Addis Ababa University

College of business and economics

Department of economics

Calculus for Economists

Learning MaterialModule
Prepared by:
Kidane Alemu(Asst.Prof.,PhD Candidate)

Edited By:Tesfaye Etensa(Asst.Prof.,PhD Candidate)

ADDIS ABABA, ETHIOPIA

FEBRUARY, 2024
Table of Contents
CHAPTER ONE:PRELIMINARY CALCULUS ............................................................................. 1

INTRODUCTION .................................................................................................................................... 1
1.1. The concept and importance of mathematical economics .................................................................. 1
1.2. Review of Economic Model and Analysis ........................................................................................ 2
1.3. The Concept and Type of Functions .................................................................................................. 3
1.4 Some Economic Functions ................................................................................................................. 8
1.5. Limits and continuity ....................................................................................................................... 14
CHAPTER TWO: TECHNIQUES OF DIFFERENTIAL CALCULUS ........................................................ 21
2.1. Introduction to Differential Calculus .......................................................................................... 21
2.2. The Concept of the Derivative ......................................................................................................... 26
2.3 The Rules or Theorems of Derivates ................................................................................................ 28
2.3.1 The constant rule ........................................................................................................................ 28
2.3.2 The Simple Power rule ............................................................................................................... 28
2 .3.3. The coefficient rule ................................................................................................................. 29
2.3.4. The sum or difference rule .................................................................................................. 29
2.3.5. The product rule ........................................................................................................................ 30
2.3.6 The quotient rule ........................................................................................................................ 31
2.3.7 .Derivatives of implicit functions ............................................................................................... 32
2.3.8 Derivatives of logarithmic and exponential functions ............................................................... 34
2.4. Differentials and Higher Order Derivatives .................................................................................... 39
2.4.1 Differentials ............................................................................................................................... 39
2.4.2 Second and higher order derivatives .......................................................................................... 40
2.5. Partial derivatives and total derivatives ........................................................................................... 42
2.5.1 Partial derivatives....................................................................................................................... 43
2.5.2 Total derivatives (differentials) .................................................................................................. 44
2.6. Some Applications of Differential Calculus ............................................................................... 45
L Hôpital’s Rule .................................................................................................................................. 47
Chapter Three: Application of differential calculus................................................................................ 52
Aims and Objectives ............................................................................................................................... 52
Introduction ............................................................................................................................................ 52
3.1. Curvature Nature of the function ................................................................................................ 53
3.1.1. Increasing and decreasing Functions ....................................................................................... 53
3.1.2. Testing for concavity and convexity ....................................................................................... 54

3.2. Unconstrained/Free optimization of functions ..................................................................................... 60

3.2.1. Unconstrained/Free optimization of functions of one variable .................................................... 60

 3.2.1.1. The concept of optimum (extreme) value ............................................................................... 61
3.2.1.2. Relative Maximum and Minimum: First derivative test .................................................... 61

3.2.1.3. Relative Maximum and Minimum: Second derivative test............................................... 64

3.2.2. Unconstrained optimization of functions of several variables ................................... 66

3.2.2.1. Unconstrained Optimization of functions of two variables .................................... 66
3.2.2.2. Unconstrained Optimization of functions of morethan two variables .................... 72
3.3. Constrained Optimization .............................................................................................. 78
Chapter Four: Integral Calculus ...................................................................................................... 83
Introduction: .................................................................................................................................................... 83
Objective: ........................................................................................................................................................... 83
4.1. The Concept of Integration ........................................................................................................ 83
4.2. The basic Rules of Integration .................................................................................................. 84
4.3. Definite integrals ........................................................................................................................... 91
4.3.1. Some Properties of Indefinite Integral ............................................................................................ 91
4.3.2. Definite Integral and Area under a Curve ....................................................................................... 92
4.4. Improper Integrals ....................................................................................................................... 95
4.5. Economic Applications of Integrals........................................................................................ 97
4.5.1. Economic Application of indefinite Integral.................................................................................. 97
4.5.2. Economic Application of Definite Integral ................................................................................... 101
Chapter Summary ....................................................................................................................................... 105
Chapter Five: Linear Difference and Differential Equations ............................................ 107
Introduction: ................................................................................................................................................. 107
Objective: ........................................................................................................................................................ 107
5.1. Definitions and Concepts ............................................................................................................. 107
5.1.1. First-Order Linear Difference Equations ...................................................................................... 107
5.1.2. First- Order Linear Differential Equations ................................................................................... 109
5.2. Economic applications of Difference and Differential Equation .................................. 112
5.2.1. Uses of Difference Equation in Economics ................................................................................... 112
5.2.2. Uses of Differential Equations in Economics............................................................................... 115
Chapter Summary: ........................................................................................................................ 122
Biblography ............................................................................................................................ 123

ii
Course Description:
It covers the concepts of functions, relations, Limit, differentiability and continuity. Techniques
of differential calculus like derivatives, rules of derivatives, partial derivatives, differential and
total differentials, total derivative and implicit differentiation and application of differential
calculus .Unconstrained Optimization (one and several variables), constrained optimization
(equality constraint) and the Lagrange method .Integral calculus, indefinite integrals, improper
integrals, definite integrals. Economic applications of definite integral: Consumers and
produce’s surplus. First order difference and differential calculus

Course Objective:
The objective of this course is to introduce some of the important concepts and methods found in
calculus and to indicate how these concepts can be used in constructing mathematical models in
economics. The course specifically aims at acquainting students with the techniques of
differential and integral calculus with their application to economic analysis and differential
equations will be covered.
CHAPTER ONE: PRELIMINARYCALCULUS

INTRODUCTION

1.1. The concept and importance of mathematical economics

As you might have recognized from Lucas’s remark, mathematical economics is of paramount
importance for economic analyses. Indeed, it is essential to know what mathematical economics
is before saying about its role in solving problems in theoretical and applied economics.

Mathematical economics is not a distinct specialization of economics; rather, it is an approach to

economic reasoning. The ultimate objective of mathematical and literary economics is to come
up with somehow valid generalizations about cause effect relationship that prevails among
economic variables. The difference, hence, lies in the ways they undertake. In mathematical
economics, economists make use of mathematical symbols in the statement of the problem and
draw upon known mathematical theorems to aid in reasoning. In mathematical economics, the
assumptions and conclusions are stated in mathematical symbols than words and in equations
rather than in sentences.

In fact, it is amazing to see people in horror with mathematics for mathematics is making things
simpler and our life less costly. An economist without the tools of mathematics is like a blind
person swimming in the middle of an ocean. Till this person gives up, he will continue to
struggle till he reaches an island; but, his blindness has left him as incapable to identify whether
swimming to the north, south, east or west is the shortest distance to an island. But an economist
equipped with the tools of mathematics is like a normal person with motorboat or ship depending
upon his personal inclination to each. As a result, most economic researchers are extensively
using the tools of mathematics to economic reasoning.

In the following sections, you will briefly refresh your memory about economic models which
are the basic tools in drawing economic policies designed to solve economic problems of
nations.
1.2. Review of Economic Model and Analysis
As you have covered in the course introduction to economics, an economic theory is necessarily
generalization or abstraction from the real world. The complexity of the real economy does not
make it possible for us to understand all the interrelationships at once; nor, for that matter, are all
these interrelationships of equal importance for the understanding of the particular economic
phenomenon under study. The wise procedure is, hence, to pick out what appeal to our reason to
be the primary factors and relationships relevant to our problem and to focus our attention on
these alone. Such a deliberately simplified analytical framework is called an economic model
since it is only a skeletal and rough representation of the actual economy.

If our model is mathematical, it will usually consist of a set of equations designed to describe the
structure of the model. By relating a number of variables to one another in certain ways, these
equations give mathematical form to the set of analytical assumptions adopted. Then, through the
application of relevant mathematical operations to these equations, we may seek to derive a set
of conclusions which logically follow from these assumptions. Hence, the ingredients to any
mathematical model are variables, constants, parameters, equations, and identities.

The main aim behind building economic models is to describe how the economy works and to
obtain somehow valid predictions about economic variables. Different models are built for
different purposes. Some of the models are designed to investigate the equilibrium value of the
variable as an ultimate end while some to investigate the movement of a variable (s) over time.
Thus, in economics, we have three types of analyses:
i. Static (equilibrium) analysis
ii. Comparative static analysis
iii. Dynamic analysis

As the name implies, static/equilibrium analysis is the study about equilibrium. That is, it studies
the determination of equilibrium values. Equilibrium is a constellation of selected interrelated
variables so adjusted to one another that no inherent tendency to change in the model which they
constitute. The mathematics of statics will be handled in linear algebra for economists. On the
other hand, comparative static studies on the comparison of two or more equilibrium values. This

2
may involve rate of changes and growth rates. Almost all of the differential calculus is related
with the comparative static.

The third form of economic analyses is dynamic analysis. It involves the time path of different
relevant economic variables. The whole of integral calculus deals with the mathematics of
dynamic analyses.
In this course, you will be introduced with the mathematics of comparative static and dynamics,
and the mathematics for static is left for the next mathematical economics course.

1.3. The Concept and Type of Functions

For calculus is the study of functions, it is necessary to see what a function is. Function, as you
might remember it, is a unique mathematical rule that relates one or more variables to determine
another variable. It is a special type of relation in which an independent variable (domain) can
never be tied with more than one dependent variable (range). It is a relationship between
numbers in which to each element in the input (domain), there corresponds exactly one element
in the output (range).
Self-test 1: Formulate functions which you see around your area.
There are four methods of representing functions. These are:
i. Vein diagram
ii. Set of order pairs
iii. Equations (commonly used in economic researches)
iv. Graphs (commonly used in economic education)
1. Representing functions using vein diagram
A B
D R D R

1 1 1 1

2 2 2 2

3 3 3 3

4 4 4

3
The column which represents initial points of the rays is the column of domain and the column to
which the rays are directed is the column of range. In this example, Vein diagram A is a function
since we don’t have any two range values mapped from a single domain. But, B is not a function
since the independent variable [domain] value 2 is tied to output [range] values of 1 and 2
2. Representing functions using set of ordered pairs.
A= { (1,2),(2,3) ,(2,4),(3,6),(4,0)}
B= {(0,1),(1,2) ,(4,8),(7,10),(8,10)}
In this example, A is not a function since domain ‘2’ is mapped to more than one element in the
range but B is a function

3. Representing functions using equations

A. Y= is a function
Domain: X+ 1≥0; i.e. {X:X>-1}

Range: Y≥0

B. Y2 = X+1 is not a function since Y can be or -

Domain: X+ 1≥0; i.e. {X:X>-1}

Range: Y  R, Why not Y ≥ 0?
4. Representing functions using graphs

Y
Y
Y2 = 2X

X X

A. It is a function B. It is not a function

4
Remark: Vertical line test states that if a vertical line crosses the graph of a function more than
once, it is not a function. But, if it crosses only once, it is a function.
Types of functions
Generally there are two major types of functions; i.e.
i. Algebraic functions
ii. Non algebraic function

I. Algebraic functions
Before generalizing what an algebraic function is (are), let’s see each type of algebraic functions.
a. Polynomial functions: polynomial function of a single variable is given by the general form
o 1 2 3 n
p(x) = Y = aox + a1x + a2x + a3x + …… + anx
Where aR
n Whole numbers
If n = 0, Y will be a constant function like Y = 3
If n = 1, Y will be a linear function like Y = 2x+3
2
If n = 2, Y will be a quadratic function like Y = 2 + 4x + x
b. Rational functions: A rational function is a function which is the ratio of two polynomial
functions. That is, R(x) =

For instance, the famous rectangular hyperbola function is a rational function with constant
numerator and variable denominator. Example of such a function is Y =

c. The third type of algebraic function is a function which is the square root of polynomial
function.
NB. An algebraic function is a function which is either polynomial, rational, or the third type of
algebraic function. They can be with one variable or n-independent variables.

II. Non algebraic functions/Transcendental functions

There are four types of non-algebraic functions that are commonly used in economics; i.e.
i. Exponential function
ii. Logarithmic function

5
 iii. Trigonometric function and
iv. Incommensurable power functions

In this course you will be introduced with the first two non-algebraic functions and the rest are
left for further studies.

1. Exponential functions

An exponential function is a function defined by the form

f(x) = bn, b> 0 and b≠ 0

b=base, x=exponent

The domain of exponential function is the set of real numbers and the range of the function is
that set of positive real numbers.

Example:

F(x) = 2x or f(x) = x

We use exponential functions for calculating economic growth.

Note: Every exponential function passes through (0, 1)

Rules of Exponents
For a>0 and b>0, a≠0, and b ≠ 0,
0
1. a =1
x y x+y
2. a .a = a

3.

x y xy
4. (a ) = a

x x x
5. (ab) =a b

6. [ =

6
 -x
7. a =

2. The Logarithmic Functions

x
If we start with an exponential functions y=b and interchanging the two variables we get an
y
expression given by x=b i.e.

= y b>0,x>0,y∈IR. Thus, exponential and logarithmic functions are inverse functions.

Note: Every logarithmic function passes through (1, 0).

Common and Natural Logarithms

Common logarithms are logarithms whose base is 10. Example of such functions is

LogX= . On the other hand, natural Logarithms-are logarithms whose base is e.

lnX = , Where e=2.71828183……..

Example: = = = = = 1.25

Rules of Natural Logarithms: there are no new rules of natural logarithms. All the rule of
logarithm you learnt in previous classes is also valid for natural logarithms.

That is,
ln (ab) = lna + lnb

ln( ) = lna –lnb

Lnam =mlna

7
 Rule of Logarithms

For any constant n and e such that n, e >1, then

1. -
2. +
3. =n

4. =

5. = =

6. [ ]X [ ]=1

1.4 Some Economic Functions

Functions, in economics, have diverse and versatile importance. To come up with neater
theoretical results, it is good to model relationships in terms of mathematical functions. Though
functions are used almost in all specializations of economics extensively, in this course you will
be introduced with the most common microeconomic and macroeconomic functions. Detailed
acquaintance with these functions is left for your “life in economics”.
The most common microeconomic functions are demand functions, supply functions, production
function, cost functions, revenue functions, profit functions, pollution functions, and other
natural resource functions. The most common macroeconomic functions are consumption,
saving, investment, and aggregate production functions. There are also, a lot of other economic
functions, but we don’t discuss them here due to time limit we have. For the sake of introduction,
let’s take some examples of economic functions.

Examples:

1. The market research department of a company recommended to management of company ‘x’

that the company manufactures and market a promising new product. After extensive
surveys, the research department backed up the recommendation with the demand function:
Dx= f(p) = 6000 – 30Px ……(1)

8
Where Dxis quantity demanded at price Px during a month. Financial department has brought the
cost function and is given by
C(x) = 72,000 + 60x ……. (2)
Find:
a. Break even prices and outputs
b. Price and output that will maximize profit

From demand equation we can see that,

x = 6000 – 30Px
30Px = 6000 – x

Px= 200-

2
Revenue = Px X = (200- ) X = - X + 200x

But, Cost = 72,000 + 60x

Therefore profit (Π) = Total Revenue –Total Cost
2
Π = - X + 200x – (72,000 + 60x)
2
Π = - X +140x-72,000 is Profit function

A. To find break even ‘x’ equate Π = 0

2
- X +140x – 72,000 = 0
2
X - 42000x + 2,160,000 = 0⇒Multiplying by -30
2
X - 42000x + 4,410,000 = 4,410,000 - 2,160,000
2
(X – 2100) = 2250,000 ⇒completing the square
X – 2100 = ±1,500
X = 2100 ±1500
X = 3600 or 600 units
Thus, break-even outputs are 600 units and 3600 units

9
Graphically
2
Π= - X + 140x –72,000

Profit function
π

0 600 3600 π (x)

After we got break-even quantities, we can easily get break-even prices by inserting it in the
demand function. That is,
X = 6000 – 30Px
600 = 6000 – 30Px or 3600 = 6000 – 30Px
30Px = 5400 or 30Px = 2400
Px= 180 Px = 80
Break-even prices are 180 or 80; i.e., in a (Q, P) order pair, break even points are:
BE = {(3600, 80), (600, 180)}
b. To find price and output that will maximize profit, let’s remember the behavior of quadratic
functions since Π(x) is a quadratic function.

2
Y = ax + bx +c

=a(x2 + +c- Completing square method

= a(x + )2 +

Y will be maximum or minimum depending the value of(x+ )2since is constant, and the

sign of a. Vertex at the optimum point will be X = and Y = . From this we see that the

10
 2
value of a; i.e., the coefficient of X is < 0, and then the vertex is a maximum point. It is given
by:

X = = = 140X15 = 2,100

π = f(2100) =( )(-72,000- (140)2

Maximum π =

π = f(2100) =

π= = -10,000x – 15/2

π = 75,000
Price that maximizes profit will be
X = 6000 – 30Px

2100 = 600 – 30PxPx = 130

Exercises
Suppose in the previous example demand function has changed to X = 9000 – 30P and the cost
equation to C = 90,000 + 30x
a. Express cost as a function of price
b. Express revenue as a function of price
c. Find beak even prices and outputs
d. Find the price that will maximize profit
Application of Function in Economics
Function have many applications in economics such as demand, supply, consumption,
investment, saving, profit, cost, production etc.
A. Market Demand Function
The market demand function for good or services is a function of many factors.
It may be a function of:
 Price of the good/services (Px)

11
  The price of other goods(P0)
 The income of the consumer(I)
 The test and preference of the consume(T)
 Price and income expectation of the consumer(E)
 The number of buyers(N)

Therefore Dx = f(Px,P0,I,T,E,N)

Example: DX = 20- 4Px

From this we can identify (show) the Dxchange due to price change.

P 5

4
3
2

4 8 12 16 20 Qx

B. The consumption Function

Consumption is the function of disposable income.

Example:

C = f(Yd) Where C = consumption expenditure and

Yd = Disposable income.

