CHAPTER ONE: PRELIMINARY CALCULUS

INTRODUCTION

1.1. The concept and importance of mathematical economics

As you might have recognized from Lucas’s remark, mathematical economics is of paramount
importance for economic analyses. Indeed, it is essential to know what mathematical
economics is before saying about its role in solving problems in theoretical and applied
economics.

Mathematical economics is not a distinct specialization of economics; rather, it is an

approach to economic reasoning. The ultimate objective of mathematical and literary
economics is to come up with somehow valid generalizations about cause effect relationship
that prevails among economic variables. The difference, hence, lies in the ways they
undertake. In mathematical economics, economists make use of mathematical symbols in
the statement of the problem and draw upon known mathematical theorems to aid in reasoning.
In mathematical economics, the assumptions and conclusions are stated in mathematical
symbols than words and in equations rather than in sentences.

In fact, it is amazing to see people in horror with mathematics for mathematics is making things
simpler and our life less costly. An economist without the tools of mathematics is like a blind
person swimming in the middle of an ocean. Till this person gives up, he will continue to
struggle till he reaches an island; but his blindness has left him as incapable to identify whether
swimming to the north, south, east or west is the shortest distance to an island. But an
economist equipped with the tools of mathematics is like a normal person with motorboat or
ship depending upon his personal inclination to each. As a result, most economic researchers
are extensively using the tools of mathematics to economic reasoning.

In the following sections, you will briefly refresh your memory about economic models which
are the basic tools in drawing economic policies designed to solve economic problems of
nations.

1.2. Review of Economic Model and Analysis

As you have covered in the course introduction to economics, an economic theory is
necessarily generalization or abstraction from the real world. The complexity of the real
economy does not make it possible for us to understand all the interrelationships at once;
nor, for that matter, are all these interrelationships of equal importance for the understanding
of the particular economic phenomenon under study. The wise procedure is, hence, to pick
out what appeal to our reason to be the primary factors and relationships relevant to our problem
and to focus our attention on these alone. Such a deliberately simplified analytical framework
is called an economic model since it is only a skeletal and rough representation of the actual
economy.

If our model is mathematical, it will usually consist of a set of equations designed to describe
the structure of the model. By relating a number of variables to one another in certain ways,
these equations give mathematical form to the set of analytical assumptions adopted. Then,
through the application of relevant mathematical operations to these equations, we may seek
to derive a set of conclusions which logically follow from these assumptions. Hence, the
ingredients to any mathematical model are variables, constants, parameters, equations, and
identities.

The main aim behind building economic models is to describe how the economy works
and to obtain somehow valid predictions about economic variables. Different models are
built for different purposes. Some of the models are designed to investigate the equilibrium
value of the variable as an ultimate end while some to investigate the movement of a variable
(s) over time. Thus, in economics, we have three types of analyses:
i. Static (equilibrium) analysis
ii. Comparative static analysis
iii. Dynamic analysis

As the name implies, static/equilibrium analysis is the study about equilibrium. That is, it
studies the determination of equilibrium values. Equilibrium is a constellation of selected
interrelated variables so adjusted to one another that no inherent tendency to change in the
model which they constitute. The mathematics of statics will be handled in linear algebra
for economists. On the other hand, comparative static studies on the comparison of two or
more equilibrium values. This may involve rate of changes and growth rates. Almost all of
the differential calculus is related with the comparative static.

The third form of economic analyses is dynamic analysis. It involves the time path of
different relevant economic variables. The whole of integral calculus deals with the
mathematics of dynamic analyses.

Habtamu L. 2
In this course, you will be introduced with the mathematics of comparative static and
dynamics, and the mathematics for static is left for the next mathematical economics course.
1.3. The Concept and Type of Functions
Since calculus is the study of functions, it is necessary to see what a function is. Function, as
you might remember it, is a unique mathematical rule that relates one or more variables
to determine another variable. It is a special type of relation in which an independent
variable (domain) can never be tied with more than one dependent variable (range). It is a
relationship between numbers in which to each element in the input (domain), there
corresponds exactly one element in the output (range).
Self-test 1: Formulate functions which you see around your area.
There are four methods of representing functions. These are:
i. Vein diagram
ii. Set of order pairs
iii. Equations (commonly used in economic researches)
iv. Graphs (commonly used in economic education)
1. Representing functions using vein diagram
A B
D R D R

