Economic Models:

Basic Mathematical Tools applied in

economics
Models in Economics
Simplified representations of reality play a
crucial role 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.: Optimization, Applied General
Equilibrium, Input-output, Econometric
& Time Series Models etc


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 of price.


P is the independent value and Q is the
dependent value
p p f Q 5 200 ) ( = =
0
50
100
150
200
250
300
0 1 2 3 4 5 6 7
Q
TR
Expressing Economic
Relationships
Equations: TR = 100Q - 10Q
2

Tables:
Graphs:
Q 0 1 2 3 4 5 6
TR 0 90 160 210 240 250 240
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

Q TC AC MC
0 20 - -
1 140 140 120
2 160 80 20
3 180 60 20
4 240 60 60
5 480 96 240
AC = TC/Q
MC = ATC/AQ
Total, Average, and Marginal
Cost
0
60
120
180
240
0 1 2 3 4
Q
TC ($)
0
60
120
0 1 2 3 4
Q
AC, MC ($)
AC
MC
Tabular form Representation
Q P=100-10Q TR=100Q-10Q
2
AR MR
0 100 0 - 0
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
TR
TR
Q
O
A
B
C
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 Slope
Optimization Techniques
In Economics different optimization techniques
use as a solution to decision making problems

Optimization implies either a variable is
maximized or minimized whichever is required
for efficiency purposes, subject to different
constraints imposed on other variables
E.g. Profit Maximization, Cost Minimization,
Revenue Maximization, Output Maximization

A problem of maxima & minima requires the help
of differential calculus
Profit Maximization
Q TR TC Profit
0 0 20 -20
1 90 140 -50
2 160 160 0
3 210 180 30
4 240 240 0
5 250 480 -230
Profit Maximization
0
60
120
180
240
300
0 1 2 3 4 5
Q
($)
MC
MR
TC
TR
-60
-30
0
30
60
Profit
Profit Maximization
Total Profit Approach for Maximization
=TR-TC The difference to be maximized
in order to Max. Profit

TR
TC
Q
O
TR, TC
A
B
Marginal Analysis to profit
maximization
Marginal Analysis requirement for profit
Maximization,

Marginal Revenue = Marginal Cost
(MR) (MC)

Marginal Value represents slope of Total
value curves

Thus slopes of TR &TC should be equal


Two output level showing same
slope, i.e. MR=MC












TR
TC
Q
O
TR, TC
A
B
Q
2
Q
1

Interpretation of the previous
diagram
MR=MC is a necessary condition for
Maximization, not a sufficient one as this
condition also hold for loss maximization

Sufficient condition requires that reaching a
point of maximization, profit should start
declining with any further rise in output, i.e.

Slope of TC should rise & Slope of TR must
fall after reaching the point of Maximization

Change in MC>Change in MR

Problem

Fill in the missing data for price (P), total revenue (TR), marginal revenue (MR), total cost (TC), marginal
cost (MC), profit (t), and marginal profit (Mt) in the following table.

Q P
TR=PQ MR=ATR/AQ
TC
MC=ATC/AQ t=TR-TC Mt=At/AQ
0 $200 $ 0 -- $ 0 -- $ 0 --
1 180 180 $180 100 $100 80 $ 80
2 320 175 65
3 420 100 240 65 180
4 120 60 55 185 5
5 100 500 350 55 150 -35
6 80 480 -20 400 -70
7 60 -60 450 50 -30 -110
8 320 -100 55 -185 -155
9 20 180 570 65 -205
10 10 -80 750 180 -650 -260

A. At what output (Q) level is profit maximized?

B. At what output (Q) level is revenue maximized?

Answer

A.
Profit increases so long as MR > MC and Mt > 0. In this problem, profit is maximized at Q
= 4 where t = $185 (and TR = $480).

Q P
TR=PQ MR=ATR/AQ
TC
MC=ATC/AQ t=TR-TC Mt=At/Q
0 $200 $ 0 -- $ 0 -- $ 0 --
1 180 180 $180 100 $100 80 $ 80
2 160 320 140 175 75 145 65
3 140 420 100 240 65 180 35
4 120 480 60 295 55 185 5
5 100 500 20 350 55 150 -35
6 80 480 -20 400 50 80 -70
7 60 420 -60 450 50 -30 -110
8 40 320 -100 505 55 -185 -155
9 20 180 -140 570 65 -390 -205
10 10 100 -80 750 180 -650 -260

B. Total Revenue increases so long as MR > 0. In this problem, revenue is maximized at Q = 5
where TR = $500 (and t = $150).

Concept of the Derivative
The derivative of Y with respect to X
is equal to the limit of the ratio
AY/AX as AX approaches zero.
0
lim
X
dY Y
dX X
A
A
=
A
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 = =
0
dY
dX
=
Rules of Differentiation
Power Function Rule: The derivative of
a power function, where a and b are
constants, is defined as follows.
( )
b
Y f X a
X
= =
1 b
dY
b a
X
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 =
dY dU dV
dX dX dX
=
Y U V =
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 =
dY dV dU
U V
dX dX dX
= +
Y U V =
Rules of Differentiation
Quotient Rule: The derivative of the
ratio of two functions U and V, is
defined as follows.
( ) U g X =
( ) V h X =
U
Y
V
=
( ) ( )
2
dU dV
V U
dY
dX dX
dX
V

=
Rules of Differentiation
Chain Rule: The derivative of a function
that is a function of X is defined as
follows.
( ) U g X =
( ) Y f U =
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 d
2
Y/dX
2
> 0, then Y is a minimum.
OR
B. If d
2
Y/dX
2
< 0, then Y is a maximum.
CENTRAL POINT
The dependent variable is
maximized when its
marginal value shifts from
positive to negative, and
vice versa
The Profit-maximizing rule
Profit( ) = TR TC
At maximum profit
ot/dQ = oTR/dQ - oTC/dQ = 0
So,
oTR/dQ = oTC/dQ (1
st
.O.C.)
MR = MC
o
2
TR/ oQ
2
= o
2
TC/oQ
2

(2
nd
O.C.) oMR/oQ < oMC/dQ
This means
slope of MC is greater than slope of MR function
Profit Maximization Problem
TATA VOLTAS., offers heating and air conditioning system inspections in the Gurgaon market. Prices are
stable at Rs 50 per unit. This means that P = MR = Rs 50 in this market. Total cost (TC) and marginal
cost (MC) relations are:

TC = $1,000,000 + $10Q + $0.00025Q
2

MC = ATC/AQ = $10 + $0.0005Q

A. Calculate the output level that will maximize profit.

B. Calculate this maximum profit.

Answer
A. To find the profit-maximizing level of output, set MR = MC and solve for Q:
MR = MC
50 = 10 + $0.0005Q
0.0005Q = 40
Q = 80,000

B. The total revenue function is:
TR = PQ = 50Q

Total profit is:

t = TR - TC
= 50Q - 1,000,000 - $10Q - $0.00025Q
2
= -0.00025Q
2
+ 40Q - $1,000,000
= -0.00025(80,000
2
) + 40(80,000) - 1,000,000
= 600,000

Constrained Optimization
To optimize a function given a
single constraint, imbed the
constraint in the function and
optimize as previously
defined
Example
Minimize TC = 4Q
1
2
+ 5Q
2
2
- Q
1
Q
2


subject to Q
1
+ Q
2
= 30.

Solve using the substitution method.
Example
Minimize TC = 4Q
1
2
+ 5Q
2
2
- Q
1
Q
2

subject to Q
1
+ Q
2
= 30.
==> Q
1
= 30 - Q
2


So TC = 4(30 - Q
2
)
2
+ 5Q
2
2
- (30 - Q
2
)Q
2
oTC/dQ
2
= -270 + 20Q
2
= 0
==> Q
2
= 13.5 and Q
1
= 16.5