Yd is also called take home pay because it is the income we get after all deductions are
subtracted. Yd = Y – Tax Where Y = total income

The functional relationship between consumption expenditure and income can be expressed as:

12
C = a + bYd

Where C = consumption expenditure a = Constant

Yd= Disposable income b = Consumption coefficient

C. The profit function

Profit is a function of output, i.e π = f(Q).

Where π = profit and Q = Output

Since total revenue is equal to revenue minus costs (π = TR- TC)

Where R= revenue and C =Cost

Π = R(Q)- C(Q)

Π = Revenue – Cost

Example let the demand function of the monopolists be :Px = 15-2X and Qx = X then the
revenue function will be R(Q) = PxQx

R =X(15-2X)

R = 15X – 2X2

Let total cost function be given by C = X2 – 2X then,

Π=R–C

= 15X – 2X2 - X2 – 2X

= 15X- X2 – 2X2 - X2

= 13X- 3X2

D. Cost function – cost is also the function of output.

C = f(Q) where C = Cost and Q = Quantity of output produced.

13
 Example: C = Q3 – 12Q2 – 45Q + 120

Cost

C = Q3 – 12Q2 – 45Q + 120

120

0Output

E. Production Function

Assume that the Quantity produced by a certain business firm is a function of only Labor
(L) and Capital (K) then

Q = f(L,K) where Q = Quantity of output produced

K = capital input

L = Labor input.

1.5. Limits and continuity

1.5.1. The concepts of Limits

When the value successively attributed to a variable approach indefinitely to a fixed value, in a
manner, so as to end by differing from it by a little as one wishes, this last is called the limit of
all the others.

The function F(x) = is undefined at x = -2. But to what value f(x) gets closer when x is
close but not equal to –2? Here we are introducing the concept of limit. By evaluating the
function at values of x at both side of and close to X=–2 but not at –2, we can see to what value
the function approaches. Let’s now inspect the function to the left and the right of X= -2.

14
 X -4 -3 -2.5 -2. 1 -2.0001
F(x) -7 -6 -5.5 -5.1 - 5.0001 From above

X 4 2 0 -1 - 1.5 -1.999
F(x) 1 -1 -3 -4 -4.5 -4.999 From below

It is apparent that as the value of x approaches –2 from both sides, the value of the function
approaches –5. In general, if f(x) approaches some finite number as x approaches e, then we can
say that:

Where: L is finite number

Lim - is limit of
x → x is closer and closer but not equal to e.
Consider the following sequence Xn = 1/n, n = 1,2,3,4…
As n become very large Xn approaches to zero (l= 0)
Therefore the limit of Xn = 0
N.B: Two basic facts regarding limits must be kept in mind.
i. The limit of a function as x approaches e- is independent of the value of the function at

e. Even though exists the value of the function

a. May be undefined
b. May be defined and different from the limit
ii. The limit is said to exist only if the following conditions are satisfied:
a. The limit L must be a finite number

15
b. The limit as x approaches a from the left written as must equal to the limit as x approaches e

from the right written as must equal to the limit as x approaches e from the right

written as

That is we must have =

Examples:

B. =0

C. Xn = = =

D. Xn = 2 + L

= ∞ ( has no limit)

If Xnis divergent, it does not have a limit.

E. If f(x) =

16
Exercises

Solve the following Problem.

1,

2,

3,

4,

5,

Properties of limits /the limit theorems

Limit of a constant number is a constant itself.

B. If a & b areconstant
Given f(x) and g(x) are the two functions, such that:

C.

D.
( ) 1
E. lim[ = ℎ
( ) 2 ≠0
→ 2

17
 F. lim √ ( ) = √
1
→

G. lim ( ) = 1 lim ( ) = 0 ℎ lim ( ). ( ) = 0

→ → →

Example:
( 2− −6) ( −3)( +2)
1. lim = lim = lim + 2 = 5
→3 −3 →3 −3 →3

2+2 lim 3 2+2

3. lim 3 = →2
=
14 = 14
→2 2−3 lim 2−3 1
→2

Applications
1. The ECC is embarking on an extensive advertising campaign to market its new detergent.
In the past, advertising has been very successful in increasing public awareness and sales
of ECC’s products. A senior advertising executive has estimated that, for the new
product, profit (Π) is related to advertising expenditure (x) according to the formula:

16 +10
Π(x) =
+3

Where x and Π are measured in units of $100,000. Find the maximum profit that the firm can
obtain using advertising.
Solution
10
16 +
lim ( ) = lim 3
= 16
→∞ →∞ 1+

Continuity
When a function g = g(h) poses a limit at V tends to the point N in the domain and when this
limits equal to g(N) that is equal to the value of function at V = N the function is said to be
continuous at N. A given function is said to be continuous over a given rage [at a point] if it is
defined for all real numbers within that range [at that point]. Graphically speaking, continuity
occurs if we can’t draw graph of a function without lifting our pen/pencil. Any function is said to
be continuous at a point such as X=C if the following conditions are satisfied. That is
a. f(x) is defined at x=c i.e. f(c)exists

18
 b. lim ( ) =
→

c. lim ( ) = ( )
→

The limit must be equal in value at g(N) i.e lim ( ) = ( )

→

Examples:

Q
Q

L L

N V N V

Example:
1. is the function f(x) = 2x + 4 continuous at x = 2?
Solution
f(2) = 8
lim( 2 + 4) = 8 ℎ , lim(2 + 4) = (2) = 8
→2 →2

Thus, f(x) is continuous at x=2.

Properties of continuities
Functions have continuity property similar to limit properties. For example, the sum, difference,
product, and quotient of two continuous functions are continuous, except for values along others
listed below will enable us to move from continuity at point to continuity over an interval. Let’s
see the properties of continuity.
1. If f(x) = K constant function, it is continuous always.
E.g. Y=2 is continuous for all values of x

19
2. If p(x) is a polynomial function, it is continuous for all values of X.
E.g. f(x) = X2 +2X+1
3. Rational functions are continuous for all values of X except those that make denominator 0.

Example: f(x) = ( =2& =3

+2)( −3)

4. If n is an odd integer greater than 1, then E.g. f(x) = 3√ 2 −4

5. If n is an even positive integer, then √ ( ) is continuous where f(x) whenever f(x) is

continuous and positive.

E.g. f(x) = √ − 2 continuous for x > 2 and discontinuous for x≤ 2

20
CHAPTER TWO: TECHNIQUES OF DIFFERENTIAL CALCULUS

2.1. Introduction to Differential Calculus

This chapter has two main parts where the first part deals with the basic techniques of differential
calculus; the second part deals with the applications of differential calculus. The first part
specifically deals with concepts such as the function and rate of change, derivative,
rules/theorems of derivative, differentials and higher order derivative, total and partial
derivatives, and finally about some applications of differential calculus such as L Hôpital’s rule,
which is used to deal with indeterminate limits, homogeneous functions and Euler’s theorem. On
the other hand, the second theorem discusses the economic applications of differential economics
to some extent.

In the first chapter we have dealt about the concepts and techniques of mathematical economics,
which is commonly, used in comparative statics analyses of economic variables. Based on the
above concepts the first part of this chapter mainly deals with the concept of instantaneous rate
of change-namely the derivative. In economics, we are interested in instantaneous rates of
changes of various economic variables. For instance, we deal with marginal utility, marginal
product, marginal revenue, value of marginal product, and other marginal values, which are the
instantaneous rate of change of their respective total functions.

Economic models provide a framework for understanding the responsiveness ofan endogenous
variable to a change in an exogenous variable. Models allow economists to pose questions such
as what is the effect of an increase in the money supply of $1 billion on national income. How
many fewer teenagers will begin smoking each year if an additional tax of $0.25 is imposed on
each pack of cigarettes? What tariff revenues will be received when a 10% duty is charged on all
imported cars? The answers to these types of questions involve a comparative static analysis,
which compares the response of endogenous variables to changes in exogenous variables.

Differential calculus shows how the value of a function varies with respect to changes in one or
more of its arguments. Differential calculus thus provides a method for analyzing economic
functions and understanding how changes in exogenous variables affect endogenous variables in

21
economic models. We begin with an example of the effect of a change in tax rates on tax
revenues to illustrate the kinds of questions differential calculus can address. A very general
method for looking at this question considers the value of the function for two different values of
its argument. This method provides an exact answer to the question of how much the value of a
function changes with a change in its argument, but it can be cumbersome to implement in many
cases. A more convenient method, which looks at the change in the value of a function for very
small changes in its argument, is presented. This method is at the heart of differential calculus.
As we discuss, very small changes in the argument of a function correspond to the important
economic notion of changes at the margin.

2.1.1. Functions and Rates of Change

Predictions of the effects of changing economic policies are often based upon
simpleextrapolation. For example, the prediction of the revenue effects of a change in the tax rate
on a certain economic activity may simply assume that the change in the tax ratedoes not affect
the level of that activity. Economic theory suggests, however, that people respond to changing
conditions. Thus tax revenues are affected both directly by a change in the tax rate and indirectly
through changes in the tax base. We can illustrate this point with the following simple example.
Consider the revenues collected from a sales tax on widgets. The amount of tax revenues, R,
equals the product of the tax rate, t, and the amount of widgets sold, Q.That is,
R =(t)(Q).

If the amount of widgets sold does not depend upon the sales tax rate, then tax revenues are a
simple linear function of the sales tax rate. This relationship is represented by the straight line
OL in the following Figure. We may expect, however, that an increase in the sales tax on widgets
lowers widget sales, thereby reducing the tax base on which revenues are raised. The tax revenue
schedule OC in following Figure captures this effect. Comparing OCwith OL shows that
revenues are lower when sales are affected by the tax rate than when sales are invariant to the tax
rate. This is shown below by the fact that DL is everywhere above DC.

22
The following figure also illustrates that the response of tax revenues to a change in the tax rate
depends upon whether sales are affected by the tax rate. The ratio of the change in tax revenues
to the change in the tax rate is represented by the quotient
Δ
Δ
Where the Greek letter, capital deltaΔ, represents the change in a variable, so, for example,
Δ represents the change in revenues. You may recognize from the discussion in Chapter 1 that
this quotient represents the slope of a secant line connecting the point on the revenue function
that corresponds to the initial tax rate and the point that corresponds to the subsequent tax rate.
When Q is independent of t (as in the case represented by DL in the following figure), the slope
Δ is constant since any segment of a straight line has the same slope as any other segment of that
Δ

line.

In contrast, the relationshipbetween the change in tax revenues and the change in tax rates when

sales areaffected by taxes is not constant. In this caseΔ is represented by the slope of asecant line
Δ

connecting two points on schedule OC. We see that the slopes of the secantlines EF, FG, and EG
are all different. The slope of any secant line connecting two points on the schedule
OCdependsupon two factors: the initial tax rate and the size of the change in tax rates. This is
evidentfrom the slopes of the secant lines in the figure. The secant line EF is steeper thanthe
Δ
secant line FG, reflecting the fact thatΔ , and thus , is larger when the tax rate rises from t1to
Δ

t2than when the tax rate rises by an equivalent amount from t2to t3. Also, the secant line EF has a
steeper slope than the secant line EG, demonstratingthatΔ is larger when the tax rate rises from
Δ

t1to t2than when the tax rate rises from t1to t3.

23
This example points out the shortcomings of determining the effect of a policychange with
simple extrapolation, whether assuming other factors will not change or assuming past
experience serves as a good guide for the future. In this example the effect on revenues of a
change in the tax rate from t2to t3along the schedule OC, is differentfrom the effect if Q does not
change (as in OL).Even taking into account the response of Q to t, the effect on revenues of a tax
increase from t1to t2differs from that of an equally large tax increase from t2to t3.

2.1.2. Differentiability and continuity

It the derivative of a function, say f x, exists at point ‘c’ then f x is said to be differentiable at
‘c’.
To say a function f x is differentiable at ‘c’ the following conditions should be fulfilled

1. f x Should be continuous at ‘c’

2. f x Should have a unique (only one) slope at ‘c’

The 1st condition requires the fulfillment of continuity conditions i.e.
1. �im f x & �im f x Should exist
xc xc

2. �im f  x   �im f  x   �im f  x 

xc xc xc

3. � im f x  f c
xc

24
 From this we can understand that continuity doesn’t necessarily mean differentiability.
Continuality rules out jumps and gaps at a point while differentiability condition requires
smoothness of the curve at the given point in addition to continuity conditions. In other words,
differentiability rules out jumps, gaps, sharps & cusp corners, while continuity rules out only the
first two.

Example show the function f x  x  2 is not differentiable at x = 2.

Steps 1 Testing continuity of the function

1. � im x  2  0

x2 

2. � im x  2  0

x2 

3. � im f x  f 2  0., so, f x is continuous at x  2

x2

Step 2 in this step we will see whether the limits of the difference quotient exist or not.
Since f x is an absolute value functions, it can be redefined as follows:

f x   x  2, for.x 

2  x, for.x  2
To see the existence of the limit of the difference quotient, we find its left & right side limits .i.e.
f x  h  f x
 �im
x  h  2x  2  1
� im
h0 
h h0  h

 

im
f  x  h  f  x
 im
2   x  h    2  x  1
h0 h h0 
h
From the above result, we can see that the left & right side limits are not equal. Therefore the
limit of the difference quotient doesn’t exist which intern means that the function f (x)  x  2 is

not differentiable at x=2.

25
 2.2. The Concept of the Derivative
If f is a function defined by y=f (x), then the derivative of f (x) for any value of x, is denoted by
′
, or f’(x) is the instantaneous rate of change of f (x) which is given by:

( + )− ( )
= lim
→0

Given a function y  f x, the derivative of f x at any point ‘x’ is given by

dy f x  x   f  x   f x: If this limit exists then f x is said to be differentiable
 �im 
dx x0 x
function at ‘x’.
f x  x  f  x 
The term , is simply slope of the functions which is an equivalent expression to
x
y
, and it represents average rate of change of a function .But the derivative approximates the
x
rate of change of the positive function when x is infinitesimal i.e. slope of a function at a point
or instantaneous rate of change.

Example: find the derivative of f (x)  x 2

Solution: f x  x   x  x 2  f x  h  subsituting.x  h

f x  x 2
df x  f x   �im f  x     f x   �im 2x  h  2x

dx h0 h h



As you might remember from the previous discussion, the derivative is also the slope of the
tangent line to f (x) at a point. Before we directly go to the discussion of the rules of derivatives,
let’s see some examples.

26
Examples:

1. Given f (x) =12x+ 18, find

2. Given f (x) = 10x2 + 120, find

n
3. Given f (x) = x , find

Solutions:

1. For f (x) =12x+ 18,

( + )− ( )
= lim
→0

[12( + ) + 18] − (12 + 18)]

= lim
→0

12 + 12 + 18 − 12 − 18
= lim
→0

12
= lim = 12
→0

Try example 2 and 3

Note that,
i. The derivative, which is one of the most fundamental concepts in calculus, is the same as
the following two concepts.
a. Slope of a line tangent to a curve at x
b. Instantaneous rate of change of f(x) at x

ii. The process of obtaining f’ (x) from f (x) is known as differentiation and if the
derivative exists, then the function is differentiable at a point or over an interval. In the
following section, we will present the rules of derivatives, which will largely simplify our
calculation of the derivative.

27
2.3 The Rules or Theorems of Derivatives
In this section, we formally state the different rules of derivatives that are important in
several problems of getting the derivative. These are the constant rule, the simple power rule,
the coefficient rule, sum/difference rule, product rule, quotient rule, chain rule, and others.

2.3.1 The constant rule

If c is constant and if f(x)=c, then f’(x)=0

Examples

a. If f (x)=15, then f ‘(x) = 0

b. If f (x) = -25, then f ‘(x) = 0

c. If f(x) = 1450, then f’(x) = 0

2.3.2 The Simple Power rule

If f(x) = Xn where n R then f’(X) = nXn-1

Example: Find f’(X) of the function
1. Y= 7X4
2. Y = 3X3 +4X2 +5X +15
3. Y = 20X2 + 8X+ 50
4. √
5. Y = X2 + √
Solution
1. Y= 7X4  =4.7X4-1 = 28X3

2. Y = 3X3 +4X2 +5X +15  = 3.3X3-1+2.4X2-1+1.5X1-1 =9X2 +8X+ 5

3. Y = 20X2 + 8X+ 50  = 2.20X2-1+1.8X1-1 = 40X+8

1 −1
4. Y = √ = X1/2 
1 −1 =1 2 = = 1
2 2 2√
2=
dy 5
5. Y = X2 + = X2X1/2 = X5/2 = 5 5−1 3
=2
√ dX
2 2
2

28
2 .3.3. The coefficient rule
For any constant C and function m(x),

If f(x) = Cm(x), then f’(X) = Cm’(x)

Example:
2
A. Y = 8x2 =8 = 8(2 ) = 16

2
B. Y = 3x2 =3 = 3(2 ) = 6

2
C. Y= 10X2 = 10 = 10(2 ) = 20

2.3.2. The sum or difference rule

If f(X) = u(X) ± v(X), then f’(X) = u’(X) ± v’(X)

Example

1. If y = x3 – 3x2 +10, then the derivative should be

( 3 −3 2 + 10 )

= 3 −3 2 + 10

= 3x2 – 6x

2. If y = x5 – 6x2 +4

( 5 −6 2 +4)

5 −6 2 + 4

29
Students’ Activities

1. The total revenue for a commodity is described by R(x) = 300x – 0.02x2 . What is the marginal
revenue when 50 units are sold and interpret your result?

2. Suppose the total cost function for the production of x units of a product is given by:
Tc=2x+120

a. Find the instantaneous rate of change of average cost with respect to the number of units
produced.

b. Find the level of production at which this rate of change equals zero.

3. The profit from the sale of x stereos per month for a certain company. is given by:

π = 800 –x2 + 0. 2x2

Find the rate of change in the monthly profit for 100 stereos.

2.3.5. The product rule

Although most of the time a function is given as a sum or difference of terms, there are times
when functions are presented in products.

