1882736

The Mathematical Foundations of Economic Theory
Author(s): R. G. D. Allen
Source: The Quarterly Journal of Economics, Vol. 63, No. 1 (Feb., 1949), pp. 111-127
Published by: Oxford University Press
Stable URL: http://www.jstor.org/stable/1882736 .
Accessed: 21/05/2014 22:01
Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .
http://www.jstor.org/page/info/about/policies/terms.jsp
.
JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of
content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms
of scholarship. For more information about JSTOR, please contact support@jstor.org.
.
Oxford University Press is collaborating with JSTOR to digitize, preserve and extend access to The Quarterly
Journal of Economics.
http://www.jstor.org
This content downloaded from 168.176.5.118 on Wed, 21 May 2014 22:01:07 PM
All use subject to JSTOR Terms and Conditions
THE MATHEMATICAL FOUNDATIONS
OF ECONOMIC THEORY
SUMMARY
I. General comments: the use of mathematics by Hicks and by Samuelson,
111.- II. Samuelson's treatment of cost and
production,
114.- III. Hicks
and Samuelson on consumers'
demand,
118.- IV. Samuelson's dynamics:
difference equations,
121.
There is no longer any doubt that mathematical methods are
appropriately and usefully employed in the development of economic
theory.
The
question, rather,
is whether the mathematics should be
discarded in the final exposition or whether they should take their
place in the main argument. Do mathematics form the scaffolding
or the steel framework of the structure?
Marshall used mathematical methods
-
relatively simple ones
as a scaffolding to assist him in constructing his theory; they were
discarded when he had finished. The Principles suffer, I believe, from
this fact; if we had been allowed to see more of the mathematical
reasoning, we would have found fewer points of ambiguity and a
generally tighter exposition. Be this as it may. The main points
are that Marshall and many of his contemporaries were content with
quite simple mathematical arguments and that the use of mathe-
matics in economics has since developed both in scope and in com-
plexity. The ways in which mathematics are used by many theorists
are such that they cannot be discarded without leaving the argument
defective and full of expressions such as "it can be proved that ...."
It is still possible, however, to confine the mathematical develop-
ment to appendices. The completed structure can be described in
general terms and, when the details of the construction need to be
shown
-
when it is important to know that the structure has a steel
frame
-
then reference can be made to technical appendices. This is
the method adopted by J. R. Hicks, particularly in Value and Capital,
which has appeared in a second edition incorporating important
revisions and extensions.' It is, undoubtedly, a successful method
in the hands of a master craftsman like Hicks.
The other possibility is the incorporation of mathematics into the
1. J. R. Hicks: Value and Capital (2d Edition, Oxford University Press,
1946).
ill
112 QUARTERLY JOURNAL OF ECONOMICS
main text, and this method is well illustrated by P. A. Samuelson,
in his recently published Foundations of Economic Analysis.2 Here
the structure is built, stage by stage, from the foundations up. If the
most difficult mathematics come early on, in the steel framework of
the building, that's the way it is. The embellishments are not there
to be admired until the frame is up. Samuelson's book may have
less popular appeal than Hicks' but it is, none the less, of great
importance. Every economic theorist worthy of the name will make
a serious effort to examine it closely.
The two books of Hicks and Samuelson have much the same
subject matter, the foundations of economic theory; they follow much
the same principles, which I regard as undoubtedly the correct ones.
They must be studied together, particularly in the light of the his-
torical development of their respective theses. Since 1937 or 1938,
each author has been re-shaping and rounding off his theory -- which
had taken a fairly comprehensive form before the war
-
and each
has been influenced (though, unfortunately, rather remotely influ-
enced in the geographical sense) by the work of the other. They
have now come together on essentials. Future development, I
believe, will not be Hicksian or Samuelsonian but will flow from an
agreed combination of the two expositions. Postgraduate courses
and seminars in economic theory will be concerned with this develop-
ment for years to come.
Hicks and Samuelson, however, had different objects in mind in
writing their books. Hicks tries to work out, if not a complete
economic theory, at least a full development of one particular line of
approach. He is not concerned if some of his conclusions can be
reached by other and perhaps better roads. Samuelson's object is
to unify diverse fields of economic theory by showing up the common,
underlying mathematical basis. He is most concerned with how
conclusions are reached, with what is valid and what is false in diverse
theories.
Samuelson concentrates attention on operational or meaningful
conclusions, i.e., conclusions which could, at least under ideal condi-
tions, be validated or refuted by empirical data. His main unifying
principle is that such conclusions are to be derived, not from the
equations of equilibrium, but from the inequalities which ensure a
maximum (minimum) position or which are required for stability.
