DIFFERENTIATION

Although this may seem like a paradox, all

science is dominated by the idea of
approximation. ─ Bertrand Russell
Review of Derivatives of
Functions of One
Variable
Review of Derivatives
n Definition. Let y = f(x). The derivative of f at x,
denoted by f ′(x), is defined as
f ( x + Dx ) - f ( x )
f ¢( x ) = lim
Dx® 0 Dx
n if the limit exists.
dy
n The derivative is also denoted by
dx
n This notation is due to Leibniz who invented
calculus independently of Newton.
Inventors of Calculus

Sir Isaac Newton Gottfried Wilhelm Leibniz

(1643-1727) (1646-1716)
English mathematician German mathematician
Review of Derivatives
n The derivative has two
important
interpretations:
n f ′(x) is the rate of
change of f(x) at the f(x) (x,f(x))
point x.
n f ′(x) is the slope of the
curve f(x) at the point
x
(x,f(x)).
Review of Derivatives
n Differentiability at x
means that the curve is
smooth at the point
f(x) (x,f(x))
(x,f(x)).
n Hence, there is only
one tangent to the x
curve at the point
(x,f(x)).
Review of Derivatives
n At points where the
curve is not smooth f(x) = ‫׀‬x‫׀‬
(e.g., kinks, corners),
the derivative does not
exist.
n Example: f(x) = ‫׀‬x‫׀‬ 0
n The derivative does
not exist at x = 0.
Review of Derivatives
n f ′(x) < 0 when f(x) is
falling;
n f ′(x) = 0 when f(x) is f ′(x) < 0 f ′(x) > 0
neither rising nor
falling; f ′(x) = 0
n f ′(x) > 0 when f(x) is
rising;
n If f ′(x) = 0, x is called
a stationary point. x
 Review of Derivatives
n Theorem. If f is
differentiable at a point a, f(x) = ‫׀‬x‫׀‬
then f is continuous at a.
n The converse of this
theorem is false, i.e.,
continuity does not imply
differentiability. 0
n Example: f(x) = ‫׀‬x‫׀‬
n f is continuous at x = 0 but
not differentiable there.
Differentiation Rules
f(x) f ′(x)

c 0

x 1

xn nxn -1 (n an integer; x ≠ 0 if n < 0)

xa axa -1 (x > 0)

cf(x) cf ′(x)

f(x) ± g(x) f ′(x) ± g′(x)

Differentiation Rules
Product Rule

d
f ( x) g( x) = f ¢( x) g( x) + f ( x) g ¢( x)
dx

Example: y = (3x – 2x2)(5 + 4x)

f(x) g(x)

dy/dx = (3 – 4x)(5 + 4x) + (3x – 2x2)(4)

= 15 + 4x – 24x2
Differentiation Rules
Quotient Rule
d f ( x ) f ¢( x ) g ( x ) - f ( x ) g ¢( x )
= , g( x) ¹ 0
dx g ( x ) [ g ( x )] 2

Example 3x - 1
y=
x 2 + 5x

dy 3( x 2 + 5x ) - (3x - 1)(2 x + 5)
=
dx ( x 2 + 5x ) 2

- 3x 2 + 2 x + 5
=
( x 2 + 5x ) 2
Differentiation Rules
The Chain Rule
d
g[ f ( x )] = g ¢[ f ( x )] f ¢( x )
dx
Example: y = (x2 + 1)3
Let y = g(z) = z3, z = f(x) = x2 + 1
y = g(f(x) = (f(x))3 = (x2 + 1)3
dy/dx = 3z2(2x)
= 3(x2 + 1)2(2x)
= 6x(x2 + 1)
Differentiation Rules
The Chain Rule in Leibniz notation:
y = g ( z), z = f ( x )
dy dy dz
=
dx dz dx

Example: y = (x2 + 1)3

Let y = z3, z = x2 + 1
dy
= 3z 2 (2 x ) = 3( x 2 + 1)(2 x ) = 6 x ( x 2 + 1)
dx
Differentiation Rules
n The Inverse Function
-1
Rule df ( y) 1
n Let f be a one-to-one
=
dy f ¢( x )
function differentiable on
an open interval (a,b) and or
let x ε (a,b) such that f ′(x)
≠ 0. dx 1
n Then x = f –1(y) and f −1 is
=
dy dy / dx
differentiable at y = f(x)
and
Differentiation Rules
n The Inverse Function Rule
n Example: q = f(p) = 5 – 2p
n dp/dq = 1/f ′(p) = 1/(−2) = − ½
n Example: y = x5 + x
n Note that dy/dx = 5x4 + 1 > 0 for all x; the given
function is monotonically increasing, and has an
inverse.
n dx/dy = 1/(dy/dx) = 1/(5x4 + 1)
Differentiation Rules
n Derivative of the Natural Logarithmic Function

d f ¢( x )
ln f ( x ) =
dx f ( x)

