Problems Book to Accompany

Mathematics for Economists

Tamara Todorova

JOHN WILEY & SONS, INC.

ACQUISITIONS EDITOR MARKETING MANAGER EDITORIAL ASSISTANT SENIOR DESIGNER MEDIA EDITOR PRODUCTION MANAGER PRODUCTION EDITOR

Lacey Vitetta Diane Mars Emily McGee Jim OShea Lauren Sapira Micheline Frederick Amy Weintraub

This book was printed and bound by Courier Westford. The cover was printed by Courier Westford. This book is printed on acid free paper. Copyright 2011 John Wiley & Sons, Inc. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc. 222 Rosewood Drive, Danvers, MA 01923, website www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030-5774, (201)748-6011, fax (201)748-6008, website http://www.wiley.com/go/permissions. Evaluation copies are provided to qualified academics and professionals for review purposes only, for use in their courses during the next academic year. These copies are licensed and may not be sold or transferred to a third party. Upon completion of the review period, please return the evaluation copy to Wiley. Return instructions and a free of charge return shipping label are available at www.wiley.com/go/returnlabel. Outside of the United States, please contact your local representative.

Library of Congress Cataloging in Publication Data: ISBN-13 978-0-470-59181-9

Printed in the United States of America 10 9 8 7 6 5 4 3 2 1

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Table of Contents
Preface Suggested Readings 1. Matrix Algebra 2. Comparative Statics I: Partial Derivatives 3. Comparative Statics II: Differentials 4. Optimization of Functions of One Variable 5. Exponential and Logarithmic Functions 6. Functions of More than One Variable 7. Constrained Optimization 8. Integration 9. Simple Differential Equations 10. Simple Difference Equations vi viii 1 67 125 202 265 311 375 464 512 579

11. Advanced Differential and Difference Equations 615 electronic website: www.wiley.com/college/todorova 12. Introduction to Dynamic Optimization: The Calculus of Variations electronic website: 701 www.wiley.com/college/todorova

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Detailed Table of Contents

Chapter 1: Matrix Algebra linear models, transposes and inverses, nonsingularity of a matrix,
determinants, matrix inversion, Cramers rule, Gauss method, market equilibrium analysis, Keynesian national-income model, Leontief input-output model, problems

Chapter 2: Comparative Statics I: Partial Derivatives derivative, rules of differentiation,

differentiation of functions of more than one variable, inverse-function rule, partial derivatives, Jacobian determinants, problems

Chapter 3: Comparative Statics II: Differentials point elasticity, partial and total differentials, rules of differentials, total derivatives of composite functions, implicit-function rule, implicit-function theorem, general-function models market equilibrium model, IS-LM model, problems Chapter 4: Optimization of Functions of One Variable first-derivative test, secondderivative test, profit maximization, cubic cost function, cubic profit function, n-th derivative test for relative extremum, problems Chapter 5: Exponential and Logarithmic Functions exponential functions, the number e , interest compounding, instantaneous rate of growth, discounting, logarithms, rules of logarithms, logarithmic functions, base conversion, derivatives of exponential and logarithmic functions, optimal timing, rate of growth of composite functions, point elasticity revisited, problems Chapter 6: Functions of More than One Variable functions of two variables, functions of
three and more variables, n-variable quadratic forms, conditions for optimization without constraints, characteristic-root test for sign definiteness, multiproduct and multimarket firm, input decisions of a firm, input decisions and comparative static aspects of optimization, problems

Chapter 7: Constrained Optimization Lagrange-multiplier method, n-variable and multiconstraint case, conditions for optimization with constraints, utility maximization, Slutsky equation, inequality constraints, homogeneous functions, Cobb-Douglas production function, elasticity of substitution, CES production function, problems Chapter 8: Integration indefinite integral, rules of integration, definite integrals, improper integrals, investment and capital formation, consumer and producer surplus, probability and definite integrals, present value of a cash flow, Domar growth model, problems

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Chapter 9: Simple Differential Equations first-order linear differential equations with

constant coefficient and constant term, dynamic model of market price, the case of variable coefficient and variable term, exact differential equations, integrating factors, separation of variables, Bernoulli equations, phase diagrams, Solow growth model, problems

Chapter 10: Simple Difference Equations first-order difference equations, general method of solving, dynamic stability of equilibrium, the Cobweb model, problems Chapter 11: Advanced Differential and Difference Equations second-order linear differential equations, the Arrow-Pratt measure of risk aversion, market equilibrium with price expectations, the relationship between inflation and unemployment, higher-order differential equations, second-order difference equations, multiplier-accelerator model, inflation and unemployment in discrete time, higher-order difference equations, problems Chapter 12: Introduction to Dynamic Optimization: The Calculus of Variations
introduction to dynamic optimization, the calculus of variations, Eulers equation, Ramsey growth model, cost-minimizing firm, constrained dynamic optimization, a glimpse of optimal control theory, problems

