Mathematical economics

Mathematical economics is the application of mathematical methods to represent theories and analyze
problems in economics. Often, these applied methods are beyond simple geometry, and may include
differential and integral calculus, difference and differential equations, matrix algebra, mathematical
programming, or other computational methods.[1][2] Proponents of this approach claim that it allows the
formulation of theoretical relationships with rigor, generality, and simplicity.[3]

Mathematics allows economists to form meaningful, testable propositions about wide-ranging and complex
subjects which could less easily be expressed informally. Further, the language of mathematics allows
economists to make specific, positive claims about controversial or contentious subjects that would be
impossible without mathematics.[4] Much of economic theory is currently presented in terms of
mathematical economic models, a set of stylized and simplified mathematical relationships asserted to
clarify assumptions and implications.[5]

Broad applications include:

optimization problems as to goal equilibrium, whether of a household, business firm, or

policy maker
static (or equilibrium) analysis in which the economic unit (such as a household) or
economic system (such as a market or the economy) is modeled as not changing
comparative statics as to a change from one equilibrium to another induced by a change in
one or more factors
dynamic analysis, tracing changes in an economic system over time, for example from
economic growth.[2][6][7]

Formal economic modeling began in the 19th century with the use of differential calculus to represent and
explain economic behavior, such as utility maximization, an early economic application of mathematical
optimization. Economics became more mathematical as a discipline throughout the first half of the 20th
century, but introduction of new and generalized techniques in the period around the Second World War, as
in game theory, would greatly broaden the use of mathematical formulations in economics.[8][7]

This rapid systematizing of economics alarmed critics of the discipline as well as some noted economists.
John Maynard Keynes, Robert Heilbroner, Friedrich Hayek and others have criticized the broad use of
mathematical models for human behavior, arguing that some human choices are irreducible to mathematics.

History
The use of mathematics in the service of social and economic analysis dates back to the 17th century. Then,
mainly in German universities, a style of instruction emerged which dealt specifically with detailed
presentation of data as it related to public administration. Gottfried Achenwall lectured in this fashion,
coining the term statistics. At the same time, a small group of professors in England established a method of
"reasoning by figures upon things relating to government" and referred to this practice as Political
Arithmetick.[9] Sir William Petty wrote at length on issues that would later concern economists, such as
taxation, Velocity of money and national income, but while his analysis was numerical, he rejected abstract
mathematical methodology. Petty's use of detailed numerical data (along with John Graunt) would
influence statisticians and economists for some time, even though Petty's works were largely ignored by
English scholars.[10]

The mathematization of economics began in earnest in the 19th century. Most of the economic analysis of
the time was what would later be called classical economics. Subjects were discussed and dispensed with
through algebraic means, but calculus was not used. More importantly, until Johann Heinrich von Thünen's
The Isolated State in 1826, economists did not develop explicit and abstract models for behavior in order to
apply the tools of mathematics. Thünen's model of farmland use represents the first example of marginal
analysis.[11] Thünen's work was largely theoretical, but he also mined empirical data in order to attempt to
support his generalizations. In comparison to his contemporaries, Thünen built economic models and tools,
rather than applying previous tools to new problems.[12]

Meanwhile, a new cohort of scholars trained in the mathematical methods of the physical sciences
gravitated to economics, advocating and applying those methods to their subject,[13] and described today as
moving from geometry to mechanics.[14] These included W.S. Jevons who presented paper on a "general
mathematical theory of political economy" in 1862, providing an outline for use of the theory of marginal
utility in political economy.[15] In 1871, he published The Principles of Political Economy, declaring that
the subject as science "must be mathematical simply because it deals with quantities". Jevons expected that
only collection of statistics for price and quantities would permit the subject as presented to become an
exact science.[16] Others preceded and followed in expanding mathematical representations of economic
problems. [17]

Marginalists and the roots of neoclassical economics

Augustin Cournot and Léon Walras built the tools of the

discipline axiomatically around utility, arguing that
individuals sought to maximize their utility across choices
in a way that could be described mathematically.[18] At the
time, it was thought that utility was quantifiable, in units
known as utils.[19] Cournot, Walras and Francis Ysidro
Edgeworth are considered the precursors to modern
mathematical economics.[20]

Augustin Cournot

Cournot, a professor of mathematics, developed a

mathematical treatment in 1838 for duopoly—a market
condition defined by competition between two sellers.[20] Equilibrium quantities as a solution to two
This treatment of competition, first published in Researches reaction functions in Cournot duopoly. Each
into the Mathematical Principles of Wealth,[21] is referred reaction function is expressed as a linear
to as Cournot duopoly. It is assumed that both sellers had equation dependent upon quantity demanded.
equal access to the market and could produce their goods
without cost. Further, it assumed that both goods were
homogeneous. Each seller would vary her output based on the output of the other and the market price
would be determined by the total quantity supplied. The profit for each firm would be determined by
multiplying their output by the per unit market price. Differentiating the profit function with respect to
quantity supplied for each firm left a system of linear equations, the simultaneous solution of which gave
the equilibrium quantity, price and profits.[22] Cournot's contributions to the mathematization of economics
would be neglected for decades, but eventually influenced many of the marginalists.[22][23] Cournot's
models of duopoly and oligopoly also represent one of the first formulations of non-cooperative games.
Today the solution can be given as a Nash equilibrium but Cournot's work preceded modern game theory
by over 100 years.[24]