If f(x) = u(x).v(x) = u’(x).v(x) +v’(x).u(x)

Example

Y = (3x – 2x2)(5+4x)

= (3 − 4 )(5 + 4 ) + (4)(3 − 2 2)

30
 = 15- 20x + 12x -16x2 +12x- 8x2

= -24x2 + 4x +15

2.3.6 The quotient rule

If u (x) and V (x) are two functions and if f(x) is the quotient,

( )= ( ) ′(
( ) ′( ) − ( ) ′( )
ℎ )=
( ) [ ( )]2

Example:

(1−2 )(3 +2)

1. Y =
5 −4

Solution
(1−2 )(3 +2)
[((5 − 4)
=
(5 − 4)2
(5 − 4)[(1 − 2 )(3) + (3 + 2)(−2)] − [5(1 − 2 )(3 + 2)]
=
(5 − 4)2

(5 − 4)(−1 − 12 ) − [(5 − 10 )(3 + 2)]

=
(5 − 4)2

−30 2+48 −6
=
(5 −4)2

2. y = −1 , find
+1

Solution
( −1) ( +1)
( + 1) − ( − 1)
=
( + 1)2

( + 1)(1) − ( − 1)(1)
=
( + 1)2

31
 +1− +1
=
( + 1)2
2
=
( + 1)2

Students’ Activities

1. The total physical output P of workers is a function of the number of workers “x”. The
function f(x) = p is called physical productivity function and is given by P = 10(3x + 1)3 find
the marginal physical productivity workers ( labor).

2. Suppose the revenue function for a certain product is given by R(x) = 15(2x + 1) -1 + 30x -5
where x is in thousands units and R is in thousands.

a. Find the MR when 200 units are sold

b. How is revenue changing when 2000 units are sold?

2.3.7 .Derivatives of implicit functions

Implicit functions are those functions whose dependent and independent variables are not
explicitly stated. That is, we don’t know whether a given variable is a cause or an effect variable
without any a priori information when we encounter implicit functions. When the dependent and
independent variables are not explicitly stated, one may not easily come up with . But using

implicit differentiation one can calculate .

Example:

A. 3xy –y = 2
(2)
[(3 − )] = … ∼ ℎ∼ ∼ . . .
( )
3
− =0

32
 =3

= 3x + … applying the product rule to (xy)

=3 +

[1]
= =
1−3 [
1−3
]
1

2 −1
=[ ][ ]since 3xy – y = 2 ,y(3x – 1) =2 and y = 2
3 −1 1−3 3 −1
−2
=
(3 − 1)2

B. Find the derivatives of of x2 + y3 = 2xy2

( 2 + 2)
2 2
= …. ℎ . . .
2 2
2x + = 2[ 2 + ]…. Applying the product rule to xy2
2 2 2
2x + . = 2[ 2 + [ . ]… ℎ ℎ

2x + 2y. =2[ 2 + 2 ]

2x + 2y =2 2 + 4

2y − 4 =2 2 − 2

2 2−2
=
2 −4

Note:

You can use the following generalized steps

1. Treat y as a function of x and differentiate each term of the equation with respect to x.

33
 2. Put all terms containing the factor on one side of the equation and the rest of the terms

on the other side.

3. Factor out from all terms that contain it.

4. Solve the equation for

2.3.8 Derivatives of logarithmic and exponential functions

The concept and rules governing logarithmic and exponential functions were described
previously in the first chapter. In this section, we will review point out how to find the
derivatives of logarithmic and exponential functions.

2.3.8.1 Derivatives of logarithmic functions

If Y = log =

y + σy = ln(x + σx)

σy = ln(x + σx) – y

= ln[x + σx) –lnx

= ln[1 + σX]

[σx] 2 σx σx
σX [ ]3 [ ]4
σy = -– + - + ……Remember the expansion form.
2 3 4

σy 1 σX σX 2 ( )3
= − + - +….
σX 2 3 3 4 4

σy
lim =1
→0 σX

Therefore lnx =1

If the function is stated to any base than e, it is possible to transform it to the natural logarithm
form and apply the above formula.
For example, if you are given:

34
y = log

lnx
d( ) 1
lna since lna and
= .
dX

1
=( )( )

1 1
= .

= 1 log

Therefore log = 1

If U = f(x), using the chain rule,

log 1
= . ′( )

Example: Find for each of the following functions below.

A. Y = x3 + 3 ln x

3
=3 2 + 3 =3 2 +

B. Y= log4( 3 + 1)
3
Let X + 1 = u
ln
So y = log4 =
4
1
= . = .( . )
4
1 1
= . .3 2
4
3 2 log4
= 3 +1

35
C. Y = lnx4

Y= lnx4let u = X4

= .

= .

= 1 .4 3

4 3
= 4

4
=

D. Y = ln√3
Let √3 =
Y = lnu

1 1
= . = . √3
2√

1 √3
= .
√3 . √2 2√
1
=
2

E. X ln y = 4
Ln y = 4
4
. = ℎ . . .
2

ℎ ℎ ℎ .

1 −4
=
2

36
 −4
= =
2

−4 4/
= 2
… ∼ = 4/

2.3.8.2 Derivatives of exponential functions.

Y = ax, a > 0 and ≠1 then can easily be found by changing it to the logarithmic function.

=
. =

1
= ln

= ln

Therefore =

x
The exponential function e is a unique function with special behavior. That is.

=
f(x)
However, in case we have e , we can use the chain rule to evaluate its derivative. That is let
u
f (x)=u and we will have e and U = f(x)

= .

= ∗ ′( )
( )
ℎ , ′
= ( ) ( )

: ℎ ℎ .
1. = 4
Directly inserting in the formula, we get =4 4
2
2. Y = 3

37
 2
=6 3

3. =

=  =

Rules of Differentiation Involving functions of Different Variables

Chain Rule (composite function rule)
Given Z  f ( y), and y  g(x)
dz dz dy
 .
dx dy dx

Eg. Given Z  x  3x  2 , find.

2 10 dz
?
dx
Solution: let y  x 2  3x  2 then Z   y 10
dz dz dy dy
  10y 9
dx dy dx dx
 10y 9 2x  3
 10x 2  3x  22x  3
Inverse function Rule
Given y  f (x)
dx  1

dy dy
dx
y 1
Eg. Given x  , find dy ?
y 1 dx
dx

y  1 y 1  2
dy  y  12  y  12
dy 1
Using inverse function rule, 
dx dx
dy
  y  12 
= 
 2 
Example : find the derivatives of the following functions.

38
 i) f (x)  3x3  4x 2  3x  2 Using rules (1), (2) and 3 above

f x  33x31  42x21  31x11  0

 9x 2  8x  3

ii) 2x  16 Here the function is a composite function where the outer function is power
function.
g(x)  2x  1

f (x)  x 6

f g x   2x 1
6

df gx 
 f g x .g  x   62x  15 .2  122x  15
dx

3x  1
 gx 
 
x 2  3x 3x  1  3x  1 x 2  3x
1
 1

iii) gx 2
x  3x x 2  3x
2
 

 
3x x 2  3x  3x  12x  3
x 


2
2
 3x

 3x 2  2x  3

x 2  3x  2

2.4. Differentials and Higher Order Derivatives

2.4.1 Differentials

Until now we have used the symbol to represent the derivative of f(x) with respect to x.

Now let’s assign different meanings to and . Let f(x) =y and be a real variable
thus, differential of y ( ) is given by:
′
= ( )

Note:
1. & are variables the former being dependent and the latter independent variable.

2. If ≠ 0 one can have = ′( )

39
 3. The main use of differentials is to find out approximations of changes. In suing them for
approximations, the value of should be very small.

Example: Find the differentials of y ( ) for the following equation.

3 2
1. y = x + 4x + 5
= (3 2 −8 )
2. y = −2
2

( − 2) 2 2 − 2 ( − 2)
= 2 − ( − 2) =
42
2 −2 2 +4
=[ ]
4

− +4
= 3

3. y = x2, find ℎ =1 0.01

=2
= 2(1)(0.1)
= 0.02

2.4.2 Second and higher order derivatives

In some cases, the derivative of a function turns to be a function. In this case, we can take the
derivative of ’( ) to determine the instantaneous rate of change of is known as the second order
derivative of f(x). One can find the second derivative of f(x) by differentiating it twice. Similarly,
( )
the third derivative of ’( ). = ′′( )=
2
ℎ ( )
2

One can find the second derivatives of ( ) by differentiating it twice. Similarly, the third
3
derivatives of ( ), , ( )three times.
3

40
Example: Find the first and second derivatives of the following function.

A. y = 2x3 + 4x2 + 5x +12

′( )
=6 2 + 8 +5
′′( )
= 12 + 8

B. y = 3x3 + 8x2 – 10x + 5

′( )
=9 2 + 16 − 10

′′( )
= 18 + 16

C. y = 5x5 - 20X3 + 10x2 -5x +24

′( )
= 25 4 − 60 2 + 20 − 5

′′( )
= 100 3 − 60 + 20

Students’ Activities

1. Given ( ) = 3 −9 2 + 33 + 30 determine the slope of marginal cost at x=7.

3/4 5/4
2. If the production function is given by Y=20L K , what is

a. The range over which there is increasing returns to capital

b. The range over which there is decreasing returns to labor

c. The nature of returns to scale of production? Is it constant, increasing, or

decreasing returns to scale?

41
 Solution: ′( ) = 3 2 − 18 measures the slope of total cost curve and to find the slope of
marginal cost curve take the derivative of MC, which is the second order derivative of total cost
function.

’’( ) = 6 − 18
’’(7) = 6(7) − 18 = 24
To answer question number 2, you need to know the concept of partial derivatives, which we
will present it below.

2.5. Partial derivatives and total derivatives

Though functions of singe variable have large simplicity, they are not commonly used in
economics. They are not common since the functions that the real economic world consisted of
are multivariate. For example, our rational consumer will not consume one commodity only;
rather, s/he consumes different combinations to maximize her/his utility. The representative
production function of a firm is not only a function of labor but it is also a function of capital.
The overall income of nations is not a function of physical capital stocks only. It is also a
function of human capital, factor productivity, institutions, and government policies. Hence, we
have to extend the concepts of univariate calculus to multivariate ones. For the time being, let’s
begin with a function of two independent variables so that we can simply extend it to n-variables
case.

= ( , )

Let’s take the Cobb Douglas production function of a hypothetical firm.

 
= 

Where:
Y-is the level of output
A-is the state of technology, which reflects productivity of factors
L & K represent the units of labor and capital
α& Β are elasticity of y with respect to labor and capital respectively

42
Example:
1. Suppose for a firm = ( , ) = 60 1/4 1/4
a. How many units output will be produced if the firm uses 81 labor and 16 capital
b. Show that the production function is constant returns to scale.

Solution:

a. = ( , ) = 60(81)3/4161/4 = 3240
b. To check for returns to scale, add the exponents of labor and capital. If the sum is greater
than one it is increasing returns to scale, less than one it is decreasing returns to scale and
if it is equal to one it is constant returns to scale. Since 3/4 +1/4=1, it is constant returns
to scale.

2.5.1 Partial derivatives

Let = ( , ) If we want to know the changes in y due to changes in x or z, we have
to find out the two derivatives of y which are known as partial derivatives with respect to
each variable.
 The partial derivative of y with respect to x written is the derivative of y when

z is considered as a constant and x is the only independent variable.

 The partial derivative of y with respect to z is written as is the derivative of y

when x is considered as a constant and z is the only independent variable.

  
= = =
 ,
 ,


Example:

1. If f(x,y) = 5x3y2, find


a.


b.


43
 c.   2
= 2

( ) = 
2
d.
 
=  ( ) = 

2
e.
 
=  ( ) = 

Solution:
a. f/x = 5y2(3x2) 2=15x2y2
b.  = 10x3y3 and 
2  2
= 10
 
c. = ( 2 2) 2
 2  15 = 30
d. =30 2

e. =30 2

2.5.2 Total derivatives (differentials)

We have seen that partial derivatives of f(x, y) indicate how much the function changes with
respect to small change in its variables. In particular ifand σyare small at the point (a, b), a
change in x of σxunits produces a change in of approximately[ ( , )] σx units; and a change in


y of σy is approximated, [ ( , )]σy and the over all change is approximated using the sum of


these terms. Thus, f(a + σx, b + σy )  [ ( , )] σx +  ( , )]σy

 

The expression on the right hand side is known as total differential.

Note that,

 
 For ( , ) total differential = [ ( , )] + ( , )]
 
 
 For ( , , )total differential =[ [ ( , , )] + ( , , )] +
 

[ ( , , )] ]

Examples:

44
 1. Given a production function = 60L1/4K1/4. The total output when L=81 and K=16
units is 3240 units, use the concept of total differentials to approximate the effect of one
unit decease in labor and one unit increase in capital on output.
Solution:
f(81-1,16 + 1)  f(81,16)  [  (81,16)(−1) + [  (81,16)(1)
 
16 1 81 1
= 45[81]4(−1) + 15[16]4 (1)
5
= -30 + 405 = 20
8 8

Thus a unit in L decreases y by 30 and a unit increase in K increases y by 405/85and in total y

increases by 205units.
8

2. Suppose the profit for a firm selling two goods at prices p and q respectively is by:
= (p,q) = -100,000 + 5000p + 10000q – 50 2 -100 2 + 10

when p =11 and q = 50  = will be $ 200000

Use total differentials to approximate the effect of a $ 1 increase in p and $0.20 increase
in q. Compare your result with (101, 50.20)

2.6. Some Applications of Differential Calculus

First order Derivatives:- the sign of first order derivative in important to determine the
behavior of functions in a given interval, i.e. weather a function is increasing or decreasing can
be determined using the sign of its first derivative.
Definition:-consider a function f(x) which is continuous in an interval I a,bwhere b>a, f(x)
is said to be
 increasing if f b  f a.or. f a  f b

 decreasing if f a  f b.or. f b  f a

suppose that f x is differentiable on the given Interval,

1. If f x  0 for all xXI, then f x is increasing on I

2. If f x  0 for all xXI, then f x is decreasing on I

45
 3. More generally, the conclusion in (1) an (2) still hold if in each finite interval say MTI
there are only finitely many point, at which the assumptions of f x  0 and f x  0
are not satisfied.

Illustrative Example

Given TR=20q-q2 find the intervals for which TR functions is

a) increasing
b) decreasing
Solution:
dTR
MR   20  2q
dQ
20  2q  0 20  2q  0
20  2q 20  2q
10  q q  10
q  10; i.e TR is increasing for q<10, and it is decreasing for g>10.

Application of derivatives in Economics

The concept of marginal analysis: - marginal analysis is very important in dealing with most
economic functions. Mathematically, marginal functions are the 1st derivatives of total functions.
dTR
 MR
dQ

dTC
 MC
dQ
d
 M …..etc.
dQ
Derivatives can also be used to determine the relationship between marginal & average
Economics functions
Example
Consider the following cost function.

46
 TC  C Q

 Q  TC
dTC
TC dAC  dQ
AC    2
(using the quotient rule).
Q dQ Q

dTC 1MC  AC  - from this we can observe that , will be increasing when MC>AC .
MC 
dQ Q

For TR function
PQ
TR = PQ & AR = P
Q
d PQ dQ Qdp
MR   p.  (Using Quotient rule)
dQ dQ dQ

MR  p  QdpdQ

The equation for a) above is a representative relation between AR & MR if the market is
perfectly competitive price will be constant &
dp
 0 & MR  p  AR
dQ
dp
It the market is monopoly  0, so MR<AR.
dQ
In general, MR can never be greater than AR. At extreme MR=AR when the market is perfectly
competitive.

L Hôpital’s Rule
In dealing with indeterminate limits, the best way to find limits is using the “L Hôpital’s Rule”.
To use this rule, let’s differentiate among the different indeterminate limits.
( )
We say lim
→ ( )

a. 0/0 indeterminate form if lim ( ) = lim ( ) = 0

→ →
∞
b. indeterminate form if lim ( ) = lim ( ) = ∞
∞ → →

47
 The following theorem allows us to deal with 0/0 indeterminate form.

First form of LH 0Pital’s Rule: Suppose that ( )= ( ) , that

( ) ( )
’( ) ’( )exist, and ’( ) =≠ 0 then lim =
→ ( ) ( )

Example:

lim
3 − 1 = 0/0
→1 −1

3x2
lim =3
→1 1

 Stronger form of L’: Suppose that f and g are differentiable on an open interval I
containing a, and that g’(x) ≠ 0 on I if ≠
( ) ′( )
Then lim = ′(
→ ( ) )

Note that the LH rule 0also applies to spital’s ∞indeterminate forms.

∞

We have also other indeterminate forms and some these are


0∞

00

1∞
 ∞0 and
 ∞-∞

To deal with these forms change them into 00or ∞∞forms by taking logarithms and performing
some algebra.

Students’ Activities

1. Find the derivative of each function.

(a) y= 3√
(b ) y=25
(c)y= 7
4

(d)y= 8x2+ 3√ - 14

48
(e) y= 7x-2- 2x
4

2. Find g'(l) and g'(4) for each function.

(a) y= g(x) = 12x2
(b) y= g(x) = ax-2
(c) y= g(x) = 4xl/2
(d) y= g(x) = e2x
3. Explain the difference between f'(x) = 0 andf'(xo) = O.
4. using the product rule, differentiate each function.
(a) y= (4x - 7)(3x + 5)
(b) y= (3x + 4)(5x2+ l0x + 6)
(c) y= (5x + 2)(x + 4)(X2)
(d) y= (x3- 10)x2
(e) y= (x-2 - 4)6x
5. In economic analysis, functions are often given in general rather than specific form, meaning
that there is no numerical specification. If average revenue, AR, is a function of Q, that is,
AR = f(Q), and TR = AR. Q, where TR is total revenue, find the derivative of the total revenue
function (that is, marginal revenue).
6. Differentiate each exponential function.
(a) y= xex
(b) y= 10e-x/5
(c) y= axebx
(d) y= 2xex2+4
(e) y= e3x-x2+5x-6
7. The assumption of profit maximization, where profit is equal to the difference between
revenue and cost, is frequently used in microeconomics. To maximize profit, or achieve the
greatest difference between revenue and cost, the firm selects thatoutput at which marginal
revenue equals marginal cost. Given the demand function
P=70-10Q,
Determine total revenue. (Hint: TR = P. Q.) Find the associatedmarginal revenuefunction, and
obtain the marginal cost function from the total cost function TC(Q) = 175 - 50Q + 20Q2.At what
quantity of output is profit maximized?

