Lecture 2

Linear Functions and their economic

applications
 Solution of linear equations/functions

• Linear equation: all variables are raised to the first power, i.e.,
it is a polynomial of degree 1.
• Can be solved by moving the unknown variable to the left-hand
side of the equal sign and all other terms to the right-hand side,
• Solve for the unknown in the ff. equation

• Slope & intercept of linear functions

– Demand function:
– Supply function:
– Total Revenue:
– Total cost:
– Budget line:
– Isocost line:
 Economic Applications
• A market is an institution or mechanism that brings together
buyers and sellers of a particular good.
• A market for a commodity has three components:
• (i) The demand function (ii) The supply function and (iii) The
equilibrium condition
• Demand: is the various amounts of a product that consumers
are willing and able to buy at each of a series of possible
prices during a specified period of time.
• Demand is a function of many variables including among
others the price of the commodity itself, consumers’
disposable income, price of related commodities (substitutes
and complements), etc.
• Mathematically this can be represented as:
 Economic Applications
• An economist researching the demand for coke assumes that:
•
• Where is the quantity of coke demanded, is the price of coke, is the
price of Fanta, is average household income, is population and is
advertising expenditure on coke.
• What does mean in words?
• Identify the dependent and independent variables
• Make up a specific (explicit) form of this function (use your knowledge
of economics to deduce whether the coefficients of the different
variables should be positive or negative)

• Make up a specific (explicit) demand function that relates quantity

demanded of coke to its price
• What assumption (s) did you use to come up with the specification
above?
 Economic Applications
• Supply: refers to the various amounts of a product that
producers are willing and able to supply at each of a
series of possible prices during a specified time period.
• Market supply is a function of many factors which
include among others, the price of the commodity,
resource prices (labour, capital, energy, etc.,),
technological progress, etc.,
•
• Mathematically this can be expressed as:
• Derive inverse functions for the following supply and
demand functions:
 Economic Applications
• Isocost line

• An isocost line represents the different combinations of two inputs or factors

of production that can be bought with a given sum of money. The general
formula is:

• ,

• Where K and L are capital and labour and are their respective prices and E is
the amount allocated to expenditures. Express the formula in terms of K as a
function of L and draw the isocost line. K Increase in wage
E/Pk rate
Increase in
rental rate
• How will the line change if:

i. Budget allocated to inputs increases?

ii. Wage rate increases?
iii. Rental rate of capital increases? 19/9 -10-11 group L
 Economic Applications
• Budget line

• A budget line represents the different combinations of two goods or commodities

that can be bought with a given sum of money. The general formula is:

• ,

• Where and are good 1 and good 2 and are their respective prices and B is the
household income allocated to expenditure on the two goods. Express the formula
in terms of as a function of and draw the budget line.
Q2
Price of good 2 falls
𝐵
• How will the line change if: 𝑄2

i. Income allocated to consumption of the two goods decreases?

Price of good 1 falls
ii. Price of good 2 decreases?
iii. Price of good 1 decreases? original

Q1
 Economic Applications
• Equilibrium condition
• A market equilibrium is established at a price
where the quantity of goods supplied equals
the quantity of goods demanded.

• Thus, the equilibrium condition can be

expressed as: or
 Economic Applications
• Equilibrium condition
• Consider: Single commodity market model

• This is a single commodity market model, where are assumed to be just

functions of the price of the commodity of interest.
• Equilibrium price and equilibrium quantity are obtained by using the equilibrium
condition to equate the demand and supply functions. Thus, means:

• Collect like terms and simplify

• Substitute in either the demand or supply function to get the equilibrium

quantity.

