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ATHE

HEMA

ATIICAL

L

E ONOM

ECO

OMIC

CS

IIIISemester

CO

OMPLEM

MENTA

ARYCOURSE

BS

ScMA

ATHE

EMAT

TICS

(201

11Admiission)

UNIVE

ERSITY O

OF CA

ALIC

CUT

SCHO

OOLOFD

DISTANC

CEEDUC

CATION

Ca

alicut Univ

versity P.O. Malappurram, Kerala

a, India 673 635

421

SchoolofDistanceEducation

UNIVERSITY OF CALICUT

SCHOOL OF DISTANCE EDUCATION

STUDY MATERIAL

B Sc Mathematics

III Semester

MATHEMATICAL ECONOMICS

Preparedby

Sri.Venugopalan.P.K,

AssistantProfessor,

DepartmentofStatistics,

SreeKeralaVarmaCollege,

Thrissur.

Layout:

ComputerSection,SDE

Reserved

MathematicalEconomics(IIISem.)

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CONTENTS

Pages

MODULEI

MODULEII

18

MODULEIII

25

MODULEIV 31

MathematicalEconomics(IIISem.)

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MathematicalEconomics(IIISem.)

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MODULEI

FIRSTORDERDIFFERENTIALEQUIATIONS

DefinitionsandConcepts

Adifferentialequationisanequationwhichexpressesanexplicitrelationshipbetween

Functiony=f(t)andoneormoreofitsderivativesordifferentialequationsinclude.

dy/dt=5t+9y=12yandy2y+19=0

Equations involving a single independent variable, such as those above, are called

ordinary differential equations. The solution or integral of a differential equation is any

equation, without derivative or differential, that is defined over an interval and satisfies the

differential equation for all the values of the independent variable (s) in the interval. See

Example1.

Theorderofadifferentialequationistheorderofthehighestderivativeintheequation.

The degree of a differential equation is the highest power to which the derivative of highest

orderisraised.SeeExample2.

Example 1. To solve the differential equation y(t) = 7 for all the functions y(t) which

satisfytheequation,simplyintegratebothsidesoftheequationtofindtheintegrals.

Y(t)={7dt=7t+c1

Y(t)={(7t+cl)dt=3.5t2+c1t+c

Thisiscalledageneralsolutionwhichindicatesthatwhencisunspecified,adifferential

equation has an infinite number of possible solutions. If c can be specified, the deferential

equationhasaparticularordefinitesolutionwhichaloneofallpossiblesolutionsisrelevant.

Example2.Theorderanddegreeofdifferentialequationsareshownbelow.

1. dy/dt=2x+6

Firstorder,Firstdegree

2. (dy/dt)45t5=0

Firstorder,Fourthdegree

3. d2y/dt2+(dy/dt)3+x2=0secondorder,Firstdegree

4. (d2y/dt2)7+(d3y/dt3)5=75yThirdorder,Fifthdegree

GENERALFORMULAFORFIRSTORDERRLINEARDIFFERENTIALEQUATIONS

For A firstorder linear differential equation, dy/dt and must be first degree and no

producty(dy/dt)mayoccurs.Forsuchanequation

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dy/dt+vy=z

Wherevandzmaybeconstantsorfunctionsoftime.Theformulaforageneral

solutionis

y(t)=e vdt A ze

dt

e

A is called the complementary function, and e

e

dtis called the

particular integral yp equals the intertemporal equilibrium level of y(t); the complementary

function yc represents the deviation from the equilibrium. For y(t) to be dynamically

negative). The solution of a differential equation can always be checked by

differentiation.

dy.dt+4y=12iscalculatedasfollows.Sincev=4andz=12,substitutinggives

y(t)=e

A 12e

dt

4dt+c,cisalwaysignoredandsubsumedunderA.Thus,

y(t)=e

A

12e dt

andsubstituting

y(t)=e

3e

=Ae4t+3

sincee4te4t=e0=1Astyc=Ae4t

stable.

To check this answer, which is a general solution because A has not has not been

specifiedstartbytakenthederivative.

Fromtheoriginalproblem,

+4y=12

=124y

Substitutingy=Ae4t+3

=124(Ae4t+3)=4Ae4t

Example.Givendy/dt+3t2y=t2Wherev=3t2andz=t2.Tofindthegeneralsolution,

firstsubstitute

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y(t)=e

t e

dt)

Integratingtheremainingintegralcallsforthesubstitutionmethod.Lettingu=t3,

du/dt=3t2,anddt=du/3t2,

t e dt

t e

du

3

1

3

13e

13e

e du

Finallysubstituting

y(t)

t3

et

Ae

t3

Ast,yc=Aet30andy(t)approaches Theequilibriumisdynamicallystable.

Differentiatingcheckthegeneralsolution,dy/dt=3t2Ae .Fromtheoriginalproblem,

+3t2y=t2

=t23t2y

Substitutingy

=t23t2(Ae +1/3)=3t2Ae

EXACTDIFFERNETIALEQUATIONSANDPARTIALINTEGRATION

Givenafunctionofmorethanoneindependentvariable,suchasF.(y,t)where

M=aFlayandN=aFlat,thetotalDifferentialiswritten

dF(y,t)=Mdy+Ndt

Since F is a function of more than one independent variable, M and N are partial

derivativesandequationiscalledapartialdifferentialequation.Ifthedifferentialissetequal

tozero,sothatMdy+Ndt=0,itiscalledanexactdifferentialequationbecausetheleftside

exactly equals the differential of the primitive function F(y,t). For an exact differential

equation, M/ t must equal N/ y, that is, 2 F| t y

a F|( y t). For proof of this

proposition.

Solutionofanexactdifferentialequationcallsforsuccessiveintegrationwithrespectto

oneindependentvariableatatimewhileholdingconstanttheotherindependentvariable s .

Theprocedure,calledpartialintegration,reversestheprocessofpartialdifferentiation.

Example.Solvetheexactnonlineardifferentialequation

1. Test to see if it is an exact differential equation. Here M 6yt 9y2 and N 3y2 8t.

Thus, aM1 at 6y and aN1 ay 6y. If aM1 at aN1 ay, it is not an exact differential

equation.

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2. SinceM AFlayisapartialderivative,integrateMpartiallywithrespecttoybytreating

tasaconstant,andaddanewfunctionZ t foranyadditivetermsoftwhichwouldhave

beeneliminatedbytheoriginaldifferentiationwithrespecttoy.Notethatayreplaces

dyinpartialintegration.

Thisgivestheoriginalfunctionexceptfortheunknownadditivetermsoft,Z t

3. Differentiatewithrespecttot,tofind

F

t

earliercalledN .Thus

3y

Z t

Since F/ t=NandN=3y2+8t,substitute

=3y2+8t

3y2+8t=3y2+Z(t)Z(t)=8t

4. NextintegrateZ(t)withrespecttottofindthemissingtterms.

Z(t)=Z(t)dt=8tdt=4t2

5. Substituteandaddaconstantofintegration

F(y,t)=3y2t+3y3+4t2+c

Thisiseasilycheckedbydifferentiation.

