Introduction to Mathematical Economics1

EC 115 Lecture Notes

Marjorie S. Muyrong, M.A.2

Mathematical Economics, as a course, familiarizes students with the mathematical methods

used in economic analysis. More specifically, the main concern of mathematical economics is
to express economic models in mathematical form, thereby allowing theories and concepts to
be expressed in a succinct and universal manner.

A. Mathematics as an Approach to Economics

In the economic profession, mathematical economics is therefore part of the methods used by
economists in order to introduce and explain the theoretical underpinnings of an analysis.
Economists also draws upon mathematical theorems to further develop economic theories.
Mathematical Economics is thus not a separate school of thought, but rather a method of
economics. Being an approach to economic analysis, it actually refers to the set of economic
concepts and principles formulated and developed through mathematical methods.

Mathematical Economics is therefore different from Statistics and Econometrics. Statistics is

mainly concerned with collecting, processing, and presenting economic data in the form of
charts and tables. On the other hand, Econometrics is the application of statistics to economic
data to lend empirical support to the models constructed from mathematical methods. It allows
the establishment of causal relationship between variables by obtaining numerical coefficients.
To put simply, mathematical economics actually guide econometric modelling while
econometric results validate the economic theories.

However, mathematical rigor is actually a fairly recent addition to the skill set of an economist.
In an effort to further develop the relationship between utility and marginal utility, Paul
Samuelson (1937) published a journal article expressing the economic concept of utility in
mathematics. Specifically, he was the first one to mathematically derive the marginal utility

1
Updated August 2017. Lectures notes are in part adopted from Chiang and Wainwright (2005) and Lanzona
(2013).
2
Department of Economics, Ateneo de Manila University, mmuyrong@ateneo.edu

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from money using the constrained optimization method. Samuelson is therefore acknowledged
for raising the level of mathematical analysis in economics. Indeed, since the mid-1930s,
economics has entered a “mathematical epoch” in which economists need to use mathematical
analysis in order to be taken seriously. Over the years, Economics has therefore gathered a
number of standard concepts that need to be learn in their mathematical forms.

For instance, price elasticity of demand can be expressed as:

𝑑𝑄
%∆𝑄 𝑄
𝜖𝐷 = = (1.1)
%∆𝑃 𝑑𝑃
𝑃

Equation (1.1) allows us estimate the responsiveness of consumer demand to price changes by
getting the growth rates of quantity and price. In Econometrics, this is easily estimated by using
the natural logs of price and quantity. By manipulating equation (1.1), we can further show that
the price elasticity of demand is the product of the slope of the demand equation and the ratio
between price and quantity. Hence, at any given level of price and quantity, we can estimate
the elasticity if we have an estimate of the demand equation. Hence, we also express 𝜖𝐷 as:

𝑑𝑄 𝑃 𝑑𝑄 𝑃
𝜖𝐷 = = (1.2)
𝑄 𝑑𝑃 𝑑𝑃 𝑄

Another quick example would be the profit-maximizing condition of the firm. A firm must
choose a level of quantity in which the marginal revenue is equal to marginal cost in order to
maximize profits. This is derived mathematically by getting the first derivative of the profit
function 𝜋 = 𝑅 − 𝐶 with respect to quantity using the sum-difference rule and then equating
the result to zero:

𝑑𝜋 𝑑𝑅 𝑑𝐶
= − =0
𝑑𝑄 𝑑𝑄 𝑑𝑄
(1.3)
𝑑𝑅 𝑑𝐶
=
𝑑𝑄 𝑑𝑄

𝑀𝑅 = 𝑀𝐶 (1.4)

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One last example would be the derivation of equilibrium price and quantity of various related
goods. Basic economics tells us that the equilibrium price and quantity of one isolated good
are derived from equating the supply and demand equations. In other words, if a particular
good is not a complement or substitute to another good or sets of goods, the prevailing market
price is simply a result of the interaction of the buyers and sellers in this isolated market. If we
look at the markets for different types of food items, some set of goods are complements while
some goods are substitute to other goods. Given this, if the price of rice increases, it can be
expected that not only will the demand for rice decrease, the demand for other sources of
carbohydrates will increase. In this case, the prevailing market price in each market must take
into account the prices of other goods. The necessary mathematical analysis will be a system
of equations, thereby allowing for use the matrix algebra. More specifically, the so-called
computable general equilibrium (CGE) model is employed in order to trace the impacts of a
change in one market to all other markets in an economy.

