Mathematics for Economics second edition The MIT Press Michaet Hoy John Livernois Chris McKenna Ray Rees Thanasis Stengos Cambridge, Massachusetts London, England(© 2001 Massachusetts Institute of Technology All rights reserved. No part ofthis book may be reproduced in any form by any lectronic or mechanical means (inching photocopying. recording. oF information storage and retrieval) without permission in writing from the publisher. ‘This hook was set in Helvetica and Times Roman by Int Corporation. tive Composition Printed and bound in the United States of America. Library of Congress Cataloging-in-Publication Data Mathentaties for economics/Michael Hy .. [et al.}—2nd ed. pcm. Includes inde. ISBN 0-262-08254-2 (he. : alk. paper)—ISBN 0-262-58207-4 (pbk. : alk. paper) 1, Economies, Mathematical. I. Hoy, Michael, 1953 Sept. 22- H1B135 M3698 2001 St. 8—ae21 100-068385,sO Preface xiii Part! Introduction and Fundamentals Chapter 1 Introduction 3 1. What Is an Economic Model? 1.2 Howto Use This Book 8 13° Conclusion 9 Chapter 2 Review of Fundamentals 11 2A. Sets and Subsets 11 22 Numbers 23 2.3 Some Properties of Point Sets in" 33 24 Functions 43 28 Proaf, Necessary and Sufficient Consitions* 60) Chapter 3 Sequences, Series, and Limits 67 Bd Definition of a Sequence 67 2 LimitofaSequence 70 3.3 Present-Value Calculations 75 34 Properties of Sequences 84 3S Series 89 Part il Univariate Calculus and Optimization Chapter 4 Continuity of Functions 118 441 Continuity of a Function of One Variable 115 4.2 Economic Applications of Continuous and Discontinuous Functions 1 43° Intermediate-Value Theorem 143viii CONTENTS Chapter 5 ‘The Derivative ana Differential for Functions of One Variable 155 $A Definition of a Tangent Line 155 5.2. Definition of the Derivative and the Differential 262 5.3 Conditions for Differentiability 169 34° Rules of Differentiation 175 3 Higher-Onder Derivatives: Concavity and Convexity of a Function 208, .6 Taylor Series Formula and the Mean-Value Theorem — 218 Chapter 6 Optimization of Functions of One Variable 227 6.1 Necessary Conditions for Unconstrained Maxima and Minima — 227 6.2 Second-Order Conditions 253 6.3 Optimization over an Interval 265 Part Ill Linear Algebra Chapter 7 Systems of Linear Equations 279. 7. Solving Systems of Linear Equations 279 712 Linear Systems in n-Variables 293 Chapter 8 Matrices 317 84 General Notation 317 8.2. Basic Matrix Operations 324 3 Maitix Transposiion 340 84 Some Special Matrices 345 Chapter 9 Determinants and the Inverse Matrix 353, YA Defining the Inverse 353 9.2 Obtaining the Determinant and Inverse of a 3% 3 Matrix 370 9.3 The Inverse of an nm Matrix and Its Properties 376 94 Cramer's Rule 386 Chapter 10 ‘Some Advanced Topics in Linear Algebra” 405 WL Vector Spaces 408 102 The Eigenvalue Problem — 421 10.3 Quadratic Forms 436CONTENTS bx Part iV. Multivariate Calculus Chapter 11 Calculus for Functions of n-Variabies 455 ALI Panial Differentiation 485 112. Second-Onder Partial Derivatives 469 U3 The First-Order Total Differential 477 324. Curvature Properties: Concavity and Convexity 498 11.5 More Properties of Functions with Economic Applications $13 11.6 Taylor Series Expansion* 534 Chapter 12 Optimization of Functions of n-Variables 845 12.1 First-Order Conditions $43 12.2 Second-Order Conditions 360 12.3 Direct Restrictions on Variables 569 Chapter 13 Constrained Optimization 585 13 Constrained Problems and Approaches io Solutions 585 13.2 Second-Order Covaltions for Constrained Optimization 616 13.3. Existence, Uniqueness, and Characterization of Solutions 622 Chapter 14 Comparative Statics 631 14.1 Introduction to Comparative Statics 631 14.2. General Comparative-Statics Analysis 643 143° The Envelope Theorem — 660 Chapter 15 Concave Programming and the Kuhn-Tucker Conditions 677 18.1 ‘The Concave-Programming Problem 677 18.2. Many Variables and Constraints. 686 Part V_ Integration and Dynamic Methods Chapter 16 Integration 701 16.2 The Indefinite Integral 704 16.2 The Riemann (Definite) Integral 709 16.3 Properties of Integrals 721x CONTENTS 16.4 Improper Integrals 733 16.5 Techniques of Integration 742 Chapter 17 ‘An Introduction to Mathematics for Economic Dynamics 753 171 Modeling Time 784 Chapter 18 Linear, First-Order Difference Equations 763 18.1 Linear, First-Order, Autonomous Difference Equations 763 182 The General, Linear. First-Order Difference Equation 780 Chapter 19 Nonlinear, First-Order Difference Equations 789 19.1 ‘The Phase Diagram and Qualitative Analysis 789 192 Cycles and Chaos 799 Chapter 20 Linear, Second-Order Difference Equations 811 20.1 The Linear, Autonomous, Second-Order Difference Equation 811 20.2. TheLinear,Second-Onder Difference Equation witha VariableTerm — 838 Chapter 21 Linear, First-Order Differential Equations 849 21.1 Autonomous Equations 849 21.2 Nonautonomous Equations 870 Chapter 22 Nonlinear, First-Order Differential Equations 879 22.1 Autonomous Equations and Qualitative Analysis 879 22.2 ‘Two Special Forms of Nonlinear, First-Order Differential Equations 888 Chapter 23 Linear, Second-Order Differential Equations 897 23.1 ‘The Linear, Autonomous, Second-Order Differential Equation 897 232. TheLinear Second-Order Differential Equation witha VariableTerm 919 Chapter 24 ‘Simultaneous Systems of Differential and Difference Equations 929 24.1 Linear Differential Equation Systems 929 24.2 Stability Analysis and Linear Phase Diagrams 981 24.3 Systems of Linear Difference Equations 976CONTENTS xt Chapter 25 Optimal Control Theory 999 25.1 25.2 283 284 255 236 ‘The Maximum Principle 1002 Optnnization Problems Involving Discounting 1014 AAltenative Boundary Conditions on «(7 1026 Tnfinite—Time Horizon Problems 1040 Constraints on the Control Variable 1083 FreeTerminai-Time Problems (7 Free) 1063 ‘Appendix: Complex Numbers and Circular Functions 1081 Answers 1091 Index 1123Lele} A major challenge in writing a book om mathematics for economists is to select the appropriate mathematical topics and present them with the necessary clarity Another challenge is 10 motivate students of economics to study these fopics by convincingly demonstrating their power to deal with economic problems. All this must be done without sacrificing anything in terms of the rigor and correctness of the mathematics itself, ‘A problem lies in the difference hetween the logic of the development of the mathematics and the way in which economies progresses from models of in- dividual consumer and firm, through market models and general equilibrium, to macroeconomic models. The primary building blocks, the models of consumer and firm behavior, are based on methods of constrained optimization that, mathe- matically speaking, are already relatively advanced. In this book we have chosen instead to follow the logic of the mathematics. After a review of fundamentals, concemed primarily with sets, numbers, and functions, we pay careful attention tothe development ofthe ideas of limits and continuity, moving then tothe ealcue lus of fumetions of one variable, linear algebra, multivariate calculus, and finally dynamics. Inthe treatment of the mathematics our goal has always been 1 give the student an understanding of the mathematical concepts themselves, since we believe this understanding is required if he or she is to develop the ability and confidence {0 tackle prublems in economic analysis, We have very consciously sought to avoid a “cookbook” approach. ‘We have tried to develop the student's problem-solving skills and motivation by working through « large number of examples and economic applications. far ‘more than is usual inthis type of book, Although the selection ofthese, and the order in which they are presemted, was determined by the logic ofthe development of the ‘mathematies rather than that of an economies course. in the end the student will hhave covered virtually all of the standard undergraduate mathematical economics syllabus, Many people helped us in the preparation of this book and itis a pleasure to ucknowledge our deb to them here, The following individuals read early versions of the manuscript and offered helpful suggestions large number of which were Ireely used:xiv PRERACE Richard Anderson Paul Anglin Walter Bossert Zhigi Chen Peter Coughlin ‘Swapan DasGupta Erie Davis ‘Allun DeSerpa Richard Fowles Jan Irvine Roger Latham Chenghu Ma Paul Segersirom James A. Stephenson Rugu Wang. Steven Williams ‘Texas A&M University University of Windsor University of Waterloo Carleton University University of Muryland at College Park Dalhousie University Carleton University Arizona State University University of Utatt Concordia University York University MeGill University Michigan State University Lowa State University ‘Queen's University University of Ulinois Drafts of the book, at various stages, have been used in classes at the Uni- versity of Guelph. We thank the many students involved for their cooperation in finding their way around incomplete manuscripts, ancl we thank Louise Grenier {for helping them do just that. For assistance in preparing answers to the exercises and for helpful comments on the text, we would like to thank Matias Polborn, Mathias Kifmann, Markus Wagoer, Erich Kolger, Tina Farber, Ursula Bachmann and Andreas Wildermuth. ‘A number of individuals who used the first edition suggested many useful changes and we thank them for that. We especially thank Naney Bower for her ‘numerous contributions.introduction and Fundamentals Chapter 4 Introduction Chapter 2 Review of Fundamentals Chapter 3 ‘Sequences, Series, and LimitsChapter 1 Introduction Aimast for as long as economics has existed as a subject of study, mathematies ‘has played a part in both the exploration and the exposition of economic ideas,! Its not simply that many economic concepts are quantifiable (examples include prices, quantities of goods, volume of money but also that mathematics enables us to explore relationships among these quantities, These relationships are explored in the context of economic models, and haw such models are developed is one of the key themes of this book. Mathematics possesses the accuracy, the rigor, and the capacity to deal clearly with complex systems, which makes it highly valuable as a method for analyzing economic issues. This book covers a wide range of mathematical techniques and outlines a large number of economic problems to which these techniques may be applied. However, mathematical modeling in economics has some unifying features and Conventions that we will summarize here at the outsct. Although model details ure problem-specific, here are rome basic principles in the modeling process that are ‘worth spelling out, 1.1. What Is an Economic Model? Av its most general, a model of anything is a representation. As sech, a model differs from the original in some way such as scale, amount of detail, or degree of complexity, while atthe samme time preserving what is important in the original in its broader or most salient aspects. The same is tre of an economic model, though unlike model airplanes, our models do not take a physical fon, Instead, we think of an economie model as a set of mathematical relationships between economic ‘magnitudes. Knowing iow to distill the important aspectsof an economic problem inte an abstract simplification is part of the formal training of an economist. The ‘model must be convincing and must be Capable of addressing the questions that the researcher has set, We now set out the central features af an economic model "The mre famous early works in economics witha aematical exposition include A. Coun, ‘Récherchessurlesprncie mathémaignerde la theriedesichesses{ 1838). WS .ev0ns, The Theory of Paliuen! Economy (1814), L. Walas, Etniens dScrmomie pric pure (4874, A. Marshal Princes of Ecos (1890), an V. Past, Cou economic prtigu | 196).4 CHAPTER 1 INTRODUCTION Quantities, Magnitudes, and Relationships We can start by thinking of how we measure things in economies. Numbers repre- Sent quantities and ultimately itis this circumstance that makes it possible to use ‘mathematics as an instrument for economic modeling. When we discuss market activity, for example, we are concerned with the quantity traded and the price at which the trade occurs. This is so whether the “quantity” is automobiles, bread, hrairwuts, shares. or treasury bills. These items possess cardinality, which means that we ean place @ definite number on the quantity we observe. Cardinaliy i absolute but isnot always necessary for comparisons. Ondinality is also-a property ‘of numbers but refers only to the ordering of items. The difference between these ‘two number concepts may be illustrated by the following {wo statements LL Last year, the economy's growth rate was 3%. 2. The economy’s output last year was greater than the year before. Both of these statements convey quantitative information. The fist of these is wcardinal property of the change in output, We are able to measure the change and put a definite value on it. The second is an onal statement about economic activity in the past year. Last year's output is higher than the year before, ‘This of course isan implication of the frst staernent, but the first statement cannot be inferred from the second statement. However, there isa greater difference between cardinality and ordinality, be- cause we cam also decide ona ranking of items hased on their gualizarive properties rather than on their quantifiable ones. Most statements about preferences are ordi hal in this sense, 50 to says “I prefer brand A to brand B, and brand B to brand C” i an ordinal statement about how one person subjectively evaluates three brands of a good. If we let larger oumbers denote more preferred brands, then we could associate brand A with the number 3, brand B with the number 2, and brand C with the number 1. However, the numbers 10, 8, and O would serve equally well inthe absence of any other information. This statement may provide useful information, and certain logical and mathematical consequences may follow from it, but itis ‘ota statement about quantities. Variables and Parameters Wren we start to build an economic model, We know thal we are not going to be able to explain everything. Some things must be treated as given or as data for our problem. These are the exogencits variables and the parameters of the model. The endogenous variables, then. are those tna are going fo be explained by the model A simple example will illustrate. Suppose that we are trying to determine the equilibrium price and quantity in market fora homogeneous good, We hypothesize that the quantity demanded of1:1 WHATISANECONOMIC MODEL? 