INTEGRATINGFACTORS

Not all equations are exact. However, some can be made exact by means of an

integratingfactor.Thisisamultiplierwhichpermitstheequationtobeintegrated.

EXAMPLE.Testingthenonlineardifferentialequation5ytdy+(5y 2+8t)dt=0revealsthatitis

notexact,withM=5ytandN=5y2+8t,

=5y

=10y.Multiplyingbyanintegratingfactor

oft,however,makesitexact:5yt2dy+(5y2t+8t2)dt=0.Now

=10yt=

,andtheequation

canbesolvedbytheprocedureoutlinedabove.

Tochecktheanswertoaprobleminwhichanintegratingfactorwasused,takethetotal

differentialoftheanswerandthendividebytheintegratingfactor.

RULESFORTHEINTEGRATINGFACTOR

Tworuleswillhelptofindtheintegratingfactorforanonlinearfirstorderdifferential

equation,ifsuchafactorexists.Assuming

=f(y)alone,thene

isan

integratingfactor.

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Rule2.If1/M(aN/ayaM/at)=g(t)alone,thene

isanintegratingfactor.

EXAMPLE.Toillustratetherulesabove,findtheintegratingfactorgiveninexample7,where

5ytdy=(5y2+8t)dt=0,M=5yt,N=5y2=8t

Applyingrule1,

=5y

10

=10y

Which is not function of y alone and will not supply an integrating factor for the

equation.ApplyingRule2,

1

5

1

10

5

5

5

e

1n t

=e

=t

SEPERATIONOFVARIABES

orderfirstdegreedifferentialequationsisoneinwhichthehighestderivativeisthederivative

dy/dtandthatderivativeisraisedtoapowerof1.Itisnonlinearifitcontainsaproductofy

anddy/dt,oryraisedtoapowerotherthan1)Iftheequationisexactorcanberenderedexact

by an integrating factor; the procedure outlined in Example 6 can be used. If, however, the

equationcanbewrittenintheformofseparatedvariablessuchthatR(y)dy+s(t)=0,whereR

ands,respectively,arefunctionsofyandtalone,theequationcanbesolvedsimplybyordinary

integration.

EXAMPLE.Thefollowingcalculationsillustratetheseparationofvariablesproceduretosolve

thenonlineardifferentialequation.

dy/dt=y2t

First,separatingthevariablebyrearrangingterms,

dy

y

tdt

y-2 dy = tdt

-1/y =

y=

Letting, c = 2c2 -2c1

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Since the constant of integration is arbitrary until it is evaluated to obtain a particular solution,

it will be treated generally and not specifically in the initial steps of the solution ec and Ln c can also

be used to express the constant

This solution can be checked as follows: Taking the derivatives of y = -2(t2+c)-1 by the

generalized power function rule,

dy/dt = (-1)(-2)(t2+c)-2(2t) =

dy/dt = y2t. substituting into

dy/dt =

EXAMPLE. Given the nonlinear differential equation

t2dy + y3 dt = 0

Intergrating the separated f(t). But multiplying by 1/(t2 y3) to separate the variables gives

1

and

dy

F(y,t) =

12y

= 12y

12y

dt

t

1/ t

For complicated function, the answer is frequently left in this form. It can be checked by

differentiating and comparing, which can be reduced through multiplication by y3t2.

ECONOMIC APPLICATIONS

Differential equations serve many functions in economics. They are used to determine the

conditions for dynamic stability in microeconomic models of market equilibrium and to trace the

time path of growth under various conditions in macroeconomic. Given the growth rate of a

function, differential equations enable the economist to find the function whose estimate the demand

growth is described; from point elasticity, they enable the economist to estimate the demand function.

They were use to estimate capital functions from marginal cost and marginal revenue functions.

EXAMPLE Given the demand function Qd =c+bp and the supply function Qsg +hp, the equilibrium

price is

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Assume that the rate of change of price in the market dp/dt is a positive linear function of

excess demand Qd Qs such that

= m(Qd-Qs)

m = a constant > 0

The conditions for dynamic price stability in the market (i.e under what conditions p(t) will

converge to p as t] can be calculated as shown below. Substituting the given parameters for Qd and

Qs

dp

dt=m[(c+bp)(g+hp0]=m(c+bpghp)

v=m(hb)andz=m(cg)

P(t)=

e

Ze

v

AeZe

Att=0,P(0)=A+z/vandA=p(0)z/v

Substituting

vv

Finally,replacingv=m(hb)andz=m(cg),

P(t)=[p(0)z]e vt+z

P(t)=

Thetimepathis

P(t)=

Sincep(0),p,m>0,thetermontherighthandsideconvergetowardszeroastand

thusp(t)willconvergetoward ponlyifhb>0.Fornormalcaseswheredemandisnegatively

sloped(b<0)andsupplyispositivelysloped(h>0),thedynamicstabilityconditionisassured.

Markets which positively slopeddemand functionsornegatively sloped supply functions will

alsobedynamicallystableaslongash>b.

PHASEDIAGRAMSFORDIFFERENTIALEQUATIONS

phase diagrams, however, offerqualitative information about the stability asfunctions that is

helpfulindeterminingwhethertheequationswillconvergetoanintertemporal(steadystate)

equilibriumornot.Aphasediagramofadifferentialequationdepictsthederivativewhichwe

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nowexpressasyforsimplicityofnotationasafunctionofy.Thesteadystatesolutioniseasily

identified on a phase diagram as any point at which the graph crosses the horizontal axis,

becauseatthatpointy=0andthefunctionisnotchanging.Forsomeequationstheremaybe

morethanoneintersectionandhencemorethanonesolution.

Diagrammatically,thestabilityofthesteadystatesolution(s)isindicatedbythearrows

of motion, The arrows of motion will point to the right (indicating y is increasing) any time

graph of y is above the horizontal axis (including y>0) and to the left (indicating y is

decreasing)anytimethegraphofyisbelowthesolutionisstable;ifthearrowsofmotionpoint

awayfromasteadystatesolution;thesolutionisunstable.

equilibriumpointtellsusiftheequilibriumpointisstableornot.Whenevaluatedatasteady

stateequilibriumpoint.

Ifdy/dy<0,theequilibriumisstable

Ifdy/dy>0,thepointisunstable

EXAMPLE.Giventhenonlineardifferentialequation

Y=8y2y2

Aphasediagramcanbeconstructedandemployedinsixeasysteps.

1. The intereporal or steadystate solution (s), where there is no pressure for change, is

foundbysetting

Y=0andsolvingalgebraically.

