Chapter one

Outcome ➜ use derivatives to solve economic problem

1. Optimization: Derivatives are used to find the maximum or

minimum value of a function, which is useful in solving optimization
problems. For example, a firm can use derivatives to determine the
optimal level of production that will maximize profits.

2. Marginal Analysis: The derivative of a function represents the rate

of change of that function, which is useful in analyzing marginal
changes. For example, a firm can use derivatives to analyze the
marginal cost and revenue of producing an additional unit of a
product.

3. Elasticity: The concept of elasticity is important in economics, and it

is calculated using derivatives. For example, the price elasticity of
demand can be calculated using the derivative of the demand
function with respect to price.

4. Risk Management: Derivatives are also used in risk management,

particularly in the field of finance. Options and futures contracts are
examples of financial derivatives that are used to manage risk.

Calculation

1. Optimization: A firm has a production function given by Q = K^(1/3)

L^(2/3), where Q is the quantity of output produced, K is the amount
of capital used, and L is the amount of labor used. The wage rate is
$10 per hour and the rental rate of capital is $20 per hour. The price
of the output is $4 per unit. Find the optimal levels of K and L that will
maximize profits.

Answer:

To maximize profits, the firm needs to set the marginal revenue

product of labor (MRPL) equal to the wage rate, and the marginal
revenue product of capital (MRPK) equal to the rental rate of capital.
We can express these conditions as:

MRPL = MPL * P = (2/3)Q/L * $4 = $8/L = w

MRPK = MPK * P = (1/3)Q/K * $4 = $4/K = r

Solving for K and L, we get: L = 12 K = 27

Therefore, the optimal levels of K and L that will maximize profits are
K = 27 and L = 12.

2. Marginal Analysis: A firm has a total cost function given by TC(Q) =

100 + 2Q + 0.5Q^2, where Q is the quantity of output produced. Find
the marginal cost function, and use it to determine the level of output
at which marginal cost is equal to marginal revenue.

Answer:
The marginal cost function is given by: MC(Q) = dTC/dQ = 2 + Q

To find the level of output at which marginal cost is equal to marginal

revenue, we need to set MC(Q) equal to the price (which is equal to
marginal revenue in a competitive market). Suppose the price is P =
$10 per unit. Then:

10 = 2 + Q

Q=8

Therefore, the level of output at which marginal cost is equal to

marginal revenue is Q = 8 units.

3. Elasticity: The demand function for a product is given by P = 100 -

2Q, where P is the price of the product and Q is the quantity
demanded. Calculate the price elasticity of demand at a price of $40
per unit.

Answer:

The price elasticity of demand is given by: E = (dQ/dP) * (P/Q)

Taking the derivative of the demand function with respect to P, we

get: dQ/dP = -2
Substituting P = $40 and Q = 100 - 2(40) = 20, we get: E = (-2/40) *
(40/20) = -1

Therefore, the price elasticity of demand at a price of $40 per unit is -

1, which means that demand is unit elastic at this price.

4. Risk Management: An investor wants to hedge against a possible

increase in the price of a commodity. The investor can buy a futures
contract that gives the right to purchase the commodity at a fixed
price of $50 per unit. The spot price of the commodity is currently $60
per unit, and the investor expects the price to rise to $70 per unit in
the future. Use calculus to determine the optimal number of futures
contracts to buy in order to minimize risk.

Answer:

Let N be the number of futures contracts the investor buys. The cost
of buying N contracts is given by: C(N) = N * $50

The payoff from the futures contracts if the price of the commodity
rises to $70 per unit is: P(N) = N * ($70 - $50) = $20N
The investor's profit from the futures contracts is: F(N) = P(N) - C(N) =
$20N - N * $50 = $10N

The investor's loss if the price of the commodity does not rise is:

L(N) = N * ($60 - $50) = $10N

The total risk (variance) is given by: V(N) = [(P(N) - F(N))^2 + (L(N) -
F(N))^2]/2

Taking the derivative of V(N) with respect to N and setting it equal to

zero, we get:

dV/dN = 0

20N - 50 + 20N - 10N = 0

30N = 50

N = 5/3

Therefore, the optimal number of futures contracts to buy in order to

minimize risk is N = 5/3. However, since the number of contracts must
be an integer, the investor should round up to 2 contracts to ensure
adequate hedging.