•
• The solution is:
 Economic Applications
• Consider:
• and , Where Y is an exogenously determined average
household income.
 (i) Find the equilibrium price and quantity if the
average household income is P45000
 (ii) Draw the demand and supply curves
 (iii) Assume income rises to P50000; write and graph
the new demand function
 (iv) Find the new equilibrium solution. What is the
impact of the rise in income?
• Solution: 19/9 -12-13 group
 Economic Applications
• and
 (i) If Y= P45000;
 ;


 (ii) Draw the demand and supply curves
 (iii) If Y rises to P50000; then,
 ; shifts outward to the right
 (iv) Find the new equilibrium solution.


 What is the impact of the rise in income? Change in intercept; Increase in both
equilibrium price and equilibrium quantity
 Applications of simultaneous linear equations
• Labour markets: Single factor market model
– Given demand and supply functions for labour
are:

– Calculate the equilibrium wage and equilibrium

number of workers hired algebraically and
graphically (use excel spreadsheet)
– Analyse the effect on the labour market if the
government introduces minimum wage law of
P6.00 per hour.
 Solution of simultaneous linear equations
• Equilibrium condition in the labour market
• (1
• ( 2
• At equilibrium L=L
•
 Solution of simultaneous linear equations
• To solve a system of two or more equations
simultaneously,
• Equations must be consistent (non-
contradictory)
• They must be independent (not multiples of
each other)
• There must be as many consistent and
independent equations as variables
• Can be solved either by substitution,
elimination or graphical method
 Solution of simultaneous linear equations
• Elimination method:
• Requires that each variable be eliminated in
turn by making the absolute value of its
coefficient equal in the system of equations
and then add or subtract the equation.
• You can make the coefficients equal by
multiplying each equation by an appropriate
numerical factor
• Equilibrium condition in the labour market
• (1
• ( 2
 Solution of simultaneous linear equations
• Equilibrium condition in the labour market
• Elimination method
• 1
 Solution of simultaneous linear equations
• Example:
• Solve the x and Y in the following two
equations:

• Eliminate x: multiply Eq.1 by 3 and Eq.2 by 2 to

get:

• y=-2 into (1) or (2) gives

•
 Solution of simultaneous linear equations
• Elimination method:
• Consider two equations:

– Solve for x and y algebraically

– Solve for x and y graphically
• Solution: Eliminate x from the system of
equations by adding (1) and (2)

 Solve for x by substituting y=2 into either equation

(1) or (2)
 Solution of simultaneous linear equations
• Elimination method:

 Solve for x and y algebraically

 Solve for x and y graphically
• Solution: Eliminate y from the system of equations
by multiplying eq. 1 by 2 and eq. 2 by -3, then add
(1) and (2)
• 4
• 18

• Solve for y by substituting x=1.2727 into either

equation (1) or (2)
 Solution of simultaneous linear equations
• Substitution method:
• It involves the following steps
• Step 1: Solve/express one of the equations in the system for
one variable in terms of the other variable
• Step 2: Substitute this equation into the other equation so
that you obtain an equation with only one unknown
variable.
• Step 3: Solve this equation for the unknown variable
• Step 4: Substitute this value into any of the original
equations
• Example:
• Equilibrium condition in the labour market
• () 1
• ( 2
 Solution of simultaneous linear equations
• Equilibrium condition in the labour market
• 1
• 2
• Substitution method
• Using equation 1, make L the subject of the
formula:
 3
• Substitute (3) into (2): → and solve for w =?
• ;
• Then substitute w into either (1) or (2)
• 4
 Solution of simultaneous linear equations
• Substitution method:
• Example:

• Make x subject of formula: using (1)

 Solution of simultaneous linear equations
• Three equations in three unknowns
• Eliminate one of the variables first by adding multiples of equations to other equations
and hence reducing the problem to two equations in two unknowns.

• Add (3) to (1) to eliminate z, leaving an equation in x and y

• Add (3) and (2) to eliminate z again, leaving another equation in x and y


• Solve for x and y from (4) and (5)

• Substitute x=1 into (4) or (5) to get y.