Example: y = ln (x + 2)
dy/dx = 1/(x + 2)
Example: y = ln (x2 + 2)
dy/dx = 2x/(x2 + 2)

Special case: y = ln x
dy/dx = 1/x
Differentiation Rules
n Derivative of the Natural Exponential
Function
d f ( x)
e = e f ( x ) f ¢( x )
dx

Example: y = e1− 5t
dy/dt = e1− 5t(− 5) = −5e1− 5t
Differentiation Rules
n Derivative of the Sine Function

d
sin x = cos x
dx

Example: y = sin2 x
dy/dx = 2(sin x)(cos x)

Example: y = sin(x2)
Let u = x2 so that y = sin u, u = x2.
By the Chain Rule:
dy/dx = (dy/du)(du/dx) = (cos u)(2x)
= 2x cos(x2)
Differentiation Rules
n Derivative of the Cosine Function

d
cos x = - sin x
dx

Example: y = cos(ex)
Let u = ex so that y = cos u, u = ex
By the Chain Rule:
dy/dx = (dy/du)(du/dx) = (−sin u)(ex)
= −(ex)sin(ex)
Implicit Differentiation
n Implicit differentiation is used when it is not easy
to express y as an explicit function of x.
n Example: y3 – 3y2 +3y + x2 = 2
n Differentiating term by term with respect to x, we
get
dy
2 dy dy
3y - 6y + 3 + 2x = 0
dx dx dx

dy - 2x
= 2
dx 3 y - 6 y + 3
Logarithmic Differentiation
n Logarithmic differentiation refers to the process
of transforming the functions by logarithms
before performing a differentiation.
n Example: y = xx, x > 0

ln y = x ln x dy æ 1 ö
= y ç x + ln x÷ = x x (1 + ln x )
dx è x ø

1 dy 1
= x + ln x
y dx x
Higher-Order Derivatives
n Since f ′ is a function, we may also define its
derivative and call it the second derivative of f
and denote it by f ″.
n We may continue this process and get the third
derivative f (3), the fourth derivative f (4) and so on.
n If y = f(x), we often use the following notations
for the higher-order derivatives:
n Second derivative:
d2y
f ¢¢( x ) º 2
dx
Higher-Order Derivatives

d 3y
n Third derivative: f ¢¢¢( x ) º
dx 3

(4) d4y
n Fourth derivative: f ( x) = 4
dx

n nth derivative: (n) dny

f ( x) º
dx n
Marginal Functions
n Marginal analysis is concerned with the effects on
the dependent variable of small changes in the
independent variable or changes on the "margin".
n Since derivatives describe such changes, they have
been called, in economics, marginal functions.
n For example, the derivative of a total cost function
is called a marginal cost function while the
derivative of a total revenue function is called a
marginal revenue function.
Marginal Functions and Average
Functions
n Marginal functions are closely associated with
another set of functions called the average
functions. Let y = f(x) where x > 0.
n The average function is defined as

f ( x)
AF ( x ) =
x
The marginal function is defined as

MF(x) = f ′(x)
 Marginal Functions and Average
Functions
n Theorem. Let f be Proof:
differentiable on the f ( x)
AF ( x ) =
set of positive x
numbers. Then dAF xf ¢( x ) - f ( x )
=
dAF dx x2
(a ) < 0 Û MF ( x ) < AF ( x )
dx 1é f ( x) ù
dAF = ê f ¢( x ) -
(b) = 0 Û MF ( x ) = AF ( x ) xë x úû
dx
1
( c)
dAF
> 0 Û MF ( x ) > AF ( x ) = [ MF ( x ) - AF ( x )]
dx x
The conclusions follow.
Marginal Functions and Average
Functions
n Example. The total cost C(x) of producing output
x is given by
n C(x) = 0.2x3 – 1.3x2 + 3.7x

n The average cost function is

n AC(x) = C(x)/x = 0.2x2 – 1.3x + 3.7

n The marginal cost function is

n MC(x) = dC/dx = 0.6x2 – 2.6x + 3.7
 Marginal Functions and Average
Functions
Illustration of the theorem
applied to a cost function: MC

dAC
(a ) < 0 Û MC( x ) < AC( x ) AC
dx
dAC dAC dAC
(b) = 0 Û MC( x ) = AC( x ) <0 >0
dx dx dx
dAC
( c) > 0 Û MC( x ) > AC( x ) dAC x
dx =0
dx
Elasticity
n Definition. Let y = f(x) where x > 0 and f is
differentiable. The point elasticity of y with
respect to x is defined as
dy / dx x dy
e yx = =
y/x y dx
n |εyx| > 1: y is elastic with respect to x.
n |εyx| < 1: y is inelastic with respect to x.
n |εyx| = 1: y is unit elastic with respect to x.
n Note: Elasticity is MF divided by AF.
Elasticity
n Theorem. Let y = f(x), where x > 0, y > 0 and f is
differentiable. Then
d ln y
e yx =
d ln x
Proof: Let u = ln y, v = ln x. Then
u = ln y, y = f(x), x = ev
By the Chain Rule,
d ln y du du dy dx 1 dy v x dy
= = = e = = e yx
d ln x dv dy dx dv y dx y dx
Price Elasticity and Revenue

n Let q = f(p) be a differentiable demand function.