Y=84y=0

2y(4y)=0

Y=0

y=4steadystatesolutions

Thephasediagramwillpassthroughthehorizontalaxisaty=0,y=4

2. Sincethefunctionpassesthroughthehorizontalaxistwice,ithasoneturningpoint.We

nextdeterminewhetherthatpointisamaximumorminimum.

dy/dy=84y=0

y=2isacriticalvalue

=4<0

concave,relativemaximum

3. Arough,butaccurate,sketchofthephasediagramcantheneasilybedrawnseeFig.

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4. The arrows of motion complete the graph. As explained above, where the graph lies

abovethehorizontalaxis,y>0andthearrowsmustpointtotheright;wherethegraph

liesbelowthehorizontalaxis,y>0andthearrowsmustpointtotheleft.

5. The stability of the steadystate equilibrium points can now be read from the graph.

Sincethearrowsofmotionpointawayfromthefirstintertemporalequilibriumy1=0,y1,

is an unstable equilibrium. With the arrows of motion pointing toward the second

intertemporalequilibriumy1=4,y2is2stableequilibrium.

6. The stop of the phase diagram at the steadystate solutions can also be used to test

stabilityindependentlyofthearrowsofmotion.Sincetheslopeofthephasediagramis

positiveaty1=0,

Wecanconcludey1isanunstableequilibrium.Sincetheslopeofthephasediagramis

negativeaty2=4,weknowny2mustbestable.

EXAMPLE.Withoutevenresortingtoaphasediagram,wecanusethesimplefirstderivative

evaluated at the intertemporal level (s) to determine the stability of differential equations.

Giveny=8y2y2

Evaluatedatthesteadystatelevels,y1=0andy2=4,

4 0

isunstable

MathematicalEconomics(IIISem.)

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USEOFDIFERENTIALEQUATIONSINECONOMICS

1. findthedemandfunctionqf(p)ifpointelasticityis1forallp>0

gQp/dpp/Q=1 dQ/dp=Q/p

separatingthevariables, dQ/Q+dp/p=0

Integrating,inQ+Inp=Inc

Qp=c

Q=c/p

2. Findthedemandfunctionf(p)if=kaconstant.

E=dQ/Dp p/Q=k

dQ/dp=kQ/p

Separatingthevariables,

dQ/Q+k/pdp=0

inQ+klnp=c

Qpk=cQ=cpk

FIRSTORDERDIFFERENCEEQUATIONS

DEFINITIONSANDCONCEPTS

Adifferenceequationexpressarelationshipbetweenadependentvariableandalagged

independentvariable(orvariables)whichchangesatdiscreteintervalsoftime,forexample,I1

= f(yt 1), where 1 and y are measured at the end of each year. The order of a difference

equation is determined by the greatest number of periods lagged. A firstorder difference

equationexpressesatimelagofoneperiod;asecondorder,twoperiod;etc.Thechangeiny

astchangesfromtto+1iscalledthefirstdifferenceofy.Itiswritten.

differentialequations.Thesolutionofadifferenceequationdefinesyforeveryoftanddoes

notcontainadifferenceexpression.Seeexamples1and2.

EXAMPLE1.Eachofthefollowingisadifferenceequationoftheorderindicated.

1t=a(yt1y12)

order2

Qs=a+bpt1

order1

Yt+39yt+2+2yt+1+6yt=8 order3

yt=5yt

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Substitutingfromforyt,above,

Yt+1yt

yt+1=6yt

order1

EXAMPLE2.Giventhattheinitialvalueofyisy0inthedifferenceequation

yt+1=byt

asolutionisfoundasfollowsbysuccessivesubstitutionsoft=0,1,2,3etc.

y1=by0

y2=by1=b(by0)=b2y0

Thus,foranyperiodt,

y3=by2=b(b2y0)=b3y0

y4=by3=(b3y0)=b4y0

Yt=bty0

Thismethodiscalledtheiterativemethod.Sincey0 isaconstant,noticethecrucialrole

bplaysindeterminingvaluesforyastchanges.

GENERALFOMULAFORFIRSTORDERLINEARDIFFERENCEEQUATIONS

Given a first-order difference equation which is linear (i.e, all the variable are raised to the

first power and there are no cross products),

yt=byt1+a

wherebandaareconstants,thegeneralformulaforadefinitesolutionis

yt=(y0a/1b)bt+a/1bwhenb1

yt=y0+at

whenb1

calledageneralsolution

equation,b=7anda=16sinceb1,

yt=(516/1+7)(7)t+16/1+7=3(7)t+2

Tochecktheanswer,substitutet=0andt=1

Y0=3(7)0+2=5since(7)0=1

Y1=3(7)1+2=19

SubstitutingY1=19forytandy0=5foryt1intheoriginalequation,

19=7(5)+16=35+16

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STABILITYCONDITIONS

Inthegeneralform

Yt=Abt+c

WhereA=y0a/(1b)andc=a/(1b),hereAbtiscalledthecomplementaryfunction

andcisthe particular solution.The particular solutionexpressestheintemporal equilibrium

level of y; the complementary function represents the deviation from that equilibrium.

Equationwillbedynamicallystable,therefore,onlyifthecomplementaryfunctionAbt0,ast.

AlldependsonthebasebassumingA=1andc=0forthemoment,theexponentialexpression

bt will generate seven different time paths depending on the value of b, as illustrated in

Example4.Asseenthere,ithetimea.if |b|>1thetimepathwillexplodeandmovetowards

equilibrium.Ifb>0,thetimepathwilloscillatebetweenpositiveandnegativevalues;b>0,the

timepathwillbenonoscillating.IfA 1,thevalueofthemultiplicativeconstantwillscaleupor

down the magnitude of bt, but will not change the basic pattern m of movement. If A = 1, a

mirrorimageofthetimepathofbtwithrespecttothehorizontalaxiswillbeproduced.Ifc0,

theverticalinterceptofthegraphisaffectedandthegraphshiftsupordownaccordingly.

THEHARRODMODEL

TheHarrodModelattemptstoexplainthedynamicsofgrowththeeconomy.Itassumes

St=syt

WheresisaconstantequaltobothMPSandAPS.

Italsoassumestheaccelerationprinciple.Theinvestmentisproportionaltotherateof

changeofnationalincomeovertime.

It=a(ytyt1)

Whereaisaconstantequaltoboththemarginalandaveragecapitaloutputratios.

Inequilibrium,It=st

Dividingthroughbyastoconformto(17.3),Yt=[a/(as)]Yt1,sinceal(as)1,

a(ytyt1)=syt=(as)yt=ayt1

Yt=(Y00)(a/as)t+0=(a/as)tY0

Thestabilityofthetimepaththusdependsonal(as).Sincea=thecapitaloutputratio,

whichisnormallylargerthan1,andsinces=MPSwhichislargerthan0andlessthan1,the

basea;(as)willbelargerthan0andusuallylargerthan1.Therefore,Ytisexplosivebutnon

oscillating.Incomewillexpandindefinitely,whichmeansithasnobounds.

EXAMPLE 8. The warranted rate of growth (i.e., the path the economy must follow to have

equilibrium between saving and investment each year)can be found as follows in the Harrod

Model.

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Yt increases indefinitely. Income in one period is a/(as) times of the income of the

previousperiod.