5 some good may be represented as ° —bp toy oy ‘which is a simple tinear demand function. Each time price, p. inereases by one dollar, the quantity demanded, q”, falls by b times one dollar. rise in income, y, ‘of one dollar increases quantity demanded fy © units, This demand curve may be chosen purely for simplicity, or it may be known, by looking at market data, that the demand curve for this gbod does take this simple forin. Now suppose that the supply of this good is fixed ar some amount which we will eall q°, and suppose hat we believe that the prevailing price in this market isthe price that equates demand with supply. Then implies. p= “4 a2) So bere, p is the endogenous variable, a and i> ate the exogenously given parame- ters, and and_y are exogenous Variables, For instance, demand is determined by tastes, weather, and many other environmental and social factors, all of which are ‘captured hereby a, b,c. All supply-side considerations ae, in this particularly simple case, surnmarized by the quantity 7°. Parameters may also incorporate the effects of exogenous variables, which we do nat wish to specify explicitly. For example, « may incorporate the effects of prices of others goods on the demand for this one. Finally, in this example, there is one furthe: endogenous variable, Since quantity demanded, 4”, depends partly on p (which is endogenous) it too is endogenous: therefore 4” is only known when the price is known, Substituting ‘egjuation (1.2) into equation (1.1) gives simply q” = g° as the value of demand In general, as in this simple example, we can use relationships between eco nomic variables and fckground parameters to reach conclusions or predictions ‘based upon the mattematical solutions of those relationships Behavior and Equilibrium ‘As we have just seen, further step in building an economic model isto identity the ‘ehavioral equations, or the equations that describe the economic environnient. and to identify the equilibrium conditions. tthe simple supply-and-demand ex:um- ple above, the behavioral equations are the demand and supply functions describing the relationships between the endogenous variables nd exogenous variables. The equilibrium condition determines what the values of the endogenous variables ‘will be, In this ease the condition is that supply equals demand. The specification of the equilibrium condition is based on our understanding of how the part of the economy in question Works, and embodies the crucial hypothesis of how the ‘endogenous variables are determined,6 CHAPTER INTRODUCTION Behavioral equations contain hypotheses about the way the individusl, market, ‘oreconomy works. Oneof the key strengths of mathematical analysis in economics is that it forces us tobe precise about our assumptions. I the implications of those behavioral equations prove (o be unsubstantiated or ridiculous, then the natural course of aetion isto lock more closely at the assumptions and o atteapt to idemify those esponsible for throwing us offcourse. Single-Equation Models and Multiple-Equation Models Although sometimes the problem we are trying to analyze may be captured in 8 single-equation model, there are many instances where two or more equations are necessary, Interactions among a number of economic agents or among different sectors of the economy typically cannot be captured in a single equation, and & system of equations must be specified and solved simultaneously. We can extend ‘our earlier example to illustrate this ‘Consider frst the demand and supply of two goods. We denote the demands by g? and g? and the supplies by 9° and gS, where the subscrips | and 2 identify which good weare referring 1, Now, as before, we may specify how demands and supplies are related to the prices of the two goods, bat this lime recognizing that the demand for and supply of good 1 may depend on both its own price und on the price of good 2. Recognition ofthis fact gives rise to an inverdependence between the two markets. For simplicity, suppose that the demand for each good depends ‘on both prices, while the supply of each good depends only on the good's own price. The question we are asking is: Ifthe interdependence between two goods takes this form, what are the consequences for the equilibrium price and quantity traded in each market in equilibrium? Again, as before, we will restrict ourselves to finear celationships only. We may write qP =a—bypy +b: dy be > 0 (ay and af = 0 Bip + Papi, aay ‘Notice that in addition to incorporating the usual negative relationship between the demand fora good and its own price, we bave included « specific assumption about tne cross-price effects, namely that these goods are yubstitufes. Ifthe price of ‘good | increases, the demand for goo! 2 inereases. and vice versa. Setting supply ‘equal 0 an exogenous amount in each market gives us(sy at Bap - a a (6) and solving gives Bila G) + (aH 1 See 7 Bala ai) + n(o ia) BiB — bapa Notice thatthe solutions hece express the two prices in terms only of the exogenous variables and the parameters—these are the reduced-form solutions. We are now set to consider the implications of our imitial model. Statics and Dynamics Inintroductory treatments of economics the time dimension ofthe problem soften ignored, or supressed for simplicity In eality, the time dimension salway’ present, In the examples of market equilibrium already discussed, we should think of the ‘quantities as flows per period of time, so that g° is the quantity demanded of a ss00d per period, however short o long that period may be in terms of calendar time. Models where we explicitly or implicitly considera situation within a single period of time we refer to as staric models. The economic activities studied in static models do not take into account the history of these activities and do not ‘consider the future consequences of these activities. Static problems are solved in- dependently of the possege of time. Put this way, it seems that the static framework for economic analysis is extremely restrictive. However, many useful models of ‘economic behavior have been developed in the static framework, and we will be studying several such examples in the book. Many problems, though, are neces- sarily dynamic in nature. The theories of economic growih, inflation, and resource depletion, for example, are impossible to model without explicit consideration of the time dimension Explicit consideration of time opens up new challenges as well as new oppor tunities for the modeler, and in the later chapters of the book we will develop the ‘more important techniques for studying dynamic models. Its useful at this point, however, to highlight some important concepts that emerge when. we explicitly account forthe passage of ime. ‘Quantities and values that recur each peried in a dynamic moxle! continue to be referred to as flows. Income, investment, saving, production, worker hires, and8 CHAPTER INTRODUCTION purchase and consumption of goods are examples. Some of these flows may be stored or accumulated into stocks. Flows of investment in machinery become the -cumulated capital stock. Accumulated savings are assets. Accumulated hires are the Workforce. Unsold production aécumlates into inventovies. Accumulated deficits are total debt, and so on. Mathematically we must specify the telationships between the flows and the stocks as part of any dynamic model, The relationship between investment andthe ‘capital sock is « useful example, Denote by J; the amount of investment during period and denote the capital stock atthe hegining of period by K;,. Then we can define the flow of investment in terms of the change in the capital stock between periods (ignoring the depreciation of capital) h Kin — Ky The flow of investment is simply the change inthe stock of capital. Nove that we use time subscripts to date the stocks and the flows dat we are interested in From the modeling point of view, we have certain choices whien we are decid- ing onthe appropriate mathematica structure fora dynamic model, One a these is the modeling of time itself, So far we have thought of time as being divided up into intervals or “periods.” Ia these models of discrete time, al zelevant economic fac torsare allowed to change between periods but aot within periods, OF eourse, since the leagth of a period is arbitrary, this condition is not very restrictive, Different mathematical techniques are required if we wish to think of time as evolving ex tinvously. In continuous time models, we date the stocks and flows by instants in time, and we can invoke calculus io define the relationships between flows and suc- ‘cessive instantaneous yalues of stocks. We show how this is dove later in the book 1.2 How to Use This Book ‘The book is intended to be comprehensive ints coverage of mathematical methods for undergraduate economics programs. The arrangement of the material follows the logic of the development af the mathematical ideas rather than those of eco- nomics. Examples and exercises relate both to purely mathematical techniques and {o their applications in economics. The book also contains extended discussions of some economic applications. Chapters, sections, exercises, examples, and eco- nomic applications that we regard as advanced or that might otherwise be onytted are indicated by an asterisk. Important concepts are highlighted. Key theorems and definitions are dis- played, while keywords are set im bold (ype. Each section ends with exercise land each chapter ends with a chapter review, consisting of a list of key concepts, {questions for discussion o¢ review, and review exercises: Answers 0 the oxd- ‘numbered questions ure given at the end of the book.4a PONCISION 9 To the Instructor... There is clearly mone material here than can be covered in a one-semester course. {A fist course is unlikely 1o progress beyond chapter 13 or possibly chapter 14 ‘Chapter 16, on integration is positioned here as a preparation for the chapters on ‘dynamic methods, though it could be brought forward if integration techniques are 10 be given a higher priority in the single-semester course, A second-semester ‘course vould be built around ehapter 15 onward To the Student... In any course, you will need to attempt exercises, and other material, that have not ‘been coveted in class. The only way to learn mathematics ancl economics isto do ‘mathematics and economics. We have provided many examples and exercises in ‘order to encourage independent study. 1.3. Conclusion ‘The aim of this book is to present the key mathematical concepts that most fre- 4uenily prove helpful in analyzing economic problems. However, the approach We take is not simply 10 provide a recipe book of results and procedures. Our imis to take students through the model-building process by working out a lange number of economic examples. BY the end of the book, in addition to acquiring particular mathematical skills, we hope that the student will have some knowledge of the ‘main economic models ant their properties.Review of Fundamentals In this chapter we give a concise overview of some funnlamental concepts that underlic everything we do in the rest of the book. In section 2.1 we present the basic clements of set theory. We then goon to discuss the various kinds of numbers, ending with a concise treatment of the properties of real oumbers. and the dimensions of economic variables. We then introduce the idea of point sets, beginning with the simplest case of intervals of the real line, and define their most important properties from the point of view of economics: closedness, boundedness, and convexity. Next we give the general definition of a function, and set out the main properties of the types of functions ‘most frequently encountered in economics, We also define the important properties ‘of concavity, convexity, and quasiconeavity and convexity. Finally. there isa short discussion of the meaning of necessary conditions and su ‘of how proofs are formulated, inthe context of an economic example, iclent conditions, and 2.1 Sets and Subsets A set is any collection of items thought of as a whole, The collection is treated ‘asa single cbject, to which mathematical operations may be applied. One way of defining a particalar set is by enumeration: we simply list the items included in the set—the elements of the set. Alternatively, we can state a specific property. If.an item possesses that property, itis an element of the set, but if it does not, it is excluded from the set, This fatter method is far more generally used because defining a set by enumeration is often very cumbersome and sometimes impossible. For example, consider the set of even numbers between 1 and 17, In the standard notation for deseribing seis, we could write (x: isuo even number between 4 and 11) (2d) or, equivalently. 