length edge to form a regular n-simplex.
In topology, simpiexes are the simplest convex sets.
Note: all balls and simplexes
the same dimension are homeomoryhic,
(homeomorphism = topological isomorphism = isomorphism between topological spaces
which preserve topological properties. Hence homeomorphic spaces can be considered
as same topological spaces)
balls and simplexes are same in topological spaces.]
of
l)
For any a> 0,px; < pci E apxi < apci which means dro) = d(a p) because the
budget constraints remain unchanged in the optimization problem when p is scaled by a
in our optimizatlon, we can scale any price vectorp'by letting a: |
p;' s.t.p;.)
newpricep:'/E pi' and summation of all these new prices
(pj' / p; '
1 (i.e.
normalize the price vector) F-9
for the following analysis, we can just use normalized price vector which means our
price vector p {p R" * and p: =1 }
p unit simplex N in Euclidean space.
/\
Ij
):
2)'.'dr(p)generatesmaxutilityinfeasiblebudgetsetsoforanyui(x')>ui(di(p))then
such \'must be outside the feasible budget region with px i ' > p d ;(p)
3) if x;* solves max{u 1(x): s.t. px;3 pc; (budget) & 0S x s Q (feasibility) V i} aad
suppose px1* < pci) by local insatiability assumption 3x;'in neighborhood of x1* s.t.
px 1' < pci and u i(xi')> u 1(x;*) conhadicting x* optimal ) pX i* = pci conshaint
binding.
Pf: by3)px1*:pcr
p Ri*and p. [}(dr(p)
pxi* -pci
:0*
- ci)l =0
p(x;* -ci
Lemma:
t)
Pf:
lim
sequence {
p, } in A'=p,
then
d;(p;
oo
d;(p)
)=0 V i
p.E(p):0
B(p)
XrI (d
iO,
ci
) so Walras Law
We use a variant of the E(p) function, call it g(p), for the proof:
Defrne g
(p):
:p;+max{0, |i(dii(p) -
Note this is a variant of normalization of price F-9, modified to have nonnegative excess
demand of all p.
t
l.
g (p): (er (p), crfu), ...,sr (p) ) is a continuous function by above lemma and also
g,(p) = 1 so g:
)
^^"
^^"
O)
p.i = g:
b)
pj:pj+max{0, }(d,;(p) - c,t)} / (1+I",'max{0, Ii(di-1p) )p: (1lX-'max{0"L(dr.6) - ci"')}): p;+max{0, }(d,:(p) -"-)})
c,:)}
lp;,' max{0, Ii(di.b) - ci,)}):max{O , l(d,:(p) - c;1)} [ff-10]
rib) - c i)} > 0; and we only need to look at cases where
pi > 0 (we restricted ourselves topl > 0andifp; = 0, commodity j is afree good and all
We know that max
{0,
tr
(d
1) max {0,
(d,:(n)
c ,,:)}
and
(d ri(O)
c11
):0
and we have
p; > 0
Ii
(d
m(p)
0 ( if p,n:01m
- c i-)
>
case
2) max {0,
[F-10]
) (tr
and for p;
max {0,
(d,:(p)
,p. >0
(d",(p)
ci.i)}
- ci-)}) > 0
Terminology:
Correspondence
: eachp point ofa setX 3 subset ofthe setX.
3 for multi-valued functions). So now f(x) is a set c X.
(use notation
l:x32r/{a}
If f
(X)
X then it's
For correspondence
Correspondence
xX = f (x)c
a self correspondence on
X.
l(x)is:
convex-valued
2) closed-valued
1)
>
(x*).
Grf:{(,{,y) Xx Y y=f(x)}
Gr
| :{(x,y) Xx Y y |
3!
(x)}
Since now we are dealing with correspondences, we wish to have the concep of
continuity to be consistent with continuity in the single-valued function case: i.e.
if we collapse a multlvalued correspondence continuity to that of a single-valued
correspondence, we should get the ordinary continuity notion. [Intuitively, ordinary
frrnction continuity is a graph showing no breakl. We can do this either by upper
semi/hemi continuity or by lower semi.&emi continuity of correspondence.
('jeuwa.r
\a^ f
+&,t
.?
tl.a!\
$.@q)
(*vt-<{-o..J.a^<t
Ytr-t
*D
And we know that to understand Kakutani's Thm properly, we need to clarify the
analogous concepts of continuif for both single-valued functions and multi-valued
conespondences.
.-.. f
Defir: Given G, dx): f: X) R is upper semicontinuous
Topqlggrg{l qpace
ifforanye>0 3
6 > 0 s.t.
d1(x*,y)<
(u.s.c.)
atx* X
6 )f(y)<(x*)+
e Vyd;(x*,y)
f is u.s.c. if it is u.s.c. Vx X.
Example:
x' foro<x<1
f(x): { 15 forx:1
1-x for I <x
Ofct)
l.>
$ ,r-s.c.
0,5
atx-
,F{
z5=t
aE x!=
X
J.'
t
Given
f is l.s.c. if it is I.s.c. Vx X.
close to or >
f(x*)]
t;,n*
fc*:
v,s.c .
Y\q
F,Of uJ. C,
t)
cert)
'.'
L.s.c.
tcrit)J
(a
In real space:
Altemative defir:
f: X c R') R is u.s.c. on X
if VrR {xX: (x) 2 r} isclosedinX.
= {x X: f(x) ( r} is open in X.
Alternative defu: f X c R.') R is l.s.c. on X
if Vr R {x X: f(x) ( r} is closed in X.
= {x X: f(x)
>
r) is open in X.
X iff
The reason we split the definition of continuity into u.s.c. and l.s.c.:
Most students lmow that real-valued function over a compact set X assumes its max/min
in X if f is continuous by the following theorem:
,v7
bound
infimum:
But actually f only needs to be u.s.c. to get the max and l.s.c. to get the min:
Lemma @aire) (X, d1) compact and continuous f: X
1)fu.s.c.
s.t. (x):sup f(X)
2)fl.s.c.
) I xX
) I xX s.t.(x):inf f(X)
u.
s.
function.
([
In fact
I )
for> iff
X)
R.
is continuous (/u.s.c.)
Terminology:
if l(x) c Y
is compact
xX.
[We leamed the following 2 definitions already. Here we just state them again but this
time in terms of metric spaces:
dv), correspondence f :X 3 Yis closed-valued if f (x)c
Deftr: given (X, dx) ,
Y is closed.
fis convex-valuedl
AND Defn: ifY
and l(x)convex V
(l
c R'
xX,
) f
Thm: Topological
spaces
I f
X and X correspondence
l: X 3l I is u.s.c- inXiff |
General Deftr:
Correspondence
a neighborhood
I.
Conespondence
Y
V open O
(Y dv)
correspondence f: X 3 Yis u.h.c. at x X
if Vopen subset Or c Y with f (x) c6r, I
Given (X, dx)
open set
6 > 0 s.t.
O{o,x(x)) qOr
Alternative Defn:
from
from X and seq{y
: X 3 Y is u.h.c. at x X if any two sequences seq{x
"}
"}
Y compact, with:
Gr
={(x,y)
Xx Y y |
Defn: If u.h.c. V x
then
X e Rl
X (compact) is u.h.c.
if
(x)}isclosed.
is u.h.c. on
[When u.h.c. (and similarly for l.h.c.) concept is reduced from set-valued conespondence
to single-valued correspondence (essentially like a single-valued function), then
fis a continuous function
single-valued correspondence fis u.h.c.
(similarly
Every u.h.c.
for l.h.c.) single-valued correspondence is a continuous
frrnction and conversely.
AND a semicont real-valued function is NOT a hemi-cont correspondence unless it is
also continuous.]
itr
[Intuitively,
u.h.c. at x means small change in x
image set
Alternatively,
l) if move from point x to nearby point x' there will not be any point in | (x') that is not
nearby to some point | (x).
2) as we move from x to nearby x', | (x) will not suddenly contain new points.
3) image set | (x) can implode but not explode given small change in xl
Numerical example:
Conespondence:
f :R3R
:
x<0 f (x) {y: x-3<y<x-1}
x:0 I-(x):{y: ,3<y<3}
x>0 I.(x): {y: x+1<y<x+3}
fNote
Vx*
R I
is convex-valued
Vx: I- (x)
u.A...
u.at
ix *e
R,
is a convex set]
is u.h.c. at x*
Check:
any sequence seq{x
from R
"}
and seq{y,} from R with:
xo)x*;
andy")
limit point
Is limit point y*
Ifyes, then
y*
(x *)
R
?
u.h.c. at x*)
<0
andseqxn)x*
WLOG let x*
ifseq
note y
{y"} r(x")
o) intewal (x*-3), (x* ,1)l
I- u.h.c.
x*-3<y*<x*-1
) y* | (x*)
at
xt
x*
Similarly for
and y*
(x,)
(x *) then u.h.c. at x*
flntuitively;
l-.A.c
d' f=o
*t *1fx"\ *
-:
t
rf
c1
f1-3 ,^.,r
1n-+
3.el-e<".)
o ere)
Numerical example:
Correspondence:
x<0 f (x) :
x:0 r(x) :
f :R3R
{y:
{0 }
Note I]
ris
-h... il z*1o
nt
R-
u,&.c,
aJ
z'x
=o
sfill cnnrrev-',ol"o.l
Vx*R x* *
'.'
x-3Sy<x- 1}
is u.h.c. at x*
same as above example.
But at x*
0 not u.h.c.:
,}> 0 from R
y* 4 |
I I
(0)
not u.h.c. at x* = 0
f
,:
v,c+
qt
L,l..c. or
r-x=o
I'ell
xl
hct u.t.c.
ax
*t
Ye>
T,^
./'"
L.las.
at4o
ltt
I
6 zrz u,j,-c
wf u,Le,
ttat
tn.4,
t,t,c.
fu>
xtr-
t-.t
.c
"t
xg3
e:
hsd,*
t.h.
c"
a.-.* L.A.e.
u+
t
I
vl
fu'.]
"/,2
al
tl
x.>
/,,
el1
r.)tf,,
g
'4|
4xt-s.,-
I"rffi-{
7t
X'1,a
vEt
t''+
v.\
1-
:ft-3eGc**)
'+
rt
>rR
,a.-+t
r -(O)= {xXs.t. f
(x)
nOl u } VOc y
Given
VcpenO G
f: X :i Y is l.h.c. at x X if
VopensubsetOr c Ywith f (x) nor I @, I6>0s.t.
correspondence
Vx'N6.11x;.
l(x,)OO1
ifany 2 sequences
inX
{x,}
andyis
is l.h.c. on
X.
It
is continuous
[Intuitiyely;
if it
image set
(x) to
]hile we are on the subject of correspondence continuity, we cover the following Berge
Maximum Thm.
Maximum
Given
Thm
@ergg Debreu)
space ofcontinuous real maps on
compact-valued correspondence B:
Xxy
3 X; uC(XxY).
IfB
)
S
if(ct
stricdy qu|si.concrve
(quasi.concave
if
,v
[ifu
strictly quasi-concave
,0<cr<l
<-Y 4
d is continuous]
ha.,',r...,k J
[when optimizing continuous real-valued firnction over compact set, and the compact set
is varying continuously with some parafteter vector, then opimal
*iution..tir ri ufp".
hemicontinuous correspondence with compact values
= optimal solution changes upper hemicontinuously when constraint set chanees
continuously.
"cono-i"
Brouwer's FP Thm
Kakutani Fp Thm.
Application:
ln the above Maxm Thm:
Let price vector p R*n (strictly positive Euclidean space); w : wealth/income R.,*
Since budget constraint p xS w depends on both parameters p R++n and w R*and
w9 can lef Y: {(n w)} and q in the above theorem becomes a budget conespondence
B(p,w):
P*'*i 311
Y3X =
ln the above Thm, d(p, w) will then be the demand correspondence, is well-defined (bv
Weierstrass Thm), dependent on parameters (p, w)and d: R*n*l j R
ur in the Thm
can be
y)
R.
Maxm Thm
B compact-valued & continuous correspondence at some (p, w)
1) demand correspondence d(p, w): R.,*"+1 3 R;
compact-valued, u.h.c. & closed at (p, w)
2) u* : {(p, w)}) R is continuous at (p, w)
y:
{ow
is a correspondence.)
Altemative Statement:
Kakutani's FP Thm
Let S be a nonempty, compact and convex subset of Euclidean space. Let | : S 3 2s
be
an uppr hemicontinuous set-valued function on s with the property that | (x) is
nonempty, closed and convex V x S. The I has a fixed point.
Pf:
chapter tr.
c.
If
G(b):
Ro.
X)
W$.
c,
cev'rS**a--'c"e*
**t Lm*gc'
+50
CotL*4-rn-lu*l*
e,"t 3 F**
?E
#F
l
(
tt>)
Application:
Game Theory: strategic interaction (action
reaction/response) of a group
of
players.
Defn: Given
G: { (Xi,
ri)
i=r.2....,p }
x*
is a Nash Equilibrium NE
if
V i:1,2,....,P
and
NE(G)
n i) i=t,2,....p }, NE(G)
is a self-conespondence with
G: { (X1 ,
b is well defined
V xb(x) )
x1
t x
b;
(x-1) V i
NE(G).
Each Xi
O.
quasiconcave
I
)
>
best responses
t
min{ [ z i(yi ,x -j):nt(zi,x
wi Xi
linear combination
b convex-valued.
_;
)]
, zr
(z;,x-; ) ]
1)
)Q
bhasaFP
means
x_
ay+(l-cr)z b(x)
i
)
> r;(wi,
xbp (x_p*)
_1
Kakutani-Glicksberg-Fan FP
topological space:
Thm:
generalize Kakutani's Fp
Given S nonempty, compact and convex subset of a locally convex topolog.ical linear
space. Let
2x be a Kakuteni map (i.e. X, y topological spu""s; y coorre*;
X
2Yis upper hemicontinuous and (x) nonempty, compact and convex V xe
f:
x.)
) f
f :X)
Lefschetz FP Thm: applies to almost all arbinary compact topological spaces. Give
conditions in terms of singular homology (set of topological invariant of topological
space X) that guarantees
a fixed point.
III
chapter
A.
don
f difference
:tion
t
Review
differential
integral
indefinite
-variable
y = f(x)
1't order derivative
af af
dxr
d2y
dx
/ d.*:
f .. (x)
2od order
af
d
dxz
6xo
(xl
t"
af"-"ffi"?*il
af
.x2) = -----
dxr
dxr
+ ____-4",
oxz
I
partial derivative
a2f a2f
a xt2 a
.l
2*
totalderivatives\
Xn)
derivative
dy/dx: f '(x)
l" r19ax
mulfivariale
d(dy/dx)
definite
,l
I
J(x)dx
\
l
----^------,_
x22
azf
o
xo2
a2f
a2f
dy0x2 dxrdx:
iip
^)^
o-r
a2f
6xzdxr
nth order derivative
b xz? xz
a"f
dxi"
nth order cross partials
6"f
dx1
dy dx called,
differentials
e.c.
(0:
8x; 6xr.......
-)
(df(t)/d0
where
-b
(t)
&
is a function
b is a
constant [f-D-9]
(df(t)/d0 / f(t)
) f(t):
exp ( - bt +
tf(t)=ce-bt
(is
:.-bt
Cl _r1l\
"-J
Cl, C2
a
oonstants of integration
cl-cz
wherec=ecl-c2
We can always check the solurio! by differentiating the solved f(t) irr
h'= -b f(l)
dfit)/dr = d(ce-"' ) / d r = c e - o , ( - b) = - b
"
and get back the original differential equatior [II-D-9].
[tr-D-10]
lll-D-l0l:
"
(O
When c is specified
.rtiffit
ffi..entiar
equation).
initial condition
or
solution called parti culzu or deftnite.
boundary conditions
by
+t;^14
g
e.g. spci& P as initial conditiol
lhen AB defurite solution
ifi(rfi;G-"
i.e.f(t)+ :
df (t)
rate of decay (d f
(t)
/ dt =-bf (t)
(a differcrrtjal
fo.l"j
(d L(t) /
dt)
/ L(t) :
Solufion: L(t)
(a!
equadon
wih I{t)
.ce 000,
but no
check:
c rs any constant.
0.09
ce
0.09 119
c:
L(t):
o.oet
( rt11
and
different categorization ofiifferential equations,
each of which has different sorution methods.
ot"titi.o, r"r"tions are not knorm.
f(x)
l-independent variable
df (t)/ dt =-bf(t)
f(x1, x2,
x:,
.,
x,r) multivariate
e.g. 4+
(y-t)dy
+ (4
l+40
dt=
ot
e g. F(y, t)
and
---
dy
dy +
dt (partial
differential
equation)
(dL(t)i dt)/L(t):0.0e
e.g.
dF(x, t)
(aF/ax) dx + (dFldt) dt
(total differential
equation)
e.g. in particular,
if d F (x, t) :
0 then
called exact differential ecuation
infactdF=0 FnoAg F constant
rn dynamics, F (x, t) called a stea<lv state
dy(t)/dt:ke et
'.' highest is
e.g.
d'?r1x;
dy
x2
dx
d,
2no order
2f(x1,
xr)
+ & :5
a xl2
e.g. n >9
aof
+
d xrn
aef
__-_____
* xt :5
6 *un
ox
e1
+ x7 :5
^
{--:-}'r
dx'
a4r1xy
{-------- }t' r
dxo
x7- :)
d5r1x;
1"t degree
3d
*'=
,
-rh
^tr qegree
v
)order ordrna.ry differential equation
!,
t: ;;;;;t""
e.C.
i(0
ji
=9
y+7
are differential
notrerm
(t) =ke5
e.g j,(t):9y2'
ii(t):kes(t+l)
Differential,equatio:r (categorization based
on order,
leading to Cauchy_peano Theorem
)
(only
I "t
order derivatrves,l
f (x1,
x2 , x:
.. xn) multivariate
- partial differential eauations
1$ order
e.s. 4+6i
df(0/dt:_b f(r)
2d order
2od order
a2 F
F(y,
m:massofy
y(t):
ji (t) :
A position
t): -:-
ofy
when A t
A_(A position of y when A t)
when A t
= acceleration a
( v(t)) ro.ce acting on y
|Law
of Motion
F(y(t!: n
a
:hit/+\
differ-rirr"
*/*\o'"
nth order
af
dy + dt
4:t"
lf
tf
(A-l)
6fi/Oui
to
1",
order
order
e.g.Y
e.c.
:cr y
ji (t) + 9iO
l9y(t):81
2od
order linear)
l2
c y(t)
+k
3
bi (t)l :e1i, 1tly1tl1s
"-"-'
)1w
them according
0.
Check
e.g.
if
d2 y (t)
----------
d t2
seeifcanJ[d2y(t)/dt2
d.
ldt
y(t)/dt
i sat
9t +c,
itav(t)lat
lat
: j(st+cr)dt
:
,/Zl- + Crt *
derivative/partials)
check solution by differentiating:
dy(t)/dr
:9De)t + cr= 9r +
:d(gt + cr)/dr :
9 which is the
Application:
Simple Endogenous Growth Model (Let
y:
nationai producvmcome; K
capital)
";;i
I"".;riog.";s
dK/K :
Y/Y
above is a
t iarlr = jayly
t
t
AK
dyrldk
= 0 not <u
then
if
we assume investment
dK : sY-6K
and
K is depreciated
at rate
of 6,
dKi K
:sY /K -AK/K
= sA
butdK/K=dY/Y (=sA - 6)
6t dy/y
as long as sA >
>0 which means national product will grow
persistently and there is no need for exogenous tech change assumptlon.
There are many forms of Endogenous Growth model with varying degree
sophistication. Please see for example Romer [2000].
of
1 Iay6
c(t):c" +c^
I(0: Ie + I^
Y(t): Y. + Y^
Assume
Cr:
16: i
dY^
Yr
c:
Y6
Y grows
Ya
-:---
: k(c+i- l)dt
Y,1
dYa
t I----- : Jt(c+i-1)dt
) In Yr : kt(c+i-1) +cl
cr:constantfrom integration
YA : ekt(c+i-l)+cl
att:0 Yr:ecr
J
Also: Y(0)-Y"
Since Y
ye
(t): Y" + y^
+ e kt(c+i-l) e c1
notek,t>0
(c+i-1)<0
(c+i)<1
Y<
df (t) /dt:-bf(t)
= df(t)/dt
be solv-ed by integration.
"' order linear differential equalion:
w*hich_ can
|
df (t)
as
/dt
+b f (r)
:0
ftnown
of
as homogeneous
form)
The derivation of solutions can be found in nrany math econ books (e.g. Hoy, Livernois
et al). Here we will just state the solutions as rules based on a few categorizaiion. the
categotizafion is by no means exluustive. we remark again that often times, solutions of
differential equations are not known.
l.
dy(t)
/dt +by(t)-a
General
solution:
-lbat (c+
e -Jbdt
(
y(0=
t-<a
Ia"
Ioot
dt;
---
oalled complementary
jlat
e -lbdt ( Jua
dt)
if lirn
t ---t a
"
-ftat
ifferential equation:
0
" = theny(t)dynamicallystable.
e.g.i+4y=16
tben solution by above formula
e -4r (c +J
16
4t dt)
there is constanl c2 of integration
which we lump to constant c as well
: e -4t(c+ (16/4)e4t)
- e
-4t -+ r
- c^ ^
ts the solution
dt : iO
t(t) =d(ce-4t+ 4)ldt: ce-4t(-4)+(0) :_4c
: 16-4ce -ot -16
check solution by differentiafing dy (I) /
e.4t
lim e -Ibdt c:
t --) co
dynamically stable
-__+
2d
j(t)
+ br
j7
(t) +
b2
y(t)
: a
a, 6 ,bz
constants
2 parl
Particular integral
f: b,*o
jfit u, =o
complemertary function
!o=Jt+Yz
It' oo
v,
l;*
rr,
*o
b'1=b2=o
Yr =
Are"t
Yu = Azet"
rr,12
A1 4,2 constants
j
: - u, t.,,6 -16.
----i=----_'
br2
+ 4b"
(and
+
if
solution
y(t):
yn +
b12
4 b2 then
y"
with distinct or
repeated real roots
complex roots
_h
___:! < 0
both
11,
r2<0
ri>0
U
convergent
il
(,. .- e--'--_+
U aS t__- oo)
not oonvergent
convergent
if
O12-4b2)<0
complex root)
t e(
Econ application:
Suppose market price P(t) of computers at time t is adjusted by hvo factors:
/\
2)
tr.^.
)15\r)0
.
Given
>
0),
D(tlldt
"As
6P1r1o"46Q): JP()
p(r)=atD(r)-s(t)l- pllsk)-
D(t)ldt
o, B
[Thm: function
br
b:
- El
-El
\
\
\,7
t,.
\'.
.r
Pc:Ar e'
continuous on closed
interval[u,v]; V
te
F(t): ltfQptl
[u,v],
F
'(t):
f(t)l
- H - Jp(t)l
E)
nore B(G
- J )+
in solution formula
plc-Jt :lHtG-Jr
pp -- PIH
>0 [rrr-D_32]
_ 4BlG _
Jl
Assume (-a(G-.I))t
+ Aze
A1 , 4,2
> lpyC-4>
arbifary constants
P(0: Pp +Pc
, \)\ -.\,i
3. Exact
Given:
ls
d F (y,
steo: check
t):
(0F/0y) dy + GF/A|
&- 0
a2F _ a2F
dtdy dydt
2"o steo:
e.g.
dF(y,0
:4::_dv +$f
+qtJ at :o
[3_3_t]
I\
a-av^{
3d:
fr{+s,t')=ts,t fr{tfr)=ttt =
re-arrangeterm"
ff=+f
lar
dt:0
!+vtay
>
exact
OF=4ryz4
=lr',' *of,l
instead of
constant c
some t terms
lefl
=4v't+G'(t\
ff
=G'(t)=4( + Jc'(t):c(r)=J+t'
tF(y,t)
cheok
ar
ff
+tt
at=
lt'
+ +rt
+c
= 2y2f +4Bf +c
4=4vt'?
fu'at
9l- =4w'
+4t'
sarne as [3-3-1]
1$ order nonlinear
f"/ar)
"rdF))
I
/Ar ir
llql-1E11=rru)' aoo.,h.o .I',,,0, isintefuatine
(A)'lfaF)l-t---ry
(ait.)
^rart ^(ar't)
ol;i
"ltra
,I
_
,.
alone then tJst'xt t integratrngTactor
'-, - aFl ry
^,
a l=sttl
[
avl
r, llc2 J
i,l'
:,
''"
. .. l- .
++{ aompreviouspage
.:
'',,
chcck (A)
, raL%t _at*Ji
jJ'-A
/L. ____:__
|
|
t
4y-*
4*
'c
li-'
r^
/1.,
-|
_ .\6*s l= -+a u
|L r+q
(''r
a fimction not
t,,.L.,,
t-.-L
*tr
rf)tr1ut
'- ad )
-t
)+l
qtr
of y alone
but ofy, t
{y,t),
i.e.
not
{y)
I
I
It
,
- *t0 r| =
tl t)
.=4rr.Xt
=l{ -tr
-a
function of t alone
i.e. onlY involve t
vl
I
^
C
.]
?ttt'lz
lJ- *
)i
lt
^
^ l.^t
(t) =
----
seoaration of variables
If
I "t
just
dx
e8 -;=x-t
ot
*$=,0,
- J[{ =f,ar
xo
11
f
-;;*"' =tt",
xo
t2
+t+
l^ +c,
Sx5
-cr =u
solullon
d(t' * I *.,
* 17 5;
I
-+ t ----;1fdx)1=g
x.1.drl
-
cnecK Dy orllerentratrng
-_+
5.
-.,.]=,*J**(a)=e
')
5 \drl
dx
x"t
-dt =
Bernoullinonlineardifferential equations.
y +p(t)y=q(t)y"
manipulation: set s(t)
) ds(t)
dt
t V(t)
t-
dy
dt
ls
Solution: s(J) :
-J(r-')pdi[c+
i(t-o) q
[qy'
_py]
Jo-n)pdt
(t_n) [q_ps]
don,
use formula
dt]
ll
lylt;1t'-";
in
1.e.
a, b >
f /y = a decreasing function
y(t):
Solution:
a/ [b+ke-"1 k oonstant
-.../.--.-\
1
-independent variable
multivariate
: partial/total
ordinary
first
l:
1"' order
(l$ derivative)
1't order
linear
nonlinear
product
linear
power
I
> l)
e.g. Solow
e.g. most simple
Growth
(no
terms, no
radioactivedecay Model
a: dy/dt + by
nonlinear
a. check
separation
variables
method
of
Io?'
ja;
e'Ibd( (c+
if
dt)
linear
in Solow, solve by
Bernoulli nonlinear
order
: a
Y(t):Yp + y"
5i1t)+brf(t) +
2
-part soln
a
b2
IA
t'=lu
'
4c
1
b2
y(t)
br*0
b,
=0
b,
=f,
+ stability conditions
!o=!t+Yz
br +0
=Q
sucoessive integration
by integrating factor
use Cobb-Douglas
+ stability conditions
2nd
differential
b. solution by
c. if not exact, make exact
I
General solution v (t)
if exact
Yr =
Jz
Are"'
= Aze"'
nth
order
nth order
II.
1$ order
2-dimensional
(2-simultaneous differential equations)
m-dimensional
linear-----\
I
stability using
eigenvalues
nonlinear
I
stability using
eigenvalues
& Jacobian
Remark: We repeat that unlike differentiation, solving differential equations are not
simple and not straightforward. That is why we have different categorization of
differential equations, each of which has different solution methods. Often times,
solutions zue not kno$'n even.
ri(1)
Chapter
III. B.
Neoclassical
Gro*th Model
Ref: Solow, R.M. "A Contribution to the Theory of Eoonomic Growth" eJE Feb/1956
Simple Solow Growth Model (1"'order 1" degree linear differential equation.)
Given
Y1
: F(Kt, Lt )
AF AF
>
AKt OLt
-----
A2F
A2F
AK,,
6L,,
Kr:(:dKt/dt):sY,
Lt:Loe"
ietkt: Kt/Lt
0<s-savingsrate<1
L o : labour at time 0 and is given
r : labour growth rate
[3-34]
t3-3-51
Implicit assumption of this model: since K1 and L l are the same in all model equations
) all Kt and L l are fully utilized
) full employment of both capital and labor are implicitly assumed.
[Standard manipulation of macro growth models: transfer the production function F with
two inputs in to production function f with k t: Kr / Lt ratio:
+ Yt lLt: F!Lt:
also ll
F(Kr
lLt, Lt/Lt):F(k,,1)
f ft 1) by definition of f
by I / L I
since F homogeneous
degree I
of
)dKt/dt:
also
ll
l*
order
ln
[3_3_6]
Lemma:
f ' (k, )
MppK
Proof:
Knowl/L1[F@t,L)J =fGr)
aF al.tf(k)
:
MPPK:---dK. 6K,
Lemma: Kt
Lt > 0 t
Prgof
<
t F:Lt(k)
a(Kt,Li)
a( K')
Ltf'(kt)-----------= L,f'G,)(1/L,) --- = f'(k,)
6K,
dK,
A?F
-ir,rto
ifandonlYiff
"(kt)
<o
ro tabour
a'F a aF a all4f(k,)l a
a(K,tL,)
: -:-[f(kt)+r,r f '(kr)-------------l
---. : --G--, : ---G------)
au, aLt aLt 6Lt 6L,
ar4
ua3-,
=
'(k,)
(K. lln
6L,
/^-4<--=-J
----
tf'G,X- k, )l
a14
:s [f(k1)] - rks
a lsr order
or
diferntirl equation
if
f(k1)notknown
if weknowf
(():
or we don't want to
solvef(\):
use phase
diagram
and
off
particular example
whenF(K1.
Lt ): L, to K,o
0 <q, < I
which is a Cobb-Douglas funotion, homog ofdegree
t f(k,):1/LtlF(Kt, Lt )l :1/LrlL,lo
: Lt o Kt": Kt" / L,*: k,o
K," l
kt :slkt"l -rkt
13-3-jl
-"
Ikr"]
- r k.)
r\t
: (1-ct)[s -rk,{r-"1
: ( l-o)[s -r m(t)]
)
(1-cr,)s:
solution by formula:
--J--
m(t)/dt
m(t):e
+ r(1-o)
-Jrrr-u)dt
[c+
rn(t)
it f-a)se Ir(r-d)dt dt j
f ,rr
f(kt
f(kr)
s f(kt)
04s4I
f'>
f"<
aa.
n')
;J'
concave functi on
equilibrium
whererkr=sf(kt)
when i. = o
7t
<oLc|.J Aga.rll-l
FldD,L-
(@9e- .L.^+t'*
for thase
i agram
&.L
('*D
:e
:e
_
-lr(r-{r)dt
-Jr(r-c')dt
[. +
[c
{(1-o,) s / (1-o)
r}
( e .(ro)t +c2)]
+ c2
(l-o)s)
oonstant ca
m(t)
="
(c
- ro-c,)t
in particular at t =
I ca:
+
m(0)
(l-ct)s
ca+
c2
{s/r}
m(0)
:(1)ca+ {Vr}
{s/r}
since
m(t): k t-"
:;'
1r
r -ct
t3-3-Sl
- e '0-)t
{si4) + {sh}
t-+co
-->
as
t-+
= k -+
l-"rl
s/r=
k t-" -+ 0+
{Vr}
(s/r1 r/(t-"1
t r<t
"
Chapter IIL C. Optimal Growth Models - Neoclassical Grow.th Model using Calculus
Variations
of
P&e,tr)
Euler further deveioped this formulation into a branch of math in 1744 called Calculus
of Variations (to find extremals and form basis for Newtonian mechanics).
Euler and his fe1low mathematicians on the Continent noticed that Nature has certain
general properties that conform to principle ofeconomy or simplicity.
e.g. in optics: Fermat's Principle which as stated by Fermat was incomplete but basically
says that actual path between 2 points taken by a beam of light is one which is traversed
surface area.
i u
optimize
i..;,ft"::
of
coraect path
s
I
c(x)
\'a"t
l\+
variation pathvariation
parameter
pl
p2
tr
I = I Ftt,x(t),i(t)1dt
t6
(t):
(xr(t) ,
x2
(t), x3(t)
...
,x.(t)
ll
AF
- ---
oxr
dt
f'st
AF
dxi
I/d
l_
-y
=0tomakeX(e)
differential dI must
:0 i = r,2, ... ,m
a 2nd order
differential equation.
tr
f
AF
equation
daF
6xi
Oxi
)=0
,i
6y1
t,
the necessary
i=1,2,...,m
rtt)
Given F tt,
x(f, i1t)1
).
,(tJ + rl1t(t)
let
+l
i(,)
x(t):
- to)
+ '"'(to ) (t
- to)t
io+mg@]
= F [t, x(t),
i(t)]
OF lA
x(t6 ) +
(to ) ( t
r'[1,
t,/
l\t,
/2!
r
+ ....
ra
* (mg) + d F /d i
x(mg) + a F ia
define
o1
(.g) * ....
i (-!., - ....
uu
I l+>)
IfF=x
6x =dx13x
(mg) +
A x /A1.
of 5x)
6i:ailax
IfF=;
@g) : mg (definition
a.
oxldx(mg)
=mg
.
1mg; +
01
6 F=(6Fldx) (5x )
+ (aFlai)(6i
""o"tul
t1
'lggsf: tl
dt:0 r larp,"1t1,i611 ot:o
l.t,x(r),i(t)l
"o"+.,
) Jl(aF/dx)6x + (dF/Ai 1o)6il dr =0
: Llno
{(aF
=
JftbFra$me
ll-(a
F /a x)gldt
@F
( inteention bv earts
/a\)
sf
o
f",
but g( t6)=C(tr)
tr
to
lpn' -prr-ltp')
rr,
1 (a F /d
)l ) dr
:0
4n
il
0...
(dF
/0x)
d,/dtt (aFiai)
Euler's Equation
,. <o iun"r"*l='J;ii";il'.'-''
*,
#;ii;bl *h";;i;t=ffi;i;;
(9
Max (ormin)
s.t.
of
boundaryconditionsx(re):aandx(r r ) =b
'
to
,,
dynamic optimization
t;
x:, ...,x^)
.rIrd
F 1t, x,
iI
x:, ...,x,n)
theorem
dl z :
d.
t2 +
to
C
joining points
x,
x (t 6 ) and b
x( t r)
.
>cct)
{r +l?tr
J dL Ike adding up
all points on C and not adding up all area urder the curve.
cet
:
f'dL
<o
: Itrr7T *;ioit
what is the shortest distance between a and b? (i.e. find a line joining a and b
that
shortest length).
We iust solve
'
"rn ;,,7- d t -minimize lengrh of line joining a and b
min L : min f.tt7-
ts
has the
"
F: {l + i (t )2, integrand
AF
(as there are no
dx
d ,l'6Fr d
-t---l :--1"%
\ail
at
dt
t
Step
2: solve Euler's
terms)
Euler's equation
i o at
J alat
) ct : \
0: d/dt[il./(f+ ir)]
t
=
Jt'J-;?;-ar
-cr2:
lcr'
)
12
,,1
ti t.l tr*
1t+ ir,
ilt
el
at
constant orintegration
'*z
= |t-cr';2=11 -c,2;i2
/11- cr2) =i2
let ll
c12
) c=i
^2
i c dt = j i at
>,
c2 constant of intesration
explicit
golimintion. (optimization being the cornerstone of modem econ). ts.g. sorow Growth
Model describes continuous equilibrium growh path based on ,uuirrgrlo.
we now study models with growth objeciive optimization, i.e. optimal
"oo.o-ption;.'
growth
-odels.
trf
Yt: F(Lt,Kt)
Lt
:Jffi
;i""$: A,x:ffif,1ffi#T'o
AF
AF
>
a2F
0
; i;
'
t' = R2,
a2F
-;-;,-;-
'
[3D-1]
1ai'nini'hing."tm lvith
'espect
to each factor)
K,"
"
t3D-21
let
z gross tr = Kr +
new net
assume
Xt :
L1
(1
inveAent
UK,
[3D-3]
in K: *, o, \
: Loe't
Lo = labour
r :
-s)(Yt -pKt)
f I ::
(oc savrns
behaviour)
[3D-4]
t3D-sl
K , I, , Xt, y,
and 5 equations.
L 1 in
forll >0
define
kr= K, /L,
capital: labour
F(Lt,Kt)=Lt f(kr)
yt= yt / Lt
ratio
Lt)o"on"
= f(k,)
Lemma: f ' (k j )
Lemma: Kt
Mppr
a2F
Lt > 0 )
AL:
Lemma: MPPL
AF / ALr =
Proof: F (Lr, K,
f(k,)
:>aF /aLt: )=L,
f(k,) +L, f,(k,)(_Kt/Lt2):(k,)+
Lemma: K,
Proof:
Lemma:
a2F
Lr > 0 1
62Fl6K,2 = o
f,(kt)(_kr)
6K"
L1/L1 =r
Proof: L.=dL,/dt=
NowYl = Xt * Ir
Assume L 1 ) 0 (atways
and(r/Lr ) [3D.6] get
need
Lee'tr =L1
X1
+(Ks + pK,)
labo*); we define
aa
note k1
t=Xt/Lt
t3D_6]
: d(Kt/Lt)/dt :Kl(l/Lt)-Kr(LrrlLt
.a
: Kt(1/L, -Lt(Kr/Lt2)
2)
,1
A _:=lL
-.'- & Lt'
/'"
=:>Kt = Lt(kt +Lt(kr /Lt
:+(kr):
))
kr, xt > 0
->kr:f(k1)-(r+p)k,-x,
[3D_7]
, x 0 specified, equations
Kt, It, Xt , yt )
[3D-7] will be
kt (Kt, L t )
x1
-;
-1
If
- I ) .-- (A
XSolow)
)
constants k s6bv', xs.q6w
and
xs.l.*
from [3D-5]
C**tffan
t(kc)
A;6.4)r<
.r
z4.b dg.Note Kt / Lt :
K sot"* rs constant
(et-=o)
I Yt
and Xr
('. : L,
andXt/
Lt:
(1
s) [f(k
soro*
grow)ng attate r)
r (. Yri Lr=
)-
[i ksoro*]
k s.6*,"
: (r +sI)ks.,.*
t s/(r +sp):
)
K1
k.o,o*t-*
V- cooslanr ,
ksoroo= ''-''! s/(r
-sF)
L,>0.
diffrial lion
t3-lJ
':ttt
Econ interpretation: we see from above equation, an economy's savings rate s and labor
growth rate determine capital size and thence affect the production level.
Solow type growth model was used to explain why postwar Japan and Germany
experienced rapid growth (due to high savings and investment rates). It can also
be used
to explain why high population growth rate countries like India and china have lowerper
capital output growth. we caution that grouth determinants are more complicated than
as proposed by the Solow model and there are many other considerations.
We note above k soto*
) K,:
k soro*
Lt
constant
K1 ,{L I
dL1
soto*
SoLod f*-q
(*t't- \*r;;
(+oF.>
Lt
[Ast-+"o kr-+ksoro*
but
Convefge tOk Solow fOY. lRefr
leb/t9ro]
But in 1950-60 much discussion on growth models and more and more jargons.
For example:
Definition: Golden Age Path - is a ne oclassical feasible path ft i, x 1 ) with k 1, x I both
constant over time t .
) set ofall balanced grou.th paths of(L r, Kt,I,, Xt, Y1 ) satisfying [3D-l]
[3D-2] [3D-31 [3D-4].: set of golden age paths.
Sincekl= constant I kt: dkt/dt:0 on golden age path
) Xsoto* = fG s"r"* ) - (r + p) k s.1o* from [3D-7]
Growth theory was firrther extended to
order condition
fconcavel fft1) - (r + p) k 1 also concave and 2od order condition satisfied. We have
both necessary and sufficient condition for
xi
at every
4
*tx
k+
where
xr:fft*)-(r+p;k*
Econ interpretation: Golden Rule patl to max per capita consumption x, ) marginal
productivity ofcapital f' (k*) : labour growth rate + capital depreciation rate.
X.J
\
PV(X,)
l.-
PV(X,)
X2
n *.n-
xt
L^TgR
,lad-
aeqs s4 71-q
1..$
c'
&rt
tv1
[3D_l_3]
kt , Xr >
Question: Find optimal time path of per capita (divided by population) consumption x
1=
X I / L 1 that satisfies the target of
max
T
J x,
{max total sum ofper capita consumption over planning period [0,
boundary condition.l
T]
,k
Problematic points:
1) planning time horizon [0, T] is crucial because if the two cwves in above Figure
converges over certain time nterval, the height difference between
the 2 curies
have different econ interpretation. So who decides which plan, S_year,
tO_year,
50-year plan?
2) should population exhaust everything on or before T, if not, how much K1 Ia
should remain at T.
3) if r very far ahead, we wi have technorogical changes(computers, more efficient
--^'
production methods etc.), labour changes (better training
aod education; trr"i
affect the factors productivity; also soiio_political changes (from
common to
private property rights, from planned scon to decentraliied
market econ), as well
as X 1 pattern may change (taste, customs changes).
In the.literatwe, always igaore all these points and assume T_+ oo paliooule
.
being all
eligible paths closely approach fixed balanced growth paths
all paths root uuo,it ,u-"
for very long T horizon. obviously math is moie simpiified. Ifnew technology,
til"" ."do problern with new tecbnology incorporated in model and let T+ oo
again.
function ... ..
aggregate production
st
e- pt
co
present generation
rnax Iru(x,1s'ot
o
dt
max
p>o
of
kr ,xt z
[3D-1-8]
k6>0 kr >0
p>0
[3D_1_e]
k;,x1)0
ko>0 kr>0
ofpaths.
{e se.e t}at [3D-l-9] is a dynamic optimization problem which we can solve by calc'rus
of variations.
To apply Euler's equation, the integrand
O:
u [f(k1)
- gk1 _ir 1 s- ot
aodao
) set
6kr
a@
0kt
d
;*
dt
ao
) : --6k, dt
( - -;-
[u
' ( - 1 ) e" et
e-pt
[_u..i, + u.pJ
Euler's equation
''nf -e - ^t'[-u"x,-u'p.l
concave
...
Xt
kr xt
for x,
optimum.
solve for
from system of differential equation, i.,
-Euler's
to get the solution path (kt,xt
called feasible
path.
Assumptions
,i, at k6 , k1
)-
u'>0 u,.<0
(A-2)f.(k,)>0 f..(kt)<0 v k,>0
(A-3) f'(0): * f'(-):0
f(0)=0
(A-4) lim u(x)--+ -o osXt*)0 xq)0 (this is to guarantee
(A-1)
+(&+)
eQt
({&+\
.&"t
&-A
f11maryis: Euler's
ollrerenuat eouatrons:
: -(u'/u")[f '(k,)-
[3D-r-lt]
(o +
p)]
[3D_1-12]
how the two solution curves behave, without actually solving for
k ,,
&
io
.".
Iastt;.
3) Do the same for i 1 :
f,
(meanskl
tastt)andi,
of
steady-state line.
A. Form the k
1-
1 on eaoh side
constantly
dividesthekl-xl
eouations.
i ,: Og
xt
Spooe
k1l
tf(kt)-cr
i, : )
-+
has the
Letk.
g
C. -From [3D-1-12] set
and let k
f .(k"1
p). Note
is a vertical line in the k t - x 1 space in {igure and divides the k , _ x ipace into
,-
regions.
of
B- From^[3D-l-l1] set
crks
<0
"1 s.t.
):(cr +
0<k,r S k. by(A-2)(A-3).
i, i,
kt:
k.r
two
In figure,
lx,
t;,
fork,2 <
{<
IK sz: -Jy-:gltt'
>o
1
>o
and
k"z
+ xtl <0
",
for k":)
) - (c[ + p)J
k.t
k"r
^i3
k,l=f Gg)k"+
crk5a
'x1
<0
)forkl<k"
: i, I :
kr>0
ra
tt: t"r
(L; o srl',4 sIrr-)
*t7o
&tto
I
Jo
I+
ne6"3"cl
J
f-tt
&r*
&,
!_
L,,<a
{(tr). *(tal
(i.:o)+
i.
56,-c *4
xr:e \
i,."
QX 7+.ro
otl ,*1
<---;n
- (.o {::-:::.
f,a
t/
'*
I"est
,/.,
')o
f, x1l
,,,
V,,
(<.
&L
=o
i\
r.,lr!
iF;i|
,,
^\
12\
,
&,r
&,r
the
Depending on initial k o and boundary condition- .k ,' &e arrows will trace out
possible p-aths which describe shape oipath satisfying the simultaneous differentjal
equations [3D-l-l l] and [3D-l-12]
i,
=O
intersecting
k1= 0
steady states
= equilibrium
Chapter III. D. Growth model with nonlinear production and ininite horizon: RamseyCass-Koopmans Model.
Ref:
narnsey,
D.,
T.,
The optimal savings rate in the previous section was originally studied by Cambridge
philosopher Frank Ramsey [1928] who did not solve the problem completely. In 1950s
the problem was revived when gro\4.th topic became popular in macro. ln 1960s Cass
and Koopmans formulated and solved the problem with nonlinear production function
and infinite time horizon. (Cass used Pontryagin Optimal Control Theory.) Basically we
wish to find optimal savings rate path s+ r that max per capita consumption (altematively
society's utility function) till eternity; noting however that more consumption (: less s 1 )
now
less capital now
less consumption in future, & vice versa.
e- pt:
[3-E-l]
[A-1] u'(x,)>0 & u"(xt)<0 Vxr)0 (strictly monotonic & strictly concave frurction)
f"(k1)< 0
V k, ] 0 (saictly concave tuncrion)
[A-2] f' (k,)>0&
f'(o ):0
x-0
lA-51
xt>0 k,>0
Vt
To solve the problem, we start with the finite horizon problem that we solved in the
previous section, namely:
max J'u(x1)e-ot
0
dt
s.t. feasibility
I
aa
e- pt
[3-E-1-A]
and we get feasible Euler path solution from previous section as:
with feasibility
0< k*(p)< k#
where k# is
@)
1co
J u(xr)
e- P'
dt
converges (i.e.
will
be meaningless)
utt&)
uLro)
uptor)
s (x*(e))
aO
-/"
,i@)
, Jo
' .,.
lj-L-l-bl
i,
i
Y_-
i
\
\
\
f@)
,l\
\
point: -\--\' .
, I
l:ou'alel'
otDeve'
....
\.
--'*-*----..*-=,?
rco
[u(x*(O)- u(x t)] d t [3-E-2-A]
....'"''
I
0
-...-"
"
Dt =---
tr"*'
---
-.,,-/
To ensure integral convergence (i.e. bounded from both above & below for optimal path):
1. We assume fiom some initial k s> 0, consumption path x, is always strictly positive
i u (x ) f shictly monotonically ) both integrals [3-E-1] & [3-E-2] are bounded from
below for the optimal path. LL
lx+ +
F-+
u(xt)f
V'e.>- 'i>lot)+
dt
2. A.lf
p > 0, [3-E-1] integral will converge as the integrand will tend to zero as t ---+
- Pt *
( since e
0 as t --I bounded fiom above)
"o
) f l! feasible Euler's path (given any positive initial k6) tending monotonically to
k*(p ) and x*(p ) as T --- o.
(ln
oo
ofdifferrtial equations, the point [k*(p), x*(p, is a saddle point SP. We can show by lineadzirg the fwo
Euler paths differential equations around SP, eigenvalues ofthe coefficient matrix will be real and of opposite signs.)
terms
Mar
*1u1x
J
00ll
,;-u(x*(O))l
dt
ptdt withp= 0
[3-E-2-Bl
where u(x*(O)) is the utility level ofper capita satiated consumption for individuals.
From the above 2 diagrams [3-E-1-B] with bliss point, the integral l3-E-z-Al
is obviously bounded from above for both two possible cases (MU constant or falling).
Hence integral l3-E-21 is also bounded from above and convergent.
""Tfl'
pt]
-pt
M* j- u(x1) e-ptdt
lThere
l:
are four types of Euler's paths in the phase diagrams [3-E-3] [3-E-4]:
xt:0
Type
if xo=0and
Vt
This is not eligible as optimal path because assumption [A-4] means utility will be -"o.
Similarly forko:0 and
V
V t means utility will
be -co; so again not eligible as optimal path.
kt:0
ttf(0):0)
xt:0
) Ik,
it
And after we reached k*(p ) and x*(p ), we just maintain the path there and this will be a
better path than type 2. So type 2 is not eligible as optimal path.
Type 3: if k, < k*(p) V t> T, given certainT>0
x 1'[ and people will keep I x1 tomaxu(x1)
such type path will eventually move to k 1< 0 violating our assumption k
and hence is not eligible for optimal path.
)
)
t>
0:
[k*(p
[A-l],
IA-21,
p:0:
if ko:
is
V t > 0.
Following is a phase diagram [3-E-5] for when p < 0 which has a funny interpretation of
a negative discount rate. Aoyway, for this case, / feasible, eligible Euler's path for the
infinite time horizon.
u(xr)
x,
t-o
0l l and>0
1-e
lnxt
0=1
x111
The
larger I
/et
more
willing to substitute.
Ramsey model has also been modified to use above CRRA utility functions and that
firms are included to hire labor and rent capital from identical households. Yet
assumptions placed on firms make t}rem merely passive agents and not intertemporal
optimizing agents. e.g. firms maximize only instantaneous profit: at every instance of
time, frms employ production factors (labor and capital) by paying them respective
marginal products and then sell resulting output, thus generating zero profit. Hence even
though the modified model looks more like a G.E. structure, yet households still are the
only intertemporal optimizing agents.
{'9
TY?E
rt
).q)
dBL-
T' "+#
&Q?
[u-*'.]
fieP
[s
-e-+1
,*;l;9-o
,t)
+{.f>
{p>
z''
xt" fdc) -"'kt
t l-e-sl
\_
.-+ +\
\*\
\t
In
of
Terminology:
Functional: an integral {*(t), u(t), tl dt whose numerical
value is
determined by each x(t) in the family of functions
of x(t).
s.t.
l't
order differentiat
fl*(tl, u(l). tJ dt
(or target
ix
itf
)t
i=I
equation
r-eal_valued firnction
(+partial
derivative)
xi:fi [x(t),u(t),t] i : 1,2,...,; p_tzl
where
s.t.
..,
u,(r)]
boundaryconditions x1(t6)=x16
[3-13]
x1(T)=x;1 i: 1.2.....n
Solution: Optimal time path u*(t) for control variable and simultaneously
optimal path x*(t; xe, t 6) which solves differential equation(s) (containing
control variable u(t)), depicted bV l3-l2l and satisf,ing condition [3-13].
Note on optimal decision path x*(t), it is optimal at each time point t, not
just at initial time t = 0 or t 6 and ending time t : T.
Pontryagin formulated necessary condition for dynamic optimization called
Pontryagin Maximum Principle, involving a function called Hamiltonian H
which is analogous to Lagrangian function in math programming.
H:
f[x(t), u(t),
Let us start with the objective function being a functional l-tl*t,1, u(t), tl dt
with fixed endpoints; x(t) and u(t) are l-dim, , and only I c'Bnstraint on x(t):
.T
Max
s.t.
J"
f[x(t), u(t), t] dt
i : g [x(t), u(t), t]
We define Hamiltonian
x (t s)
H:
: x6
f[x(t), u(t),
x(T):
t]
If H is differentiable in u(t)
A)
aH
0u
B)
-0
AH
0oc
Pontryagin's
Maximum
Principle
0t
C)
dx
AH
dt
0x.
boundary conditions x (t 6)
: x6 x(T):
Remark: If above f, gare differentiable and jointly concave in x(t) and u(t)
with oc(t)
0 when constraints
are nonlinear in
{t x*[u(t)]'zdt
t*
IEll
s.t.
i(t)
:10u(r)
tE2l
s.t.
x(0):2 x(l): 5
tE3l
H: x - u ' + oc ( l0 u)
A) setO: a H I 0 u :-2u+10oc ) u:5oc [E4]
B)seti=-0H/Ox:-l
tE5l
BY IE4l
seti: 0 H / O x - constraint:rcu1ton
tE6l
\ t bt
[gs]+ a(t)
1*at:J(-1)dt
- -t +kr
kr:constantof integration
x(1):5:-25Q)2 +50
kr
(1)+2
2 + 28 L+ 2
-25 t
optimal path x*(t)
- 5t+ 2.8 with u(0)
optimal control u*(t)
)
I
kl:28150:14125
2.8 andu(l)
-2.2
Second Case: continuous finite time case but with free endpoint:
T
tvtax
s.t.
f[x19, u(t), t] dt
i : g [x(t), u(t), t]
if
x (t6)
: xe
x(T) free
interior solution, then the maximum conditions remain the same except
for the boundary condition, namely:
A)
aH
:0
0u
Pontryagin's
B)
Ooc
0t
0x
at
c)
boundaryconditions x (to)
AH
Maximum
0x
Principle
AH
Doc
x6
oc
(T)
:0
oc (T) = 0 is called transversality condition for the free point. Since the
condition means value ofx at T is free. the relevant constraints is
rrlal [ax-5
s.t. i:l0u
x(0):5
u21dt
x(4) free
We setupHamiltonianH:
A) set0: a H
B) set& =
- d H / 6 x -- -4
[E4-1]
tE5-11
n1[E+-11
k1
tE6-11
constant of integration
x(0):5
=. {-4012
(0)'
)k' :16
+ l0 kr (0) + k2
(T):0 )
optimal control
u*(t;:6. (T):
- 4t
oc
5
16
(4): 0:
k2
-4(4) + kr
t6
s.t.
=g
[x(t), u(t), t]
s.t.boundaryconditions
x(ts) : x6
x(T)>x1
r)
xr
Example:
4
Maxi t4x-5u21dt
s.t.
i :10 u
x(0):5
x(4)>
225
(T):
- 4t + 16
xd|,
(xr(t),
x3(t), ...,
x,(t))
u(t)
nx
u(t)
r-dim
i'(t)=r'tx(t),u(t),tl i=1,...,n
(3-F-12)
7
\
,/
real-valued function
...,x(t)) I
u(t) = (ul(t), ur(t), ..., u(t))
tr-r-tr)
)|
i:1,...,n
boundaryconditions x'(t")=19
where x(t):(xl(t),xr(t),x3(t),
If u(t) e U :
set
u(0]
for existence of
of admissible controls
range
../
u(t)
domain
U ------+
x(t)
objective function
nt-
e.g.Max
S=l
i:l
u(t) e U
1*6;,
qx1
"1t1,
tl
(T)
T:fixedconstant
i:
1, . . . , n
o):
1u i:1,. .,n
o
with u(t) deiined on t < t <T
and x 1(t
of
differential equations
(x', t" )
s.t. x' e X
x(t" ) = x'
P(t)l not
2) P(t)
aPJ*.,u.
*-/
II.AMILTONIAN system:
i'-:aH*/ap,
aHl
i, - f;
4l
Pontryagin Maximum
Principle
3) TRANSVERSALITY Condition
RMK:
.' I
constants
ofintegr
get family
to
P(r)
:q
4) x11t)=*o
i:
)
t,2,
... , n
c; x1(T)
i:1,...,n
then
x*(t), u*(t)
solve
max
^+
S=)c,x,(T)
u(0u
T:
hxed constant
i=t
s.t.
xi(t)=fi
[x(t), u(t),
t]
i=1,...,n
xi(to):x o
i--l,...,n
iffl
Analogy: H &
Lagangian
Pi
./
COSTATE variables
Rewrite (3-F-12) as
i,*:-
i,-(t):f;[x*(t),u*(t),t]
oH*
loxi
z --'
tsf.
=I-P,'&,
;
:+ 2n equations (lst order differential
ii:...
equations)
i Pi:....
i:1,.,.,n
2n variables
xi, Pi
i:1,...,n
2n boundary conditions
xi(to):x o
PiG):ci
i:1,...,n
//
rocket
Ifwedefinex0(t) by
with
x"(t')=o
x" = If" dt
k'
then t =
J'f. Ix(t), u(t), t]dt = x. (t)Ji
:
so
x"(T)
maxl:.l*j]tt
I dt = max
x.(T)
s.t. io(t) :
f6 [x(t),
xi(t):Ii
xi (t') = x: =0
=
=
x.(t):0
u(t), t]
{{[x,u,t] + lP,{
i=l
[x,u, t]
f4**,u*,t,n,p(t)l> Hlx*,u,t,p.,p(t)l
vu
y'drop
P(t), x
*(t),
P(T):0 i :0,1,...,n
P.(T):1
2
(3-F-1s)
u*
ii:afi*m,
(t)
(3-F-16)
Pi:-AH */axi
i:0,1,2,...,n
(3-F-14)
): J)
b:q)
/r7f)
Since
P.(T):
1, by
(3-F-I4)
:0)
N.
>P"(t)=l
:+ A witten
Vt
'.' Po:0
as
io:afi*/aPo:o
tr
tr,!(x,u,q ,/
p
= 1t;q1*1t;, o1t),9 +
is funotion of x, u, t,
,/
=Htx(t).u(t),t,P(t)l
,/
t/
Since P.(t) = 1 then AH */A Po : 0 '.'no P6 term in H
so can omit
t, PC)] >
H[x*(t), u(t),
t,
P(t)] Vz(r)
no need 0
IJ *
3P,
3) q(7)=0
6H*
i=1,2,...,n
I : max I q1*1t;,o1t1,tpt
ueU
s.t.
xt(t)=f,[x(t),u(t),t]
xi
(t')
Note 5 =
AS
s=
i = 1,...,
-t
,,--z r
I
(3-F-17)
(3-F-18)
-,t"
rtrt
ueU
x: i=1,...,n
I.c,x, (T)
J'
i=1,2,...,n
oxi
Ic;x;(t)
.T
llc,x,(t)
L i=l
Jr"
|
pt
"
+)c,x,tt"
'=,
nan
=
!c,x,
i=l
(T)
lcixi
i=l
(t")
Icixi(t")
i=l
/
.no
s.t. (3-F-17)
(3-F-18)
i(t)
x,(T)
not
fixedfor i:m+1,"',n
P'(T)=c'
P,
+Ii
(T) = c,
i=1,"',m
i=m+1,'..,n
(3-F-1e)
[x1t1. u1t1.
xi
1]
x,(T) = x]
i=1,...,n
i=1,.",n
\\-,2
\\
T frxed and fixed
J]D
xo( 0:0
[x(t), u(t), t]
TT
)x6fi): 00
I ro at =J xo dt so
(3-F-19) =max
rv
xol = xo(T)
0
Theorem
if
(z')
ii:
pt
P]
vu
with
aH rcPi
Pi: - aAlaxi
i:l,2,...,n
Vt 0<t<T
(4')
x'(t")=xi
xi(T)=xI i=l,A,n
We have conesponding corollary theorems when T open and not fixed but we will not
cover as we only need above Pontryagin Theorem 2 for optimal growth theory.