Y1=(a/as)Y0

TherateofgrowthGbetweentheperiodsisdefinedas

G=

Substituting

G=

1=

Thewarrantedrateofgrowth,therefore,is

Gw=

Ref:IntroductiontoMathematicalEconomics3rdedition.

ByEDWARD.T.DOWLING

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MODULEII

PRODUCTIONFUNCTION

providesabasefortheanalysisofrelationsbetweencostsandvolumesofinputcostsinfluence

supplieswhichalongwithdemand determineprices.Thetheory ofproductionservesabase

for the theory of demand for factors of production. Production means a transformation of

inputs into outputs. The inputs are the things brought by the firm and the outputs are the

thingswhichthefirmsells.

Productiontakesplacebythecombinedforcesofvariousfactorsofproductionsuchas

land, labour capital and enterprise. In production there are two processes, namely theory of

production and theory of costs. The theory of production shows the physical relationship

betweeninputsandoutputs.Thetheoryofcostsrepresentthelevelofoutputandcosts.

processofproduction.

commodity depends on the employed inputs. Production function explains the physical

relationship between the units of employed inputs and the output. The money price do not

appearinaproductionfunction.

MathematicallyX=f(L,K,l,E)

WhenX=output,L=labour,K=capital,l=landandE=Enterprise

Theoutputinthedependentvariableandallothersareindependentvariables.

Ifanyfirmwantstoincreaseitsproductionitcandointwoways.Eitheritcanincrease

all the units of required inputs or can increase the units of some inputs white others remain

constant.

Production not only depends on the quantity of inputs but also depend upon the

technique of production. The improvement in technology results in increased production,

withoutanyincreaseininputs.Inthiscaseproductionfunctionitselfchanges.Theproduction

function depends upon two things i) The quantity of production and ii) The range of

production techniques. The possibility of substituting different factors of production play an

importantroleintheproductionprocess.

Production Analysis: The production of certain commodities requires use of two or more

factorsofproduction.Theamountofproductionofanycommodityuniquelydependsuponthe

amountsofdifferentfactorsusedundercertaintechnicalconditions.

SupposethequantityxofcommodityXisproducedbyusingamountsa1a2offactorsA1

andA2.Thentheproductionfunctionisx=f(a1a2).

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We assume that only factor A1 is varied and A2 is held constant. Then the ratio is

is termed as marginal

productionoffactorA1

Lawofvariableproportions

Relation ship between average product (AP), Marginal production (MP) and total

product(TP)curves.

Totalproduct,averageproductandmarginalproductarerelateddifferentways.Their

relationshipisdifferentindifferentstagesofproduction.

StageIMPbeginstodeclinebutAPreachesitsmaximumandMPcurvecutsAP

curveatitsmaximum.

StageIIAPandMPbothfallandMP=0,thenT.Pismaximum.

StageIIIMPisnegative:TPandAPbothfall.

EndofstageIiswhereAPismaximumandatthismaximumAP=MP.

EndofstageIIiswhereMP=0andTPismaximum.

Thethreephasesoflawofvariableproportionsare

i)

Stageofincreasingaveragereturns

ii)

Stageofdiminishingaveragereturns

iii)

Stageofabsolutediminishingreturns.

proportionsoperatesbyassumingthattechnologicalproductionremainunchanged.

APandMPCurve

T.P.Curve

TP

A1

TPCurve

AP

MP

MPCurve

APCurve

FactorX1

MathematicalEconomics(IIISem.)

FactorX1

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TP,APandMPCurveinastageproportion

StageIII

StageII

AP StageITPCurve

TP

MP

MPCurve

APCurve

Factorx1

Isoquants

Isoquantsorequalproductcurvesarealsoknownasproductionindifferencecurves.It

isacurvewhichrepresentsthedifferentcombinationsoftwofactorsofproductionwhichare

capable of producing the same output. These curves may be infinite numbers. Different

isoquantssharedifferentlevelsofoutputthatcanbeobtainedfromdifferentcombinationsof

factorsofproduction.Theisoquantcurvehavethefollowingproperties.

i)

Theisoquantsslopedownfromlefttoright

ii)

Isoquantscannotcuteachother.

iii)

Isoquantsareconvextoorigin.

ISOQUANT

UnitsoffactorX2

Isoquant

UnitsoffactorX1

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ProducersEquilibrium

satisfaction for his fixed income. Likewise a producer also tried to maximize his output at

minimum cost. If he attains such a point then he has no tendency to move further Thus,

producers equilibrium is that situation where he has no tendency to move further or where

producers gain is mazimum. The maximum gain can be achieved through two method i)

Maximisationofproductionandii)Minimisationofproductioncost.

MaximisationofProduction

TC=x1p1+x2p2,wherep1 andp2betheunitpricesoffactorsx1 andx2respectively.Themain

aimofaproduceristoattainthemaximumoutputforthegivenlevelofinputs.

Theconstrainedobjectivefunctionis

WhereistheLagrangesmultiplier

Letq=f(x1,x2)betheproductionfunction

Then dq =

Z=f(x1,x2)+[TCx1p1x2p2]

changeininputs.

Sinceonbeingthesameisoquant,outputremainsunchanged.

f1dx1+f2dx2=0

iscalledtherateoftechnologicalsubstitution.

representsthemarginalrateat

whichtheproducercansubstituteinputX2forX1orX1forX2,inordertomaintainspecificout

levelq.

Themarginalrateoftechnicalsubstitution

MRTS=

. .

. .

representtheslopeofisoquanthavinganegativesign.

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MRTSofX2forx1isthatamountoffactorX2whichtheproducerisreadytosacrificeto

getanadditionalamountoffactorX1.

OndifferentiatingZPartially,weget

And =TCx1p1x2p2

Byapplyingtheconditionsformaximum

Weget

=f1p1,

=f2p2

wheref1=

. .

. .

i.e,

andf2=

MinimumisationofCost

Here,theobjectiveistominimizethecostatoptimumoutput

Heretheobjectivefunctionis

Thentheminimisingconditionare

=p1f1=0

=p2f2=0

And

Usingthereconditionweget

Z=x1p1+x2p2+[qf(x1,x2)]

=qf(x1,x2)=0

or

ExpansionPath

Intheproducersequilibriumconditionitisassumedthatproducerscostremainfixed.

Butifthechargeinthecosttakeplacewhilepricesoffactorsofproductionremainsamethen

what will be the effect in equilibrium point? When isocost line changes the producers

equilibriumwillcharge.Ifweconnectalltheproducersequilibriumpointsofdifferentisocost

lines,wegettheexpansionpathofaproducer.Thesizeofexpansionpathdependsuponthe

natureofproductionfunction.