2.4.6.8, 10) The first way of writing S corresponds to definition by property (the "should be42° CHAPTER? [REVIEW OF FUNDAMENTALS Example 2.1 read as "given that”); the second to definition by enumeration. The key aspects of this notation are as follows + A capital leter denoting the set, here S. ‘© A lowercase letter denoting a typical element ofthe set, here x ‘* Braves, |...) that enclose the elements ofthe set and emphasize that we treat them as a single entity In general, a lowercase letter such as x denotes items that may or may not be clements of some particular set. For example, here x can represent any number ‘whatsoever. Then, if takes on a Value that is inthe set, we write xes and if it takes on a value that is notin the set, we write res Also, in general, the definition of a set by property may be written X= |r: Poy) where P is a property that x may or may not have, so P(x) is equivalent t0 the statement “x possesses the property P.” Consider now three further sets of numbers: Zy = (x sx isa positive imeger) (23) Aa (re Zoe SU) =(,2,3,4,5,6,7.89, 1011] 24) Ba{reAsx/leZ, (2.4.6.8, LO} es) Note that in the case of A and B we have extended the notation slightly by writing, the set to which must belong fa property of A and B) to the left ofthe colon, Deline the set Z,, in equation (2.3) by enumeration Solution ‘The difficulty here fs thatthe set of positive integers is very large. The way around this istohave anotation to stand for “and so on” once a pattern has been established so that there i litle ambiguity about what follows, One suggestion inthis example right be Z= 1234.0)24 SETSAND SUBSETS 13 Where"... stands for “and so on.” Notice. however, that this notation only suggests the nature of Wy infinitely long sequence of integers could follow 4, . We observe also that all the elements of A are also elements of Zand that all the elements of B are also elements of A, This observation leads 10 the following important definition: If all the elements of a set X are also elements of a set ¥. then X is a subset of ¥. and we write xey Where C is the set-inelusion relation. In our cxamples we have B © A and A Z,. Note also that these two facts feud BC Z,, Since A contains B and Z, contains A, then Z4 must contain B. Is Z, subset of A? Clearly not, because there exist numbers x > 12 that are in Z,. bul oot in A. This observation leads 10 PERRIER 2 tic ctemens in a set © are ova sr ¥, hur nov alle elements of ¥ ae in X then X is a proper subset of ¥, and we write cY So, for our examples, we certainly have AC Z,. Itmust ther also be true that BC Zz, Since B < A, Now consider the relationship between A and B. Is Ba proper subset of A? Clearly. B CA because the ad integers 1, 3,..., 1] ate in A bat not in B, The equality between two sets is defined by PEST 0 set: ¥ and ¥ ave equal if they contain exactly the same elements. and we write14 CHAPTER 2 _ REVIEW OF FUNDAMENTALS [Note thatthe equality of two sets means cha they are identical. as is the ease with S and B defined earlier, Formally, we demonstrate that two sats are equal by showing that they are both subsets of each other. That is, XCY and YOX & x implies and is implied by So far we have considered examples that are sets of numbers. Itis important to emphasize, though, that we cun tlk of w huge variety of things that we ean eollect into sets. Some economic examples are as Follows: 4 ‘The set of all the firms in an economy, ‘# The setof firms producing a particular good, usually referred to asthe industry for that good. “© The set of buyers and sellers of good, usually ferred 16 as the market for that good, + The set of quantities of goods and servicesthat consumers physically capable of consuming, usually called the consumption se for the consume: © The set of bundles of goods and services that consumer ean afford to buy, usuilly called the budget ser of the consumer. + The set of output quantities » frm is technologically capable of producing and the input quantities required to produce these, usually called the production ser forthe firm. * The set of output quan ‘economy given the ay day set for an economy es technologically capable of being produced in an ble resources, usually called the production possibit Set Operations We are now going to define operations on sets that can be thought of as roughly analogous to the basie operations of addition, subtraction, multiplication, and di- vision that we earry oveon numbers. To avoid some logical problems that can arise {f we continue to asstine that we are dealing With any kinds of sets whatsoever, we take i that we have some given set of items of some specific kind, called the universal set, U/, and we define the set-theoretic operations i terms of subsets of UA Venn diagram, shown in figure 2.1, is useful device for ilustrating the relationships between sets and subsets. The rectangle represents the universal set, UW, so that any point in U7 is an item x, The sets we are interested in are shown by collections of points such as A and # o¢ X and ¥. Note that this isa purely schematic representation, and #/ should be thought of as-a set of items in xen eral, not necessarily as points in a plane, When we think about the relationship between the sets, we notice a difference between the cases shown in (a) and (b) of figure 2.1. l(b). X and ¥ overlap, whereas in (a) A and B do not21 SETSAND SUBSETS 15 @ om) Figure 2.1 Venn diagrams ‘The intersection, W, of two sets X and ¥ is the set of elements that are in borh X and ¥, We write W=xXOY=(xixeXandxe¥) ‘Thus the intersection is the set of common elements. The expression Xr ¥ is read “Whe intersection of X and Y.” What about the intersection of the sets A and & in figure 2.4 (a)? Clearly, it does not exist, since there are no com: ‘mon clements shared by A snd B. This leads to the idea of a set that has no elements “The empty set or the mull set is the set with no elements. The empty setts always written Since there are no common elements shared by A and B, we can write ANB=6 2.6) land these two sets are said to be disjoint. Sinc® all the sets under discussion sire in U, we have @ © U. We can also think about the total of elements in a number of sets16 CHAPTER? REVIEW OF FUNDAMENTALS Cam PERE Te union of wo sets A and # is the set of elements We write ‘one or other ofthe set C=AUB= (vse AorB) The expression AU B is read "the union of A and B.” In Sgure 2.1 (a), C simply consists of the points in A and the points in B thought of now as a single set. Ifwe let R = X UY, then, in figure 2.1 (b), is the set shaped something like 00" Note that we must have XOYCR, where R= XUY and if we now define (10 be a proper subset of any nonempty subset of U,, we can also write where C = AUB ‘So we see that intersections of sets are always contained in theie unions, Example 2.2 Take as our univer set the set of postive integers, Zand let N= (ee Z.x 2)18 CHAPTER2 REVIEW OF FUNDAMENTALS 1,2, 25259) 11, 1B, 25 25, 26,002) eZ, ox <= 10, orx > 24, orl0 20, or 24) Since XZ, =X, wehave XZ, =¥. Since XUZ,=Z,,wehave UZ, = Z.=0. . ‘These examples show that if we have a set X © U or X = (x € U : Pla} so that elemenis x in have the property P. then the complement of X is the set of values that do not possess property P or X= [x © U : not PCs) ‘We can think of the complement of a set X © Uas the difference between the sets X and U. This can be generalized to indicate the difference between any two sets Poe EEE) the relative difference of X and Y, denoted X that are not also in ¥ is the set of elements of X XaV=(xeU sre Xande? Y) ‘As the Venn diagram in figure 2.1 (b) shows, we can think of X — Yas the part of X remaining when we take out the intersection of X and ¥, so we may write Example 25 If X =Y.showtha X-¥=¥—X Solution WX = Yatben ¥ —¥ =X —X=XOX=GWX =VabenY—X=¥—-Y= Y 1) ¥ = 8, since no element of a set ean be an element of its complement, and vice versa, . Example 26 IF X 1 ¥ =), show that X2) SETSAND SUBSETS 19 Solution First note that if XP) ¥ = @, shen X 0 Y = X. Itshen follows immediately that x- =xny We have considered only individual subsets of the universal set U. We now consider ‘wo important collections of subsets A partition ofthe universal set 1 is acallection of disjoint subsets of U, the union ‘of which is Thus, if we have n subsets X).i «7, such that xn and. X/UXUXL nau them these 7 subsets form a partition of (. This result is Mlustrated in figure 2.3, ‘The key point is that each element of U fies in one and only one of the subsets. Let ‘S denote this collection of subsets, and let the union of the m subsets be denoted “oh Figure 2.3 partition of U20 CHAPTER? REVIEW OF FUNDAMENTALS Example 2.7 Example 2.8 Example 2.9 by Uy Xi. Then we have isa partition of U. ‘Show that (X, X), for X © U. is a panttion of U. Solution By the definition of acomplement, we know that XUX = U. Buralso, XX = ‘Thus (X, X) is panition of U. . Do the sets X and ¥ of example 2.2 form a partition of 2,7 Solution No, sitee VF # Band XUV CZy. . Consider the collection of subsets of Z., defined as follows: X= (we ZIM i (and j > i+ ).1fx € Xi,then-x < IF = 101) — 1), and sox ¢ X).Ifx © Xj, then x > 10(/— 4) > 10¥ and so x ¢ Xy. Thus the subsets are disjoint. To prove that any element of Z, is in one of these sets, take any « € Z. and note that either x is a multiple of 10 or itis not, IF it is, then let,Example 2.10 Example 2.11 21 SETSAND SUBSETS 21 i = x/10. Then we have x € X). If itis not, then x/10 can be written a + (b/10), where a € Z, and (b/10) < 1. Then setz = a + 1, and it is straightforward to show that x © X; . “The power set of a set X isthe set of all subsets of X, and is written P(X). That is, PIX) = (AZ AC Xi}, Find the power set of X = (1,2. 3} Solution Note first that @ is a subset of every set X CU and by convention, we take X itself to be a subset of X. We also have {1}, (2}, {3}, and the sets of pairs o give PEK) = (1). (2). (Ys (1.29. (1, 3}, 2.3}. X.) . ‘Note that P(X) in this example has exactly 2° = 8 elements, For any set X with a finite number of elements, it can be shown that its power set has exactly 2° elements, In other words, a set with n elements has 2° subsets, Find the power sets of the following sets: wo Gi) X = fa) Gi) 2, = (1,2.3...4 Solution Gi) The only possible subset of is itself and so P(@) = (4). Note that using the formula for finding the number of subsets of a set, we have n = () and Pal i) A set with only one element is usoally called a singleton, and it has (wo subsets, so P(X) = (fal, i] = (X, 4) (iii) We cannot construct the power set of Z., by enumeratior itby 1, but we can define P(Z4) =X 2X SZ.) the set of all possible sets of positive integers. .eae Explain the difference between the statements X, where A = (x) Define the relationships (C: if any, among the following sets: O O and x < 0} equals the empty set. 7. A.consumer’s consumption set is given by Clann): and her budget set ven by B= (025,22): piss + pa O are prices, and M > 0 Ilustrate in a diagram the sets @) B.C22 NUMBERS 23 (bh) Buc w anc and interpret each of these 8. Given twa subsets X and ¥ of a universal set U, prove that (a ¥AV=xuy ) FUV=koP () X-y=xnF (a) X CV implies PX (©) XS ¥ implies ¥ UO’ — x) ) x-vexuy (@) XP Y =Himplies YX = Ilusteate each case on a Venn diagram, 9. A firm's production st is given by PalaOsysvi0srsr) where y is output and x is labor input. Sketch and interpret P in economic terms. How would you interpret 52 10, Prove that for subsets X.Y, and Z of a given universal set @ X-Y¥=x-(xnyy=ukUy-¥ ) (X=) -Z=N-UZ) @ X=(¥-Z)=(-YUUKNZ) @ (xUY)-Z=(x-ZuUY-2) @ x-(WuZ=-NA(X-2) Mustrate each case on a Venn diagram, 2.2 Numbers ‘The most basic and familiarkinds of sumbers are natural numbers, of the set ‘They arise naturall counting objects of all kinds. What does it mean to count a24 CHAPTER? =a aot Figure 2.4 The set Z 234 REVIEW OF FUNDAMENTALS. set of objects, say a pile of dollar bills? When we count dollar bills, we take each element in the set of dollar bills and pair it with an element of 2. starting with I and moving successively through the set. When we have exhausted the elements of the first set (of dollar bills) the clement of Z,. that we have reached in this process gives us the number of dollar bills. This number is called the cardinality Of the set of dollar bills the cardinality of a set isthe number of objects it contains, As we saw in section 2.1, Z.. has an infinite number of elements, Given any positive integer, we can always find a larger one. We now define some properties (of natural numbers and show that ather types of nutmbers arise Irom the operations cf addition, multiplication, subtraction, and division. Consider the addition or multiplication of any two elements, a and b. of Z,. These two operations are closely related, since multiplying a and b is simply adding a to itself b times or b to itself «times. The first thing we note is thatthe result of this is itself always an element of Z. UtbeZ., ubeZ, This is formally expressed by saying that the set Zs 18 closed under the operations ‘of addition and multiplication. Is Z;, closed under the operations of subtraction and division? Clearly not, i a b> 0), Itis also clear that ZC Z.22 NUMBERS 25 The set of integers is closed under addition, subtraction, and multiplication. However, neither Z nor Z,. is closed under division, since, for example, a/b ¢ Z if@ = ~2 and 6 = 3, though both a and b are in Z. This means, for example, that ‘we could not in all cases find x © Z such that be=a, abez This leads to the definition ofthe set Q of rational numbers @ fraezvez~(o}] Note that ZC Q, since we could clearly choose a = kb for k € Z. Note also that we rule out division by zero, We say that any expression involving zer0 inthe ‘denominators undefined. The reason forthiscan be een from the equation bx = a. fb = 0, then no.x exists such that bx =a for any a % 0,and so ruling out division by zero recognizes tis fact. (The term “rational number” comes fromthe facrthese rumbers are ratios of integers.) Figure 2.5 shows the set of rational numbers and indicates that these include points between the integers. Take any two points om the line that give distinct rational nurnbers. There is an infinity of other rational numbers between those points. To see this, consider the two rational numbers L and 2, and note that 1 +2 ~1)/e with € Z... must be rational number between 1 and 2. Each value of ¢ gives a different rational number, and since Z, has an infinite number of elements there must be an infinite number of rational numbers between | and2, Replacing t by a and2 by b > a, where a and/ are any elements in Q, shows that is must be true in genera. = 3 0 t 7 Figure 2.5 The set 0 An important observation i that the segment hetween the numbers | snd 2 (or between any two rational numbers) is not entirely composed of rational numbers. Other numbers exist, In figure 2.6 we have constructed a right-angle triangle with sides A and 8 of length 1 and hypotenuse of length L lying along the line. From the Pythagorean theorem we know that the square ofthe distance L along the line is given by +0 so L.= VE. The following theorem, the proof of which was well known o the26 CHAPTER? REVIEW OF FUNDAMENTALS ancieot Greeks, shows that V3 is nota rational number. This tells us that Q is not closed under the operation of taking square routs Alternatively, it ells us that there must be numbers other than rational numbers. These ate irrational numbers, ‘which eannot be expressed a the ratio of two integers 4 2b = ofr im: « G Figure 26 Vis ination os = 0 = Figure 27 The sct of real numbers. Proof ‘The proof is by contradiction, Suppose that /3 e Q. Then there exist integers p and q such that p/q = V2, where we choose the smallest such p and g. Now P'[q? = 2, or p? =24°, so p must be an even number. Since the square of an (00d number is always odd, pis even, and we may write p = 2r, where ris also an iteger, We then have and so g® = 2r?, Clearly, 2, and hence q, must be even. This result contradicts the assumption teat p and.q sere the smallest numbers to give p/q = +/7. Thus ‘the statement /2 © @ must be false. . ‘This result establistes the fact thatthe line in figure 2.6 must contain at feast one number that is not rational. Altematively, it shows that if we wish to solve a simple ‘equation such as v-2=0 then we need a set of mumbers larger than Q. since x cannot belong to Q. In fact there are « farge number of irrational numbers. The Real Numbers and Their Properties ‘The union ofthe sets of rational and irrational numbers isthe set of real numbers, We think of the set of real numbers, R, as extending along 2 line to infinity in each direction having no breaks or gaps, as in figure 2.7, We refer to 2his as the real line. ‘The properties of B define the basic operations that we can carry out on the elements of R. Consider three (not necessarily distinct) elements of Ra, b. and c. ‘We can postulate the following properties: 1, Closure Ifa,b © B, then a+b € Rand ab ¢ BR, So R is closed under addition and maltiplication22 NUMBERS 27 Example 242 Commutativetaws Forall a,b €B a+b a and ab=ba ‘which simply says that the order in which we ada or multiply two veal numbers does not affect the outcome. 3. Associativelaws For all a, b,c € at(btey=la+b)+e and athe) = (abe so thatthe order in which we add or multiply three real numbers does not mater 4, Distributive law Forall a,b ¢ © R, ab +0) =ab-+ac 5. Zero The element 0) € ® is defined as having the property that for all a € BR, a+0=a and ad=0 6. One The element | € Bis defined ay having she property that Masa 7. Negation For each a € R, there is a number ~a © K defined as having the property a+(-a)=0 8. Reciprocals For each element a R ~ (0), there is an element I/a =H efined as having the property For a = 0, the reciprocal is undefined. Forull a,b € Byifa +b = ) showy that28 CHAPTER? REVIEW OF FUNDAMENTALS Solution Start with a + b =O and add —a to both sides to obtain -atat+b=-a (-atay+b O+b b= —a (from property 3) —a (from property 7) a (from property 5) ” The following are also the more obvious consequences of these properties: (a) Foralla eR, 1a (b) Forall a,b € B, (a +b) = (©) Foralla © R,(-a) =a. (4) Forall a,b © R, (—a)(—b Indeed all the standard rules of algebra follow from properties | through 8. The Order Properties of 8 First we define two important subsets of R. PEE 2c se: CR consists oF the strictly postive real numbers with the character: istics that (By. is closed under addition and multiplication. (ii; For any a © R, exactly one of the following is true: aeRy or or =a E Rey By 2 = (0) i the ser oF nonnegative real aumbers Dingrammatically, the set By. is the right half of the real line in figure 2.7, excluding zero, while Bt, is that half including zero, We may simmiarty identify the left half of the real line, excluding zero, as the complement R. (note that this isnot closed under multiplication) and including zero as B., = RU (0). ‘The inequality symbols “>" and “=” may be given formal meaning in terms of Ry, and B.22 NUMBERS 29 WEEE Gites nyodew (i) a—beR,,,thena > b. Gi) I (@~b) © Ry, then b > a. Git) a —b € By, thena > b. (iv) If (ab) € Ry, then b > a. We referto“>"as the strict inequality and “>” as the weak inequality, since it per- ‘The properties of these inequalities are stated inthe following theorem. The Completeness Property of R We have already indicated that che set of real numbers has the property that there are no “gaps.” That is, between any two points (nurnbers) on the rea line, ‘every point is occupied by 2 number that is either a rational number or an irational ‘number. In other words, corresponding to each point on the real Hine there is a real ‘number, and vice verse This is known as the completeness property, and we can express this property formally by considering the concepts of the greatest lowest ‘bound and the least upper bound of a subset of I. We develop these ideas in the following definitions. ‘A set $C R is bounded above if there exists b € R such that forall x € S,.x = by bis then called an upper bound of S. A set T is bounded below if there exists ae R such that for all x € T, > a;a is then called a fower bound of T. For example, the set Z;= 1.2.3...) is bounded below but unbounded R—R,=[x ¢R=x <0) is unbounded below but bounded30 CHAPTER? _ REVIEW OF FUNDAMENTALS fa subset of R has an upper (lower) bound, it has an infinity of upper (lower) ‘bounds, This follows from the transitivity property of the inequality relation (part (Gi) of theorem 2.2), since if x € Sand x < band b < y, then. < y and y is also an upper bound of 5, However, we are interested in just one upper bound of ‘S—the smallest upper bound, called the supremum—and just one lower bound of §—the largest lower bound, called the infimum, R88 se prernor oF a ser 5, writen sup 8, has the properties: (i) x < sup Sforallx eS. (Gi) If is an upper bound of S, then sup 5 < b. PY 18 itis oF 5e07, orten ink 7. has the properties: (x= inf 7 forall x = 7, Gi) TFa isa tower bound of T then a < inf T- Here we see that inf Z = I while sup Z, does not exist; inf %, does not exist while sup B., = 0. These show thatthe inf and sup ofa subset of R may or ‘may notexist, and when either of these does exist, it may or may not be an element of the set. (Look at the sup of B,.) ‘The completeness property of R may now be stated as sups SS Ss set of upper bounds of ‘See the application of this theorem, for sup S, in figure 2.8. ensions of Economic Variables Figure 2.8 Completeness property The variables in economic models are usually represented by real numbers corres- of ponding to quantities such as cost, profit, and price or to amounts of goods and services such as coal, bread, and haircuts. These variables are measured in22 NUMBERS 31 particularkinds of units that we refer to as the dimensions of these variables, For ‘example, cost, revenue, and profit are measised in units of money (dollars): a price is measured in terms of units of money per physical unit of a good (dolurs/anit ‘quantity); coal, potatoes, wine will be measured by weight (pounds, kilograms) or ‘volume (liters, gallons), and so on. Economists, unlike engineers and physicists, are often rather careless about defining the way in which their variables are measured. The standard rules of arithmetic apply not only to the variables themselves bt also to the units in which they are measured—you cannot add apples and pears! Teke, as an example, total revenile measured in dollars. This is the product of the total sales of physical ‘output, whose units depend om the output concemed, s9y tons, and the price perton ‘Thus, corresponding to the identity Revenu Price x quantity \we have the identity in terms of dimensions a Dollars = soles > tons An equation involving economic variables that does not satisfy the arithmetic relationship among the dimensions ofthe variables earinot be s valid equation, For example, suppose that after a complicated bit of mathematical analysis we derive the solution Revenue = marginal cost Since revenue is meas proposing the equation +d in dollars amd marginal cost im dollars per unit_we are: dollars ton Dollars which cannos be trve. Maybe what we should have obtained was Marginal revenve = marginal cost ‘Dimeasionally, this equation is correct, with units of dollars per ton on each side. ‘A pure number is 1 aumber that does rot have « dimension. For example, consider profit expressed as a rate of return on sales revenue: profit Fevenue Rate of return =32 CHAPTER2 REVIEW OF FUNDAMENTALS ince both profit and revenue are measured in dollars, the rate of return has dh ‘mension dollars/dollars and so is a pure number. se 1. Demonsicate the boundedness or unboundedness of the following sets @) Z.=11,2.3,.04 ib) Zz © @ (@) S=weR:0 a.we | deline * the closed interval: (a, b] = |x €R:a =x =) * the half-open interval: [a, b) ~ [x Ra ) = (x €R sa 1, the Euclidean Yea =r28 SOME PROPERTIES OF PONT SETS INR" 37 Example 2.13 Find the Buclidean distances between the following points: (i) 2and3 in (ii) @,3yand (4,1) in (ii) (2.3.4) and G4, 1, ~5) in BE Giv) 2,3,4.5) and (2.4, |, =5) io et Solution ( 42,3) = (@-9=1 Gi) d{@.3), 4, N= f2—9? + B= 1 = VB = 2.83 ii) U2, 3,4), (4 1.5) = VRP += PF VB =9.43 (iv) {02 3, 4). (-2, =V@-Co346-F + 4-) /126 Given this definition of distance, we can now generalize the ideas of openness, closedness, boundedness, and coavesity fo points sets in general. First we define ‘an é-neighborhood neo ighborhood of a point x) € Ris given by the set Netto) = (x € RY A(ay,-r) < €). Simply. N, (a0) isthe set of points lying within a distance ¢ of xo Example 2.14 Describe the following ¢-neightarhoods: ) N@ i) NL23)1 Gil) N23.) Solution t Tate fate W NQ)=(r ER: vi 0, y2 y' > O} Ilustrate this sot. Is it closed? bounded? convex? How would you interpret + andy"? A consumer's budget set is B=((x,y) ERE: pix t poy smb where py, p> > O are prices and > 0 is income. Ilustrate this set, Is it closed? bounded? convex? Consider the set X = BOC where C is detined in exercise 2. Sketch this set. How would you interpret the case X =? Is X closed? bounded? convex? A consumer's preferences over bundles of two goods (x. y) are represented by the smooth, convex-to-the-origin indifference curves of standard economics textbooks. Take the consumption bundle (x’, »’) and define the hewter set BQ’, y") = (x.y) © RE + (x.y) is preferred or indifferent to (x", y9} Is this set closed? bounded? convex? nd the Euclidean distance between the following pairs of points: fa) 4and -Sin (b) (6,2) and (8, ~1) in BP fe) (5,-3.0, 8) and (12, ~6,3. 1) in 6. Prove that Jhborhood is an open set ¢b) an open set does not contain its boundary points24 FUNCTIONS 43 (©) the intersection of two closed sets is closed {d) the Cancsian product of two closed sets is closed (e) the intersection of two convex sets is convex (1) ({rom definitions 2.18, 2.19, and 2.20) a closed set contains its boundary points {g) the union and imersection of wo bounded sets is bounded 7. Fore =0.1 and ¢ = 10, describe the e-neighborhoods (@) Ni-1) MCL) © MGLAD 8 Prone that the set X =U, 2UB41CR 2.4 Functions We define a function as follows: Given two sets X and ¥,afunetion from X to ¥ isanute that associates with each ‘element of X, one and only one element of ¥. The set X is called the domain ofthe function, ¥ is called the codomaim and the set of elements in ¥ (which may or may not be the whole of ¥) associated with the elements of X by the function is called the range of the function. Denoting the rule for associating the elements of the to sets by /', we can vite the function as pkey y=s, rex Where »’ is often referred to as the image of x or the value ofthe Tu This book, we will be mainly concerned with cases in which ¥ is tion fal x. In the set of real44 CHAPTER2 REVIEW OF FUNDAMENTALS Example 2.16 numbers, and XC R",n > 1, while the cule f isa standard algebraic expression. For example, we have the functions atbx, xeR axish, (yx) © RE yolgx, re ae’, reR each of which we will be examining. in some detail below, However, definition 2.27 is more general than these examples, since it applies to sets X and ¥ and rules of association fof any kind. To emphasise this generality, we also use the term mapping ss a synonym for function, We refer to the above examples, then, as real-valued functions or moppings. ‘The range ofa function can be writen as the image set NX=lyer: FO), © eX} that is, asthe entire set of y's that we obtain when we substitute into the fametion theentire set of x's IF (2) C Y,wesay that f maps X into ¥, whileif (X) = Ys wwe say that f maps X onto ¥. tn the hist case not every y € F isan image of an x € X; in the second case itis ‘emay be the case that a given y may be the image of more than one x. An extreme case ofthis would be the constant mapping /(X) ~ y°. a single element of ¥. On the other land, it may be that each x has as its image a different element of ¥,n which case the mapping is sid wo be one-to-one, A mapping that is both ‘one-to-one and onto is called « one-to-one correspondence. Corresponding 10 cach x there js. distinct element of ¥ and all the elements of ¥ aze images of points xin X. Given y = f(), We may often want to invert this function and write x as function of y, written asx = f-!