49
8. Use the chain rule to find thederivative, f'(x), of each function.
(a)f(x) = (x + 1)3 + (x2- 2x)2 - 5
(b) f(x) = (2x + 4)99
(c) f(x) = (5x2+ l0x + 3)20
(d) f(x) = [ex] ab
(e) f(x) = [eax]b
2 l0
(f) f(x) = ( + + )

9. Use the quotient rule to differentiate each function.

(a) f(x) = 2 +7
2−1

3+ 2+ −4
(b)f(x) = 2−1
2
(c)f(x) =
2
2
(d) f(x) = (3 +2)
2

(e) f(x) = 2 +7
2 +20

4 3+15 2+6 −14

(f) f(x) =
2
ln(15 4+11)
(g) f(x) = 7 4 +8

10. Consider a total cost functionf(x) and its average cost function A(x) =f(x)/x.
(a) Using the quotient rule, take the derivative of the average cost functionA'(x) to obtain a
relationship between average cost and marginal cost, f'(x).
(b) WhenA'(x) < 0, is marginal cost greater orless than average cost? Is the average cost function
decreasing or increasing in this scenario?
(c) When A'(x) > 0, is marginal cost greater orless than average cost? How does this affect the
slope of the average cost function?
(d) If marginal cost equals average cost; what does this suggest about the slopeofA'(x)?

11. Use the rules for differentiating logarithms to find the derivative of each function.
(a) f(x) =X-4+ lnax

50
(b)f(x) =4x31nx2
(c) f(x) = lnx- ln(1 + x)
2 3
(d) f(x) = log( )
5

(e) f(x) = loglog2( 6 )

12. Find the second derivative of each function.

(a)y= 9 - 3x + 7x2- x3
(b) y= 4 +5
5

(c) y= ln4x
(d) y= x2ex
(e) y= (x-6)4
13. Differentiate f(x) = 3x8/3 three times.Show that the third derivative of this function cannot be
evaluated
14. A standard tool of economic analysis is the Cobb-Douglas production function. This function
shows how much output (Q) is produced with a given amount of labor (L) and capital (K) as
follows:Q=AKaL1-a. The parameter A represents the efficiencyof the economy,so A increases
with technologicalchange. Suppose that, over time, efficiency,capital, and labor each grow at the
rates
A(t) = Aoect, K(t) = Koeft, and L(t) = Loegt,
Where Ao, Ko, and Loare initial values for technology, capital, and labor, respectively, and c, f,
and g are their respective rates of growth. What is the percentage growth rate of output in terms
of the production parameters and the growthparameters c,f, and g?

15. Assuming that Xo= 1 and ∆ = 1, find the value of the difference quotient for each of the
following functions. Now calculate each value assuming that Xo = 2. Finally, assuming that ∆ =
2, determine the value of each difference quotient. What is the relative impact, on each function's
difference quotient, of doubling the value of xo? Of doubling the value of Ax?
(A)y= 10x - 4
(B) y= 3X2 + 6x - 5
(C)y= x3 + 4x2 - 6x + 12

51
 16. The following wage function presents the relationship between the age of an employee and
his wages:
Wage = 10 + 60age - 0.25age2.
Using the difference quotient, find the change in wages at the beginning of each ofthe
following decades: age = 20, age = 30, age = 40, and age = 50. Consider thecase of ∆age
= 1.What happens to this employee's earnings as he gets older?
17. Find the differential dyfor a given change in x, dx, for each function.
A)y= 7x2- 3x + 5
B)y=10x-1x2
4

C)y= X3 + 3x – 6

Chapter Three: Application of differential calculus

Aims and objectives:

After successfully completing this chapter, students are expected to:
 Understand the curvature nature of different types of functions
 Know how to solve extreme values of functions of one variable when there is no
constraint
 Solve extreme values of functions of several variables when there is no constraint
 Two variables optimization problems with equality constraint

Introduction

Dear distance learners in the previous sections we have dealt with the techniques of differential
calculus. Now it is essential to see its applications. The two of the most important applications of
derivatives are obtaining the graphs of functions and finding the optimum values. Optimization is
the “quest for the best!” It involves either maximization or minimization. Since the economic
person is an optimizer, most part of the chapter deals with the applications of derivate to static
optimization problems .However; this doesn’t mean the application of derivatives to find out a
graph of a function is irrelevant for economists. I hope no one forgets the relevance of graphs in
economics for Paul. A. Samuelson has said it “a graph is worth more than thousand words.” In
52
fact, we will briefly see the applications of derivatives to graphing functions first and divert our
attention to optimizations.

Curve sketching- involves identifying the x-intercept and y-intercepts, whether a function is
increasing or decreasing in a given range, finding out its extreme points, and finally checking
whether the function is concave up or concave down at a point or a point is an inflection point.
Let’s see each of these concepts and tie them with the derivatives ofdifferent types of functions.
Note that we commonly read graphs from left to right.

When finding the relative extreme of objective functions of more than one choice variable which
are independent of one another, the decision made regarding one variable does not affect the
choice of the other variable. Such functions which involve no constraints are called
unconstrained functions & the optimization process is called unconstrained or free optimization.

From the point of view of economics, extreme (equilibrium) points may be of two types. These
are goal equilibrium and non-goal equilibrium. The former is equilibrium point which the
economic agent is deliberately striving to achieve, and entails maximization of any form of
benefit and minimization of costs (of any form). The general term for this type of economic
problem is optimization. In this chapter, we will focus on optimization problems using the
classical method of optimization (the concept of derivatives).

3.1. Curvature Nature of the function

3.1.1. Increasing and Decreasing Functions

A function f(x) is increasing if the value of the dependent and the independent variables are
directly related. That is as the value of x increases, the value of f(x) increases too and vice versa.
Mathematically speaking: A function f(x) is increasing over an interval if whenever X1>X2 , then
f(X1)> f(X2) for any X1 and X2 in that interval.

53
On the other hand, a function f(x) is decreasing if the value of the independent and the dependent
variables are inversely related. That is, as the value of X increases, the value of f(x) decreases
and vice versa. Thus f(x) is decreasing over an interval if for any X1 and X2, when X1>X2 then

f(X1) < f(X2) over that interval.

The graphs of some functions, like that of marginal utility, have increasing or decreasing
property throughout. But, most of functions are increasing in a given range and decreasing in
another range. For example, the graph of total product increases first, reaches maximum and then
decreases. Most of the economic functions are not increasing or decreasing throughout. Graphs
of marginal cost, average total cost, average variable costs, average product, and marginal
product are not increasing or decreasing throughout. The point at which the graph changes from
decreasing to increasing or vice versa is known as an extreme point or critical point or stationary
point. An extreme point is a point of relative maximum or relative minimum.

If a function is increasing, it has positive slope which implies that f ’(x) is positive. If a function
is decreasing, it has negative slope and negative first derivative. If the point is an extreme pint,
there is zero slope or undefined slope at that point and is zero or undefined.
In summary for y=f(x)
 If < 0, then f(x) is decreasing function

 If > 0, then f(x) is increasing function

 If = 0 then, f(x) has extreme value at this value of x

3.1.2. Testing For Concavity and Convexity

Knowing the range over which the function increasing, decreasing, and achieving relative
extreme point is important to draw graphs of functions but they are not all about. A given
function increases over a range but it can increase at an increasing rate, a constant rate or at a
decreasing rate. Thus, we have to see the concavity of graphs to add this dimension.

Concavity

54
The concavity of a function used in economics often corresponds to an important economic
concept. For example, as shown previously, the concavity of a utility function, which illustrates
how marginal utility changes with consumption, reflects the concept of diminishing marginal
utility. Likewise, the concavity of a production function, which shows how marginal product
declines with the increased use of an input, is the mathematical counterpart to the economic
concept of diminishing returns to inputs.

A function is strictly concave over an interval if asecant line connecting any two points in that
interval lies wholly below the graph of that function. The sign of the second derivative of a
function provides information on its curvature. A functionf(x) is concave over an interval iff"(x)
< 0 forall values of x in that interval. A given function is concave (changes at a decreasing rate) if
the function lies below its tangent line.As we move from left to right the slope of f(x) decreases;
i.e., f’(x) is a decreasing function. Thus, if a function is concave,thenf"(x) < 0.

Convex
A function is convex over an interval if f"(x)>0 for all values of x in that interval. A given
function is convex (changes at an increasing rate) if the function lies above its tangent line.As we
move from left to right the slope of f(x) increases. This shows that f’(x) is an increasing function
implying that f"(x) >0. Hence, if a function is convex, then f"(x) is positive.

55
In summary for y=f(x)
 If f"(x) < 0, then the function is concave
 If f"(x) > 0, then the function is convex
 Iff"(x) = 0 then, it may or not be point of inflection. At point of inflection the function
transforms itself from changing at an increasing rate to decreasing rate and vice versa.

Note that if a function changes at constant rate, f’(x) is a constant function andf"(x) = 0. These
curves are linear curves. Hence, getting f“(x)=0 may not be a sufficient condition for a point to
be an inflection point.

Examples
1. Given f(x)=x3-3x-2 then find
A. The ranges of x over which f(x) is decreasing and increasing
B. The point at which f(x) attains its relative extreme value
C. The ranges of x over which f(x) is concave and convex
D. The point of inflection
E.Sketch the graph
2. Given TVC(x)=18x-15x2+4x3 then find
A. MC Function
B. The point of diminishing returns
56
 C. The point at which stage II of production begins

Solution
1. f’(x) =3x2-3 f"(x)=6x
A. If f(x) is increasing if f‘(x)>0. If f(x) is decreasing if
That is, 3x2-3 >0 f‘(x)<0. That is, 3x2-3 <0
x2−1>0 x2−1 <0
(x-1)(x+1) >0 (x-1)(x+1) <0
(x-1)(x-(-1)) >0 -1<x<1
x>1 or x< -1
Thus, the function f(x) is increasing for the value of x>1 or x<-1. It is decreasing in the range -
1<x<1.
B. At the point of extreme, f‘(x)=0. That is 3x2-3 =0 implying x2=1 which equals to
x=±1f(1)=(1)3-3(1)-2=-4 &f(-1)=(-1)3-3(-1)-2=0.Hence, the extreme points are (1,-4) and (1,
0).

C. Since f"(x) =6x if f(x) is concave f"(x)<0, 6x<0 and hence for x<0 the function is concave. If
f(x) is convex f"(x)>0, 6x>0 and hence for x>0 the function is concave down

D. At the point of inflection f"(x) =0. That is 6x=0 this occurs when x=0.

E. By finding the x and y-intercepts we can plot the graph of the function as

2. TVC(x)=18x-15x2+4x3 then find

57
A. Marginal cost function

B. Point of diminishing returns

C. The point at which stage II of production begins.

Solution

A) MC= =18-30x+12x2

B) At the point of diminishing returns MP is maximum and MC is minimum. Thus at this point =0,-
30
30+24x=0 from this x= =1.25
24

) At the point where stage II begins AP is maximum and AVC is minimum. Thus,
AVC=18-15x+4x2
AVC 15
=0, -15+8x=0 from this x= =1.875.
8

3. Given the cost function TC  0.5Q3  0.7Q2  30Q  256, then

a) Find the values MC
b) Find the interval for which AC & MC are concave upward & concave down ward.

Solution:-
dTC
MC   1.5Q 21.4Q  30
dQ
TC 0.5Q3  0.7Q 2  30Q  350
AC  
Q Q
350
 0.5Q 2  0.7Q  30 
Q
d 2 AC
 AC will be concave upward 0
dQ2
dAC 350
 Q  0.7 
da Q

58
 d 2 AC 512
2
 1  3  0
dQ Q

512
1
Q3

Q3  512
Q  8  Concave upward

4. Given f (x)  ax2  bx  c, for a>0 check the concavity or convexity of the function?
Answer since f  (x)  2a  0 it is a strictly convex function

5. Check the concavity and /or convexity of the following functions

a) f (x)  ax2  bx  c
Answer f  (x)  2a : - concave when 2a <0
a<0
- Convex when 2a>0
a>0
b. Given the production function y  AK  , A  0,0    1

d2y 
2
  ( 1) AK  2  0  concave.
dk

c. Suppose the functions U & g are both increasing and concave so that U   0,U   0, g   0,
and g   0. prove that the composite function f (x)  g(U (x)) is also increasing and
concave?
Solution : f (x)  g(u(x))
dg(us du(x)
f (x)  .
du(x) dx

59
  g  (u(x)).u  (x)
0 0
0(increaing)

 The increasing transformation of an increasing function is increasing.

f  (x)  g(u(x).u(x)
  g(u(x)).u(x)  g(u(x).u (x)
 g  u(x)). u(x)  u (x). g(u(x) 
2

 
 0 0 0 0 




(-) _ (-) =  0 concave.
 An increasing concave transformation of a concave function is concave

Student Activities

Determine whether each function is convex or concave. Do any of the functions exhibit both convexity
and concavity? What does this imply about the second derivative? Assume that the interval is the set of
real numbers unless otherwise indicated.

A) y = 4 - 4x + X2
B) y=9-x2
C) y=9x2-4x+2
D) y=-3x2+39
E) y=8-3x+x2

3.2. Unconstrained Optimization

3.2.1. Unconstrained/Free optimization of functions of one variable

Dear distance learners’ optimization, as described earlier involves maximization or minimization
of a given objective function. Most of our problems in economics are optimized subject to some
constraints but to grasp the basic idea, let’s begin how one can handle optimization problems

60
 functions without any constraint. In the next section we will extend the technique to the
constrained one. We will begin by briefly describing an optimum value and proceed to the next
section.
3.2.1.1. The concept of optimum (extreme) value
Economics is by and large a science of choice. Common criterion of choice among alternative in
economic is the goal of maximizing something or minimizing something. Optimization – means
quest for the best. Maximum and minimum as mathematical concepts as collective term is called
optimization.
 Optimization:
o delineate an objective function
o independent variables are choice variables
eg. ∏ is the object of maximization and Q is the choice variable.

In the optimization process, we need to identify the objective function to optimize. In the objective
function the dependent variable represents the object of maximization or minimization

• Example:

- Define profit function:  = PQ - C(Q)

- Objective: Maximize 

- Tool: Q
An extreme value of a function is the maxima or minima value of that function. We can have two
types of extreme values: Local (relative) and Absolute (Global)extreme values.

3.2.1.2. Relative Maximum and Minimum: First Derivative Test:

Relative extreme value: is an extreme value when compared with the values near to it. It can be
relative maxima (when it is higher than any other point near to it) or relative minima (when it is
lower than any value near to it).

In general
If a function f has a relative maxima at x= x0 if there exist an interval around x0 on which
f(x0) ≥ f(x) for all x in the interval.

61
 If a function f has a relative minima at x= x0 if there exist an interval around x0 on which
f(x0) ≤f(x) for all x in the interval.

Given y  f (x), the first derivative f (x) plays a major role in the search for extreme values. It is
easy to find out relative extreme values using the derivative. Previously we have seen that a
function changes from increasing to decreasing and vice versa. Since a function changes from
decreasing to an increasing at a relative minima, we have f‘(x)=0 or f‘(x) is undefined at relative
minima or maxima. Minimum and maximum values of a function occur either at stationary
points or at end points. So, to find the extreme values of a continuous function, the 1st
requirement is to find stationary points. This is called 1st order condition and tested using 1st
derivatives. i.e.

=0

Hence, we can find relative maxima and minima for a function by finding the values of x for
which f‘(x)=0 or f‘(x) is undefined. Once we get the critical value(s), we can use the behavior of
f‘(x) near the extreme point to know whether it is a relative minima or relative maxima point.
To find out relative minima or maxima using first derivative test assuming that y  f (x) is
continuous and possesses a continuous derivative,

st
1 Find f‘(x)
nd
2 Solve for the value of x which will make f‘(x)=0
rd
3 Use the above value to get the extreme value of the function (i.e, insert the value you got in
nd
the 2 step in f(x) to get the extreme value).
th
4 Evaluate the first derivative function at some values of x to the left and the right of each
critical point. Then
 A relative minimum if f '(x*) changes its sign from negative to positive from the immediate left
of x to its immediate right. (First derivative test of min.)
0

 A relative maximum if the derivative f '(x) changes its sign from positive to negative from the
immediate left of the point x* to its immediate right. (First derivative test for a max.)

62
  Neither a relative maxima nor a relative minima if f '(x) has the same sign on both the
immediate left and right of point x0. (first derivative test for point of inflection)
Example-1
1. Find the relative extreme of the following functions
A. f(x)=1x3-x2-3x+2
3

B. f(x)=2x3-6x2+6x+1
C. f(x)= x3-3x +6
Solution
A) f(x)= 1x 3-x 2-3x+2
3

f'(x)=x -2x-3=0 which means x2-2x+1=3+1

2

x-1= ±2 implying x=3 or x=-1

1
f(3)= 33-32-3(3)+2=-7
3
1 11
f(-1)= (-1)3-(-1)2-3(-1)+2=
3 3

Thus the critical values are (3,-7) and (-1,11).