Preface
This supplement is intended to complement any course in quantitative methods in economics, mathematical economics for undergraduate students, or introductory mathematical economics for graduate students. The key purpose is to provide a variety of problems with fully worked out solutions, which will enable students to reinforce and strengthen the theory they have learnt from standard textbooks in mathematical economics. The book supplements any of the most widely used texts, such as Mathematics for Economists by Carl Simon and Laurence Blume and Fundamental Methods of Mathematical Economics by Alpha Chiang. While these books are predominantly theoretical texts, the problems book is a practice text illustrating a large number of mathematical tools to be applied in economics. All problems are economic applications, and no problem is purely mathematical without relevance to economics. In fact, many problems can be seen as simple economic models that challenge student thinking and knowledge. While most undergraduate textbooks in the area stress the math theory and illustrate it with some economic applications, this book is as much an economics book as it is a math book. For completeness, short theoretical summaries of the relevant theory and descriptions of economic applications are provided in the beginning of each chapter so as to introduce students to the essentials of the subject. However, these theoretical summaries are only prefatory material, secondary to the main purpose of the book, with no claim to originality on my part except in some sections. The theory is only meant to orient the readers before they plunge into the problems, which I have tried to make as wideranging as possible. I regard the problems and solutions as the essence of the book and the justification for it. The book is designed for students of economics who are taking mathematical economics as part of their education. About 70 percent of the economics content, herein, is drawn from microeconomics, and the rest from macroeconomics. Thus, courses in intermediate micro- and macroeconomics are suitable prerequisites for this book. A first course in calculus is desirable as well. An essential aim of the book is to popularize the subject of mathematical economics and make it more accessible to beginning economists. While a large number of students around the world are intrigued by economics and finance, particularly amid a global financial and economic crisis, fewer are eager to pursue economics because of the math they would have to do as economics majors. Hard-core mathematics bordering on the graduate level scares a great many students and deters them from studying economics. This book reduces the intimidation with math and helps make economics a more interesting and approachable subject. While the problems book may be used by beginning graduate students of economics, it is not perfectly suited for them. Rather, at this advanced level, students might use the book as a reference guide to refresh some lost knowledge. Therefore, the book is appropriate for the masters level and perhaps only the beginning of a doctoral program in economics. Students from such areas as business and finance interested in applying various quantitative tools to their fields of study may also use the book. Yet, it is not a perfect substitute for a book in applied mathematics for business or financial mathematics. Neither is it a substitute for a course in intermediate microeconomics, although many of the problems in this book are drawn from such a course. Problems Book to Accompany Mathematics for Economists was written as a response to an insufficiency in the field of mathematical economics of appropriate study tools and exercise books. Students of economics lack robust homework-type problems with which to test their knowledge. As a professor I have found that to be a serious handicap in my teaching. My students have had no substantial learning aids or tools, and hence have

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asked for a book that gives exercises at the level of exams in the course. This resulted in the design of a large number of problems, the product of years of work. The problems are easy for students to work with as they closely follow the theory covered in the beginning of each chapter. Many problems expand on the economic models and applications provided in the theoretical part. Problems are arranged thematically, starting with the easier ones and moving to the more challenging ones. Students can try to solve a problem without looking at its solution this is what I call active solving. Only afterward should they look up the solution and compare it with their own results. Otherwise, they would be tempted to follow the solution passively and without much understanding. In terms of content, the problems book covers the most essential applications of mathematics in economics that are key to undergraduate learning. There is no stress on sets and vectors, for example, but there is extensive coverage of matrix algebra, exponential functions, logarithmic functions, unconstrained and constrained optimization, and integral calculus. The last part of the book discusses differential and difference equations, starting with first-order equations and moving to higher-order ones. These last topics are more challenging for undergrads, and there is rarely time to discuss them in a one-semester course. Yet, they are included for those students taking rigorous math courses or double-majoring in mathematics and economics, as well as for some beginning graduate students who want to brush up on their knowledge of differential calculus. There is also introduction to basic dynamic optimization, with a focus on the calculus of variations and its parallel with optimal control theory. These last topics are discussed in bonus chapters located at the Wiley website www.wiley.com/college/todorova. The book covers the essential parts of theory in the simplest possible terms; thus, sophisticated mathematical proofs are omitted. I thank my editor, George Lobell, who believed in this project and gave me a helping hand. His skilful guidance and editing of the book helped me overcome numerous problems and my inexperience as an author. I am also thankful to Constance Adler, Emily McGee, Lacey Vitetta, and Amy Weintraub from WileyBlackwell for coordinating the process of book preparation and assisting my work. Special thanks go to Amy Weintraub who was my Production Editor and who followed her deadline strictly. I am indebted to John Drexel for proofreading a manuscript full of equations and variables. I also thank the following reviewers whose helpful comments contributed to improvements in the book: Steven Antler (Roosevelt University), Mak Arvin (Trent University, Canada), Monica Costa Dias (University College London), Brian Gross (University of California, Berkeley), Kareem Ismail (Johns Hopkins University), Mina Baliamoune-Lutz (University of North Florida), Wing Suen (University of Hong Kong), Rossitza Wooster (Portland State University), and Wendy Wu (Wilfrid Laurier University). Bharath Ramachandran, who is my spiritual mentor and father, gave me much inspiration in writing the book. He was always there to advise me and encourage me, especially in moments of distress and disappointment. I am also truly grateful to three work-study students of mine. Yordanka Kostova and Martin Milev meticulously solved and corrected problems for me, the first for the early version of the book and the second for the later. I express my thanks to Alexandru Andronic, one of my first work-study students, who gave me the idea of writing my problems electronically. Alex was the first to write those in Microsoft Equation. This ultimately brought me to the idea of writing the book. I should also mention that all my students taking Quantitative Methods in Economics with me at the American University in Bulgaria receive my appreciation. The students from the last four years helped me the most as the book was tested on them numerous times. Finally, I wish to thank my family, my mom and Iliya, who had patience in the eternal writing of the book. I dedicate this book to my daughter Tatyana, who grew along with the book and was delivered several months before the manuscript was complete. Tamara Todorova American University in Bulgaria e-mail: ttodorova@aubg.bg