• Using 4:
• Find z by substituting x=1 and y=4 into (1), (2) or (3)
• Using (2):
•
 Applications of simultaneous linear equations
• Goods markets: two commodity market model
(related goods)
• Recall, demand for a product is not only a function
of the price of the good itself, it is also a function
of several other variables, including prices of
complementary (Pc) and or substitute (Ps) goods.
• A two-commodity market model connects
markets for the two related goods together and
studies how the equilibrium quantities and price
are simultaneously determined.
• Substitutes:
• Complements:
 Applications of simultaneous linear equations
• Goods markets: two commodity market model
(related goods)
• Substitutes:
• Complements:
• Note: For:
• Substitutes: the price of each good is entered
with a positive coefficient in the demand
equation for the other good.
• Complements: the price of each good is
entered with a negative coefficient in the
demand equation for the other good.
 Applications of simultaneous linear equations
• Goods markets: two commodity market model (related
goods)
• Find the equilibrium price and quantity for substitute
goods x and y given their respective demand and supply
functions as:
•

• To determine the equilibrium prices and quantities, we

utilize the standard market equilibrium condition that
• and
 Applications of simultaneous linear equations
• Goods markets: two commodity market model
(related goods)

•
• And
•
•
 Applications of simultaneous linear equations
• and

•
• We now have a system of two equations with two unknowns
•
•
• We can use the elimination and substitution method to solve for the
system of two equations. Complete….
 Applications of simultaneous linear equations
• and

•
• We now have a system of two equations with two unknowns
 1
 2
• We can use the elimination and substitution method to solve for the
system of two equations. Complete….
 Applications of simultaneous linear equations
• By Elimination
• Step 1: multiply equation (1) by 2 and equation (2) by 7 so
that the coefficient of is the same in both equations.
• =>
• =>
• Step 2: add equation (3) to (4) to eliminate .
•
•
•
•
• Step 3: Simplify and solve for
•

•
 Applications of simultaneous linear equations
• Substitute in either equation (1) or (2) to get

• Substituting in Eq. 2 we get

• To get and substitute and in any of the supply or demand equations in both markets.

•
 Applications of simultaneous linear equations
• By Substitution
• (1)
• (2)
• Step 1: write or express equation (2) in terms
of (make the subject in equation 2)
 Applications of simultaneous linear equations
• By Substitution
• Step 2: Substitute in step 1 above in equation
(1) so that we have one equation in one
unknown ()
•
•
•
•
•
•
•
 Applications of simultaneous linear equations
• Step 3: Substitute in equation (3) to get
•
•
•
• To get substitute and in or and to get substitute and in
either or .
 Application of simultaneous linear equations
• Equilibrium conditions for two products; milk and butter
• 1
• 2
• Substitution method
• Using equation 2, make Pb the subject of the formula: 3
• Substitute (3) into (2): → and solve for Pm =3
• Then substitute Pm into either (1) or (2)
• 4
• Elimination method
• Multiply (1) by the coefficient Pb (or Pm) in (2) and (2) by the coefficient of Pb (or
Pm) in 1
• Select Pm
• 5
• 6
• Subtract (6) from (5) to eliminate the selected variable (Pm)
• 7
• Substitute Pb=2 into (5) or (6) to find Pm, Pm=3.
 IS-LM Analysis
• IS schedule- is a locus of points representing all different
combinations of interest rates and income levels consistent
with equilibrium in the goods (commodity) market
• LM schedule – is a locus of points representing all different
combinations of interest rates and income levels consistent
with equilibrium in the money market
• IS-LM analysis seeks to find the level of income and the rate
of interest at which both the commodity market and the
money market will be in equilibrium.

•
 IS-LM Analysis

• Equilibrium in the goods market – the IS schedule

• Equilibrium in the money market the LM

• (1)

curve

• (2)
• Condition for equilibrium in both markets can be
found by solving (1) and (2) simultaneously
 IS-LM Analysis

• (1)
• (2)
• …………………………………………………………………………………
• (1)
• (2)
•

• Substituting: