CHAPTER 3 Matrix Theory64 Chapter 3 * Matrix Theory 3.1 Introduction } Students of economics know that economics involves systems of relationships among ; many variables. These systems can be very intricate, involving many layers of feedback effects. ‘When two markets are related, a shift in a supply or demand function in one mar- ket can generate a sequence of feedback effects that reverberate through both markets, ‘Suppose, for example, that consumers regard hot-dogs and hamburgers as partial sub- stitutes. An upward shift of the supply curve for hot dogs will raise the price of hot dogs and reduce the quantity demanded. Then, through a substitution effect, the de- ‘mand curve for hamburgers will shift rightward. The resulting increase in the price of hamburgers will create @ secondary substitution effect that will shift the demand curve for hot dogs rightward. This rightward shift in the demand curve for hot dogs will increase the quantity of hot dogs demanded. Thus, the net effect on the quantity of hot dogs demanded of the initial upward shift of the supply curve for hot dogs is ambiguous. In Figure 3.1 we see the initial effects on the markets for hot dogs and hamburgers when the supply curve for hot dogs shifts upward. The initial equilibrium in the market for hot dogs is at point 4’ in Figure 3.la. In the market for hamburgers the initial equi- librium is at point Bin Figure 3.1b. First the supply function for hot dogs shifts up- ward to Sto, moving the equilibrium to point A’. The resulting increase in the price of hot dogs shifts the demand function for hamburgers rightward to Dj. The new equi- librium in the hamburger market is at point B". This increase in the price of hamburg- ers shifts the demand function for hot dogs rightward to Dijp, moving the equilibrium in the hot dog market to point A". Whether the quantity of hot dogs supplied and Effects of an Upward Shift of the Supply Curve for One Good on the Equilibria in Two Related Markets: Hot Dogs and Hamburgers P, DifPay=P ig) PPP io) Hot dogs Quy Hamburgers Qy @ © (a) Upward shift of the hot dog supply curve Syp and consequent shifts of the equilibrium A in the hot dog market (b) Shift of the equilibrium B in the hamburger market resulting from the upward shift of the hot dog supply curve =3 Introduction 65 demanded in the new equilibrium at point A” is larger or smaller than the quantity at point 4’ depends on the relative values of the parameters. We can see that the rightward shift of the demand curve for hot dogs creates a fur- ther increase in the price of hot dogs and that this secondary increase in the price of hot dogs sets off a sequence of feedback effects through both markets. How, then, are we to determine the net effect of an upward shift of the supply curve for hot dogs on the equi- librium quantity of hot dogs demanded? ‘Comparative static analyses of related systems would be extremely difficult (if not impossible) if we had to rely on the kinds of graphical analysis presented in intro- ductory economics courses. Fortunately, economists can often use matrix algebra to obtain comparative static results in complicated systems of economic relationships. For small changes in the parameters, we can approximate the consequent changes in the equilibrium values of the endogenous variables by creating systems of linear equa- tions. Then using matrix algebra, n solve these equations to obtain comparative static results The purpose of this chapter is to introduce matrix algebra, and to develop those features of it that are widely used in economic analysis. But before we present matrix theory, let us consider two analytical questions that would be difficult to handle with- out matrix algebra. 