hof3238x_ch05_442-453.

qxd 7/30/11 12:27 PM Page 442

442 CHAPTER 5 Integration 5-68

SECTION 5.5 Additional Applications of Integration to Business

and Economics
Learning Objectives
1. Use integration to compute the future and present value of an income flow.
2. Define consumer willingness to spend as a definite integral, and use it to
explore consumers’ surplus and producers’ surplus.

In this section, we examine several applications of definite integration to business and

economics, specifically to finding the future and present value of an income flow, con-
sumer willingness to spend, and consumers’ surplus and producers’ surplus.

Future Value and The revenue generated by a business operation can often be regarded as a continuous
Present Value of an income stream which may then be invested to generate even more income. The future
value of the income stream over a specified term is the total amount (money trans-
Income Flow
ferred into the account plus interest) that is accumulated during the term.
An annuity is a special kind of income flow in which payments are made (or
received) at regular time intervals over a specified term. Home mortgage payments
are one kind of annuity as are the payout arrangements for certain kinds of retirement
plans. Annuity payments are often constant amounts (like a monthly car loan pay-
ment). In Example 5.5.1, we illustrate how the future value of any income stream can
be computed by finding the future value of an annuity.

EXAMPLE 5.5.1 Finding the Future Value of an Annuity

Yuanxi has an annuity that pays $1,200 per year and earns interest at the annual rate
of 8% compounded continuously. How much will Yuanxi’s account be worth at the
end of 2 years? Assume that the annuity is deposited continuously into the account.

Solution
Recall from Section 4.1 that P dollars invested at 8% compounded continuously will
be worth Pe0.08t dollars t years later.
To approximate the future value of the income stream, divide the 2-year time
interval 0 ! t ! 2 into n equal subintervals of length "t years and let tj denote the
beginning of the jth subinterval. Then, during the jth subinterval (of length "t years),
Money deposited $ (dollars per year)(number of years) $ 1,200¢t
If all this money were deposited at the beginning of the subinterval (at time tj), it
would remain in the account for 2 # tj years and therefore would grow to
(1,200¢t)e0.08(2#tj) dollars. Thus,
Future value of money deposited
! 1,200e0.08(2#tj)¢t
during jth subinterval
The situation is illustrated in Figure 5.18.
The future value of the entire income stream is the sum of the future values of
the money deposited during each of the n subintervals. Hence,

Future value of income stream ! a 1,200e0.08(2#tj)¢t

n

j$1
hof3238x_ch05_442-453.qxd 7/30/11 12:28 PM Page 443

5-69 SECTION 5.5 ADDITIONAL APPLICATIONS OF INTEGRATION TO BUSINESS AND ECONOMICS 443

2 – tj years
1,200Dt 1,200e0.08(2 – t j) Dt

0 Dt 2
t
t1 tj tj + 1

FIGURE 5.18 The (approximate) future value of the money deposited during the jth
subinterval.

(Note that this is only an approximation because it is based on the assumption that
all 1,200"tn dollars are deposited at time tj rather than continuously throughout the
jth subinterval.)
As n increases without bound, the length of each subinterval approaches zero and
the approximation approaches the true future value of the income stream. Hence,

$ lim a 1,200e0.08(2#tj)¢t
n
Future value of
income stream nS %& j$1

$ "
0
2
1,200e0.08(2#t) dt $ 1,200e0.16 " 2

0
e #0.08t dt

1,200 0.16 #0.08t 2

$# e (e ) ` $ #15,000e0.16(e #0.16 # 1)
0.08 0
$ #15,000 % 15,000e0.16 ! 2,602.66
so the annuity account is worth roughly $2,602.66 at the end of the 2-year term.

By generalizing the reasoning illustrated in Example 5.5.1, we are led to this inte-
gration formula for the future value of an income stream with rate of flow given by
f(t) for a term of T years with interest rate r:

FV $ " T

0
f (t) er(T#t) dt er(T#t) $ e(rT#rt) $ erTe #rt

$ " 0
T
f (t) erT e#rt dt factor constant erT outside integral

$ erT "
T

0
f (t) e#rt dt

The first and last forms of the formula for future value are both listed next for future
reference.

Future Value of an Income Stream ■ Suppose money is being trans-

ferred continuously into an account over a time period 0 ! t ! T at a rate given
by the function f (t) and that the account earns interest at an annual rate r com-
pounded continuously. Then the future value FV of the income stream over the
term T is given by the definite integral

FV $ " T

0
f (t) er(T#t) dt $ erT "
0
T
f (t) e #rt dt
hof3238x_ch05_442-453.qxd 7/30/11 12:28 PM Page 444

444 CHAPTER 5 Integration 5-70

In Example 5.5.1, we had f (t) $ 1,200, r $ 0.08, and T $ 2, so that

FV $ e0.08(2) " 0
2
1,200e #0.08t dt

The present value of an income stream generated at a continuous rate f(t) over
a specified term of T years is the amount of money A that must be deposited now at
the prevailing interest rate to generate the same income as the income stream over the
same T-year period. Since A dollars invested at an annual interest rate r compounded
continuously will be worth AerT dollars in T years, we must have

AerT $ erT " T

f (t) e #rt dt divide both sides by erT

"
0
T
A$ f (t) e #rt dt
0

To summarize:

Present Value of an Income Stream ■ The present value PV of an income

stream that is deposited continuously at the rate f(t) into an account that earns inter-
est at an annual rate r compounded continuously for a term of T years is given by

PV $ " 0
T
f (t) e #rt dt

Example 5.5.2 illustrates how present value can be used in making certain financial
decisions.

EXAMPLE 5.5.2 Using Present Value to Compare

Two Income Streams
June is trying to decide between two investments. The first costs $9,000 and is expected
to generate a continuous income stream at the rate of f1(t) $ 3,000e0.03t dollars per year.
The second investment is an annuity that costs $12,000 to purchase and generates income
at the constant rate of f2(t) $ 4,000 per year. If the prevailing annual interest rate remains
fixed at 5% compounded continuously, which account is better over a 5-year term?

Solution
The net value of each investment over the 5-year time period is the present value of
the investment less its initial cost. For each investment, we have r $ 0.05 and T $ 5.
For the first investment, the net value is

PV # cost $ " 5

0
(3,000e0.03t)e #0.05t dt # 9,000

$ 3,000 "0
5
e0.03t#0.05t dt # 9,000

$ 3,000 "0
5
e #0.02t dt # 9,000

e #0.02t 5
$ 3,000 a b ` # 9,000
#0.02 0
$ #150,0003e #0.02(5) # e0 4 # 9,000
$ 5,274.39
hof3238x_ch05_442-453.qxd 7/30/11 12:28 PM Page 445

5-71 SECTION 5.5 ADDITIONAL APPLICATIONS OF INTEGRATION TO BUSINESS AND ECONOMICS 445

The net value of the annuity is

PV # cost $ "
5

0
(4,000)e #0.05t dt # 12,000

e #0.05t 5
$ 4,000 a b ` # 12,000
#0.05 0
$ #80,000[e #0.05(5) # e0] # 12,000
$ 5,695.94
Thus, the net income generated by the first investment is $5,274.39, while the annuity
generates net income of $5,695.94. The annuity is a slightly better investment.

A general formula for the present value of an annuity is given in Exercise 45.

Consumer Willingness Suppose a young couple is willing to spend up to $500 for a television set. For the
to Spend and convenience of having two sets (say, to settle disputes about which show to watch),
they are willing to spend an additional $300 for an additional set, but since there would
Consumers’ Surplus
be relatively little advantage in having more than two sets, they might be willing to
spend no more than $50 for a third set. Thus, the couple’s demand function p $ D(q)
for television sets would satisfy
500 $ D(1) 300 $ D(2) 50 $ D(3)
and their total willingness to spend for as many as three television sets would be
$500 % $300 % $50 $ $850
Now consider a commodity like grain that can be sold in any quantity q up to q0
units (so 0 ! q ! q0), and let p $ D(q) be the demand function for the commodity.
To find the total consumer willingness to buy as many as q0 units, we cannot simply
add up potential payments (demand values) as we did for the television set example
because there are too many available levels of production q between 0 and q0, so
instead we use a definite integral.
Specifically, as shown in Figure 5.19, we divide the interval 0 ! q ! q0 into n
evenly spaced subintervals and assume the demand is D(qk–1) for all values of q in the
kth subinterval, where qk–1 is the left endpoint of that subinterval, for k $ 1, 2, . . . , n.
Then the consumer willingness to buy between qk–1 and qk units is approximately

p (price)

p 5 D(q)

p 5 D(q)

q (units)
q2 . . . qk21 qk
0 q1 q0

FIGURE 5.19 Computing total consumer willingness to spend.