Léon Walras

While Cournot provided a solution for what would later be called partial equilibrium, Léon Walras
attempted to formalize discussion of the economy as a whole through a theory of general competitive
equilibrium. The behavior of every economic actor would be considered on both the production and
consumption side. Walras originally presented four separate models of exchange, each recursively included
in the next. The solution of the resulting system of equations (both linear and non-linear) is the general
equilibrium.[25] At the time, no general solution could be expressed for a system of arbitrarily many
equations, but Walras's attempts produced two famous results in economics. The first is Walras' law and the
second is the principle of tâtonnement. Walras' method was considered highly mathematical for the time
and Edgeworth commented at length about this fact in his review of Éléments d'économie politique pure
(Elements of Pure Economics).[26]

Walras' law was introduced as a theoretical answer to the problem of determining the solutions in general
equilibrium. His notation is different from modern notation but can be constructed using more modern
summation notation. Walras assumed that in equilibrium, all money would be spent on all goods: every
good would be sold at the market price for that good and every buyer would expend their last dollar on a
basket of goods. Starting from this assumption, Walras could then show that if there were n markets and n-1
markets cleared (reached equilibrium conditions) that the nth market would clear as well. This is easiest to
visualize with two markets (considered in most texts as a market for goods and a market for money). If one
of two markets has reached an equilibrium state, no additional goods (or conversely, money) can enter or
exit the second market, so it must be in a state of equilibrium as well. Walras used this statement to move
toward a proof of existence of solutions to general equilibrium but it is commonly used today to illustrate
market clearing in money markets at the undergraduate level.[27]

Tâtonnement (roughly, French for groping toward) was meant to serve as the practical expression of
Walrasian general equilibrium. Walras abstracted the marketplace as an auction of goods where the
auctioneer would call out prices and market participants would wait until they could each satisfy their
personal reservation prices for the quantity desired (remembering here that this is an auction on all goods,
so everyone has a reservation price for their desired basket of goods).[28]

Only when all buyers are satisfied with the given market price would transactions occur. The market would
"clear" at that price—no surplus or shortage would exist. The word tâtonnement is used to describe the
directions the market takes in groping toward equilibrium, settling high or low prices on different goods
until a price is agreed upon for all goods. While the process appears dynamic, Walras only presented a static
model, as no transactions would occur until all markets were in equilibrium. In practice, very few markets
operate in this manner.[29]

Francis Ysidro Edgeworth

Edgeworth introduced mathematical elements to Economics explicitly in Mathematical Psychics: An Essay

on the Application of Mathematics to the Moral Sciences, published in 1881.[30] He adopted Jeremy
Bentham's felicific calculus to economic behavior, allowing the outcome of each decision to be converted
into a change in utility.[31] Using this assumption, Edgeworth built a model of exchange on three
assumptions: individuals are self-interested, individuals act to maximize utility, and individuals are "free to
recontract with another independently of...any third party".[32]
Given two individuals, the set of solutions
where both individuals can maximize utility is
described by the contract curve on what is
now known as an Edgeworth Box.
Technically, the construction of the two-person
solution to Edgeworth's problem was not
developed graphically until 1924 by Arthur
Lyon Bowley.[34] The contract curve of the
Edgeworth box (or more generally on any set
of solutions to Edgeworth's problem for more
actors) is referred to as the core of an
economy.[35]

Edgeworth devoted considerable effort to

insisting that mathematical proofs were An Edgeworth box displaying the contract curve on an
appropriate for all schools of thought in economy with two participants. Referred to as the "core" of
economics. While at the helm of The the economy in modern parlance, there are infinitely many
Economic Journal, he published several solutions along the curve for economies with two
articles criticizing the mathematical rigor of participants[33]
rival researchers, including Edwin Robert
Anderson Seligman, a noted skeptic of
mathematical economics.[36] The articles focused on a back and forth over tax incidence and responses by
producers. Edgeworth noticed that a monopoly producing a good that had jointness of supply but not
jointness of demand (such as first class and economy on an airplane, if the plane flies, both sets of seats fly
with it) might actually lower the price seen by the consumer for one of the two commodities if a tax were
applied. Common sense and more traditional, numerical analysis seemed to indicate that this was
preposterous. Seligman insisted that the results Edgeworth achieved were a quirk of his mathematical
formulation. He suggested that the assumption of a continuous demand function and an infinitesimal
change in the tax resulted in the paradoxical predictions. Harold Hotelling later showed that Edgeworth
was correct and that the same result (a "diminution of price as a result of the tax") could occur with a
discontinuous demand function and large changes in the tax rate.[37]

Modern mathematical economics

From the later-1930s, an array of new mathematical tools from the differential calculus and differential
equations, convex sets, and graph theory were deployed to advance economic theory in a way similar to
new mathematical methods earlier applied to physics.[8][38] The process was later described as moving
from mechanics to axiomatics.[39]