Let R denote total revenue, i.e., R = pq. Then

dR dq q æ dq ö
=p +q = çp + q÷
dp dp q è dp ø

dR æ p dq ö dR
= qç + 1÷ = q (e qp + 1)
dp è q dp ø dp
 dR
Price Elasticity and Revenue = q (e qp + 1)
dp

If the demand function is downward sloping, i.e.,

dq/dp < 0, then εqp < 0. p dq
e qp =
q dp
Suppose demand is price inelastic, i.e., εqp > –1;
then, εqp + 1 > 0.
dR
dp
( )
= q e qp + 1 > 0

This says that a price increase will increase revenue.

 dR
Price Elasticity and Revenue = q (e qp + 1)
dp

n If demand is unit elastic, then εqp = –1; hence,

dR
= q (e qp + 1) = 0
dp
Thus, a price change will not affect revenue.
If demand is price elastic, then εqp < –1; hence,
εqp + 1 < 0.
dR
= q (e qp + 1) < 0
dp
In this case, a price increase will decrease revenue.
Rates of Growth
n Definition. Let y = f(t) where y > 0, t > 0, f
is differentiable, and t denotes time.
n The instantaneous rate of growth of y is
defined as 1 dy
ry =
y dt
1 dy d
Note that ry = = ln y
y dt dt
Rates of Growth
n Theorem.
n ρuv = ρu + ρv
n ρu/v = ρu − ρv

n Example 1:
n GNP(t) = nominal GNP
n P(t) = price deflator at time t
n GNP(t)/P(t) = real GNP at
time t
n Rate of growth of real GNP is
ρGNP − ρP
n Example 2:
n Y(t) = national income
n N(t) = population at time t
n Y(t)/N(t) = per capita income
at time t
n Rate of growth of per capita
income is ρY − ρN
Partial Derivatives
 Partial Derivatives
n Let y = f(x1, x2, . . .,xn). The partial derivative of f
with respect to xi at the point x = [x1 x2 . . . xn] is
defined as
f ( x1 ,.., x i + D x i ,.., x n ) - f ( x1 ,.., x i ,.., x n )
f i (x) = lim
D xi ® 0 D xi

if the limit exists.

¶y ¶ f
Other notations: f i ( x) º º
¶ xi ¶ xi
 Partial Derivatives
The vector of partial derivatives is called the
gradient of f at x and is written as
é f 1 ( x) ù
ê f ( x) ú
f ¢ ( x) = ê ú
2
ê ! ú (read “f prime of x”)
ê ú
ë f n ( x) û
or as
é f 1 ( x) ù
ê f ( x) ú
Ñ f ( x) = ê 2 ú (read “del f(x)”)
ê ! ú
ê ú
ë f n ( x) û
Partial Derivative: Example
The Cobb-Douglas Production Function
a b
Q = f ( K , L) = AK L , A>0

Gradient of f
é f K ( K , L) ù é aAK a -1 Lb ù
f ¢ ( K , L) = Ñ f ( K , L) = ê ú = ê a b - 1 ú
ë f L ( K , L) û êë bAK L úû
 Partial Derivative: Example
n The Stone-Geary utility function

u = f ( x1 , x 2 , x 3 ) = a 1 ln( x1 - g 1 ) + a 2 ln( x 2 - g 2 ) + a 3 ln( x 3 - g 3 )

¶u a1
= f 1 ( x1 , x 2 , x 3 ) = Gradient of u:
¶ x1 x1 - g 1
¶u a2 é a1 ù
= f 2 ( x1 , x 2 , x 3 ) = ê x1 - g 1 ú
¶ x2 x2 - g 2 a2
u ¢ ( x) = Ñ u ( x) = x 2 - g 2 ú
ê
ê a ú
¶u a3 ê x -3g ú
= f 3 ( x1 , x 2 , x 3 ) = ë 3 3û
¶ x3 x3 - g 3
Geometric Interpretation of the
Partial Derivative
n Given z = f(x,y) z = f(x,y)
n Let L be a line parallel
to the x-axis (y
constant).
n Consider the curve on
the surface above L. y
n The slope of this curve
is the partial derivative
fx(x,y).
L
x
Geometric Interpretation of the
Partial Derivative
n Let L1 be a line z = f(x,y)
parallel to the y-axis (x
constant).
n Consider the curve on
the surface above L1.
n The slope of this curve y
is the partial derivative
fy(x,y). L1

x
Marginal Functions
n Partial derivatives are also referred to as marginal
functions.
n Thus, if C = f(q1,q2, . . .,qn) is the joint cost of
producing quantities q1, q2, . . ., qn of n
commodities, then fi is the marginal cost of qi.
n Similarly, if Q = F(K, L) represents a production
function with output Q corresponding to inputs K
and L, then FK is the marginal product of input K
and FL is the marginal product of L.
 Partial Elasticity
Definition. Let y = f(x1,x2, . . .,xn). The partial elasticity
of y with respect to xi is defined as
xi ¶ y
e yxi =
y ¶ xi