B. Dissecting an Economics Research Paper

The best economic papers are always with a good theoretical framework expressed in
mathematical formulations and this course will equip students with the necessary tools in order
to understand the economic models of journal articles in Economics as well as understand the
theoretical discussions in advanced Economics textbooks. For students of Economics,
Mathematical Economics and Econometrics serve as a complementary course to Economic
Research. More specifically, this course will assist students in building up their literature
review and in developing their own theoretical framework.

A research paper in economics has the following outline: (1) Introduction, (2) Review of
Related Literature, (3) Theoretical Framework, (4) Empirical Results, and (5) Conclusions and
Recommendations. While the literature review contains a survey of various studies previously
published, the theoretical framework identifies the principal economic model that the economic
researcher uses for the analysis. This framework is derived from the review and expanded in
this particular section of the paper. The expansion of such model, of course, depends upon the
degree of knowledge and skills from Mathematical Economics. As mentioned above, this
serves as a guide for the empirical modeling in the next section.

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To demonstrate the role of Mathematical Economics in Economic Research, a sample paper
maybe studied. Dr. Lanzona (2013) seeks to understand how human capital affects agricultural
productivity of Filipino farmers. In other words, the paper attempts to understand the marginal
product of education in the agricultural sector of the Philippines, i.e. the additional increase in
the gross value added (GVA) of agriculture from additional increases in the level of education.
Do more educated farmers have higher productivity compared to their fellow farmers with less
years of education? Are farm households with more educated members more productive than
other farm households?

Mathematically, getting the marginal product would mean getting the change in the value of
production in the agricultural sector given unit changes in education. This further implies that
quantity is now no longer just a function of fixed (𝑧) and variable inputs (𝑥) but also of
education. Hence, if we can define the marginal product of education as 𝜕𝑄⁄𝜕𝐸 , then we need
to specify the production in agriculture. If 𝑄 = 𝑓(𝑥, 𝑧, 𝐸), how should we then define the
function?

In deriving the sectoral contributions to the Gross Domestic Product (GDP), the concept of
value added is pertinent. If the production of the sector can be aggregated into food (𝑞1 ) and
non-food products (𝑞2 ), the total value in monetary terms of produced goods can be given as:

𝑄 = 𝑝1 𝑞1 (𝑥1 , 𝑧1 , 𝐸1 ) + 𝑝2 𝑞2 (𝑥2 , 𝑧2 , 𝐸2 ) − 𝑝𝑥 𝑋 (1.5)

This is actually none other than your value-added formula (i.e. profit) for the case of two
goods. The first two terms of equation (1.5) tell us that quantity, which determines revenue, is
a function of (1) variable inputs 𝑥𝑖 , (2) fixed inputs 𝑧𝑖 , and (3) human capital or education 𝐸𝑖 .
By adding the expenditures from variable costs, 𝑄 becomes a function from the agricultural
GVA. Recall tht the value-added concept tells us that we have to not include the value of inputs
to avoid double counting. Further, it also indicates that a farmer must learn how to best allocate
his inputs among different types of crops he is planting since 𝑋 = 𝑥1 + 𝑥2 , 𝑍 = 𝑧1 + 𝑧2 , 𝐸 =
𝐸1 + 𝐸2 . To identify the different sources of an increase in marginal product, the total
derivative may be determined.
𝑑𝑄 𝜕𝑄 𝑑𝑞1 𝜕𝑄 𝑑𝑞2 𝜕𝑄 𝑑𝑥1 𝜕𝑄 𝑑𝑧1 𝜕𝑄 𝑑𝐸1 𝜕𝑄 𝑑𝑋
= + + + + + (1.6)
𝑑𝐸 𝜕𝑞1 𝑑𝐸 𝜕𝑞2 𝑑𝐸 𝜕𝑥1 𝑑𝐸 𝜕𝑧1 𝑑𝐸 𝜕𝐸1 𝑑𝐸 𝜕𝑋 𝑑𝐸