1 1 1 1

2 2 2 2

3 3 3 3

4 4 4

The column which represents initial points of the rays is the column of domain and the
column to which the rays are directed is the column of range. In this example, Vein diagram
A is a function since we don’t have any two range values mapped from a single domain. But B
is not a function since the independent variable [domain] value 2 is tied to output [range] values
of 1 and 2
2. Representing functions using set of ordered pairs.
A= { (1,2),(2,3) ,(2,4),(3,6),(4,0)}
B= {(0,1),(1,2) ,(4,8),(7,10),(8,10)}
In this example, A is not a function since domain ‘2’ is mapped to more than one element in
the range but B is a function

Habtamu L. 3
3. Representing functions using equations

A. Y= is a function
Domain: X+ 1≥0; i.e. {X: X > -1}
Range: Y≥0

B. Y2 = X+1 is not a function since Y can be or -

Domain: X+ 1≥0; i.e. {X:X>-1}

Range: Y  R, Why not Y ≥ 0?
4. Representing functions using graphs
Y Y

Y2 = 2X

XX

A. It is a function B. It is not a function

Remark: Vertical line test states that if a vertical line crosses the graph of a function more than
once, it is not a function. But, if it crosses only once, it is a function.

Types of functions
Generally, there are two major types of functions; i.e.
i. Algebraic functions
ii. Non algebraic function
I. Algebraic functions
Before generalizing what, an algebraic function is (are), let’s see each type of algebraic
functions.
a. Polynomial functions: polynomial function of a single variable is given by the general form
o 1 2 3 n
p(x) = Y = aox + a1x + a2x + a3x + …… + anx

Habtamu L. 4
Where aR
n  Whole numbers
If n = 0, Y will be a constant function like Y = 3
If n = 1, Y will be a linear function like Y = 2x+3
2
If n = 2, Y will be a quadratic function like Y = 2 + 4x + x
If n= 3, Y will be cubic function
And so forth. The superscript indicators of the powers of x are called exponents. The
highest power involved, i.e. the value of n, is often called the degree of the polynomial
function; a quadratic function, for instance, is a second degree polynomial, a cubic function
is a third degree polynomial.

𝑦 𝑦

𝑦 = 𝑓ሺ𝑥ሻ = 𝐶 𝑦 = 𝑓ሺ𝑥ሻ = 𝑎0 + 𝑎1 𝑥

𝑥 𝑥

Constant function Linear function

Habtamu L. 5
 𝑦
𝑦
𝑦 = 𝑓ሺ𝑥ሻ = 𝑎0 + 𝑎1 𝑥 + 𝑎2 𝑥 2

𝑎2 > 0

𝑦 = 𝑓ሺ𝑥ሻ = 𝑎0 + 𝑎1 𝑥 + 𝑎2 𝑥 2 + 𝑎3 𝑥 3
𝑥 𝑥

𝑦 = 𝑓ሺ𝑥ሻ = 𝑎0 + 𝑎1 𝑥 + 𝑎2 𝑥 2

𝑎2 < 0

Quadratic function Cubic function

b. Rational functions: A rational function is a function which is the ratio of two polynomial

functions. That is, R(x) =

For instance, the famous rectangular hyperbola function is a rational function with

constant numerator and variable denominator. Example of such a function is Y =

c. The third type of algebraic function is a function which is the square root of polynomial
function.
NB. An algebraic function is a function which is either polynomial, rational, or the third
type of algebraic function. They can be with one variable or n-independent variables.

II. Non algebraic functions/Transcendental functions

There are four types of non-algebraic functions that are commonly used in economics; i.e.
i. Exponential function
ii. Logarithmic function
iii. Trigonometric function and
iv. Incommensurable power functions
In this course you will be introduced with the first two non-algebraic functions and the rest
are left for further studies. Exponential function which has a form of 𝑦 = 𝑏 𝑥 and logarithmic
functions which are 𝑦 = log 𝑏 𝑥 are applicable in different economics concepts and thus better discussed
later in detail.

