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Quantitative Methods for Economic Analysis

EC2104
Lecturer: Chua Yeow Hwee

Lecture 1
11th August 2015

John Maynard Keynes

The master-economist must possess a rare combination of

gifts .... He must be mathematician, historian, statesman,


philosopher in some degree. He must understand symbols
and speak in words. He must contemplate the particular, in
terms of the general, and touch abstract and concrete in the
same flight of thought. He must study the present in the light
of the past for the purposes of the future. No part of mans
nature or his institutions must be entirely outside his regard.
He must be purposeful and disinterested in a simultaneous
mood, as aloof and incorruptible as an artist, yet sometimes
as near to earth as a politician.

Outline

Readings: SH, Chapters 4, 5.1-5.4


Models in Economic Analysis
Logic
Functions of one variable
Common functional forms
Shifting Graphs
Composite Functions
Inverse Functions

Models in Economic Analysis

Real world is complex.


An economic model is a simplified analytical framework to

analyze important factors and relationships.


The structure of a model is described by equations.
Equations relate a number of variables to model key economic

relationships.
Working with equations, the aim is to derive a set of logical

conclusions that follow from the assumptions.


This course is designed to give you the tools to make those

conclusions.

An equation is a mathematical statement setting two

algebraic expressions equal to one another.


Definitional equations: Sets up an identity between two

alternative expressions that have exactly the same meaning.


R C
Behavioral equations: Specifies the manner in which a variable

behaves in response to changes in other variables.


C = 75 + 10Q
Sleep
HW
Conditional equations: States a requirement to be satisfied.
For example, the standard market model requires the
equilibrium condition, which describes the pre-requisite for
there to be an equilibrium in the market:
U=

Quantity demanded = Quantity supplied

Simple Logic

P is a sufficient condition for Q ( If P, then Q)


P is a necessary condition for Q ( If Q, then P)
P is a necessary and sufficient condition for Q ( P if and only

if Q)
Example: If x is a square, then it is a rectangle. However, if x

is a rectangle, it need not be a square!

Functions of One Variable


If y depends on the value of x, we might be able to say that y

is a function of x, or
y = f (x)
Here, f is the function. The actual symbol for the function is

not important, but f and g are commonly used for generic


functions. f (x) is the value that the function generates when
given input x.
x is the independent variable or the argument, and y is the

dependent variable. Again, the symbols are unimportant


(e.g. Q = D(P), Cost = C (Output), R = R(x))
Every value of x must generate a unique value of y = f (x) for

f to be a valid function. However, there can be multiple


values of x that generate the same y .

Functions of One Variable


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

x
-4

-3

-2

-1

0
-1

Domain and Range of a Function

The domain of function f is the set of values of the argument

x for which the function is defined.


The range of function f is the set of possible resulting values

of f (x).

Formal Definition of a Function

A function f of a variable x with domain D is a rule that assigns a


unique number f (x) to each x in D.

A Note on Graphing Functions


In economics, we generally use Cartesian coordinates, aka xy

or xyz coordinates.
In most graphs, the independent variable goes on the x-axis

and the dependent variable goes on the y -axis.


In price-quantity graphs in economics, the reverse is true.
Price, the independent variable, is always on the y -axis.
Example: Demand functions. D(p) = 6 2p
Quantity
7

Price
4

2
2

1
1

Price

0
0

Quantity

0
0

Common Functions
Here are some types of functions frequently encountered in
economics:
Polynomial function: f (x) = an x n + an1 x n1 + ... + a1 x + a0
where n is a non-negative integer, and the coefficients ai are
constants
Linear function: f (x) = ax + b where a and b are constants
Quadratic function: f (x) = ax 2 + bx + c where a, b and c are

constants
(x)
Rational function: f (x) = gh(x)
where g (x) and h(x) are

polynomials and h(x) 6= 0.


Power function: f (x) = ax r where a and r are constants, and

x >0
Exponential function: f (x) = Cax , where C and a are positive

constants.
Logarithmic function: f (x) = loga x, where a is a positive

constant.

Polynomial Functions
General form for a polynomial function:
f (x) = a0 + a1 x + a2 x 2 + ... + an x n
where n is a non-negative integer and a0 , a1 , a2 , ..., an are
constants.
Terminology:
The superscript indicators of the powers of x are called

exponents. The highest power, n, is called the degree of the


polynomial.
Depending on the degree n, we have the following subclasses:
Constant function (n = 0): f (x) = a0
Linear function (n = 1): f (x) = a0 + a1 x
Quadratic function (n = 2): f (x) = a0 + a1 x + a2 x 2
Cubic function (n = 3): f (x) = a0 + a1 x + a2 x 2 + a3 x 3

Linear Function
We often deal with linear relationships in economics.
y = f (x) = ax + b
Slope defined as 4y
4x .
Take 2 points that lie on the line: (x1 , y1 ) and (x2 , y2 ).
Since they lie on the line, these are the same as (x1 , ax1 + b)

and (x2 , ax2 + b).


Slope is then

(ax2 + b) (ax1 + b)
a(x2 x1 )
=
=a
x2 x1
x2 x1
If x = 0, then y = f (0) = a 0 + b = b, so b is the y -intercept.
Graph is a straight line with slope a and y -intercept b.

Linear Functions

Here are some useful formulas:


Point-slope formula of a straight line: The equation of the

straight line passing through (x1 , y1 ) with slope a is:


y y1 = a(x x1 )
Point-point formula of a straight line: The equation of the

straight line passing through (x1 , y1 ) and (x2 , y2 ), where


x1 6= x2 , is:
y2 y1
(x x1 )
y y1 =
x2 x1

Example: Market Model


Suppose the market demand and supply are given by the following
behavioral equations.
Demand: q D = 10 2p, Supply: q S = 5 + 3p
Market equilibrium requires the following:

qD = qS
10 2p = 5 + 3p p = 3
qD

When p = 3,
= 4, q S = 4.
Alternatively, we can write the equilibrium condition as:
qD = q = qS
Substituting this into the behavioral equations, we get the
following system of two equations:
q = 10 2p
q = 5 + 3p
We can solve these simultaneously to obtain p = 3, q = 4.

Graphical Solution
Demand: q D = 10 2p, Supply: q S = 5 + 3p
Price
5
qS = -5 + 3p
4

qD = 10 - 2p

Quantity

0
0

10

Quadratic Functions
Quadratic functions are polynomial functions of degree 2:
f (x) = a + bx + cx 2
Example: Solve 2x 2 + x 6 = 0 (find the roots). Draw the graph
of the function y = f (x) = 2x 2 + x 6.
Solution 1: By factoring:

2x 2 + x 6 = 0
3
(2x 3)(x + 2) = 0 x = , x = 2
2
Solution 2: Using the quadratic formula. The quadratic

b 2 4ac
formula states that for ax 2 + bx + c = 0, x = b 2a
as
2
long as b 4ac 0 and a 6= 0. Plugging in a = 2, b = 1 and
c = 6 into the equation, we get:
p

1 12 4(2)(6)
1 49
x=
x =
22
4
which simplifies to x = 32 , x = 2.

How to graph a quadratic function

Take the roots of the function. In example, the roots of

2x 2 + x 6 are, as we found, x = 2 and x = 32 .


Quadratic functions have parabolas as graphs. Find the vertex
of the parabola:
For a quadratic function in the form ax 2 + bx + c, the vertex
b
1
occurs at x = 2a
. In the example, this is x = 22
= 14 .
Plug this x value into the function to find the y -coordinate of
the vertex. Example:

1
y = 2x + x 6 = 2
4
2

2

1
+
4


6 = 6

1
8

Graph of 2x 2 + x 6
y
1
(3/2, 0)

(-2, 0)

0
-3

-2

-1

0
-1

-2

-3

-4

-5

-6
(-1/4, -6 1/8)
-7

Rational Functions
P(x)
that can be
A rational function is a function R(x) = Q(x)
expressed as the ratio of two polynomials P(x) and Q(x).