3.14 Keynesian Systems ' In the simplest Keynesian system we consider only one market, a market for goods and services. To establish equilibrium, we equate aggregate demand and supply, which gives us the familiar condition Y = C(Y) + J + G. In this equilibrating condition ¥ is the rate of national income (or national output), C(Y) is the consumption function that determines how the rate of consumption spending depends on the rate of national in- come, / is the rate of spending on investment goods, and G is the rate of government spending for goods and services. In this model the variables Y and C(Y) are endoge- nous and the variables / and G are exogenous. In such a simple model we can easily determine the effect of an exogenous change in governmental spending, G, on the equi- librium rate of national income, ¥. We have no need for matrix algebra. Suppose, however, we augment our simple Keynesian system by making invest- ment spending depend on both the interest rate and the rate of national income. And suppose we add a market in which the supply and demand for monetary balances must be equal. Typically, the quantity of money supplied by the monetary authorities is exogenous in such a model. Tn this augmented system it is no longer easy to determine the effect of an increase in government spending on the equilibrium rate of national income, Analytical diffi- culties arise because two or more interrelated markets will undergo a sequence of feed- back effects like those we encountered in the markets for hot dogs and hamburgers. If ‘we were to extend our Keynesian system still further by adding @ market for labor as ‘well as markets for imports, exports, and foreign currencies, the feedback relationships would become intricate indeed. ‘The world does, in fact, involve systems of many interrelated markets, and matrix algebra is well suited to sort through all these intricate feedback circuits. Using matrix66 Chapter 3 ® Matrix Theory algebra, we can quickly determine the net effect of a change in the value of an exoge- ‘ous variable, such as the quantity of money or the rate of spending by the government, ‘on endogenous variables, such as equilibrium national income. In Chapter 4 we will show specifically how we use matrix algebra to analyze the equilibrium in a linear Keynesian system. Then in Chapter 6 we will see how the methods of matrix algebra can be extended to nonlinear macroeconomic models, in- cluding Keynesian models. We will use systems of linear equations to approximate the effects of small changes in the parameters on equilibrium values of the endogenous variables. We conclude this section with a very simple, specific example. 3.1.2 A Competitive Market Suppose that in a perfectly competitive market the quantities supplied Qs and de- manded Qp of some good depend linearly on the price P as follows: Qn =a ~ bP Gn) Os=ct+ dP, where a, b, and d are positive constants, ¢ is @ constant of unrestricted sign, and c yy slew, by. ‘We define A(i) to be the matrix obtained by replacing column i of the matrix A with the column vector B: ay an Bro aw an an boo aay AQ = : 8.66) ay ayn by aa Then by Cramer's rule, the solution value for x,, the ith element of the vector X, is A(i)| aT (3.67) 3.9.2 Applying Cramer's Rule To solve equations (3.55) by Cramer's rule, we calculate three ratios of determinants Let A(i) be the matrix obtained by replacing column i of matrix A with the column vector B of constants from the right-hand side of equations (3.55). Then the solution value for the first variable x is 140) zy 1 12 5-4 =a/-9 10 0 co 10 -7 3 = BIC vl - NEA] + 10 -+N[a@) - ao-4)]} 6.68) 1 = 3g lS ~ 28) + 10(36 + 40)]Problems 93 Notice that in equations (3.68) we calculated | A(1)| by using the cofactors of the sec- ond row of the matrix A(1) ‘The solution for y is found by _ 142)| 14] 1 3°12 -4 =z/-6 -9 0 oe 8 0 3 a Fal-o-vlane) — (10)(-4)] = +L) - @(-4)]} G.69) 1 456 — 369 = Fl + 40) ~ 919 + 32)] = = 0.26 Finally, the solution for z is _ - |G)! lal 1 305 12 =z |-6 1 -9 aa 8 -7 10 a pO vLi00 = (-(-9)] + 5(-D[(-6)40) - ((-9)]—B.70) + 12(+D[(-6(-7) ~ (8)(19)}} 5 spoon — s{-60 + 72] + 12[42 - 80}} =-122. Problems 835 34 civena = [8 s 3} (@) Write the elements a23, azz, a13 of matrix A, (b) Write all (1 x 3) row vectors and all (2 X 1) column vectors of matrix A. 32 Given A'=[3 -4 9 12]andB’=[-1 0 4 5] (@) Compute 34 and 5B. (b) Compute 24 ~ 38 and A + B. (© Compute 4B.94 Chapter 3 © Matrix Theory 33 34 35 36 37 38 39 37 -15 GivenA=|-2 4]andB=| 0 7]. 58 -2 9 (a) Compute 5A + B. (b) Compute 4’, (©) Compute AB’ and BA’. -1 -2 o 1 GivenA=| 5 ]and B oa) (a) Calculate AB. (b) Is BA defined? Explain. Write the following system of equations in matrix form: Q - SP = 100 20 - 3P = 80 Pre- and postmultiply the following matrices with appropriate identity matrices and show that in each case you reproduce the original matrix. 