Example Q = f ( K , L) = AK a Lb , A>0
K ¶Q K a -1 b
e QK = = a b
aAK L =a
Q ¶ K AK L

L ¶Q L a b -1
e QL = = a b
bAK L =b
Q ¶ L AK L
Higher-Order Partial Derivatives:
Notations
n Let y = f(x1,x2, . . .,xn). Since the partial derivative
is a function, we may also define its partial
derivatives.
n The second-order partial derivatives are denoted
as follows:
¶ ¶y ¶2y
f ij º º
¶ x j ¶ xi ¶ x j ¶ xi

¶ ¶y ¶2y
f ii º º
¶ x i ¶ x i ¶ x i2
 Higher-Order Partial Derivatives:
Notations
n If z = f(x,y), then the second-order partial
derivatives are denoted by the following symbols

¶ ¶z ¶ 2z ¶ ¶z ¶ 2z
f xx º ( fx)x º º f xy º (fx)y º º
¶ x ¶ x ¶ x2 ¶ y ¶ x ¶ y¶ x

¶ ¶z ¶ 2z ¶ ¶z ¶ 2z
f yx º ( f y )x º º f yy º (fy)y º º
¶ x ¶ y ¶ x¶ y ¶ y ¶ y ¶ y2
 Higher-Order Partial Derivatives:
Example
(a ) z = x 3 + 2 xy + y 3
¶z ¶z
f x ( x, y) = = 3x 2 + 2 y f y ( x, y) = = 2 x + 3y 2
¶x ¶y

2
¶ z f xy ( x , y ) =
¶ 2z
=2
f xx ( x , y ) = = 6x
¶x 2 ¶ y¶ x

¶ 2z ¶ 2z
f yx ( x , y ) = =2 f yy ( x , y ) = = 6y
¶ x¶ y ¶y 2
Higher-Order Partial Derivatives:
A Cobb-Douglas Production Function
n Q = f(K,L) = KαLβ (0 < α, β < 1)
n Marginal product of capital:
n fK(K,L) = αKα−1Lβ
n Differentiating fK with respect to K:
n fKK(K,L) = α(α−1)Kα−2Lβ < 0
n The negative sign indicates diminishing marginal
productivity. The marginal product of capital decreases as
more of capital is used, holding labor constant.
n Differentiating fK with respect to L:
n fKL(K,L) = αβKα−1Lβ−1 > 0
n The marginal product of capital increases as more of labor
is used, holding capital constant.
Higher-Order Partial Derivatives:
A Cobb-Douglas Production Function
n Q = f(K,L) = KαLβ (0 < α, β < 1)
n Marginal product of labor:
n fL(K,L) = βKαLβ−1
n Differentiating fL with respect to L:
n fLL(K,L) = β(β−1)KαLβ−2 < 0
n The negative sign indicates diminishing marginal
productivity. The marginal product of labor decreases as
more of labor is used, holding capital constant.
n Differentiating fL with respect to K:
n fLK(K,L) = αβKα−1Lβ−1 > 0
n The marginal product of labor increases as more of capital
is used, holding labor constant.
Young’s Theorem
n From the preceding examples we notice that the
cross partial derivatives are equal. This is true
provided that the function has continuous second
order partial derivatives.
n Theorem (Young). Let f have continuous second
order partial derivatives. Then fij = fji.
n Remark: If a function of many variables has
continuous higher-order partial derivatives, then a
repeated application of Young’s Theorem results in
the invariance of higher-order partial derivatives
to the order of differentiation.
Total Differentials and
Total Derivatives
Total Differentials and Total
Derivatives
n A partial derivative measures the effect of an independent
variable while holding other independent variables fixed. If
several independent variables change, their joint effects
cannot be captured by the partial derivative.
n Joint effects are captured by including the effect of each
independent variable as part of the total. This leads to the
idea of total differentials and total derivatives.
n Definition. Let y = f(x) where f is differentiable. A
differential dx is any increment in x. The differential dy
corresponding to the differential dx is defined as
n dy = f ′(x)dx ■
Differentials
n Let y = f(x) where f is
differentiable. A
differential dx is any
increment in x.
n The differential dy
Δy
corresponding to dx is
defined as dx
n dy = f ′(x)dx
x x+dx
n Let Δy = f(x+dx) – f(x)
Differentials
n Let T be the tangent to the
curve at the point (x, f(x)).
T
n Consider the segment a.
n Slope of T = f ′(x) = a/dx
n Hence, a = f ′(x)dx a Δy
n By definition, dy = f ′(x)dx
n Hence, a = dy,
dx
x x+dx
n i.e., dy is an
approximation of Δy.
Differentials
n As differentials, dy and dx may be treated just like
numbers.
n Although there is no restriction on the value of dx,
the concept of the differential is, as a rule, used
when dx is small.
n The preceding figures show that dy approximates
the actual change Δy and the smaller dx is, the
better the approximation.
Rules for Differentials
Derivative Differential
dc
(a ) = 0, dc = 0
dx