Differential calculus

Vilfredo Pareto analyzed microeconomics by treating decisions by economic actors as attempts to change a
given allotment of goods to another, more preferred allotment. Sets of allocations could then be treated as
Pareto efficient (Pareto optimal is an equivalent term) when no exchanges could occur between actors that
could make at least one individual better off without making any other individual worse off.[40] Pareto's
proof is commonly conflated with Walrassian equilibrium or informally ascribed to Adam Smith's Invisible
hand hypothesis.[41] Rather, Pareto's statement was the first formal assertion of what would be known as
the first fundamental theorem of welfare economics.[42] These models lacked the inequalities of the next
generation of mathematical economics.
In the landmark treatise Foundations of Economic Analysis (1947), Paul Samuelson identified a common
paradigm and mathematical structure across multiple fields in the subject, building on previous work by
Alfred Marshall. Foundations took mathematical concepts from physics and applied them to economic
problems. This broad view (for example, comparing Le Chatelier's principle to tâtonnement) drives the
fundamental premise of mathematical economics: systems of economic actors may be modeled and their
behavior described much like any other system. This extension followed on the work of the marginalists in
the previous century and extended it significantly. Samuelson approached the problems of applying
individual utility maximization over aggregate groups with comparative statics, which compares two
different equilibrium states after an exogenous change in a variable. This and other methods in the book
provided the foundation for mathematical economics in the 20th century.[7][43]

Linear models

Restricted models of general equilibrium were formulated by John von Neumann in 1937.[44] Unlike
earlier versions, the models of von Neumann had inequality constraints. For his model of an expanding
economy, von Neumann proved the existence and uniqueness of an equilibrium using his generalization of
Brouwer's fixed point theorem. Von Neumann's model of an expanding economy considered the matrix
pencil  A - λ B with nonnegative matrices A and B; von Neumann sought probability vectors p and q and a
positive number λ that would solve the complementarity equation

pT (A − λ B) q = 0,

along with two inequality systems expressing economic efficiency. In this model, the (transposed)
probability vector p represents the prices of the goods while the probability vector q represents the
"intensity" at which the production process would run. The unique solution λ represents the rate of growth
of the economy, which equals the interest rate. Proving the existence of a positive growth rate and proving
that the growth rate equals the interest rate were remarkable achievements, even for von
Neumann.[45][46][47] Von Neumann's results have been viewed as a special case of linear programming,
where von Neumann's model uses only nonnegative matrices.[48] The study of von Neumann's model of an
expanding economy continues to interest mathematical economists with interests in computational
economics.[49][50][51]

Input-output economics

In 1936, the Russian–born economist Wassily Leontief built his model of input-output analysis from the
'material balance' tables constructed by Soviet economists, which themselves followed earlier work by the
physiocrats. With his model, which described a system of production and demand processes, Leontief
described how changes in demand in one economic sector would influence production in another.[52] In
practice, Leontief estimated the coefficients of his simple models, to address economically interesting
questions. In production economics, "Leontief technologies" produce outputs using constant proportions of
inputs, regardless of the price of inputs, reducing the value of Leontief models for understanding economies
but allowing their parameters to be estimated relatively easily. In contrast, the von Neumann model of an
expanding economy allows for choice of techniques, but the coefficients must be estimated for each
technology.[53][54]

Mathematical optimization
In mathematics, mathematical optimization (or optimization or
mathematical programming) refers to the selection of a best element
from some set of available alternatives.[55] In the simplest case, an
optimization problem involves maximizing or minimizing a real
function by selecting input values of the function and computing the
corresponding values of the function. The solution process includes
satisfying general necessary and sufficient conditions for optimality.
For optimization problems, specialized notation may be used as to
the function and its input(s). More generally, optimization includes
finding the best available element of some function given a defined Red dot in z direction as maximum
domain and may use a variety of different computational for paraboloid function of (x, y)
optimization techniques.[56] inputs

Economics is closely enough linked to optimization by agents in an

economy that an influential definition relatedly describes economics qua science as the "study of human
behavior as a relationship between ends and scarce means" with alternative uses.[57] Optimization problems
run through modern economics, many with explicit economic or technical constraints. In microeconomics,
the utility maximization problem and its dual problem, the expenditure minimization problem for a given
level of utility, are economic optimization problems.[58] Theory posits that consumers maximize their utility,
subject to their budget constraints and that firms maximize their profits, subject to their production
functions, input costs, and market demand.[59]

Economic equilibrium is studied in optimization theory as a key ingredient of economic theorems that in
principle could be tested against empirical data.[7][60] Newer developments have occurred in dynamic
programming and modeling optimization with risk and uncertainty, including applications to portfolio
theory, the economics of information, and search theory.[59]

Optimality properties for an entire market system may be stated in mathematical terms, as in formulation of
the two fundamental theorems of welfare economics[61] and in the Arrow–Debreu model of general
equilibrium (also discussed below).[62] More concretely, many problems are amenable to analytical
(formulaic) solution. Many others may be sufficiently complex to require numerical methods of solution,
aided by software.[56] Still others are complex but tractable enough to allow computable methods of
solution, in particular computable general equilibrium models for the entire economy.[63]

Linear and nonlinear programming have profoundly affected microeconomics, which had earlier
considered only equality constraints.[64] Many of the mathematical economists who received Nobel Prizes
in Economics had conducted notable research using linear programming: Leonid Kantorovich, Leonid
Hurwicz, Tjalling Koopmans, Kenneth J. Arrow, Robert Dorfman, Paul Samuelson and Robert Solow.[65]
Both Kantorovich and Koopmans acknowledged that George B. Dantzig deserved to share their Nobel
Prize for linear programming. Economists who conducted research in nonlinear programming also have
won the Nobel prize, notably Ragnar Frisch in addition to Kantorovich, Hurwicz, Koopmans, Arrow, and
Samuelson.