Chapter two
Outcom ➜ solve a range of mathematically formulated economics problems

1. A consumer has an income of $100 and faces a price of $10 per unit for good
X and $5 per unit for good Y. The consumer's utility function is U(X,Y) =
X^0.5Y^0.5. Find the optimal quantities of X and Y to maximize utility subject to
the budget constraint.

Answer:

The problem can be formulated as:

Maximize U(X,Y) = X^0.5Y^0.5

Subject to P_X*X + P_Y*Y = I

Where P_X = $10, P_Y = $5, and I = $100

Using Lagrange multipliers, we can set up the following equation:

L(X,Y,λ) = X^0.5Y^0.5 - λ(P_X*X + P_Y*Y - I)

Taking partial derivatives with respect to X, Y, and λ, we get:

dL/dX = 0.5*X^(-0.5)*Y^0.5 - λ*P_X = 0

dL/dY = 0.5*X^0.5*Y^(-0.5) - λ*P_Y = 0

dL/dλ = P_X*X + P_Y*Y - I = 0

Solving for X, Y, and λ, we get:

X = 20, Y = 40, λ = 0.1

Therefore, the optimal quantities of X and Y to maximize utility subject to the
budget constraint are X = 20 and Y = 40.

2. A firm has a production function given by Q = K^(1/3) L^(2/3), where Q is the

quantity of output produced, K is the amount of capital used, and L is the
amount of labor used. The firm has a budget of $1000 to spend on capital and
labor, and the rental rate of capital is $20 per hour while the wage rate is $10
per hour. Find the optimal levels of K and L that will maximize output subject to
the budget constraint.

Answer:

The problem can be formulated as:

Maximize Q = K^(1/3) L^(2/3)

Subject to P_K*K + P_L*L = I

Where P_K = $20, P_L = $10, and I = $1000

Using Lagrange multipliers, we can set up the following equation:

L(K,L,λ) = K^(1/3) L^(2/3) - λ(P_K*K + P_L*L - I)

Taking partial derivatives with respect to K, L, and λ, we get:

dL/dK = (1/3)*K^(-2/3)*L^(2/3) - λ*P_K = 0

dL/dL = (2/3)*K^(1/3)*L^(-1/3) - λ*P_L = 0

dL/dλ = P_K*K + P_L*L - I = 0

Solving for K, L, and λ, we get:

K = 243.9, L = 101.5, λ = 0.002

Therefore, the optimal levels of K and L that will maximize output subject to the
budget constraint are K = 243.9 and L = 101.5.

Calculation
1. A firm has a production function given by Q = K^(1/3) L^(2/3), where Q is the quantity of
output produced, K is the amount of capital used, and L is the amount of labor used. The firm
has a budget of $1000 to spend on capital and labor, and the rental rate of capital is $20 per
hour while the wage rate is $10 per hour. Find the optimal levels of K and L that will maximize
output subject to the budget constraint.

Answer:

The problem can be formulated as:

Maximize Q = K^(1/3) L^(2/3)

Subject to P_K*K + P_L*L = I

Where P_K = $20/hour, P_L = $10/hour, and I = $1000

Using Lagrange multipliers, we can set up the following equation:

L(K,L,λ) = K^(1/3) L^(2/3) - λ(P_K*K + P_L*L - I)

Taking partial derivatives with respect to K, L, and λ, we get:

dL/dK = (1/3)*K^(-2/3)*L^(2/3) - λ*P_K = 0

dL/dL = (2/3)*K^(1/3)*L^(-1/3) - λ*P_L = 0

dL/dλ = P_K*K + P_L*L - I = 0

Solving for K, L, and λ, we get:

K = 125, L = 500, λ = 0.2

Therefore, the optimal levels of K and L that will maximize output subject to the budget
constraint are K = 125 and L = 500.

