First Class Notes on Mathematical Economics

1.1 Background
In the recent times, Mathematical Economics and Econometrics have attracted attention of
engineering students. Some of the important reasons are:

i. Need to understand the economic forces and develop models at Micro level and
ii. Secondly, to understand the economic environment at Macro level.
iii. Some of them like to explore other disciplines where they can use their basic analytical
reasoning and vast knowledge of mathematics, statistics and other similar subjects.
iv. There is so much discussion on Big data.

1. What it Mathematical Economics?

Mathematical economics is not a branch of Economics as Monetary Economics or

International Economics but just application of Mathematics to the purely theoretical aspects
of economic analysis. It mainly expresses economic theory in mathematical forms.

It may be considered as a theoretical and applied science, whose purpose is to mathematically

formalized description of economic objects, processes, and phenomena. Most of the
economic theories are presented in terms of economic models. In mathematical economics,
the properties of these models are studied based on formalizations of economic concepts and
notions. In mathematical economics, theorems on the existence of extreme values of certain
parameters are proved, properties of equilibrium states and equilibrium growth trajectories
are studied, etc. This creates the impression that the proof of the existence of a solution
(optimal or equilibrium) and its calculation is the main aim of mathematical economics.
However, the most important purpose is to formulate economic notions and concepts in
mathematical form, which will be mathematically adequate and self-consistent, and then, on
their basis to construct mathematical models of economic processes and phenomena.
Moreover, it is not enough to prove the existence of a solution and find it in an analytic or
numerical form, but it is necessary to give an economic interpretation of these to obtain
mathematical results (Tarasov, 2019).

2. What is Econometrics?

As the word ‘Metric’ refers to measurement, Econometrics in simple words means

measurement of economic data to verify an Economic Theory. It deals with the study of
empirical observations for estimation, inference and forecasting.

Econometrics may be defined as the quantitative analysis of actual economic phenomena

based on the concurrent development of theory and observation, related by appropriate
methods of inferences (P.A. Samuelson T.C. Koopmans and J.R.N. Stone, “Report of the
Evaluation Committee for Econometrica,”Econometrica, 22(2)1954 pp. 141-146).

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Econometrics may be defined as the social science in which the tools of economic theory,
mathematics, and statistical inferences are applied to the analysis of economic phenomena
( Arthur S. Golberger, Econometric Theory, John Wiley & Sons, New York, 1964, p.1).

In the beginning, statistics was used for Econometric studies. However, over the years other
similar branches as operational research game theory, fuzzy logic etc. are being used for
Econometrics studies.

As empirical studies and theoretical analysis are often complementary and mutual
reinforcing, knowledge of both Mathematical Economics and Econometrics are important but
knowledge of Mathematical Economics may be considered as the more basic of the two to
undertake Econometrics study. Hence, knowledge of Mathematical Economics is useful not
only for those who are interested in theoretical Economics, but also for those seeking a
foundation for the pursuit of Econometric studies.

3. Difference between Mathematical Economics and Econometrics

SN Mathematical Economics Econometrics
1. Mathematical Economics refers The ‘metric’ part implies that
to the application of econometrics is mainly
mathematics to the purely concerned with measurement
theoretical aspects of economic of economic data.
analysis, with little or no
concern about such statistical
problems as the measurement
errors of the variables under
study.
2. Deductive reasoning- Inductive reasoning- dealing
dealing primarily with with empirical material
theoretical material
3. On the one hand, Statistical work needs
theories must be tested economic theory as a guide in
against empirical data order to determine the most
for validity before they relevant and fruitful direction
can be applied of research.
confidently.
4 In Mathematics and Randomness is involved.
Physics, a deterministic Significance of Stochastic
system has no Disturbance Term
randomness and is The disturbance term, ‘µ’,
involved in the represents all those variables
development of the that are omitted from the
future state of the model but that collectively
system. A deterministic affect ‘Y’.
model will produce the Assumption of ‘Ceritus
same output. In Paribus’ (when other
economics, a variables remain the same)
production function is a As we have studied, D is
deterministic model. Or inversely related to the Price

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 when you calculate of the product when other
price elasticity of things such as taste, fashion,
demand, that is a and price of the substitute
deterministic goods, and complimentary
relationship. The goods remain the same.
Ramsay-Cass- However, due to the paucity
Koopmans model is a of time or data, we may not
deterministic model. study whether all other
variables remain the same or
not. So, we cannot say that

5. Empirical studies and theoretical analysis are often complimentary

and mutually reinforcing.

