FUNDAMENTAL METHODS OF Mathematical Economics ALPHA C. CHIANG Peat enh atc hePreface This book is written for those students of economics intent on Icarning the basic mathe- matical methods that have become indispensable for a proper understanding of the current economic literature. Unfortunately, studying mathematics is. for many, something akin to taking bitter-tasting medicine—absolutcly necessary, but extremely unpleasant. Such an at- titude, referred to as “math anxiety,” has its roots—we believe—largely in the inauspicious manner in which mathematics is often presented to students, In the belief’ that conciseness means elegance, cxplanations offered are frequently too brief for clarity, thus puzzling stu- dents and giving them an undeserved sense of intellectual inadequacy. An overly formal style of presentation, when not accompanied by any intuitive illustrations or demonstra- tions of “relevance,” can impair motivation. An uneven progression in the level of material can make certain mathematical topics appear more difficult than they actually are. Finally, exercise problems that are excessively sophisticated may tend to shatter students’ confi- dence, rather than stirnulate thinking as intended. With that in mind, we have made a serious effort (o minimize anxiety-causing features. To the extent possible, paticnt rather than cryptic explanations are offered, The style is de- liberately informal and “reader-friendly.” As a matter of toutinc, we try to anticipate and answer questions that are likcly to arise in the students’ minds as they read. To underscore the relevance of mathematics 10 economics, we let the analytical needs of economists mo- tivate the study of the related mathematical techniques and then illustrate the latter with ap- propriate economic models immediately afterward. Also, the mathematical teol kit is built up on a carefully graduated schedule, with the elementary toels serving as stepping stones to the more advanced tools discussed later. Wherever appropriate, graphic illustrations give visual reinforcement to the algebraic results, And we have designed the exercise problems as drills to help solidify grasp and boister confidence, rather than cxact challenges that might unwittingly frustrate and intimidate the novice. In this book, the following major types of economic analysis are covered: statics (equi- librium analysis), comparative statics, optimization problems (as a special type of statics), dynamics, and dynamic optimization. To tackle these, the following mathematical methods are introduced in due course: matrix algcbra, differential and integral calculus, differential equations, difference equations, and optimal control theory. Because of the substantial number of illustrative economic models—-both macro and micro—appearing here, this book should be useful also to those who are already mathematically trained but still mneed of a guide to usher them from the realm of mathematics to the land of economics. For the same reason, the book should not only serve as a text for a course on mathematical meth- ods, but also as supplementary reading in such courses as microeconomic theory, macro- economic theory, and economic growth and development. We have attempted to retain the principal objectives and style of the previous editions. However, the present edition contains several significant changes. The material on mathe- matical programming is now presented earlier in a new Chap. 13 entitled “Further Topics in Optimization.” This chapter has two major (hemes: optimization with inequality con- straints and the envelope theorem, Under the first theme, the Kuhn—Tucker conditions are viivili Preface developed in much the same manner as in the previous edition. However, the topic has been enhanced with several new economic applications, including peak-load pricing and con- sumer tationing. The second themc is related to the development of the envelope theorem, the maximum-value function, and the notion of duality. By applying the envelope theorem to various economic models, we derive important results such as Roy’s identity, Shephard’s lemma, and Hotelling’s lemma. The second major addition to this edition is a new Chap. 20 on optimal control theory. The purpose of this chapter is to introduce the reader to the basics of optimal control and demonstrate how it may be applied in economics, including examples from natural re- source economics and optimal growth theory. The material in this chapter is drawn in great part from the discussion of optimal control theory in Elements of Dynamic Optimization by Alpha C. Chiang (McGraw-Hill 1992, now published by Waveland Press, Ine.), which pre- sents a thorough treatment of both optimal control and its precursor, calculus of variations. Aside from the two new chapters, there are several significant additions and refinements to this edition, In Chap. 3 we have expanded the discussion of solving higher-order poly- nomial equations by factoring (Sec. 3.3). In Chap, 4, a new section on Markov chains has been added (Sec. 4.7). And, in Chap. 5, we have introduced the checking of the rank of a matrix via an echelon matrix (Sec. 5.1), and the Hawkins-Simon condition in connection with the Leontief input-output model (Sec. 5.7). With respect to economic applications, many new examples have been added and some of the existing applications have been en- hanced. A linear version of the IS-LM model has been included in Sec, 5,6, anda more gen- eral form of the model in Sec. 8.6 bas been expanded to encompass both a closed and open economy, thereby demonstrating a much richer application of comparative statics to general-function models. Other additions include a discussion of expected utility and risk preferences (Sec. 9.3), a profit-maximization model that incorporates the Cobb-Douglas production function (Sec. 11,6), and a two-period intertemporal choice problem (Sec. 12.3). Finally, the exercise problems have been revised and augmented, giving stu- dents a greater opportunity to hone their skills.