2. A consumer has a utility function given by U(X,Y) = X^(1/2) Y^(1/2), where X is the quantity
of good X consumed and Y is the quantity of good Y consumed. The consumer has a budget of
$50 to spend on the two goods, and the prices of the goods are $5 per unit for X and $10 per
unit for Y. Find the optimal quantities of X and Y that will maximize utility subject to the
budget constraint.

Answer:

The problem can be formulated as:

Maximize U(X,Y) = X^(1/2) Y^(1/2)

Subject to P_X*X + P_Y*Y = I

Where P_X = $5, P_Y = $10, and I = $50

Using Lagrange multipliers, we can set up the following equation:

L(X,Y,λ) = X^(1/2) Y^(1/2) - λ(P_X*X + P_Y*Y - I)

Taking partial derivatives with respect to X, Y, and λ, we get:

dL/dX = (1/2)*X^(-1/2)*Y^(1/2) - λ*P_X = 0

dL/dY = (1/2)*X^(1/2)*Y^(-1/2) - λ*P_Y = 0

dL/dλ = P_X*X + P_Y*Y - I = 0

Solving for X, Y, and λ, we get:

X = 10, Y = 20, λ = 0.05

Therefore, the optimal quantities of X and Y that will maximize utility subject to the budget
constraint are X = 10 and Y = 20.

Chapter three
Outcome ➜ apply mathematical approach in formulating and analyzing economic problems in static
settings
Suppose a firm has a production function given by Q = L^(1/2) K^(1/2), where Q is the quantity of
output produced, L is the amount of labor used, and K is the amount of capital used. The firm faces a
wage rate of $10 per hour and a rental rate of $20 per hour for capital. Suppose the firm can hire up to
1000 hours of labor and rent up to 500 hours of capital.

1. Find the optimal levels of labor and capital that will maximize the firm's output.

To find the optimal levels of labor and capital, we need to solve the following optimization problem:

Maximize Q = L^(1/2) K^(1/2)

Subject to L <= 1000 and K <= 500

Using Lagrange multipliers, we can set up the following equation:

L(Q,L,K,λ,μ) = L^(1/2) K^(1/2) - λ(Q - L^(1/2) K^(1/2)) - μ(L - 1000) - ν(K - 500)

Taking partial derivatives with respect to L, K, λ, μ, and ν, we get:

dL/dL = (1/2)*L^(-1/2)*K^(1/2) - λ*1/2*L^(-1/2)*K^(1/2) - μ = 0

dL/dK = (1/2)*L^(1/2)*K^(-1/2) - λ*1/2*L^(1/2)*K^(-1/2) - ν = 0

dL/dλ = Q - L^(1/2)*K^(1/2) = 0

dL/dμ = L - 1000 = 0

dL/dν = K - 500 = 0

Solving for L, K, λ, μ, and ν, we get:

L = 500, K = 250, λ = 1/4, μ = 0, ν = 0

Therefore, the optimal levels of labor and capital that will maximize the firm's output are L = 500 and
K = 250.

2. Find the elasticities of output with respect to labor and capital.

To find the elasticities of output with respect to labor and capital, we need to take the partial
derivatives of the production function with respect to L and K:

dQ/dL = 1/2*L^(-1/2)*K^(1/2)

dQ/dK = 1/2*L^(1/2)*K^(-1/2)

Then, we can calculate the elasticities of output with respect to labor and capital using the following
formulas:

Elasticity of output with respect to labor = (dQ/dL)*(L/Q) = (1/2)*(L^(-1/2)*K^(1/2))*(L^(1/2)*K^(-

1/2))/(L^(1/2)*K^(1/2)) = 1/2

Elasticity of output with respect to capital = (dQ/dK)*(K/Q) = (1/2)*(L^(1/2)*K^(-

1/2))*(L^(1/2)*K^(1/2))/(L^(1/2)*K^(1/2)) = 1/2

Therefore, the elasticities of output with respect to labor and capital are both 1/2.

Chapter four
Outcome ➜ apply differential equation for economic analysis

Suppose a firm produces a single output using two inputs, labor (L) and capital (K), with production
function given by Q = K^(1/2) L^(1/2). The firm faces wages (w) of $10 per unit of labor and rental rate
(r) of $20 per unit of capital. The firm's profit function is given by π = Q - wL - rK.
1. Write down the firm's profit function in terms of only one input variable.

Using the production function, we can solve for K in terms of Q and L:

K = (Q/L)^2

Substituting this into the profit function, we get:

π = Q - wL - r[(Q/L)^2]

Simplifying, we have:

π = Q - wL - r(Q^2/L^2)

2. Use differential calculus to find the firm's optimal input levels.

To find the firm's optimal input levels, we need to maximize the profit function with respect to L:

dπ/dL = 0

Taking the derivative of the profit function with respect to L, we get:

dπ/dL = -w + 2rQ^2/L^3

Setting this equal to zero and solving for L, we get:

L* = (2rQ^2/w)^(1/3)

Substituting this into the production function, we get the optimal level of capital:
K* = (Q/L*)^2

3. Use differential equations to analyze the firm's output response to changes in input prices.

To analyze the firm's output response to changes in input prices, we can use the concept of elasticity
of substitution. The elasticity of substitution measures the percentage change in the ratio of input
quantities in response to a one percent change in the ratio of input prices. It is given by:

σ = -dln(L*/K*)/dln(w/r)

Taking the logarithmic derivative of the expression for L* and K*, we get:

dln(L*)/dln(w) = -1/3

dln(K*)/dln(r) = 2/3

Substituting these into the expression for σ, we get:

σ = (-1/3)/(2/3)(w/r) = -1/2

This means that the firm's output response to changes in input prices is relatively insensitive, with a 1
percent increase in the wage-rental ratio leading to a 0.5 percent decrease in the ratio of labor to
capital.

Calculation
1. Suppose a firm has a production function given by Q = K^(1/2) L^(1/2), where Q is the
output, K is the capital input, and L is the labor input. The firm faces wages (w) of $10 per unit
of labor and rental rate (r) of $20 per unit of capital. The firm's profit function is given by π =
Q - wL - rK. Use differential calculus to find the firm's optimal input levels.

Solution: We need to maximize the profit function with respect to L and K:

dπ/dL = 0

dπ/dK = 0

Taking the derivatives of the profit function with respect to L and K, we get:

dπ/dL = 1/2 K^(1/2) L^(-1/2) - w

dπ/dK = 1/2 K^(-1/2) L^(1/2) - r

Setting these equal to zero and solving for L and K, we get:

L* = (K/r)^2

K* = (w/r)^2

Therefore, the firm's optimal input levels are L* = (K/r)^2 and K* = (w/r)^2.

2. Consider a population of fish that grows according to the logistic equation dN/dt = rN(1 -
N/K), where N is the population size, t is time, r is the intrinsic growth rate, and K is the
carrying capacity. If the current population size is 500 and the intrinsic growth rate is 0.05,
what is the expected population size after 5 years if the carrying capacity is 1000?

Solution: The logistic equation can be solved using separation of variables:

dN/N(1 - N/K) = r dt

Integrating both sides, we get: ln|N/(K - N)| = rt + C

where C is the constant of integration.

Solving for N, we get: N(t) = K/(1 + (K/N0 - 1) e^(-rt))

where N0 is the initial population size.

Substituting the given values, we get: N(t) = 1000/(1 + 0.5 e^(-0.05t))

At t = 5 years, we have:

N(5) = 1000/(1 + 0.5 e^(-0.05*5))

N(5) ≈ 759.16

Therefore, the expected population size after 5 years is approximately 759.16 fish.

Chapter five
Outcome ➜ apply difference equations to solve economic problems

Suppose a firm produces a single output using two inputs, labor (L) and capital
(K), with the production function given by Q = K^(1/2) L^(1/2). The firm faces
wages (w) of $10 per unit of labor and rental rate (r) of $20 per unit of capital.
The firm's profit function is given by π = Q - wL - rK. Suppose the initial values of
labor and capital are L(0) = 100 and K(0) = 400. Use difference equations to find
the optimal input levels for the next period.
Solution:

To find the optimal input levels for the next period, we need to use the first-
order conditions for profit maximization:

dπ/dL = 0

dπ/dK = 0

Taking the partial derivatives of the profit function with respect to L and K, we
get:

dπ/dL = 1/2 K^(1/2) L^(-1/2) - w

dπ/dK = 1/2 K^(-1/2) L^(1/2) - r

Setting these equal to zero and solving for L and K, we get:

L* = (K/r)^2

K* = (w/r)^2
Now, we can use difference equations to find the optimal input levels for the
next period:

L(t+1) = (K(t)/r)^2

K(t+1) = (w/r)^2

Substituting in the initial values of L(0) and K(0), we get:

L(1) = (400/20)^2 = 10000

K(1) = (10/20)^2 = 0.25

Therefore, the optimal input levels for the next period are L(1) = 10000 and K(1)
= 0.25.

Calculation
Exercise:

Suppose the price of a product is currently $10 per unit and the company
expects the price to increase by 5% every year. If the company plans to sell
1,000 units in the first year, how many units will they sell in the fifth year? Use
difference equations to solve the problem.

Answer:
Let Yt be the number of units sold in year t. We can write the following
difference equation to model the problem:

Yt = (1 + 0.05)Y(t-1)

where Y(t-1) represents the number of units sold in the previous year.

Using this equation, we can calculate the number of units sold in each year as
follows:

Year 1: Y1 = 1,000 units

Year 2: Y2 = (1 + 0.05)Y1 = 1,050 units

Year 3: Y3 = (1 + 0.05)Y2 = 1,102.5 units

Year 4: Y4 = (1 + 0.05)Y3 = 1,157.63 units

Year 5: Y5 = (1 + 0.05)Y4 = 1,215.51 units

Therefore, the company will sell approximately 1,216 units in the fifth year if
the price of the product increases by 5% every year.

Exercise:

Suppose a company is considering investing in a new machine that costs

$10,000 and has a useful life of 5 years. The company estimates that the
machine will generate an annual revenue of $3,000 in the first year, and this
revenue will increase by 10% every year. If the company's discount rate is 5%,
should they invest in the machine? Use difference equations to solve the
problem.

Answer:

Let Rt be the annual revenue generated by the machine in year t, and C be the
cost of the machine. We can write the following difference equation to model
the problem:

Rt = (1 + 0.10)R(t-1)

where R(t-1) represents the revenue generated by the machine in the previous
year.

Using this equation, we can calculate the revenue generated by the machine in
each year as follows:

Year 1: R1 = $3,000

Year 2: R2 = (1 + 0.10)R1 = $3,300

Year 3: R3 = (1 + 0.10)R2 = $3,630

Year 4: R4 = (1 + 0.10)R3 = $3,993

Year 5: R5 = (1 + 0.10)R4 = $4,392.30

To determine whether the company should invest in the machine, we need to

calculate the present value of the expected revenue stream using the discount
rate of 5%. The present value of an amount Rt received after t years is given by:

PV(Rt) = Rt / (1 + r)^t
where r is the discount rate.

Using this formula, we can calculate the present value of the expected revenue
stream as follows:

PV(R1) = $3,000 / (1 + 0.05)^1 = $2,857.14

PV(R2) = $3,300 / (1 + 0.05)^2 = $2,818.74

PV(R3) = $3,630 / (1 + 0.05)^3 = $2,797.32

PV(R4) = $3,993 / (1 + 0.05)^4 = $2,792.18

PV(R5) = $4,392.30 / (1 + 0.05)^5 = $2,802.68

The total present value of the expected revenue stream is $14,068.06.