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Suggested Readings
1. Arrow, Kenneth J., Hollis B. Chenery, Bagicha S. Minhas, and Robert. M. Solow. Capital-Labor Substitution and Economic Efficiency. Review of Economics and Statistics (August 1961): 225250. 2. Baldani, Jeffrey, James Bradfield, and Robert Turner. Mathematical Economics. Boston, MA: Thomson Learning, 2001. 3. Blanchard, Olivier. Macroeconomics. 2nd ed. Englewood Cliffs, NJ: Prentice Hall International, 2000. 4. Chiang, Alpha C. Fundamental Methods of Mathematical Economics. 3rd ed. New York: McGrawHill Inc., 1984. 5. de la Fuente, Angel. Mathematical Methods and Models for Economists. Cambridge: Cambridge University Press, 2000. 6. Domar, Evsey, Capital Expansion, Rate of Growth, and Employment, Econometrica, April 1946, 137147; reprinted in Domar, Essays in the Theory of Economic Growth. Oxford University Press, 1957, 7082. 7. Dixit, Avinash. Optimization in Economic Theory. 2nd ed. Oxford University Press, 1990. 8. Dowling, Edward T., Introduction to Mathematical Economics, in Schaum's Outline Series, 2nd ed. New York: McGraw-Hill, 1992. 9. Jacques, Ian. Mathematics for Economics and Business. 5th ed. Englewood Cliffs, NJ: Prentice Hall, 2006. 10. Keynes, John M. The General Theory of Employment, Interest and Money. Amherst, NY: Prometheus Books, 1997. 11. Leonard, Daniel, and Ngo Van Long. Optimal Control Theory and Static Optimization in Economics. Cambridge: Cambridge University Press, 1998. 12. Leontief, Wassily W. Input-Output Economics. 2nd ed. New York: Oxford University Press, 1986. 13. Mas-Colell, Andrew, Michael D. Whinston, and Gerry R. Green. Microeconomic Theory. Oxford University Press, 1995. 14. Nicholson, Walter. Microeconomic Theory: Basic Principles and Extentions. Fort Worth, TX: Dryden Press, 1992. 15. Pemberton, Malcolm, and Nicholas Rau. Mathematics for Economists. Manchester, UK: Manchester University Press, 2001. 16. Phillips, Alban H. The Relationship between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 18611957. Economica (November 1958) 283299. 17. Rainville, Earl David, Phillip E. Bedient, and Richard E. Bedient. Elementary Differential Equations. 8th ed. Upper Saddle River, NJ: Prentice Hall, 1996. 18. Samuelson, Paul. Foundations of Economic Analysis. Cambridge, MA: Harvard University Press, 1947. 19. Silberberg, Eugene, and Wing Suen. The Structure of Economics: A Mathematical Analysis. New York: McGraw-Hill/Irwin, 2000. 20. Simon, Carl, and Lawrence Blume. Mathematics for Economists. New York: W. W. Norton, 1994. 21. Solow, Robert M. A Contribution to the Theory of Economic Growth, Quarterly Journal of Economics (February, 1956): 6594.

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22. Solow, Robert M. Technical Change and the Aggregate Production Function. The Review of Economics and Statistics, 39: no. 3 (August 1957): 312320. 23. Stiglitz, Joseph E., and Carl E. Walsh. Economics. 3rd ed. New York: W. W. Norton and Company, 2002. 24. Sydsaeter, Knut, and Peter Hammond. Essential Mathematics for Economic Analysis. 2nd ed. Englewood Cliffs, NJ: Prentice Hall, 2006. 25. Varian, Hal. Microeconomic Analysis. New York: W.W. Norton, 1984.

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