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The marginal product of education in the agricultural sector may therefore be further expressed
as the following:

𝑑𝑄 𝜕𝑞1 𝜕𝑞2 𝜕𝑞1 𝜕𝑞2 𝑑𝑥1 𝜕𝑞1 𝜕𝑞2 𝑑𝑧1

= 𝑝1 + 𝑝2 + (𝑝1 − 𝑝2 ) + (𝑝1 − 𝑝2 )
𝑑𝐸 𝜕𝐸 𝜕𝐸 𝜕𝑋 𝜕𝑋 𝑑𝐸 𝜕𝑍 𝜕𝑍 𝑑𝐸
𝜕𝑞1 𝜕𝑞2 𝑑𝐸1 𝜕𝑞1 𝜕𝑞2 𝑑𝑋 (1.7)
+ (𝑝1 − 𝑝2 ) + (𝑝1 + 𝑝2 − 𝑝𝑥 )
𝜕𝐸 𝜕𝐸 𝑑𝐸 𝜕𝑥1 𝜕𝑥2 𝑑𝐸

Deriving the worker effect is straightforward from the first two terms of equation (1.7). If a
farmer has more education, he has the capacity to increase the production of both crops by
being a more efficient worker in both types of production. If knowledge and skills increases,
you can directly increase the production of both goods. With more education, a farmer is more
easily able to understand how to adopt new farming technologies as well as more easily gather
information about the production of these types of crops. For instance, an highly-educated
farmer would be able to adopt organic farming technologies much easier since these types of
farming methods require an intensive knowledge on biology and environmental studies. In
addition to that, he is actually able to better manage risks involved in new technologies. By
allowing Filipino farmers to become more educated, the sector can increase their productivity.

Through what other channels can human capital development affect agricultural productivity?
To put the question in other words, if the inputs to 𝑞1 are increased (thereby decreasing inputs
to 𝑞2 ), how does education play a role in this allocation decision? Higher educational
attainment may allow farmers to choose input allocations that will maximize the yield they can
get from both crops. To put simply, education allows farmers to choose levels of 𝑥1 , 𝑧1 , and 𝐸1
that maximize the aggregate production. If a farmer knows that another crop yields more and
therefore provides him more income, then his understanding of agricultural sciences alongside
some agribusiness principles must allow him to invest more inputs to this crop. Thus, allocative
effects refer to the indirect effect of education to total production through the determination of
the best allocation of inputs between the two crops 𝑞1 and 𝑞2 .

If you look closely at the terms inside the parentheses of the third, fourth and fifth terms, they
look similar to the equal marginal principle. To simplify, if we are only considering variable
inputs, 𝑄 = 𝑝1 𝑞1 (𝑥1 ) + 𝑝2 𝑞2 (𝑥2 ) is maximized when 𝜕𝑄⁄𝜕𝑥1 = 0. This can be derived as
the following:

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 𝜕𝑄 𝜕𝑞1 𝜕𝑞2
= 𝑝1 − 𝑝2 =0
𝜕𝑥1 𝜕𝑥1 𝜕𝑥2
(1.8)
𝜕𝑞1 𝜕𝑞2
𝑝1 = 𝑝2
𝜕𝑥1 𝜕𝑥2

Equation (1.8) says that farmers must allocate variables inputs between two goods until the
marginal product for the case of the first crop is equal to the marginal product of the second
crop. To put it in a more straightforward manner, “the marginal value product of 𝑋 be equated
between its competing uses” (Welch 1970, 43). Further, from equation (1.8), 𝜕𝑄⁄𝜕𝐸 =
𝜕𝑞1 𝜕𝑞2 𝜕𝑞1 𝜕𝑞2 𝑑𝑋 𝑑𝑥1
𝑝1 + 𝑝2 + (𝑝1 − 𝑝2 ) 𝑑𝑥 . If variable inputs are the only resources considered,
𝜕𝐸 𝜕𝐸 𝜕𝑋 𝜕𝑋 1 𝑑𝐸

the marginal product of education is simply the worker effect and the allocative effect of
education on the farmer’s decision of how much inputs to allocate between the two goods. The
allocative effect therefore has a very insightful policy implication on the current issues of food
self-sufficiency versus food security.