Linear optimization
Linear programming was developed to aid the allocation of resources in firms and in industries during the
1930s in Russia and during the 1940s in the United States. During the Berlin airlift (1948), linear
programming was used to plan the shipment of supplies to prevent Berlin from starving after the Soviet
blockade.[66][67]

Nonlinear programming

Extensions to nonlinear optimization with inequality constraints were achieved in 1951 by Albert W.
Tucker and Harold Kuhn, who considered the nonlinear optimization problem:

Minimize subject to and where

is the function to be minimized
are the functions of the inequality constraints where
are the functions of the equality constraints where .

In allowing inequality constraints, the Kuhn–Tucker approach generalized the classic method of Lagrange
multipliers, which (until then) had allowed only equality constraints.[68] The Kuhn–Tucker approach
inspired further research on Lagrangian duality, including the treatment of inequality constraints.[69][70] The
duality theory of nonlinear programming is particularly satisfactory when applied to convex minimization
problems, which enjoy the convex-analytic duality theory of Fenchel and Rockafellar; this convex duality
is particularly strong for polyhedral convex functions, such as those arising in linear programming.
Lagrangian duality and convex analysis are used daily in operations research, in the scheduling of power
plants, the planning of production schedules for factories, and the routing of airlines (routes, flights, planes,
crews).[70]

Variational calculus and optimal control

Economic dynamics allows for changes in economic variables over time, including in dynamic systems.
The problem of finding optimal functions for such changes is studied in variational calculus and in optimal
control theory. Before the Second World War, Frank Ramsey and Harold Hotelling used the calculus of
variations to that end.

Following Richard Bellman's work on dynamic programming and the 1962 English translation of L.
Pontryagin et al.'s earlier work,[71] optimal control theory was used more extensively in economics in
addressing dynamic problems, especially as to economic growth equilibrium and stability of economic
systems,[72] of which a textbook example is optimal consumption and saving.[73] A crucial distinction is
between deterministic and stochastic control models.[74] Other applications of optimal control theory
include those in finance, inventories, and production for example.[75]

Functional analysis

It was in the course of proving of the existence of an optimal equilibrium in his 1937 model of economic
growth that John von Neumann introduced functional analytic methods to include topology in economic
theory, in particular, fixed-point theory through his generalization of Brouwer's fixed-point
theorem.[8][44][76] Following von Neumann's program, Kenneth Arrow and Gérard Debreu formulated
abstract models of economic equilibria using convex sets and fixed–point theory. In introducing the Arrow–
Debreu model in 1954, they proved the existence (but not the uniqueness) of an equilibrium and also
proved that every Walras equilibrium is Pareto efficient; in general, equilibria need not be unique.[77] In
their models, the ("primal") vector space represented quantities while the "dual" vector space represented
prices.[78]

In Russia, the mathematician Leonid Kantorovich developed economic models in partially ordered vector
spaces, that emphasized the duality between quantities and prices.[79] Kantorovich renamed prices as
"objectively determined valuations" which were abbreviated in Russian as "o.  o.  o.", alluding to the
difficulty of discussing prices in the Soviet Union.[78][80][81]

Even in finite dimensions, the concepts of functional analysis have illuminated economic theory,
particularly in clarifying the role of prices as normal vectors to a hyperplane supporting a convex set,
representing production or consumption possibilities. However, problems of describing optimization over
time or under uncertainty require the use of infinite–dimensional function spaces, because agents are
choosing among functions or stochastic processes.[78][82][83][84]

Differential decline and rise

John von Neumann's work on functional analysis and topology broke new ground in mathematics and
economic theory.[44][85] It also left advanced mathematical economics with fewer applications of
differential calculus. In particular, general equilibrium theorists used general topology, convex geometry,
and optimization theory more than differential calculus, because the approach of differential calculus had
failed to establish the existence of an equilibrium.

However, the decline of differential calculus should not be exaggerated, because differential calculus has
always been used in graduate training and in applications. Moreover, differential calculus has returned to
the highest levels of mathematical economics, general equilibrium theory (GET), as practiced by the "GET-
set" (the humorous designation due to Jacques H. Drèze). In the 1960s and 1970s, however, Gérard
Debreu and Stephen Smale led a revival of the use of differential calculus in mathematical economics. In
particular, they were able to prove the existence of a general equilibrium, where earlier writers had failed,
because of their novel mathematics: Baire category from general topology and Sard's lemma from
differential topology. Other economists associated with the use of differential analysis include Egbert
Dierker, Andreu Mas-Colell, and Yves Balasko.[86][87] These advances have changed the traditional
narrative of the history of mathematical economics, following von Neumann, which celebrated the
abandonment of differential calculus.

Game theory

John von Neumann, working with Oskar Morgenstern on the theory of games, broke new mathematical
ground in 1944 by extending functional analytic methods related to convex sets and topological fixed-point
theory to economic analysis.[8][85] Their work thereby avoided the traditional differential calculus, for
which the maximum–operator did not apply to non-differentiable functions. Continuing von Neumann's
work in cooperative game theory, game theorists Lloyd S. Shapley, Martin Shubik, Hervé Moulin, Nimrod
Megiddo, Bezalel Peleg influenced economic research in politics and economics. For example, research on
the fair prices in cooperative games and fair values for voting games led to changed rules for voting in
legislatures and for accounting for the costs in public–works projects. For example, cooperative game
theory was used in designing the water distribution system of Southern Sweden and for setting rates for
dedicated telephone lines in the USA.
Earlier neoclassical theory had bounded only the range of bargaining outcomes and in special cases, for
example bilateral monopoly or along the contract curve of the Edgeworth box.[88] Von Neumann and
Morgenstern's results were similarly weak. Following von Neumann's program, however, John Nash used
fixed–point theory to prove conditions under which the bargaining problem and noncooperative games can
generate a unique equilibrium solution.[89] Noncooperative game theory has been adopted as a fundamental
aspect of experimental economics,[90] behavioral economics,[91] information economics,[92] industrial
organization,[93] and political economy.[94] It has also given rise to the subject of mechanism design
(sometimes called reverse game theory), which has private and public-policy applications as to ways of
improving economic efficiency through incentives for information sharing.[95]