Econ application: optimal gro*th theory again, using optimal control theory.
like
fo
maxJ u(x(t))e-e'dt
i,
I ike u
/ -_'rir"r
s.t.k(t):ftk(t) -ok(t) -x(t) k(0):k0>0
like
p>0
Assumptions:
Vx>0
f(k)>O
(A-3)
f(0) > 0
f(0)
oo
f(o)
Vk>0
=6
k, state variable
control region f) S R nonnegative
>
closed set
H [k (t ), x(t), t,
Po: constant
P @]
= P.u[x (t )]e
-P
/uno'
t
+ P @V Ik (t )l
Gk (t )
- x Ol
pIi - ak -;l>
crk
- xl
u[x]e-ct * Ort'
r,
Vx(t)>0 0<t<T
=P(i)-Px
assume
liq
u(x)
- i1
-oo
u(x)= -oo
=i(t)=0
=
(boundary) lJ
not optimal
=*(r)>0 Vt 0<t<T
/\
A
^n
(from dH /APi =) k(t) =r(k(t)) -ck(t) -x(t)
>0
(from - aA/a
:) i t = - p(t)tf 'G(O)- o l
afr
- dx
^ =0
+:
-
kO
afr
dx
(1') for H
critical point
=0 =u'(ile-o' +P(lX-l)=0
tdP(t)i dt:itt)
rittl:
:t"ie-p'+f,'
(Qt" -pt')
e-p' (-p)
)(it"
-pt') : -0'rtrlth
-t'
/1
1*1e*'gr'6y *
a1
-qr
t ?: -G'rirrrGt -ot-pt')rt/\.
UA
G)
/
I
I
\
rtx(t), x(t),tldt
s.t.
x(a)=c {b)=p
like f, in theorem
\o'oJ'{*to,u(t),tldt
x(a)=g
x(b)=
'
+--
^
= P.f + /P,u,ftl
,=l
,arr
=x,' =-=u,
,p.
6:-drl:-pld
ox,
=max
crifical point
note
Vi
('.' u(t)
\ ox,
no
x,term) (3-F-20)
aH _
af = 0
= P. :+l -set
iou, ou, r---\
=constant>0; suppose
Po
=0+
i=1,".,n
P;
Vi
=0
contradicting
all P1
vanishing simultaneously.
= r-" > u
=)lf
ers
'
P
_at= ____
aui P.
P
.d(af\
_l _,1_ l= ___
and
dt[aa,
. af draf)
eouauon
ax, dt [ai(r)/
\
aui
( ar\
\ a,'/ I af
P. =-L0t,
'.\
(3-F-20)-plal
P.
i=1,...,n
not
chapter
A.
IV.
greatest number
l'lorder
nth-order
Ax
Ax, = -------- - xr -t At
GDP
Xr
t.
It is therefore a
Further categorization:
+ a"
xr :b(x,-r )'*
*tion:
xt :
In the previous chapter, we derived the general formula for l tt-order linear autonomous
difference equation as follows:
* &
xt:bXt-r
d,b constants
..,
Xr: bxo + a
x:=bxr+a=b(bxo+a)+a
=b2xo+ba+a
x:: bxz + a:
b2xo+ a(b
+l)
I a(b +l))+a
+b'a
*ba *a
= b'xo
b(b2xo
X1
= iiiiiiii
: btxo + a(bt-l
:::::::::::::
+ bt-2
l)
+ ... + b+ l)
:
(St-1 ',r-6t-z
i__1_l-
Xt:
+... + b+l) {
:
)
ifbrl
ifb=l
Ix s-(a/(l-b))] bt
[a/(1
_b)]
xs f !t
If initial condition
is specified
b+ 1
b=l
tz_rl
of
x1: Abj
?"
complementa.y
firnction =
deviation ftom equilibrium
If
deviation
.Cr
\
where
A=xo - (a/(l-b))
particular solution
= intertemporal equilibrium level
A bt + 0
ast-+ co
C=
a/(l
*b)
t22l
ofx
then solutionx,*
C = intertemporal equilibrium
also steady state of the system (= rest point, stationary value).
-)
Acfually Steady State x * means: as t-t oo, xt - xr+t: Xt+2 -- ...... =somex *
and we will retum to this subject later in our discussion of dynamics of the system.
Remark: We have to be very specific with the categorization of both difference and later
differential equations because there are different approaches and different solutions for
each categorization. Above system is single difference equation, i.e. one-dimensional.
Later we will look at simultaneous system of m difference equations i.e. m-dimensional.
Finance application as illusEation: deriving formula for Future Value FV using
difference equation:
Given present value P 1 for period t, interest rate per
) P,:
(1
period: i
(v=
?o
7,
=Qti,)f"
f,.(+i)(
-
Fv',=
Pr,=
[+e
Po
,.L ^
Q+t)
ro
( I rt
SIMPLE RI,CURSION:
=a P1
solution by iteration is much simpler & we can solve without using solution formula:
whent:0
Po*r=Pr=a
Po
t:l
Pr*r=P2:a
P1
t-*2
Pz*r = P: =
=a(aPe):
aPz
a2p6
a(a2po)= a.po
t=n-1
Pn
=a Pn-1:a(ao-tP6 )=
We
Iet P6
anP6
FV:
a-1+i wi
bethe
FVn
i,
what is the
pV
6?
o : p,' /( l +i)'
) PV=FV"/(1+i)"
ln particular, we let 1/1+ i: B, then pV: B 'FV"
A formulation we will see in macro growth model lften.
E.g. social planner maximizing discounted society's utility stream Max
tS
tU( c,
).
l.
*i
state when x
V t > some n.
"onu".g"
For
a descripti.,r"
growh
.oa"tlGg
aiff".err""
-t-.
"q*ti_-_
St = sYt
= a(Yt - Yt-r
St:
) a>I
(this is Acceleration
Principle in Macro which
says aggfegate Investment
is proportional to rate of
AY
equilibrium
-9
U<s<
l
Ir
i.e. rate
of
ly t )
I 1)
(a-s) Y1 =oYtr
t, : (a/ (a-s))Y, + 0
solution by formula
) Y, = 1Yo:
(a / (a-s.1)
(a-s))
Ys {a/(a-s) }t
But
a>_1 s< 1)
non-oscillating.
(a-s) > 0 t
a/(a-s)
1 (non
Ya
t,
uv
/ (a-s)
non oscillating
<1
<1
) a<a-s
) s<0
) a:als
fraction
t*0
i (+ve fraction)
) convergent
as
t---
) s:0
Y,:
yo{1}, = yo
ast___} oo
oo
conversent
convergent
a1=Lo
thenYt:Yo{0}':0
,>
is, yt :
or: yo
so depending on where Y6
0 maybe below
note the econ implication of a zero national income over time.
and
tg,
We know Y r =Yo
{ a /(a-s)}t
[Not: using solution of lst sequence to get equil for whole recursiv
probleml
= ( Y1- Y6)/ Y6
) g = ( Y6 {a / (a-s)}'- Yo)/ Yo= a/(a-s) : (a-a+s)i (a-s) : s/(a-s)
and definition
Econ policy
of growth rate g
implication:
s:
= s/ (a-s; :
to ensure S t = I t foreacht.
growhatrate g
15% / (115-15)%
15o/o
/ 100%o:
15%
fu.;il;.
we
It
Yr: (Yr-r)"'
Find steady state:
y=(y)"
)
Y c-l
Yt =ytr :y:
y(y3-l)=o ) y:0
or
Note: Y r-r
:0 )
Y, = 0
so the
1-1
horizontal
dY,
d Yt-r
(Ya)-%
>0(=slope)
,,
tfrl,r
d, Y,
=
dYu,'
(-3/4) (1/4) (y
-1-3la <
)
aaaa,
-9
L.-)
Y4
)function
Yr-r
yt:1
t(l,1)
Lo,
o.t=Io
Tt-l
6s7
If
d Y,
d Y,-r
l*,
If
l-rl
Again using the example
aty:9
dY,
------------__l
ury-o
dY,-r
<
>
of y t = (y .r ) ".
: %8 ,, )
t'ol
non oscillatine
dY,
-----_-___l
d Y"l
I aty=0
co )
locally unstable
)0
non oscillating
: %<1
locally stable
.---+
atY=1
dY,
-----*-llatY=l
dYur
dYt
"-----*-lI
d Yt-r
atY= I
r/a
Given:
Yt
Aggregate
production:
Investment
yt = kto
) kt+r = kt
6<
1 0< s <l
dkt +skt"
= (1 -6)kt
+slt"
=ft'5k +sk
t k[6-sk"-1 ]-0
t k=0 or !=o-r.i(o I s)
l(
d ktu
---.'.-...-..1latv
dkt
(1
'o) + cr s k," - t
v >0
>0
>0
>
>0
d2kt+r
.........,.-......1
latr
kt
-concave
(o-1)
q s kr"-2
e <0 >0 >0 >O
<0
ft,t*
+50
r
llt=-rr-
-ar
arD
to chaos theorv..l
,.L
tb41r7;E-
Summary:
Difercnce equations
--t
nonlinear
- in general no explicit solutions
- use phase diagram to analyze
Solution
+ stability ofsieady states
i/
autonomous
nonautonomous
autonomous
nonautonomous
l"
order
*, = t1",., n
Solution by fomula
(recursive method)
bx, l+at
xl = blnxr-l+a
,/
some functions
xl - rxr-r(l-
xl_ r)
b, a are b, a i- or both
xl = br xr-l+ar_
order
xr = bxr-l *axr-u *c
Solution by formula
&
eigenvalue/roots
(@
Chapter IV. A. iii) Briefreview of eigenvalue and eigenvectors for square matrices.
Stochastic descriptive dynamic model with Markov transition probability matrix:
fsurvival of firms)
In above two sections we studied single difference nions. How about n-dimension
difference equation models consisting ofn simultaneous difference equations?
To handle such n-dim difference models we need EIGENVAIUE in linear algebra.
We recall to solve a set of n simultaneous linear equations with n variables, we set it up
in matrix form A x : K , where A is a square matrix, x and K are vectors:
E.g. Given linear system:
x1* apx2 :
O2yXr* A22x2 :
311
k1
kr
RHS
K:
:[:;r
lt
IKI
Ll
;i[:;]
rrJ
:
if J
1 !
x:
[for eigenvalue, we first note if x is not null and given scalar ct,
..1
e.g. for 2x2 case.
-lr -!
f
If
0ll*, 1:
ax:lc x' l= rla 0lP,'l11
"
1l I x)
| 0 JL-J
L
L" *'l Lo "JL]'J
|
[-a
',
lu:'
x,
o,,
a ,:
a22
a23
crx: crIx
a Ix
l
+0
l:
I
i_i9.;
is called eigenvector
t A l: s x : crl x
) (A- crl)x:0: null matrix
(A- crI)called
characteristic matrix
x : 0
+
B-rBx
il * tIx:0
iltx
t
lBl:0
So by above lemma,
lBl:0
B-ro
il-
[-
confradicting x-+ 0
deteminant l(A
a I )l :0
o I )l : 0
In fact $(cr)
l(A
o I )l
:0
:crn+aroo-l +
polynomial
"'2 + a:ct"-3 +
arc
of
... + a,,-lctl+an
:0
a;i
- aI)issingular
matrix (A - cr I ) is linearly dependent
vector x can assume an infinite number of solutions.
Since (A
I
)
ln order to get
by
x i2
L=
Eigenvalues analogy
Mafix
Person
:l
"= [-s
[: -e)
we know for eigenvalue
ct
butlA-"tt: [n^-*
L'
A-o,
Il=0
:
',
(-9-cr;2-f1:;
"]
) ct : 1- rat./1tt'-+1t11tzy1y t z1t1
) cr: {-tst.[TFZEE]l7z
)
cr,
*= {- ax,,[*G"11r zu
substitutinginro
-3
(A-
, say use
xt +3xz=0
Ir
L.,J
o: -
L3
;lf; I
:|l,.il
and
xr - 3x2 = 6
x 1 : x2 and to normalize x 12 + 1r2 =
t
t
xt2
+xr2
=1
.) 2 x12 :1
xr ={-072
-r
f
'- andx =lfat72l
+ x2= xr ={(l/2)
I
lwz'l
L
Similarly using the other eigenvalue = -12, we get the conesponding eigenvector as:
=[l
=fsl
'''
,-',,,1
lfll
lt,]
['-
f'l
LOJ
t
)
t
t *' ={@) t
*r, =l
[1.':?,,1
lu
Ll l
det lA - crtl
l-6 - o
Ir
ro
o-"1
= 6 s, +
check
az
-7
",41,
l"i' ,.,1:,
l=,
r-t
A lt t
4ll:
lz 6
4 5J
et
l:
We note symmehical mahi*
rri.t
U. square because a
ij
ji
in symmetrical matrix.
economists many time assume matrix symmetry when modeling for optimization
or statistical (econometric) problems.
e ; denote
eigenvalues)
givensymmetricalmaiixa f-s
12{
set
21
lA-eI | =9
->(_5__)2-
l;4: 0:>
{-10
(-
10+ 116)
/2 : -7 or -3
all e < 0:> A negative definile and all e are real numbers.'.. A_symmehical
can furd eigenvectors x-,
from e, f.o. = -3
ar_
J./tal
Lr'4
-7 ",
{'lltfl"
hi,oj
",
e2
we can
lr
1-dimensional difference equation with single difference equation enables us to study e.g.
how price of apple in period 1 will affect price and consumption of apple in period 2 etcl
In real life, we require more complicated dynamic systems than those described by I
equation. We need dynamic systems describing economic phenomena and their
intertemporal relationship as well as their intenelationship. This necessitates a system of
n simu^ltaneous difference equations. e.g. this month's price of apples and oranges will
{fect ltue months'price and consumption ofapples, oranges, banana .... as described
by difference equations; or present period R&D (research and development) will affect
future technological level
affect future production
affect futuri supply, prices,
demand etc.....
ott
Yn+l
ilz t Xn
Xn
* av Yn
+ a, v^
-^il".
*t+l
I
znr|n
I n+l
I14',-
[-"-,.l
tll
n+r =
Zn
A solution to the system means Z n = ( x, , y n ) that solves all the difference equations
in the system simultaneously.
To derive a solution, we need to assume that A has 2 distinct real eigenvalues
(characteristic roots) e1 ,
and corresponding eigenvectors 11
v2.
e2
Review:
[1
-e I )y
11: ]
:0
null vector
is the transformation
.l
Then T_'A
matrix:
T =le1 0
[ 0 er
0
0
I'
t:
o
lo
L
v1
y_2
...