d (cu) du
(b) =c , d (cu) = cdu
dx dx

d (u ± v ) du dv
( c) = ± d (u ± v ) = du ± dv
dx dx dx
 Rules for Differentials
Derivative Differential

d (uv ) dv du
(d ) =u +v d (uv ) = udv + vdu
dx dx dx

æ uö æ du ö æ dv ö
dç ÷ v ç ÷ - uç ÷
è vø è dx ø è dx ø æ u ö vdu - udv
( e) = dç ÷ = , (v ¹ 0)
dx v2 è vø v 2
 Rules for Differentials: Examples

2 6x + 1
(a ) y = 4 x + 8x - 6 (b) y=
2x
dy dy (2 x )6 - (6 x + 1)2 1
= 8x + 8 = =- 2
dx dx 4x 2
2x

1
dy = 8( x + 1)dx dy = - dx
2
2x
Total Differentials
n Definition. Let y = f(x1,x2, . . .,xn). Given the
differentials dx1, dx2, . . ., dxn, the total
differential dy is defined as
n dy = f1dx1 + f2dx2 + … + fndxn (1)
n Let y = f(x1, x2, . . .,xn) and suppose that
n x1 = u1(t), x2 = u2(t), …, xn = un(t)
n Dividing (1) by dt, we get

dy dx1 dx 2 dx n
= f1 + f2 + ! + fn
dt dt dt dt
Total Derivatives
n Theorem. Let y = f(x1,x2, . . ., xn), where f has
continuous partial derivatives and
x1 = u1 (t ), x 2 = u2 (t ), ! , x n = u n (t )
Then
dy dx1 dx 2 dx n
= f1 + f2 + ! + fn
dt dt dt dt

Definition. The derivative dy/dt is called the

total derivative of y with respect to t.
Total Derivative: Special Case
n Total derivative:

dy dx1 dx 2 dx n
= f1 + f2 + ! + fn
dt dt dt dt
When t is equal to x1 (or any xi), then the total
derivative of y with respect to x1 is

dy dx 2 dx n
= f1 + f 2 + ! + fn
dx1 dx1 dx1
Total Derivative: Special Case
n Let y = f(x1, x2) and x2 = u(x1).
n Then y

dy dx 2
= f1 + f 2
dx1 dx1 x1 x2

x1 has a direct effect on y

x1 has an indirect effect on y via x2

 Total Derivative : Example

2 2 3
(a ) z=x +y , x = t, y = t +3
¶z ¶z
dz = dx + dy = 2 xdx + 2 ydy
¶x ¶y
dz ¶ z dx ¶ z dy
= + = 2 x (1) + 2 y (3t 2 )
dt ¶ x dt ¶ y dt
= 2t (1 + 3t 4 + 9t )
Total Derivative
Example: Rates of Growth
Q(t ) = AK (t ) a L(t ) b
dQ ¶Q dK ¶Q dL
= +
dt ¶ K dt ¶ L dt

a -1 bdK a b - 1 dL
= aAK L + bAK L
dt dt
1 dK
a b a b 1 dL
= aAK L + bAK L
K dt L dt
1 dK 1 dL
= aQ + bQ
K dt L dt
Total Derivative
Example: Rates of Growth
1 dQ 1 dK 1 dL
=a +b
Q dt K dt L dt