In 1994, Nash, John Harsanyi, and Reinhard Selten received the Nobel Memorial Prize in Economic
Sciences their work on non–cooperative games. Harsanyi and Selten were awarded for their work on
repeated games. Later work extended their results to computational methods of modeling.[96]

Agent-based computational economics

Agent-based computational economics (ACE) as a named field is relatively recent, dating from about the
1990s as to published work. It studies economic processes, including whole economies, as dynamic
systems of interacting agents over time. As such, it falls in the paradigm of complex adaptive systems.[97] In
corresponding agent-based models, agents are not real people but "computational objects modeled as
interacting according to rules" ... "whose micro-level interactions create emergent patterns" in space and
time.[98] The rules are formulated to predict behavior and social interactions based on incentives and
information. The theoretical assumption of mathematical optimization by agents markets is replaced by the
less restrictive postulate of agents with bounded rationality adapting to market forces.[99]

ACE models apply numerical methods of analysis to computer-based simulations of complex dynamic
problems for which more conventional methods, such as theorem formulation, may not find ready use.[100]
Starting from specified initial conditions, the computational economic system is modeled as evolving over
time as its constituent agents repeatedly interact with each other. In these respects, ACE has been
characterized as a bottom-up culture-dish approach to the study of the economy.[101] In contrast to other
standard modeling methods, ACE events are driven solely by initial conditions, whether or not equilibria
exist or are computationally tractable. ACE modeling, however, includes agent adaptation, autonomy, and
learning.[102] It has a similarity to, and overlap with, game theory as an agent-based method for modeling
social interactions.[96] Other dimensions of the approach include such standard economic subjects as
competition and collaboration,[103] market structure and industrial organization,[104] transaction costs,[105]
welfare economics[106] and mechanism design,[95] information and uncertainty,[107] and
macroeconomics.[108][109]

The method is said to benefit from continuing improvements in modeling techniques of computer science
and increased computer capabilities. Issues include those common to experimental economics in
general[110] and by comparison[111] and to development of a common framework for empirical validation
and resolving open questions in agent-based modeling.[112] The ultimate scientific objective of the method
has been described as "test[ing] theoretical findings against real-world data in ways that permit empirically
supported theories to cumulate over time, with each researcher's work building appropriately on the work
that has gone before".[113]

Mathematicization of economics
Over the course of the 20th century, articles in "core
journals"[115] in economics have been almost exclusively
written by economists in academia. As a result, much of
the material transmitted in those journals relates to
economic theory, and "economic theory itself has been
continuously more abstract and mathematical." [116] A
subjective assessment of mathematical techniques[117]
employed in these core journals showed a decrease in
articles that use neither geometric representations nor
mathematical notation from 95% in 1892 to 5.3% in
1990.[118] A 2007 survey of ten of the top economic
journals finds that only  5.8% of the articles published in
2003 and 2004 both lacked statistical analysis of data and
lacked displayed mathematical expressions that were The surface of the Volatility smile is a 3-D
indexed with numbers at the margin of the page.[119] surface whereby the current market implied
volatility (Z-axis) for all options on the
Econometrics underlier is plotted against strike price and
time to maturity (X & Y-axes).[114]
Between the world wars, advances in mathematical
statistics and a cadre of mathematically trained economists
led to econometrics, which was the name proposed for the discipline of advancing economics by using
mathematics and statistics. Within economics, "econometrics" has often been used for statistical methods in
economics, rather than mathematical economics. Statistical econometrics features the application of linear
regression and time series analysis to economic data.

Ragnar Frisch coined the word "econometrics" and helped to found both the Econometric Society in 1930
and the journal Econometrica in 1933.[120][121] A student of Frisch's, Trygve Haavelmo published The
Probability Approach in Econometrics in 1944, where he asserted that precise statistical analysis could be
used as a tool to validate mathematical theories about economic actors with data from complex sources.[122]
This linking of statistical analysis of systems to economic theory was also promulgated by the Cowles
Commission (now the Cowles Foundation) throughout the 1930s and 1940s.[123]

The roots of modern econometrics can be traced to the American economist Henry L. Moore. Moore
studied agricultural productivity and attempted to fit changing values of productivity for plots of corn and
other crops to a curve using different values of elasticity. Moore made several errors in his work, some from
his choice of models and some from limitations in his use of mathematics. The accuracy of Moore's models
also was limited by the poor data for national accounts in the United States at the time. While his first
models of production were static, in 1925 he published a dynamic "moving equilibrium" model designed to
explain business cycles—this periodic variation from over-correction in supply and demand curves is now
known as the cobweb model. A more formal derivation of this model was made later by Nicholas Kaldor,
who is largely credited for its exposition.[124]

Application
Much of classical economics can be presented in simple geometric terms or elementary mathematical
notation. Mathematical economics, however, conventionally makes use of calculus and matrix algebra in
economic analysis in order to make powerful claims that would be more difficult without such
mathematical tools. These tools are prerequisites for formal study, not only in mathematical economics but
in contemporary economic theory in general. Economic problems often involve so many variables that
mathematics is the only practical way of attacking and
solving them. Alfred Marshall argued that every
economic problem which can be quantified,
analytically expressed and solved, should be treated by
means of mathematical work.[126]

Economics has become increasingly dependent upon

mathematical methods and the mathematical tools it
employs have become more sophisticated. As a result,
mathematics has become considerably more important
to professionals in economics and finance. Graduate
programs in both economics and finance require strong
undergraduate preparation in mathematics for
admission and, for this reason, attract an increasingly
high number of mathematicians. Applied
mathematicians apply mathematical principles to
practical problems, such as economic analysis and The IS/LM model is a Keynesian macroeconomic
other economics-related issues, and many economic model designed to make predictions about the
problems are often defined as integrated into the scope intersection of "real" economic activity (e.g.
of applied mathematics.[18] spending, income, savings rates) and decisions
made in the financial markets (Money supply and
This integration results from the formulation of Liquidity preference). The model is no longer
economic problems as stylized models with clear widely taught at the graduate level but is common
assumptions and falsifiable predictions. This modeling in undergraduate macroeconomics courses.[125]
may be informal or prosaic, as it was in Adam Smith's
The Wealth of Nations, or it may be formal, rigorous
and mathematical.

Broadly speaking, formal economic models may be classified as stochastic or deterministic and as discrete
or continuous. At a practical level, quantitative modeling is applied to many areas of economics and several
methodologies have evolved more or less independently of each other.[127]

Stochastic models are formulated using stochastic processes. They model economically
observable values over time. Most of econometrics is based on statistics to formulate and
test hypotheses about these processes or estimate parameters for them. Between the World
Wars, Herman Wold developed a representation of stationary stochastic processes in terms
of autoregressive models and a determinist trend. Wold and Jan Tinbergen applied time-
series analysis to economic data. Contemporary research on time series statistics consider
additional formulations of stationary processes, such as autoregressive moving average
models. More general models include autoregressive conditional heteroskedasticity (ARCH)
models and generalized ARCH (GARCH) models.
Non-stochastic mathematical models may be purely qualitative (for example, models
involved in some aspect of social choice theory) or quantitative (involving rationalization of
financial variables, for example with hyperbolic coordinates, and/or specific forms of
functional relationships between variables). In some cases economic predictions of a model
merely assert the direction of movement of economic variables, and so the functional
relationships are used only in a qualitative sense: for example, if the price of an item
increases, then the demand for that item will decrease. For such models, economists often
use two-dimensional graphs instead of functions.
 Qualitative models are occasionally used. One example is qualitative scenario planning in
which possible future events are played out. Another example is non-numerical decision tree
analysis. Qualitative models often suffer from lack of precision.

Example: The effect of a corporate tax cut on wages

The great appeal of mathematical economics is that it brings a degree of rigor to economic thinking,
particularly around charged political topics. For example, during the discussion of the efficacy of a
corporate tax cut for increasing the wages of workers, a simple mathematical model proved beneficial to
understanding the issues at hand.

As an intellectual exercise, the following problem was posed by Prof. Greg Mankiw of Harvard
University:[128]

An open economy has the production function , where is output per worker and
is capital per worker. The capital stock adjusts so that the after-tax marginal product of
capital equals the exogenously given world interest rate ...How much will the tax cut
increase wages?

To answer this question, we follow John H. Cochrane of the Hoover Institution.[129] Suppose an open
economy has the production function:

Where the variables in this equation are:

is the total output

is the production function
is the total capital stock
is the total labor stock

The standard choice for the production function is the Cobb-Douglas production function:

where is the factor of productivity - assumed to be a constant. A corporate tax cut in this model is
equivalent to a tax on capital. With taxes, firms look to maximize:

where is the capital tax rate, is wages per worker, and is the exogenous interest rate. Then the first-
order optimality conditions become:

Therefore, the optimality conditions imply that:

Define total taxes . This implies that taxes per worker are:

Then the change in taxes per worker, given the tax rate, is:

To find the change in wages, we differentiate the second optimality condition for the per worker wages to
obtain:

Assuming that the interest rate is fixed at , so that , we may differentiate the first optimality
condition for the interest rate to find:

For the moment, let's focus only on the static effect of a capital tax cut, so that . If we
substitute this equation into equation for wage changes with respect to the tax rate, then we find that:

Therefore, the static effect of a capital tax cut on wages is:

Based on the model, it seems possible that we may achieve a rise in the wage of a worker greater than the
amount of the tax cut. But that only considers the static effect, and we know that the dynamic effect must
be accounted for. In the dynamic model, we may rewrite the equation for changes in taxes per worker with
respect to the tax rate as:

Recalling that , we have that:

Using the Cobb-Douglas production function, we have that:

Therefore, the dynamic effect of a capital tax cut on wages is:

If we take , then the dynamic effect of lowering capital taxes on wages will be even larger
than the static effect. Moreover, if there are positive externalities to capital accumulation, the effect of the
tax cut on wages would be larger than in the model we just derived. It is important to note that the result is a
combination of:

1. The standard result that in a small open economy labor bears 100% of a small capital
income tax
2. The fact that, starting at a positive tax rate, the burden of a tax increase exceeds revenue
collection due to the first-order deadweight loss

This result showing that, under certain assumptions, a corporate tax cut can boost the wages of workers by
more than the lost revenue does not imply that the magnitude is correct. Rather, it suggests a basis for policy
analysis that is not grounded in handwaving. If the assumptions are reasonable, then the model is an
acceptable approximation of reality; if they are not, then better models should be developed.

CES production function

Now let's assume that instead of the Cobb-Douglas production function we have a more general constant
elasticity of substitution (CES) production function:

where ; is the elasticity of substitution between capital and labor. The relevant quantity we
want to calculate is , which may be derived as:

Therefore, we may use this to find that:

Therefore, under a general CES model, the dynamic effect of a capital tax cut on wages is:

We recover the Cobb-Douglas solution when . When , which is the case when perfect
substitutes exist, we find that - there is no effect of changes in capital taxes on wages. And
when , which is the case when perfect complements exist, we find that - a cut in
capital taxes increases wages by exactly one dollar.

Criticisms and defences

Adequacy of mathematics for qualitative and complicated economics

The Austrian school — while making many of the same normative economic arguments as mainstream
economists from marginalist traditions, such as the Chicago school — differs methodologically from
mainstream neoclassical schools of economics, in particular in their sharp critiques of the mathematization
of economics.[130] Friedrich Hayek contended that the use of formal techniques projects a scientific
exactness that does not appropriately account for informational limitations faced by real economic agents.
[131]

In an interview in 1999, the economic historian Robert Heilbroner stated:[132]

I guess the scientific approach began to penetrate and soon dominate the profession in the past
twenty to thirty years. This came about in part because of the "invention" of mathematical
analysis of various kinds and, indeed, considerable improvements in it. This is the age in
which we have not only more data but more sophisticated use of data. So there is a strong
feeling that this is a data-laden science and a data-laden undertaking, which, by virtue of the
sheer numerics, the sheer equations, and the sheer look of a journal page, bears a certain
resemblance to science . . . That one central activity looks scientific. I understand that. I think
that is genuine. It approaches being a universal law. But resembling a science is different from
being a science.

Heilbroner stated that "some/much of economics is not naturally quantitative and therefore does not lend
itself to mathematical exposition."[133]

Testing predictions of mathematical economics

Philosopher Karl Popper discussed the scientific standing of economics in the 1940s and 1950s. He argued
that mathematical economics suffered from being tautological. In other words, insofar as economics became
a mathematical theory, mathematical economics ceased to rely on empirical refutation but rather relied on
mathematical proofs and disproof.[134] According to Popper, falsifiable assumptions can be tested by
experiment and observation while unfalsifiable assumptions can be explored mathematically for their
consequences and for their consistency with other assumptions.[135]

Sharing Popper's concerns about assumptions in economics generally, and not just mathematical
economics, Milton Friedman declared that "all assumptions are unrealistic". Friedman proposed judging
economic models by their predictive performance rather than by the match between their assumptions and
reality.[136]

Mathematical economics as a form of pure mathematics

Considering mathematical economics, J.M. Keynes wrote in The General Theory:[137]

 It is a great fault of symbolic pseudo-mathematical methods of formalising a system of
economic analysis ... that they expressly assume strict independence between the factors
involved and lose their cogency and authority if this hypothesis is disallowed; whereas, in
ordinary discourse, where we are not blindly manipulating and know all the time what we are
doing and what the words mean, we can keep ‘at the back of our heads’ the necessary reserves
and qualifications and the adjustments which we shall have to make later on, in a way in
which we cannot keep complicated partial differentials ‘at the back’ of several pages of algebra
which assume they all vanish. Too large a proportion of recent ‘mathematical’ economics are
merely concoctions, as imprecise as the initial assumptions they rest on, which allow the author
to lose sight of the complexities and interdependencies of the real world in a maze of
pretentious and unhelpful symbols.

Defense of mathematical economics

In response to these criticisms, Paul Samuelson argued that mathematics is a language, repeating a thesis of
Josiah Willard Gibbs. In economics, the language of mathematics is sometimes necessary for representing
substantive problems. Moreover, mathematical economics has led to conceptual advances in
economics.[138] In particular, Samuelson gave the example of microeconomics, writing that "few people
are ingenious enough to grasp [its] more complex parts... without resorting to the language of mathematics,
while most ordinary individuals can do so fairly easily with the aid of mathematics."[139]

Some economists state that mathematical economics deserves support just like other forms of mathematics,
particularly its neighbors in mathematical optimization and mathematical statistics and increasingly in
theoretical computer science. Mathematical economics and other mathematical sciences have a history in
which theoretical advances have regularly contributed to the reform of the more applied branches of
economics. In particular, following the program of John von Neumann, game theory now provides the
foundations for describing much of applied economics, from statistical decision theory (as "games against
nature") and econometrics to general equilibrium theory and industrial organization. In the last decade, with
the rise of the internet, mathematical economists and optimization experts and computer scientists have
worked on problems of pricing for on-line services --- their contributions using mathematics from
cooperative game theory, nondifferentiable optimization, and combinatorial games.

Robert M. Solow concluded that mathematical economics was the core "infrastructure" of contemporary
economics:

Economics is no longer a fit conversation piece for ladies and gentlemen. It has become a
technical subject. Like any technical subject it attracts some people who are more interested in
the technique than the subject. That is too bad, but it may be inevitable. In any case, do not kid
yourself: the technical core of economics is indispensable infrastructure for the political
economy. That is why, if you consult [a reference in contemporary economics] looking for
enlightenment about the world today, you will be led to technical economics, or history, or
nothing at all.[140]

Mathematical economists
Prominent mathematical economists include the following.