3
So the function has relative maximum value equals to f(x)=11at x=-1 and relative minimum value
3

equals to f(x)=-7 at x=3

B) f(x)=2x3-6x2+6x+1
f'(x)=6x2-12x+6=0 which means x2-2x+1=0

(x-1)2= 0 implying x=1

f(1)=2(1)3-6(1)2+6(1)+1=3

The only critical value is (1,3)

So the function has inflection value (no relative maximum value) equals to f(x)=3 at x=1
C)f(x)= x3-3x+6

f'(x)=3x2-3=0
3(x-1)(x+1)=0 implying x=1 or x=-1
f(1)=4 or f(-1)=8

63
 Critical values are (1,4) and (-1,8)
So the function has relative maximum value equals to f(x)=8 at x=-1 and relative minimum value
equals to f(x)=4 at x=1.So the function has relative maximum value equals to f(x)=40 at x=2 and
relative minimum value equals to f(x)=8 at x=6

Example-2
Find the relative extrema of the function
y  f (x)  x3 12x 2  36x  8
First derivative:
f '(x)  3x2  24x  36
To obtain critical values, equate f '(x)  0.
x1  2 [at which we have f '(2)  0 and f (2)  40.
Sxel2f 
te6
st E[xaetrw seich we have f '(6)  0 and f (6)  8
cih

1) Given Q  p , where  and  are constants: find price elasticity of demand?
2) Given y  f (x), show that the derivative
 
d log ya 
dy x
, a  c  . y 
d log 
x
dx ?
a
 
3) Given Y= 19 x 3  1 6 x 2 2 3 x  1 , find the critical points and determine wether they are

maximum or minimum.
4) Given the total cost function:
C(Q)  aQ2  bQ  c, (Q  0). Find the minimum point of the average cost function?
5) Find the intervals where the following cubic cost function is convex and where it is
concave and find the point of inflection (quasi)?
C(Q)  aQ3  bQ2  cQ  d

6) For the function y  (x  8)4

a) Find the critical value (s)?
b) Test to see if at the critical values the function is at a relative max, min or possible
inflection point?

3.2.1.3. Relative Maximum and Minimum: Second derivative test

64
  d2y
Second derivative is the derivative of a derivative: f (x) or .If the second derivative exists
dx2
for all x values in the domain, the function f (x) is said to be twice differentiable. Interpretation:
rate of change of the first derivative of function i.e rate of change of the rate of change of the
original function.

However; the 1st order condition is not sufficient to say a function achieves maximum or
minimum, because it tells us only that the function has stationary point (zero slopes). The
sufficient condition is the rate of change of the slope (the 2nd derivative).Given a two variable
function y = f(x), the extreme values can be fixed using the following general rule.

F.O.C:The derivative version

dy 
 f x  0

dx

d 2 y      
 
2


f x 0 min
S.O.C : dx
 0  max

=0 test inconclusive
If the first derivative of a function f (x) at x  x0 is f (x0 )  0, then the value of the function at
x0 will be

a. a relative maximum if the 2nd derivative value at x0 is f (x0 )  0.

b. a relative minimum if the 2nd derivative value at x0 is f (x0 )  0.
nd
c. Inflection value if the 2 derivative value at x0 is f’’(xo)=0

Drawback: no unequivocal conclusion can be drawn in the event that f (x0 )  0. And hence, the
stationary value f (x0 ) can either be a relative maximum, or a relative minimum or even and
inflection point. When this is encountered, resort to first derivative test.

Summary of conditions and decision rules for optimizing one variable objective function

Conditions Maximum Minimum Inflection

F.O.C f‘(x)=0 f‘(x)=0 f‘(x)=0

65
 S.O.C f"(x)<0 f"(x)>0 f"(x)=0

3.2.2. Unconstrained optimization of functions of several variables

Many problems in economics reflect a need to choose among alternatives. Forexample,

consumers choose among a wide set of goods, producers choose from a number of possible input
sets or output mixes, and policy-makers may have several instruments at hand for achieving a
particular end. Formal economic analyses of these types of problems require a technique for
identifying and characterizing the extreme points of multivariate functions. We present these
techniques in this sub-topic. The multivariate techniques featured in this sub-topic are a
generalization of the univariate techniques presented in previoussub-topic .We will make this
clear by reinterpreting the results from the previous sub-topic in the context of the differential.
Placing the univariateresults in this context demonstrates a natural and straightforward link
between the univariate and multivariate first-order conditions. The use of the differential also
provides a link between the second-order conditions in the univariate and multivariate cases. The
second-order conditions are more complicated in the multivariate case than in the univariate case
due to the presence of cross partial derivatives. Therefore we begin with the general results for
the simplest twovariable cases and extend the second-order conditions to a more general
multivariate setting.
3.2.2.1. Unconstrained Optimization of functions of two variables

Given the objective function with two variables as z=(x,y) the following is summary of conditions and
decision rules for optimizing two variables objective function

CONDITIONS FOR RELATIVE EXTREMUM

MAXIMUM MINIMUM
FOC - first order conditions fx  f y  0 fx  f y  0
SOC - 2nd order conditions fxx  0, f yy  0 fxx  0, f yy  0
fxx f yy  fxy 2 fxx f yy  fxy 2

66
 Violation (failure) of the S.O.C
If the second order conditions for maximum and minimum are not fulfilled, the points will be
either of the following.

i) If f xx f yy   f xy  f xx f yy  0 , the point is saddle point

2
and
  f xy  and f xx f yy
2 o
ii) If f xx f yy , the point is inflection point

iii) If
  , Test inconclusive
f xx  f xy
2

Note: - always, we test a point for second order condition only if it passes the first order
condition (first order partial derivative test)

Algebraic Method and Second Order Condition

Having represented the second order partial differentials as quadratic forms, let us see how to
determine maximum and minimum points using a relatively easy method.
In the case of optimization with one variable, it is easy to test both 1st order and 2nd order
conditions. But in the case of multi-variable functions, it may be very complex to test the second
order conditions. The complexity increases as the number of variables increase since we will
have many direct and cross partials. In such cases, we resort to the concept of matrix algebra to
simplify our computation.

Given the objective function with two variables as follow:

67
 z  f (x, y)
dz  fxdx  f ydy
dz  0  f x  f y  0 for dx and dy not both zero
z z
f  , fy  first partials
x
x y
 2z   z 
fxx  ( f x ) or    
x x 2 x  x  second order partials
  z
2
  z 
f yy  ( f y ) or   
x y 2 y  y 
  z  2 z
fxy    or
x  y  xy
  z  2z
f yx    or
y  x  yx
Young's theorem: fxy = fyx

Examples:

1. z  x3  5xy  y2

f x  3x 2  5 y
f y  5 x  2 y
f xx  6 x
f yy  2
f xy  5

2. z  x2e y

fx  2xe y fxx  2xe y fxy  2xe y

f y  1x2e y f yy  x2e y

68
2ND Order Total Differential

dz  fxdx  f ydy
 
d 2 z  d (dz)  (dz)dx  (dz)dy
x y
 
 ( fxdx  f ydy)dx  ( fxdx  f ydy)dy
x y
 ( fxxdx  f yxdy)dx  ( fxydx  f yydy)dy
 fxxdx2  f yxdydx  fxydxdy  f yydy2
 fxxdx2  2 fxydxdy  f yydy2

3. z  x3  5xy  y2 , find dz, d 2 z

dz  fxdx  f ydy

 
 3x2  5 y dx  5x  2 y  dy
d 2 z  6xdx2  2(5)dxdy  2dy2

Second Order Condition:

z  f (x, y)
d 2z  0 for maximum, arbitrary values of dx and dy
d z02
for minimum
d z02
iff fxx  0, f yy  0, fxx f yy  fxy 2
fxx fxy
0
f yx f yy

d 2z  0 iff fxx  0, f yy  0, fxx f yy  fxy 2

69
 Example-1 : optimize the following functions
z  f x, y  6x 2  9x  3xy  7 y  5y 2

Solution: F.O.C f x  12x  9  3y  0

f y  3x  7 10y  0

Solving simultaneously yields the critical values x =1 & y=1

S.O.C f xx  12, f yy  10 and f xy  3

Determinant Test
12 3
H1  12  0, and. H 2   121  0
3 10

Thus, d 2 z >0 (positive definite).i.e. the equation is minimized at the critical values.

Example-2
A firm produces three products Q1, Q2 ,and Q3. The profit function is given by:
Q ,Q Q   180Q  200Q 150Q  3Q Q  2Q Q  2Q Q  4Q2  5Q2  4Q2 ,
1 2 3 1 2 3 1 2 2 3 1 3 1 2 3

then optimize the profit function?

Solution:
F.O.C: 1  0

2  0
3  0
Critical values: Q*  14.53,Q*  13.27, and.Q*  11.79
1 2 3

Example-3 : Optimize the following function

z  2x 2
 x x  4x 2
 x x  x 2
2
1 1 2 2 1 3 3

f1  4 x1  x2  x3  0
f 2  x1  8x2 0
f3  x1  2 x3  0

70
Solution

x1 x1
x  , x3
2
8 2
x1 x1
4x1   0
8 2
32x1  x1  4x1  0
27x1  0
x1  0, x2  0, x3  0, z 2

f11 f12 f13 4 1 1

H  f21 f22 f23  1 8 0
f31 f32 f33 1 0 2

H1  f11  4

H  f11 f12  4 1  31
2
f21 f22 1 8
H3  H  4(16  0) 1(2  0) 1(0  8)  64  2  8  54

H1  0, H2  0, H3  0 positive definite, z*=2 is a minimum

Self-test Exercise
1. For each of the following functions, find the critical values, and determine whether the
function is at a relative max, min, an inflection or saddle point?
(a) z  f x, y  3x2  2 y 2  sy  4x  7 y  12
(b) z  f x, y  x  2ey  e x  e2 y
(c) z  e 2x  2x  2 y 2  3
2) Given TC=5x+200 andTR=10x-0.01x2, what is the value of x, which will maximize profit
3) Given TC=200+25x+2x2what is the level of x which minimizes average cost?
4) Find the stationary point(s) of each function.
(a) f(x, z) = 4x – 2z2+ x2+ z
(b) f(x, z) = 8x - x2+ 14z – 7z2
(c) f(x, z) = 4x - xl/2+ 1z – 2zl/2
3
(d) f(x, z) = x + 3ez– ex- e3z

71
5) Find the stationary point(s) of each function.
(a) g(u, v) = 10 + 20u – 2u2+ 16v - v2- 2uv
(b) g(u, v) = 100 - 5u + 4u2- 9v + 5v2+ 8uv
(c) g(u, v) = 1u3+ 3uv + 2u - 3v2
3 2
6) Find the stationary points for each function.
(a) h(a, b) = (a + 5)2 - (b + 3)2
(b) h(a, b) = 1a4- b6
2
(c) h(a,b) = 3a2+ 6a - b2+ 4b - 2ab
(d) h(a, b) = a-l+ b-l+ ab
7) Use the first-order condition to identify the stationary points of each function below. Evaluate
each function in the neighborhoods of its stationary points x* + a, z* + a, x* - a, and z* - a,
where x* and z* are the critical points of the function[(x, z) and a = 1.Determine whether the
stationary points identified represent a maximum, minimum, or saddle point.
(a) f(x, z) = 6x - x2+ 16z – 4z2
(b) f(x,z) = 50 + l0x - 1x2+ 14z – 2z2+ xz
2
2 2
(c) f(x, z) = 4x z - 16x - 4z
(d) f(x, z) = 6x + 2z2- x2+ 4z

3.2.2.2. Unconstrained Optimization of functions of more than two variables

First order condition:

z  f (x1, x2 , x3 )

First partials: f1, f2 , f3

2 z
Second partials: fij 
xix j

Young’s theorem: fij  f ji

For max, min, dz  0 (for arbitrary values of dx1, dx2, dx3, not all zero)

dz  f1dx1  f2dx2  f3dx3  0

72
  f1  0, f2  0, f3  0, is the necessary condition for extreme

Second Order Condition:

At stationary value of z, or dz=0,

if d 2 z is positive definite, sufficient condition for minimum

if d 2 z is negative definite, sufficient condition for maximum

For three variables:

dz  f1dx1  f 2 dx2  f3dx3

d 2z (dz ) (dz ) (dz )
 x dx1  x dx 2  x dx 3
1 2 3

 ( f dx f dx f dx )dx
1  2 
x1 1 2 3 3 1


 ( f dx f dx f dx )dx
1  2 
x2 1 2 3 3 2


 ( f dx f dx f dx )dx
1  2 
x3 1 2 3 3 3

2
d z  f11dx 2
 f dx dx  f dx dx
1 12 1 2 13 1 3

 f 21dx2 dx1  f 22 dx2 2  f 23dx2 dx3

 f31dx3dx1  f32 dx3 dx2  f33dx32

This is a quadratic form

Technique: regard dxi as variables that can take on any values, fij as coefficients

We have a symmetric Hessian Determinant

f11 f12 f13

H  f21 f22 f23
f31 f32 f33

Successive principal minors

73
 H  f , f11 f12 H  H
1 11
H2  , 3
f21 f22

Rules:  

z is a maximum   0, H2  0, H3 
 H1   0
 or 
 

d 2 z is negative definite 
2

minimum  if  0, H  0, H 0 d z is positive definite 

   H
 1 2 3  
 
 



Example: Find the extreme values of

z  2x 2
 x x  4x 2
xx x 2
2
1 1 2 2 1 3 3

f1  4x1  x2  x3  0
f2  x1  8x2 0
f3  x1  2x3  0

Solution: 
 x1  x1
x2  , x3 
8 2
 x1  x1
4x1   0
8 2
32x1  x1  4x1  0
27 x1  0
x1  0, x2  0, x3  0, z  2

f11 f12 f13 4 1 1

H  f21 f22 f23  1 8 0
f31 f32 f33 1 0 2

H1  f11  4

H  f11 f12  31
2
f21 f22
H3  H1  54

H1  0, H2  0, H3  0 positive definite, minimum

74
For the n-variable case:

z  f (x1, x2, , xn )
dz  f1dx1  f2dx2   fndxn
f11 f12 f1n
f21 f22 f2n
H 

fn1 fn2 fnn

Principal minors: H1 , H 2 , , Hn
F.O.C.: f1  f2   fn  0
S.O.C.: n principal minors must be positive (minimum)
n principal minors must alternate in sign (maximum)

75
Exercises
1) A firm produces two products x & y. the cost of producing the products is :
c(x, y)  0.04x2  0.01xy  0.01y 2  4x  2 y  500. Suppose that the firm sells all its output
at a per unit price of birr 15 for X, and birr 9 for y. optimize the profit function of the firm.

2) The production function for product Q is given by: Q  f L, K   6 K 3 L . Let the
price per unit of output be birr 0.5. The cost per unit of capital is birr 0.1 and the price per
unit of labor be birr 1. Optimize the profit function of the firm?
3) Consider a profit maximizing firm that sales its output Q at a constant unit price, P and
purchases two inputs X1& X2 at constant unit factor prices w1&w2 respectively. The firm
faces competitive input & output market and the production function is given by:
Q X 1 , X 2 . then optimize the profit function of the firm and provide economic
interpretation of the first & second order conditions.
4) Consider a monopolist firm that produces two products Q1& Q2. Suppose that the
demands facing the firm are as follows:
P1  55  Q1  Q2
P2  70  Q1  2Q2
The total cost function is given by: cQ , Q   Q2  Q Q  Q2 , then optimize the profit
1 2 1 1 2 2

function of the firm and determine the optimal levels of output, price and profit.
5) Suppose a monopolist firm sales a certain product Q in three separate markets. The
demands facing the firm are as follows.
P1  63  4Q1
P2  105  5Q2
P3  75  6Q3

The total cost function is: CQ  2015Q

Where Q  Q1  Q2  Q3
Then optimize the profit function in of the firm, i.e. determine the prices charged, the
quantities sold as well as the optimal profit.

76
6) Suppose a monopolist is practicing price discrimination in the sale of product Q by
charging different prices in two separate markets. The demand functions in the two
markets are given by:
P1  100  Q1
P2  80  Q2

Suppose the cost function is: C  6Q Where Q  Q1  Q2

i) a) How much would be sold in the two markets to maximize profit?
b) What are the prices charged?
c) How much is the maximum profit?
ii) If price discrimination is made illegal:
a) How much would be sold in the two markets?
b) What prices would be charged?
c) How much profit would be lost?

77
 3.3. Constrained Optimization

Introduction
In economic optimization problems, the variables involved are often required to satisfy certain
constraints. In the case of unconstrained optimization problems, no restrictions have been made
regarding the value of the choice variables. But in reality, optimization of a certain economic
function should be in line with certain resource requirement or availability. This emanates from
the problem of scarcity of resources. For example: consumers maximize utility; but, under the
constraints of income and prices. Producers maximize profit; but, under the constraints of labor’s
and capital’s price.Maximization of production should be subject to the availability of inputs.
Minimization of costs should also satisfy a certain level of output. The other constraint in
economics is the non-negativity restriction. Although sometimes negative values may be
admissible, most functions in economics are meaningful only in the first quadrant. So, these
constraints should be considered in the optimization problems. Since most of our optimization
problems are somewhat constrained it is necessary to extend the tools of calculus for
unconstrained to constrained optimization. This extension had first emerged in the monumental
work of Joseph Louis Lagrange. His research has illustrated how one can obtain maxima or
minima of a function f(x, y) subject to a constraint g(x, y) =0. The method of obtaining this
optimum value is known as Lagrange Multiplier. Constrained optimization deals with
optimization of the objective function (the function to be optimized) subject to constraints
(restrictions).

In the case of two choice variables, optimization problem with equality constraint takes the form
Max / Min : y  f x1 , x 2 , Subjectto : g x1 , x 2   c . This type of optimization problem is
x1 ,x2

commonly used in economics. Because, for the purpose of simplification, two variable cases are
assumed in finding optimum values. For example in maximization of utility using indifference
approach, the consumer is assumed to consume two bundles of goods.
Example: Max utility, u(x1,x2), subject to budget constraint ,p1x1+ p2x2,
In this section, we will see two methods of solving two variable optimization problems with
equality constraints.