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Problem:Findthefirmsexpansionpathiftheproductionfunctionisq=12logx1+30logx1

andtheinputpriceofunitvaluesofx1andx2respectivelyareP1andP2andP1=2,P2=5

Solution

UsingLagrangesmultiplication,theobjectivefunctionbe

Z=12logx1+30logx2+[TC2x15x2]

Thenthemaximisingconditionsare

=0

=0

=0

2=0,

5=0

Usingtheseconditions,weget

=2and

Ondivision,weget

Onsimplificationwegetx1=x2

Hence

TC=2x1+5x1

TC=2x2+5x2

Thesevalueconstitutestherequiredexpansionpath

AndTC2x15x2=0

or

=5

x1= ,

x2= andhence=

ElasticityofSubstitution

Theelasticityofsubstitution,,isdefinedas

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Ifi) =,thenbothfactorsx1andx2areperfectsubstitutesforeachother.

ii) >0ie,0< <thenbothfactorsx1andx2areclosesubstitutesforeachother.

Ifiii) =0,thenthereisnopossibilityofanysubstitutionbetweenthem.

Problem:Iftheprofitremainsunaltered,theratioofamountofcapitalemployedperunitof

labourshiftsfrom10:10to12:11,giventhatriseinwagesis25%.

Determinetheelasticityofsubstitution.

Solution:

WhereK=Capital,L=Labour

= andchangedto =

Thewagesareincreasedby25%

Theinitialratioofpricesoflabourandcapitalbe

Thewagesareincreasedby25%.Sotheratiobecomes1.25:1=

= =

= =

i.e,

MathematicalEconomics(IIISem.)

changein =

=1:1

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MODULEIII

EULERSTHEOREM

Eulers theorem states that when all factors of production are increased in a given

proportion,theresultingoutputwillalsoincreaseinagivenproportion,providedeachfactors

ofproductionispaidthevalueofitsmarginalproductandthetotaloutputisjustexhausted.

Iftheproductionfunctionq=f(x1,x2)isalinearhomogeneousfunction,them

Whereq=totaloutput,x1=unitofoneinput,x2=unitofsecondinput

Iftellsusthatfactorx1willgetitsawardequalto

+x2.

q=x1.

=MP and

=MP

andx2willget

Sinceifafirmpaysthesuppliesofaninputitsawardequaltomarginalphysicalproduct,

thetotaloutputisjustexhausted.

Eulerstheoremplaysanimportantpartintheeconomicfield especiallyinthefieldof

distribution. The theorem suggests to afirm howtheinputs should be employed. Theinput

shouldbeemployedtothatextentatwhichthepriceoffactorisequaltoitsmarginalrevenue

product.Thusitalsosuggeststhedeterminationofpriceofafactorofproductions.

Eulerstheoremisbasedonfollowingassumption.

a) Thelawofconstantreturnstoscaleisbeingapplied.Itholdsgoodonlyinthecaseof

alinearlyhomogeneousproductionfunctionofdegreeone.

b) Thereisperfectcompetitioninthemarket.

c) Itassumerperfectdivisibilityofthefactorsofproduction.

d) Thetechnologyremainconstantinthegiventimeperiod.

CobbDouglasProductionFunction

ThegeneralformofCobbDouglasProductionFunctionis

Q=AKL

whereQ=output,K=capital,L=labour

KandLarethecapitalandlabourinputs.

Q=AKL

MathematicalEconomics(IIISem.)

Aisaconstantandarepositiveparameters

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If+=1,theproductionfunctionwilloperateunderconstantreturntoscale.

If+>1,therewillbeincreasingreturnstoscale.

If+<1,therewillbedecreasingreturnstoscale.

Properties

a) Iftheinputsareincreasedbyttimes,thetotaloutputwillalsoincreasebyttimes

Proof

Q=AKL

IfKandLareincreasedbyttimes

Q1= A(tK)(tL)=t

= t. AK L (if+=1)

= tQ

. AK L

b) Theproductionfunctionishomogeneousofdegreeone.

Proof

Iftheproductionfunctionishomogenousofdegreeonethentheproductionisoperating

underconstantreturnstoscale.i.e+=1

Q=AKL

i.e,logQ=log A

log K

log L

OndifferentiationpartiallywithrespecttoKandL,respectivelyweget

Then .

=Qif+=1

= and =

=Q+Q=(+)Q

c) Iftheproductionfunctionislinearandhomogeneous,thenelasticityofsubstitution

equaltounity(if+=1).

Proof

Theelasticityofsubstitution,

%

=

%

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Q=AKL

DifferentiatingwithrespecttoKandLrespectively,

Wehave

Onsubstitutionweget

Then=

=A.K1.Land =A.K.L1

= .

=1

Hencetheelasticityofsubstitutionisunity.

d) andrepresentsthecapitalshareandlaboursharetothetotaloutputrespectively.

Proof

Q=AKL

ThenlogQ==log A

DifferentiatingpartiallywithrespecttoK,weget

log K

log L

i.e,

i.e,

Similarly,differentiatingpartiallywithrespecttoL,weget

MathematicalEconomics(IIISem.)

M. Pofcapital

MarginalProductivityoflabour

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i.e,=

labourrespectively.

Proof

Q=AKL

logQ==log A

DifferentiatingpartiallywithrespecttoK,weget

i.e,

Similarlyweget

Then

%

=

%

Similarly

log K

log L

= .

= .

andpassesthroughorigin.

Proof

Proceedingasintheearlierproperties,weget

and =

i.e,MP

andMP

Usingtheconditionforoptimization,weget

MathematicalEconomics(IIISem.)

i.e.,

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i.e.,

i.e,

.L.PL=.K.PK

functionwhichislinearhomogeneousandPassesthroughorigin.

ImportanceofCobbDouglasproductionfunction

CobbDouglasproductionfunctionismostcommonlyusedfunctioninEconomics.This

function is helpful in wage determination principles. This function is helpful in explaining

marginal productivity principles and used to explain product exhaustion theorem. The

parameterandrepresentelasticitycoefficients.Theyarehelpfulincomparinginternational

levels.Thisfunctionishelpfulinthestudyofdifferentlawsofreturnstoscale.Thisfunction

playsanimportantroleineconomicfield.Itisusedtodeterminewagepoliciesundersector

comparisons,substitutabilityandthedegreeofhomogeneity.

Limitations:CobbDouglasproductionfunctionhascertaindrawsbacks.

a) Ifcontainsonlytwoinputs,capitalandlabour.Thereareseveralotherfactorswhichare

equallyimportantinproduction.

b) The production function operates under constant returns to scale. The conditions of

increasingreturnsanddiminishingreturnsareignored.

c) Thefunctionassumesthattechnologicalconditionsremainsconstant.Butitisnottime.

Theoutputconditionsvarywiththechangeintechnologicalconditions.

d) The function assumes that all inputs are homogeneous. In practice, all factors are not

equallyefficient.

e) Itassumesperfectcompetition.Butifthereisimperfectcompetitionthisfunctiondoes

notholdgood.

f) Thisfunctionignoresthenegativemarginalproductivityofafactor.

ConstantElasticityProductionFunction(C.E.S.function)

CobbDouglasproductionfunctionisafunctionwhoseelasticityofsubstitutionisunity

everywhere.Anyproductionwhoseelasticityofsubstitutionisconstantbutotherthanunityis

calledConstantElasticitysubstitutionproductionfunctionorC.E.S.Productionfunction.

