9/11/2018

Lesson 1
Overview and Preliminaries
- Math review
- Introduction to Microeconomic
analysis: the market

MATH REVIEW

The Mathematics of Optimization

• Many economic theories begin with the
assumption that an economic agent is seeking
to find the optimal value of some function
– consumers seek to maximize utility
– firms seek to maximize profit
• This chapter introduces the mathematics
common to these problems

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Maximization of a Function of One Variable

• Simple example: Manager of a firm wishes
to maximize profits
  f (q)

Maximum profits of
* * occur at q*
 = f(q)

Quantity
q*
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Maximization of a Function of One Variable

• The manager will likely try to vary q to see
where the maximum profit occurs
– an increase from q1 to q2 leads to a rise in 


0
*

q
2  = f(q)

1

Quantity
q1 q2 q*
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Maximization of a Function of One Variable

• If output is increased beyond q*, profit will
decline
– an increase from q* to q3 leads to a drop in 



0
*

 = f(q)
q
3

Quantity
q* q3
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Derivatives

• The derivative of  = f(q) is the limit of

/q for very small changes in q
d df f (q  h)  f (q1 )
  lim 1
dq dq h  0 h

• The value of this ratio depends on the

value of q1

Value of a Derivative at a Point

• The evaluation of the derivative at the
point q = q1 can be denoted
d
dq q  q 1

• In our previous example,

d d d
0 0 0
dq q q
1
dq q q3
dq q  q *
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First Order Condition for a Maximum

• For a function of one variable to attain its
maximum value at some point, the
derivative at that point must be zero

df
0
dq q q*

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Second Order Conditions

• The first order condition (d/dq) is a
necessary condition for a maximum, but it
is not a sufficient condition

If the profit function was u-shaped,
the first order condition would result
in q* being chosen and  would
be minimized

*

Quantity
q*
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Second Order Conditions

• This must mean that, in order for q* to be

the optimum,
d d
 0 for q  q * and  0 for q  q *
dq dq

• Therefore, at q*, d/dq must be

decreasing

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Second Derivatives

• The derivative of a derivative is called a

second derivative
• The second derivative can be denoted by

d 2 d 2f
2
or or f " (q )
dq dq 2

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Second Order Condition

• The second order condition to represent a

(local) maximum is

d 2
 f " (q ) q  q *  0
dq 2 q q *

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Rules for Finding Derivatives

db
1. If b is a constant, then 0
dx
d [bf ( x )]
2. If b is a constant, then  bf ' ( x )
dx

dx b
3. If b is constant, then  bx b 1
dx
d ln x 1
4. 
dx x 14

Rules for Finding Derivatives

da x
5.  a x ln a for any constant a
dx
– a special case of this rule is dex/dx = ex

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Rules for Finding Derivatives

• Suppose that f(x) and g(x) are two functions
of x and f’(x) and g’(x) exist
• Then
d [f ( x )  g ( x )]
6.  f '(x)  g'(x)
dx

d [f ( x )  g ( x )]
7.  f ( x )g ' ( x )  f ' ( x )g ( x )
dx
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Rules for Finding Derivatives

 f (x) 
d  
g ( x )  f ' ( x )g ( x )  f ( x )g ' ( x )
8.  
dx [g ( x )]2
provided that g ( x )  0

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Rules for Finding Derivatives

• If y = f(x) and x = g(z) and if both f’(x) and
g’(x) exist, then:
dy dy dx df dg
9.    
dz dx dz dx dz
• This is called the chain rule. The chain
rule allows us to study how one variable
(z) affects another variable (y) through
its influence on some intermediate
variable (x)
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Rules for Finding Derivatives

• Some examples of the chain rule include

deax deax d (ax )

10.    eax  a  aeax
dx d (ax ) dx
d [ln( ax )] d [ln( ax )] d (ax )
11.    ln( ax )  a  a ln( ax )
dx d (ax ) dx
d [ln( x 2 )] d [ln( x 2 )] d ( x 2 ) 1 2
12.    2  2x 
dx d(x 2 ) dx x x
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Example of Profit Maximization

• Suppose that the relationship between profit
and output is
 = 1,000q - 5q2
• The first order condition for a maximum is
d/dq = 1,000 - 10q = 0
q* = 100
• Since the second derivative is always -10,
q = 100 is a global maximum
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Functions of Several Variables