Another point he makes is that it is just as easy, and sometimes easier,
to handle simultaneous change in many variables as in a few. The
achievement of Walras and Pareto was to show the essential sim-
2. P. A. Samuelson: Foundations of Economic Analysis (Harvard University
Press,
1947).
FOUNDATIONS OF ECONOMIC THEORY 113
plicity of equilibrium of many variables. Samuelson's mathematical
technique goes beyond Walras' and Pareto's and deals easily with
many variable changes or shifts, something which is rather lost in
Hicks' non-mathematical exposition of comparative statics.3 A third
point is that results can be obtained, and often easily obtained, in
terms of finite changes and discontinuity, and not only in differential
or continuous forms. Indeed, if conclusions are to measure up to
empirical data, this is almost essential.
Like Hicks, then, Samuelson is much concerned with comparative
statics, with the answers to such questions as: if demand shifts
upwards, does the price increase? He goes on, moreover, to a sketch
of what might be achieved in a field about which very little has been
said, comparative dynamics. It is often thought that we progress
naturally from statics to comparative statics and that we then switch
into something different called dynamics, something better and more
realistic. Samuelson emphasizes that statics and dynamics refer to
the formulations of economic systems. Moreover, all formulations
which involve time are not dynamic; a static system can easily include
a secular or historical movement. Finally, Samuelson maintains,
statics and dynamics cannot be kept as quite distinct branches of
analysis. Comparative statics can be defined as the comparison of
one position of equilibrium with another without reference to the
path of transition from one to the other. This does not appear to
involve any dynamic formulation. But Samuelson shows that
meaningful conclusions in comparative statics come from conditions
of stability of equilibrium positions. And these can only be derived
from a dynamic model which shows under what circumstances a
displacement from equilibrium will be followed by a return (perhaps
oscillatory) to equilibrium.
It is just not possible in any one review to deal with all aspects
of Samuelson's book. In the following sections, I concentrate on
certain basic matters which happen to interest me. I would add that
what makes the book such essential reading for the economist is not
so much Samuelson's mathematical treatment as his economic
insight. So many things which have worried the economist for years
past appear so simple in Samuelson's devastating analysis. He is
quite ruthless in casting out what is really irrelevant.4
3. Hicks' exposition is made possible by the use of the concept of a com-
posite commodity on the assumption that the prices of the components vary
in
proportion. One result is that he gets rather tangled up with various concepts
of "money."
4. This may be the place to register some (relatively minor) complaints.
Samuelson has clearly been lax in editing and proofreading
his book; there are
numerous misprints and slips, some quite confusing, and the system of cross
II
The most definitive parts of Samuelson's work are those on the
theory of cost and production and on the theory of consumers'
demand. Here he has undoubted success in his attempt to unify,
simplify and codify existing theories. Many of the constructions
and concepts which have exercised the minds of economists in the
past are shown to be of little significance, except perhaps for exposi-
tory purposes. The linear homogeneous production function, con-
sumers' surplus, and the assumption of constant marginal utility of
money" are only some of the more notable casualties. Some may
wish to revive them, but very potent restoratives will be needed.
Samuelson himself has very little use for them; he remains somewhat
uncertain only in the case of the "integrability" conditions on the
consumers' scale of preferences, which (as an economist) he would
like to dismiss but which (as a mathematician) he cannot quite ignore.
Samuelson differs from Hicks in his treatment of the theory of
production. He takes it before, and not after, the theory of con-
sumers' demand. He presents it in a stage by stage analysis, in
contrast to the wider but more formal method of Hicks. There is
room for both treatments although, personally, I prefer Samuelson's.
His analysis throws more light on matters which have troubled
economists and which have been the subject of heated controversy.
The implications of "pure" competition, the "adding up" problem
and the question of discontinuities in the production function are
examples. Samuelson, however, assumes that the firm has only one
product; he might well have indicated the obvious extensions to the
case of joint production.
The stages in the analysis are: (1) the combination of inputs
(at given prices to the firm) to minimize cost for a given output;
(2) the choice of output to maximize net revenue to the firm; and (3)
the external relations of a firm to the rest of the industry. The first
references is inadquate. He is sometimes obscure in his wording and he might
well have spared us such monstrous concoctions as "monotonicity" (p. 12). He
is not always happy on the mathematical side and tends to fall between two stools.
His mathematical treatment is not simplified enough for the economist and not
rigorous enough to satisfy the mathematician. (As a small example, on pp. 65-
66, he says: "This can be proved rigorously in two ways ... .". But when he
comes to the second proof he starts: "More rigorously . . ."). His compromise
is particularly unsatisfactory in his handling of matrix algebra. He would seem
to have decided to keep the matrix notation to footnotes, without detailed explani-
ations; unfortunately, matrices have tended to creep back into the text ili a
rather untidy and confusing way. A text on matrix algebra suitable for the
economist is badly needed and it is a pity that Samuelson has not added a third
mathematical appendix to those in which he discusses quadratic forms and
difference equations.
two can be run together, but the third raises different problems and
must be kept separate.
With>(1) as an illustration, I would make first a mathematical
point which is not always appreciated. A problem of maximum
(minimum) subject to single constraint can always be posed
in two
ways with identical results. Generally, the maximum (minimum)
of one function is sought subject to the constancy of a second function.
This can be turned round to give the minimum (maximum)
of the
second function subject to a constant value of the first. For example,
let x
=
X(VV2
......x . ) be the production function and y =
Y(VlV2 . v. . ) be the cost function of a firm, the v's being inputs.
Stage (1), as posed above, is to Minimize y for given x. The solution
is obtained by minimizing (y - Xx) where X is a Lagrange multiplier,
i.e.
dyax
-y=
X
ax(i
=
1, 2, ..............
n)
avi avi
with x(v1, V2 . v. A ) = x = constant.
This gives y and the v's as functions of x
(and
of the
given input
3y~
prices
which are The alternative formulation is to maximize
avi)
x for a given y (maximum output at a given cost.) Here we maximize
(x
-
gy),
i.e.
ax
ay
(i
=
1, 2, ..... n)
avi avi
with y (VI,
v2,
.
v
. vn)
=
y
=
constant.
giving x and the v's as functions of y (and
the
input prices). The
result is identical with the first, setting =-X
and
inverting
x as a
function of y into y as a function of x.
In stages (1) and (2) together, with a continuous production
function, one of the few meaningful results which can be obtained
is Vi <
0
where
wi
is the
price
of the
input
vi. The firm's use of
awi
an input decreases as the price of the input increases (other input
prices constant). This is the continuous case. But little difficulty
is found in the analysis, or in the interpretation of the operation of
the firm, if certain discontinuities are assumed. Finite differences
then replace differentials or partial derivatives, and the meaningful
n
result appears as i
Avi Awi
% 0. If all input prices are raised or
i
=
1
remain unchanged
(Awi
) 0), then the amounts used cannot all
increase. A difficulty with this kind of condition is to be sure about
dropping or retaining the equality sign. (Samuelson is perhaps not
always above criticism on this point.) Here the equality sign is
essential. We cannot quite say that the amount of an input used
will decrease if its price rises (other prices remaining unchanged).
There is always the possibility, in the discontinuous case, that no
change in the use of an input follows a rise in its price.
Samuelson has much that is sensible to say about the "adding
up" problem, with particular reference to the linear homogeneous
production function and the analysis of stage (3) when external
forces are brought to bear on the firm. Many economists appear
fascinated by the linear homogeneous production function, by the
attainment of minimum unit cost under "pure" competition and by
the complete distribution of the product with net revenue (or profits)
zero. Here is complete confusion. For one thing, a U-shaped unit
cost curve (i.e. a curve with a minimum at all) is not consistent with
a linear homogeneous production function, for which unit and mar-
ginal costs are both constant. Samuelson attributes the confusion
to a desire to explain everything in terms of marginal productivity
with nothing left as a residual. Further, even if we want complete
distribution, there is no need to demand it at all outputs (as with
the linear homogeneous production function); it is sufficient to get
it at one output (where unit cost is a minimum).