r Q = ar K + br L

The rate of growth of output of a Cobb-Douglas

production function is proportional to the rates of
growth of capital and labor, the proportions being
the elasticities.
Change in Market Equilibrium
n Demand Function
n Qd = D(p,r,y), (Dp < 0)
n Qd = quantity demanded
n p = price of the good
n r = price of a relevant good
n y = consumer’s income
n Dp < 0 => demand curve is downward sloping
with respect to p.
Change in Market Equilibrium
n Supply Function
n Qs = S(p,v,w), (Sp > 0)
n Qs = quantity supplied
n p = price of the good
n v = price of an input in producing the good
n w = price of another input in producing the good
n Sp > 0 => Supply curve is upward sloping with
respect to p.
Change in Market Equilibrium
n Equilibrium Condition
n D(p,r,y) = S(p,v,w)
n Total differential:
n Dpdp + Drdr + Dydy = Spdp + Svdv + Swdw
n For given values of r, y, v, and w let p* and q* be
the equilibrium values of price and quantity.
n We wish to determine the effects of a change in
income (y) on equilibrium price (p*) while
holding r, v, and w fixed.
Change in Market Equilibrium
n Total differential:
n Dpdp + Drdr + Dydy = Spdp + Svdv + Swdw (A)
n Let dp* denote the change in price at equilibrium
corresponding to a change dy in income.
n Holding r, v, and w fixed means dr = dv = dw = 0.
n Equation (A) reduces to
n Dpdp* + Dydy = Spdp*
n Dpdp*/dy + Dy = Spdp*/dy
n (Dp − Sp)dp*/dy = − Dy
n dp*/dy = − Dy/(Dp − Sp)
Change in Market Equilibrium

dp * Dy
=
dy S p - Dp

Sp – Dp > 0.
Hence, dp*/dy depends on the sign of Dy.

For a normal good, Dy > 0; hence, dp*/dy > 0

Thus, for a normal good, an increase in income

increases equilibrium price.
Changes in Equilibrium in an IS-
LM Model
n Goods Market
n Consumption (C) is a function of income (Y):
n C = C(Y) (0 < C′(Y) < 1)
n Investment (I) is a function of interest rate (R):
n I = I(R) (I′(R) < 0)
n Government expenditure G is exogenous:
n G = G0
n Equilibrium condition:
n Y = C(Y) + I(R) + G0
Changes in Equilibrium in an IS-
LM Model
n Equilibrium Condition in the Goods Market :
n Y = C(Y) + I(R) + G0
n This equation relates income Y to interest rate R.
n Its graph on the RY-plane is called the IS-curve.
n Taking total differentials (and noting that G0 is
fixed, i.e., dG0 = 0), we get
n dY = C′(Y)dY + I′(R)dR
n dY/dR = I′(R)/(1 − C′(Y)) < 0.
n Hence, the IS-curve is downward-sloping.
Changes in Equilibrium in an IS-
LM Model
n Money Market
n Demand for money (Md) is a function of Y and R:
n Md = M(Y,R) (MY > 0, MR < 0)
n Supply of money (Ms) is determined by the
Central Bank and is, therefore, exogenous, say
n Ms= M0
n Equilibrium Condition in the Money Market
n M(Y,R) = M0
Changes in Equilibrium in an IS-
LM Model
n Equilibrium Condition in the Money Market
n M(Y,R) = M0
n This equation relates income Y to interest rate R.
n The graph of this equation in the RY-plane is called the
LM-curve.
n Taking total differentials (and noting that M0 is fixed, i.e.,
dM0 = 0), we have
n MYdY + MRdR = 0 MY > 0
n dY/dR = − MR/MY > 0 MR < 0
n Hence, the LM-curve is upward sloping.
Changes in Equilibrium in an IS-
LM Model
n The Overall Equilibrium
n The overall equilibrium in both markets is the
intersection of the IS-curve and the LM-curve, i.e.,
the solution of the system of equations:

n Y = C(Y) + I(R) + G0
n M(Y,R) = M0
Changes in Equilibrium in an IS-
LM Model
n Y = C(Y) + I(R) + G0 (1)
n M(Y,R) = M0 (2)
n Let (R*,Y*) be the overall equilibrium.
n Suppose we wish to determine the effects on R*
and Y* of a change in money supply, holding
government expenditure constant.
n Totally differentiate (1) and (2):
n dY = C′(Y)dY + I′(R)dR + dG0
n MY(R,Y)dY + MR(R,Y)dR = dM0
Changes in Equilibrium in an IS-
LM Model
In matrix form

é 1 - C ¢ (Y ) - I ¢ ( R) ù édY ù é dG0 ù
ê M ( R, Y ) =ê
ë Y M R ( R, Y ) û ëdR û ëdM 0 úû
ú ê ú

J
Denoting the coefficient matrix by J 0 < C′ < 1
we get I′ < 0
MY > 0
det( J ) = (1 - C ¢ (Y )) M R + M Y I ¢ ( R) < 0 MR < 0
Changes in Equilibrium in an IS-
LM Model
Solving for dY and dR (using Cramer’s Rule):

M R dG0 + I ¢( R)dM 0
dY =
det( J )

(1 - C ¢(Y ))dM 0 - M Y dG0

dR =
det( J )
Changes in Equilibrium in an IS-
LM Model
If money supply is increased by dM0 while holding
government expenditure constant (i.e., dG0 = 0), we get
dY * I ¢( R)
= >0
dM 0 det( J )

dR * 1 - C ¢(Y )
= <0
dM 0 det( J )
Holding government expenditure constant, an increase in
money supply increases income.
Holding government expenditure constant, an increase in
money supply decreases interest rate.
Changes in Equilibrium in an IS-
LM Model
Let government expenditure be increased by dG0 while holding
money supply fixed (i.e. dM0 = 0). Then
dY * MR
= >0
dG0 det( J )

dR * - M Y
= >0
dG0 det( J )
Holding money supply constant, an increase in government
expenditure increases income.