C.E.S Production function represents the more general form of production technique

than Cobb Douglas production function. In C.E.S. Production function,

1,butaconstantC.E.S.Productionfunctionhaswiderscope,substitutabilityandefficiency.

C.E.S. Production function removes all the difficulties and unrealistic assumptions of

CobbDouglas production function. Cobb Douglas production function is a special case of

C.E.S.productionfunction.

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A.C.E.S.Productionfunctionisexpressedas

Q=r c

WhereQ=output,C=Capitalinput

N=labourinput,=Substitutionparameter

1=labourintensitycoefficientand

V=degreeoffreedom

C.E.S.Productionfunctionhasseveraladvantages

Ithassomelimitations

,(r>0

0<<1and>1)

a) ItconsideronlytwofactorNandC.

b)

C.E.S. function contains only one parameter, V, which is affected by the scale of

operationandtechnologicalchange,Theretwofactorsmayaffectthedegreeofreturnstoscale

butcannotdistinguishthemseparately.

c)

Itisassumedthatinthisfunctionthat changesinresponsetotechnologyonly

andfactorproportionsdonotaffectit.

Whiletheempiricalstudyshowsthattheelasticityofsubstitutionalsochangesdue to

changedfactorproportions.Thefunctionhasignoredthisimportantfact.

Returnstoscale

Aproductionfunctionexhibitsconstantreturnstoscaleifwhenallinputsareincreased

by a given proportion, K, output increases by the same proportion. If output increase by a

proportion greater than K, there are increasing returns to scale. If the output increase by a

proportion smaller than K,thereare diminishing returns to scale. If a productionfunction is

homogeneousofdegreegreaterthan,equalto,orlessthanonereturntoscaleareincreasing,

constantordiminishing.EconomicanalysisemploystheCobbDouglasproductionfunctionQ

=AKL,whereQisthequantityoutput,Kisthecapitalinput.Lislabourinput.,andAare

parameters.If+=1,CobbDouglasfunctionshowsconstantreturnstoscale.

Optimisation of Cobb Douglas production function is performed subject to a budget

constraint.

Forfurtherreadingreferto

i) Edward.T.Dowling:

IntroductiontoMathematicalEconomics(3rdedition)

ii) S.P.Sing.A.K.Parashar,H.P.Singh

EconometricsandMathematicalEconomics

iii) C.R.Kothari.

AnintroductiontooperationResearch(3rdedition)

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MODULEIV

INVESTMENTDECISIONS&ANALYSISOFRISK/UNCERTAINTY

NATUREOFINVESTMENTDECISIONS

represent a long term commitment. Such decisions form the framework for future

developmentofanorganization.Theyhaveaprofoundeffectonitsfutureearningsand

growth. They are a major determinant of efficiency and competitive strength of a

businessfirm.Toreachsuchdecisionsthefollowingstepsaretobefollowed.

a. Formulationofobjectives.

b. Establishingexistingdemandandfuturedemandforaservice.

c. Determinewhetherthedemandcanbemetwithexistingproductivecapacityor

whethernewinvestmentisrequiredtoincreasesupply.

d. Consideralternativeprojectsthatwouldenabletheobjectivetobeachieved.

e. Appraisetheinvestmentprojects.

AppraisalNecessary

appraisalhappenstobeanaidtodecisionmakingintheallocationofscarceresources

tocompetingusesofbothinpublicandprivatesectors.Iftheappraisalindicatesthata

projectcanbeundertakenprofitably,thentheinvestmentprojectthatshowsthebiggest

return on the investment capital should be chosen. But if it is a case of public sector

investment projectswhich are to provide socialservices then the criterion adopted in

selecting such project happens to be one of maximizing social benefit. Investment

decisionsinpublicsectorarenotonlygovernedbyananalysisofaccountingcostsand

benefitsbutalsoinfluencedbyseveralotherfactorssuchaspoliticalorsocialpressure.

For proper and appropriate investment decisions the information required are

givenbelow.

a. Estimatesofcapitaloutlayfortheproject.

b. Estimatesofthefuturecashflowsoftheproject

c. Estimateoftheavailabilityofcapitalalongwiththecostofcapital.

d. Setofstandardsfortheselectionofprojectsforexecution.(biggerbenefitsare

preferabletosmallerones;earlybenefitsarepreferabletolaterbenefits.)

There are several appraisal techniques for judging the profitability of new

investmentsinassets.

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TheymaybeclassifiedasNondiscountingandDiscountingtechniques.

Nondiscountingtechniquesare

1. Paybackmethod.

2. Averagerateofreturnmethod(ARRMethod)

Discountingtechniquesare

1. NetpresentvalueofNPVmethod

2. ProfitabilityIndex(P.I)

3. NetterminalvalueorNTVmethod.

4. InternalrateofreturnorIRRmethod.

PAYBACKMETHOD

Underthismethodprojectsareassessedonthebasisoftheperiodthatitwould

take to generate sufficient income to repay the original outlay. Payback is simply a

measureofthetimerequiredforthecashincomebeforechargingdepreciationbutafter

payment of tax from a project to return the initial investment to the firms treasury.

Payback occurs when the cumulative cash inflows from a project minus the initial

investmentisequaltozero.

Theadvantagesofpaybackmethodare

1. It is the most simplest criterion for appraising investment proposals since

shorterpaybackispreferredtolongerpayback.

2. Ittakesintoaccountpreferenceforanearlyrepaymentofcapitalinvested,the

capitalisthenavailableforotheruses.

3. Themethodispreferredbecauseofthefactthatthereturnsbeyondthreefour

yearsarequiteuncertain.

The method has some drawbacks. It fails to allow returns after the end of the

payback period. This method gives weights only to cash flows before the recovery of

investmentzeroweightstoallsubsequentreceipts.Itoveremphasizesliquidityaspect.

It ignores time value of money. Projects with longer gestation periods can never be

launched if we use this method since they begin to give return after a lapse of

considerableperiodoftime.

Paybackmethodispopularmethodforevaluatinginvestmentproposals.

AVERAGERATEOFRETURNorARRmethod

Thismethodofevaluatinginvestmentproposalsisprimarilybasedonaccounting

approach rather thancashflowapproach.Thismethodconsists ofaggregatingallthe

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earnings from the project after depreciation and dividing them by the projects life to

obtain the average annual earnings and then this average earning is divided by the

averaged investment and the resulting figure is multiplied by 100 so as to obtain the

desireARR.

ARR=(averageannualearnings)/(averageinvestment) 100.

NETPRESENTVALUEorNPVmethod

Payback and ARR methods do not consider the time value of money which is a

factor of basic importance in evaluating investment proposals. The money received

todayisworthmorethanthesameamounttobereceivedatalatertime.Itispreferable

to have money now than the same amount in future. The future is uncertain and in

meantimecapitalmaybeearningareturn.Discountedcashflow(DCF)techniquedos

considerthetimevalueofmoneyandisconsideredmoreobjectivebasisforevaluating

investmentproposals.UnderDCFtechniquethecashflowsarediscountedatacertain

rate. i.e; the rate must be earned so that the value remains constant over a period of

time. DCF method is superior on another ground as well since it does consider all

benefits and costs of the project during the entire period of its life. DCF methods are

mainlyoftwotypes.Netpresentvaluemethodandtheinternalrateofreturnmethod.