The first conclusion is that the assumption of a linear homo-
geneous production function should be dropped, except as a very
special case which is "singular" in the mathematical as well as the
general sense. If we feel we need some explanation of why doubling
the use of all factors does not double the output, we might agree
with Samuelson to include in the production function, not all "fac-
tors," but only "inputs" limited to measurable economic goods and
services. Or we might quote Hicks' assumption that the firm "pos-
sesses some fixed productive opportunity which limits the scale of pro-
duction, and to which the surplus can be imputed as earnings."5 Or
we might follow Chamberlin and maintain that, while, with larger
input aggregates, increased specialization and technical economies
may dominate at first, eventually they will be more than offset by
rising costs of co-ordination.6
5. Op. cit., p. 322.
6. E. H. Chamberlin, "Proportionality, Divisibility and Economies of
Scale," this Journal, February 1948. Chamberlin appears to consider the more
general case where all factors are variable and included in the production function,
as against Samuelson who excludes, and Hicks who fixes, some factors. I doubt,
FOUNDA TIONS OF ECONOMIC THEORY 117
Thle production function tiot t)e ing lIonmogencous, the unit cost
curve can take the familiar U-shape. Under "pure" competition, the
price of the product being given to the firm, equilibrium for stage (1)
and (2) combined occurs at the output which makes marginal cost
equal to price. This is not at the point of minimum unit cost, except
by accident, and the firm makes a profit. (The profit could be a loss
but then the firm goes out of business in the long run.) The common
objection is that this is inconsistent with "pure" competition. The
concept of "pure" competition here is clearly wider than the one
used above (where the prices of product and of inputs are given to
the firm). Something new has been added, something of a quite
different nature, namely the condition that the firm's profit be zero,
implying that unit cost is minimal. It is not always clear which of
these two, zero profit or minimum unit cost, is to be regarded as the
condition. But, whichever it is, it is an inappropriate addition which
serves only to confuse the issue.7
Having got the equilibrium of the firm under "pure" competition
(in the above sense) or under other conditions, we can indeed proceed
to a quite distinct analysis, that of stage (3). Here we seek to explain
however, whether he differs from the others, except in exposition. Would any
of them object to the following?
The theory of the firm deals with an entity which, whatever adjustments
it makes in its
organization,
remains the co-ordinating and decision-making unit.
The production function is defined for, and is peculiar to, this entity. All factors
which can be measured in quantitative units appear as variables in the function.
(If a "factor" is not so
measurable,
how can its use be doubled?) The function
expresses the maximum output the firm can get from stated amounts of the
factors,
the best combination of the factors the firm can achieve as a co-ordinating unit.
The form of the function reflects the firm's coordinating power in its own environ-
ment; it shows what the firm is technically capable of achieving. Not all aspects
of co-ordination appear in the form of the function; some are expressed as measur-
able factors (such as the use of punch-card equipment). But there is always
something
-
some non-measurable "factor" - which can only show up in the
form of the function. The net revenue the firm can derive, as a maximized residual
or surplus, is dependent on the technical conditions expressed in the production
function in conjunction with the conditions of factor supply and of demand for
the product. The net revenue of one firm can differ from another's, not only
because it faces different supply-demand conditions, but also because its produc-
tion function is different. As indicated here, the determination of maximum net
revenue can be shown in two stages. The first fixes the proportions in which
factors are combined for any scale of production; the second determines the scale
of production. Chamberlin's analysis now falls into place. And at no point do
we feel driven to assume a linear homogeneous production function, except as a
singular case.
[See below, p. 143, note 7, for comment- Ed.]
7. It can be noticed that "pure" competition was introduced (Chamberlin:
The Theory of Monopolistic Competition, pp. 6-7) precisely because the concept
of "perfect" competition had grown too wide and variable. It has since tended
to suffer the same fate.
11.8 QUA RTERLY JOURNAL OF ECONOMICS
how the level of profits is determined in any industry. In particular,
we can lay down certain conditions on "free entry," on potential
competition from outside firms. The conditions may imply
-
though
this is not necessary
-
that net revenue for the marginal firm is zero,
and hence that this firm's output is at minimum unit cost. As
Samuelson points out, however, there is no empirical evidence in
real life that there are "competitive" forces driving profits to zero.
But there are many ways in which "free entry" conditions can be
framed; the point here is that they are additional to the analysis of
the firm. They can be added, or left to be swallowed up in the wider
analysis of market equilibrium where prices of products and inputs
are determined.
III
In the theory of consumers' demand, we have a single consumer
with given income I able to purchase n goods on the market at given
prices PI, P2y
.....
Pn. We
want, first,
to be able to
say
that the
consumer's demand is uniquely determined, i.e., that his purchases,
X12 X2. . .
xn
are single-valued functions of I,
Pi, P2
...... Pn.
rrhe demand, moreover, should be invariant to proportionate changes
in income and all prices, i.e., the demand functions are homogeneous
of order zero. Secondly, as a problem of comparative statics, we
want to trace how demand changes as income and prices are varied.
In particular, we seek general restrictions on these changes, restric-
tions which (ideally) could be verified or refuted from empirical data.
We must expect that there are several constructions, or sets of
hypotheses, which serve to "explain" the same phenomena. Our
choice must then be for the simplest model. As economists, we do
not wish to introduce complications not needed for an explanation
of empirical economic facts. In particular, we have no direct interest
in features of consumer behavior which may appeal, for example, to
the psychologist.
