Economic Models:

Basic Mathematical Tools

applied in economics

Why models?

Simplified representations of reality play a

crucial role in economics.

Models in Economics
A model is a simplified representation
of a real situation that is used to better
understand real-life situations.
Create a real but simplified economy
Simulate an economy on a computer
Ex.: Tax models, money models

The other things equal

assumption means that all other
relevant factors remain unchanged.

Demand
A relation showing how
much of a good
consumers are willing and
able to buy at each
possible price during a
given period of time,
other things held constant

Law of Demand
A decrease in the price of a good, all
other things held constant, will cause
an increase in the quantity
demanded of the good.
An increase in the price of a good, all
other things held constant, will cause
a decrease in the quantity demanded
of the good.

The Demand Curve

The
Thedemand
demandcurve
curve
slopes
slopesdownward
downward
because
becauseof
ofthe
thelaw
law
of
ofdemand
demand

Demand curve
$1.25
$1.00

Price

Demand schedule
Quantity
Price Demanded
$ 1.25
8
$ 1.00
14
$ 0.75
20
$ 0.50
26
$ 0.25
32

$0.75
$0.50

D
$0.25
$2

14

20

Quantity

26

32

Functional
Relationships
Relationship between two variables, for e.g.
price and output sold, expressed in various
ways
Table or graph
Use of equations Quantity sold depends
on the price, in other words quantity sold is
a function
Q f (ofp)price.
200 5 p

P is the independent value and Q is the

dependent value

Linear Demand Function

QX = a0 + a1PX + a2N + a3I + a4PY + a5T
PX

Intercept:
a0 + a2N + a3I + a4PY + a5T

Slope:
QX/PX = a1 =-5

QX

Non-linear functions
For e.g. Total Revenue
TR=PQ
Marginal Revenue (Slope of Total
revenue)
MR=Change in TR associated with
change in Q

Tabular form
Representation

Q P=100-10Q

TR=100Q-10Q2

AR

MR

0 100

1 90

90

90

90

2 80

160

80

70

3 70

210

70

50

4 60

240

60

30

5 50

250

50

10

6 40

240

40

-10

Graphical Representation &

Concept of Slope & Curvature
TR

B
C
A

TR

Changes in Slope
Slope of TR Curve at a particular
point represents MR at a particular
output, i.e., change in TR for an
infinitesimal change in output level
Implication of slope for any variable
implies marginal value of the same
variable
Curvature depends on changes in
slope or changes in marginal value

Changes in Curvature
Linear Curve Marginal value
constant, no change in curvature
Curve Convex to the origin Marginal
value (Slope) changing at an
increasing rate
Curve Concave to the origin
Marginal value ( Slope) changing at a
decreasing rate

Average and Marginal

Graphically Average value can be derived from
the total value curve.
Average at a point on the Total value curve is
equal to the slope of the ray from the origin to
that particular point
To increase (decrease) the average value,
Average value should be less (more) than the
Marginal value
Average Value constant implies its equality with
Marginal Revenue

Find out from Total Cost,

Average, & Marginal Cost
AC = TC/Q
MC =
TC/Q

Q
0
1
2
3
4
5

TC AC MC
20 140 140 120
160 80 20
180 60 20
240 60 60
480 96 240

Average Cost (AC)

AC = TC/Q

Q
0
1
2
3
4
5

TC AC MC
20 140 140 120
160 80 20
180 60 20
240 60 60
480 96 240

Total, Average, and

Marginal Cost
AC = TC/Q
MC =
TC/Q

Q
0
1
2
3
4
5

TC AC MC
20 140 140 120
160 80 20
180 60 20
240 60 60
480 96 240

Total, Average, and Marginal Cost

TC ($)
240
180
120
60
0
0

AC, MC ($)

Q
MC

AC

120

60

0
0

Optimization Techniques
In Economics different optimization techniques as
a solution to decision making problems
Optimization implies either a variable is
maximized or minimized whichever is required for
efficiency purposes, subject to different
constraints imposed on other variables
E.g. Profit Maximization, Cost Minimization,
Revenue Maximization, Output Maximization
A problem of maxima & minima requires the help
of differential calculus

Profit Maximization

Q
0
1
2
3
4
5

TR
0
90
160
210
240
250

TC Profit
20
-20
140
-50
160
0
180
30
240
0
480 -230

Profit Maximization
($)

300
TC
240
TR
180
MC
120
60
MR

60

30
0
-30
-60

Profit

Marginal Analysis to profit

maximization
Marginal Analysis requirement for
profit Maximization,
Marginal Revenue = Marginal Cost
(MR)
(MC)
Marginal Value represents slope of
Total value curves,
Thus slopes of TR &TC should be
equal

Conditions of Profit
Maximization
MR=MC is a necessary condition for
Maximization, not a sufficient one as this
condition also hold for loss maximization
Sufficient condition requires that reaching a point
of maximization, profit should start declining with
any further rise in output, i.e. Slope of TC should
rise & Slope of TR must fall after reaching the
point of Maximization,
Change in MC>Change in MR
*Case Study to be discussed: An alleged blunder in
the stealth bombers design

Concept of the
Derivative
The derivative of Y with respect
to X is equal to the limit of the
ratio Y/X as X approaches
zero.

dY
Y
lim
dX X 0 X

Rules of Differentiation
Constant Function Rule: The derivative
of a constant, Y = f(X) = a, is zero for
all values of a (the constant).

Y f (X ) a
dY
0
dX

Rules of Differentiation
Power Function Rule: The
derivative of a power function,
where a and b are constants, is
defined as follows.

Y f (X ) aX

dY
b 1
baX
dX

Rules of Differentiation
Sum-and-Differences Rule: The
derivative of the sum or difference of
two functions U and V, is defined as
follows.

U g(X )

V h( X )

Y U V

dY
dU
dV

dX
dX
dX

Rules of Differentiation
Product Rule: The derivative of the
product of two functions U and V, is
defined as follows.

U g(X )

V h( X )

Y U V
dY
dV
dU
U
V
dX
dX
dX

Rules of Differentiation
Quotient Rule: The derivative
of the ratio of two functions U
and V, is defined as follows.

V h( X )

U g( X )
dY

dX

V dU

dX

U
Y
V

U dV

dX

Rules of Differentiation
Chain Rule: The derivative of a
function that is a function of X is
defined as follows.

Y f (U ) U g ( X )
dY dY dU

dX dU dX

Using derivatives to solve max and min

problems

Optimization With Calculus

To optimize Y = f (X):

First Order Condition:

Find X such that dY/dX = 0

Second Order Condition:
A. If d2Y/dX2 > 0, then Y is a
minimum.
OR

CENTRAL POINT
The dependent variable is maximized
when its marginal value shifts from
positive to negative, and vice versa

rule
Profit() = TR TC
At maximum profit
/dQ = TR/dQ - TC/dQ = 0
So,
TR/dQ = TC/dQ (1st.O.C.)
==> MR = MC
2TR/ Q2 = 2TC/Q2 (2nd O.C.)
==> MR/Q < MC/dQ
This means

slope of MC is greater than slope of MR function

Constrained
Optimization
To optimize a function
given a single constraint,
imbed the constraint in
the function and optimize
as previously defined