Holding money supply constant, an increase in government

expenditure increases interest rate.
The Implicit Function
Theorem
The Implicit Function Theorem
n Consider the implicit function
n F(x,y) = 0.
n Sometimes it is possible to solve for y as an
explicit function of x.
n But there are cases when it is not possible to
express y as a function of x.
n The question is: under what conditions can we
express y as a function of x?
n The answer is given by the Implicit Function
Theorem.
The Implicit Function Theorem:
F(x,y) = 0
n Let F(x,y) be defined on an open disk D containing (x0,y0)
and suppose that
n (a) F(x0,y0) = 0;
n (b) Fy, Fx are continuous on D;
n (c) Fy(x0,y0) ≠ 0;
n Then there exists a function f defined on an interval (a,b)
containing x0 such that
n (1) y = f(x) on (a,b);
n (2) F(x,f(x)) = 0 on (a,b);
n (3) f has a continuous derivative on (a,b).
Implications of the Implicit
Function Theorem
Theorem. If y is defined implicitly as a function
of x by the equation F(x,y) = 0, where Fy and Fx are
continuous and Fy(x,y) ≠ 0, then

dy Fx ( x , y )
=-
dx Fy ( x , y )
Level Curves
Let z = f(x,y). A level curve of f is the curve defined by
f(x,y) = c, where c is a constant. Thus, y is defined
implicitly as a function of x by the equation

F ( x, y) = f ( x, y) - c = 0
Assuming that the conditions of the Implicit Function
Theorem hold, we can get the slope of the level curve
by the formula
dy Fx ( x , y ) f x ( x, y)
=- =-
dx Fy ( x , y ) f y ( x, y)
Level Curves: Isoquants
A level curve of a production function is called an
isoquant. If the production function is Q = f(K,L),
then the slope of an isoquant is given by
dK f L ( K , L)
=-
dL f K ( K , L)
Example: Cobb-Douglas production function
Q = f ( K , L) = AK a L1- a ( A > 0)
Slope of an isoquant
dK f L ( K , L) AK a (1 - a ) L- a (1 - a ) K
= - = - a a = -
dL f K ( K , L) AaK - 1
L1- aL
 Level Curves: Indifference Curve
The level curve of a utility function is called an
indifference curve. Let the utility function be given by
u = f ( x1 , x 2 )
where xi is the consumption of good i (i = 1,2).
Slope of an indifference curve is given by
dx 2 f 1 ( x1 , x 2 )
=-
dx1 f 2 ( x1 , x 2 )
Example u = f ( x1 , x 2 ) = a ln x1 + b ln x 2
dx 2 f 1 ( x1 , x 2 ) a / x1 ax 2
=- =- =-
dx1 f 2 ( x1 , x 2 ) b / x2 bx 1
The Implicit Function Theorem:
F(x,y,z) = 0
n Let F(x,y,z) be defined on an open ball B containing
(x0,y0,z0) and suppose that
n (a) F(x0,y0,z0) = 0;
n (b) Fx, Fy, Fz are continuous on B;
n (c) Fz(x0,y0,z0) ≠ 0;
n Then there exists a function f defined on an open disk
D containing (x0,y0) such that
n (1) z = f(x,y) on D;
n (2) F((x,y),f(x,y)) = 0 on D;
n (3) f has continuous partial derivatives on D.
 Implications of the Implicit
Function Theorem
Theorem. Let z be defined implicitly as a function of x and y by
the equation F(x,y,z) = 0 such that Fx, Fy, and Fz are continuous,
and Fz(x,y,z) ≠ 0. Then
¶z Fx ( x , y , z) ¶z Fy ( x , y , z )
=- =-
¶x Fz ( x , y , z) ¶y Fz ( x , y , z)
Example A production function is given implicitly by F(K,L,Q) =
0, where Q = output, K = capital input, and L = labor input. If the
conditions of Implicit Function Theorem hold, then the marginal
products of capital and labor are
¶Q FK ( K , L, Q) ¶Q F L ( K , L , Q)
=- =-
¶K FQ ( K , L, Q) ¶L FQ ( K , L, Q)
Taylor's Theorem
n Among the differentiable functions, the
polynomials are the most well-behaved and are the
easiest to handle.
n This explains why polynomial approximations of
differentiable functions are useful in mathematical
analysis.
n Taylor's Theorem states that a differentiable
function can be approximated by a polynomial.
n In fact, a linear or a quadratic approximation is
often adequate for many purposes.
 Taylor's Theorem for a Function
of One Variable
Let f have continuous derivatives up to the (n + 1)th
order on an open interval (a,b). For every pair of
points x and x1 in (a,b), there is a point p between x
and x1 such that
f ¢ ( x1 ) f ( n ) ( x1 ) n
f ( x ) = f ( x1 ) + ( x - x1 ) + ! + ( x - x1 )
1! n!
f ( n +1) ( p) n +1
+ ( x - x1 )
(n + 1)!
The Mean Value Theorem:
f(x) = f(x1) + f ′(p)(x − x1)
n We derive this equation
by using a graph. B
n Slope of AB: f(x) − f(x1)
f ( x ) - f ( x1 ) A
x − x1
m AB =
x - x1
a x1 x b
The Mean Value Theorem:
f(x) = f(x1) + f ′(p)(x − x1)
n Draw a line parallel to AB
and tangent to the curve at
B
P. P
n Let p be the x-coordinate f(x) − f(x1)
of P. A
x − x1
n Slope of tangent = f ′(p)
n Slope of tangent = slope
of AB
a x1 p x b
n Hence,