This function is defined for all x where Q(x) 6= 0.


The rational function R(x) is proper if the degree of P(x) is

less than the degree of Q(x). It is improper if the degree of


P(x) is greater than the degree of Q(x).
Example: One of the simplest types of rational function is
R(x) =

ax + b
cx + d

(c 6= 0)

The graph of R(x) is a hyperbola.


When a = d = 0, the function has the form f (x) = kx where

k = b/c. Example: Graph of y = x5 .

Power Functions

A function f is a power function if it is defined by the formula


y = f (x) = ax r for all x > 0
for some fixed constants a and r .
Three classes (for a > 0):
r > 1: function is increasing and convex.
0 < r < 1: function is increasing and concave.
r < 0: function is decreasing and convex.

Graphs of Power Functions (a = 1, r > 1)


y
x4 x3

x2

0
0

Graphs of Power Functions (a = 1, 0 < r < 1)


y
2
x1/2
x1/3
x1/4
1

0
0

Graphs of Power Functions (a = 1, r < 0)


y
4

1
x-1/2
x-1
x-2

0
0

Exponential Functions
A quantity y that increases (or decreases) by a fixed factor when x
increases by 1 is said to increase (or decrease) exponentially. If the
fixed factor is a > 0, then y is an exponential function f of x where
y = f (x) = Cax for all x 0

To see this, if f (x) = Cax , then

f (x + 1) = Cax+1 = Cax a1 = af (x)

f (x + 1)
=a
f (x)

If a > 1 then f (x) is increasing and if 0 < a < 1, then f (x) is

decreasing.
Exponential functions with x = t, or time, are used in

studying economic growth, population growth, continuously


accumulated interest, radioactive decay, etc.

The Natural Exponential Function

The most common base (a in Cax ) of an exponential function is


the irrational number e 2.71828.
The corresponding exponential function f (x) = e x is called

the natural exponential function. This can also be written as


f (x) = exp(x).
Many formulas in calculus become much simpler when e is

used as the base for exponential functions.

Graph of y = e x and y = 5e x
y
5ex

10

ex

0
-5

-4

-3

-2

-1

Example: Compound Interest

A savings account of K that increases by p% interest each year


p t
) . Why?
will have increased after t years to K (1 + 100
p
Notice that at t = 1, the amount of money is K (1 + 100
). At
p
p 2
p
t = 2, this becomes (1 + 100 ) K (1 + 100 ) = K (1 + 100
) . At
p T
time t = T , the total amount of money is K (1 + 100 ) .

Logarithmic Functions
In some cases, we are interested in questions that involve

solving equations of the form ax = b for x. For example:


e x = 4 or ax = 2.
In these equations, the unknown x occurs as an exponent.

Therefore, we introduce the logarithm as the inverse


operation of exponentiation.
If ax = b, take the logarithm of base a on both sides of the

equation:
loga ax = loga b
By definition, loga ax x, so x = loga b.
The order of the two operations can be changed as well, so

aloga x = x
We also have a special name for loge : the natural logarithm,

and we use ln rather than loge (e.g. ln x).

Graph of y = ln x
y
2

0
0

-1

-2

Some Rules of Exponents

Assuming a, b > 0; a, b 6= 1; and x and y are real numbers:


a0 = 1, a1 = a
ax+y = ax ay
x

axy = aay
axy = (ax )y
ax b x = (ab)x

Some Rules of Logarithms

Assuming a, x, y > 0; n any real number, and a 6= 1:


loga 1 = 0, loga a = 1, loga ax = x, aloga x = x
loga xy = loga x + loga y
loga yx = loga x loga y
loga x n = n loga x
loga

x=

1
n

loga x

For the natural logarithmic function ln, just replace loga with ln
and a with e in the above equations.

Shifting Graphs

If you know the graph of f (x), you also know the graphs of
f (x) + c, f (x + c), cf (x), and f (x).
If y = f (x) is replaced with y = f (x) + c, the graph is moved

up by c units if c > 0 (down if c is negative).

Shifting y = f (x) =

f(x)
6

0
-1

0
-1

-2

Shifting Graphs

If you know the graph of f (x), you also know the graphs of
f (x) + c, f (x + c), cf (x), and f (x).
If y = f (x) is replaced with y = f (x) + c, the graph is moved

up by c units if c > 0 (down if c is negative).


If y = f (x) is replaced with y = f (x + c), the graph is moved

left by c units if c > 0 (right if c is negative).

Shifting y = f (x) =

f(x)
3

0
-4

-3

-2

-1

0
-1

Shifting Graphs

If you know the graph of f (x), you also know the graphs of
f (x) + c, f (x + c), cf (x), and f (x).
If y = f (x) is replaced with y = f (x) + c, the graph is moved

up by c units if c > 0 (down if c is negative).


If y = f (x) is replaced with y = f (x + c), the graph is moved

left by c units if c > 0 (right if c is negative).


If y = f (x) is replaced with y = cf (x), the graph is stretched

vertically if c > 1 and compressed vertically if 0 < c < 1 (For


c < 0, also reflected about the x-axis).

Shifting y = f (x) =

f(x)
2

6
5
4
3
2

0.5
1

0
-1

-1

0.5
-2
-3
-4
-5
-6

Shifting Graphs

If you know the graph of f (x), you also know the graphs of
f (x) + c, f (x + c), cf (x), and f (x).
If y = f (x) is replaced with y = f (x) + c, the graph is moved

up by c units if c > 0 (down if c is negative).


If y = f (x) is replaced with y = f (x + c), the graph is moved

left by c units if c > 0 (right if c is negative).


If y = f (x) is replaced with y = cf (x), the graph is stretched

vertically if c > 1 and compressed vertically if 0 < c < 1 (For


c < 0, also reflected about the x-axis).
If y = f (x) is replaced with y = f (x), the graph is reflected

about the y -axis.

Shifting y = f (x) =

f(x)
3

0
-5

-4

-3

-2

-1

0
-1

Composite Functions

Suppose that f and g are two functions such that the range

of f is contained in the domain of g . We define the


composite function g f :
g f (x) = g (f (x))
g (f (x)) is not the product of g and f (i.e. g (x) f (x) = g f ).
g (f (x)) 6= f (g (x))
Example: If f (x) = x 2 and g (x) = 2 + 5x, then

g f (x) = 2 + 5x 2 , and f g (x) = (2 + 5x)2 = 4 + 20x + 25x 2

Inverse Functions

We usually treat quantity demanded as function of price:

Q = D(P). This is the consumers perspective.


Producers choose a quantity to produce, which determines the

price according to the demand function.


We need the inverse of the demand function to represent

this: P = D 1 (Q).
In the original demand function, simply solve for P in terms of

Q.
By definition, D(D 1 (Q)) = Q and D 1 (D(P)) = P.
1
Note: f 1 (x) 6= f (x)

Formal Definition of Inverse Function

Let f be a function with domain A and range B. If and only if f is


one-to-one, it has an inverse function g with domain B and range
A.
The function g is given by the following rule:
For each y in B, the value g(y) is the unique number x in A such
that f(x) =y.
g(y) = x iff y = f(x)

Graphing Inverse Functions


To graph f 1 (x), reflect the graph of f (x) about the line y = x:
f (x) =

2x1
x+3

y
y=x

10
9
8
7
6
5
4
3
2

y = f(x)

1
-10 -9

-8

-7

-6

-5

-4

-3

-2

0
-1-1 0

x
1

10

-2
-3
-4
-5
-6
-7
-8
-9
-10

y = f-1(x)

Graphing Inverse Functions


To graph f 1 (x), reflect the graph of f (x) about the line y = x:

f (x) = 3 x + 2
y = g-1(x)

y=x

y = g(x)

0
-5

-4

-3

-2

-1

0
-1

-2

-3

-4

-5