One explanation of consumers' demand is based on the assump-
tion of an ordinal preference field with properties ensuring that, for
any given income and prices, there is a unique set of purchases at the
maximum level on the preference scale. Hicks has shown how neatly
this can be worked out. There are certain equations, invariant with
respect to an ordinal utility function, which determine equilibrium
and show how the demand functions of the required form arise. There
are certain incualities, again invariant with respect to the ordinal
utility function, which ensure a maximum rather than a minimum.
These can be translated into restrictions on the variation of the
demand functions as income and prices change. As in the theory of
production, these conditions can be obtained from alternative formit-
lations of the problem; the consumer either maximizes utility for a
given income or minimizes expenditure for a given utility level,
prices being given in each case. We can choose between the formu-
lations according to convenience of exposition.
In developing his theory, Hicks was disturbed by the fact that
he could not use all his inequalities in deriving restrictions on the
demand functions. Samuelson has now shown, what Hicks had
begun to suspect,8 that there is just one inequality, and a very simple
one, from which we can derive all restrictions on demand. The
inequality turns on "cross" valuations of purchases at different sets
of prices in the manner of standard index number practice. Indeed,
the inequality serves as the basis, not only for the analysis of demand
functions, but also for index number theory and other purposes.9
We compare two equilibrium situations, denoted by suffixes
o and 1, for the consumer. Writing the summation z over the n
goods, we first compare the cost of the purchases of the second situa-
tion at the prices of the first with the actual cost of the purchases of
the first situation, i.e., we compare I
pox1, with z poxo. If I poxi ?
z poxo,
then the
quantities x1 could have been
purchased
in the first
situation with the income then available (1poxo), whereas in fact the
quantities xo were purchased. The consumer prefers the quantities
xo
to the quantities xi. The second comparison is between
2plxo
and lp1x1. Here, if 'p1xo
<
Ip1xI,
then the consumer prefers the
xl quantities to the x( quantities. For consistent consumer behavior,
if the first inequality holds, the second cannot hold, and conversely.
Hence, lpox1 < Z2poxo implies 2p1xo > lp1x1. Translating into
finite difference form, we have
if 2pAx
<
0, then (p + Ap)Ax < 0 ...... (1)
where Ap, Ax are changes from one situation to the other. (1) is the
inequality condition which Samuelson shows to be basic to the theory.
Now, the last paragraph, leading to (1), does not refer at all to
a utility function or a preference scale, only to what Samuelson calls
"revealed preferences." If we simply lay down (1) as our basic
hypothesis
-
and it is in a form (ideally) refutable from empirical
data
-
then we get practically everything we want. First, it follows
that the demand functions are unique and homogeneous of zero
8. Op. cit., pp. 51-2, 311, and Additional Note A.
9. Cf. J. R. Hicks: "The Valuation of the Social Income," Economica (1940),
an(l "Consumers' Surplus and Index Nunmbers,
"
Review of Economic Studies (1942).
120 QUAARTERJLY JOURNAL OF ECONOMICS
order.1 Secondly, a particular case included in (1) is
if ZpAx = 0, then 2;ApAx < 0. ......... (2)
The meaning of this needs to be examined carefully. There have
been changes (Ap) in the prices. There has also been a change in
the income of the consumer:
AI = 2(p + Ap) (x + Ax) - 2px = v2xAp
i.e., the price changes have been compensated by a change 2xAp in
income. The compensation is such that the quantities now purchased
(following the compensated price changes) could have been bought
at the old prices and income: :(x + Ax)p = 2xp. For such com-
pensated price changes, lApAx < 0. If the price changes are all
upwards (or some up and others unchanged), then we cannot say
that all demands are decreased but we can say that on balance there
is a decrease in demand. In particular, if there is a rise (Ap) in one
price only (other prices unchanged) compensated by an increase
(xAp) in income, then the demand for the good falls.2 Finally, in
the limiting form with differentials and rates of change, (2) becomes
2dp dx < 0 if 2p dx = 0 so that dI = 2x dp is the compensating
change in income. Hence
2
Y
+
r
Xr
dPrdps
<
0.
(3)
r=1 8= 1
aPr
01
We are now on familiar ground. From (3), if only
pr
changes, then
ax"
r
ax
-+ ar
=<
?
aPr d9l
which is Hicks' substitution effect. On the other hand,
(ax:
+
?
ax)
can be of either sign, which is Hicks' complementarity. These
expressions are, of course, Slutsky's compensated variations in demand.
It appears, therefore, that all we need about demand derives
from the single condition (1). There is no need to postulate an
1. Samuelson, op. cit., pp. 111-12.
2. If we admit the hypothesis of an ordered preference field, then there is
another compensated price change, namely a change in prices accompanied by
a change in income sufficient to maintain the consumer on the same indifference
surface. The compensated price change of the text maintains the consumer on
the same price plane, not the same indifference surface. The two compensations
are thus different for finite changes; they coincide for differential changes. It
can be shown, however, the s2zpax < 0 holds equally for both. Samuelson does
not make the distinction here drawn.
indifference map or to assume that the consumer acts to maximize
utility or minimize expenditure. We gain a good deal by concentrat-
ing on the condition (1) and shaking ourselves free of traditional
utility analysis. For one thing, we get away from the concept of
elasticity of demand with respect to variation in a single price; it is
really easier to let all prices vary together. Again, we find we can
operate with finite changes (and not only with rates of change) and
so approach nearer to empirical tests. To take one example, we can
follow Hicks3 in extending (1) from a single consumer to the whole
body of consumers. If we find 2pox1 < lpoxo and lp1x0 > Xpixi
are both true, then (1) is satisfied. We know that the behavior of
consumers is consistent in the two periods and we can say that there
has been a fall in real social income. On the other hand, we could
find lpox1 <
lpoxo
and 2plxo <
2pixi
which contradicts (1); some-
thing has happened between the two periods to change the pattern
of consumers' behavior. This is an exercise in the New Welfare
Economics.
But does it follow that we should scrap utility analysis altogether?
We should not be too hasty. I am inclined to think that we should
keep utility analysis, as developed by Hicks and others, at least for
purposes of exposition and interpretation. It is useful to be able to
say, when faced with the contradiction just mentioned, that it seems
probable that the indifference maps of consumers have changed. It
is useful to be able to describe the well-known terms in (3) as com-
pensated price changes, corresponding to the maintenance of a given
utility level. Any change whatever in prices is conveniently split
into a change along the indifference surface (the substitution effect)
and a proportionate change in all prices (the income effect).
IV
So far, equilibrium positions have derived from conditions of
maximum (minimum). The inequalities which ensure a maximum
rather than a minimum (or conversely) then give the operative results
in comparative statics. The mathematics of the analysis turn largely
on the theory of quadratic forms. The inequalities are the stability
conditions and they do not involve, except implicitly, considerations
which can be described as dynamic.
In other problems, equilibrium positions arise, not from condi-
tions of maximum (minimum), but from the equation of certain
variables. Questions of comparative statics now involve stability
conditions which are more difficult to formulate and which (as Samuel-
3. "The Valuation of t he Social Income," Economica (1940).
son shows) must be based explicitly on dynamic models. A typical
case is the equation of demand and supply on a market, and stability
considerations can lead to the familiar "cobweb" theorem. Dynamic
systems are needed in comparative statics just as much as in (say)
a theory of industrial fluctuations.
The definition of dynamics adopted by Samuelson follows Frisch.
A system is dynamic "if its behavior over time is determined by
functional equations in which 'variables at different points of time'
are involved in an 'essential' way." 4 From the mathematician's
point of view, therefore, dynamic relations are essentially difference
equations. It may be appropriate sometimes to introduce continuity,
to replace finite differences by rates of change, and sums by integrals.
The relations are then differential, integral or mixed equations.
But, whereas in physics differential or integral equations are usually
appropriate, this seems to be less often the case in economics. A ball
set rolling down a hill will continue to roll until it reaches the bottom.
However, even in the most rapid collapse of prices on the stock
exchange, prices are only marked down at definite points of time and
business is suspended at closing time.
Economic dynamics must thus be based firmly on a theory of
difference equations. Hitherto no account of such a theory has been
available to economists. Samuelson makes good the deficiency in a
long mathematical appendix. But it is very tough going, partly
because the exposition is formal and lacks illustrative examples
designed to maintain the economist's interest. Examples are useful,
not only in illustrating general methods, but also in showing how
actual difference equations arise in economic problems. The following
examples are offered in the hope that they may help economists to
follow Samuelson's formal development.
A difference equation involves variables at different points of
time. Perhaps the simplest example is the growth of a sum at interest,
of lOOr per cent per year compounded annually. If y(t) is the amount
at the end of year t, then
y(t + 1) (1
+ r) y(t) * (4)
This relation involves two points of time or one time lag; it is a
difference equation of the first order. It is also linear since only y(t)
and y(t + 1) appear, and not powers, etc. Finally, it is non-historical
since time does not appear explicitly; the relation is not dated but
holds for any two consecutive years whatever. A general solution
of (4) is an expression of y as a function of t, and it can be written
4.
Sarnuelson, op.
cit., p. 314,
once a single initial condition is specified, a condition which serves
to "start up" the system. Suppose we specify the initial sum
yo.