(y), Clearly, this can only be done if fis one-to cone (into or Onto), since othersvise for some y we would have more thas one x as the image, and this condition viclates the definition of function. If is one-to-one ‘onto, then the domain of the inverse function will be Y, ane (f~!)"! >= Ff Find the inverse of y £eR, Solution As figure 2.19 shows, this Function dogs not possess an inverse, since, for every nonzero value of y, there are 1W0 °S—the positive and the negative square roots0 Figure 219 Graph of y 24 FUNCTIONS 45 However, if we had two Functions xeR, rem, then each of these is a one-to-one correspondence and theie ittverses exist, Ifthe mapping fis one-to-one into (ic. not onto), then we can stil define an inverse Function, but we must take care with its domain, Let ¥’=/(X) CY denote the image set of /. Then we can define ¥’ as the domain of the inverse function. Finally, we can define the composite mapping of two mappings f= X > ¥ :¥ + Zas and. BofiXsZ al feo) We substitute each x © X into f and then substitute the resulting image y into g to obtain an element: € Z so that overall we havea mapping from to Z, Note that, {or a composition of mappings to be possible, the range of the first mapping () must be « subset of the domain of the second mapping (), as figure 2.20 makes cleat‘We will be concerned exclusively with real-valued functions, and we now describe some commen types of functions encountered in economies along with some of their properties. Linear Functions ‘The function ver an where a is some real number, is graphed in figure 2.21. In (a) of the figure the parameter « is positive, and in (b) it is negative. @ Figure 2.21 ear functions The reason for calling this function linear is obviously that its graph is straight line. The steepness of the line is determined by the absolute value of a ‘Taking wo x-values, we ean write d=an, =a implying that ye- yates a)22 Lincarfunesion wit postive intercept 24 FUNCTIONS 47 where Ay is read “the change in," and likewise for Ax. ‘The ratio Ay/Ax is called the slope of the line and so a is the slope coefficient. Note that the line ) = ax is fully determined once a is chosen. In equation (2.7) y is olten referred to as the dependent variable and x as the independent variable. This terminology suggests that often we will have a particular ceusality im mind when writing down the relationship between variables, such as “a change in x causes a change in y.” When both x andy can serve as dependent or independent variables (i.e. where the causation is unknown ot ‘unimportant), we can write the equation as an implicit function: flry) The lines so far have passed through the origin. We cat displace them, so that their position changes but not their slope, by adding the intereept term b = Thus, if we write rth, xeR then, since » = b when.x =O, the fine cuts the y-axis at b, as figure 2.22 shows. ‘Varying b generates « whole family of parallel lines We can express the same idea in the implicit form as axtay—e=0, nyeR where we now have b = c/a. Varying © with ay and a: fixed again generates family of parallel lines, Seting y= 0 allows us to obtain the intercept ofthe line fom the x-axis simply as Note that if (x).-y)) and (x3, ys) are any two points on a line, then we have ¢ = (yo = yi)/(a2 — 1). Now, since for all x ysarto we have ‘as agenteral equation forthe line, Thisis the algebraic form of the obvious geometric fact that any two points fully determine a line48 CHAPTER 2 REVIEW OF FUNDAMENTALS Finally, we consider futher the important concept, already introduced in section 2.3, of # convex combination of points. To start, suppose that we have two numbers x', x” € R, with x’ 0. it could be used (0 depict a typical U-shaped average or marginal-cost curve, while i ts concave form, with a < 0, it coulddepict atypical total-revenue or total-protit curve, (Note that in these examples the domain ofthe funtion must be restricted to B,, since negative ousputs are riot allowed.) The unique minimum (in the convex case) oF maxianum (in the concave case) always ‘cer atthe point.x* = —b/2a. Thus, if We want a function to have a maximum at a positive value of x, we must choose b > 0, while if we want a function to have a ‘minimum at positive value of x, we must choose b ~ 0. Finally, the value of e will determine whether y is positive, negative, or zero at this maximam or minimum. Figure 2.24 Quadratic functions Rectangular Hyperbola ‘A rectangular hyperbola may be written xy veR—(0} for some positive sonstant ov, The name stems from the fact that every rectangle | ‘drawn to the curve has the same area c. Note that the graph of the fimction in figure 2.25 hus two parts, one entirely in the positive quadrant and the om entirely in the negative quadrant. In economics we often restrict x to R.., so only the upper curve is relevant. As x tends to zero, the curve approaches the y-axi asymptotically, and as x tends to infinity, it approaches the x-axis asymptotically Increasing a shifts the curve outward, while retaining the general shape.24 FUNCTIONS 51 Power, Exponential, and Logarithmic Functions When a number a is multiplied by itself m times, we write a”, where 1 is called the expontent, This leads to the rules of exponents: =) Intuitively, we may think of as an integer: but in fact m could be any real number. The power function akes the form ax’, xeRa>t (Note thatthe rectangular hyperbola isa special form of the power function with +b = =I. The linear function is also a special case with b = 1. The quadratic may be thought of asthe sum of two power functions.) Figure 2.26 shows two power functions for € R, where b > Land b= —1. bot bed @ () Figure 2.26 Power functions ax? : Ry + ®. If we take the exponent as the variable in the function, we then obtain the expo nential function y =ab! where bis called the base ofthe function. In many applications this hase is taken to Fqure2.27 Exponential function ‘Se the number e = 2.718. For a > 0 the general shape of the exponential function k= is shown ‘in figure 2.2752 CHAPTER? REVIEW OF FUNDAMENTALS bel o Oo) Figure 2.28 The logarithmic function Jog, x > Rs + R If-x = bY, then we say that y isthe fogaridium of x to base h, and we write y log, x ‘This expression defines y asa logarithmic function of x. We define the domain of this function to be Rand we choose & > 6. Moreover, since | raised to any power is still 1, we exclude b = 1, As figure 2.28 shows. if b < 1, the function is decreasing and convex, while if > 1, its inereasing and concave. Very often base, b, is chosen to be ¢ so thitx = e. The corresponding logarithm is call the natural logarithm, and we write (ie. Ina = log, x). By combining the definition of ye logarithm with the rul of exponents, we have x= be and 2 =) ‘which implies that og, (rz) = logy. + log, =24 FUNCTIONS 58 Similarly tos, (=) = ig, 3 ~ loz Moreover we have = (phterye which implies that log, (x) = a log, x Concavity, Convexity, Quasiconcavity, Quasiconvexity In our description of some speeitic Functions we used the terms “convexity” and concavity” Visually the meaning should be clear, but we now present formal efintion. Figure 2.29 shows how we proceed inthe case of a concave function Fist we must assume thatthe domain of the function is & convex set, because We ‘Want convex combinations of points in the domain to be in the domain, Take any ‘wo points x’ and x” in the domain ofthe function and the corresponding function values /(x’) and (0"5. The key characteristic of a concave function is that it “arches above" the line joining these (0 fonction values. That is, the valve of the function a an x between x’ and x” is higher than the point onthe fine immediately 0 = above that value, Thus we have Figure 2.29. Swict concavity b+", E101 Since the point on a line joining x’ and x" has the y-coordinate value FOU MSO, — KEL trict concavity can be expressed asthe property /() > f. This is apparent from figure 2.29 and is summarized in PER Me tinct J is concave if FPS ASO) HU AVF” where £ = Ax! + (1 ~A)x" and 2 € (0, 1, Ik is Strictly concave if the strict inequality holds when A € (0,1),54 CHAPTER2 REVIEW OF FUNDAMENTALS [Note that the curve in figure 2.29 is strictly concave while the linear function is concave but not strictly concave. By a similar argument we obtain B88 tection fis comesit F(R) SAF U =D Where. =Ax'+-(1~A).c" and € [0,1], Itisstrietly convex if the strict inequality holds when 2 € (0, 1) A convex function “bends below" a line joining any two function values. This is iflustrated in figure 2.30. Clearly, fis (strictly) convex if — fis (strictly) concave From these definitions it follows that a linear function is both convex and concave but strictly neither Example 2.17 The point + in definitions 2.28 and 2.29 is a convex combination of the two points wand x”, Suppose that the function is f(x) = x7. Then, if we choose A = 0.4 2vand.x” = S, we have no way 0.65 =38 sG) = G8) = G8) = 14.44 isthe height of the function at the point X. This is shown in figure 2.31, Now, from the convex combination, we can obtain a straight line connecting the two function | values f(x’) and. f(x"): Ase) Faye) or 0.412) +0.6(5*) = 16.6 ‘which isthe height of a straight line connecting the points (2, 4) and (5, 25) atx = 3.8 in figure 2.31. Clearly, fx To show generally that f(x) strictly convex between these two points is strictly convex, we need to show that A) < afe) 4"24 FUNCTIONS 55 for any pair of x’ and x” with ¥ = Ax'+ (1 —A)x" and 2 € (0, 1). The lefichand side ofthe inequality is JQ) =P’ $1 ye" P = POP $20 ayes” + APP ‘The right-hand side of the inequality is 166 sas de + DOr"? Hence we have Mee? +21 — ane’ +0 PO")? < aa’ + De? (2 = ayte’ P+ 21 — ayae’s” +1 =F = = alee’)? <0 AL = 2) +21 — A'R"—A(L= Q"Y <0 es ee | ‘To develop the idea of quasiconeavity, we first define the notion of a level set of Figure 2.31 The function sureties ota telalen Jl8) = is stnctly convex ‘A level set of the flr: pst) RM: Flt ee for some given number ¢ € B. In other words, the level set shows the set of points in the domain of the function that gives equal values of the function. As special cases we take two functions of Iwo variables, the linear Function yH ater, (412) ER m a> 0 and an example of a power function, called in economics the Cobb-Douglas function, att, (ume RR ab> O.a+b>1 Figure 232. The function ‘The three-dimensional graphs of these functions are shown in figures 2.32 and yan + 3x: 2.33 for particular parameter values.56 CHAPTER? REVIEW OF FUNDAMENTALS ol j j Figure 2.33 The function y = Figure 2.34 Level sesso the function y= 2x) + 38: Applying the detinition of a level set gives xi}se or x r ar") “The level sets can be graphed in two dimensions, with each curve representing & diferent value ofc. Examples from figures 2.32 and 2.33 are shown in figures 2.34 and2.35.In economics, level sets are encountered in consemer theory (where they are cated indifference curves), producer theory (where they are called isoquants), and a large range of other applications. Quasiconcavity is essentially concemed with the shapes of the level ses of 4 function, First, define the better set of a point x), 32, ...x! in the domain XC RY ofthe function fn. 2.- 1.0m funetion y “The better set of the point (x)x8,-... 9) is Bx} 900-89) (i Rayo otg) EME flan te) 2 A24 FUNCTIONS 57 ‘That is, the better set of point is simply the set of points in the domain that yields at feast as large a function value. In figures 2.34 and 2.35 he better sets of the point xo are shaded. ‘A function / with domain X © R” is quasiconeave if, for every point in X, the better set B of that point is a convex set [Lis strietly quasiconeave if B is strictly ‘Thus we see that the linear function shown in figure 2.34 is quasiconeave but nol strictly quasiconcave, while the Cobb-Douglas function shown in figure 2.35 is strictly quasiconcave, ‘The precise shapes ofthe level sets of quasiconcave functions will depend on the direction in which the function increases. Inthe examples shown in figures 2.34 ‘and 2.35, the functions are increasing in both variables, so the level sets must have negative slopes and the convexity of the better sets implies the shapes shown, However, if the function were increasing in one variable and decreasing in the other, or decreasing in both variables, then quasiconcavity would imply quite different shapes for the level sets. Exercise 10 of this section asks you to explore this situation further. The terminology in use here may be confusing. Why the \erm quasiconeevity ‘when the relevant set must be convex? ‘The reason becomes clear if we recall the definition of a concave functiow: f(x) is concave if, given x’ and x” in its (convex) domain, we have PO ZMOVFU VIO") where f= Ax’ + (1 ~ Ax" and A © [0,1]. Since this holds for any points x and x", Ummst hold tora point x” € B(x’). This implies that B(x") is a convex set and therefore that any cancave fiction is also quasiconcave. The converse. however, is not true. For example, the Cobb-Douglas feaction a,b >0.a+b>1 (see tigure 2.33), is quasiconceyve but not concave. We can proceed in a similar way with the property of quasiconvexity. Given a funetion f(s{,x2, +. %,) with domain X CR", we can define the worse set of 8 point (x2...) in the domain:“The worse set ofthe point (x0...) is Woh aessor a) = foresee) EXE fore Bn) SP (ap Rea) ‘Then we have Pee Re ‘A function /(24,x2..