• Most goals of economic agents depend on
several variables
– trade-offs must be made
• The dependence of one variable (y) on a
series of other variables (x1,x2,…,xn) is
denoted by

y  f (x1, x2 ,..., xn )

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Partial Derivatives

• The partial derivative of y with respect to x1

is denoted by
y f
or or fx or f1
x1 x1 1

• It is understood that in calculating the

partial derivative, all of the other x’s are
held constant
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Partial Derivatives

• A more formal definition of the partial

derivative is

f f ( x1  h, x 2 ,..., x n )  f ( x1, x 2 ,..., x n )

 lim
x1 x 2 ,...,x n
h 0 h

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Calculating Partial Derivatives

1. If y  f ( x1, x 2 )  ax12  bx1 x 2  cx 22 , then
f
 f1  2ax1  bx 2 and
x1
f
 f2  bx1  2cx 2
x 2

2. If y  f (x1, x2 )  eax  bx , then 1 2

f f
 f1  ae ax  bx and 1
 f2  be ax  bx
2 1 2

x1 x2
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Calculating Partial Derivatives

3. If y  f (x1, x2 )  a ln x1  b ln x 2 , then
f a f b
 f1  and  f2 
x1 x1 x2 x2

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Partial Derivatives

• Partial derivatives are the mathematical

expression of the ceteris paribus
assumption
– show how changes in one variable affect some
outcome when other influences are held
constant

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Partial Derivatives

• We must be concerned with how variables

are measured
– if q represents the quantity of gasoline
demanded (measured in billions of gallons) and
p represents the price in dollars per gallon,
then q/p will measure the change in demand
(in billiions of gallons per year) for a dollar per
gallon change in price

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Elasticity
• Elasticities measure the proportional effect
of a change in one variable on another
– unit free
• The elasticity of y with respect to x is

y
y y x y x
ey , x     
x x y x y
x 28

Second-Order Partial Derivatives

• The partial derivative of a partial derivative
is called a second-order partial derivative

(f / xi )  2f
  fij
x j x j xi

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Young’s Theorem

• Under general conditions, the order in

which partial differentiation is conducted to
evaluate second-order partial derivatives
does not matter

fij  f ji

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Total Differential
• Suppose that y = f(x1,x2,…,xn)
• If all x’s are varied by a small amount, the
total effect on y will be

f f f
dy  dx1  dx 2  ...  dx n
x1 x 2 xn

dy  f1dx1  f2dx 2  ...  fndx n

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First-Order Condition for a Maximum (or

Minimum)
• A necessary condition for a maximum (or
minimum) of the function f(x1,x2,…,xn) is that
dy = 0 for any combination of small changes in
the x’s
• The only way for this to be true is if
f1  f2  ...  fn  0
• A point where this condition holds is
called a critical point
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Finding a Maximum
• Suppose that y is a function of x1 and x2
y = - (x1 - 1)2 - (x2 - 2)2 + 10
y = - x12 + 2x1 - x22 + 4x2 + 5
• First-order conditions imply that

y
 2 x1  2  0 x1*  1
x1 OR
y x2*  2
 2 x 2  4  0
x 2
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Lagrangian Multiplier Method

• Suppose that we wish to find the values of
x1, x2,…, xn that maximize
y = f(x1, x2,…, xn)
subject to a constraint that permits only
certain values of the x’s to be used
g(x1, x2,…, xn) = 0

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Lagrangian Multiplier Method

• The Lagrangian multiplier method starts
with setting up the expression
L = f(x1, x2,…, xn ) + g(x1, x2,…, xn)
where  is an additional variable called a
Lagrangian multiplier
• When the constraint holds, L = f because
g(x1, x2,…, xn) = 0

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Lagrangian Multiplier Method

• First-Order Conditions
L/x1 = f1 + g1 = 0
L/x2 = f2 + g2 = 0
.
.
.
L/xn = fn + gn = 0
L/ = g(x1, x2,…, xn) = 0
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Lagrangian Multiplier Method

• The first-order conditions can generally be
solved for x1, x2,…, xn and 

• The solution will have two properties:

– the x’s will obey the constraint
– these x’s will make the value of L (and therefore
f) as large as possible

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INTRODUCTION TO MICROECONOMIC
ANALYSIS: THE MARKET

Modeling Apartment Demand

• The lower is the rental rate p, the larger is the
quantity of close apartments demanded
p   QD .
• The quantity demanded vs. price graph is the
market demand curve for close apartments.

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Market Demand Curve for Apartments

p

QD

Modeling Apartment Supply

• Supply: It takes time to build more close
apartments so in this short-run the quantity
available is fixed (at say 100).

Market Supply Curve for Apartments

p

100 QS

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Competitive Market Equilibrium

• “low” rental price  quantity demanded of
close apartments exceeds quantity available
 price will rise.
• “high” rental price  quantity demanded less
than quantity available  price will fall.

Competitive Market Equilibrium

• Quantity demanded = quantity available
 price will neither rise nor fall
so the market is at a competitive equilibrium.

Competitive Market Equilibrium

p

100 QD,QS

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Competitive Market Equilibrium

p

pe

100 QD,QS

Competitive Market Equilibrium

p

People willing to pay pe for

close apartments get close
apartments.

pe

100 QD,QS

Competitive Market Equilibrium

p

People willing to pay pe for

close apartments get close
apartments.

People not willing to pay

pe for close apartments
get distant apartments.
pe

100 QD,QS

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Comparative Statics
• What is exogenous in the model?
– price of distant apartments
– quantity of close apartments
– incomes of potential renters.
• What happens if these exogenous variables
change?

Comparative Statics
• Suppose the price of distant apartment rises.
• Demand for close apartments increases
(rightward shift), causing
– a higher price for close apartments.

Market Equilibrium
p

pe

100 QD,QS

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Market Equilibrium
p
Higher demand

pe

100 QD,QS

Market Equilibrium
p
Higher demand causes higher
market price; same quantity
traded.

pe

100 QD,QS

Comparative Statics
• Suppose there were more close apartments.
• Supply is greater, so
the price for close apartments falls.

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Market Equilibrium
p

pe

100 QD,QS

Market Equilibrium
p
Higher supply

pe

100 QD,QS

Market Equilibrium
p
Higher supply causes a
lower market price and a
larger quantity traded.

pe

100 QD,QS

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Comparative Statics
• Suppose potential renters’ incomes rise,
increasing their willingness-to-pay for close
apartments.
• Demand rises (upward shift), causing
higher price for close apartments.

Market Equilibrium
p

pe

100 QD,QS

Market Equilibrium
p
Higher incomes cause
higher willingness-to-pay

pe

100 QD,QS

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Market Equilibrium
p
Higher incomes cause
higher willingness-to-pay,
higher market price, and
the same quantity traded.

pe

100 QD,QS

Pareto Efficiency
• Vilfredo Pareto; 1848-1923.
• A Pareto outcome allows no “wasted welfare”;
i.e. the only way one person’s welfare can be
improved is to lower another person’s welfare.

Pareto Efficiency
• Jill has an apartment; Jack does not.
• Jill values the apartment at $200; Jack would
pay $400 for it.
• Jill could sublet the apartment to Jack for
$300.
• Both gain, so it was Pareto inefficient for Jill
to have the apartment.

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Pareto Efficiency
• A Pareto inefficient outcome means there
remain unrealized mutual gains-to-trade.
• Any market outcome that achieves all possible
gains-to-trade must be Pareto efficient.

Pareto Efficiency
• Competitive equilibrium:
– all close apartment renters value them at the
market price pe or more
– all others value close apartments at less than
pe
– so no mutually beneficial trades remain
– so the outcome is Pareto efficient.

Pareto Efficiency
• Discriminatory Monopoly:
– assignment of apartments is the same as with the
perfectly competitive market
– so the discriminatory monopoly outcome is also
Pareto efficient.

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Pareto Efficiency
• Monopoly:
– not all apartments are occupied
– so a distant apartment renter could be assigned a
close apartment and have higher welfare without
lowering anybody else’s welfare.
– so the monopoly outcome is Pareto inefficient.

Pareto Efficiency
• Rent Control:
– some close apartments are assigned to renters
valuing them at below the competitive price p e
– some renters valuing a close apartment above p e
don’t get close apartments
– Pareto inefficient outcome.

Long-run equilibrium Discussion

• Over time, will
– the supply of close apartments increase?
– rent control decrease the supply of apartments?
– a monopolist supply more apartments than a
competitive rental market?

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