Economic theory advises producers to invest more of their resources in goods that will provide
them with higher production level. For the case of the agricultural sector, farmers who are able
to successfully engage in high-value crops to increase their incomes. For instance, Dr. Habito
(2015) cites that in his talks with Mindanao farmers, these farmers pose the question as to why
Luzon farmers insist on farming rice when the crop has failed to provide them gainful incomes.
Such question springs from the fact that farmers in Mindanao, perhaps mostly through efforts
of large private corporations, now have gainful income from planting rubber, cacao, bananas
and oil palm. Further, it is also puzzling for Dr. Habito and other economists he cited why 70
percent of the agriculture budget goes to rice farming when rice only contributes 20 percent to
the gross value added (GVA) of agriculture. The answer is of course related to the fact that rice
is a highly-political commodity.

This indicates that the marginal productivity in these types of crops are higher compared to
rice. It becomes puzzling therefore why the self-sufficiency remains to be the policy stance of
the government if farmers will be better off with cash crops. With higher levels of analytical
thinking and decision-making processes that comes along with educational attainment, farmers
may be able to push beyond the risks of shifting to cash crops on their own. If farmers are more

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abreast with principle in agribusiness, they may be more confident in such types of business
decisions.

Finally, another indirect effect of education that allows the farmer to increase productivity by
choosing the amount inputs that will maximize value added. In other words, the farmer will
also wish to maximize profits (or in the same way, minimize costs) given the entire set of
variable inputs he has to purchase. Again, if a farmer is more educated and can easily assimilate
agribusiness principles, he must now that he cannot continue increasing production is
additional revenue can no longer cover his additional costs. This cost-minimization effect
actually demonstrates the capacity of farmers to determine the point at which 𝑀𝑅 = 𝑀𝐶. In
other words, the marginal product of 𝑋 must be equal to the price of 𝑋.

The economics research paper obviously does not stop here and the economic model of the
marginal product of education is validated by empirical results. Lanzona (2013) used two
different regression analyses to measure the (1) worker effect and (2) allocative effect of
education to agricultural production. For the worker effect, he seeks to find out the impacts of
education in one type of crop so that the results reflect only how education makes the farmer
more productive. For the case of allocative effects, he seeks to find out the impacts of education
on the total production of various crops so that the results reflect how the farmer manages to
efficiently allocate among different crops.

Source: Lanzona (2013)

Table 4 from Lanzona (2013) shows t he worker effect. The question here is whether the typical
farmer increase his production of rice given increases in education holding the number of
inputs constant. Results show that when Green Revolution happened, a higher education leads

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to higher rice production validated by the results with asterisks. This shows us that education
indeed has the worker effect. More educated farmers can increase production by being more
efficient with resources.

Source: Lanzona (2013)

Table 5 shows the impacts of education through allocative effects. Did the typical farmer
increase his total production given increases in education by finding the best combination of
crops holding the number of inputs constant? This shows us that education indeed has the
allocative effect. With 20 years of experience with HYVs, more educated farmers have become
better in allocating resources among competing crops in order to maximize production of all
types of crops.

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Works Cited

Habito, Cielito F. 2015. Ironies in rice self-sufficiency. Inquirer.net.

http://opinion.inquirer.net/86268/ironies-in-rice-self-sufficiency.

Lanzona, Leonardo A., Jr. 2013. Human Capital and Agricultural Productivity. The Case of
the Philippines. Productivity Growth in Philippine Agriculture Series. Philippines:
Southeast Asian Regional Center for Graduate Study and Research in Agriculture
(SEARCA), Bureau of Agricultural Research (BAR), and Philippine Rice Research
Institute (PhilRice).

Welch, F. 1970. Education in Production. Journal of Political Economy, 78 (1): 35-39.