--,a%y) with domain X © Ris quasiconvex if, for every xl) © X.the worse set WGA?, x2,....x2) isa convex set. Itis strietly quasiconvex if W is strictly convex. Again, it is possible to show that an versa. This topic is further explored in the exerci aes 1. Give equations and sketch graphs of the fines convex Function is quasiconvex, und not viee (a) passing through (0,1) and having slope (b) passing through (—2, 2) and parallel wo y = (©) passi through (~1, 1) and parallel to 2. Inaclass of 120 students, everyone would take two hamburgers ifthe price \were zero, and no one would buy hamburgers if the price were $4 or more, Assume that the class demand curve for hamburgers is linear and give its ‘equation. Explain what this implies about the demand for hamburgers when the price is $3.99. Find the convex combinations of the following pairs of points and, where possible, show them graphically (a) —2and4 () (1, 1) and 3,4) cy O.Tyand (1,-2.2) 4. Total revenue is price % quantity sold. Show that the total revenue curye,24 FUNCTIONS 59 corresponding to the demand curve found in exercise 2 is a quadratic, Is it convex or concave? At what value of x does its maximum or minimum oecur? S.A firm’s average-cost function is given by the quadratic y 20x +120 where ¥’ is average cost in dollars per unit of output. The output price is $10 per unit, and is the same at all levels of output. Find the output levels at ‘which the firm just breaks even (ic, price = average cast ‘Sketch the average-cost function and show the solution. Over what range of prices does the firm make a loss at all output levels? 6, Simplify the following expressions: (a) Va/o* (b) bor © “sjextay! tay alibegyie fe) 63°? 1» (solve for y in terms of x) (= 2718)-1? Golve for x) (e) y =axitx!tx? (Whatis log 92) (A) togp(b*) () b-Paur G)logplb(log, 22) 7. Sketch typical level sets of the following functions and state whether they are (strictly) quasiconcave or (strictly) quasiconvex. Then say whether the functions are concave, convex, or neither. (a) () y= @Sx3 +08)" Wu fe) y= 24/70) Qomn thd 8. (a) Given the strictly quasiconcave.timetion y= cal level set in each of the following cases: (on).43), sketch a () The Function is increasing in x) snd decreasing in x2 (3) ‘The function is decreasing in x, and inereasing in x. (ii) ‘The function is decreasing i both variables60 CHAPTER? _ REVIEW OF FUNDAMENTALS (Hint: First determine which way the curve ofthe level set must slope, then identify the area that gives the better set, and then find how the curvature must look to make the better set convex.) (b) Repeat part (2), assuming that the function is striely quasiconves, and illustrate the level set in each case, 9. Construct an example of u strictly quusiconeave function that is nota concave function. 10, Using the poinis x’ = {, x" =9, and = 5/8, the concave function Vustrate definition 2.28 for ®, x > 0, Use a graph in your answer 11. Show that the function y = .c', x > 0, is strictly concave according to " for “if and only if” We use capital letters such as P and Q to stand for basie statements such as “the money supply increases" (P) or “prices rise" (Q). We could then ‘write the statements above as psaFigure 2.36 P = means rc 25 PROOF NECESSARY AND SUFFICIENT CONDITIONS 61 ‘There are several way’ in which these statements can be read, and it is useful to spell these out: P= Qcanbe read if Phen O © P implies 0 * P isa sufficient condition for Q * isa necessary condition for P » Ponly iO “P is suficient for Q" means thatthe truth of P guarantees the truth of Q. is always tue when P is true. It follows that if Q isnot true, then P cannot be true, Thus itis necessary that Q is true for P to be true. n other words, P can be tove only if Q is tue We illustrate this in the Venn diagram of figure 2.36. ‘The rectangle in figure 2.36 denotes the universal set ofall possible cases, ‘The set P’ corresponds tothe subset of eases for which the statement P is tue and the set Q" the set of cases for which the statement Q is true. Then P => Q can be interpreted as P' ¢ @’, since, whenever we have u case for which P is tue, Q is also true, so P" must be contained in Q'. It follows that for a case to be in Pt mnust also be in Q', soit s necessary tobe in Q' i order to bein P’. P & Q can be read © Pifand only if @ © Pisequivalent to 0 ‘© Pisa necessary and sufficient condition for ‘© P implies and is implied by Q The last two statements reflect the fact that P< Q means the same thing as P = Q and Q + P." So, in set theoretic terms, P” SQ" and Q! © P” so that P’ = O' (sce section 2.1), ‘The following economic example illustrates haw we might prove a statement Ps. A Simple Model of the Quantity Theory of Money ‘We wish to prove the statement, “If the money supply increases, then the price level rises." Suppose that we have the following theory of the demand for money. The total amount of money that households in the economy want to hold is proportional to their level of nominal income. Nominal income is simply the product of real income (income measured at constant prices) ¥ and the price level P. So demand for money is kPY, where & is some positive constant. Now suppose that real62 CHAPTER? _ REVIEW OF FUNDAMENTALS: income is fixed (e.z., because the economy is fully employing all of its resources) and the price level is free to vary. Finally, we assume that in equilibrium, money demand equals money supply M. or MakPY, k>O Money supply is taken to be determined exogenously by the government, With & and ¥ constant, we ean write this equation simply as P=aM. =< (aconstant a= pp constant {tis obvious from this that an increase in M, say from) Mj to) Mz leads to a chasige in price of P,P) =a(M;—M)) >0 ‘Thus we liave proved that jf the money supply increases, the price level rises. We want toillustrate wo things with this example, First, it shows that proofs ‘of propositions in economics must be model-specific. The proposition follows logically from the assumptions of our model, We have not proved that actual increases in the money supply lead to price rises—that is » matter for statistical ‘and econometric analysis Second. the proof is an example ofa direct proof. The following are examples of indireet proof, Proof of the Contrapositive Proposition ‘The contrapositive statement to P => @ is “not @ = not P." In our example this, would be: Ifprices do not rise then there is noincrease in the raamey suppl A contrapositive statement is equivalent tothe original statement, or (P > @) = (oot >not P) and so proving the contrapositive is equivalent to proving the original proposition, To illustrate, our theory tells us that Py~ Py =a(My ~ Mth) ‘The contrapositive & that P= P).sowe must have M;=Mssincee > 0.Proof by contradiction or the “ leductio ad absurdum” Let us assume that P is true but that Q is false (i.e..that Q does not follow from P), or P= not Q, We need to show that this leads to a contradiction or a statement that is false. To illustrate with our example, we assume that M ~ My >0 but ’s— P; <0. 1n cur theory, these can only be true atthe same time if a < 0, which is a contradiction to our assumption that a > 0. . EXERCISES 1. The equilibrium price in a model ofa simple market is found by setting supply equal to demand. Assuming that price can never be negative, show which one fof the following propositions is true and which one is false: ( Ifthe demand function in @ market is D=a-bp. ab>0 and the supply function is a+fp. ap>0 then an equilibrium price exists (b) Ifthe demand and supply functions are as in part (a) and a > a. then aan equilibrium price exists, 2, Prove by contradiction that the empty set is a subset of every subset of some universal set. The overall effect of a change in the price of a good om the demand for itis the sum of two separate component effects: The substitution effect (demand for the good will increase when price falls because it is now cheaper relative {o its substitutes), and the income effect (a fall in the price of a good increases the consumer's real income, leading to an increase in demand if the good is a normal good and a fall in demand if the good is an inferior good). (a) Prove the following statements using each of the three methods of proof iisenssed in this section: ()__Asufficient condition for the demand for a good to increase when its price falls is that itis a normal good A necessary but not sufficient condition for the demand for a good to decrease when its price falls is that itis en inferior good,CHAPTER 2 _ REVIEW OF FUNDAMENTALS G HOA P T_E-R RE V cc (b) Ina Venn diagram, illustrate the relationships among the Following four sets “ Gi) i) iv) “The set of goods for which demand increases when prices fall “The set of ods for which demand falls when prices fall ‘The set of normal goods ‘The set of inferior goods Cea base independ beater set indifferent curves boundary point infimum ‘bounded imegers cardinality intercept term Cartesian product interior numbers Cobb-Douglas function interior point stosed interval intersection codomain intervals compact irational numbers complement isoquants completeness property level set ‘composite mapping lineas function concavity logarithmic function convex combination ‘mapping convexity natural logarithm coordinate system natural numbers dependent variable neighbortood dimensions nonnegative numbers disjoint ‘one-to-one correspondence distance ‘ordered pai domain pantvion exponent point sets exponential function power funetion elements power set empty set proper subset Euclidean distance pure number function quasiconcavity image quasiconvesity image set rational numbers plicit function rangerectangular hyperbola real fine real numbers real-valued functions relative difference set singleton slope slope coetficient subset supremum versal set Venn diagram worse set Es 1. How doesa Venn diagram help to illustrate the possible relationships between sets and subsets? 2. What is meant by “the rea! fine”? 3. What is 2 supremum? What is an infimum? 4. What is « point set? What is a convex set? 5. Distinguish between closedness and boundedness of a point set 6. Distinguish berween concavity and convexity of a function, 7. Distinguish between quasiconcavity and concavity. dition’? . Distinguish between quasiconverity and convexity 1. What is the difference between a necessary condition and a sufficient con- 10, Oulline the three methods of proof discussed in this chapter, Reto Write out the convex combinations of the following pairs of points (a) —2and2 in (b) (2,2) and (—3, 3) in (©) @,0) and (xy, 29) in BE (@) (2,2, 5) and (3,3, 8) in R? Tn cases (b) and (c), draw a graph to show that the convex combination lies fn the line segment between two points in R°. 2. A firm’s production set is36 CHAPTER2 REVIEW OF FUNDAMENTALS Sketch this set in B®, Is it closed? bounded? convex? Explain why we would interpret a boundary point of the set as “efficient” and an interior point as “inefficient.” Give the equation and sketch the graph of the fine (@) passing through (~1, 20) and having slope 2 (b} passing through (—2, 1) and parallel to 3x ~ 4y = 2 Find the convex combinations of the pair of points (8,—2. 1, —1) and (13,2. Simplify th following expressions (a) (ab)?Ja°b () aby" fc) 10x = (@) tog, (o*? Sketch typical level sets of the function 7 (solve for vin terms of x) and state whether itis (striety) quasiconcave or (strictly) quasiconven, Is the function concave, convex. or neither? ‘Show thatthe funetion y = 10 228, is strietly concave according to definition By using the points x’ for the concave funetion « = 6.and 2 = 1/2, illustrate definition 2.28 1 —, Use a graph to demonstrate tis. ‘Show that the function f(s, 62) = Gx + 3)¥, xox > 0 is concave: according to definition 228,ace Sequences, Series, and Limits ‘Studying sequences and series isthe best way (0 gain intuition about the rather perplexing notions of arbitrarily large numbers (infinity) and infinitesimally small (bat nonzero) numbers, We gain such understanding by using the idea of the limit ofa sequence of numbers, Thus, froma mathematical perspective, this chapter pro- vides Very useful background to the important property of continuity of a function, which we will explore fullyin chapter 4, There are also some interesting economic plications of series and sequences, in particular the notion of discounting a future stream of payments or receipts, which is a aspect of judging the value of an investment by a business or a government, 3.1 Definition of a Sequence A sequence is simply a succession of numbers, For example, the sequence of numbers 1, 4,9, 16, ... appears fo consist of the squares of the natural numbers (ie., 1°, 27,3, 47, ..). It is common to see questions on IQ or mathematical aptitude tests asking one to fill in the next number in a sequence, which involves figuring out or guessing the formula that generates the numbers ofthe given terms fof the sequence. We could write that formula for the sequence above as fa)=n, n= 1,234 ‘Then the “next” term in the given sequence of numbers is 5* = 25. Example 3.1 Finda function or formula that corresponds to te first tee terms ofthe sequence 14.7, Solution ‘One function that works is Fn)=3n-2% nhAnother is Fin) =(n~2)' $20 n=l 62) . Example 3.) illustrates the general result that for any m numbers intended to de- scribe sequence, there is more than one funetion that can be used to generate the sequence of nu bers given. In fact there are an infinite number of possi ies. ‘Therefore such questions on IQ rests requesting one to fill the-aext numberof a sequence are poorly designed. If the respondent considering example 3.1 had in ‘mind the equation (3.1), then she would offer 10 as the “next number" while if she had in mind the equation (3.2), she would offer 76 as the “next number.” A formal definition of a sequence fotfows, along with several examples, PEN 6 seq0e nce is 2 function whose domain isthe postive integers. The following are examples of sequences: 1. fon or 2,4,6,8, 10, 2 fn) or 1, 1/2.1/3, 1/4 1/5, 3. flr) or Lb 1/2,-1/3.