Lecture Notes1 Mathematical Ecnomics Guoqiang TIAN Department of Economics Texas A&M University College Station, Texas 77843 ([email protected]) This version: August 2018 1The lecture notes are only for the purpose of my teaching and convenience of my students in class, please not put them online or pass to any others. Contents 1 The Nature of Mathematical Economics 1 1.1 Economics and Mathematical Economics . 1 1.2 Advantages of Mathematical Approach . 2 2 Economic Models 4 2.1 Ingredients of a Mathematical Model . 4 2.2 The Real-Number System . 4 2.3 The Concept of Sets . 5 2.4 Relations and Functions . 7 2.5 Types of Function . 8 2.6 Functions of Two or More Independent Variables . 10 2.7 Levels of Generality . 10 3 Equilibrium Analysis in Economics 12 3.1 The Meaning of Equilibrium . 12 3.2 Partial Market Equilibrium - A Linear Model . 12 3.3 Partial Market Equilibrium - A Nonlinear Model . 14 3.4 General Market Equilibrium . 16 3.5 Equilibrium in National-Income Analysis . 19 4 Linear Models and Matrix Algebra 20 4.1 Matrix and Vectors . 20 4.2 Matrix Operations . 23 4.3 Linear Dependance of Vectors . 25 4.4 Commutative, Associative, and Distributive Laws . 26 i 4.5 Identity Matrices and Null Matrices . 27 4.6 Transposes and Inverses . 29 5 Linear Models and Matrix Algebra (Continued) 32 5.1 Conditions for Nonsingularity of a Matrix . 32 5.2 Test of Nonsingularity by Use of Determinant . 34 5.3 Basic Properties of Determinants . 38 5.4 Finding the Inverse Matrix . 42 5.5 Cramer's Rule . 45 5.6 Application to Market and National-Income Models . 49 5.7 Quadratic Forms . 51 5.8 Eigenvalues and Eigenvectors . 54 5.9 Vector Spaces . 56 6 Comparative Statics and the Concept of Derivative 62 6.1 The Nature of Comparative Statics . 62 6.2 Rate of Change and the Derivative . 63 6.3 The Derivative and the Slope of a Curve . 64 6.4 The Concept of Limit . 64 6.5 Inequality and Absolute Values . 68 6.6 Limit Theorems . 69 6.7 Continuity and Differentiability of a Function . 70 7 Rules of Differentiation and Their Use in Comparative Statics 73 7.1 Rules of Differentiation for a Function of One Variable . 73 7.2 Rules of Differentiation Involving Two or More Functions of the Same Vari- able . 76 7.3 Rules of Differentiation Involving Functions of Different Variables . 79 7.4 Integration (The Case of One Variable) . 82 7.5 Partial Differentiation . 84 7.6 Applications to Comparative-Static Analysis . 87 7.7 Note on Jacobian Determinants . 89 ii 8 Comparative-static Analysis of General-Functions 92 8.1 Differentials . 93 8.2 Total Differentials . 95 8.3 Rule of Differentials . 96 8.4 Total Derivatives . 97 8.5 Implicit Function Theorem . 100 8.6 Comparative Statics of General-Function Models . 104 8.7 Matrix Derivatives . 105 9 Derivatives of Exponential and Logarithmic Functions 107 9.1 The Nature of Exponential Functions . 107 9.2 Logarithmic Functions . 108 9.3 Derivatives of Exponential and Logarithmic Functions . 109 10 Optimization: Maxima and Minima of a Function of One Variable 111 10.1 Optimal Values and Extreme Values . 111 10.2 General Result on Maximum and Minimum . 112 10.3 First-Derivative Test for Relative Maximum and Minimum . 113 10.4 Second and Higher Derivatives . 115 10.5 Second-Derivative Test . 116 10.6 Taylor Series . 118 10.7 Nth-Derivative Test . 120 11 Optimization: Maxima and Minima of a Function of Two or More Vari- ables 122 11.1 The Differential Version of Optimization Condition . 122 11.2 Extreme Values of a Function of Two Variables . 123 11.3 Objective Functions with More than Two Variables . 128 11.4 Second-Order Conditions in Relation to Concavity and Convexity . 130 11.5 Economic Applications . 133 12 Optimization with Equality Constraints 136 12.1 Effects of a Constraint . 136 iii 12.2 Finding the Stationary Values . 137 12.3 Second-Order Condition . 141 12.4 General Setup of the Problem . 143 12.5 Quasiconcavity and Quasiconvexity . 145 12.6 Utility Maximization and Consumer Demand . 149 13 Optimization with Inequality Constraints 152 13.1 Non-Linear Programming . 152 13.2 Kuhn-Tucker Conditions . 155 13.3 Economic Applications . 160 14 Linear Programming 164 14.1 The Setup of the Problem . 164 14.2 The Simplex Method . 166 14.3 Duality . 174 15 Continuous Dynamics: Differential Equations 177 15.1 Differential Equations of the First Order . 177 15.2 Linear Differential Equations of a Higher Order with Constant Coefficients 180 15.3 Systems of the First Order Linear Differential Equations . 184 15.4 Economic Application: General Equilibrium . 190 15.5 Simultaneous Differential Equations. Types of Equilibria . 194 16 Discrete Dynamics: Difference Equations 197 16.1 First-order Linear Difference Equations . 199 16.2 Second-Order Linear Difference Equations . 201 16.3 The General Case of Order n . 202 16.4 Economic Application:A dynamic model of economic growth . 203 17 Introduction to Dynamic Optimization 205 17.1 The First-Order Conditions . 205 17.2 Present-Value and Current-Value Hamiltonians . 207 17.3 Dynamic Problems with Inequality Constraints . 208 17.4 Economics Application:The Ramsey Model . 208 iv Chapter 1 The Nature of Mathematical Economics The purpose of this course is to introduce the most fundamental aspects of the mathe- matical methods such as those matrix algebra, mathematical analysis, and optimization theory. 1.1 Economics and Mathematical Economics Economics is a social science that studies how to make decisions in face of scarce resources. Specifically, it studies individuals' economic behavior and phenomena as well as how individual agents, such as consumers, households, firms, organizations and government agencies, make trade-off choices that allocate limited resources among competing uses. Mathematical economics is an approach to economic analysis, in which the e- conomists make use of mathematical symbols in the statement of the problem and also draw upon known mathematical theorems to aid in reasoning. Since mathematical economics is merely an approach to economic analysis, it should not and does not differ from the nonmathematical approach to economic analysis in any fundamental way. The difference between these two approaches is that in the former, the assumptions and conclusions are stated in mathematical symbols rather than words and in the equations rather than sentences so that the interdependent relationship among economic variables and resulting conclusions are more rigorous and concise by using math- 1 ematical models and mathematical statistics/econometric methods. The study of economic social issues cannot simply involve real world in its experiment, so it not only requires theoretical analysis based on inherent logical inference and, more often than not, vertical and horizontal comparisons from the larger perspective of history so as to draw experience and lessons, but also needs tools of statistics and econometrics to do empirical quantitative analysis or test, the three of which are all indispensable. When conducting economic analysis or giving policy suggestions in the realm of modern eco- nomics, the theoretical analysis often combines theory, history, and statistics, presenting not only theoretical analysis of inherent logic and comparative analysis from the historical perspective but also empirical and quantitative analysis with statistical tools for exami- nation and investigation. Indeed, in the final analysis, all knowledge is history, all science is logics, and all judgment is statistics. As such, it is not surprising that mathematics and mathematical statistics/econometrics are used as the basic analytical tools, and also become the most important analytical tools in every field of economics. For those who study economics and conduct research, it is necessary to grasp enough knowledge of mathematics and mathematical statistics. There- fore, it is of great necessity to master sufficient mathematical knowledge if you want to learn economics well, conduct economic research and become a good economist. 1.2 Advantages of Mathematical Approach Mathematical approach has the following advantages: (1) It makes the language more precise and the statement of assumptions more clear, which can deduce many unnecessary debates resulting from inaccurate definitions. (2) It makes the analytical logic more rigorous and clearly states the boundary, application scope and conditions for a conclusion to hold. Otherwise, the abuse of a theory may occur. (3) Mathematics can help obtain the results that cannot be easily attained through intuition. (4) It helps improve and extend the existing economic theories. 2 It is, however, noteworthy a good master of mathematics cannot guarantee to be a good economist. It also requires fully understanding the analytical framework and research methodologies of economics, and having a good intuition and insight of real economic environments and economic issues. The study of economics not only calls for the understanding of some terms, concepts and results from the perspective of mathematics (including geometry), but more importantly, even when those are given by mathematical language or geometric figure, we need to get to their economic meaning and the underlying profound economic thoughts and ideals. Thus we should avoid being confused by the mathematical formulas or symbols in the study of economics. All in all, to become a good economist, you need to be of original, creative and academic way of thinking. 3 Chapter 2 Economic Models 2.1 Ingredients of a Mathematical Model A economic model is merely a theoretical framework, and there is no inherent reason why it must mathematical. If the model is mathematical, however, 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.