Habtamu L. 6
Multivariate function
The concept of a function can be readily extended to the case of two or more independent
variables. Given a function

𝑧 = 𝑔ሺ𝑥, 𝑦ሻ

A given pair of X and Y value will uniquely determine a value of the dependent variable Z.
Such a function is exemplified by the

𝑧 = 𝑐𝑥 + 𝑏𝑦 or 𝑧 = 𝑎0 + 𝑎1 𝑥 + 𝑎2 𝑥 2 + 𝑏1 𝑦 + 𝑏2 𝑦 2
The domain in this case is no longer a set of numbers but a set of ordered pairs ሺ𝑥, 𝑦ሻ,
because we can determine z only when both x and y are specified. Functions or more than
one variable can be classified into various types. For instance, a function of the form

𝑦 = 𝑎1 𝑥1 + 𝑎2 𝑥2 + − − − + 𝑎𝑛 𝑥𝑛
It is a linear function, whose characteristic is that every variable is raised to the first power
only. A quadratic function, on the other hand, involves first and second powers of one or more
independent variables, but the sum of exponents of the variable appearing in any single term
must not exceed 2.

Inverse and Implicit Function

Inverse function:

If the function 𝑦 = 𝑓ሺ𝑥ሻ represents a one-to-one mapping, i.e., if the function is such that each
value of y is associated with a unique vale of x, the function 𝒇 will have an inverse function
𝒙 = 𝒇−𝟏 ሺ𝒚ሻ (read: “x is an inverse function of y”). Here, the symbol 𝒇−𝟏is simply signifies a
function related to the function; it does not mean the reciprocal of the function 𝒇ሺ𝒙ሻ.

Not all functions have an inverse function. The mathematical condition necessary for a
function to have a corresponding inverse function is that the original function must be
‘monotonic’. This means that, as the value of the independent variable x is increased, the value
of the dependent variable y must either always increase or always decrease. It cannot first
increase and then decrease, or vice versa. This will ensure that, as well as there being one
unique value of y for any given value of x, there will also be one unique value of x for any
given value of y.

Habtamu L. 7
What the existence of an inverse function essentially means is that, in this case, not only will a
given value of x yield a unique value of y [that is, 𝑦 = 𝑓ሺ𝑥ሻ], but also a given value of y will
yield a unique value of x.

Given a function 𝒇ሺ𝒙ሻ, if successively larger value of the independent variable x always led to
successive larger value of 𝒇ሺ𝒙ሻ, that is, if

𝒙𝟏 > 𝒙𝟐 ⇒ 𝒇ሺ𝒙𝟏 ሻ > 𝒇ሺ𝒙𝟐 ሻ

Then the function 𝒇 is said to be a strictly increasing function. If successive increases in x

always lead to successive decreases in 𝒇ሺ𝒙ሻ, that is, if

𝒙𝟏 > 𝒙𝟐 ⇒ 𝒇ሺ𝒙𝟏 ሻ < 𝒇ሺ𝒙𝟐 ሻ

On the other hand, the function said to be a strictly decreasing function. In either of these
cases, an inverse function 𝒇−𝟏 exists.

Example:
1
a. 𝑓ሺ𝑥ሻ = 𝑦 = 5𝑥 + 25 ⟹ 𝑓 −1 ሺ𝑦ሻ = 𝑥 = 5 𝑦 − 5
b. 𝑓ሺ𝑥ሻ = 𝑦 = 4 + 5𝑥 ⟹ 𝑓 −1 ሺ𝑦ሻ = 0.2𝑦 − 0.8
Note: Both functions are strictly increasing

c. 𝑓ሺ𝑥ሻ = 9𝑥 − 𝑥 2 0≤𝑥≤9
The above function is not monotonic. Each value of x will determine a unique value of y.
However, some values of y will correspond to two values. This can be established by
calculating y for a few selected values of x:

x 1 2 3 4 5 6 7
y 8 14 18 20 20 18 14

These figures show that y first increases and then decreases in value as x is increased and so
there is no inverse for this non-monotonic function.

In general, if an inverse function exists, the original and the inverse function must both be
strictly monotonic. Moreover, if 𝒇−𝟏is the inverse function of 𝑓, then the 𝒇 must be the inverse
function of 𝒇−𝟏 : that is 𝒇 and 𝒇−𝟏 must be inverse functions of each other.