78
 i) Direct substitution Method:
Direct substitution method is used for a two variable optimization problem with only
one constraint. It is relatively simple method. In this method, one variable is
eliminated using substitution before calculating the 1st order condition.Consider the
consumer problem in the above example.
P2 x2  M  P1x1
m p
x  1x
2 1
P2 p2
Now x2 is expressed as a function of x1. Substituting this value, we can eliminate x2 from the
equation.
 Ma.x.u  ux1 , x2 x1 
du  u  u x2

 . 
0
dx1 x1 x2 x1


 Mu1  Mu 2   p1 p   0
 2 

p
 Mu1  Mu2 . p1
2

Mu1 p
  1
Mu2 p2
Example u  x1 x2 , subjectto, x1  4x2  120
4x2  120 x1

x2  30  1 x1
4

 
 u  x 1 30  1 x1  30x1  1 x12
4 4
du
F.O.C.( First Order Condition)  30  1 x1 =0


dx1 2

 x1  60, and, x2  15

79
 ii) Lagrange Multiplier Method
When the constraint is a complicated function or when there are several constraints, we resort
to the method of Lagrange.
Max : f x1 , x2  subject to g x1 , x2   c
L  f x1 , x2    c  g x1 , x2  L denotes the Lagrange.
An interpretation of the Lagrange Multiplier
The Lagrange multiplier,  , measures the effect on the objective function of a one unit change
in the constant of the constraint function (stock of a resource) .To show this; given the
Lagrangian function;
L  f x1 , x2    c  g x1 , x2 
F.O.C.
L1  f 1 x1 x 2   g1 x1 , x 2   0
L2  f 2 x1 x 2   g 2 x1 , x 2   0
L   c  g  x 1, x 2   0

dL*  *
dc

Note :- If   0, it means that for every one unit increase ( decrease ) in the constant of the
constraining function, the objective function will decrease ( increase by a value approximately
equal to  .

If   0, a unit increase (decrease) in the constant of the constraint will lead to an increase
(decrease) in the value of the objective function by approximately equal to  .

Max : f x, y subjectto, gx, y=c

L  f x, y   (c  gx, y)

F.O.C.
L  c  gx, y  0 x
Lx  f x  gx  0 y
Ly  f y  gy  0 

80
Example 1:Max: z(x,y)=2xy subject to 3x+4y=90
L  2xy  90  3x  4y 
The subsequent equations can be solved by either of the following ways.

L  90  3x  4 y  0 x*  15
F.O.C:- Lx  2 y  3  0 y*  11.25
Ly  2x  4  0 *  7.5
are critical values. While the maximum value of the objective function is
z(15,11.25)=2(15)(11.25)=337.5

N-Variable and Multi-constraint Cases

z  f (x1, x2 , , xn )
s.t.
g(x1, x2 , , xn )  c
Z  f (x1, x2 , , xn )  [c  g(x1, x2 , , xn )]
Necessary conditions:
Z  c  g(x1, x2 , , xn )  0
Z1  f1  g1  0
Z2  f2   g 2  0

Zn  fn   g n  0
Suppose there are two constraints:
g(x1, x2 , , xn )  c
h(x1, x2 , , xn )  d
Z  f (x1, x2 , , xn )  [c  g(x1, x2 , , xn )]  [d  h(x1, x2 , , xn )]
Necessary conditions:
Z  c  g(x1, x2 , , xn )  0
Z  d  h(x1, x2 , , xn )  0
Zi  fi   g i  hi  0

81
98
1. Optimize: y  3x2  5x  x x  6x 2  4x  2x x  4x 2  2x  3x x .
1 1 1 2 2 2 2 3 3 3 1 3,

a) Compute the critical values using F.O.C.

b) Calculate the relative extreme values using S.O.C.
2. A monopolistic firm produced two related goods. The demand and total cost functions
are:
Q1  100 2 p1  2 p2
Q2  75 0.5 p1  p2
TC  Q 2  2Q Q  Q 2
1 1 2 2

Optimize the firms profit function by:

a) Finding the inverse demand function.
b) Find profit maximizing level of prices and outputs using f.o.c.
c) Compute the maximum profit of the firm using s.o.c.
3. Minimize a firm’s total cost:
c  45x2  90xy  90y2 , when the firm has to meet a production quota: 2x  3y  60, :
a) Find the cost minimizing input mix (the critical values)
b) Compute the minimum cost of the firm.
4. A monopolist firm produces two substitute goods and faces the following demand
functions.
X  80  Px  2 py

y  110  2 px  6 py

Its total cost function is: TC  0.5x 2  xy  y 2

What is the profit maximizing level of output if the firm has to meet a production quota
of 3x  4 y  350?

5. Maximize utility: ux, y  x0.25 y 0.4 , subjectto, 2x  8y  104(use any method).

6. If the utility function for two commodities is u=x2y and the budget constraint is 4x+5y=60, then
find the values of x and y that maximize utility.

82
Chapter Four: Integral Calculus

Introduction:
In the previous chapters, you have discussed derivate and related concepts. If you are given a primitive
function ( ), you can find its derivative function ( ) using techniques of derivative. For example, if
( ) = = 3 is given, the first derivative ( ) = = 3 2 applying the techniques of derivative.
However, if the derivative function ( ) = =3 2 is given and F(x) were not known, how can you get
( ). It is not possible using the techniques of derivative, since the process is opposite of derivative.
Obtaining a primitive function ( ) given the derivative function ( ) is known as Integral calculus. The
process is known as integration or anti derivative. In this chapter, you will understand the concept of
integration, techniques of integration as well as its application in economics.

Objective:
After completing this chapter, students will be able to be:

Understand the concept of integration

Use the rules of integration to solve integration problems
Apply the rules and techniques of integration to solve economic problems
4.1. The Concept of Integration
If ( ) is the derivative of ( ), it possible to integrate f(x) to find the primitive function F(x), provided
that appropriate information is given. Integration is the opposite of derivative. Derivative and
integration may thus be likened two ways of studying the family tree: differentiation seeks out the
progeny the function ( ); integration is tracing back the parentage of the function ( ). Since
integration is different from differentiation we should use a different notation of integration as given
below.

( )=∫ ( )

In the integral notation on the left, ∫ is the sign of integration while ( ) is known as the integrand
(the function to be integrated. The part of the notation refers to which variable the integration is
performed; in this case, it reminds that the integration is performed with respect to the variable .

Suppose you are required to find the F(X) given its derivative

( ) = 4 3.

By straightforward inspection the answer could be

( ) = 4, Since ′( ) = 4 3 = ( ). However, the derivative of ( ) = 4 + 5 is also 4 3 = ( ).

This is because the derivative of a constant is zero. if you also introduce any constant number other than
5, the derivative is 4 3 . Therefore we can rewrite as

83
 ∫ ( ) = ∫4 3 = 4 +

Where C refers the arbitrary constant

In general, if ( ) is any function that differentiates to ( ) then, so does ( ) + . Hence

∫ ( ) = ( )+

The arbitrary constant is called the constant of integration. The presence of an arbitrary constant of
integration serves to indicate the multiple parentage of the integrand. That is

( )=∫ ( ) = ( )+

The integral ∫ ( ) is known as indefinite integral of ( ), because it has not define numerical value.

4.2. The basic Rules of Integration

To begin the rules of integration, let’s begin developing the basic rules from differentiation.

If ( ) = , then
+1
∫ = + , ≠1
+1
+1
( +1 + ) +1
Since = +1−1 = = ( )
+1

Example:

Find the indefinite integral of the following functions applying the basic rule of integration

a) ( )= 3

b) ( )= 7

Solution:
1 1
a) ∫ ( ) =∫ 3 = 3+1 + = 4 +
3+1 4
1 1
b) ∫ ( ) =∫ 7 = 7+1 + = 8 +
7+1 8
Rule I. Constant rule

Given a constant function ( ) =

∫ = +

Where k and C are constants

84
Example:

Find the integral of the following constant functions with respect the variable x.

a) ( )=4
1
b) ( )=
5
c) ( )=1
Solution:

a) ∫ 4 =4 +
1
b) ∫ 5 =1 +
5
c) ∫ 1 =∫ = +
Rule II. Constant multiple rule

Where k is a constant

∫ ( ) = ∫ ( )

Example:

Find the integral of the following functions.

a) ( )=4 3
1 3
b) ( )=
4
Solution:
3+1
3 = 4( )+ = +
a) ∫ 4 3 = 4∫ 4
3+1
1 3+1 1 4
b) ∫ 1 3 = ∫ 3 = 1( )+ = ( )+ = 1 4 +
4 4 4 3+1 4 4 16
Rule III. Sum or difference rule:

Given two functions ( ) and ( )

∫[ ( ) ± ( )] =∫ ( ) ±∫ ( )

Example:

Find the integral of the following functions.

a) ( )=9 2+6
b) ( )=3 3− 4
c) ( )= 2+4 3−

85
Solution:

a) ∫(9 2 + 6) = ∫9 2 + ∫6
= [3 3 + 1] + [6 + 2]

=3 3 +6 +

b) ∫(3 3 − 4) = ∫3 3 −∫ 4
3 1
=[ ]−[ 5+ ]
4 +
1 2
4 5
3 1 5
= 4− +
4 5
c) ∫( 2 +4 3 − ) =∫ 2 + ∫4 3 − ∫
1 1
= [ 3+ ]+[ 4+ ]−[ 2 + ]
1 2 3
3 2
1 1
= 3
+ 4− 2+
3 2
Rule IV. The power rule:

Given a function ( ) = , then its integral is obtained as

+1
∫ = + , ≠1
+1

This is the simple power rule that we have considered as the basic rule of integration. It is based on this
rule all other rules are developed. Using this rule, we can solve the following examples.

Example:

Find the integral of the following functions

a) ( )= 5
b) ( )=
c) ( )=4
d) ( )=√ 7
1
e) ( )= , ≠0
3

Solution:

a) ( )= 5. Here, you have = 5, and therefore

5+1 6
∫ 5 = + = +
5+1 6
b) ( ) = . Here, you have = 1, and therefore
1+1 2
∫ = + = +
1+1 2
c) ( ) = 4 = 4 0. Here, you have = 0, and therefore

86
 4 0+1 4
∫4 = ∫4 0 = + = + =4 +
0+1 1

7⁄ 7
d) ( )=√ 7 = 2. Here, you have = , and therefore
2
7 9
7 2+1 2 2 9 2
∫ ⁄2. =7 + == + = 2 + = √ 9 +
9
+1 9 9
2 2

1
e) ( )= = −3. Here, you have = −3, and therefore
3
−3+1 −2
1
∫ −3 = + = + =− +
−3 + 1 −2 2 2
Rule V. The exponential rule:

We have discussed that to differentiate an exponential function, all we need to do is to multiply by

the coefficient of x. To integrate we do exactly the opposite and divide by the coefficient of x, so
1
∫ = +

Example:

Find the integral of the following functions

a) ( )= 2

b) ( )= 3

c) ( )=
Solution:
a) ∫ 2 =
1 2
+
2
1 2
b) ∫ 3 = +
3
c) ∫ = +
Rule VI. The logarithmic rule:
1
∫ = + ( > 1)

1
The integrand = −1, which is a special form of the power function where the power is negative one.
The particular integrand is inadmissible under the power rule, but now is duly taken care of by the
logarithmic rule. As stated, the logarithmic rule is placed under the restriction > 1, because logarithms
do not exist for non- positive values of . A more general formulation of the rule, which can take of
negative value of , is

1
∫ = | |
+ ( ≠ 1)

87
Example:

Find the integral of the following function

3
a) ( )=

Solution:
3 1
a) ∫ = 3∫ =3 | | +

Rule VII. The Substitution Rule:

The integral of ( ) ( ) with respect to the variable is the integral of ( )with respect to the
variable is

∫ ( )( ) =∫ ( ) = ( )+

Example:

Find the integral of

a) ( ) = 2 ( 2 + 1)
b) ( ) = 6 ( 3 + 2)99
c) ( ) = 8 2 +3
Solution:

a) ∫ 2 ( 2 + 1)
Let = 2 + 1, then = 2 which means = . Then by substitution
2

∫2 ( 2 + 1) 1 2
=∫ = +
2 2
1
= ( 2 + 1)2 +
1
2
1
= ( 4 +2 2 + 1) +
1
2
=1 4 + 2 1
2 + + 1
1
2
1 + , where
= 4
+ 2
= 2+ 1
2

b) ∫ 6 2 ( 3 + 2)99

88
 Let = 3 + 2, then =3 2

∫2 2 ()99 = ∫6 2 ( 3 + 2)99
3 2 3 2

= ∫2 99

= 2∫ 99

1
= 2( ) 100
+ 100
2
= ( 3 + 2)100 +
100
1
= ( 3 + 2)100 +
50
c) ∫ 8 2 +3

Let = 2 + 3, then =2
∫8 2 +3 = ∫4
2
= 4∫
= 4( ) +
= 4 2 +3 +
Rule VIII. Integration by parts:

∫ = −∫

The rationale behind this result is relatively simple. First, the product rule of differentials gives us

( )= +

And then, if we integrate both sides of the equation

∫ ( )=∫ +∫

=∫ +∫

∫ = −∫

Example:

Find the integral of

1
a) ( ) = ( + 1)2
b) ( )= ( > 0)

89
Solution:
1
a) ∫ ( + 1)2
1 1 2 3
Let = and = ( + 1)2 , thus = ∫( + 1)2 = ( + 1)2 + . Then
3

1
∫ ( + 1)2 =∫ = −∫

2 3 2 3
= ( + 1)2 − ∫ ( + 1)2
3 3
2 3 2 3
= ( + 1)2 − ∫( + 1)2
3 3
2 3 22 5
= ( + 1)2 − ( + 1)2 +
3 35
2 3 2 5
= [ ( + 1)2 − ( + 1)2] +
3 5

b) ∫ , ( > 0)
1
Let = . Then = and = . =∫ = +

∫ =∫ = −∫

1
= −∫

= −∫

= − +

= [ − 1] +

Exercise:

1. Find the indefinite integral of the following functions

a) = ( )= 3+ + d) = ( ) = 100 99
14 1
b) = ( ) = 2 2 + e) = ( )=
7 2+5 2
3 2
c) = ( ) =5 − 2 + , ≠0 f) = ( )=7 − +
2. Apply the substitution rule or integration by parts rule to find the indefinite integral of the
following functions.
a) = ( ) = 8 2 +3 c) = ( ) = 2 −2
b) = ( )= d) = ( ) = 3 −(2 +7)

90
 2+3
e) = ( )=4
4.3. Definite integrals
All integrals sited previously are of the indefinite variety, each in a function of a variable and hence
possess no definite numerical, i.e. ∫ ( ) = ( ) +

If we choose two values of x in the domain (say a and b, b>a), substitute them successively in to the right
of equation and f form the difference, we will have the following.

[ ( )+ ]−[ ( )+ ]= ( )+ − ( )− = ( )− ( )

We get a specific numerical value free of the variable x, as well as the arbitrary constant c. This value is
called the “the definite integral” of ( ) from a to b. we refer to ‘a’ the lower limit of the integration
and to ‘b’ as the upper limit of the integration. In order to indicate the limit of the integration, we have
to modify the integral sign to the form of ∫ . Then the integration can be written as;

∫ ( ) = ( )] = ( ) − ( )

Example:

Find the definite integral of the following function.

a) ( ) = 3 2; For the lower limit 1 and upper limit 5.

b) ( )= , ℎ ; For the lower limit ‘a’ and upper limit ‘b’.
1
c) ( )= + 2 , ≠ 1; For the lower limit 0 and upper limit 4.
1+
Solution:
5 3]5
a) ∫ 3 2 = = 53 − 13 = 125 − 1 = 124
1 1
b) ∫ = ] = − = ( − )

c) ∫ 4 1
+2 = |1+ | + 2] = |1+4| + 42 − |1+0| + 02 = 5 + 16
0 1+
4.3.1. Some Properties of Indefinite Integral
Property I. The interchange of the limits of the integration changes the sign of the definite integral:

∫ ( ) = −∫ ( )

Proof:

∫ ( ) = ( ) − ( ) = −[ ( ) − ( )] = ∫ ( )

Property II. A definite integral has a value of zero when the two limits of integration are identical:

∫ ( ) = ( )− ( )=0

91
Property III. A definite integral can be expressed as a sum of a finite number of a definite
sub-integrals as follows

∫ ( ) =∫ ( ) +∫ ( ) +∫ ( ) ,( < < < )

Property IV.

∫− ( ) = −∫ ( )

Property V.

∫ ( ) = ∫ ( )

Property VI.

∫ [ ( ) + ( )] =∫ ( ) +∫ ( )

Property VII.
= −
∫ = | −= − ∫
− −
4.3.2. Definite Integral and Area under a Curve
Every definite integral has a definite value. The value may be interpreted geometrically to a
particular are under a given curve. The graph of a continuous function = ( ) is drawn in the
following figure.

( )

( 1)

a b
∆ 2 ∆ 3 ∆ 4
∆ 1
1 2 3 4 5

If we seek to measure the shaded area, , enclosed by the curve and the x-axis between the two
points a and b in the domain we may proceed in the following manner. First we divide the − in
to ‘n’ sub-intervals. Since each interval represents change in x, we may refer to them as
∆ 1, ∆ 2, − − −, ∆ respectively.

92
 Let’s assume = 4. On the sub-intervals, let’s construct four rectangular blocks. The highest of
each block is equal to the highest value of the function attained in that block. The first block has the
highest ( 1) and the width∆ 1, and in general the ℎblock has the highest of ( ) and the
width∆ . The sum of the areas of the four blocks gives as the area of the shaded portion of
rectangular blocks which is plus the unshaped portion of the rectangular blocks. If we assume the
area of the blocks is represented by ∗, then it can be given as;
=4
∗ = ∑ ( )∆
=1

The area of ∗ is not the exact are of , and the only difference is that, ∗ inlcudes the unsahded
portion. Therfore, we should minimize the unshaded portion so that area of ∗ best approximates
the shaded area which is area of . In order to shrunk the size of the unshaded portion of the
rectangular blocks, we may subdivide a-b in to many more small blocks. For example, if we subdivide
in to eight blocks, as it can be seen in the follwing figure, the usnshded portion is shrunk compared
to when we ther were only four blocks. Further, we observe that the width of each block (∆ ) has
beocme short.