13 1-24 A=|3 6] and B=|5 28 57 10 6 7. Calculate the determinants of the following matrices: (2 3] e-E 3] ¢ 12 5 16 3 ie 0035 GienA=] 25 1JandB=l 7 Gg 301 3 2 For any matrix let cy be the cofactor of the element in row i and column j. (a) For matrix A, calculate cs, 632. Cx2- (b) For matrix B, calculate cx, cx. Use expansion by cofactors to calculate the determinants of matrices A and B in Problem 3.8. 3.10 Using matrix A in Problem 3.8, calculate (a) adj A and (b) A“. 3.11 Solve the following system of equations using matrix inversion: 4x + 5y 2 lix+ y+22=3 xt Syt2—1 3.12 Solve the system of equations in Problem 3.11 using Cramer’s rule.CHAPTER 4 Applications of Matrix Theory to Linear Models96 Chapter 4 * Applications of Matrix Theory to Linear Models 4.1 Introduction In this chapter we demonstrate several applications of matrix theory, choosing exam- Ples from both microeconomics and macroeconomics that are graduated in complexity. In each example we will first obtain reduced-form solutions which define equilibrium values of the endogenous variables as functions of the exogenous variables. We will then conduct comparative static analyses of these solution: 7 ‘We begin by using matrix algebra to reformulate the simple model of a single com- etitive market first analyzed in Chapter 1. Then we turn to a system with two com- Petitive markets, using the power of matrix algebra to examine the interactions that arise between markets when goods are substitutes or complements. We consider substi- tutability and complementarity both for consumers and producers. Our next two examples come from the model of duopoly presented in Chapter 2. ‘We begin with the simplest version of duopoly, then relax the Cournot assumption to consider the effect of nonzero conjectural variations. Then we build on our analysis of duopoly to examine two models of triopoly. ‘We conclude the chapter by analyzing two macroeconomic models. The first is the simple Keynesian model in which both the interest rate and the rate of government spending are exogenous and investment spending depends on the interest rate, The sec- ond model is an IS-LM model. The endogenous variables are the rate of national income, the interest rate, and the rates of spending for consumption and investment, ‘The money supply and the rate of government spending are exogenous, In the models that we examine in this chapter all relationships are linear. This is 'y if we are to use matrix algebra. In Chapters 5 and 6 we will use matrix alge- ‘comparative static analyses for linear approximations of nonlinear systems. 4.2 ASingle Competitive Market In the model of a competitive market for a single good that we examined in Chapter 1 the inverse demand and supply functions are P=a-6Q) (demand) (4.0) P=c+dQs (supply). ‘The endogenous variables in this system are P, Qo, and Qs. The parameters are a, b, c, and d. ‘We will use matrix algebra to determine the equilibrium values of the endogenous variables in terms of the parameters. Our first step is to impose the equilibrium condi- tion Op = Qs. If we let Q be the (common) equilibrium value of Qo and Qs, we can rewrite equations (4.1) as the system P+bQ=a (4.2) P-dQ=c. In system (4.2) the endogenous variables P and Q are on the left-hand side and the Parameters a and c are on the right-hand side. This reformulation leads easily to the4.2.A Single Competitive Market matrix form 4 _Q=B 1 ofp] _[a [i -alle]-[4 “ Note that the matrix system (4.3) is equivalent to the system in equations (4.1); that is, both systems express the same relationships among variables. If two systems of equa- tions are equivalent, any solution to either system is a solution to the other system. Let P* and Q* be the values of P and Q that will satisfy system (4.3). The values P* and Q* are, of course, equilibrating (market-clearing) values for price and quan- tity in the market represented by system (4.3). We will use Cramer's rule to find P* and Q*. According to Cramer's rule, the value of the ith variable in system of linear equations is equal to a quotient of two determinants. The denominator is the determi- nant of the coefficient matrix A. The numerator is the determinant of the matrix formed by replacing the ith column of the matrix A by the column of constants on the right-hand side of the matrix equation (4.3). Let |A| be the determinant of the original coefficient matrix A, and let | A()| be the determinant of the matrix formed by replacing the ith column of A by the column vector of