Economic Models:

Basic Mathematical Tools

applied in economics

Why models?

Simplified representations of reality play a

crucial role in economics.

Models 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.: Tax models, money models

The other things equal

assumption means that all other
relevant factors remain unchanged.

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
Q f (ofp)price.
200 5 p

P is the independent value and Q is the

dependent value

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.
For e.g. change in total revenue earned by
a firm associated with an increase in output
sold by one unit, is the marginal revenue

TR PQ

MR=Change in TR associated with change

in Q

Tabular form
Representation

Q P=100-10Q

TR=100Q-10Q2

AR

MR

0 100

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 & Curvature
TR

B
C
A

TR

Changes in Slope
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 Curvature
Linear Curve Marginal value
constant, no change in curvature
Curve Convex to the origin Marginal
value (Slope) changing at an
increasing rate
Curve Concave to the origin
Marginal value ( Slope) changing at a
decreasing rate

Linear Curve
Slope = constant/ curvature =none

Concave to the origin

Slope = positive decreasing/ curvature =concave t

Convex to the origin

Slope = positive increasing/ curvature =convex to th

Concave to the origin

Slope = negative decreasing/ curvature =concave to

Convex to the origin

Slope =negative increasing/ curvature =convex to th

Average and Marginal

Graphically Average value can be derived from
the total value curve.
Average at a point on the Total value curve is
equal to the slope of the ray from the origin to
that particular point
To increase (decrease) the average value,
Average value should be less (more) than the
Marginal value
Average Value constant implies its equality with
Marginal Revenue

Find out from Total Cost,

Average, & Marginal Cost
AC = TC/Q
MC =
TC/Q

Q
0
1
2
3
4
5

TC AC MC
20 140 140 120
160 80 20
180 60 20
240 60 60
480 96 240

Average Cost (AC)

AC = TC/Q

Q
0
1
2
3
4
5

TC AC MC
20 140 140 120
160 80 20
180 60 20
240 60 60
480 96 240

Total, Average, and

Marginal Cost
AC = TC/Q
MC =
TC/Q

Q
0
1
2
3
4
5

TC AC MC
20 140 140 120
160 80 20
180 60 20
240 60 60
480 96 240

Total, Average, and Marginal Cost

TC ($)
240
180
120
60
0
0

AC, MC ($)

Q
MC

AC

120

60

0
0

Concept of the
Derivative
The derivative of Y with respect
to X is equal to the limit of the
ratio Y/X as X approaches
zero.

dY
Y
lim
dX X 0 X

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
dY
0
dX

Rules of Differentiation
Power Function Rule: The
derivative of a power function,
where a and b are constants, is
defined as follows.

Y f (X ) aX

dY
b 1
baX
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 )

Y U V

dY
dU
dV

dX
dX
dX

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 )

Y U V
dY
dV
dU
U
V
dX
dX
dX

Rules of Differentiation
Quotient Rule: The derivative
of the ratio of two functions U
and V, is defined as follows.

V h( X )

U g( X )
dY

dX

V dU

dX

U
Y
V

U dV

dX

Rules of Differentiation
Chain Rule: The derivative of a
function that is a function of X is
defined as follows.

Y f (U ) U g ( X )
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 d2Y/dX2 > 0, then Y is a
minimum.
OR

CENTRAL POINT
The dependent variable is maximized
when its marginal value shifts from
positive to negative, and vice versa