Fundamenta

Methods of
Mathematical
Economics
Fourth Edition

Alpha C. Chiang
Professor Emeritus
University of Connecticut

Kevin Wainwright
British Columbia Institute of
Technology and
Simon Fraser University

Me
Graw
Hill
Boston Burr Ridge, IL Dubuque, IA Madison, Wl New York San Francisco St. Louis
Bangkok Bogota Caracas Kuala Lumpur Lisbon London Madrid Mexico City
Milan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto

Contents
PART ONE

PART TWO

INTRODUCTION 1

STATIC (OR EQUILIBRIUM)

ANALYSIS 29

Chapter 1
The Nature of Mathematical
Economics 2

Chapter 3
Equilibrium Analysis in Economics 30

1.1 Mathematical versus Nonmathematical

3.1
3.2

1.2

Economics 2
Mathematical Economics versus
Econometrics 4

Chapter 2
Economic Models 5
Ingredients of a Mathematical
Model 5
Variables, Constants, and Parameters 5
Equations and Identities 6
2.2 The Real-Number System 7
2.3 The Concept of Sets 8
Set Notation 9
Relationships between Sets 9
Operations on Sets 11
Laws of Set Operations 12
Exercise 2.3 14
2.4 Relations and Functions 15
Ordered Pairs 15
Relations and Functions 16
Exercise 2.4 19
2.5 Types of Function 20 >
Constant Functions 20
Polynomial Functions 20
Rational Functions 21
Nonalgebraic Functions 23
A Digression on Exponents 23
Exercise 2.5 24
2.6 Functions of Two or More Independent
Variables 25
2.7 Levels of Generality 27

3.3

2.1

3.4

3.5

The Meaning of Equilibrium 30

Partial Market EquilibriumA Linear
Model 31
Constructing the Model 31
Solution by Elimination of Variables 33
Exercise 3.2 34
Partial Market EquilibriumA Nonlinear
Model 35
Quadratic Equation versus Quadratic
Function 35
The Quadratic Formula 36
Another Graphical Solution 37
Higher-Degree Polynomial Equations 38
Exercise 3.3 40
General Market Equilibrium 40
Two-Commodity Market Model 41
Numerical Example 42
n-Commodity Case 43
'
Solution of a General-Equation System 44
Exercise 3.4 45
Equilibrium in National-Income Analysis 46
Exercise 3.5 47

Chapter 4
Linear Models and Matrix Algebra

48

4.1 Matrices and Vectors 49

4.2

Matrices as Arrays 49
Vectors as Special Matrices 50
Exercise 4.1 51
Matrix Operations 51
Addition and Subtraction of Matrices 51
Scalar Multiplication 52

xii

4.3

4.4

4.5

4.6

4.7

Contents

Multiplication of Matrices 53
The Question of Division 56
The S Notation 56
Exercise 4.2 58
Notes on Vector Operations 59
Multiplication of Vectors
59
Geometric Interpretation of Vector
Operations 60
Linear Dependence 62
Vector Space 63
Exercise 4.3 65
Commutative, Associative, and Distributive
Laws 67
Matrix Addition 67
Matrix Multiplication 68
Exercise 4.4 69
Identity Matrices and Null Matrices 70
Identity Matrices 70
Null Matrices 71
Idiosyncrasies of Matrix Algebra 72
Exercise 4.5 72
Transposes and Inverses 73
Properties ofTransposes 74
Inverses and Their Properties 75
Inverse Matrix and Solution of
Linear-Equation System 77
Exercise 4.6 78
Finite Markov Chains 78
Special Case: Absorbing Mfirkov Chains 81
Exercise 4.7 81

5.3

5.4

5.5

5.6

5.7

Chapter 5
Linear Models and Matrix Algebra
(Continued) 82
5.1

5.2

Conditions for Nonsingularity of a Matrix 82

Necessary versus Sufficient Conditions 82
Conditions for Nonsingularity 84
Rank of a Matrix 85
Exercise 5.1 87
Test of Nonsingularity by Use of
Determinant 88
Determinants and Nonsingularity 88
Evaluating a Third-Order Determinant 89
Evaluating an nth-Order Determinant by
Laplace Expansion 91
Exercise 5.2 93

