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.
o
o
o

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.
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
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
6 40

250
240

50
40

10
-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

Average Cost (AC)

AC = TC/Q

Total, Average, and

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

Total, Average, & Marginal Cost

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

Profit Maximization

Profit Maximization
Total Profit Approach for Maximization
=TR-TC=> The difference to be maximized
in order to Max. Profit
TR, TC

TC
A
TR

Marginal Analysis to profit

maximization
Marginal Analysis requirement for profit
Maximization,

Marginal Revenue (MR) = Marginal Cost (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

B
A

O
Q1

TR

Q
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 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.

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

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

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

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

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

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

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