-1/4. 1/5, 4 fn) or =LL=hi he 5. fim= or 1,4, -9, ~16,-25, 6. fin) or 2,4, -8, 16, 32, (igure 3.1) (figure 2.2) (figure 3.3) (figure 34) (figure 3.5) (figure 3.6) Iiselear that the terms in the sequences for examples 2 and 3 above are getting smaller in absolute value and closer and closer to zero. We say that such sequences hhave a limit, and in these two cases the limit is the same (zero) even though no {two elements of the sequences equal each ofher and no term in either Sequence ever actusily lakes on the value zero, The ferms in the other sequences do not tend, to spproach 3 single, finite value, and so they do not have a fimit. In examples 1 and 5 we can see that the values of the sequence become either arbitrarily large or arbitrarily small, and so we say the Sequences are not bounded. The sequence in example 4 is bounded, but still the elements don’t become arbirarily close to any single value, and so we also say i has no limit. The idea of fimits is presented ‘more formally in the following section.3.1__ DEFINITION OF A SEQUENCE ae Determine the first 10 terms of each of the following seque draw a graph such as those in figures 3.1 t0 3.6. Ineach case (a) fin) =S41/n tb) fon = 50/2) © ron) hin) 10 1 9 09 s 08 7 07 6 06 5 os 4 oa 3 03 2 02 ' on Figure 3.1. The fist five terms of th Figure 3.2 The first five terms ofthe sequence fn) = 20 sequence fn) = I/n a) ron) Figure 3.3 The int five terms of the Figure 3.4 The lint fv sequence fn) =—I/n sequence fn) = (—1)"70 CHAPTERS SEQUENCES, SERIES. AND LIMITS, fev) Figure 3.5 the first ive terms ofthe Figure 3.8 The frst five wrms ofthe sequence f(n) =n? sequence f(n) = (—2» 2. Determine the first 10 rerms of each of the following sequences. In each ease, draw a graph such as those in figures 3.1 103.6. (a) fi =5-1/n tb) fo =afin gD FOr) =e (1) /)] for € constant 3. Show how the sequence of terms f07) = 2n.n = 0, 1, 2,...-can be written using the domain m = 1.2.3 4 Show how the sequence of rms Fn) = nn = 5, 6,74... canbe writen using the domain 1 = 1, 5. Show how to write all terms beginning with the 26th term of the sequence Fin) = (1+ ren «using the same domain, n = 1,2,3,.-- 3.2 Limit of a Sequence It is convenient to refer co each term of a sequence by dy where ay = J(u). « corresponding to definition 3.1. ‘The incuitive notion of a for a sequence is that the terms dy "get close” to some unique and finite value as) nn gets “large.” Ifa Sequence does have a limit, we say itis convergent, while iit) does not, we say itis divergent.32 LIMTTOFASEQUENCE 71 ‘A sequence is said to have the limi L if, for any « > 0, however small, there is some value I such that jay — Li N, Such a sequence is said 0 be convergent, and we write its limit a lity) = Le In ess formal language, the definition above states that a sequence has a limit £ provided that al values of the sequence "beyond some term” can be made asclose (0 L as one wishes Le. tbe condition ja, ~ L| 100, while la, — 0) <0,002 for any choice of WV’ 500. More yenerally, |1/n ~0|-<€ requires a choice of > Ie One can think of NV as formally being a function of € and so write ve) ‘Asis also the case for functions in general (see chupter 2), a sequence may he ‘bounded or unbounded. In particular, We say thats sequence is bounded if there is some finite value K > 0 such that for some N it follows that a, N bounded above and 4g>—K forallnN pounded below and is not bounded if one or both of these conditions fails to hold. For example the sequence Sin) illustrated in Figure 3.1 is unbounded because itis nor hounded abave, while the sequence fin illustrated in figure 3.5 is unbounded because itis not bounded below. A sequence nay also be unbounded because it is neither bounded above nor below, asin the sequence fon)72 CHAPTERS SEQUENCES, SERIES, AND LIMITS I is quite easy to see that a sequence that grows without bound cannot have a limit and so doesn’t satisfy definition 3.2 for convergence. The sequence a, (-1)" (figure 3.4) ilustrates another type of sequence that is not convergent. The terms do not grow without bound, yet there is no limit because all terms of the sequence beyond the Vth term must satisfy definition 3.2 if the sequence is 10 hhave a limi. Tis clear that whatever choice of Lis made, terms of ay for m greater thea any NV will include the values +1 and —I, and so all werms heyond ay cannot be made arbitrarily close to any single value L, Thus a bounded sequence is ot necessarily convergent. Example 3.2 ‘We can classify divergent sequences in two ways, either as defintely divergen! ‘orsimply as divergent. Forexample.the sequence a, = 2n figure 3.1) isdivergent, se is no (finite) number L which the terms of the sequence approuch. However, the terms grow without bound in a positive direction, and so we say the sequence approaches positive infinity (+00), This is an example of what is called a definitely divergent sequence. ‘A divergent sequence is said to be definitely divergent ifeither one of the following conditions holds: (@) Uf for any (arbiranity large) value of K there is an N sufficiently Large that diy > K forall n > N, then we say the sequence is definitely divergent and limy-o0 ay = 20 (08) Af for any (arbitrarily large) Value of K there is an NV sulficiently large that (iq < ~ K forall n> N, then we say the sequence is definitely divergent and Yimy 36 te = 08 Notice that the sequences in figures 3.13.4, 3.5, and 3.6 are all divergent but only the ones in figure 3.| and 3.5 are defintely divergent. Also note that the sequence in figure 3,6 is not bounded yer its terms do not approach either +96 oF ~20. ‘The following set of examples illustrates how one can show formally thata sequence either converges or diverges, as the case may be, Show that the sequence (1) = 1/m litty sa 1/m = 0, and so converges to zero. 5 has the limit zero; tharExample 3.3 3.7 _ Illustration that fin) = (—19" has no limit {sample 3.3) Solution According to definition 3.2 we need to show that for any € > there must be some value N’ such that for every n> N. In other words, we need to find an N’ such that I/ntN By muliplying both sides of this inequality by r., we have that the condition becomes Leen o>) “Thus if we choose A to be the next integer greater than 1 /e, we will satisfy the copdition. . Show that the sequence f(n) = Ion = 1,2, 3... is divergent. Solution According to definition 3.3 a sequence is divergent if it has no limit, LI is easy to illustrate diagrammatically that there is no value L. such that ali the terms in the sequence f(n) = (—1)", m= N, lie within distance € of L for every € > 0, 10 imatier bow lange we choose WV to be. The reason is that no matter how large we choose NV, the terms of the sequence (nm) = (—1)",n > N will include beth the values ~1 and +1, So, if we take € = 1/2, for example. there is no number J. which lies within 1/2 of a unit of both —1 and +1, We see this in figure 3.7. For the limit 1. to be within © = 1/2 of the namber —1, it must lie in the interval marked t, while forthe limit L to be within © = 1/2 of the number-+1, it must lie in the interval /2, Since these two intervals do not intersect, there is no value £ that satisies both conditions (ie.. no number lies in both of these Intervals). Algebraically, for L to be limit ofthis sequence, it must satisfy both74 CHAPTERS SEQUENCES, SERIES, AND LIMITS Example 3.4 of the following conditions for every > 0: Condition A, |=1~L) <« Condition B, (+1 — L] <€ For € = 1/2, for example, condition A requires that Ir}=Li= which will not hold if Z. > O, since in that case | than 1/2. while condition B requires that —L| = 1+ 0 which is greater HI-L< Which will not hold yf Z. <0, since jo dat ease [+1 — greater than 1/2 Therefore, since cant be bth negative and positive, there an benoit | to this sequence. 1 1+ [L| whieh is also ‘Show that che sequence ay = 21, n= 1,2. 3,,.. is definitely divergent Solution By definition 3.4, a sequence is definitely divergent if either lity 2c de = 4-90 0€ lity sc @ = —90: The first of these two cases holds for the sequence a, = 2n, ‘To see this Formally, we need to show that for any (arbitrarily large) value Kone can always find an N large enough that ag > K for every n> N. This is Cleary | the case for ay, = 2n. since for any K we have mo | provided n > K /2. Therefore, we need only choose our value for N to be the next integer greater than K /2 in onder to satisfy the condition Ta 2. Using definition 3.2, show that each of the following sequences has the limit) as specified (a) timtines (0) ipo (4) % 2, Determine the limit for each of the following sequences, and prove that your choice is eorect according to definition 3.2: () timon i EF ©) limon 3. Show that each of the following sequences is divergent. If the sequence is definitely divergent, show this tobe the case aceonding to definition 3.4 (a) timy 1 (b) him, son) (©) fim, .c(—e)" (ea constant and &- 4 0) 3.3. Present-Value Calculations ‘An important economic application of sequences is the determinetion of the present value of a sum of money 9 be received at some point in the future. ‘This computation isthe inverse of determining how much money one would have inthe furure upon investing 2 certain amount novi Suppose, For example, that one ‘had $90.91 to invest currently at an annval interest rate of 10%. Then the amount of ‘money received atthe end sf one year would be $90.91(1 +0.1) = $100, In gen- eral, investing $X today at an annual rate of rewuen¢ will eenerate ¥ = X(1-+7) a te end of one year. Therefore itis equivalent 10 say thatthe present value of amount V ibe received in ane year's time is X= V/(1 +r), where r isthe rate of return (or rate f interest). The same rationale can be used to value at amount received any number of periods into the future. If one received SY now and could invest at 10% per yea, ‘with compounding (ic. the accumulation and reinvestment of interest payments) at the end of etch year, then the $¥ would be worth YC + 0.1) at the end of the frst year and, after reinvesting (including mterest payments), would bee worth [YC +0.1]¢1 + 0.1) = ¥(L + 0.1)? atthe end of the second year. Therefore the present value of $100 to be received in two years” time is Y, where ¥4(1-+ 0.1 VW oF ¥ = $100/(1 + 0.1)? = $82.64 (approximately). Following this line of argument leads tothe following formula, which determines the present value PY. ‘of amount V 10 be received 1 periods from now when the interest rate iS r per76 CHAPTERS Example 35 Example 3.6 ‘period and compounding occurs at the end of each period: v Maa oa Notice that forr > O the denominator of (1 +r) hecemes larger asf hecomes | larger, and thus PV, gets smaller, In other words. receiving a certain sum in the | future has a lower present value the Jonger one has to wait for the payment. This | is natural since the forther in the future one receives the fixed amount V, the less tone woufd need to invest now to replicate that future payment, For tis resson economiss refer tothe diconnting of future benefits and the value 1/(V ++) | referred to as the discount rate, or discount factor. Moreover {1 + r)/ grows out boundast > co,andso PY, — Yast —> 20. The proof af this statement | {efi as an exercise at the end of this section, Compute the present value of $500 to be received ia one years time given the Interest rte of 8% Solution According to equation (3.3) we have 7 Py = v dent ‘Compute the presemt value of receiving $1 million at the end of each of the nex! three years given the interest rate of 12%. Solution $31,000,000 12 = $892,857.14 PV of $1 milton atthe end of the first year = PV of St mines et the sso gear = $1000 = $797,193.88 $31,000,000 ma = $711,780.25 PY of $1 million atthe end of the third year = Total: §2.401,831.27Example 3.7 33 _PRESENTVALUE CALCULATIONS 77 So the present value of the sam of these three annual payments of $1 million ts S2401,831.27 . Given an interest rate of 12%, guaranteed for the next three years, how much ‘money would one ned to be given presently as a Jump sum in order to finance expenditures of SI million to occurat the end of each of the next three years? Solution From example 3.6 we can see immediately that the answer to this question is 2,401,831.27. “To see that this is so, suppose that we start with $2.01 831.27, invested at 12% for one year, thus generating, $2,401,831.27 » 1.12 = $2,690,051.02 atthe end of the first year, After spending $I milion. we have $1,690,051,02 left ‘over 10 invest forthe second year, thus generating '$1,690,051,02 1.12 = $1,892,857.14 at the ond of the second year: Ater spending $1 million, we have $892,857,14 10 invest for the third and final year, thus generating $892,857.14 » 1.12 = $1,000,000.00 as required for expenditures at the end of that year, . Continuous Compounding Although iis conventional to quote interest rates on the basis of anual payments, itis not unusual to see a different length of time used to determine the compounding. of interest earned or owed, For example. itis not anusual to have interest earned in a Savings acewunt accrue and be automatically reinvested (compounded) on a ‘monthly basis. The result of doing this is that more money is eared than in the case of only u single instance of coumpounding at the end of the full yer. This result is developed below through the use of an example, ‘Suppose that the annual rae of