5.8

Basic Properties of Determinants 94

Determinantal Criterion for
Nonsingularity 96
Rank of a Matrix Redefined 97
Exercise 5.3 98
Finding the Inverse Matrix 99
Expansion of a Determinant by Alien
Cofactors 99
Matrix Inversion 100
-" Exercise 5.4 102
Cramer's Rule 103
Derivation of the Rule 103
Note on Homogeneous-Equation Systems 105
Solution Outcomes for a Linear-Equation
System 106
Exercise 5.5 107
Application to Market and National-Income
Models 107
Market Model 107
National-Income Model 108
IS-LM Model: Closed Economy 109
Matrix Algebra versus Elimination of
Variables 111
Exercise 5.6 111
Leontief Input-Output Models 112
Structure of an Input-Output Model 112
The Open Model 113
A Numerical Example 115
The Existence of Nonnegative Solutions 116
Economic Meaning of the Hawkins-Simon
Condition 118
The Closed Model 119
Exercise 5.7 120
Limitations of Static Analysis 120

PART THREE
COMPARATIVE-STATIC
ANALYSIS 123
Chapter 6
Comparative Statics and the Concept
of Derivative 124
6.1
6.2

The Nature of Comparative Statics 124

Rate of Change and the Derivative 125
The Difference Quotient 125

Contents

The Derivative 126

Exercise 6.2 127
6.3 The Derivative and the Slope of a Curve 128
6.4 The Concept of Limit 129
Left-Side Limit and Right-Side Limit 129
Graphical Illustrations 130
Evaluation of a Limit 131
Formal View of the Limit Concept 133
Exercise 6.4 135
6.5 Digression on Inequalities and Absolute s
Values 136
Rules of Inequalities 136
Absolute Values and Inequalities 137
Solution of an Inequality 138
Exercise 6.5 139
6.6 Limit Theorems 139
Theorems Involving a Single Function 139
Theorems Involving Two Functions 140
Limit of a Polynomial Function 141 .
Exercise 6.6 141
6.7 Continuity and Differentiability of a
Function 141
Continuity of a Function 141
Polynomial and Rational Functions 142
Differentiability of a Function 143
Exercise 6.7 146

7.3

Chapter 7

8.1

7.4

7.5

7.6

Chapter 8
Comparative-Static Analysis of
General-Function Models 178

Rules of Differentiation and Their Use

in Comparative Statics 148
7.1 Rules of Differentiation for a Function of
One Variable 148
Constant-Function Rule 148
Power-Function Rule 149
Power-Function Rule Generalized 151
Exercise 7.1 152
7.2 Rules of Differentiation Involving Two or
More Functions of the Same Variable 152
Sum-Difference Rule 152
Product Rule 155
Finding Marginal-Revenue Function from
Average-Revenue Function 156
Quotient Rule 158
Relationship Between Marginal-Cost and
Average- Cost Functions 159
Exercise 7.2 160

Rules of Differentiation Involving

Functions of Different Variables 161
Chain Rule 161
Inverse-Function Rule 163
Exercise 7.3 165
Partial Differentiation 165
Partial Derivatives 165
Techniques of Partial
Differentiation 166
Geometric Interpretation of Partial
Derivatives 167
Gradient Vector 168
Exercise 7.4 169
Applications to Comparative-Static
Analysis 170
Market Model 170
National-Income Model 172
Input-Output Model 173
Exercise 7.5 .175
Note on Jacobian Determinants 175
Exercise 7.6 177

8.2
8.3
8.4

8.5

Differentials 179
Differentials and Derivatives 179
Differentials and Point Elasticity 181
Exercise 8.1 184
Total Differentials 184
Exercise 8.2 186
Rules of Differentials 187
Exercise 8.3 189
Total Derivatives 189
Finding the Total Derivative 189
A Variation on the Theme 191
Another Variation on the Theme 192
Some General Remarks 193
Exercise 8.4 193
Derivatives of Implicit Functions 194
Implicit Functions 194
Derivatives of Implicit Functions 196
Extension to the Simultaneous-Equation
Case 199
Exercise 8.5 204

xii

xiv

8.6

Contents

Comparative Statics of General-Function

Models 205
Market Model 205
Simultaneous-Equation Approach 207
Use of Total Derivatives 209
National-Income Model (IS-LM) 210
Extending the Model: An Open
Economy 213
Summary of the Procedure 216
Exercise 8.6 217

8.7

Limitations of Comparative Statics

218

PART FOUR
OPTIMIZATION PROBLEMS 219
Chapter 9
Optimization: A Special Variety of
Equilibrium Analysis 220
9.1
9.2

Optimum Values and Extreme Values 221

Relative Maximum and Minimum:
First-Derivative Test 222
Relative versus Absolute Extremum
First-Derivative Test 223
Exercise 9.2 226

9.3

9.4

9.5

Second and Higher Derivatives

222

227

Derivative of a Derivative 227

Interpretation of the Second Derivative 229
An Application 231
Attitudes toward Risk 231
Exercise 9.3 233
Second-Derivative Test 233
Necessary versus Sufficient Conditions 234
Conditions for Profit Maximization 235
Coefficients of a Cubic Total-Cost
Function 238
Upward-Sloping Marginal-Revenue
Curve 240
Exercise 9.4 241

Maclaurin and Taylor Series

242

Maclaurin Series of a Polynomial

Function 242
Taylor Series of a Polynomial Function 244
Expansion of an Arbitrary Function 245
Lagrange Form of the Remainder 248
Exercise 9.5 250

9.6

Mh-Derivative Test for Relative Extremum of

a Function of One Variable 250
Taylor Expansion and Relative Extremum 250
Some Specific Cases 251
Nth-Derivative Test 253
Exercise 9.6 254

Chapter 10
Exponential and Logarithmic
Functions 255
10.1 The Nature of Exponential Functions 256
Simple Exponential Function 256
Graphical Form 256
Generalized Exponential Function 25 7
A Preferred Base 259
Exercise 10.1 260
10.2 Natural Exponential Functions and the
Problem of Growth 260
The Number e 260
An Economic Interpretation ofe 262
Interest Compounding and the Function
Ae" 262
Instantaneous Rate of Growth 263
Continuous versus Discrete Growth 265
Discounting and Negative Growth 266
Exercise 10.2 267

10.3 Logarithms

267

The Meaning of Logarithm 267

Common Log and Natural Log 268
Rules of Logarithms 269
An Application 271
Exercise 10.3 272
10.4 Logarithmic Functions 272
Log Functions and Exponential Functions 272
The Graphical Form 273
Base Conversion 274
Exercise 10.4 276
10.5 Derivatives of Exponential and Logarithmic
Functions 277
Log-Function Rule 277
Exponential-Function Rule 278
The Rules Generalized 278
The Case of Base b 280
Higher Derivatives 280
An Application 281
Exercise 10.5 282

Contents

10.6 Optimal Timing 282

A Problem of Wine Storage 282
Maximization Conditions 283
A Problem of Timber Cutting 285
Exercise 10.6 286
10.7 Further Applications of Exponential and
Logarithmic Derivatives 286
Finding the Rate of Growth 286
Rate of Growth of a Combination of
Functions 287
Finding the Point Elasticity 288
Exercise 10.7 290

