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ECON509 Introduction to Mathematical Economics I - Lecture Notes

ECON509 Introduction to Mathematical Economics I - Lecture Notes

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Econ 509,

Introduction to Mathematical Economics I

Professor Ariell Reshef University of VirginiaLecture notes based on Chiang and Wainwright,

Fundamental Methods of Mathematical Economics

.

1 Mathematical economics

Why describe the world with mathematical models, rather than use verbal theory and logic? After all, thiswas the state of economics until not too long ago (say, 1950s).1. Math is a

concise, parsimonious

language, so we can describe a lot using fewer words.2. Math contains many

tools and theorems

that help making

general statements

.3. Math forces us to

explicitly state all assumptions

, and help preventing us from failing to acknowl-edge implicit assumptions.4.

Multi dimensionality

is easily described.Math has become a

common language

for most economists. It facilitates communication between econo-mists.

Warning:

despite its usefulness, if math is the only language for economists, then we are restrictingnot only communication among us, but more importantly we are restricting our understanding of the world.Mathematical models make strong assumptions and use theorems to deliver insightful conclusions. But,remember the

A-A’ C-C’ Theorem:

Let C be the set of conclusions that follow from the set of assumptions A. Let A’ be a small perturbation of A. There exists such A’ that delivers a set of conclusions C’ that is disjoint from C.

Thus, theinsightfullness of C depends critically on the plausibility of A.The plausibility of A depends on empirical validity, which needs to be established, usually using econo-metrics. On the other hand, sometimes theory informs us on how to look at existing data, how to collectnew data, and which tools to use in its analysis. Thus, there is a

constant discourse

between theory andempirics. Neither can be without the other (see the inductivism v deductivism debate).Theory is an abstraction of the world. You focus on the most important relationships that you considerimportant a priori to understanding some phenomenon. This may yield an economic model.

2 Economic models

Some useful notation:

8

for all,

9

exists,

9

!

exists and is unique. If we cross any of these, or pre…x by

:

or

, then it means "not".1

2.1 Ingredients of mathematical models

1. Equations:De…nitions

:

=

R

C

:

Y

=

C

+

I

+

G

+

E

M

:

K

t

+1

= (1

)

K

t

+

I

t

Behavioral/Optimization

:

q

d

=

p

:

MC

=

MR

:

MC

=

P

Equilibrium

:

q

d

=

q

s

2. Parameters: e.g.

,

,

from above.3. Variables: exogenous, endogenous.Parameters and functional forms govern the equations, which determine the relationships between variable.Thus, any complete mathematical model can be written as

F

(

;Y;X

) = 0

;

where

F

is a set of functions (say, demand and supply),

is a set of parameters (say, elasticities),

Y

areendogenous variables (price and quantity) and

X

are exogenous, predetermined variables (income, weather).Some models will not have explicit

X

variables.

2.2 From chapter 3: equilibrium analysis

One general de…nition of a model’s equilibrium is "a constellation of

selected

,

interrelated

variables soadjusted to one another that no

inherent

tendency to change prevails in the model which they constitute".

Selected

: there may be other variables. This implies a choice of what is endogenous and what isexogenous, but also the overall set of variables that are explicitly considered in the model. Changingthe set of variables that is discussed, and the partition to exogenous and endogenous will likely changethe equilibrium.

Interrelated

: all variables must be simultaneously in a state of rest, i.e. constant. And the value of each variable must be consistent with the value of all other variables.

Inherent

: this means that only the relationships within the model are setting the equilibrium. Itimplies that the exogenous variables and parameters are all …xed.2

Since all variables are at rest, an equilibrium is often called a

static

. Comparing equilibria is called therefore

comparative statics

.An equilibrium can be de…ned as

Y

that solves

F

(

;Y;X

) = 0

;

for given

and

X

. This is one example for the usefulness of mathematics for economists: see how much isdescribed by so little notation.We are interested in …nding an equilibrium for

F

(

;Y;X

) = 0

. Sometimes, there will be no solution.Sometimes it will be unique and sometimes there will be multiple equilibria. Each of these situations isinteresting in some context. In most cases, especially when policy is involved, we want a model to havea unique equilibrium, because it implies a function from

(

;X

)

to

Y

(the implicit function theorem). Butthis does not necessarily mean that reality follows a unique equilibrium; that is only a feature of a model.

Warning

: models with unique equilibrium are useful for many theoretical purposes, but it takes a leap of faith to go from model to reality – as if the unique equilibrium pertains to reality.Students should familiarize themselves with the rest of chapter 3 on their own.

2.3 Numbers

Natural,

N

:

0

;

1

;

2

:::

or sometimes

1

;

2

;

3

;:::

Integers,

Z

:

:::

2

;

1

;

0

;

1

;

2

;:::

Rational,

Q

:

n=d

where both

n

and

d

are integers and

d

is not zero.

n

is the numerator and

d

is thedenominator.

Irrational numbers: cannot be written as rational numbers, e.g.,

,

e

,

p

2

.

Real,

R

: rational and irrational. The real line:

(

1

;

1

)

. This is a special set, because it is dense, inthe sense that there are just as many real numbers between 0 and 1 (or any other real numbers) as onthe entire real line.

Complex: an extension of the real numbers, where there is an additional dimension in which we addto the real numbers imaginary numbers:

x

+

iy

, where

i

=

p

1

.

2.4 Sets

We already described some sets above (

N

,

Q

,

R

,

Z

). A set

S

contains elements

e

:

S

=

f

e

1

;e

2

;e

3

;e

4

g

;

where

e

i

may be numbers or objects (say: car, bus, bike, etc.). We can think of sets in terms of the numberof elements that they contain:3

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