Mathematical Economics

Hasin Yousaf

Week 1

Equilibrium Analysis, Linear Models and Matrix Algebra

 Organizational Issues

Course Staff:

• Lecturer: Hasin Yousaf

Email: [email protected]

Office Hours: Wednesday 14:00 to 16:00 - QUAD 3120

• Tutor:

– Nadine Yamout [email protected]

 Organizational Issues

References:

• The website for this course is on UNSW Moodle at:

http://moodle.telt.unsw.edu.au

• The required textbook for this course:

• Alpha C. Chiang, Kevin Wainwright, Fundamental Methods of
Mathematical Economics, McGraw-Hill Education, 4th ed. 2005

• Other recommended textbooks:

• Simon, Carl P., Lawrence Blume, Mathematics for Economists, W.
W. Norton, 1994.
• Klein, W. Michael, Mathematical Methods for Economics, Addison
Wesley, 2002.
 Organizational Issues

Assessments:

• Two assignments (Week 3 and 8) → 20%

• Mid-Session Exam (100 minutes, Week 5) → 30%

• Final Exam (120 minutes, University Exam Period) → 50%

 Mathematical Economics?

• The purpose of this course is to provide you with a working knowl-

edge of the mathematical tools used in economic analysis.
 Partial Market Equilibrium - A Linear Model

Consider the so-called partial equilibrium model, i.e. a model of price

determination in an isolated market. To construct the model, the
following elements are required:

• Variables
– Quantity demanded of the commodity (Qd )
– Quantity supplied of the commodity (Qs )
– Price of the commodity (P )

• Equilibrium Condition
– Quantity demanded equals quantity supplied (Qd = Qs )

• Behavioural Equations
– Qd is a decreasing function of P Qd = a − bP (a, b > 0)
– Qs is an increasing function of P Qs = −c + dP (c, d > 0)
 Partial Market Equilibrium - A Linear Model

Graphical Solution

Qs = −c + dP (Supply)
a Qd = a − bP (Demand)

Q∗ = Q∗d = Q∗s (P ∗ , Q∗ )

0 P
P∗
-c
 Partial Market Equilibrium - A Linear Model

Analytical Solution

In equilibrium, quantity demanded equals quantity supplied. Let

Q = Qd = Qs . Rewrite the model equivalently as:
(
Q = a − bP
Q = −c + dP

Solving these two equations in two variables gives the solution:

a+c
P∗ =
b+d
∗ ad − bc
Q =
b+d

Note that to be economically meaningful, the model should contain the

additional restriction that ad > bc.
Click for Detailed Solution
 Partial Market Equilibrium - A Nonlinear Model

Now let the linear demand in the isolated market model be replaced by
a quadratic demand function. To construct the model, the following
elements are required:

• Variables
– Quantity demanded of the commodity (Qd )
– Quantity supplied of the commodity (Qs )
– Price of the commodity (P )

• Equilibrium Condition
– Quantity demanded equals quantity supplied (Qd = Qs )

• Behavioural Equations
– Qd is a decreasing function of P 2 Qd = 4 − P 2
– Qs is an increasing function of P Qs = 4P − 1
 Partial Market Equilibrium - A Nonlinear Model

Graphical Solution

Q
Qs = 4P − 1 (Supply)

Q∗ = Q∗d = Q∗s (1,3)

Qd = 4 − P 2 (Demand)

P
-2 0 P∗ 2
-1
 Partial Market Equilibrium - A Nonlinear Model

Analytical Solution

In the view of equating Qd and Qs by the equilibrium condition, let

Q = Qd = Qs . Rewrite the model equivalently as:
(
Q = 4 − P2
Q = 4P − 1

Solving these two equations in two variables gives the quadratic

equation:
P 2 + 4P − 5 = 0
The two solutions are: P1∗ = 1 and P2∗ = −5. But, only the first is
economically admissible, as negative prices are ruled out.
Given the equilibrium price P ∗ = 1, the equilibrium quantity is given
by
Q∗ = 3
Click for Detailed Solution
 General Market Equilibrium

• A more realistic depiction of the demand and supply functions

of a commodity should take into account the effect not only of
the price of the commodity itself, but also of the prices of related
commodities.