Chapter 11
The Case of More than One Choice
Variable 291
11.1 The Differential Version of Optimization
Conditions 291
First-Order Condition 291
Second-Order Condition 292
Differential Conditions versus Derivative
Conditions 293
11.2 Extreme Values of a Function of Two
Variables 293
First-Order Condition 294
Second-Order Partial Derivatives 295
Second-Order Total Differential 297
Second-Order Condition 298
Exercise 11.2 300
11.3 Quadratic FormsAn Excursion 301
Second-Order Total Differential as a Quadratic
Form 301
Positive and Negative Definiteness 302
Determinantal Test for Sign
Definiteness 302
Three-Variable Quadratic Forms 305
n-Variable Quadratic Forms 307
Characteristic-Root Test for Sign
Definiteness 307
Exercise 11.3 312
11.4 Objective Functions with More than Two
Variables 313
First-Order Condition for Extremum 313
Second-Order Condition 313
n-Variable Case 316
Exercise 11.4 317

xv

11.5 Second-Order Conditions in Relation to

Concavity and Convexity 318
Checking Concavity and Convexity 320
Differentiable Functions 324
Convex Functions versus Convex Sets 327
Exercise 11.5 330
11.6 Economic Applications 331
Problem of a Multiproduct Firm 331
Price Discrimination 333
- _
Input Decisions of a Firm 336
Exercise 11.6 341
11.7 Comparative-Static Aspects of
Optimization 342
Reduced-Form Solutions 342
General-Function Models 343
Exercise 11.7 345

Chapter 12
Optimization with Equality
Constraints 347
12.1 Effects of a Constraint 347
12.2 Finding the Stationary Values 349
Lagrange-Multiplier Method 350
Total-Differential Approach 352
An Interpretation of the Lagrange
Multiplier 353
n- Variable and Multiconstraint Cases 354
Exercise 12.2 355
12.3 Second-Order Conditions 356
Second-Order Total Differential 356
Second-Order Conditions 357
The Bordered Hessian 358
n-Variable Case 361
Multiconstraint Case 362
Exercise 12.3 363
12.4 Quasiconcavity and Quasiconvexity 364
Geometric Characterization 364
Algebraic Definition 365
Differentiable Functions 368
A Further Look at the Bordered Hessian 3 71
A bsolute versus Relative Extrema 3 72
Exercise 12.4 374
12.5 Utility Maximization and Consumer
Demand 374
First-Order Condition 375
Second-Order Condition 376

xvi

Contents

Comparative-Static Analysis 378

Proportionate Changes in Prices
and Income 381
Exercise 12.5 382
12.6 Homogeneous Functions 383
Linear Homogeneity 383
Cobb-Douglas Production Function 386
Extensions of the Results 388
Exercise 12.6 389
12.7 Least-Cost Combination of Inputs 390
First-Order Condition 390
Second-Order Condition 392
The Expansion Path 392
Homothetic Functions 394
Elasticity of Substitution 396
CES Production Function 397
Cobb-Douglas Function as a Special Case of
the CES Function 399
Exercise 12.7 401

Chapter 13
Further Topics in Optimization

The Arrow-Enthoven Sufficiency Theorem:

Quasiconcave Programming 425
A Constraint-Qualification Test 426
Exercise 13.4 427
13.5 Maximum-Value Functions and the
Envelope Theorem 428
The Envelope Theorem for Unconstrained
Optimization 428
The Profit Function 429
__. Reciprocity Conditions 430
The Envelope Theorem for Constrained
Optimization 432
Interpretation of the Lagrange Multiplier 434

13.6 Duality and the Envelope Theorem 435

The Primal Problem 435
The Dual Problem 436
Duality 436
Roy's Identity 43 7
Shephard's Lemma 438
Exercise 13.6 441 x

13.7 Some Concluding Remarks 442

402

13.1 Nonlinear Programming and Kuhn-Tucker

Conditions 402
Step I: Effect of Nonnegativity
Restrictions 403
Step 2: Effect of Inequality Constraints 404
Interpretation of the Kuhn-Tucker
Conditions 408
The n-Variable, m-Constraint Case 409
Exercise 13.1 411
13.2 The Constraint Qualification 412
Irregularities at Boundary Points 412
The Constraint Qualification 415
Linear Constraints 416
Exercise 13.2 418
13.3 Economic Applications 418
War-Time Rationing 418
Peak-Load Pricing 420
Exercise 13.3 423
13.4 Sufficiency Theorems in Nonlinear
Programming 424
The Kuhn-Tucker Sufficiency Theorem:
Concave Programming 424