Habtamu L. 8
Implicit function:

A function given in the form of 𝒚 = 𝒇ሺ𝒙ሻ, say 𝑦 = 𝑓ሺ𝑥ሻ = 3𝑥 4 is called an explicit function,
because the variable Y is explicitly expressed as a function of X. If this function is written
alternatively in the equivalent form 𝒚 − 𝟑𝒙𝟒 = 𝟎

However, we no longer have an explicit function. Therefore, when specific form may not even
be known to us is referred to as implicit function. The above implicit function can be denoted
in general by 𝑭ሺ𝒚, 𝒙ሻ = 𝟎, because its left side is a function of the two variable Y and X. Note
that we are using the capital letter F here to distinguish it from the function 𝒇: the function 𝐹,
representing the left side expression in the equation, has two argument, y and x, whereas the
function 𝒇, representing the implicit function, has only one argument, x. There may be more
than two arguments in the 𝑭 function. For instance, we may encounter an
equation 𝐹ሺ𝑦, 𝑥1 , 𝑥2 , … , 𝑥𝑚 ሻ = 0.

For, whereas an explicit function, say, 𝒚 = 𝒇ሺ𝒙ሻ, can always be transformed into an equation
𝑭ሺ𝒚, 𝒙ሻ = 𝟎 by simply transposing the 𝑓ሺ𝑥ሻ expression to the left side of the equals sign, the
reverse transformation is not always possible. Indeed, in certain cases, a given equation in
the form of 𝑭ሺ𝒚, 𝒙ሻ = 𝟎 may not implicitly define a function 𝒚 = 𝒇ሺ𝒙ሻ. For instance, the
equation 𝑥 2 + 𝑦 2 = 0 is satisfied only at the point of origin (0,0), and hence yields not
meaningful function to speak of. Another example

𝐹ሺ𝑦, 𝑥ሻ = 𝑥 2 + 𝑦 2 − 9 = 0

implies not a function, but a relation, because it plots a circle, so that no unique value of y
corresponds to each value of x.

 Non algebraic functions

Exponential and Logarithmic Functions

Exponential Function:

As introduced in connection with polynomial functions, the term exponent means an

indicator of the power to which a variable is to be raised. In power expressions such as 𝒙𝟑
or 𝒙𝟓 , the exponents are constants; but there is no reason why we cannot also have a variable
exponent, such as in 𝟑𝒙 or 𝒙𝒕 , where the number 3 is to be raised to varying powers (various
values of x or t). a function whose independent variable appears in the role of an exponent
is called an exponential function.

Habtamu L. 9
An exponential function may be represented in the form of

𝒚 = 𝒇ሺ𝒙ሻ = 𝒃𝒙 , ሺ𝒃 > 𝟏ሻ

Where y and x represent the dependent and independent variables, respectively, and b
denotes a fixed base of the exponent. The domain of such a function is the set of all real
numbers. Thus, unlike the exponents in a polynomial function, the variable exponent x is not
limited to positive integers – unless we wish to impose such a restriction.

Why the restriction b>1? Since the domain the function consists of set of all real numbers, it is
1
possible for x to take a value such as 2. If b is allowed to be negative, the half power of b will

involve taking the square root of a negative number. While this is not an impossible task, we
would certainly prefer to take the easy way out by restricting b to be positive. Once we adopt
the restriction 𝑏 > 1. However, we might as well go all the way to the restriction 𝑏 > 0: The
restriction 𝑏 > 1 differs from 𝑏 > 0 only in the further exclusion of the case of 𝑜 < 𝑏 < 1 and
𝑏 = 1; but as will be shown, the first case can be subsumed under the restriction 𝑏 > 1, whereas
1
the second case can be dismissed outright. Consider the first case. If 𝑏 = 5, then we have

1 𝑥 1
𝑦 = ( ) = 𝑥 = 5−1
5 5

This shows that a function with a fractional base can be easily be rewritten into one with a
base greater than 1. As for the second case, the fact that b=1 will give us the function 𝑦 = 1𝑥 =
1, so that the exponential function actually degenerates into a constant function: it may
therefore de disqualified as a member of the exponential family.