( )

( 1)

a b

Thefore, if we subdivide the interval − in to large number of blocks, the size of the unshaded
protion will become zero. As a result, as number of blocks increases to a larger numebr, the area of
sum of blocks ( ∗) equals the area of the shaded area under the curve ( ). That is;
=4
lim ∑ ( )∆ = lim ∗ =
→∞ →∞
=1

, provided that the limit does exist.

As n increases to a very large number, ∆ becomes very small which can be represented by the
differential . Accordingly, ( )∆ is rewritten as ( ) . In the other hand, as n approaches to

93
 infinity, the summation notation ∑ which represents the sum of finite number of terms is
substituted by the definite integral symbol∫ . Then,

∫ ( ) = lim ∑ ( )∆ =
→∞
=1

In general, given a fucntion ( ), the area under the curve for the interval a-b equals the definte
integral of the function for the interval.

Example:

Given the following graph, find the area of

a) BFDA
b) BFC
44
= ( )=20+4
40
36
32
28
24
20
16
12
8
4
0
0 1 2 3 4 5 6

Solution:

a) The area of BFDA is given as the area under the curve betaween 1 and 3. That is
3
= ∫ (20 + 4 )
1
= 20 + 2 2]13
= (20 ∗ 3) + 2(9) − (20 ∗ 1) − (2 ∗ 1)
= 60 + 18 − 20 − 2
= 78 − 22

= 56

94
 b) The area of BFC is given as the area BFDA minus the area of the rectangle BCDA. That is;
= −
3
= ∫ (20 + 4 ) − (24 ∗ 2)
1
= 56 − 48

=8

Activity:

Given the above graph, find the area of BEF

Exercise:

1. Find the following

2 6
a) ∫1 2 d) ∫5 (6 0.5 − 3 −2 + 85 4)
2
b) ∫4 ( 1 + 2 ) , ≠ −1 e) ∫ −2
0 1
2 1+ −2
c) ∫ (2 3 − 1)2(6 2) f) ∫
1 1 +2
2. Find the area under the curve for the following function
a) ( ) = 4 3 − 3 2 + 4 + 2between = 1 and = 2
b) ( ) = 2– 1 for the interval 1 ≤ ≤ 2
4.4. Improper Integrals
I. Infinite limits of integration
When we have a definite integral of the form
∞
∫ () ∫ ( )
−∞
With one limit of integration being infinite, we refer to them as improper integral. In these cas it is not
possible to evaluate the integral as, respectively.
∞
∫ ( ) = (∞) − ( )

∫ ( ) = ( ) − (−∞)
∞
This all is because ∞ is not a number, and therefore it cannot be substituted for in the function ( ).
Instead, we must resort once more to the concept of limits. That is;
∞ ∞
∫ ( ) ≡ lim ∫ ( )
→∞

∫ ( ) ≡ lim ∫ ( )
∞ →−∞ ∞

95
If the limit exists, the improper integral is said to be convergent (or to converge) and the limiting process
will yield the value of the integral. If the limit does not exist, the improper integral is said to be divergent
and is in fact meaningless.

Example:

Consider the following integration

∞
∫
2
1

We first denote as of

−1 −1
∫ 2 = ] = +1
1 1

Applying the limit of the integral;

∞ −1
∫ 2 = lim ∫ 2 = lim ( + 1) = 1
1 →∞ 1 →∞

Therefore, the improper integral does converge and it has a value of 1.

Example:

Consider also the following case;

∞
∫
1

First we denotes as of;

∫ = ] = − 1 =
1
1

As → ∞, → ∞. Thus the given improper integral is divergent.

II. Infinite integrand

Even with finite limits of integration, an integral can still be improper, if the integrand becomes infinite
somewhere in the interval of integration [a, b]. To evaluate such an integral, we rely up on the concept
of a limit.

Example:

Consider the following

11
∫
0

96
 1
This integral is improper because, the integrand is infinite at the lower limit of integration ( → ∞ as
→ 0−). Therefore we should find first find the integral as
11
∫ = ln ]01 = 1 − =− [ > 0]
0

And then evaluate its limit as → 0:

11 11
∫ ≡ lim ∫ = lim −
0 →0+ 0 →0+

Since this limit does not exist (as → 0+, → −∞), the given integral is divergent.

Example:

On the other hand consider the following example;

9
∫ −1⁄2
0

1
When → 0+, the integrand becomes infinite; the integrand is therefore improper. Accordingly, let’s
√
apply the limit as;
9
⁄ ⁄ 9
∫ −1 2 =2 1 2] = 6 − 2√
0

The limit of this expression as → 0+ is 6 − 0 = 6. Thus the given integral is convergent (to 6).

4.5. Economic Applications of Integrals

4.5.1. Economic Application of indefinite Integral
Integration is the opposite of differentiation, and marginal functions are the derivatives of total
functions. Therefore, the integration of marginal function should result the total functions. For example,
the integration of marginal revenue function results in the total revenue function; the integration of
marginal cost function results in the total cost function; the integration of marginal propensity to
consume results the consumption function; the integration of marginal propensity to save results in the
saving function; etc.

I. Finding Total Cost Function from Marginal Cost Function:

Example:

If the marginal cost (MC) of a firm is given as ′( ) = 2 0.2 , and if the totac fixed cost is = 90, then
find the total cost fucntion ( ).

Solution:

97
Margina cost is the slope of total cost fucntion, and thus the integration of marginal cost fucntion resluts
in the total cost function. Accordingly integrating ′( ) = 2 0.2 with respect to , gives us the
folloing integral fucniotn.

( ) = ∫ ′( ) = ∫2 0.2 = 10 0.2 +

Since total fixed cost equals total cost when Q is zero, we can rewrite the total cost fucntion at = 0 as

( = 0) = 10 0.2(0) + = 90

⇒ 10 0 + = 90

⇒ 10 + = 90

⇒ = 90 − 10

⇒ = 80

Therefore, the total cost fucntion is

( )= 0.2 + 80

II. Finding Total Revenue Function from Marginal Revenue Function:

Example:

If the marginal revenue fucntion (MR) of a particular firm is given as ′( ) = 360 − 2.6 , then find the
total revenue fucntion ( ).

Solution:

The total revenue function is the integral of marginal revenue function. That is

=∫ ′( ) = ∫(360 − 2.6 ) = 360 − 1.3 2 +

Since total revenue is zero when output is zero, we have

( = 0) = 360(0) − 1.3(0) + =0

⇒ 0−0+ =0

⇒ =0

Therefore, the total revenue function is

( ) = 360 − 1.3 2

98
 III. Finding Saving Function from Marginal Propensity to Save Function:
Example:
−1⁄
If the marginal propensity to save (MPS) is given as ’( ) = 0.3 − 0.1 2 and if aggregate saving is
zero when income (Y) is 81, find the saving fucntion ( ).

Solution:

Marginal propensity measures the change in aggregate saving resulting from a unit income change. That
implies MPS is the derivative of saving function. Accordingly, the integration of marginal propensity to
save with respect to income results in the aggregate saving function. That is

−1⁄ 1⁄
( ) = ∫ ’( ) = ∫ (0.3 − 0.1 2) = 0.3 − 0.2 2 +

The value of C is obtained based on the information that saving is zero when income is 81. That is
1⁄
( = 81) = 0.3(81) − 0.2(81) 2 + =0

⇒ 24.3 − 0.2(9) + =0

⇒ 24.3 − 1.8 + =0

⇒ 22.5 + =0

⇒ = −22.5

Therefore, the saving function is given as

1⁄
( ) = 0.3 − 0.2 2 − 22.5

IV. Finding Consumption Function from Marginal Propensity to Consume Function:

Example:

Find the consumption function ( ), if the marginal propensity to Consume (MPC) is given as ’( ) =
0.1
0.5 + and aggregate consumption is 85 when income (Y) is 100.
√

Solution:

As we have done in the previuos examples, the integration of marginal propensity consume with respect
to income gives us the consumtion fucntion. This is because, marginal propensity to consume is the
change in consumption as a result of a unit inomce, which is the derivative of consumtoion. Therofre,
0.1
( ) = ∫ ′( ) = ∫ (0.5 + ) = 0.5 + 0.2√ +
√

Since aggregate consumption is 85 when income (Y) is 100, the value of C can be obtained as

99
 ( = 100) = 0.5(100) + 0.2√100 + = 85

⇒ 50 + 0.2(10) + = 85

⇒ 50 + 2 + = 85

⇒ 52 + = 85

⇒ = 85 − 52

⇒ = 33

Therefore, the consumtion fucntion is

( ) = 0.5 + 0.2√ + 33
V. Investment and Capital Formation

Capital stock of a country is the productive capicity of a country. Therofere, a country should increase its
capital accumulated every period or time. The process of adding new capital to the existing capital stock
is called capital formtion. As a result, we may express capital scock as a fucntion of time [ ( )] and the
rate of capital formation over time as the derivative of capital stock with respect to time ( ). By
defintion, the rate of capital formation at time t is equal to the rate of net investment flwo at time t
denoted by ( ). Thus capital stock K and net investment I can be related as

- The derivative of capital stock with respect ot time equals the net investment at periond t. That
is

= ()

- This again imples, the integration of net investment fucntion at time t equals the capital stock at
period t. That is
()=∫ ()

Example:
1⁄
Suppose that the net investment flow is described by the ( ) = 3 2 and that the intial capital stock (K
at time = 0) is (0). What is the time path of capital K?.

Solution:

Capital (K)as a fucntion of time equals the integration of net investment function. Thus , when net
1⁄
investment fucntion is ( ) = 3 2 , the capital function is given as

1⁄ 3⁄
()=∫ () = ∫ (3 2) =2 2+

100
Since K at period = 0 is (0), the constant C can be obtained as
3⁄
( = 0) = 2 (0 2) + = (0)

⇒ = (0)

Therefore, time path of capital K which is the capital stock fucntion over time is
3⁄
( )=2 2 + (0)

4.5.2. Economic Application of Definite Integral

I. Consumers’ Surplus and Producers’ Surplus

Consumer s’ Surplus:
Example:

If the market demand fucntion is give by = 30 − 4 , find the conumes’ surplus at = 5.

Solution:

When = 5 price equals

= 30 − 4(5) = 30 − 20 = 10

Then, the consumers’ surplus can be shown graphically as follows.

35

30
P Consumer's Surplus
25

20

15

10
B C
5
DD
A D
0
0 1 2 3 4 5 6 7 8
Q

101
 In order to find the consumers’ surplus (CS), we apply the definite integral which was stated as
means of finding area under the curve between two points. Therefore, the above consumers’ suplus
(CS) can be interpreted as the area under the curve between 0 and 5 minus area of rectangle ABCD.
That is
5
= (∫ (30 − 4 ) = 30 − 2 2]5)
0 −
0

= [30(5) − 2(25)] − [(30 ∗ 0) − (2 ∗ 0)] − 5 ∗ 10

= 100 − 50

= 50

Producer’s Surplus:
Example:

If the market Supply fucntion is give by =3+ 2, find the Producers’ surplus at = 5.

Solution:

When quantity supplied = 5 , the price equals = 3 + 52 = 3 + 25 = 28. Given all this information,
the consumers’ surplus is shown graphically as follows.

44
40
P 36 Producers' Surplus SS
32
28 F G
24
20
16
12
8
4
0 E H
0 1 2 3 4 5 6 7
Q

In order to find the proucers’ surplus (PS), we apply the definite integral which was stated as means
of finding area under the curve between two points. Therefore, the above producers’ suplus (PS) can
be interpreted as the area of rectangle EFGH minus area under the curve between 0 and 5. That is
5
= − ∫ (3 + 2)
0

102
 1 5
3)]
= (5 ∗ 28) − (3 +
3 0

= 140 − 56.67

= 83.33

II. Cost of Production

Example:

Find the total varible cost at = 8, if marginal cost funtion of the firm is = 7.5 + 0.3 2

Solution:

The total variable cost when = 8 is equal to the area under the marginal cost curve between =
0and = 8. That is
8
= ∫ (7.5 + 0.3 2) = (7.5 + 0.1 3)]8
0= 7.5(8) + 0.1(83) = 60 + 51.2 = 111.2
0

III. Revenue of a Firm

Example:

If the linear demand dunction for a firm is given as = 60 − 2 , find the maximum total revenue using
definte integral.

Solution:

Total revenue of a firm equals price times quntity. = ∗ = 60 − 2 2. Thus, total revenue is
maximized when marginal revenue zero. That is

= 60 − 4 = 0

⇒ −4 = −60
60
⇒ =
4
⇒ = 15

Therefore, total revenue is maximized when output is 15. The maxmized total revenue will then be
computed using definte integral as the area under marginal revenue curve between 0 and 15. That is,
15
( = 15) = ∫ (60 − 4 ) = (60 − 2 2)]15
0 = (60 ∗ 15) − (2 ∗ 152)
0

= 900 − 450

= 450

103
 IV. Investment Flow
Example:

If the net investment fucntion is given as ( ) = 9000√ , find

a) The capital formation from the end of the first year to the end of the fourth year
b) The number of years required before the capital stock exceeds 100, 000
Solution:

a) The capital formation from the end of the first year to the end of the fourth year is given as
4 4 4
2
∫ ( ) = ∫ 9000√ = 6000 √ 3]
1 1 1
2 2
= 6000√43 − 6000 1
3√ 2
= 6000 √64 − 6000
= 6000(8) − 6000
= 48000 − 6000
= 42000
b) In this case, we supposed to find the numberof years required (T) for the capital stock to reach
100,000. This can be expressed as

∫ () = ∫ 9000√ = 100,000
0 0

2
⇒ 6000 √ 3] = 100,000
0

2
⇒ 6000√ 3 = 100,000

2
3
100,000
⇒√ =
6000
2
3
100
⇒√ =
6
100 2
⇒ 3 =( )
6

3 10000
⇒ =
36

3 10000
⇒ =√
36

⇒ = 6.5

104
Chapter Summary:
- Derivative and integration may thus be likened two ways of studying the family tree:
differentiation seeks out the progeny the function ( ); integration is tracing back the
parentage of the function ( ).
- The integral of the form∫ ( ) is known as indefinite integral of ( ) because it has not
definite numerical value.
- The integral of the form ∫ ( ) is known as definite integral of ( ) because it has definite
numerical value
- Every definite integral has a definite value. The value may be interpreted geometrically to a
particular are under a given curve for the given intervals.
- Integral calculus can be applied in different economic analysis such as to find
 Total cost from marginal cost
 Total revenue form marginal revenue
 Saving from marginal propensity to save
 Consumption from marginal propensity to consume
 Consumer and produce surplus
 Investment flow
 etc
Exercise:

1. Find the following

a) Find the total cost if the marginal cost is MC = Q + 5 and fixed costs are 20.
b) Find the total cost if the marginal cost is MC = 3e0.5Qand fixed costs are 10.
c) Find the total revenue and demand functions corresponding to each of the following
marginal revenue functions:
i. = 20 − 2
6
ii. =
√
d) Find the consumption function if the marginal propensity to consume is 0.6 and
consumption is 10 when income is 5. Deduce the corresponding savings function.
e) If a firm spends 650 ETB on fixed costs what is its total cost function if its marginal cost
function is MC = 82 – 16Q + 1.8Q2?
f) What total revenue will a firm earn if it charges a price of 715 ETB and its marginal revenue
function is MR = 960 − 0.15Q2?
2. Find the following
a) Given the non-linear demandschedule P = 600 − 6Q0.5 and the corresponding marginal
revenue function MR = 600 − 9Q0.5, use definite integrals to find:
i. Total revenuewhen Q is 2,500;
ii. The change in total revenue when Q increases from 2,025 to 2,500;
iii. Consumer surplus when Q is 2,500 and price is 300;
iv. The change in consumer surplus when Q increases from 2,025 to 2,500 owing to a price
fall from 330 to 300.
b) If a firm faces the marginal cost function MC = 40 – 18Q + 4.5Q2, what would be the
increase in total cost if output were increased from 30 to 40?

105
c) Find the short-run production functions corresponding to each of the following marginal
product of labor functions:
i. 1000 − 3 2

ii. 6 − 0.01
√
d) If net investment is a constant flow at I(t) = 1,000 ETB per year, what will be the total
net investment (capital formations) during a year, from t = 0 to t = 1?
1
e) If I(t) = 3t ⁄2 (thousands of ETB per year) – a constant flow- what will be the capital
formation during the time interval [1, 4], that is during the second, third, and fourth years.
f) If the net investment function is given by I(t) = 800t1/3 calculate
i. The capital formationfrom the end of the first year to the end of the eighth year
ii. The number of years required before the capital stock exceeds 48 600 ETB.
g) Given the demand equation P = 50 − 2Qd and supply equation P = 10 + 2Qs in pure
competition, calculate at the equilibrium
i. The consumer’s surplus
ii. The producer’s surplus

106
Chapter Five: Linear Difference and Differential Equations

Introduction:
In the previous discussions, we assumed equilibrium are achieved instantaneous or immediately.
However, economic variable take time vary. This means, equilibriums are not achieved as they are
calculated or known, they need some time to make adjustment. The incorporation of time in economic
models is known as dynamics. Dynamic analysis enables us to decide whether equilibriums values are
actually achieved and, if so, exactly how individual variables approach these values. On the other hand,
economic models which do not incorporate time variables are known as static and the corresponding
equilibriums are static equilibriums. Thus, all the previous discussions are static equilibriums analyses.

This chapter introduces you with the dynamic economic analyses through explaining the basics of
difference and differential equations.

Objective:
After completing this chapter, students will be able to be:

Solve the general solution of a linear difference and differential equation

Solve the specific solution of a linear difference and differential equation
Analyze the linear economic difference and differential equations
5.1. Definitions and Concepts
A difference equation (sometimes called a recurrence relation) is an equation that relates consecutive
terms of a sequence of numbers. We express the dependence using an obvious subscript notation. For
example, the price during the first period is denoted by , the price during the second period is 2, and
so on.
Sometimes a mathematical formulation of a problem involves an equation in which a quantity and rate
of change of that quantity are related by an equation. Rate of changes can be expressed in terms of
derivatives or differential and thus an equation is appropriately called differential equation. Therefore,
a differential equation is an equation that involves the derivative of an unknown function. Here, the
expression of the dependency is using the usual function notation. For example, the price of a product
at period t and the rate of change of price over time is expressed as ( ) and ’( ) respectively.

5.1.1. First-Order Linear Difference Equations

For example, consider the following.

= 2 −1
This descries that one number is twice its predecessor.
There are many sequences that satisfy this requirement including the following.
2, 4, 8, …
5, 10, 20, 40, …
−1, −2, −4, −8, …

107
Therefore, in order to determine the sequence uniquely, we need to be given with some additional
information. This additional information might be the first term denoted as 0. Once the first term is
known, all the remaining terms are known.

If 0 = 3 for the sequence equation =2 −1

1=2 0
= 2 1 = 2(2 0) = 22 0
2
3 = 2 2 = 2(2 0) = 2 0
2 3

4 = 2 3 = 2(2 0) = 2 0
3 4

ℎ =2 0
Since 0 = 3, = 3(2 )
In general, given 0 = , the general equation can be rewritten as

= (2 )
However, the difference equation may be given in different form such as = 2 −1 + . In this case,
the general solution is the sum of a complementary function (CF) and particular function.
Complementary function is when the constant C is assumed to zero. On the other hand, particular
solution is when a particular value (constant value ) is considered. This implies, the general solution
(PS) is

= +
If the difference equation is given as = −1 + ,
The complimentary function (CF) is computed assuming = 0. That is,
= −1 + 0
⇒ = −1
∴ 1= 0
2= 1= ( 0) =
2
0
3= 2= ( 0) =
2 3
0
∴ = 0
⇒ = ( ), where = 0
The Particular Solution (PS) is computed assuming = , where D is a constant. That
is,

= +
⇒ − =
⇒ (1 − ) =
⇒ =
(1 − )
Example:

Find the general solution and specific solution ( 0 = 1) of the unknown function, if the differnce
equation is given as = 4 −1 + 21
Solution:

108
 General solution is that = +
CF is when = 0
⇒ = 4 −1
⇒ = (4 )
PS is when = , D is a constant value. This implies all have the constant value D,i.e.
= −1 =
⇒ = 4 + 21
⇒ − 4 = 21
⇒ −3 = 21
21
⇒ =−
3
⇒ = −7

∴ The general solution is

= (4 ) − 7

The specific solution is computed when additional information is provided. Since 0 = 1 is given
as the first term of the sequence, the particular solution is
0 = (4 ) − 7 = 1
0

⇒ −7=1
⇒ =1+7
⇒ =8
∴ The specific solution when 0 = 1 is

= 8(4 ) − 7

5.1.2. First- Order Linear Differential Equations

For example, net investment ( ) is expressed as the derivative of capital stock ( ).

()
()=

This equation represents the differential equation of the unknown function ( ). This means, we are
()
given the derivative function equation ( ) = while the ( ) function is yet to be found.
Therefore, the direct method is to integrate both sides of the equation to find the unknown function.
Say for example

()
()= =

To find ( ), we should integrate as follows

() 1
( )=∫ =∫ = 2
+
2

Where

C is the constant of integration

109
This solution is known as general solution. In order to find a specific solution of the unknown
function ( ), we should get some additional information like the value of at period = 0, which
is (0). If the initial capital sock for the above example is given as (0) = 500, the specific solution
can be computes as follows
1
( = 0) = (02) + = 500
2
⟹0+ = 500

⟹ = 500

Therefore, the specific solution when (0) = 500 is given as

1
()= 2
+ 500
2
Differential equations usually have general and specific solution. When the differential equation more
complicated (if the right hand side of the equation are given terms the unknown rather than t), a general
solution itself is composed of a complementary function and particular solution. Further, differential
equations may have different order (determined by the degree of the leading term) and may involve
nonlinear case. In this course, we are going to discuss only those of first order linear differential
equations.

Example:

Find the general solution and specific solution ( (0) = 10) of the unknown function, if the differnce
equation is given as = −2 + 100

Solution:

The general solution

(0) = +
CF is when the constant is assumed to be zero
⟹ = −2

⟹ = −2

⟹ = −2

⟹∫ = ∫ −2

⟹ ln = −2 +

110
 ⟹ ( )= −2 +

⟹ ( )= −2

⟹ ()= −2 , where = ( = 0)

PS is when particular value is considered, say ( ) =

= −2 + 100
⟹ 0 = −2 + 100

100
⟹ = = 50
2
∴ The general solution is

( )= +

= −2 + 50

The specific solution is when additional information is given. Since (0) = 10

(0) = −2(0) + 50 = 10
⟹ + 50 = 10

⟹ = 10 − 50

⟹ = −40

∴ The specific solution when (0) = 10 is

( ) = −40( −2 ) + 50

Exercise:

1. Find the general and definite solution of the following difference equations
1
a) =4 −1 +6; 0 =1
b) = −4 −1 + 5 ; 0 =2
1
c) = − 2 −1 + 6 ; 0 = 0
d) = −2 −1 + 9 ; 0 = 4
e)
2. Find the general and the definite solution of the following differential equations
3
a) + 4 = 0 ; (0) = 1 d) 2 + 4 = 6 ; (0) =
2
b) = 2 ; (0) = 5 e) =4 ; (0) = 6
c) + 10 = 15 ; (0) = 0 f) = −5 ; (0) = 2

111
 5.2. Economic applications of Difference and Differential Equation
5.2.1. Uses of Difference Equation in Economics

Supply and Demand Analysis

If assume the demand and supply functions are both linear, then we have the following relations for
some positive a, b, c, and d.

=− +

= −

Where represents demand function and represents supply function.

In thus equations, it is implicitly assumed that only one time period is involved, that supply and demand
are independently only on the price in the period under consideration, and thus the equilibrium values
are attained instantaneously. However, for some goods, there is a time lag between supply and price.
For example, a farmer needs to decide precisely how much of any crop to sow well in advance of the
time to sale. This decision is made on the basis of the price at the time of planning and not on the price
prevailing at harvest time, which is unknown. In other word, the supply, , in period t depends on the
price, −1, in the preceding period − 1. Therefore, the time dependent supply and demand functions
can be written as

=− +

= −1 −

Assume that, with in each time period, demand and supply are equal, so that all goods are sold, then we
have equilibrium as
=

⇒− + = −1 −

⇒− = −1 − −

⇒ =− −1 + +

As you can observe, that last equation is a difference equation. So that, you can find the general and
specific (given additional information) solution using the usual method you applied in the previous.

Example:

The demand and supply functions are gives as

= −5 + 35
= 4 −1 − 10
Then, the expression for and when 0 = 6 assuming that market is in equalibrium.

112
Solution

At equilibrium
=

⇒ −5 + 35 = 4 −1 − 10

⇒ −5 =4 −1 − 10 − 35

⇒ = −0.8 −1 +9

General Solution is
= +
CF is when the constant is assumed to be zero
⇒
= −0.8 −1
⇒ = (−0.8) , where = 0
PS is when = −1 = , where is a constant value
= −0.8 −1 + 9
⇒ = −0.8 + 9
⇒ + 0.8 = 9
⇒ 1.8 = 9
9
⇒ = =5
1.8

∴ The general solution is

= +
⇒ = (−0.8) + 5
The specific solution when 0 = 6 is
= (−0.8) + 5
⇒ 0 = (−0.8) + 5 = 6
0

⇒ +5=6
⇒ =6−5
=1
∴ The specific solution is
= (−0.8) + 5
⇒ = (−0.8) + 5
In order to find the expression for , you can substitute the expression of in the demand equation as

= −5[(−0.8) + 5] + 35

⇒ = −5(−0.8) − 25 + 35
⇒ = −5(−0.8) + 10

113
 National Income Model
Lets assume a simplified two sector national income model which comprises only consumption (C) which
is a fucntion of income and investment (I) which is given as autonomous. That is

= +

= +

= ∗

Where b and ∗ denote autonoums consumption and investment, a is the marginal propensity to
consume, which lies in the range of 0 < < 1. In dealing with this, we are assuming implicitly that only
one time period is involved, that consumption depends on nationa income within this period and that
equalibrium values are attained instananouesly. However in practice, there is a time lag between
consumption and national income. Consumption, , in period t depends on national income, −1, in
the previous period − 1. Accordinlgy, consumption fucntion function is given by

= −1 +

Therfore, assuming that investment is autonous, the national income equlibrium can be given as

= + ∗

⇒ = −1 + + ∗

As we can observe, the last equation is in the form of differnce equation and thus can be solved using
the usual method.

Example:

Consider a two sector national income model given as

= + ∗

= 0.8 −1 + 100

= 200

Find an expression for when 0 = 1700.

Solution:

At national equilibrium, you have

= + ∗

⇒ = 0.8 −1 + 100 + 200

⇒ = 0.8 −1 + 300

114
 The general solution is the sum of comolementary fucntion and particluar fucntion
= +
CF is when the constant is assumed to be zero
⇒ = 0.8 −1
⇒ = (0.8) , where = 0
PS is when = −1 = , where is some constant value
= 0.8 −1 + 300
⇒ = 0.8 + 300
⇒ − 0.8 = +300
⇒ 0.2 = 300
300
⇒ = = 1500
0.2
∴The general solution is

= +
⇒ = (0.8) + 1500

The specific solution when 0 = 1700

= (0.8) + 1500
⇒ 0 = (0.8)0 + 1500 = 1700
⇒ (0.8)0 = 1700 − 1500
⇒ = 200
∴The specific solution is

= (0.8) + 1500

⇒ = 200(0.8) + 1500

5.2.2. Uses of Differential Equations in Economics

Supply and Demand Analysis:

If assume the demand and supply functions are both linear, then we have the following relations for
some positive a, b, c, and d.

=− +

= −

Where represents demand function and represents supply function.

In thus equations, it is implicitly assumed that only one time period is involved, that supply and demand
are independently only on the price in the period under consideration, and thus the equilibrium values
are attained instantaneously. However, we fail to consider how this is achieved. To be reasonable, the
rate of change of price is proportional to the excess of demand and supply ( − ). With some
adjustment coefficient, say , the rate of change of price with respect to time is expressed as

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 = ( − )

The assumption seems reasonable because

- If > , it gives ⁄ > 0 and so P increase in order to achieve a balance between supply
and demand
- If = , it gives ⁄ = 0 and so P remains constant at the equilibrium
- If < , it gives ⁄ < 0 and so P decrease in order to achieve a balance between supply
and demand
Substituting =− + and = − in the = ( − ) results in

= (− + − + )

=− ( + ) + ( + )

As we can observe, the last equation is in the form of differential equation and thus can be solved using
the usual method to find the expression of ( )

Example:

Consider a market model

= −5 + 20

=3 −4

= 0.2( − )

Find the expression for ( ), ( ) and ( ) when (0) = 2

Solution:

= 0.2( − )

⇒ = 0.2(−5 + 20 − 3 + 4)

⇒ = 0.2(−8 + 24)

⇒ = −1.6 + 4.8

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 The general solution is
( )= +
CF is when the constant is assumed to be zero
⇒ = −1.6

⇒ = −1.6

⇒∫ = ∫ −1.6

⇒ = −1.6 +

⇒ ()= −1.6 +

⇒ ( )= −1.6

⇒ ( )= −1.6 , =

The PS is when P(t) take some constant value D

= −1.6 + 4.8
⇒ 0 = −1.6 + 4.8
4.8
⇒ = =3
1.6
∴ The general solution is
( ) = −1.6 + 3
The specific solution when the additional information (0) = 2
( ) = −1.6 + 3
⇒ (0) = −1.6(0) + 3 = 2
⇒ =2−3
⇒ = −1
∴ The specific solution given (0) = 2 is
( ) = − −1.6 + 3
Accordingly, the corresponding values of ( ) and ( ) can be computed by substituting P(t) as
follows.

- For ()
= −5 + 20
⇒ ( ) = −5(− −1.6 + 3) + 20
⇒ ( ) = 5 −1.6 − 15 + 20
⇒ ( ) = 5 −1.6 + 5
- For ()
=3 −4

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 ⇒ ( ) = 3(− −1.6 + 3) − 4
⇒ ( ) = −3 −1.6 + 9 − 4
⇒ ( ) = −3 −1.6 + 5
National Income Determination:
Consider the usual two-sector model
= +
= +
= ∗

The first of these is simply a statement that the economy is already in balance. The left-hand side of
equation the first equation is the flow of money from firms to households given as payment for the
factors of production. The right-hand side is the total flow of money received by firms, either in the form
of investment, or as payment for goods bought by households. In practice, the equilibrium values are
not immediately attained and we need to make an alternative assumption about how national income
varies with time. It seems reasonable to suppose that the rate of change of Y is proportional to the
excess expenditure, ( + ) − : that is, with some adjustment coefficient

= ( + − )
- If C + I > , it gives dY/dt > 0 and so Y rises in order to achieve a balance between
expenditure and income
- If C + I = Y, it gives dY/dt = 0 and so Y is held constant at the equilibrium level
- If C + I < , it gives dY/dt < 0 and so Y falls in order to achieve a balance between
expenditure and income.
The usual relations and can be substituted into the new equation to obtain

= ( + + ∗ − )

⇒ = [( − 1) + + ∗ )]

⇒ = ( − 1) + + ∗ )

As we can observe, the last equation is in the form of differential equation and thus can be solved using
the usual method.

Example:

Consider the two-sector model

dY
= 0.5(C + I − Y )
dt
C = 0.8Y + 400

I = 600

Find an expression for Y(t) whenY(0) = 7000.

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Solution:
dY
= 0.5(C + I − Y )
dt
dY
⇒ = 0.5(0.8Y + 400 + 600 − Y )
dt
dY
⇒ = 0.5(0.8Y − Y + 1000 )
dt
dY
⇒ = 0.5[(0.8 − 1)Y + 1000 )]
dt
dY
⇒ = 0.5[−0.2Y + 1000 )]
dt
dY
⇒ = −0.1Y + 500
dt
The general solution is
( )= +
CF is when the constant is assumed to be zero
dY
⇒ = −0.1Y
dt
dY dt dt
⇒ = −0.1Y
dt Y Y
dY
⇒ = −0.1dt
Y
dY
⇒∫ = ∫ −0.1dt
Y

⇒ = −0.1t + C

⇒ ()= −0.1t+C

⇒ ( )= C −0.1t

⇒ ()= −0.1t, ℎ = C

The PS is when ( ) = , where D is some constant value

= −0.1 + 500
⇒ 0 = −0.1 + 500
500
⇒ =
0.1
⇒ = 5000

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 ∴ The general solution is
( ) = −0.1t + 5000
The specific solution when (0) = 7000 is
( ) = −0.1t + 5000

⇒ (0) = −0.1(0) + 5000 = 7000

⇒ = 7000 − 5000

⇒ = 2000

∴ The specific solution when (0) = 7000 is

( ) = 2000 −0.1t + 5000

120
121
Chapter Summary:
- A difference equation (sometimes called a recurrence relation) is an equation that relates
consecutive terms of a sequence of numbers
- A differential equation is an equation that involves the derivative of an unknown function
- Both difference equation and differential equations have general solution and definite solutions.
The general solution itself is composed of complementary function and particular solution.
- Both difference and differential equations can be applied in market equilibrium and national
income determinations analyses.

Exercise:

I. Solve the following

1. Find the expression of , if a two sector model is given as
= +
= 0.9 −1 + 250
= 350
0 = 6500
2. For the expression for and , when 0 = 11, assuming equilibrium and for a demand and
supply functions given respectively as
= −2 + 22
= −1 − 8
3. For the expression for and , when 0 = 8 , assuming equilibrium and for a demand and
supply functions given respectively as
= −2 + 80
= 3 −1 − 20
4. Find the expression of , if a two sector model is given as
= +
= 0.7 −1 + 400
= 0.1 −1 + 100
0 = 3000
II. Solve the following
1. Find the expression for ( ) when (0) = 2000
= 0.1( + − )
= 0.9 + 100
= 300
2. Find the expression of ( ), ( ), and ( ) of the market model when (0) = 1
=− +4
=2 −2
1
= ( − )
3
3. Find the expression for ( ) when (0) = 15000
= 0.5( + − )
= 0.7 + 500
= 0.2 + 500

122
BIBLOGRAPHY
Chiang, A. C., & Weinwright, K. (2005). Fundamental Methods of Mathematical Economics (4th
ed.). New York: McGraw-Hill/Irwin.

Jacques, I. (2006). Mathematics for Economics and Business (5th ed.). Eidenburgh Gate, Harlow:
Pearson Education Limited.

Rosser, M. (2003). Basic Mathematics for Economists (2nd ed.). London: Routledge.

Binges B.R. and Elizabeth Hoffman, Microeconomics with Calculus

Barnett, R.A. and Ziegler, M.R. Applied Calculus: For Business, Economics. Life Sciences,

And Social Science, and Social Sciences, Fourth Edition, Macmillan, Inc., 1991

Holden, K. and Pearson, A.W. Introductory Mathematics for Economics and Business.

Second Edition, Macmillan, 1992.

Henderson, J.M. and Quandt, R.E, Microeconomic Theory: a Mathematical Approach,

Third Edition, McGraw-Hill, 1980.

Louis Leithold, Essentials of Calculus, Harper & Row,1984

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