Twovariantsofnetpresentvaluemethodhappenstobe1.Netterminalvaluemethod

and2.Theprofitabilityindex.

NPVisoneoftheDCFtechniquesofevaluatinginvestmentproposals.Inapplying

NPVmethodthefollowingstepsaretobefollowed.

a. First the annual net cash flow expected from a project is calculated by

estimating all cash receipts and deducting from them all expenditure arising

outoftheproject.

b. Thenetcashflowisthendiscountedtogiveitspresentvalue.Therateusedto

discount the cash flow is the required rate of return. The minimum rate of

returnexpectedtobeearnedfromtheinvestmentprojects.

c. Thenetpresentvalueofaninvestmentproposalisthencomputed.Itisequal

tothesumofthepresentvalueofitsannualnetcashflowsaftertaxlessthe

investmentsinitialoutlay.

NPV=

whereCFt=netcashflowintimeperiodt, r=rateofdiscount

I0=Initialcashoutlay,

n=projectsexpectedlife

AcceptprojectifNPV>0,RejectifNPV<0IfNPV=0,apromotionofindifference

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TheadvantageofNPVmethodare

a. Thismethoddealswithcashflowsratherthanaccountingprofits.Thus,itis

sensitivetotruethetimingonthebenefitsassumingfromtheinvestment.

b. Itrecognizesthetimevalueofmoneyandallowscomparisonofbenefitscosts

inalogicalmanner.

c. This method is consistent with the goal of maximizing the shareholders

wealth since projects under this method are accepted only if they have

positiveNPVwhichinfactincreasesthevalueofthefirm.

d. Thismethodisspeciallyusefulinevaluatingmutuallyexclusiveprojects.

The major limitation of this method is that it requires detailed long term

estimates of the incremental benefits and costs. There may also arise difficulty in

decidingtheappropriaterateofdiscountforfindingthepresentvaluesofthecashflows

coming in over projects life. The relative desirability of an investment proposal may

changewithachangeinthediscountrate.Anothershortcomingofthismethodisthatit

maynotgivedependableresultsincaseofprojectsinvolvingdifferentoutlaysorhaving

differenteffectivelives.

practice.

THEPROFITABILITYINDEX(P.I)

Theprofitabilityindexistheratioofthepresentvalueofthefuturenetcashflows

totheinitialoutlayoftheproject.Thusindexprovidesarelativemeasureforjudging

desirabilityandevaluatingtheworthofaninvestmentproposal

P.I=

Where

CFt=netcashflowintimeperiodt

r=rateofdiscount

n=Theprojectsexpectedlife

I0=Initialcashoutlay

AccepttheprojectifitsP.I>1

RejecttheprojectifitsP.I<1

RemainindifferentbetweenacceptanceandrejectionifPI=1

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TheAdvantagesare

1. Itusescashflows.

2. Itrecognizesthetimevalueofmoney.

3. Itisconsistentwiththegoalofmaximizingtheshareholderswealth.

Themaindisadvantageofitisthatitrequiresdetailedlongtermforecastsofthe

incremental benefits and costs. It also poses difficulty in determining appropriate

discountrate.

NETTERMINALVALUE(NTV)method

NetterminalvaluemethodisanimportantvariantofNPVmethodbutseparates

the timings of the cash inflows and outflows more distinctly. The assumption

underlying this method is that each cash inflow is reinvested in another asset at a

certain rate of return from the moment it is received till the termination of project.

Under thus method we calculate the compounded reinvestment cash flows and then

take their total and of this total and present value is determined at a given rate of

discount.Fromthispresentvaluewesubtracttheoriginaloutlaysoastoobtainthenet

terminalvalue,NTV.

AccepttheprojectifNTVispositive

RejecttheprojectifNTVisnegative

RemainindifferentbetweenacceptanceandrejectionoftheprojectifNTViszero

bettermanner.Thismethodiseasiertounderstand.Themaindrawbackofthismethod

liesindeterminingthefutureratesofinterestatwhichthecashinflowsreceivedareto

bereinvested.

INTERNALRATEOFRETURN(I.R.R)METHOD

Internalrateofreturnisthediscountratecorrespondingto whichtheNPVofa

projecthappenstobezero.Internalrateofreturnmaybedefinedasthediscountrate

thatequatesthepresentvalueofprojectsfuturenetcashflowwiththeprojectsinitial

cashoutlay.

AcceptinvestmentproposalifitsIRRisgreaterthantherequiredrateofreturn

byinvestors.RejecttheinvestmentproposalifitsIRRislessthantherequiredrateof

returnbyinvestors.

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IRRbeingoneofthediscountedcashflowcriteriaisconsistentandprovidesthe

same acceptreject decision for an investment proposal as is being provided by either

NPVmethodorPI.

AprojecthaveonlyoneNPVandonePI.Butundercertainsituationsitcanhave

morethanoneIRR.ThisistheproblemofmultipleIRRs.

IRRmethodhascertainadvantages.

a. Ittakesintoaccountthetotalcashinflowandoutflows.

b. Itrecognizesthetimevalueofmoney.

c. Itisconsistentwiththeobjectiveofmaximizingshareholderswealth.

d. IRRmethodiseasytounderstand.

IRRmethodhassomelimitations.

a. Itinvolvestediouscalculations.

b. Itrequiresdetailedlongtermforecastsofincrementalbenefitsandcosts.

c. Possibility of multiple IRRs remains in some situations which reduces the

utilityofthismethod.

ANALYSISOFRISK/UNCERTAINTY

Whilemakinginvestmentdecisionswemakeanestimateofbenefits,intermsof

cashflows,tobederivedfromtheprojectonthebasisofcertainassumptions.Butthe

actualflowdependsonseveralotherfactorssuchaspriceofproduct,volumeofsales,

therateofinflationetc.Theactualcashflowsmaynotcorrespondtotheestimatedcash

flow.Thevariationbetweenactualandestimatedcashflowsoftheinvestmentproject

istermedasrisk.Theriskofaprojectdependsuponthedegreeofvariabilitybetween

thetwo.Ifthevariabilityhappenstobegreater,theprojectisconsideredmorerisky.

Riskreferstothesetofuniqueoutcomesforagiveneventwhichcanbeassigned

probabilitieswhileuncertaintyreferstotheoutcomesofagiveneventwhichareunsure

tobeassignsprobabilities.Inrisksituationtheprobabilitydistributionisknowntothe

decisionmaker.Whenuncertaintyexists,thedecisionmakerhastocomputesubjective

probability on the basis of his experience. Variability is less in the situation of risk

comparedtovariabilityinuncertainsituations.