,n
] and
if
-r
exists,
ol
:l
9rn I
Proof: for
By defurition T
But
Iv
Av; : eillj
follows
) AT = [e ryJ ezv z I
: r,r
..,,
0",]
1r,
:T
['
:,]
T-rA T :T-r
t'
ler
Lo
iJ 'f' :J
:
F'
:l
Qet
Corollary: if A is in addition
-r: J r
:
'l
I.".
ttl :
L'' 'J
UU
[,
L"''
AZ"
Zn+t
A is a square matrix
eigenvectors y1 L2.
and
I't step:
LetZ
useT:Ivr
i=T
^-J L'"J
v z ] to transform Z:
i.e.
Qt
UU
[t
[z
and 2 conesponding
Zn
:TQ.
Zn+r
=TQ
o*r
,,,,1 [0,,,,.l
rrrzJ
[er;nJ
) q= T-t Z
for
allz
Qn = T-rZn
including
Q nrt = I
LD*t
T-r (Az^)
r-'
A (rQ.)
(T-' A T)e"
Lo
ol
[0,",,-l
.,J p.,4
:
:
t q(n+l)t =
:
q (n + r) 2
l-l'
'*',,.*"]
= een
[:;n]
er
g(n)r
e2 q
(n)2 t2-31
are
Q n = eo Qs
welet
where Q
ofQ n+t: eQ n
to
solve
the solution is
is value of Q at period 0
f r f I
Qo= lCrorrl:1c11
rorz-l L. ,l
[o
where c
c 2 are constants
>2, :re"
:rfo,",,l:rF,:.,1
Lo,",,J [:,".'J
=[rr
"r,[:;::J
The above can easily be extended to m-dimensional (i.e. m simultaneous I "t-order linear
difference equations) system:
l':Ct,'
Zn+t
zn
j
[i::lt;*
z 6yr
z 612
:
z6y^
-^
where c;
er' yt
+c2 e2" L2 +
: constant i=
1,2, ...,m
Economic application of m-dimensional difference equation system (discrete mdimensional d1'namic model) :
We construct a descripive dynamic model for growth of firms. To add more realism, we
rntroduce risks into the model. This can be done through Markov process
a stochastic
dynamic model with Markov transition probability matrix. A model for firms growth can
be stretched to imply econ growth with policy implications.
Some preliminaries:
Markov matrix M is a mahix whose entries are > 0 and whose columns (or rows) each
add up to l. This property means Markov matrices are suitable for handling probability
dishibution (or density) p.d. functions. In other words for stochastic models:
row = 1(orl00%)
row = I (or100%)
=l
[Review: P is a p.d.
if
P1
>0
and
iwk)
e.g. tossing of
coin 2 outcomes
PH(H)=%>
Pr(T)
:% > 0
IPi =l
Defir:
Sn+r
Stochastic process is a rule assigning probty that dynamic system will be in state
attime n*1, givenprobty of system being in state Sn, Sn-r, Sn-2, .... So in
previous periods.
In particular, ifprobty that system will be in state Sn+r at time n+1, is dependent only on
the previous state Sn , then called Markov process (i.e. only immediate past state matte6).
M.,
Markov process Z n+ 1 =
Z6+gr
:
gt
Zrrrl
ml1
m2l
Z 6+ r)2
Zn\
z61z
;l
zr"rkl
mkl
+ r'sk
column
:l
matrix.
Econ interpretation: if econ is in state j (e.g. good econ, bad econ, depression, recession,
boom cycle etc ) at time n then m;.; is the probability of econ will be in state i at time n
+ I (i.e. probability ofintertemporal change in econ state).
Application:
Let x n : 7o of companies in an economy growing at end of period
! n :
%o
of
n t
2 states of econ
periodn+l:90%
:>
:>
Let probability
periodn +
of NOT growing
1=40%
Q4)
:>
:)
Zn*r
Zn
(2 dimensional)
X column
-l-l
Znn'L
:>
F,,l
: [:
Zn
s{ FI
one of Markov matrix M eigenvalues.: 1 and the other eigenvalue from solving
:1 s, = [1.5+
:)
eigenvectors by solving
M-e;I v:0
',:1;
[:
=
0.1 vr
vl - 0.4v2 :
- 0.1 Vl + 0.4v2
0.4 Vl +
0.4
vz
0.1 VI +
0.7
v2
u
v1
:4
il []
-0
u
v2
V2
normalized
v12
+ vrz :
l'1){
[l fl,;;l
(4:1
cc
- i;] lil;J
(1: -1
cc)
Alternatively
By Theorem, solutionofZn+r
will work
will work
= M Zn
tl
L'J
- cr (t)' f+l
e2n L2
L'J
L 'I
As n ---
llll
['"J
"o
"
---, 0
L'l
We wish to get this term into p.d. form (i.e. % terms) which can be achieved by letting
ct: l/(4+1): 1/ 5
lllrfrir
loul=1aoxi
=
=L,yA
=l
Jolumn
I.nA)
Chapter IV.A. iv). Discrete dynamic macro employment model to explain long run
unemplol'rnent (R.8. Hall model for finding employment pattem).
Macro unemplolnnent rates are not useful for formulating macro policy because it does
not give us information to which group our policy should be targeting.
We wish to know whether there are struchral or just short term reasons. E.g. low skill
manufacturing workers in HK maybe unemployed for a long time because low-skill
manufacturing jobs have moved to China (structural change in HK economy). During
SARS and recent deflationary period in early 2000s, workers in all industries were losing
jobs (short term reasons). 2005-2007 and 2008 saw some employment recovery and hints
of inJlation. Therefore typical macro employrnent models are tamed as follows:
p:
)
So
Let y
py
will
I
I
Ln-l
(2 dimension&l)
xr+l
yn+r
Ln
:
q xo + py"
: (1-q) x'' + (l-p)y,
Xn+l :
yn+r :
0.998
0.002
x
x
y
" ++ 0.136
"
0.864 y
"
"
Let
(I
-q)
y n:
,;s
of econ
I
:>
:>
:5%
:
l:45%
:> probty of unemployed person to remain unemployed at end of period n + 1= 55%
by
:>
mzz
.55
n+
n+ t
Zn
= 0.95 x n + 0.45 yo
= 0.05 x " + 0.55y"
tr
I column
note
X column
-l-l
Zn+t
:>
one of Markov matrix M eigenvalues: 1 and the other eigenvalue frorn solving
0.95 0.45
:0
e
0.05 0.55 - e
:>(0.95 -
:>=
0
:MZN
e) (0.55
- e) - 0.0225:0
0.5225
\D75@3jf
{6:ttl
t2
= [r.s + 0.s1 t z
t or lz
17tO)
:>
eigenvectors by solving
I-rrr
lo.ss-r
llv, l
tttl
| 0.05 O.ss -l -LI I v, I
M-e 1I v:0
:io 'rf
o.4s
lo.es-%
lo.ot
L
lol
L.I
,:;:;
=i'l
[;J
L'J
= 0
0.05 -v1 - 0.45 v2 = 0
vz
0.45 v1 + 0.45
0.5
vr
+ 0.5
vl:-
=9V2
normalized
v12
+ yr2 :
uf",i
U".l
"1:,1
v2:0
v
V1
v2=0
:tl ie./
tl
vaz
(9:1
| {vaz I
cc
| 't uzl
=L
L"'l
L.)
(1: -1
c)
"C
Alternatively
n+r
will work
tl
l: -l
: MZ"
any vector
L'.I
+c,,112)n
'\[ \
tI
{_
lt_i
,
'
---+ 0
:"'
|;]
tJ
We wish to get this term into p.d. form (i.e. % terms) which can be achieved by letting
cr=1/(9+1;:1719
:>
Zn
Ll
"''[:]
vt r:r)
I column I
=l
column
=1
10%o)
Policy implication:
If
there is a persistent LR unemployment rate of l0%, then this is not due to business
cycles and policy must be geared toward frrding out the cause of this structural hend and
relevant remedy.
For example, we mentioned structural change of HK economy from manufacturing to
service (banking & finance, entrepot and logistics, tourism) sector in the last twenty
years. The cause is the loss ofHK comparative advantage (higher labor and other costs)
to mainland in such manufacturing sector. HK Government policy seems to favor rekaining ofthe displaced manufacturing workers or outright subsidization. Effectiveness
of such policy is hampered by reluctance ofdisplaced workers to switch, especially to
low-paying jobs; &/or displaced worksrs cannot be re-trained for higher paying jobs; the
usual mismanagement of bureaucrats includes wrong estimation ofpossiblejob vacancies
and placements, increasing licensing requirement barriers preventing workers ability to
switch jobs; waste due to bureaucratic rigidities (versus market allocation and discipline);
abuse and sometimes fraud by subsidy recipients.
x(t) or
numbers)
discrete time x t
(t by integers).
In pure math econ, most models are continuous time. Main analytical tools are
differential equations and optimal control.
However, most macro math models (e.g. macro growth, business cycles, employnent
theory) are of discrete time. Hence difference equations and Bellman's dynamic
programming are the main tools.
assume such discrete period to be points of time and
differential equations and get useful result.l
still use
(: multi-period:
)
)
stagelperiod
policy
decision
stage,
2"d
3'd
transfer transfer
state-l A
51a1s-/ nr
51a1s-3
l
"
opt
opt
opt
value-l value-2 value-3
th
.. . .. ...
transfer
state-t
/}
opt
value-t
DP Terminology: there are two variables in DP. One is decision (= choice = control)
variable and the other state variable. Every path decision at period
affects value of
state variable in all future periods t + 1,t+2, ......... hence affect overall value of state
variable.
t)
How to do DP?
Illustrate basic notions and terminology by an example of minimizing budgeted expense
(abbreviated as exp) for economic development (growth):
You are appointed as minister for economic development in country Planningland. You
have to draft a 4-year plan to develop the countqr from economic state A (manufacturingbased) to economic state O (service-based). There are altemative ways to achieve this as
given by the following graph. The numbers represent respective exp levels of altemative
intermediate stages necessary to reach stage O.
stages/periods
I
Feb/2009
Feb/2010
34
Feb/2011
Feb/2012
)e
Objective: find optimal path to min overall exp to reach state O.
A : manufacturing-based econ state
3 : gov build IT network for all office buildings downtoun
C : gov build another theme park
D = subsidize private IT companies
E : increase funding of finance schools in universities
F : special tax allowance for tourist and finance industries
G : build east, west, north, south Kowloon cultural centres
H : expand airport
I : build additional shipping terminals
@,
One possible approach: grind out all possible paths, (in this case, all 18 paths) and
compare overall exp for each path. Tedious, even for our simple problem.
A) B '.' 3 is smallest
then
B) F'.'5
is smallest
then
F) I '.'3 is smallest
then
A> C ) F ) I ) g
523s
) total exp: 15 < above 16
DP Procedure:
Bellman discovered the following technique, called Bellman's Principle of Optimality:
Various ways to state this Bellman's Principle of Optimality:
optimal policy has following property: startiag from ANY initial and ANY optimal first decision,
the remaining decisions constitute an optimal policy for the state resulting from the first decision.
A. Al
B. Optirdze {optimized objective of current period + optimized objective of all subsequent periods
get the solution for the overall problem.
using recursion- based on current period decision)
C. Starting from any point on an optirnal trajectory, remainder trajectory is optimal for the
corresponding problm initiated from that point.
Above all mean that with Principle of Optimality, we can convert an n-period problem
into an equivalent 2-period problem, namely current period and all-future periods (or
all- previous periods). All-future (all-previous) period treated as one period. In
addition, we assume that we have already optimized the objective for all-future period
(or for all-previous period). Then we only need to optimize the current period and tag
on the already-optimized all-future period. We repeat this process for each period
(either forward or backward in time) recursively and the problem is solved.
t-r
'
2-peri od probl
't+t
COnVerI
lfconvert
lr
tl
em
optimize
[ (t-1
&
all
previous)
and t]
optimize I
& al I futurel
.ti:\
x1
)A=xo
xr )
x2 )x3)
current state
means wg move from state S
xt:Q
5
immediate next
state x
is @
S+ /{
4.4.
stage at penod 4
,.4
tFt
(He)
-\/,2
(L, )
\/
Define: value function F t (S, x t ) for exp = total exp of already- minimized overall
policy from stage t onward.
Define: f(
S,
1)
zt)
F. (s,
Letx
):
denoted
by Fs*(S)
vt
Value function F 1 can be written in the following form called policy decision function:
X1
sFe
zt
'.'
both F
-ion.
When working with time, we move backward stage by stage tbrough recursive equation
until we get the first stage and we get the overall optimal solution for the whole problem.
(-D
t
)
t=4
F+*(S)
t=
(t
F3(S,x3):
min {f (S,x3)
X4*
+ F+*(x:)}
il
X3 t
F:*(S)
l+4=5 4+5=9
=10 3+5:8
min{5,9} =
min{10,8}
:8
t7
min{7,8}
I
l
t
: 2 ()
\t/
Fz(S,xz) =
min
{f(
S,
2)
+I
Fr *(x z)l
tl
F z* (s)
X2+
tl
B
3+5:8
2+8=10 4+7=11
1+8=9
5+7=12
EElG
t=
| (t
['
I (S, X r
rneans
= min{f(s,x;) +
pr*(*v
Fr*(S)
Xt'
ll
A
optimal path(s)
xo* )
x r*
orA
orA
)D
x2r
x 3*
'F
'I
xq*
iJ
4+9=13
econ development
5+8:13
3+13:16
l
t
l3
IJ
)a
Remark A:
Above DP can have infinite staees
f=
Remark B:
Often times there are no solution or no closed form solution (only approximation).
Remark C:
Above DP require two pre-conditions:
Principle of Optimality: At current stage, an optimal policy for the remaining stage is
independent ofprevious stage policy. This is analogous to EfFrcient Market
Hypothesis in Finance that current stock price reflects all relevant information of
previous periods so we don't need to know tlle previous period information.
i)
ii)
3 recursive relationship: consecutive stages are related and such relationship is same
for all consecutive stages.
Remark D:
Many time solution by common sense, not by elegant deep math manipulations.
Remark E.
There is only one national product (a composite good) Y 1 in cunent period t which can
be consumed or saved-invested, two inputs labor (assume: population) n 1 and capital
k1. A production ftrnction F relating these 3 variables F( k1, nt
Yt and F( k 1, n1) is
homogeneous of degree l, differentiable and concave.
Assume labor constant over time periods so can write n 1 = 1 unit .