Rules of Exponent:

i. 𝑎0 = 1
ii. 𝑎 𝑥 𝑎 𝑦 = 𝑎 𝑥+𝑦
𝑎𝑥
iii. = 𝑎 𝑥−𝑦
𝑎𝑦
iv. ሺ𝑎 𝑥 ሻ𝑦 = 𝑎 𝑥𝑦
x x x
v. (ab) =a b
𝑎 𝑥 𝑎𝑥
vi. (𝑏 ) = 𝑎 𝑥
1
vii. 𝑎−𝑥 =
𝑎𝑥

Habtamu L. 10
Logarithmic Function:

Exponential functions are closely related to logarithmic functions (log functions, for short).
Let’s first understand the meaning of the term logarithm.

When we have two numbers such as 4 and 16, which can be related to each other by the
equation 𝟒𝟐 = 𝟏𝟔 , we define the exponent 2 to be the logarithm of 16 to the base of 4, and
write

log 4 16 = 2

It should be clear from this example that the logarithm is nothing but the power to which a
base must be raised to attain a particular number. In general, we may state that

𝒚 = 𝒃𝒙 ⇔ 𝒙 = 𝐥𝐨𝐠 𝒃 𝒚
Which indicates that the log of y to the base b is the power to which a base b must be raise in
order to attain the value y: For this reason, it is correct, though tautological, to write

𝒃𝐥𝐨𝐠𝒃 𝒚 = 𝒚
Given y, the process of finding its logarithm 𝐥𝐨𝐠 𝒃 𝒚 is referred to as taking the log of y to the
base b. The reverse process, that of finding y from a known value of its logarithm log 𝑏 𝑦, is
referred to as taking the antilog of 𝐥𝐨𝐠 𝒃 𝒚

In the discussion of exponential functions, we emphasized that the function 𝒚 = 𝒃𝒙 (with 𝑏 >
1) is strictly increasing. This means that, for any positive value of y, there is a unique exponent
x (not necessarily positive) such that 𝒚 = 𝒃𝒙 ; moreover, the larger the value of y, the larger
must be x. translated into logarithms, the strict monotonicity of the exponential function implies
that any positive number in the exponential function 𝒚 = 𝒃𝒙 ; consequently, a negative number
or zero cannot possess a logarithm.

The base of logarithm, b > 0, does not have to be restricted any particular number, but in actual
log application two numbers are widely chosen as bases- the number 10 and the number
e. when 10 is the base, the logarithm is known as the common logarithm, symbolize by log10 𝑥
(or simply log if the context is clear). With e as the base, on the other hand, the logarithm is
referred to as the natural logarithm and is denoted by 𝐥𝐨𝐠 𝒆 𝒙 or 𝒍𝒏.

Note: exponential and logarithmic functions are inverse functions of each other.

Habtamu L. 11
Rules of Logarithms:

i. log 𝑐 𝑥𝑦 = log 𝑐 𝑥 + log 𝑐 𝑦

ii. log 𝑐 𝑥 ⁄𝑦 = log 𝑐 𝑥 − log 𝑐 𝑦
iii. log 𝑐 𝑥 𝑛 = 𝑛 log 𝑐 𝑥
log𝑛 𝑥
iv. log 𝑐 𝑥 =
log𝑛 𝑐
log𝑥 𝑥 1
v. log 𝑐 𝑥 = =
log𝑥 𝑐 log𝑥 𝑐
vi. log 𝑐 𝑥 log 𝑥 𝑐 = 1

Homogeneous Functions
A function is said to be homogeneous fo degree r, if multiplication of each of its independent
variables by constant j will alter the value of the fucntion by the proportion 𝒋𝒓 , that is, if