constants from the right-hand side of equation (4.3). These determinants are 14] =[@)(-4) — )Q)] = -(@ + 4) |A()| = [@(-d) ~ &@] = aa [4@|=[@)@ - @@)] =¢-4 Using Cramer's rule, the solution to (4.3) is | AQ)| _ ad + be p+ = AM] jal a+b (4.5) « 4Ql_a-e om Tal dt for P* and Q* ot identical to the values that we obtained in Chapter 1, where we used the conventional “method to solve a system of two linear equations In Chapter 1 we also considered the effect of @ unit tax on the equilibrium values for price and quantity. We did this by replacing the parameter c by c + ¢, and defining as the unit tax rate. As you know, the imposition of a unit tax r shifts each firm's marginal cost curve upward by the amount of the tax. Consequently, the competitive industry's supply curve shifts upward by the amount of the tax. Clearly, we ean con- duct the same kind of analysis using matrix algebra, We simply replace the parameter with a new parameter, ¢ + 1, in the column vector of constants on the right-hand side of system (4.3). 9798 Chapter 4 Applications of Matrix Theory to Linear Models 4.3 Two Competitive Markets: Substitutability and Complementarity In the preceding section we had only two variables—equilibrium price and quantity for a single good. With only two variables, and hence only two equations, it would have been easy to obtain the equilibrating values P* and Q* by using ordinary algebra. Us- _ing matrix algebra to solve a (2 X 2) system is like building an entire railroad to haul {just one ton of coal. It’s more ttduble than it's worth! In this section, however, we will analyze the equilibrium of two related competitive markets in which we have FouR variables and Four equations—a supply equation and a demand equation for each of the two markets. In this case, matrix algebra is worth the trouble; in fact, the larger the system under analysis, the greater the advantage of using matrix algebra. Solving a sys- tem of four or more simultaneous equations using ordinary algebra is not fun. ‘Suppose there are perfectly competitive markets for goods 1 and 2. Suppose also that the quantity demanded of each good depends linearly on the prices of both goods. This structure of dependence will enable us to consider cases in which consumers re- gard the two goods as substitutes, complements, or neither. We can now construct @ model that can handle the kinds of questions we raised at the outset of Chapter 3 about interrelated markets for goods like hot dogs and hamburgers. Let the demand functions for the two goods be OP = dy + duP, + duPr (4.6) QP = dy + dP, + daaPr. The signs of dy: and dz, depend on the relationship between goods 1 and 2. If the two goods are substitutes, so that an increase in the price of one good will increase the quantity demanded of the other good, the signs of diz and dz; will be positive. If goods 1 and 2 are complements, so that an increase in the price of one good will decrease the quantity demanded of the other good, the signs of diz and dz, will be nega- tive, If there is no relationship between the quantity demanded of one good and the price of the other good, both diz and ds, will be ze 4.3.1 Graphical illustration ‘There is a graphical way to exhibit the relationships of substitutes and complements. If we solve the demand function for good I to obtain P;, we have the inverse demand "Hf goods 1 and 2 are complements or substitutes in consumption, then the quantity demanded of good 1 will depend on both the price and quantity demanded of good 2, as well as onthe price of good 1. Simi- larly, the quantity demanded of good 2 will depend on the quantity demanded of good 1 and on both prices. For example, automotive gasoline and oil are complements. The quantity demanded of either will depend on the quantity demanded of the other ‘To show this interdependence of quantities demanded, we might rewrite equations (4.6) as OP = d+ dP + dP + enO? (4.62) Q2 = dy + dP, + diaP: + en OF. If goods 1 and 2 are complements, then and en willbe positive. Systems (4.6) and (4.68) are equivalent. In (3.68) we use the Second equation to substitute for O? inthe first equation. Solving the first equation for Qf will produce the frst equation in (6.6) if we define 4) = (4) + endi)/(1 ~ ements dum (di + end)/(1 ~ even). and d= (da + exd)/(l ~ een. ‘An analogous manipulation will produce the second equation in (4.6).