Since the present value of the expected revenue stream is greater than the cost
of the machine ($10,000), the company should invest in the machine.

Chapter six
Outcome ➜ apply mathematical approach in formulating and analyzing
economic

Dynamic optimization is a mathematical approach used in economics

to analyze economic problems in dynamic settings. In dynamic
optimization, the objective is to maximize or minimize a function over
time while taking into account the constraints and the dynamics of
the system.
The basic framework of dynamic optimization involves three
components: the state variables, the control variables, and the
objective function. The state variables represent the current state of
the system, such as the level of output, capital stock, or employment
rate. The control variables represent the actions that can be taken to
influence the state of the system, such as investment decisions, hiring
or firing workers, or setting prices. The objective function represents
the goal of the decision-maker, which can be to maximize profits,
minimize costs, or achieve a certain level of welfare.

One of the most common techniques used in dynamic optimization is

the Euler equation, which relates the marginal benefits and marginal
costs of a decision over time. The Euler equation states that the
optimal value of a control variable at any point in time is equal to the
discounted marginal benefit of the decision minus the discounted
marginal cost of the decision. This equation takes into account the
fact that the future benefits and costs of a decision are less valuable
than the present benefits and costs due to the time value of money.

Another important concept in dynamic optimization is the Bellman

equation, which is a recursive formula used to solve dynamic
programming problems. The Bellman equation breaks down a
complex optimization problem into a series of smaller subproblems,
each representing a decision at a specific point in time. By solving
these subproblems one by one and propagating the results backwards
in time, the Bellman equation allows us to find the optimal solution to
the original problem.
Overall, dynamic optimization is a powerful tool for formulating and
analyzing economic problems in dynamic settings, such as investment
decisions, labor supply decisions, or environmental policy decisions.
Its mathematical rigor and flexibility make it an essential tool for
economists working in a wide range of fields.

Calculation
Exercise:

Consider a firm that produces a single product and faces a

demand curve given by Q = 100 - 2P, where Q is the quantity
demanded and P is the price of the product. The firm has a
production function given by Q = K^(1/2)L^(1/2), where Q is
the quantity produced, K is the capital stock, and L is the labor
input.

Assume that the firm wants to maximize its profits over an

infinite time horizon. The production function is subject to the
following constraints:

- The initial capital stock is K(0) = 100.

- The labor input is L = 25 units per period.
- The rate of capital depreciation is δ = 0.1 per period.
- The rate of technological progress is g = 0.05 per period.

The firm faces the following costs:

- The rental rate for capital is r = 0.1 per unit of capital per
period.
- The wage rate for labor is w = 0.5 per unit of labor per
period.

a) Write down the firm's profit function.

b) Write down the Euler equation for the firm's optimization

problem.

c) Solve the Euler equation and determine the optimal path

for the firm's capital stock.
Answer:

a) The firm's profit function is given by:

π = PQ - rK - wL

Substituting the demand and production functions, we get:

π = (100 - 2P)Q - rK - wL
π = (100 - 2P)(K^(1/2)L^(1/2)) - rK - wL

b) The Euler equation for the firm's optimization problem is:

rK(t) = (δ + g)K(t) - 2P(t)Q(t) + 2P(t)Q'(t)

where Q'(t) is the derivative of the production function with

respect to K.

Substituting the demand and production functions, we get:

rK(t) = (δ + g)K(t) - 2P(t)(K^(1/2)L^(1/2)) + P(t)(1/2)(K^(-1/2))
(L^(1/2))

c) Solving the Euler equation, we get:

K'(t) = (r + δ + g)K(t) - P(t)L/(2K(t))

Using the initial conditions K(0) = 100 and L = 25, we can solve
for the optimal path of the firm's capital stock using numerical
methods such as the forward-backward sweep algorithm or
the shooting method. The optimal path will depend on the
initial price of the product and the discount factor used in the
optimization problem.