PART FIVE
DYNAMIC ANALYSIS 443
Chapter 14
Economic Dynamics and Integral
Calculus 444
14.1 Dynamics and Integration 444
14.2 Indefinite Integrals 446
The Nature of Integrals 446
Basic Rules of Integration 447
Rules of Operation 448
Rules Involving Substitution 451
Exercise 14.2 453
14.3 Definite Integrals 454
Meaning of Definite Integrals 454
A Definite Integral as an Area under a
Curve 455
Some Properties of Definite Integrals 458
Another Look at the Indefinite
Integral 460
Exercise 14.3 460

Contents

14.4 Improper Integrals 461

Infinite Limits of Integration 461
Infinite Integrand 463
Exercise 14.4 464
14.5 Some Economic Applications of
Integrals 464
From a Marginal Function to a Total
Function 464
Investment and Capital Formation 465
Present Value of a Cash Flow 468
Present Value of a Perpetual Flow 470
Exercise 14.5 470
14.6 Domar Growth Model 471
The Framework 471
Finding the Solution 472
The Razor's Edge 473
Exercise 14.6 474

Chapter 15
Continuous Time: First-Order
Differential Equations 475
15.1 First-Order Linear Differential Equations
with Constant Coefficient and Constant
Term 475
The Homogeneous Case 476
The Nonhomogeneous Case 476
Verification of the Solution 478
Exercise 15.1 479
15.2 Dynamics of Market Price 479
The Framework 480
The Time Path 480
The Dynamic Stability of Equilibrium 481
An Alternative Use of the Model 482
Exercise 15.2 483
15.3 Variable Coefficient and Variable Term 483
The Homogeneous Case 484
The Nonhomogeneous Case 485
Exercise 15.3 486
15.4 Exact Differential Equations 486
Exact Differential Equations 486
Method of Solution 487
Integrating Factor 489
Solution of First-Order Linear Differential
Equations 490
Exercise 15.4 491

xvii

15.5 Nonlinear Differential Equations of the First

Order and First Degree 492
Exact Differential Equations 492
Separable Variables 492
Equations Reducible to the Linear Form 493
Exercise 15.5 495
15.6 The Qualitative-Graphic Approach 495
The Phase Diagram 495
Types of Time Path 496
Exercise 15.6 498
15.7 Solow Growth Model 498
The Framework 498
A Qualitative-Graphic Analysis 500
A Quantitative Illustration 501
Exercise 15.7 502

Chapter 16
Higher-Order Differential
Equations 503
16.1 Second-Order Linear Differential Equations
with Constant Coefficients and Constant
Term 504
The Particular Integral 504
The Complementary Function 505
The Dynamic Stability of Equilibrium 510
Exercise 16.1 511
16.2 Complex Numbers and Circular
Functions 511
Imaginary and Complex Numbers 511
Complex Roots 512
Circular Functions 513
Properties of the Sine and Cosine
Functions 515
Euler Relations 517
Alternative Representations of Complex
Numbers 519
Exercise 16.2 521
1 6 . 3 Analysis of the Complex-Root
Case 522
The Complementary Function 522
An Example of Solution 524
- The Time Path 525
The Dynamic Stability of
Equilibrium 527
Exercise 16.3 527

xviii

Contents

16.4 A Market Model with Price

Expectations 527
Price Trend and Price Expectations 52 7
A Simplified Model 528
The Time Path of Price 529
Exercise 16.4 532
16.5 The Interaction of Inflation and
Unemployment 532
The Phillips Relation 532
The Expectations-Augmented Phillips
Relation 533
The Feedback from Inflation to
Unemployment 534
The Time Path ofn 534
Exercise 16.5 537
16.6 Differential Equations with a Variable
Term 538
Method of Undetermined Coefficients 538
A Modification 539
Exercise 16.6 540
16.7 Higher-Order Linear Differential
Equations 540
Finding the Solution 540
Convergence and the Routh Theorem 542
Exercise 16.7 543

Chapter 17
Discrete Time: First-Order Difference
Equations 544
17.1 Discrete Time, Differences, and Difference
Equations 544
17.2 Solving a First-Order Difference
Equation 546
^
Iterative Method 546
General Method 548
Exercise 17.2 551
17.3 The Dynamic Stability of Equilibrium 551
The Significance of b 551
The Role of A 553
Convergence to Equilibrium 554
Exercise 17.3 554
17.4 The Cobweb Model 555
The Model 555
The Cobwebs 556
Exercise 17.4 558

17.5 A Market Model with Inventory 559

The Model 559
The Time Path 560
Graphical Summary of the Results 561
Exercise 17.5 562
17.6 Nonlinear Difference Equations
The Qualitative-Graphic Approach 562
Phase Diagram 562
Types of Time Path 564
. ..- A Market with a Price Ceiling 565
Exercise 17.6 567

Chapter 18
Higher-Order Difference Equations

568

18.1 Second-Order Linear Difference Equations

with Constant Coefficients and Constant
Term 569
Particular Solution 569
Complementary Function 570
The Convergence of the Time Path 573
Exercise 18.1 575
18.2 Samuelson Multiplier-Acceleration
Interaction Model 576
The Framework 576
The Solution 577
Convergence versus Divergence 578
A Graphical Summary 580
Exercise 18.2 581
18.3 Inflation and Unemployment in Discrete
Time 581
The Model 581
The Difference Equation in p 582
The Time Path ofp 583
The Analysis ofU 584
The Long-Run Phillips Relation 585
Exercise 18.3 585
18.4 Generalizations to Variable-Term and
Higher-Order Equations 586
Variable Term in the Form of cm' 586
Variable Term in the Form ct" 587
Higher-Order Linear Difference
Equations 588
Convergence and the Schur
Theorem 589
Exercise 18.4 591

Contents xix

Chapter 19
Simultaneous Differential Equations and
Difference Equations 592
19.1 The Genesis of Dynamic Systems 592
Interacting Patterns of Change 592
The Transformation of a High-Order Dynamic
Equation 593
19.2 Solving Simultaneous Dynamic
Equations 594
Simultaneous Difference Equations 594
Matrix Notation 596
Simultaneous Differential Equations 599
Further Comments on the Characteristic
Equation 601
Exercise 19.2 602
19.3 Dynamic Input-Output Models 603
Time Lag in Production 603
Excess Demand and Output Adjustment 605
Capital Formation 607
Exercise 19.3 608
19.4 The Inflation-Unemployment Model Once
More 609
Simultaneous Differential Equations 610
Solution Paths 610
Simultaneous Difference Equations 612
Solution Paths 613
Exercise 19.4 614
19.5 Two-Variable Phase Diagrams 614
The Phase Space 615
The Demarcation Curves 615
Streamlines 617
Types of Equilibrium 618
Inflation and Monetary Rule a la Obst 620
Exercise 19.5 623
19.6 Linearization of a Nonlinear DifferentialEquation System 623
Taylor Expansion and Linearization 624

The Reduced Linearization 625

Local Stability Analysis 625
Exercise 19.6 629

Chapter 20
Optimal Control Theory

631

20.1 The Nature of Optimal Control 631

Illustration: A Simple Macroeconomic
Model 632
Pontryagin s Maximum Principle 633
20.2 Alternative Terminal Conditions 639
Fixed Terminal Point 639
Horizontal Terminal Line 639
Truncated Vertical Terminal Line 639
Truncated Horizontal Terminal Line 640
Exercise 20.2 643
20.3 Autonomous Problems 644
20.4 Economic Applications 645
Lifetime Utility Maximization 645
Exhaustible Resource 647
Exercise 20.4 649
20.5 Infinite Time Horizon 649
Neoclassical Optimal Growth Model 649
The Current-Value Hamiltonian 651
Constructing a Phase Diagram 652
Analyzing the Phase Diagram 653
20.6 Limitations of Dynamic Analysis 654

The Greek Alphabet 655

Mathematical Symbols 656
A Short Reading List 659
Answers to Selected Exercises 662
Index 677