Economic Models:
Basic Mathematical Tools
applied in economics
Why models?
Simplified representations of reality play a
crucial role in economics.
Models in Economics
A model is a simplified representation
of a real situation that is used to better
understand real-life situations.
Create a real but simplified economy
Simulate an economy on a computer
Ex.: Tax models, money models
The other things equal
assumption means that all other
relevant factors remain unchanged.
Functional
Relationships
Relationship between two variables, for e.g.
price and output sold, expressed in various
ways
Table or graph
Use of equations Quantity sold depends
on the price, in other words quantity sold is
a function
Q f (ofp)price.
200 5 p
P is the independent value and Q is the
dependent value
Marginal Concepts & Slope
of a Curve
Marginal Value is defined as change in a
dependent value associated with a 1-unit
change in an independent value.
For e.g. change in total revenue earned by
a firm associated with an increase in output
sold by one unit, is the marginal revenue
TR PQ
MR=Change in TR associated with change
in Q
Tabular form
Representation
Q P=100-10Q
TR=100Q-10Q2
AR
MR
0 100
1 90
90
90
90
2 80
160
80
70
3 70
210
70
50
4 60
240
60
30
5 50
250
50
10
6 40
240
40
-10
Graphical Representation &
Concept of Slope & Curvature
TR
B
C
A
TR
Changes in Slope
Slope of TR Curve at a particular
point represents MR at a particular
output, i.e., change in TR for an
infinitesimal change in output level
Implication of slope for any variable
implies marginal value of the same
variable
Curvature depends on changes in
slope or changes in marginal value
Changes in Curvature
Linear Curve Marginal value
constant, no change in curvature
Curve Convex to the origin Marginal
value (Slope) changing at an
increasing rate
Curve Concave to the origin
Marginal value ( Slope) changing at a
decreasing rate
Linear Curve
Slope = constant/ curvature =none
Concave to the origin
Slope = positive decreasing/ curvature =concave t
Convex to the origin
Slope = positive increasing/ curvature =convex to th
Concave to the origin
Slope = negative decreasing/ curvature =concave to
Convex to the origin
Slope =negative increasing/ curvature =convex to th
Average and Marginal
Graphically Average value can be derived from
the total value curve.
Average at a point on the Total value curve is
equal to the slope of the ray from the origin to
that particular point
To increase (decrease) the average value,
Average value should be less (more) than the
Marginal value
Average Value constant implies its equality with
Marginal Revenue
Find out from Total Cost,
Average, & Marginal Cost
AC = TC/Q
MC =
TC/Q
Q
0
1
2
3
4
5
TC AC MC
20 140 140 120
160 80 20
180 60 20
240 60 60
480 96 240
Average Cost (AC)
AC = TC/Q
Q
0
1
2
3
4
5
TC AC MC
20 140 140 120
160 80 20
180 60 20
240 60 60
480 96 240
Total, Average, and
Marginal Cost
AC = TC/Q
MC =
TC/Q
Q
0
1
2
3
4
5
TC AC MC
20 140 140 120
160 80 20
180 60 20
240 60 60
480 96 240
Total, Average, and Marginal Cost
TC ($)
240
180
120
60
0
0
AC, MC ($)
Q
MC
AC
120
60
0
0
Concept of the
Derivative
The derivative of Y with respect
to X is equal to the limit of the
ratio Y/X as X approaches
zero.
dY
Y
lim
dX X 0 X
Rules of Differentiation
Constant Function Rule: The derivative
of a constant, Y = f(X) = a, is zero for
all values of a (the constant).
Y f (X ) a
dY
0
dX
Rules of Differentiation
Power Function Rule: The
derivative of a power function,
where a and b are constants, is
defined as follows.
Y f (X ) aX
dY
b 1
baX
dX
Rules of Differentiation
Sum-and-Differences Rule: The
derivative of the sum or difference of
two functions U and V, is defined as
follows.
U g(X )
V h( X )
Y U V
dY
dU
dV
dX
dX
dX
Rules of Differentiation
Product Rule: The derivative of the
product of two functions U and V, is
defined as follows.
U g(X )
V h( X )
Y U V
dY
dV
dU
U
V
dX
dX
dX
Rules of Differentiation
Quotient Rule: The derivative
of the ratio of two functions U
and V, is defined as follows.
V h( X )
U g( X )
dY
dX
V dU
dX
U
Y
V
U dV
dX
Rules of Differentiation
Chain Rule: The derivative of a
function that is a function of X is
defined as follows.
Y f (U ) U g ( X )
dY dY dU
dX dU dX
Using derivatives to solve max and min
problems
Optimization With Calculus
To optimize Y = f (X):
First Order Condition:
Find X such that dY/dX = 0
Second Order Condition:
A. If d2Y/dX2 > 0, then Y is a
minimum.
OR
CENTRAL POINT
The dependent variable is maximized
when its marginal value shifts from
positive to negative, and vice versa