19th century
Enrico Barone Irving Fisher Vilfredo Pareto
Antoine Augustin Cournot William Stanley Jevons Léon Walras
Francis Ysidro Edgeworth

20th century
Charalambos D. Roger Nimrod Megiddo Reinhard Selten
Aliprantis Guesnerie Jean-François Amartya Sen
R. G. D. Allen Frank Hahn Mertens Lloyd S. Shapley
Maurice Allais John C. James Mirrlees Stephen Smale
Kenneth J. Arrow Harsanyi Roger Myerson Robert Solow
Robert J. Aumann John R. Hicks John Forbes Hugo F.
Yves Balasko Werner Nash, Jr. Sonnenschein
Hildenbrand John von
David Blackwell Nancy L. Stokey
Harold Hotelling Neumann
Lawrence E. Blume Albert W. Tucker
Leonid Hurwicz Edward C.
Graciela Chichilnisky Hirofumi Uzawa
Leonid Prescott
George B. Dantzig Robert B. Wilson
Kantorovich Roy Radner
Gérard Debreu Abraham Wald
Tjalling Frank Ramsey
Mario Draghi Koopmans Hermann Wold
Donald John
Jacques H. Drèze David M. Kreps Roberts Nicholas C. Yannelis
David Gale Harold W. Kuhn Paul Samuelson
Nicholas Georgescu- Edmond Yuliy Sannikov
Roegen Malinvaud Thomas Sargent
Andreu Mas- Leonard J.
Colell Savage
Eric Maskin Herbert Scarf

21st century
Ejaz Gul

See also
Business and
economics portal
Mathematics
portal

Econophysics
 Mathematical finance

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Further reading
Alpha C. Chiang and Kevin Wainwright, [1967] 2005. Fundamental Methods of
Mathematical Economics, McGraw-Hill Irwin. Contents. (http://www.mhprofessional.com/pro
duct.php?isbn=0070109109)
E. Roy Weintraub, 1982. Mathematics for Economists, Cambridge. Contents (https://archive.
org/details/mathematicsforec0000wein).
 Stephen Glaister, 1984. Mathematical Methods for Economists, 3rd ed., Blackwell. Contents.
(https://books.google.com/books?id=Ct2nrJSHxsQC&pg=PR5=onepage)
Akira Takayama, 1985. Mathematical Economics, 2nd ed. Cambridge. Contents (https://book
s.google.com/books?id=685iPEaLAEcC&pg=PR9=onepage).
Nancy L. Stokey and Robert E. Lucas with Edward Prescott, 1989. Recursive Methods in
Economic Dynamics, Harvard University Press. Desecription (http://www.hup.harvard.edu/c
atalog.php?isbn=9780674750968) and chapter-preview links (https://books.google.com/boo
ks?id=tWYo0QolyLAC&q=f%3Dfalse&pg=PR11).
A. K. Dixit, [1976] 1990. Optimization in Economic Theory, 2nd ed., Oxford. Description (http
s://books.google.com/books?id=dHrsHz0VocUC&pg=PA194=false) and contents preview (h
ttps://books.google.com/books?id=dHrsHz0VocUC&dq=false&pg=PR7).
Kenneth L. Judd, 1998. Numerical Methods in Economics, MIT Press. Description (https://we
b.archive.org/web/20020923144108/http://mitpress.mit.edu/catalog/item/default.asp?ttype=2
&tid=3257) and chapter-preview links (https://books.google.com/books?id=9Wxk_z9HskAC
&pg=PR7).
Michael Carter, 2001. Foundations of Mathematical Economics, MIT Press. Contents (https://
books.google.com/books?id=KysvrGGfzq0C&pg=PR7=onepage).
Ferenc Szidarovszky and Sándor Molnár, 2002. Introduction to Matrix Theory: With
Applications to Business and Economics, World Scientific Publishing. Description (http://ww
w.worldscientific.com/worldscibooks/10.1142/4595) and preview (http://www.worldscientific.
com/doi/suppl/10.1142/4595/suppl_file/4595_chap01.pdf).
D. Wade Hands, 2004. Introductory Mathematical Economics, 2nd ed. Oxford. Contents (htt
p://www.oup.com/us/catalog/he/subject/Economics/OtherCourses/MathematicalEconomic
s/?view=usa&sf=toc&ci=9780195133783).
Giancarlo Gandolfo, [1997] 2009. Economic Dynamics, 4th ed., Springer. Description (http
s://www.springer.com/economics/economic+theory/book/978-3-642-03862-4) and preview (h
ttps://books.google.com/books?id=ZMwXi67nhHQC&pg=PR9).
John Stachurski, 2009. Economic Dynamics: Theory and Computation, MIT Press.
Description (https://web.archive.org/web/20120916032346/http://johnstachurski.net/book/bo
ok.html) and preview (https://books.google.com/books?id=IzW5rSzlluIC&pg=PR7).

External links
Journal of Mathematical Economics Aims & Scope (http://www.elsevier.com/wps/find/journal
description.cws_home/505577/description#description)
Mathematical Economics and Financial Mathematics (https://curlie.org/Science/Math/Applic
ations/Mathematical_Economics_and_Financial_Mathematics/) at Curlie
Erasmus Mundus Master QEM - Models and Methods of Quantitative Economics (http://eras
musmundus-qem.univ-paris1.fr/), The Models and Methods of Quantitative Economics -
QEM

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