f ( x ) - f ( x1 )
= f ¢ ( p) f ( x ) = f ( x1 ) + f ¢( p)( x - x1 )
x - x1
 Taylor's Theorem for Functions of
Several Variables
Let f be a function of x = [x1,x2, . . .,xn]. Suppose that f has
second-order partial derivatives. The Hessian matrix of f at
x is defined as
é f 11 (x) f 12 (x) ! f 1n (x) ù
ê f ( x) f 22 (x) ! ú
f 2 n ( x) ú
H f ( x) = ê 21
ê " " " " ú
ê ú
ë f n1 (x) f n 2 ( x) ! f nn (x) û
The Hessian matrix of f at x is also denoted by f ″(x).
If f has continuous second-order partial derivatives,
then fij = fji; the Hessian matrix in this case is symmetric.
 Taylor's Theorem for Functions of
Several Variables
n Let f have continuous second-order partial derivatives
on an open ball B in Rn.
n For each pair of points x, x1 ε B, there is a point p on
the line segment joining x and x1 such that
n f(x) = f(x1) + f ′(p)T(x – x1).

n For each pair of points x, x1 ε B, there is a point p on

the line segment joining x and x1 such that
n f(x) = f(x1) + f ′(x)T(x – x1) + ½(x – x1)THf (p)(x – x1).
Homogeneous Functions
Homogeneous Functions
n Definition. A function f is said to be
homogeneous of degree k iff f(tx) = t kf(x) for
every t > 0.
n Definition. A homogeneous function of degree 1
is said to be linearly homogeneous.
n Remark. If y = f(x1,x2,…,xn) is a linearly
homogeneous production function, then
f(tx1,tx2,…,txn) = tf(x1,x2,…,xn), i.e., if each input is
increased by the same proportion, output will
increase by a like proportion. In Economese,
production exhibits constant returns to scale.
 Homogeneous Functions:
Examples
Degree
1 1
(a ) f ( x ) = f (t x ) = = t -1 f ( x ) -1
x tx
x1 t x1
(b) f ( x1 , x2 ) = f ( t x1 , t x 2 ) = = t 0 f ( x1 , x 2 ) 0
x2 t x2

( c) f ( x ) = x f (t x ) = t x = t 1/ 2 x ½

(d ) f ( x , y ) = x + y f (t x , t y ) = t x + t y = t f ( x , y ) 1
D
 Euler’s Theorem
n Theorem. Let y = f(x),
where x = [x1,x2,...,xn]. If f
is homogeneous of degree
k, then its partial derivatives
are homogeneous of degree
k–1.
n EULER’S THEOREM. Let y
= f(x), x = [x1,x2,...,xn]. If f
is homogeneous of degree
k, then
n f1(x)x1+...+fn(x)xn = kf(x).

Leonhard Euler (1707-1783)

Swiss mathematician
Example: A Cobb-Douglas
Production Function
Consider the Cobb-Douglas production function:
a 1- a
Q = f ( K , L) = K L
This Cobb-Douglas function is linearly homogeneous or
homogeneous of degree 1:

f (tK , tL) = (tK ) a (tL) 1- a = tK a L1- a = t f ( K , L)

Example: A Cobb-Douglas
Production Function
The marginal products are homogeneous of degree 0:
f K ( K , L) = aK a -1 L1- a
f K (tK , tL) = a (tK ) a -1 (tL) 1- a = t 0 f K ( K , L)

f L ( K , L) = (1 - a ) K a L - a

f L (tK , tL) = (1 - a )(tK ) a (tL) - a = t 0 f L ( K , L)

Euler's Theorem is satisfied:
f K K + f L L = aK a -1
L K + (1 - a ) K L L
1- a a -a

= K a L1-a = f ( K , L)