):
) |
ln1 [F(k1,
dfined
ofbothkl and c1
U(k 1, c, )
Social planner's problem for population is to maximize this period's, next period's, and
Ifwe
Max
[l for
IU(kt,cs) + [3U(k6r,
)]
ct*r
t+l
Suppose T + I is the last period, so we solve only for the periods T and
solve recursively backward to I "t period:
1"' step: Max B U(k t*t , c r+r ) wrt decision variable c r+r to get the optimal decision
function for c 1*1 in terms of a function h r+r of k r+r :
(by setting partial derivative = 0
:0
)get
0"t-'t
nothing after T+l pe.iod
example
Max {U(k r*r , c r*r ) * fl V r*z (k r*z )}
V is analogous to F in previous
2nd
= U(k r*r , h
r*r (k r*r ))
all same
k r+t
3'd step: set up objective firnction for the consecutive period problem:
U(k1,c1) + [3U(kr+r,cr*r )
: U(kr,cr) + BVr*r(f(kr,cr))
4d step:
Max
c1
Setting partial = 0
aUGr,cr) D(kr,cr)
? Vr*r (krrr)
+B
ct
c,
I :
)getcr*:hr(kr)
k r*r
i\J.u,
5m
*:hr(kr)
cr
Max{U(k1,c1) + BVr*r(kr*r)
Cl
} = Vr(kr)
t2-61
if
V t Gt
ft1)
[2-6] becomes
[2-7] is a functional equation (i.e. same function V appearing on both sides ofthe
equation) and when we solve this functional equation for V, we get solution for the
dynamic optimization. This method is Bellman dynamic programming.
We see the parallel similarities of the previous example and above problem:
}-policydecisionfcn12-71
C1
l.
&'
K*r-4Kt:E,
;: ri
4-^.0-A,L
You know at present K, represented by K6 = 5 (billions of $). You are glad the cost
function is quadratic which means I a soln. Your appointment is only for 2 years (T = 2)
so you only wish to solve the following problem:
rOl
Min : (p,'+ K2) *
E t=0
Kr2
s.t. Kt*r-4Kt:&
lrrB-rl
*."1
[IIB-2]
Ko:5
bo
[IB-3]
To solve:
We start from T-1 period
Min
F-
p12
s.t.
Kz
- 4 Kr :
Kr
Kr
1118-5-61
K1
2; +
t
K22
Er
lrrB-4I
[IIB-5]
to be determined [118-6]
into [IIB-4]
@1
+4S)2
: -
K1_
[IIB-7]
4Ki1 q-+
: Kl
e
4Kr
IrrB-81
) t:0
Min (Eo' + Ko') +
For T-2 period
s.r.
set to = 0)
&-
Ko:
I Min (E62
) Min (Eo2
aItu =
Eo
+
+
Vr @r
UrB-t0l
urB_31
2s)
25)
9Kt2
T;L
gGko +Eo)2
IIIB-91
K""
>
)
Eo=-18 [IrB-11]
following
2F4
18 (4(5)
+EoXl):0
& : 4 Ko + E6 = 29 a 1-t*, -,
Et: - 2Kr :-4
from[IIB-7]
from [IIB-10]
36: 385
fiom[IIB-3-8-9-11]
In other words, you will budget to cut initial expenditure Eo : -18 and next period cut
expenditure Er = - 4 and the total minimized expenditure will be Vo(Eo
385.
):
Remark:
We note that we did not discount the FV in the various periods. The implicit assumption
is interest rate i in Planningland is zero, then there is not need to discount the FV to PV.
(discounting factor B': I / (l+tt
1)
X;
set
Feasible plan
s.t.
(:
xl ef (x6)
and
xn+r
ofall
sequences in
X1
Xsequences
f (x") n:1,2,3,...:N++veintegers
ofthe system for period n+1]
Max
u(xo, x
r)
seq(xJ
* L-
p, u(x,,
x i+r
IDPU
s.t.
x"11
lim
*)
XN po u1xn, x,,11) IR
n=o
:{seq(x")
:XJ
Xsequences
Xt"au"n"""
: xrf (x)
nN+}
>zu)
Max
s.t.
H6.t(seq (x" ), x)
u(x,
" ')
* _l-l
(x ) x {x}with x e X} )
pn u(x",
seq(x")F1(x)
xo11)
tDp2j
[this [DP2] is same as [DPl] except initial x6 in [Dpl] is replaced by any x e X in[Dp2] l
[By assumption [A-DP-l], HE,1 (seq (x, ) , x) is well-defined real valued function. Since
u is bdd, H1q ,1 also bdd.l
Define value function V(x)
:X )
sup {
Hp,l(seq(x,),x) :
seq(xn)
eF1(x)}
[Dp3]
Thm: (Bellman)
Given any [DPl] problem with any initial state xo X and see x(n*) e F r (xo
V(x6)
H6
(seq
(x*
"1
)]
) , xo)
V(xo*):
And conversely
u (xn*,
ifu
u(x6*,x1*)+1,-p"u(xn*,xn11*)
o=l
u(*0,
x1)+xn=l
Fo u(xo, xo*r)
Vx(")eFr(xo)
Now due to recursive sfucture of the DP problem, for feasible (xz, x:, ...) eFp(x1*)
(x 1*, x2, x3. ...) e F 1(x6)
[if (x2, x3. ...)is feasible plan induced by initial state x1* implies(x1*,x2, x3. ...)is
feasible plan induced by initial state xa with next state xr*l
u(*o*, x1*)
+t - pou(xn*, xo11*)
n=1
Z u(*o,xr*)+ F u(x1*,x2) *
V(x1*)
V(xo)
H1Il ut (seq
(x2*
Hrrq(seq (*"* ),
: u(xo,xr*)+
:
u(x6,x1*)+
u(xo, x r*)
And by iteration:
V(xn*): u (xo*, xo*r*)
Conversely,
ifu
We have V(xo)
p'u(xo,x"+r)
But
:;
u(xo,
PIu(xr*,
*r*) * Xn=2
F lHrr,ul (seq
p[V(xr* )]
* 0V(x^*r*) V nell*
x1*)+
&,... ),xr*)
u(xo , x 1*)
fv(xt* )l
u(xs,x1*)+
1!r
ju(x,*,
F
x1*r*)
+ F'*tv1"r*,*y V reN*
I
t
Visbdd
UB>0s.t.
=
lVl <
UB
*
t
the term p
V(xo):
=
r*lV(xr*r*)
u(xo, x
H1q
't
r*)
(seq
) 0 as J)
p, u(x,*, x.;*r*)
P,-
(x'* ),
(J)
co
xo)
[The converse part of the Thm tells us in case u is continuous and bdd and if f solution
(a set of maximizer sequences) to [DPl], tien we can go from the value firnction to the
set of maximizer seq. In other words, we can use the value ftnction to solve Dp
problems, under the stated assumptions.]
Principle of Optimality:
V(x)l
Bellman [1957j: "an optimal policy has the property that, whatever the initial state aad
decision are, the remaining decisions must constitute an optimal policy with regard to the
state resulting from the first decision."
policy, whatever initial
[Means: policy function is opt for the infinite summation
state and decision are, remaining decisions as per Bellman equation must be optimal
policy with regards to resultant state from initial state/decision.l
Terminology: BtX)=
Note: B(X)
Q(x):
max
Q(x)
d-
i.e. B(X)
A(!:
will:max { Hpol
(seq
[DP4]
V xeX
Pf:
For [DP4] Pick any arbitrary x X and for any arbitrary seq(x,) e F p (x), we have
pe(xr) lZ-\
incorporating
-u(x,x1)+
F{
Q(x)
(x1
)}
/Z (u(x,xr)+
u(x,,x2)+ pe(x2)
(x2
tz-l-Al
)}
j=1
then asJ
Q(x)
oo
Q(x):u(x,xr*)+ I
F Q(x"*r*)
n:1,2,
foranyJ eN+
(u (x, x r*)
!r
Fr
u(x
j*,
x1*'*)
) +
p r+r
q1;,-'*;
...
As J
X-
F, u(*;*,xi*r*) )
if
seq(x,)
eFp(x)} V xeX
et
Chapter IV.
i)
C.
In 1970s economists like Lucas (Nobe1 prize 1995: rational expectation) think if
government policy changes (announced at discrete time point, applicabie to discrete
periods, e.g. increase in income tax for the fisca.l year 2008-2009, raising of benchmark
interest rate between policy meetings), then rational economic agents will react
accordingly by changing their decision rules for each period.
econometricians cannot assume fixed behavioral equations for empirical work. More
importantly, policy implication is that people's reaction based on expectation on
govemment policy car render policymakers' effort useless.
Counter argument:
1. Such changes in behavioral equation parameters are either too smali or too slow
to seriously affect the usefulness of optimal control calculations.
2. Sims [1980]: govemment policy rule can be framed in the form ofa reaction
function (e.g. monetary policy as a function of observed state like differential
between TIPS and straight treasurys, inflation rates, credit expansion . .. .).
With the above caveat, we will proceed with discrete growth models and re-visit
Bellman's dynamic programming for applying to such models.
Let us start with some preliminaries of a deterministic (no risk) optimal growth model:
Given: Time
ID'
Capital kt J
>
inputs
Labor n, J
Product
y, J
r
ouput
JI
h,t'
F(&,nt)
F:
r:
I
I
I
differentiable;!
uolllllluuusly ult.teterrlraurr
continuouslY
quasi-concave;
strictly
homogeneous ofdegree I
f;
F(0,n)=0
nk,.Fn,>0;
li. Fr, =o
kt,nt
*' *'
|
I
lim Ft, =-
II
k'
{/
-'"
ka
allocated by
consumption-savings decision
to
/\,
currentconsumption
C1
-.--:'--"
grossinvestments
lg
- cr * irS
lfl
machy
)c1+kt*r
-(1
Yt
depreciatedmchY
- 6)k, S
= tllU(ct)
P.V.
Y,
P'u(t'){"(tl
n,=
(normalized) V
0<[l<l
t=0
[!0
u(co
lL
h",rG)
new machy
0<6<1[N-0]
i,
ul&,)
) + [3'U(c1 )+t!'?u(cz)
u(c.)
[3'U(ct ) +
u(
concave,
c
lim U ' (c r;
t*-
: 5
Wenote
it -
A recursive equation!!
and is additive over discrete time period. Discount rate Bt for each period t are given so
that we can discount different future period utility to PV
r
Social planner wishes: find sequence consumption and capital{c r , k t. n, }oo to:
@
0<f3<1
Max IBtu(ct)
IIV-U
t=0
ct
6) k,
f(kt) -
)c,:
kt*r
Lemma:
Pf:
Since
- 6)kt cont diffble, stictly 1, linear (i.e. both concave and convex)
) f:F+(l - 6)kt also continuously diffble, strictly 1, concave
f (0) : F(0,1 ) +(1- 6)0 : 0
(1
f'(kt)= Ft,(kt'1)+
>0
(1
-6)>0
>0
er,
lim
'(k,)
lim
kt-.
k,-- -
kt-'co
f
'(k,)
k, '0
(1
- 6) =
- 6)
(1
"o
rt + lim (1 - 6):o+
k,...'0
k,.-'0
lim F
(1
- 6 )=-
Note: similarity between above F & f and Solow Growth Model F & f.
can rewrite
[IV-l]
as
@ll
ulf(kt)-kr*rl
tIV-21 =MaxI[l'
t=0
s.t. feasibility constraint 0
<
k,*r
< f(k,)
o<[!<1
-{'.'
L
glven ko and
ko >
0 < ct
tk.r
:f(kt)-kt*r
S (k,)and
o< k.''
J(et)
0.
1*rr'
#ft
&-t
*.T
&")=o
tIV-31
Max t
0<B<1
r=0
[3'ulf(k,)-k,*r]
0.
'\-""11\
Since cont.
diflble
t-r)
ak
k1
[IV-5] k t*t:6
given k 6 > 0
to determine specific solution
TD
t) :
-14,
-{t-
tI-'
-')
o(
&
o(
a_ttca4 &
t
-t ) = l-
ltt =a,t=&
:- l- 4- +<
+
-6.
kr*ttt= *-l-{
l3ou'eult*
yr
9+-
t*
/ft-t
-)T
o( p
( /t-.{
-r-
o<.lt +
. +(F
,-
/+ <A+
/+a(p
+gpf- vg(r+
- o<6(,+*
YP"+G
r)
rt <6 +("a6)'+for
+<p,t$cf)
Ig-c-r8-,rJ
+ - --- +(*
3+ - - -- t("crs)Ft +U
>A
->
(r-<F) ar
t =l4C -:l
"<s(
T-t+l
e9
<(\ /
/r,-"(F
Lg-t'
=l 2 - -- -
ff=1)
e.'+r"t*
q,*7.-*
fu {r"-c-}"EL
[o -t']
f r {"zF)r*t+rl
:k
Fr'-
a4
-K.
Cr-LqFf-LJ
r-QrPlT*trl
'-Qcl3i*:*'
t- sF)
(t- *
: 421 T+A
T+o
*7 L;
SO
,-EF
=4.
lw-1-t
a*Lt- L /*r/t*.r
a***dat
Lagrangian method
f(kr)
kf
0< q < 1
=kf -
aldkr*r
ko>
ct
Max
B, In
0<B<l
Ct
t=0
s.t.
kt+r =kto
- Cr
\ kt*r - kto
ct=
cJ
Lagralgian:
T
O= : Bt ln cr
ll
- Bi+l L
where
.L
lrv-91
ao
Bt
[lt*r).tnr =0 )
Act
I
.-"-
Blt*r=0
t=0,
llv-lol
a@
dkt
1, 2, ...,
* ,
[3t].t .tr
B t ( - tr
t+
t*
Wenotekr"r
) kr+r = 0
[3
t*r
o k 1o-1; = e
I
and [rV-g]
Forperiod
cr* =kr
" tomaxutility(U'
B.tr
r*r
Irv,10]
trv-91 I
=
c
f3Lr = f3(o
T.1
cr-r
from
* = kr,t" / ( 1+ qB)
IIV.1ol
tw-el
=
c
fJ.Lr.r = f3(q(1+a13
) /kr.r)
T.2
ct
B+
tcrB)2
[v.1ol
l\ r.z
* = [11+qf!1r+atl )) q] / krz
::
;;
/ kr2
T -t
try-ll]
Ir.'*=
tiv-i2l
kt*r * = kt"
= k,o
=
kf
- ct
- t(t-dt3)kt. l
(1
= crBkf
_r(1-cB)l
whichis [V-g.r]
)
)
kf
above [fV-13] becomes c r., * = (1.q8)Ar kr_to
production function f (k t
)=
At
[V.lA-A]
IfV.t4-Al
(e
Equation (3.22) srates thar c, equals (0,,{,)y,,, and equation (3.24) srates that
x,,, = (py,a/'l)Y 1,, p being the discount factor. Thus, consumption o[ sood i is
proportional ro lhe out.put Y,r of good i, and so is the demand lor gooJ i in the
production of good k. Equations (3.23) and (3.25) state that leiiute W, and
labor input l, used in producing good f are both given fractions of total hours
H. If random shock 2,, is introduced in the production of Y,, output of each
good i is subject to this shock. Consumption cu of each good i and the use of
good i as input r^ir in rhe production of good /< will be affected proportionally,
because both are given fractions of Y/r. Because
multiplicative shock
Cfrot/J
ousi t,ts
Lyctas
6J
""
O,
is whether the
ifS;,lh;t",
dynamiJ"ir"r""t'-.lti*
T:"::::il"T"_11iables
mooers ol optlmizing
.Dy
:jl,,"g:il::
"":werprofession.
red by the economics
The remainde,
n".i""n
;h;;;;*_".
the resulrs of some recent studies, \4,ith th" p".p;;;iili;ni
"f
so_e
on this question.
thi,
aagveloniye
Long and Plosser (1983) also examine the dynamic properties of pnce, wage
rates, and interest rates. Prices and wages are studied by using ihe partLl
derivatives of the value function with respect to the state variables output
and leisure W,. Using the Lagrange method to solve the dynamic optimization
problem for the centralplanner (or equivalently for the market economy), one
can obtain prices and wages by the Lagrange multipliers themselves. The
rate
of interest is found as the ratio of prices of goods in I and , + 1, as discussed in
section 4.4, 4.5, and 4.6. As the optimal decision functions for the control::
y!