𝑓ሺ𝜆𝑥1 , … , 𝜆𝑥𝑛 ሻ = 𝜆𝑟 ሺ𝑥1 , … , 𝑥𝑛 ሻ

Example:
𝑥 2𝑤
a. Given the fucntion 𝑓ሺ𝑥, 𝑦, 𝑤ሻ = 𝑦 + 3𝑥
If we multiply each by 𝜆

𝜆𝑥 2𝜆𝑤 𝜆 𝑥 2𝑤
𝑓ሺ𝜆𝑥, 𝜆𝑦, 𝜆𝑤ሻ = + = ( + ) = 𝜆0 𝑓ሺ𝑥, 𝑦, 𝑤ሻ
𝜆𝑦 3𝜆𝑥 𝜆 𝑦 3𝑥

Therefore, the fucntion is homogenous for degree 0

𝑥2 2𝑥 2
b. Given g 𝑔ሺ𝑥, 𝑦, 𝑤ሻ = +
𝑦 𝑥
If we multiply by 𝜆

ሺ𝜆𝑥ሻ2 2ሺ𝜆𝑥ሻ2
𝑔ሺ𝜆𝑥, 𝜆𝑦, 𝜆𝑤ሻ = + = 𝜆𝑔ሺ𝑥, 𝑦, 𝑤ሻ
𝜆𝑦 𝜆𝑥

Therefore, the fucntion is homogenous of degree 1

Excersise

Check whether the following fucntion are homogeous or not.

1. ℎሺ𝑥, 𝑦, 𝑤ሻ = 2𝑥 2 + 3𝑦𝑤 − 𝑤 2
2. 𝑓ሺ𝑥, 𝑦ሻ = √𝑥𝑦
3. 𝑓ሺ𝑥, 𝑦ሻ = 𝑥 3 − 𝑥𝑦 + 𝑦 3

Habtamu L. 12
1.4 Some Economic Functions
Functions, in economics, have diverse and versatile importance. To come up with neater
theoretical results, it is good to model relationships in terms of mathematical functions. Though
functions are used almost in all specializations of economics extensively, in this course you
will be introduced with the most common microeconomic and macroeconomic functions.
Detailed acquaintance with these functions is left for your “life in economics”.

The most common microeconomic functions are demand functions, supply functions,
production function, cost functions, revenue functions, profit functions, pollution
functions, and other natural resource functions. The most common macroeconomic
functions are consumption, saving, investment, and aggregate production functions. There are
also, a lot of other economic functions, but we don’t discuss them here due to time limit we
have. For the sake of introduction, let’s take some examples of economic functions.

I. Demand and Supply

1
Given the following 𝑃 = −2𝑄𝑑 + 50;𝑃 = 2 𝑄𝑠 + 25, find
i. Find market equilibrium price and quantity
ii. Determine effect of 5 ETB tax on equilibrium price and quantity
Solution:

a) At equilibrium, market demand equals market supply

1
−2𝑄 + 50 = 𝑄 + 25
2
−5
𝑄 = −25
2
𝑄 = 10

The equilibrium Price will be

1
𝑃= ሺ10ሻ + 25
2
= 5 + 25
= 30
b) When 5 birr tax is introduced to the supply function, the supply function will be
decrease accordingly. This can be shown as follows resulting new supply function

1
𝑃−5= 𝑄 + 25
2 𝑠
1
𝑃 = 𝑄𝑠 + 25 + 5
2

Habtamu L. 13
 1
𝑃= 𝑄 + 30
2 𝑠
Then the new equilibrium will be computed be equating the demand equation with
the new supply function. This implies
1
−2𝑄 + 50 = 𝑄 + 30
2
−5
𝑄 = −20
2
𝑄=8

The equilibrium price will be

1
𝑃= ሺ8ሻ + 30
2
= 4 + 30
= 34
Exercise:
1
Given the following 𝑃 = −4𝑄𝑑 + 120;𝑃 = 3 𝑄𝑠 + 29, find

i. Find market equilibrium price and quantity

ii. Determine effect of 5 ETB tax on equilibrium price and quantity
II. Production and cost of production
Production

Function can be applicable in theory of production. Among other application, it is possible to

determine the returns to scale of a production function. In doing so, we find out the degree of
homogeneity of a production function. If the degree of homogeneity is less than, the production
has decreasing returns to scale; if the degree of homogeneity is equal to one, the production
has constant returns to scale; if the degree of homogeneity is greater than one, the production
has increasing returns to scale.

Example:

Given 𝑄 = 𝑓ሺ𝐾, 𝐿ሻ = 2𝐾 0.4 𝐿0.2, determine the returns to scale of the production function.

