Mathematical Economics

dr Wioletta Nowak

Lecture 1
 Syllabus

Mathematical Theory of Demand

Utility Maximization Problem
Expenditure Minimization Problem
Mathematical Theory of Production
Profit Maximization Problem
Cost Minimization Problem
General Equilibrium Theory
Neoclassical Growth Models
Models of Endogenous Growth Theory
Dynamic Optimization
 Syllabus

Mathematical Theory of Demand

• Budget Constraint
• Consumer Preferences
• Utility Function
• Utility Maximization Problem
• Optimal Choice
• Properties of Demand Function
• Indirect Utility Function and its Properties
• Roy’s Identity
 Syllabus

Mathematical Theory of Demand

• Expenditure Minimization Problem

• Expenditure Function and its Properties
• Shephard's Lemma
• Properties of Hicksian Demand Function
• The Compensated Law of Demand
• Relationship between Utility Maximization and
Expenditure Minimization Problem
 Syllabus

Mathematical Theory of Production

• Production Functions and Their Properties

• Perfectly Competitive Firms
• Profit Function and Profit Maximization
Problem
• Properties of Input Demand and Output
Supply
 Syllabus

Mathematical Theory of Production

• Cost Minimization Problem

• Definition and Properties of Conditional Factor
Demand and Cost Function
• Profit Maximization with Cost Function
• Long and Short Run Equilibrium
• Total Costs, Average Costs, Marginal Costs,
Long-run Costs, Short-run Costs, Cost Curves,
Long-run and Short-run Cost Curves
 Syllabus

Mathematical Theory of Production

Monopoly
Oligopoly
• Cournot Equilibrium
• Quantity Leadership – Slackelberg Model
 Syllabus

General Equilibrium Theory

• Exchange
• Market Equilibrium
 Syllabus

Neoclassical Growth Model

• The Solow Growth Model
• Introduction to Dynamic Optimization
• The Ramsey-Cass-Koopmans Growth Model

Models of Endogenous Growth Theory

Convergence to the Balance Growth Path

 Recommended Reading

• Chiang A.C., Wainwright K., Fundamental Methods of

Mathematical Economics, McGraw-Hill/Irwin, Boston,
Mass., (4th edition) 2005.

• Chiang A.C., Elements of Dynamic Optimization, Waveland

Press, 1992.

• Romer D., Advanced Macroeconomics, McGraw-Hill, 1996.

• Varian H.R., Intermediate Microeconomics, A Modern

Approach, W.W. Norton & Company, New York, London,
1996.
 The Theory of Consumer Choice

• The Budget Constraint

• The Budget Line Changes (Increasing Income,
Increasing Price)

• Consumer Preferences
• Assumptions about Preferences

• Indifference Curves: Normal Good, Perfect

Substitutes, Perfect Complements, Bads, Neutrals
• The Marginal Rate of Substitution
 Consumers choose the best bundle of
goods they can afford
• How to describe what a consumer can afford?

• What does mean the best bundle?

• The consumer theory uses the concepts of a

budget constraint and a preference map to
analyse consumer choices.
 The budget constraint – the two-good case

• It represents the combination of goods that

consumer can purchase given current prices
and income.
• x1 , x 2 , x i  0, i  1, 2 - consumer’s
consumption bundle (the objects of consumer
choice)
• p1 , p 2 , p i  0, i  1, 2 - market prices
of the two goods
 The budget constraint – the two-good case

• The budget constraint of the consumer (the amount of

money spent on the two goods is no more than the total
amount the consumer has to spend)

p1x1  p 2 x 2  I

• I  0 - consumer’s income (the amount of money the

consumer has to spend)
• p1x1 - the amount of money the consumer is
spending on good 1
• p 2 x 2 - the amount of money the consumer is
spending on good 2
 Graphical representation of the budget set and the budget line

• The set of affordable consumption bundles at

given prices and income is called the budget set
of the consumer.
The Budget Line
 The Budget Line Changes

• Increasing (decreasing) income – an increase (decrease) in

income causes a parallel shift outward (inward) of the budget
line (a lump-sum tax; a value tax)
 The Budget Line Changes

• Increasing price – if good 1

becomes more expensive,
the budget line becomes
steeper.
• Increasing the price of good
1 makes the budget line
steeper; increasing the price
of good 2 makes the budget
line flatter.
• A quantity tax
A value tax (ad valorem tax)
A quantity subsidy
Ad valorem subsidy
Exercise 1
Consumer Preferences
 Consumer Preferences

Ps  ( x, y)  X  X x  y relation of strict preference

I  ( x, y)  X  X x ~ y relation of indifference

 
P  ( x, y)  X  X x  y  relation of weak preference
~
Assumptions about Preferences
Assumptions about Preferences
Assumptions about Preferences
Assumptions about Preferences
The relations of strict preference, weak preference and
indifference are not independent concepts!
Exercise 2
Exercise 3
 Indifference Curves

• The set of all consumption bundles that are

indifferent to each other is called an
indifference curve.

• Points yielding different utility levels are each

associated with distinct indifference curves.
Indifference curves are
Indifference curve for normal goods
 Perfect substitutes

• Two goods are perfect

substitutes if the consumer
is willing to substitute one
good for the other at a
constant rate.
• The simplest case of perfect
substitutes occurs when the
consumer is willing to
substitute the goods on a
one-to-one basis.
• The indifference curves has
a constant slope since the
consumer is willing to trade
at a fixed ratio.
 Perfect complements

• Perfect complements are

goods that are always
consumed together in
fixed proportions.

• L-shaped indifference
curves.
Bads: a bad is a commodity that consumer doesn’t like
Neutrals: a good is a neutral good if the consumer
doesn’t care about it one way or the other
 The Marginal Rate of Substitution (MRS)

• The marginal rate of substitution measures the slope of the

indifference curve.
The Marginal Rate of Substitution (MRS)
 The Marginal Rate of Substitution (MRS)

• The MRS is different at each point along the

indifference curve for normal goods.

• The marginal rate of substitution between

perfect substitutes is constant.
Mathematical Economics
dr Wioletta Nowak

Lecture 2
• The Utility Function,
• Examples of Utility Functions: Normal Good,
Perfect Substitutes, Perfect Complements,
• The Quasilinear and Homothetic Utility
Functions,
• The Marginal Utility and The Marginal Rate of
Substitution,
• The Optimal Choice,
• The Utility Maximization Problem,
• The Lagrange Method
 The Utility Function

• A utility is a measure of the relative

satisfaction from consumption of various
goods.

• A utility function is a way of assigning a

number to every possible consumption bundle
such that more-preferred bundles get assigned
larger numbers then less-preferred bundles.
 The Utility Function

• The numerical magnitudes of utility levels have no intrinsic

meaning – the only property of a utility assignment that is important
is how it orders the bundles of goods.

• The magnitude of the utility function is only important insofar as it

ranks the different consumption bundles.

• Ordinal utility - consumer assigns a higher utility to the chosen

bundle than to the rejected. Ordinal utility captures only ranking
and not strength of preferences.

• Cardinal utility theories attach a significance to the magnitude of

utility. The size of the utility difference between two bundles of
goods is supposed to have some sort of significance.
 Existence of a Utility Function

• Suppose preferences are complete, reflexive,

transitive, continuous, and strongly monotonic.
• Then there exists a continuous utility function

u:   2


which represents those preferences.

 The Utility Function

• A utility function is a function u assigning a

real number to each consumption bundle so
that for a pair of bundles x and y:
Examples of Utility Functions
Exercise 1
 The Quasilinear Utility Function

• The quasilinear (partly linear) utility function

is linear in one argument.
• For example the utility function linear in good
2 is the following:

u  x1 , x2   v x1   x2
 The Quasilinear Utility Function

• Specific examples of quasilinear utility would

be:

u  x1 , x2   x1  x2
or
u  x1 , x2   ln x1  x2
The Homothetic Utility Function
The Homothetic Utility Function
 The Homothetic Utility Function

• Slopes of indifference curves are constant

along a ray through the origin.

• Assuming that preferences can be represented

by a homothetic function is equivalent to
assuming that they can be represented by a
function that is homogenous of degree 1
because a utility function is unique up to a
positive monotonic transformation.
Exercise 2
The Marginal Utility
 The Marginal Rate of Substitution

• Suppose that we increase the amount of good i;

how does the consumer have to change their
consumption of good j in order to keep utility
constant?
The Marginal Rate of Substitution
 The Optimal Choice

• Consumers choose the most preferred bundle from their budget sets.
• The optimal choice of consumer is that bundle in the consumer’s budget
set that lies on the highest indifference curve.
The Optimal Choice
The Optimal Choice
 The Optimal Choice

• Utility functions

• Budget line
The Optimal Choice
 The Utility Maximization

• The problem of utility maximization can be written as:

• Consumers seek to maximize utility subject to their budget

constraint.

• The consumption levels which solve the utility maximization

problem are the Marshallian demand functions.
 The Lagrange Method

• The method starts by defining an auxiliary

function known as the Lagrangean:

• The new variable l is called a Lagrange

multiplier since it is multiplied by constraint.
The Lagrange Method
Mathematical Economics
dr Wioletta Nowak

Lecture 3-4
• Properties of the Demand Function: the Marginal
Demand, the Price, Income and Cross Price Elasticity of
Demand,

• Classification of Goods: Normal Goods, Inferior Goods,

Ordinary Goods, Giffen Goods, Perfect Substitutes,
Perfect Complements,
• The Total Change in Demand: The Substitution Effect
and the Income Effect,
• Comparative Statics: Income Offer Curve, Price Offer
Curves and Engel Curves
• The Indirect Utility Function: Definition and Properties,
• The Roy's Identity,
 The Demand Function

• The value of ~
x that solves the utility
maximization problem
max u  x1 , x2 
x1 , x2

such that
p1 x1  p2 x2  I
is the consumer’s demanded bundle.
• It expresses how much of each good the consumer
desires at a given level of prices and income.
 The Demand Function

• The function that relates p and I to the

demanded bundle is called consumer’s demand
function:  : 3   2  

:  p, I     p, I   ~
x

  1  p1 , p2 , I ,  2  p1 , p2 , I 
 Elasticities of Demand

• Elasticity is the ratio of the per cent change in

one variable to the per cent change in other
variable (is a measure of sensitivity of one
variable to another).

Price elasticity of demand

Cross price elasticity of demand
Income elasticity of demand
 Elasticities of Demand

• Price elasticity of demand is defined as the measure of

responsiveness in the quantity demanded for a good as a result of
change in price of the same good. It is a measure of how consumers
react to a change in price of a given good (a measure of the
sensitivity of quantity demanded to changes in price).

• Cross price elasticity of demand measures the responsiveness of

the quantity demanded of a good to a change in the price of another
good.

• Income elasticity of demand measures the responsiveness of the

quantity demanded of a good to the change in the income of the
consumer.
The Classification of Goods – An Ordinary Versus a
Giffen Good
The Classification of Goods – An Ordinary Versus a
Giffen Good
The Classification of Goods – Perfect Substitutes
Versus Perfect Complements
 The Classification of Goods – A normal Versus an
Inferior Good

• Normal goods: if a good is normal, then the demand for

it increases when income increases, and decreases when
income decreases. The quantity demanded always
changes in the same way as income changes.

• If income elasticity of demand of a commodity is less

than 1, it is a necessity good. If the elasticity of demand
is greater than 1, it is a luxury or a superior good.
 The Classification of Goods – A normal Versus an
Inferior Good

• Interior goods: An inferior good is one for which the

demand decreases when income increases.
The Classification of Goods – A normal Versus an
Inferior Good
 The Total Change in Demand: The Substitution
Effect and the Income Effect
• When the price of good decreases, there will be two
effects on consumption.
• The change in relative prices makes consumer want to
consume more of the cheaper good. The increase in
purchasing power due to the lower price may increase
or decrease consumption, depending on whether the
good is a normal good or an inferior good.

• The change in demand due to the change in relative

prices is called the substitution effect; the change due
to the change in purchasing power is called the income
effect.
The Total Change in Demand: The Substitution
Effect and the Income Effect
 The Income Offer Curve (Income Expansion Path)
and the Price Offer Curve
• The income offer curve depicts how consumption changes with income.
• The price offer curve represents the bundles that would be demanded at
different prices for a given good.
 The Engle Curve

• The Engle curve is a graph of the demand for a one of the

goods as the function of income, with all prices being held
constant.
The Indirect Utility Function
Example
Properties of the Indirect Utility Function
Roy’s Identity
Mathematical Economics
dr Wioletta Nowak

Lecture 5-6
• The Expenditure Minimization Problem,
• Properties of the Hicksian Demand Function,
• The Expenditure Function and its Properties,
• The Shephard's Lemma,
• Relationship between the Utility Maximization
and the Expenditure Minimization Problem,
• The Slutsky Equation
 The Expenditure Minimization Problem

• Instead of maximizing utility given a budget

constraint we can consider the dual problem of
minimizing the expenditure necessary to
obtain a given utility level:
 The Hicksian demand function

• The solution to this problem is the optimal

consumption bundle as function of p and u i.e.
f ( p, u )

• It is the expenditure-minimizing bundle

necessary to achieve utility level u at prices p.
 The Hicksian demand function

• The Hicksian demand function is sometimes

called compensated demand function.
• This terminology comes from viewing the
demand function as being constructed by
varying prices and income so as to keep the
consumer at fixed level of utility.
• Thus, the income changes are arranged to
compensate for the price changes.
 The Hicksian demand function

• The Hicksian demand functions are not

directly observable since they depend on
utility, which is not directly observable.
• The Marshallian demand functions expressed
as function of prices and income are
observable.
Example 1
Properties of the Hicksian Demand Function
The Expenditure Function
Example 2
Properties of the expenditure function
Relationship between the Utility Maximization and the
Expenditure Minimization Problem
The Slutsky Equation
The Hicks Decomposition of a Demand Change