"
.,rroy
!E,p,rnc,
r-0
ln z,*, = ln z, + p+ e,.,
(s.4)
lnz, =p+e,
ln i<,.,
=g+G,ln!
G"lnE,
l)=[o.zrs
(o.oroa),
o.wr
+ e,
(5.6)
'
smoothed residuals. The result is a tactor of 2.0 in per capita ootput in L992
I ,using the residuals free of the effects of the Great I-eap,
and a factor of 1.2
:,using the residuals free of the effects of the Cultural Revolution. The latter
estimate appears reasonable, because this estimate is concerned only with
measured physical output and not with emotional sufferings.
E,| Esllmollng ond lestlng o Bose-llno Reol Buslness
Cvcle Model
is
reasonable. The large p = 0.9999 shows that the Chinese planners place great
weight on future consumption as compared with current consumptiqn, thus
devoting a large fraction of output to investment, which is in the neighborhood
of 0.35 for most years from 1952 to 1993. The annual labor augmented technological progress of2 percent is reasonable if I include the years 1979-1993 after
the economic reform. In Chow (1993c), a Cobb-Douglas production function
with constant total factor productivity was shown to fit China data from 1952
eie,p,[tnr,
_.
1980, excluding certain abnormal yeari, but total factor productivity increased substantially after 1980. The current production function incorporates
total factor productivity and fits ihe data well enough for the entire
sample from 1952 to 1993 to be included in estimating the parameters.
Figure 5.1 shows the estimated residual0, in the log productivity equation.
The impacts of the Great Leap and the Cultural Revolution on this residual is
obvious. To estimate the economic effects of the Great Leap, smooth out the
residuals , and e, in the Great [-eap period and simulate the model using the
dt
eln(l - a..)l
= (t
(s.7)
Jr,,
-6)r,, +r,,
(s.8)
to
a random
1970
(s.5)
with lnk,*, as the control variable, and lnZr and ln&, as two state variables. The
coefficients (g, G,, Gr) are derived from optimization, given the structural
parameters o, 0, and T = sp. The residual e, is added to the optimal control
equation for ln k,.r to account for the fact that the simple model cannot explain
the actual data on lnk4r cornpletely. Given the structural parameters, and
time-series data on per capita output q, and per capita capital stock k, we can
construct z, by solving q,= zf kl-) and derive the coefficients (9, G,, G) and
hence the residuals q and e, in the above statistical model. Assuming (g, e,) to
be jointly normal, we can evaluate the likelihood function and maximize it
with respect to the parameters o, p, T and p.
The results are, with standard errors in parenlheses,
(a, 0,
rsso
c,
= sr"(z,ur,)" -uu
s,,
117,
(s.e)
the,conslrainl on
..ot
::"::
in
19,,16
at the agc of
5,
despite
vaiqr!
war-related
fe& tbea about the term" matlenatical Tbe RAND Corpcration was cnployed by the Air Force, and the Air Force
had Mlson as ia boss, essentirlly. Henc, I felt I hsd to do
something to shield Tilson and tbe Air Force from the fact
that I was rcally doing mathematics inside the RAND Ccrrpcration Wlat title, wbat name, could I choose? In the fust
place I was intercsted in plaaning, in decision making, in
thinking. But planning, is Dot a good word for vrious reasons. I decided therEfqe to use the wo4 programmiag.'
I wanted to get adoss th idea that this was dynamic, this
was multistage, tbis was time-varying-I tbought, let's kil
two birds witb one storc. IJt's take a word that has an
absolutely precise neaaing, namely dynamic, in tbe c.lassical physical sense. It also has a very interesting property
as an adjcctive, and that is it's impossible to use the word,
dynaEic, in a pejorative sense. Try tbinking of some combination that will possibly give it a pcjorative me3dn8.
It's impossible. Thus, I thought dynadic pmgrarudng was
academic carecr, Beulca& dudng the period under consideratiorl cast his lot instead
'r'ith tbc kind of applied
mathematics later to h hown as opcf,atioDs rar."t"i. to
those days applied practitiooers wre regarded as distinctly
second-class citizcns of the matbematical Aatcmity. Always
one to enJoy conEoverst when invited to spea& at various univenity mat[ematics depdtmeft seminars, Bellman
delighted in jusdfying his choice of applied over purc matheoatics as being motivaEd by the real world's greater challenges aDd mrtbematical dcmands.
gd
a
nam. It was soEethirg not svcn a Congressman
could objcct to. So I used it as al umbrella for my activi
Stuafi Drtlrls
Op.rdd n....rt
\,b1. 50. No.
l.
O 2qn INFORMS
m3{!364xi12l5m104 t&t.@
48
152&J{d} clcdto.ic
[;sN
f>,rs)
i.:,fl-',*
nd to'solvc
mber tbcory,
firDc-
doing tlis.
whicb
aay othrs
whcn I found
se9n Pr
was clcar
ClictrbrCl
Ivinq
lngeD'ous
mattrceaticirns-
:",. T*_
,*
IoT
*T
to do analytic
I bchanc.
do since
nad wa.nted
to iL
"I.
_sfTt cnough timc in Los Angeles to know that I
would_enjoy living there. I also knew th;
Los Aagetes had
many fiae bouses. although it was not undl
196g that I had
one that was btr than lhc one up in Stanford.
"I was htrigued by dynanic progasming. It was clear
^
T"
:o
F.u1tbrTorc,
.y ,"r"*l
**
ASSOCIATED FUNCTIONAL
'I,
rrs
EOUAIOIS
"A number of mathematical models of dynamic programning typ were analyzed using the calculus of variations.
The treatmeDt was not rortiae since we suffered cithcr Aom
tbc prcsenc of constraiDts or from an excess of lincrity.
Ar itrterBsting fact that cmerged ftom this detailed scrutiny
was that tie way on utilized rcsourccs deprnded critically
upon the levcl of these rcsources, and 6e tinc remaining
in tbc process. Nanrrally this was surlnising only to soEone u rscd in ecoaooics such as mvself. But this was
my condition wi6 rbe rcsult that the observation of rbis
phenomenon came as quite a sbock" Again the indgling
thoughe A solution is not mercly a sct of functions of time,
as a
Do desir to
wod
scri_
sEams, or at last
diftrcnt
ones.
of potcy
e": ry"."
A SYST$'ANC METHODOLOGICAL
APPROACH TO MAIHEMAfICS
"As pointed out abovc, as of 1954 or so I had stumblcd into
some importaat types of pmblems and had ben pushe4
willy-nilly, into answcring somc significant kinds of guestions. could handle deterministic conaol ptocesses to
some extent and stochastic decision orocess in ecolomics
and operations rcscarch as well Where next? At 6is point,
.I began !o thiD& in a logical fashio4 using a systeEatic
methodological approach. The point about th suitable ph.ilosophy Plcpaing ouc for the fortunate accident sbould bc
kpt in nind.
'Thf,e are sevenl ways in which a mathmatician can
Pmced to extend his rcsearch eforts, particularly one who
is deeply intercsted in problems arising from the physicsl
world He can, on onc hand, examine thc equations he has
been vorking witb and modify thea in a vriety of ways.
Or hc can ask questions tbat have not been asked beforc
conceming the Datul! of the solution of the original cquations. This is basically a very dificult way to carry out
rcscarch- It is very casy to cbaagc tbe form of at cquation in a largc number of ways. Th glEar orajorify of the
ns, equatioDs ee not Eesningful, and, i-n conscgueoce,
lcad to both difficult and unimporant problems. Similarly,
&cre are many questions that are diffcult to answcr, but
hardly worth asking. The weU-taincd mathematician docs
not Ecasule tbe valuc of a problem solely by ia int-actability- The challenge is thec, but cnen very small boys do not
acc?t all
dares.
uisc
df
!gF,'alt
qongo!
'
of tbc co
ls tle assunptlon Uat ril
of
-*fo
it
tbe
was
ical algorith'n".
this Sorccreds
not always, impossible to predict where a theoretical iavestigation will end onc started But wbat one can be certain
of is that the investigation of a meaningfirl scientific area
will lead to meaningfrl mathematics. Inevitably, as soon as
Chapter
IV
C.
ii)
Max
{ ct, kt*r},-6'
s.t.
BtU(ct)
0<B<1
,:o
-ct
kt+r =g(ct,kt)=(k)
t2
1i'.'-'-
{o76
u(co)J
e"
pu cct)
Q
r'u-trr
&s
$-y
t3
(c")
f .r(c6;1
Max Bb(c
6)
BlU1c,;
B2U(c2)
+ ... + ntU1c,; + .. ..
s.t.kt*r=(k)-ct
If can find value fcn V(k J = max (all future utility) fmm time t = I onwards
s.t. lerr=f(kJ-ct
then [IV-15] =
Itv-f6l (T uo
u(co)"' BV(kr)
o"?"oov(t
\cr
I s.t. co+>kr :f(ko)
I\ stven ko o
That is, we convert [IV-15] Max
to
o)
Bt
U( c t )
[IV-16] MaxU + BV
without any
:(44,
First we notice above [v-16] reasoning applies to all periods (not just initial period 0).
i.e. social planner actually max the following for EVERy period t (recursive):
ko>
t
&(
o t 23
[v-17]
[ry-18]
t+t
t*z
tt*t
pz'"*aL+ uz-I^-z-
and
k1a1
[IV-I7-18-19] means
)
)
control
kt*r:
g(kt,
c1) (which
oo
=f
ft)
sequence {
}=o
""
'-1..,
u(h(k))
v(f (k)
h(k)
which
[rv-21]
There are 3 methods to solve the Bellman Equation, depending on U and g, namely:
Here we will just cover method 1) value function iteration. (We have seen a crude
version ofthis method in our min effort example in previous chapter):
From Vo , construct
V;*r (k)
s.t.
k-:
+ B q G)}
max {U (c)
for
j:
0,
r,2,
Iterate V.;tr until sequence of value functions converges and we solved the Dp problem.
Retuming to our example (2 alternative approaches), we know by the Lagrangian
approach, the optimal path for capital in the oo horizon planning case is
k+r: o0kt"
[IV-09-1]
We want to check
if this
rr\
|
^ 04
t-+oz at-,
ol Bk,
=
st.
Ca+
*]2.fr-eJ,
s!,0!4r,t4@-
k-,. =
<A
(--(+@D-
t
'al
{ii
r/-,-(kt.(,-<
,z Ltt+94t +1,
(t t-*(,-<
" /.- (L"
t-("p
2 *il
+ <"/^.(Lo)
A(+) r
+[E:-*]
,=
[g:"-a] >
lsf
P2AJ.v
h+,1u+
z-aa*<';
t. .4- t -"a,
V'= k.,
i;:
L,
t"
It
sK>
ts'
k'
tt pKr
Kr
tL&')
pV
(r.
v-Lt)
rv:-r:- A]
u-'
+ gk,+
a'.-
u:a-f el*&-k,
rc-,-
tlpEt-)4 =
k, = - [r+Ak,-)
IAJ(l+pt!)tAt,
--------s
+ F k, +Fkz
? tt6k'= w *-J
t1
-r-*F /
= :- ./
= /-(r'<p)
...,.........-:--
t<l?
+ kf
\7{ u.
)2 s, = -+-l
- : ;
l^, Q'<F)
-F
frl
=*P-
From above,
g(k) (:
-q=k1*1)which
f(k)
(k)
Max U(
(k) - g(k)
) + 0 V (g(k))
FKz
g(k) = ------- h"
1+ BK2
q
where Kz
l-crF
of Kz into g function
cG,) =
o/ (l -
we get
cxp)]
Kt-
1+ BIo/(1-qF)]
F I cxl (1
cxp)]
k"
which
In particular, if we assume
g(k):s
ktnr
0<
s< I
and invested)
Since
phase diagram:
{&tr
!(111
Aj&t)= 1Gt)
?6'
&t'
tx
ft.r,'
,
: .gi:'l
only k * steady
but
k1
state
Stability: pick arbitrary kt point (e.g. kr , ka ) and trace out lines vertically to g, the
horizontally to 45o line, vertically to g ..... to see if convergent or divergent.
From above phase diagram, ifka > or
(note: divergent away from k1 :0)
k,*r
.\
In particular g (k)
k *, all
fraction
convergent to k * as t
) o
fraction
{{
cx B f (lq)
{ k r}'=o
<
0<o
ft)
B<1
Chapter IV.
D.
Ref
Wu,
L,
Terminology:
Random experiment / transaction: Given experimenVtransaction under identical
conditions, if outcomes will not be the snme every time (: no certainty outcome), then
experimenVtransaction is called random.
COINTOSSING
(by same person, same coin)
H, T, T, H, T, H, T,
8......
z00r
3.6%
U 03 04 0s 06
07
-7% -2%
5%
4%
-5o/o 6%o
Since outcome are not certain, we wish to find a way to assign probability (chance) P
each outcome occurring.
outcome)
12.760/0
t:
Population: complete
5%):
of
t.
,..,f*:tu
BASIC POSTULATE:
random experiment.
P which assigrrs probability to each fl = q (a quantity or number) in population.
=l
P(t;
Q: q e PoPulation)
>
P(fi) > 0
r
1u;
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Above is a brief review of probability and statistics theory. Based on that we proceed to
a short inhoductory note on stochastic models:
Recall Ramsey's Model on optimal savings (continuous, infinite horizon case):
tech is viewed as
A production set
tr
represented by
J o=s)
But if the model is stochastic (uncertain outcomes after action), k t*r depends on both k
AND as-yet-to realize technology shock
k,*tt,
{k,itt',
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B.
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Note: if z1 negative
output.
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consumption sequences (Von Neumann- Morgenstem Expected Utility Thm)
social planner
T
MaxE[
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lt3'u(cs)]
[Iv-24]
t=0
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ct S zt(kt)
ct, kt*t}
Vt'V{ zt\AY-251
Assume
Begiruring
ofperiod
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t(k ), cs known
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deterministic model
Social
Planner
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