Theimportantriskhandlingapproachesare

a. Riskadjusteddiscountrateapproach(RADapproach)

b. Certaintyequivalentapproach

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c. Probabilitydistributionapproach(FrederickHilliermodels)

d. Decisiontreesapproach

e. Simulationapproach

f. Sensitivityanalysis.

Riskadjusteddiscountrateapproach

It is the most simple and widely used approach for incorporating risk into

investmentdecisions.Underthisapproachthediscountrateusedinthepresentvalue

calculationissoadjustedastoincorporatetheamountofriskinherentinaproject.For

moreriskyprojectsthehigherdiscountratesandforlessriskyprojectslowerdiscount

ratesareusedforpresentvaluecalculations.RADapproachcanbeusedwithNPVand

IRRtechniquesofevaluatinginvestmentproposals.IncaseofNPVmethod,theNPVwill

becalculatedusingtheriskadjustedrateandtheprojectwouldbeacceptedinNPVis

positive. In case of IRR, the internal rate of return would be compared with the risk

adjusted rate of return. If IRR exceeds the riskadjusted rate, the project would be

accepted.

RAD approach is simple and easy to understand and possesses the merit of

operationalfeasibility.Thusitisfrequentlyusedinpractice.RADapproachisacrude

methodofincorporatingriskintoinvestmentdecisions.

CertaintyEquivalentApproach

Underthisapproachofincorporatingriskinevaluatinginvestmentproposals,the

expected cash flows are soadjustedas to takecare of theinherent risk of the project.

Thefollowingstepsareinvolvedunderthisapproach.

a. Astheexpectedcashflowaretobemodified,thefirststephappenstobethe

determinationofbasisformodifyingthecashflowstoadjustforrisk.Thisis

done by computing the certaintyequivalent coefficient which shows the

relationship between certain and uncertain cash flows. This coefficient is

calculatedwhenwedividerisklesscashflowbyriskycashflow.

Certaintyequivalentcoefficient=Risklesscashflow/riskycashflow

b. Withthehelpofcertainty=equivalentcoefficientstheexpectedcashflowsare

convertedtocertaintyequivalents.

c. Thepresentvaluesofcashflowscalculatedareworkedoutusingtheriskfree

discountrateortheratewhichappropriatelyreflectsthetimevalueofmoney.

d. Foracceptingtheprojectornotacceptingit,eitherNPVorIRRmethodmaybe

used.

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ForthepurposeofcomputingNPVundercertaintyequivalentapproachweuse

NPV=

Where

at=Certaintyequivalentcoefficientfortheyeart.

I=risklessinterestrate

C=Cashoutflow(ortheinitialinvestment)

Thisapproachissimpleandeasytounderstand.Itissuperiortotimeadjusted

discountrateapproach.

ProbabilityDistributionApproach

approach, the degree of risk associated with a project is measured in terms of the

varianceofNPVdistribution.Investmentdecisionsaretakenonthebasisofmeanand

standarddeviationvaluesofthenetpresentvaluedistribution.Inthismethodnetcash

flow from an investment in each period is viewed as a random variable which can

assumeanyoneofthepossiblevalues.Itrequiresthatprobabilitydistributionofcash

flows for each of the years be obtained and made use of it. The expected value and

varianceofNPVdistributionarecalculatedas

ExpectedvalueofNPV

E(NPV)= =

Where

E(NPV)=expectedNPVoftheproject

ct=meanofthecashflowsinyeart

i=rateofdiscount

VarianceofNPV(HillierModel)

i.

Independentcashflows:Whencashflowsofoneperiodarenotrelatedto

cashflowsofanotherperiod.

VarianceofNPV;V(NPV)=

Where =Varianceofcashflowsinyeart,i=rateofdiscount

ii.

Perfectlycorrelatedcashflows:whencashflowsareperfectlycorrelated,

MathematicalEconomics(IIISem.)

V(NPV)=

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Where

iii.

=Standarddeviationofcashflowsinyeart.i=rateofdiscount

Mixedcashflows:(whereapartofcashflowsareperfectlycorrectedand

partareindependent)

V(NPV)=

C =independentcashflowsinyeart, i=rateofdiscount

C =Correlatedcashflowsinyeart,correlatedwithanyotherperiod.

V=Variancecashflowstreams

100

CoefficientofVariation=

Ahighercoefficientofvariationindicateshigherriskintheconcernedproject

DecisionTreesapproach

Decision trees approach is considered very useful and convenient approach for

incorporating risk into investment decisions. Under this approach the problems of

investmentdecisionsaredepictedintheformofdiagramsonthebasisofwhichthebest

course of action is suggested. The main feature of this approach is that it takes into

accounttheimpactofallprobabilisticestimatesofpotential outcomes.Thisapproach

particularlysuitsthosesituationswhereindecisionsatonepointoftimealsoaffected

decisions at some later date. Projects requiring sequence of decisions over time and

having several possible outcomes are most suitable to be tackled by decision tree

approach.

Simulationapproach

Simulationapproachmaybeusedininvestmentdecisionsespeciallywhendueto

uncertaintiesasatisfactorymathematicalmodelcannotbeused.Simulationtechnique

can be used to approximate NPV or IRR and its dispersion about the expected value.

Thefollowingstepsareinvolvedinsimulationapproach.

a. The various factors influencing cash and NPV of an investment proposal are

identified.

b. Theprobabilitydistributionsofeachofidentifiedfactorsare obtainedeither

usingpastdataorbyanexperienceofdecisionmaker.

c. Then the values of each of variables are simulated with the help of random

numbers.Avalueforeachofthefactorsisthenselectedatrandom.

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SchoolofDistanceEducation

d. OnthebasisofthesetofvaluessoobtainedNPVorIRRiscomputedforeach

combinationofidentifiedfactors.

e. RepeattheaboveproceduretodevelopprobabilitydistributionofNPVorIRR

and calculate mean standard deviation and statistical parameters. Then a

decisionistakenontherelatedproposal.

Sensitivityanalysis

decisions.

Followingstepsareinvolvedinusingsensitivityanalysisininvestmentdecisions.

a. Data relating to cash flows of an investment proposal are broken down into

some major variables like initial outlay required, wage rates, selling prices,

interest rates, etc. A model of the project is drawn up on the basis of some

estimatedvaluesofrelatedvariables.

b. Eachvariableisconsideredinturnanditsvalueischangedbothupwardand

downwardfromitsoriginalestimate.

c. TheNPVorIRRvaluesrecomputedbytakingeachnewestimateinturn.

d. WithrecomputedNPVorIRRvaluesaneffortismadetodetermineastowith

whichvariablefluctuationsthegivenprojectisparticularlysensitive.

Sensitivity analysis serves as a guide and indicate areas where additional

effort to produce better estimates may be made. In view of this sensitivity

analysisiswidelyusedinpractice.

Forfurtherreadingandreference:

AnintroductiontooperationsresearchbyKOTHARI.C.R.

******

MathematicalEconomics(IIISem.)

Page40

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