• When several interdependent commodities are simultaneously con-

sidered, equilibrium would require that quantity demanded equals
to quantity supplied for each and every commodity included in the
model.
Qdi = Qsi for i = 1, 2, ..., n

• The solution will then consist of a set of prices Pi∗ and correspond-
ing quantities Q∗i such that all commodities’ markets will be in
equilibrium.
 Two-Commodity Market Model

Consider a simple model in which only two commodities are related to

each other. To construct the model, the following elements are
required:

• Variables
– Quantity demanded of each commodity (Qd1 and Qd2 )
– Quantities supplied of each commodity (Qs1 and Qs2 )
– Price of each commodity (P1 and P2 )

• Equilibrium Condition
– Quantity demanded equals quantity supplied of each commodity
(Qd1 = Qs1 and Qd2 = Qs2 )

• Behavioural Equations
– Qd1 = a0 + a1 P1 + a2 P2 and Qd2 = α0 + α1 P1 + α2 P2
– Qs1 = b0 + b1 P1 + b2 P2 and Qs2 = β0 + β1 P1 + β2 P2
 Two-Commodity Market Model

Analytical Solution

In the view of equating Qd and Qs by the equilibrium condition, let

Q1 = Qd1 = Qs1 and Q2 = Qd2 = Qs2 . Rewrite the model equivalently
as:
(
(a0 − b0 ) + (a1 − b1 )P1 + (a2 − b2 )P2 = 0
(α0 − β0 ) + (α1 − β1 )P1 + (α2 − β2 )P2 = 0

Solving these two equations in two variables gives the equilibrium

prices:
c2 γ0 − c0 γ2
P1∗ =
c1 γ2 − c2 γ1
c0 γ 1 − c1 γ 0
P2∗ =
c1 γ2 − c2 γ1
where ci = ai − bi and γi = αi − βi (i = 0, 1, 2)
Click for Detailed Solution
 Equilibrium in National-Income Analysis

Consider the simple Keynesian national-income model:

Y = C + I0 + G0
C = a + bY (a > 0, 0 < b < 1)
where Y and C stand for endogenous variables national income and con-
sumption expenditure, respectively. I0 and G0 represent the exogenously
determined investment and government expenditures.

Solving these two equations in two variables gives the equilibrium

national income and consumption expenditure:
a + I0 + G0
Y∗ =
1−b
a + b(I0 + G0 )
C∗ =
1−b
The restriction b 6= 1 is necessary to ensure the denominator is non-zero.
Since b, the marginal propensity to consume is assumed to be a positive
fraction, this restriction is automatically satisfied.
Click for Detailed Solution
 Linear Models and Matrix Algebra

• So far, the models we have considered are relatively simple, even

though a number of parameters are involved.

• As more and more variables (e.g. commodities) are incorporated

into the model, the solution methods we have considered quickly
become cumbersome and unwieldy.

• One method which is suitable for handling a large system of simul-

taneous equations is matrix algebra.

• Matrix algebra
– provides a compact way of writing an equation system;
– leads to a way of testing the existence of a solution;
– gives a method of finding the solution (if it exists).
 Matrices as Arrays

Definition: Matrix

An m × n matrix is a rectangular array with m rows and n

columns:
 
a11 a12 · · · a1n
 a21 a22 · · · a2n 
A = [aij ]m×n =  .
 
.. .. ..
 ..

. . . 
am1 am2 ··· amn

The number of rows and the number of columns in a matrix together

define the dimension of the matrix. Since the matrix A in the definition
contains m rows and n columns, it is said to be of dimension m × n.

In the special case where m = n, the matrix is called a square matrix.

 Matrices as Arrays

Definition: Linear System

A linear system of n equations and n unknowns

a11 x1 + a12 x2 + · · · + a1n xn = d1

a21 x1 + a22 x2 + · · · + a2n xn = d2
.. .. .. ..
. . . .
an1 x1 + an2 x2 + · · · + ann xn = dn

can be written in the form Ax = d where

     
a11 a12 · · · a1n x1 d1
 a21 a22 · · · a2n   x2   d2 
A= . .. , x =  .. , d = 
     
.. .. ..
 ..

. . .   .   . 
an1 an2 · · · ann xn dn
 Matrices as Arrays

For example, the following system of equations

x1 + 2x2 − x3 =4
3x1 + 5x2 =5
−x1 − 3x2 + 6x3 =7

can be written in the form Ax = d where

     
1 2 −1 x1 4
A= 3 5 0  , x =  x2  , d =  5 
−1 −3 6 x3 7
 Vectors as Special Matrices

Definition: Column Vector

A column vector is an m × 1 matrix, i.e. a matrix with only one

column:  
x1
 x2 
xm×1 =  . 
 
 .. 
xm

Definition: Row Vector

A row vector is an 1 × n matrix, i.e. a matrix with only one row:

x1×n = x1 x2 . . . xm
 
5
For example, x2×1 = is a column vector.
12

For example, x1×4 = 2 6 8 1 is a row vector.
 Matrix Operations

Definition: Matrix Addition

The sum of two m × n matrices A = [aij ]m×n and B = [bij ]m×n

is the component-wise sum:
 
a11 + b11 ··· a1n + b1n
 a21 + b21 ··· a2n + b2n 
A+B = (aij )m×n +(bij )m×n = 
 
.. .. .. 
 . . . 
am1 + bm1 ··· amn + bmn

The sum of matrices is defined if an only if they have the same

dimension, i.e. the matrices should be conformable for addition.

For example,
       
3 4 −1 0 3−1 4+0 2 4
 6 7 + 6 5  =  6 + 6 7 + 5  =  12 12 
−1 3 −1 3 −1 − 1 3 + 3 −2 6
 Matrix Operations

Definition: Matrix Subtraction

The difference of two m × n matrices A = [aij ]m×n and B =

[bij ]m×n is the component-wise difference:
 
a11 − b11 · · · a1n − b1n
 a21 − b21 · · · a2n − b2n 
A−B = (aij )m×n −(bij )m×n = 
 
.. .. .. 
 . . . 
am1 − bm1 · · · amn − bmn

The difference of matrices is defined if an only if they have the same

dimension, i.e. the matrices should be conformable for subtraction.

For example,
       
19 3 6 8 19 − 6 3−8 13 −5
− = =
2 0 1 3 2−1 0−3 1 −3
 Matrix Operations

Definition: Scalar Multiplication

The product of an m × n matrix A = [aij ]m×n with a scalar

r ∈ R is the component-wise multiplication:
 
ra11 · · · ra1n
 ra21 · · · ra2n 
rA = (raij )m×n =  .
 
.. .. 
 .. . . 
ram1 ··· ramn

For example,
     
3 2 2×3 2×2 6 4
 1 6   2×1 2×6   2 12 
2 = = 
 7 3   2×7 2 × 3   14 6 
8 −2 2×8 2 × −2 16 −4
 Matrix Operations

Definition: Matrix Multiplication

The product of an m × n matrices A = [aij ]m×n and an n × p

matrix B = [bij ]n×p is the m × p matrix C = [cij ]m×p whose
element in the ith row and the j th column is the product on the
ith row of A and the j th column of B. That is,
n
X
cij = air brj = ai1 b1j + ai2 b2j + · · · + ain bnj
r=1

The product AB is defined only if the number of columns of the matrix

A is equal to the number of rows of the matrix B.

For example,
     
1 3   1(5) + 3(9) 32
 2 8 × 5 =  2(5) + 8(9)  =  82 
9
4 0 4(5) + 0(9) 20
 Matrix Operations

Exercise

Let      
3 5 1 2   1
1
A= 2 1 ,B =  4 7 ,C = ,D =  0 
3
6 0 0 3 0

Compute each of the following matrices, if defined.

(i) (A + D)C

(ii) (A − B)C

(iii) (A + B)D

Click for Detailed Solution

 Commutative, Associative and Distributive Laws

Theorem: Matrix Addition Laws

If A, B, and C are matrices with dimension m × n such that the

given operations are defined, then the basic properties of matrix
addition are:
• Commutative Law A+B =B+A

• Associative Law (A + B) + C = A + (B + C)
 Commutative, Associative and Distributive Laws

Theorem: Matrix Multiplication Laws

If A, B, and C are matrices whose dimensions are such that the

given operations are defined, then the basic properties of matrix
multiplication are:
• AB 6= BA except in special cases.

• AB = 0 does not imply that A or B is 0.

• AB = AC and A 6= 0 do not imply that B = C

• Associative Law (AB)C = A(BC)

• Left Distributive Law A(B + C) = AB + AC

• Right Distributive Law (A + B)C = AC + BC

 Linear Dependence

Definition: Linear Dependence

A set of vectors v1 , ..., vn is said to be linearly dependent if and

only if one of the vectors can be written as a linear combination
of the others.

The vectors are linearly independent if none of the vectors can

be written as a linear combination of the others.

     
2 1 4
For example, the three vectors v1 = , v2 = , and v3 =
7 8 5
are linearly dependent because v3 is a linear combination of v1 and v2 .
     
6 2 4
3v1 − 2v2 = − = v1 = = v3
21 16 5

The last equation is alternatively expressible as 3v1 − 2v2 − v3 = 0

 Linear Dependence

Theorem: Linear Dependence

Consider a set of vectors v1 , ..., vn and scalars k1 , ..., kn . These

vectors are linearly independent if and only if

k1 v1 + k2 v2 + ... + kn vn = 0

has a unique solution given by k1 = k2 = ... = kn = 0.

The vectors are linearly dependent if and only if there exists
k1 , ..., kn with at least one ki 6= 0 for i = 1, ..., n.

Exercise
     
1 1 1
Show that v1 =  −1 , v2 =  0 , v3 =  −2  are linearly
0 1 −1
dependent.

Click for Detailed Solution

Detailed Solutions
Substitute the first equation into the second equation

a − bP = −c + dP

Rearrange to have P on one side of the above equation

(b + d)P = a + c

The result is the solution for equilibrium price P ∗

a+c
P∗ =
b+d

To find the equilibrium quantity Q∗ , substitute P ∗ into either demand

or supply equation.
(a + c) a(b + d) − b(a + c) ad − bc
Q∗ = a − b = =
b+d b+d b+d

Go Back
 Theorem: Quadratic Equation

Given a quadratic equation of the form

ax2 + bx + c = 0

there are two roots, which can be obtained from the quadratic
formula √
∗ ∗ −b ± b2 − 4ac
x1 , x2 =
2a

For the equation P 2 + 4P − 5 = 0, the two roots are given as

√
∗ ∗ −4 ± 16 + 20
P1 , P2 = = 1, −5
2

To find the equilibrium quantity Q∗ , substitute the positive P ∗ into

either demand or supply equation.
Q∗ = 4 × 1 − 1 = 3
Go Back
Let ci = ai − bi and γi = αi − βi (i = 0, 1, 2), then the system of
two equations can be rewritten as

(
c1 P1 + c2 P2 = −c0
γ1 P1 + γ2 P2 = −γ0

From the first equation, it can be found that P2 = −(c0 + c1 P1 )/c2 .

Substituting this into the second equation and solving gives
c2 γ0 − c0 γ2
P1∗ =
c1 γ2 − c2 γ1
From the second equation, it can be found that P1 = −(γ0 + γ1 P1 )/γ2 .
Substituting this into the first equation and solving gives
c0 γ1 − c1 γ0
P2∗ =
c1 γ2 − c2 γ1
Note that we must require the common denominator to be nonzero, i.e.
c1 γ2 6= c2 γ1 .
Go Back
Substitute the second equation into the first equation to reduce the
system into a single equation in one variable, Y.

Y = a + bY + I0 + G0
(1 − b)Y = a + I0 + G0

The result is the solution value of equilibrium national income Y ∗

a + I0 + G0
Y∗ =
1−b
To find equilibrium consumption expenditure C ∗ , substitute Y ∗ into
the consumption equation

b(a + I0 + G0 ) a + b(I0 + G0 )
C ∗ = a + bY ∗ = a + =
1−b 1−b
Go Back
 (i) Since A is a 3 × 2 matrix and D is a 3 × 1 matrix, (A + D)C is not
defined.
(ii)
   
3 5 1 2  
1
(A − B)C =  2 1  −  4 7 
3
6 0 0 3
 
2 3  
1
=  −2 −6 
3
6 −3
 
(2)(1) + (3)(3)
=  (−2)(1) + (−6)(3) 
(6)(1) + (−3)(3)
 
11
=  −20 
−3
(iii) (A + B) is a 3 × 2 matrix and D is a 3 × 1 matrix. Since the number
of columns of (A + B) is not equal to the number of rows of D ,
(A + B)D is not defined.
Go Back
Consider the equation

k1 v1 + k2 v2 + k3 v3 = 0
       
1 1 1 0
k1  −1  + k2  0  + k3  −2  =  0 
0 1 −1 0

which can be written as

k1 + k2 + k3 =0
−k1 − 2k3 =0
k2 − k3 =0

The third equations implies that k2 = k3 and substitution reduces

the first and second equations to k1 + 2k2 = 0 which can be solved
by k2 = −1/2 and k1 = 1. Therefore, the system can be solved by
k = (1, −1/2, −1/2). Therefore, the vectors are linearly dependent.
Go Back