Then we have the following step-by-step solution:
y(0)
=
yo; y(1)
= (1 + r)y(0)
=
yo(l
+ r);
y(2)
=
(1
+
r)y(1)
=
yo(l + r)2;
.....
and generally y(t) = yo(l + r)t
A slightly more complicated case arises when the difference
equation has a term not involving the variable y. For example, in
the compound interest problem, suppose that a fixed bonus of a is
added each year. Then y(t + 1) is the sum of (1 + r)y(t) and a, i.e.,
the difference equation is
y(t + 1) - (1 + r)y(t) = a ...... .(5)
With the same initial condition, the step-by-step solution is now
y(t)
=
yo(i
+r )t+ a(1 + r)t1- + a(1 + r) t2 + .... + a
or y(t)
=
yo(l + r)t +
? [(1 + r)t -1
r
The general solution of (5) is in two parts. One part is yo(l + r)t
which is the general solution of the "reduced equation" y(t + 1)
-
(1 + r)y(t)
=
0. The other part is
a
(1
+ r)t- 1] which can
r
be checked to be a particular solution of the full equation (5).5 This
suggests what is indeed one of the main working rules for solving
difference equations. To solve (5), we first find by trial and error
some particular solution of it, and we then add the solution of the
simpler equation (4) to get the general solution.
A further complication arises when the difference equation is
historical, involving time explicitly. Suppose that a bonus is added
each year as in (5) but that its amount is declared year by year. Let
1929 be the initial year (t
=
0) when the sum
yo
is put at compound
interest. Suppose, as a matter of history, the bonuses declared are
a,
in 1930 (t
=
1), a2 in 1931 (t
=
2)
.Y.....
Then
y(t + 1)
-
(1 + r)y(t)
=
at+. .......... (6)
is the difference equation. The solution is found step by step to be
y(t)
=
y((1 + r)/ + ai(l +- r)t-1 + a2(1 + r)-2
? . + a
a a
5. Put y(t)
=
[ (1 +
r)t -1], y(t + 1)
= [(1
+
r)i4-l -1]; then
r r
y(t + 1)
-(1
+ r)y(t)
=
+
r)t+1
a
+
r)t+1- (1 + r)
1
r
~~~~~~r
The solution of (6) is the sum of the solution of the same "reduced
equation" and a particular solution which depends on the historical
run of bonuses.
We can now pass to a difference equation of second (or higher)
order involving two (or more) time lags. The well-known auto-
regressive system of Yule and Kendall provides an illustration.6
The second order case, in linear form, is:
y(t + 2) + ay(t + 1) + by(t) = Et+2 . . . . . . . . . .
(7)
where a and b are constants of the structure of the system, and where
t
?2
is
an historical disturbance.
Any
term in the series is determined
by the two preceding terms, except that a disturbance peculiar to
the term in question is added. Without the disturbance, we have the
non-historical form:
y(t + 2) + ay(t + 1) + by(t)
= O ..... ..... (8)
Here (8) is the "reduced equation" corresponding to (7). The method
of attack is as before. We find a general solution of the reduced
equation (8), a solution which involves only the structural constants
a and b but which needs two initial conditions, e.g., y(O)
=
yo
and
y(l) =
y',
to "start up" the series. Next, we try to get some particu-
lar solution of the full equation (7). The sum of the two provides the
general solution of (7). The general solution, then, consists of a
systematic part independent of the historical disturbance and a part
which arises historically. What we look for in the first part generally
is a damped oscillation. This kind of system is clearly relevant to
certain theories of industrial fluctuations.
The general method is very similar to that adopted in the theory
of differential equations. There are some rather formal "existence"
theorems which ensure that a unique solution exists.7 In practice,
success depends on trying out a box of tricks, e.g., to find some
particular solution of (7) to add to a general solution of (8). It is all
rather scrappy and hit-or-miss. With difference equations, however,
we can always fall back on the step-by-step method to trace the course
of the variables, given by specific difference equations, starting from
specified initial conditions.
The use of "operators" is very helpful. Let E be an operator
which turns y(t) into y(t
+
1), i.e., Ey(t)
=
y(t
+
1). Then E2y(t)
6. See M. G. Kendall: Contributions to the Study of Oscillatory Time Series
(Cambridge, England, 1946).
7. The existence theorems for difference equations are rather glossed over
by Samuelson, e.g., op. cit., p. 385.
Ey(t + 1)
=
y(t + 2),
and so on. Let A be the usual
operator
for finite differences. Then Ay(t) = y(t + 1) - y(t); A2y(t) =
Ay(t + 1) - Ay(t) = y(t + 2) - 2y(t + 1) + y(t); and so on. Any
difference equation can be represented alternatively in terms of E
and in terms of A. Equation (4) can be written
[E- (1 + r)]y(t) = 0 or (At-r)y(t) = 0 .... .... (9)
Equation (8) can be written
(E2+aE +[b)y(t)
=
Oor
[A2 + (a + 2)A + (a + b + 1)] y(t) =
0 ..... .......... (10)
To get the second form, some rearrangement of terms is needed in
each case. But the utility of operators in practice arises from the
fact that they can be handled as though they were quantities. By
definition
Ay(t) = (E - 1)y(t)
We can write A
=
E - 1 or E = A + 1 and transform the equation
in one form to the other. So, in (10)
E2+aE+b = (Az+ 1)2+a(A + 1) +b
= A2
+ (a + 2)A + (a +
b
+ 1)
It is to be noticed that a difference equation written in terms of
finite differences (with the operator A) is in analogous form to a
d
differential equation in which the operator is D =
.
For example,
the difference equation (9) for interest compounded annually is
Ay(t) = ry(t). The corresponding differential equation for interest
compounded continuously is Dy(t)
=
ry(t).
The nature of difference equations which arise in the dynamic
formulation of a problem in comparative statics can be illustrated
by a simplified example used by Samuelson. Equilibrium on the
market for a single good is determined by the equation of demand
and supply: the equilibrium price p is a solution of D(p) = S(p).
If price is initially fixed at po(7 p ), what happens over time? Of
the many different dynamic formulations of this problem, two can
be noticed here. First, we start with the assumption that price will
rise as long as demand exceeds supply and will fall as long as supply
exceeds demand. We add an
assumption,
which involves continuous
changes, that the speed of adjustment is proportional to the differ-
ence between demand and supply. A differential equation is the
appropriate expression of the dynamic relation:
dp=
X[D(p)
-
S(p)]
=
X[D'(-)
-
S'(j)] (p
-
approximately by expansion. Here X is the speed of adjustment
and positive. The equation is easily solved to show that p moves
continuously towards or away from p according as S'(p) is greater
or less than D'(p). It is a feature of differential equations (such as
this) that they permit only continuous movement one way or the
other and exclude the possibility of oscillatory movements. For
this reason alone, they are not altogether appropriate in economic
dynamics.
Secondly, we start by assuming that demand adjusts itself
immediately to price but that supply reacts only after a time lag.
Supply at time (t + 1) is S[p(t)] when p(t) is the price at time t.
Demand at time (t + 1) is D[p(t + 1)] and p(t + 1) is fixed to clear
supply:
D[p(t + 1)] = S[p(t)]
This is a difference equation which, from a given initial price
po,
gives step by step the price p(t) as it develops over time. In the
particular case of linear demand and supply (with constants a, ,
a and
b),
we have
a -
fOp(t
+ 1) = a + bp(t)
.e., p(t + 1) +
b
p(t)=
a
which is a linear difference equation of the same type as (5). The
solution, easily derived, shows a greater range of possibilities;
in
particular, p can oscillate around, towards or away from p. This is
the familiar "cobweb" result.
This example indicates the limitation of Samuelson's work.
Why should supply at time (t + 1) depend on price at time t? We
might say that it depends on what suppliers at time t expected the
price at time (t + 1) was going to be, and that the expectation
depends on the price at time t. But the expectation depends on other
things as well. The concept of expectation is one which finds no
prominent place in Samuelson's theory. He gives a comprehensive
and satisfying treatment of comparative statics, including the
dynamic formulation of stability conditions. But he does not
provide anything like the Hicksian analysis based on expectation.
On economic dynamics in the wider sense, and particularly on trade
cycle theory, he is content with some indications of what is to be
done, making valuable suggestions of interest particularly to the
mathematician. He points to the need to explore the almost unknown
territory of comparative dynamics in which the whole course of an
economic system over time can be varied by some change (e.g.,
in
the marginal propensity to consume). He stresses the potential
importance of non-linear difference or differential equations and of
systems with stochastic elements. We are here in a mathematical
domain presenting formidable problems and still awaiting systematic
development.
Mathematical economics in the past has been dominated by the
mathematical convenience of linear systems. It seems likely that
linear assumptions are not adequate in the treatment of economic
dynamics. If so, some other simplification is needed to prevent the
mathematics from getting too formal. No one has yet hit upon the
appropriate simplification. There is much to be done by the mathe-
matician as well as by the economist.
R. G. D. ALLEN.
LONDON SCHOOL OF ECONOMICS

1882736

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

1882736

Uploaded by

Copyright:

Available Formats

The Mathematical Foundations of Economic Theory

You might also like