interest on money in a savings aeeount is 125% (r =0.12) and an individual places $1,000 into her account, No withdrawals are ‘made until the end of the year. If jmerest is compounded on an annual basis, the amount in her account atthe end of one year will be $1,000 (1 ++0,12) = $1,120. ‘Alternatively, suppose that the bank computes its interest pay ments on ahalf-yearly basis and deposits the appropriate sim into their custamers” savings accountsaccordingly. This means that interest is compounded semiannual interest rate of 12% implies a semiannual interest rate of 6%. this means that the $31,000 on deposit earns $1,000 x 0,06 = S60 interest inthe first half-year. When deposited into the account, this means that the principal forthe second half-year {$1,060 which ears $1,060 x 0.06 = $63.60 and so the total value of the deposit at the end of the yeur is $1,000 + $60 + $63.60 = $1,123.60. A more mathematically convenient way to express this is to note that sfter the frst half- ‘year there is $1,009 x (1 +0.06) in the account and this ammount earns 64% interest in the sevond half-year, implying that atthe end of the year £51,000 > (1 +0.06)} x (1 +0.06) = $1,000(3.06) $1,123.60 {is the amount inthe account, Suppose that the bank instead decides to offer compounding every three months (ie. exch quarter of a year). The interest rate for a quarter of & your is 3% and compounding quarterly means the value of $1,000 the end of a year will be ] 1,000(1.03)" = $1,125.51) $1,001 + 0.03)(1 +0.03)(1 + 0.08)(1 + 1.03) = 1f the bank offered compounding monthly, the relevant imerest rat is 1% (per month) and the value of $1,000 at the end of a year becomes $1,000(1.01)! (+001) 1,126.82 Not surprisingly, the more frequently interest payments art compounded, areater isthe value of the savings atthe end of the year. IE we letr represent the annual interest rate snd the number of times per ‘year that interest is compounded, then the relevant per period interest rate is /n and so in each period we need to apply the factor (1 +r /m) to determine the valu ‘of each dollar atthe end of that period. It follows that the value of SP invested tin annual rate of interest r compounded mimes per year is worth needed) oe) times at the end of a year. (Try this formula for the example developed above whet n= 1,4, and 12 for annual, quarteriy, and monthly compounding respectively} By continuous compounding we mean that interest 1s compounded insan ‘neously or in effect, > 26. Thus We can treat the term (1 + r/n)" in te Formeove as a sequence with its limit lim .-(1 +r/n)*, giving us the factor to be applied to the principal P in order to determine the value of SP invested for a ‘year with continuous compounding. It turns aut that for the special case of r = 1 (100% interest ate), we get an(it;) =* Where e isthe so-called natural number first introduced in ehapter 2. Recall that it hhas approximate value ¢ = 2.71828, ‘Although interesting, this formula itself has litle application, since interest rates are rarely 100% per year, IFthe interest rae is r, then the relevant calculation for continuous compounding becomes variables where y =n/r. Then r/n = 1/5 and n= sr. Upon substituting these values for r/n and n into the formula above, and nating that as. > 90 0 does > 00, we get gin (14£)'= un (1+2)" Ignoring the term r for a moment. we see that sell] since it is exactly the same expression as before except for a change in variable loo] Thus'$P invested forone year atan interest rate of r with continuous compounding ra [(ve 2] 2680 CHAPTERS SEQUENCES, SERIES, AND LIMITS: atthe end of one year. For our example with # = $1,000 and r = (1.12, this value is Pe =81,000e"* 1,127.50 Alltat remains to be able t apply generally the idea of compounding interest payments is to asides whet happens when the investment period diffe from one ‘year. In the ease of compounding n times per year, where n is finite and r is the annual cate of interest, the following formula indicates the value of SP invested ved(4iy]-eiy ‘This formula is derived by noting thatthe factor (1 +r/) must be applied n times ‘each year for each of ¢ years, which implies thatthe exponent inthis expression is mt. For oue own exemple this means that ifthe $1,000 were left in the savings account for two years, it would be worth 51,6001 +0,12)" 1,000(1 + 0.06)¢ $1,000(1 + 0.01) {$1,254.40 with annual compounding 1,262.48 with semiannual compounding $1,269.73 with monthly’ compounding ‘An analogous result applies to the ease of continsous compouneding with the value of $P invested at interes cer for periods being worth V=Ple'y = Pet atthe end oft periods. For our example, the value of $1,000 invested for two years av interest rate 12%, compounded continuously will be = $1,006 = $1,271.25 Itis worth noting that even if the process of contiquous compounding seems implausible in a real-world context, it may nonetheless be a sufficiently accurate and useful approximation. Notice tha the difference in te value of $1,040 invested fortwo years with interest compounded monthly, compared tothe case of interes being compounded continuously, is minimal. Since the formula for continuous ‘compounding is mach easier t¢ Work with, economists often assure that they can apply it even if it is not exactly correct ‘Since computing the present value of @ payment to be received in the future means determining how much money one would need now to generate this fo ture amount, it follows that the frequency with which money invested now could38 PRESENT-VALUE CALCULATIONS 81 be compounded mast be fictored into present-value calealavions, For example, $31,000 received one yest From now has present value $909.09 if the interest rate is 10% and interest is compounded annually: that is, since 1,000 or 58 — s999,09 110) = $$900,09(1.10) ‘sith However if interest were compounded twice annually the $909.09 would generate ‘more than $1,000 after one year. t would generate $5909.09 +-0.05)? 1,002.27 and so the preseat value of $1,000 received in one year's tine is wort less than '$909,09 jn this scenario, The correct computation is $4,000 907.03, Lose ‘To check the intuition, note that $907.03 invested al interest rate 10% (per year) ‘ith compounding of a semtiannual basis generates $9472 (13(1.05)° = $1,000. In general terms, if $V is tobe received ? years from now and the interest rate is (per year) with compounding 7 times per year. then one would weed $X now to generate this future Value, where x(i4£)" =v or x ¥ +07" Thus the appropriate discounting formula for finding the present value PV, of a future amount V when discounting oscurs n times per year is v pt a cnr Similarly, if interest is compounded continuously, the amount (SX) needed. row to generate $V in 4 years’ time is determined by the relationship ‘and So the appropriate diseonnting formula under continuous discounting is PY, = Ver"Example 3.8 Example 3.9 All of these results are illustrated in the following two examples. Note that 4 case where compounding occurs a finite number of times per year is referred to as discrete compounding, while if » —> oo, itis referred to as continuous compounding. Determine how much money an investment of $10,000 will generate in the fol- lowing situation, tn each case assume thatthe annual interest rate is 3% (i) At the end of one year given semiannual compounding (Gi) At the end of five years given semiannual compoundiag (iii) Atthe end of one year given monthly compounding Gv} Atthe end of five years given monthly compounding (v) At the end of one year given continuous compounding (vi) At the end of five years given continuous compounding Solution Using the formulas v= v(t +5) fordiserete compounding va Pe for continuous compounding we get ove s1o,00( wii v= si0.900( iy) v s10,000( 6) v =sia.000( 10,0000" 310,000" Determine the present value of'$25,000 to be received in the future in the following situations. In each ease, assume the interest rate is 8%.39_PRESENT-VALUE CALCULATIONS 83 (i) Payment is eceived atthe end of one year's time given annual compounding Gi) Payment is received at the end of 20 years’ time given annual compounding (ii) Paymentisreceived atthe end of one year’stime given quarterly compounding (ie., every three months) (iv) Payments received atthe end of 20 years’ time given quarterly compounding (vy) Payment is received af the end of one year’s time given continuous com- pounding (vi) Payment is received at the end of 20 years’ time given continuous com- pounding Solution Using the fornuulas ee PV=Ve™ for continuous compounding or (iy 225000 _ $2500 oases “i waits Sen = $5,263.70 Gi) $23,096.14 525,000 yy SRO = SOE = 85,127.74 © TF eos ~ (07 (y) $25,000¢~"™ = $25,000(0.9231163) = $23,077.91 (vi) $25,000"! = $25,000(0.2018965) = $5,047.41 As.the applications above indicate, computing the present value of streams of payments or periodic payments can be quite tedious. These computations, howeves, are essential to banks and other financial institutions that need to determine the. ‘equivalence of a stream af payments to a fixed current amount. Some further techniques and formulas for this purpose are developed in section 3.5,84 CHAPTERS SEQUENCES, SERIES, AND UMTS: ess 1. Find the present value of $100 to be received three years from now, assuming annual compounding of interest, given an interest rate of 12% 2. If the interest rate is 10% how much money would one need to receive now 1 be equivalent to $1 million received two years from now it: (a) Interest is compounded annually? (b) Interest is compounded semiannually’? (c) Interest is compounded monthly? (@) Interest is compounded continuously? 3. Suppose that the interest rate (r) is such thatthe present value of receiving ta Years from new isthe same as the present value of receiving SV, in us from now, fj. Assume that interest is compounded annually, Show that V3 > (b) Show that the present value of receiving $V, (fz + &) years from now is also equal to the present value of receiving SV. (t) + &) years from now for any value of k. (That is, itis the absolute difference between time periods that matie.) 4. Prove, according to definition 3.2. that the prevent value of an amount of ‘money, V, received ¢ periods from now and evaluated at an interest rate r > 0) Appen Suppose a country with current population of 100 snllion is expected to experience a population growth rate of 2% per year for the next 50 years. As. suming continuous compounding, what is the expected size of the population: hes 2er0 aS 1 > 20 (a) 5 years from now (b) 10 years from now fe} 20 years from now 6. Making use of the same situation and assumptions as in question 5 above.) Find the length of time requited for the population in this country to double, 3.4 Properties of Sequences ‘The following results concerning convergent sequences are straightforward and si) are given without proofExample 3.10 ‘The usefulness of theorem 3.1 lis in the fact that it is sometimes easier 10 determine independently the limits of certain parts of the terms of 2 sequence. ‘Consider, for example, the sequence formed by the terms 2 ores p+ ‘To expand this and determine the limit as» ~> a would be a tedious exercise. However, it is clear thatthe limit of the numerator. and the limit of the denom- inator is B. Thus one can apply result (iv) of theorem 3.1 10 see that the limit of the expression is «/. The following two examples illustrate the frst two results of theorem 3, ‘Use the result that lity.o0 1/m sequence fn) = 2/n,n= 1,23 and theorem 3.1 (i) to find the limit of the Solution Since ‘we can write86 CHAPTERS _SEQUENOES, SERIES, AND LIMITS, Example 3.11 Example 9.12 Use the results that Limy-sac 1/n = O and, limy. 1/(m + 1) = 0, and theo- ‘em 3.1 (i) to find the limit of the sequence ntl {0 = a 22.3, Solution Since Qn _mentt on net U men mt MeN) at att ‘we can write + im +-0+0-0 eet ee “Theorem 3.2 provides some simple and weful results when we are faced | with algebraic combinations of definitely diverge sequences in conjunction wi convergent sequences. ‘The following examples illustrate results (i) and (iv) of theorem 3.2, Use the result that imy-.o%=-+00 and result (i) of theorem 3.2 to find Timy- 20/2, An analogous set of results applies for the case in which by has limit 20,3.4 PROPERTIES OF SEQUENCES 87 Example 3.13 Solution im dm ty alin) and 50 Fim 01/2 = +90: . Use the results that tim 243 = | Paar and result (iv) of theorem 3.2 to find (a+ 308 =) pg SEN Ae Solution Since we can write n+3 li tim “*— +00 Another useful application of this theorem concerns the present-value formula developed in section 3.3: v ei a+r ‘Theorem 3.2 provides proof of the claim hat. if r= 0. then PY, +0 as (+00, Since the denominator is a defintely divergent sequence (if r 0) and the numerator isa constant, then part (v) of theorem 3.2 establishes the result Since sequences are functions with their domains being the set of positive integers, one can define characteristics of monotonicity and boundedness in an analogous manner as was done for general functions in chapter 2, This is done formally below. (The property of boundedness was addressed informally earlier inthis chapter.)88 CHAPTERS SEQUENCES, SERIES, AND LIMITS ‘A sequence is monotonically inereasing if a, ay > ay > ‘monotonic. - and is monoton- In either case the sequence is said to be WMDs :e20e i bounded if and ony iit as a tower bound and an upper bound. ‘The following theorem is of obvious use in determining whether certain sequences are convergent. Example 3.14 Use theorem 3.3 to show that the sequence dy = 1/2", = 1.2.4... iscomver gent Moreover this sequence is bounded, since <<] forevery m= 1.2.3, ‘Therefore the sequence is convergent. « Example 3.15 Usetheorem3.310show thatthe sequenced, = —2n,yr = 1,2,3,..., isdivengent Solution ