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.
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 of
price.
Q  f ( p)  200  5 p
 P is the independent value and Q is the
dependent value
Marginal Concepts & Slope of a
Curve
 Marginal Value is defined as change in a
dependent value associated with a 1-unit change
in an independent value.
 For e.g. change in total revenue earned by a firm
associated with an increase in output sold by one
unit, is the marginal revenue

TR  PQ
 MR=Change in TR associated with change in Q
Tabular form Representation
Q P=100-10Q TR=100Q-10Q2 AR MR

0 100 0 - 0

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
TR
A

Q
O
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
Q TC AC MC
0 20 - -
AC = TC/Q 1 140 140 120
2 160 80 20
MC = TC/Q
3 180 60 20
4 240 60 60
5 480 96 240
 Average Cost (AC)

Q TC AC MC
0 20 - -
AC = TC/Q
1 140 140 120
2 160 80 20
3 180 60 20
4 240 60 60
5 480 96 240
 Total, Average, and
Marginal Cost
Q TC AC MC
0 20 - -
AC = TC/Q
1 140 140 120
MC = TC/Q
2 160 80 20
3 180 60 20
4 240 60 60
5 480 96 240
Total, Average, and Marginal Cost
TC ($)
240

180

120

60

0
0 1 2 3 4
Q

AC, MC ($) MC
AC

120

60

0
0 1 2 3 4 Q
 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 TR TC Profit
0 0 20 -20
1 90 140 -50
2 160 160 0
3 210 180 30
4 240 240 0
5 250 480 -230
 Profit Maximization
($) 300
TC

240
TR
180
MC

120

60

MR
0 Q
0 1 2 3 4 5
60
30
0
-30 Profit
-60
 Profit Maximization
 Total Profit Approach for Maximization
 Π=TR-TC=> The difference to be maximized
in order to Max. Profit
TC
TR, TC
A

TR

B Q
O
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
 Two output level showing same
slope, i.e. MR=MC
TR, TC TC

A
TR

Q
O
Q1 Q2
Interpretation of the previous
diagram
 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 bomber’s 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
 lim
 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 b

dY
 baX b 1

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.
U
U  g( X ) V  h( X ) Y 
V

dY


V dU
dX  
 U dV
dX 
2
dX V
 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
B. If d2Y/dX2 < 0, then Y is a maximum.
 CENTRAL POINT
The dependent variable is maximized when its
marginal value shifts from positive to
negative, and vice versa
 The Profit-maximizing 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