Solution:

𝑓ሺ𝜆𝐾, 𝜆𝐿ሻ = 2ሺ𝜆𝐾ሻ0.4 ሺ𝜆𝐿ሻ0.2 = 𝜆0.6 ሺ2𝐾 0.4 𝐿0.2 ሻ = 𝜆0.6 𝑓ሺ𝐾, 𝐿ሻ

Since the degree of homogeneity is 0.6, the production function has decreasing returns to
scale.

Exercise:

Determine the returns to scale of the following production functions

a. 𝑓ሺ𝐾, 𝐿ሻ = 7𝐾𝐿
Habtamu L. 14
 b. 𝑓ሺ𝐾, 𝐿ሻ = 0.5𝐾 2 𝐿0.3
Cost of Production:

In theory of production, function can be applicable. Among other the following can be
mentioned.

Given 𝑇𝐹𝐶 = 1000and 𝑇𝑉𝐶 = 4𝑄, it is possible to find out the total cost of production
and average cost of production.

𝑇𝐶 = 𝑇𝐹𝐶 + 𝑇𝑉𝐶 = 1000 + 4𝑄

And

1000 + 4𝑄 1000
𝐴𝐶 = = +4
𝑄 𝑄

III. Revenue and Profit functions

The concept of revenue and profit of a firm can be addressed using functions. If the demand
function faced by a firm is given, it is possible to develop the total revenue and profit
function of the firm.

Example:

Given 𝑃 = 10 − 2𝑄; 𝑇𝐶 = 𝑄 + 4

a. Find the total revenue function

b. Find the total profit function
Solution:

a. Find the total revenue function

𝑇𝑅 = 𝑃𝑄 = ሺ10 − 2𝑄ሻ𝑄 = 10𝑄 − 2𝑄 2

b. Find the total profit function

𝜋 = 𝑇𝑅 − 𝑇𝐶 = 10𝑄 − 2𝑄 2 − ሺ𝑄 + 4ሻ = 9𝑄 − −2𝑄 2 − 4
Exercise

Given 𝑃 = 20 − 𝑄; 𝑇𝐶 = 2𝑄 + 25

a. Find the total revenue function

b. Find the total profit function
IV. National Income
The application of function can be extended to macroeconomics. Among other application in
macroeconomics, it can used to find our macroeconomic variables functions and compute
macroeconomic equilibrium. That means, it is possible to find out the equilibrium national
income, consumption, tax and others.

Habtamu L. 15
 Example:

i. Given 𝐶 = 0.6𝑌 + 10
a. MPC and MPS
b. Find the national saving function
Solution:

a. 𝑀𝑃𝐶 = 0.6 and 𝑀𝑃𝑆 = 0.4

b. 𝑌 = 𝐶 + 𝑆
𝑆 =𝑌−𝐶
𝑆 = 𝑌 − 0.6𝑌 − 10
𝑆 = 0.4𝑌 − 10
ii. Given the following information for a country’s economy operates under closed
economy
𝐶 = 0.9𝑌𝑑 + 70; 𝐼 = 35;𝐺 = 20; 𝑇 = 0.2𝑌 + 25
Find the equilibrium

a. National income,
b. Tax
c. Consumption and
Solution:

a. 𝑌 = 𝐶 + 𝐼 + 𝐺 = 0.9ሺ𝑌 − 𝑇ሻ + 70 + 𝐼 + 𝐺
𝑌 = 0.9ሺ𝑌 − 0.2𝑌 − 25ሻ + 70 + 35 + 20
𝑌 = 0.9𝑌 − 0.18𝑌 − 22.5 + 125
𝑌 = 0.72𝑌 + 102.5
𝑌 − 0.72𝑌 = 102.5
0.28𝑌 = 102.5
𝑌 ≈ 366
b. 𝑇 = 0.2𝑌 + 25 = 0.2ሺ366ሻ + 25 = 98.2
c. 𝐶 = 0.9𝑌𝑑 + 70 = 0.9ሺ366 − 98.2ሻ + 70 = 311.02
Exercise:

1. Determine the saving function when 𝐶 = 0.8𝑌 + 25

2. Find the equilibrium level of national income, tax and consumption given the following
about a closed economy of a hypothetical country
𝐺 = 40
𝐼 = 55
𝐶 = 0.8𝑌𝑑 + 25
𝑇 = 0. 𝑌 + 10

Habtamu L. 16