4. Various concepts used in Mathematical Economics Analysis

Like any other subject of science, economics is concerned with the explanation and
prediction of observed phenomena, which can only be done based on theories.
However, economic theories, like any other subject, are applicable only under
certain circumstances. Following are some of the concepts which we consider
helpful in explaining and predicting economic phenomena:

4.1 Assumption
Economics analysis explains the economic behaviour of a human being, which
depends on several factors. These factors are highly unpredictable and uncertain.
Thus, each individual behaves and responds differently under particular
circumstances. Also, each factor is dependent on other factors along with several
other factors. In that circumstance, no linear or non-linear relationship can be
established between two variables. However, when two variables are considered
keeping others as constant, they show certain relationship. As in case of demand
and price, they are inversely related when other variables are assumed constant. If
any of the variables also changes, the inverse relationship does not hold good. For
example, if income of the household increases, demand for a particular product
increases even if its price also increases. Similarly, during winter season, demand
for woollen clothes increase even if its price also increases.

1.2 Stock dimension and Flow dimension of an Economic Variable

In case of stock dimension, value of a variable has no time dimension. Physical quantities
which exist at any point of time are measured through stock dimension. Some of the

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 examples of stock dimensions are stock of finished product of a firm, stock of raw material
with a firm. On the contrary, value of variable which has time dimension is considered under
flow dimension. It is discussed in reference of time generally a year. Requirement of raw
material per year by a firm or national income of a country during a year are some of the
examples.
1.3 Equilibrium: Statics and Dynamics

Equilibrium refers to a market condition where demand of and supply for the product
is same. Once the situation of equilibrium by a firm or industry is achieved, it tends
to persist. Equilibrium is achieved by the balancing of market forces. In comparative
static studies, equilibrium and other positions are considered without discussing the
transitional period and process in between these two situations. On the other hand,
dynamics deals with the time path and the process of adjustment in course of
achieving equilibrium. Engineering students whose mathematics is undoubtedly very
good, can discuss dynamic equilibrium also.

Model:

Model in economics may be representation of a theory or part of a theory which is

made with the application of statistical and mathematical techniques. It is used to
gain an understanding in cause-and-effect relationship between variables and to
measure the phenomena more accurately. It is similar to a situation where an
automobile engineer makes a model of car before making the actual car. The model
may be similar to actual car but simple in comparison of actual car. The engineer
may use the model to do experiment regarding various performance indicator of the
actual machine. Similarly, models in Economics are very helpful in understanding
the state through which the firm is undergoing and to make appropriate decision for
the benefit of the firm while dealing in microeconomics and how high economic
growth may be achieved by an economy or inflation may be controlled in
macroeconomics.

3 Tools of Economic Model

3.1 Graphs

In Economics, Management and Business, cause and effect relationship is

omnipresent. When price increases, a consumer is tending to demand less. For
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 better understanding of the relationship. So relationship between price and demand
can be shown as a Graph.
3.2 Functions
A function is a mathematical relationship in which the values of a dependent
variable are determined by the values of one or more independent variables.
Functions with a single independent variable are called Simple Univariate functions.
There is a one to one correspondence. Functions, with more than one independent
variable, are called Multivariate functions. The independent variable is often
designated by X. The dependent variable is often designated by Y. For example, Y
is function of X which means Y depends on X or the value of Y is determined by
the value of X. Mathematically one can write Y = f(X).
3.3 Equation

A function has at least 2 variables: an output variable and one or more input
variables. An equation states that two expressions are equal, and it may
involve any number of variables (none, one, or more). A function can often be
written as an equation, but not every equation is a function.
3.4 Type of Function

3.2.1 Polynomial Function

Polynomial is made up of two words, poly, and nomial. "Poly" means many, and
"nomial" means the term, and hence when they are combined, we can say that
polynomials are "algebraic expressions with many terms". A polynomial function
is a function that involves only non-negative integer powers or only positive integer
exponents of a variable in an equation like the quadratic equation, cubic equation,
etc. In Economics, it is used to model economic growth patterns.

C= a+bY
Where C = consumption

3.2.2 Linear Function

A statement of relationship between two quantities is called an equation. In an
equation, if the largest power of the independent variable is one, then it is called as
Linear Equation. Such equations when graphed give straight lines.
For example Y = 100+10X.
Where Y = Total Cost;
100 = Faxed Cost and X= Variable Cost

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 Deman Qd f (Px )
d
where
Functio
Qd stands for
n
Quantity
demand of a
commodity a
nd Px is the
price of that
commodity.
Supply Qs  f (Px)
Functio where
n ‘Qs’ stands
for Quantity
supplied of a
commodity a
nd Px is the
price of that
commodity.

4. Equilibrium
The point at which demand line and supply line cut each other is known as point of
equilibrium which can be obtained the values of two unknowns with two equations.
At equilibrium point,
Example 2.1 If demand and supply functions Qd  1005P and Qs  5P
respectively.
Demand = Supply

Solution: At Equilibrium, Qs  Qd;

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Or, 5 P  100  5 P
Or, 10P  100; P  10
When P  10, In supply function, Qs  5 P  5 x 10  50
In demand function, Qd  100  5 P  100  5(10)  50

Hence at
P  10, Qd  50, Qs  50. So, Quantity demanded is equal to supply
at 50 units when price is Rs.10
Example: 2.2: The market demand curve is given by D  50  5P. Find the
maximum price beyond which nobody will buy the commodity.

Solution:
Given, Qd  50  5P; 5P  50  Qd; 5P  50 when Qd is zero.
P=50/5; P  10 When P  10, Demand is 0
Hence P  10, which is the maximum price beyond which nobody will
demand the commodity.
1.3.2 Quadratic Functions

A function of the general form y=ax2+bx+c y = a x 2 + b x + c where a , b and c are

real numbers and a≠0 is called a Quadratic function. These functions are called
quadratic as x is raised to the power of 2.

Example- 2.3 In economics, a quadratic equation may be used where as a product of

two linear expressions.

TR = x . p

Where,
TR =Total Revenue;
X= quantity Sold
P= Price of the product

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Because the quantity of a product sold often depends on the price, you sometimes
use a quadratic equation to represent revenue as a product of the price and the
quantity sold.

Because the quantity of a product sold often depends on the price, you sometimes
use a quadratic equation to represent revenue as a product of the price and the
quantity sold. Quadratic forms are important in testing the second order conditions
that distinguish maxima from minima in economic optimization problems, in
checking the concavity of functions that are twice continuously di§erentiable and in
the theory of variance in statistics.

Example 1: You have designed a sports T-shirts, now you want to make it a business venture.
The Cost, Fixed Cost = Rs. 700,000
Variable Cost = Rs. 110/shirt
Based on existing market demand, the demand curve will be,
QD = 70,000- 200p where p = price and the demand curve will be
If p = 0, 70,000 is the demand and Price
P =Rs. 350, demand is 0
P= 300; demand will be10,000 t-shirts

Unit sale = X = 70,000- 200p

Total revenue = PX = (70,000- 200p) P = 70,000 P – 200P2
Total Cost= 700,000 + 110 (70,000- 200 P)= 700,000 + 7700000 – 22000P
= 8400000 – 22000P
Profit (π) = TR = TC = 70,000 P – 200P2 - 8400000 + 22000P
Or, -200P2 + 92000 P – 8400000 = 0 (QUADRATIC EQUATION)
Divide both side by -200,
Or, P2 – 460 P +42000 = 0
Or, P2 – 460 P = - 42000
Add 52900 on both sides
Or, P2 – 460 P + 52900 = - 42000 + 52900
Or (P – 230)2 = 10900
Take square root on both side of the equation
Or, P- 230 = +/- 104 (to the nearest whole number)
Or P = 230 +/- 104 = 334 or 126

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At, both points, profit is zero. But in Economic analysis, we want to know maximum profit
which is exactly halfway.
Profit

1 price
2.3.3 Power Function vs. Exponential Function
F(x) = Kxr where K ≠ 0

Where x, the independent variable is base which is raised to a. This is called power
function.
Again,
G(x) = ax where x, the independent variable s raised to the base ‘a’.

2.3.4 Logarithmic Functions

Logarithm values are commonly used in econometric analysis for following reasons:

1. Linearization of Relationships: Many economic relationships are multiplicative

rather than additive. By taking the logarithm of variables, we can linearize these
relationships, making it easier to analyze and interpret them. For example, a Cobb-
Douglas production function can be transformed into a linear form using
logarithms.
2. Interpretation of Elasticities: Logarithmic transformations allow for
straightforward interpretation of coefficients in regression models as elasticities.
For instance, in a log-log model, the coefficient of a variable represents the
percentage change in the dependent variable for a 1% change in the independent
variable.
3. Normalization: Logarithmic transformation helps in normalizing data that are
skewed or have outliers. This can lead to more reliable statistical inference and
better model performance.
4. Diminishing Returns: In many economic contexts, the concept of diminishing
returns applies. Logarithmic transformations can help reflect this phenomenon,
where the incremental effect of a variable decreases as its level increases.
5. Handling Growth Rates: In time series analysis, using logarithms allows
economists to easily compute growth rates. The difference in logarithmic values
between two time periods approximates the percentage change, making it useful for
analyzing growth trends.
6. Reducing Heteroscedasticity: Logarithmic transformations can stabilize variance
across observations, which is a common assumption in regression analysis. This
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 helps in meeting the assumptions of homoscedasticity required for valid hypothesis
testing.
7. Scale Independence: Logarithms allow for comparisons across different scales and
units. This is particularly useful in econometrics, where variables may be measured
in different units (e.g., income in dollars, population in thousands).
Overall, the use of logarithmic values in econometric analysis enhances model accuracy,
interpretability, and robustness, making it a valuable tool for economists and analysts.

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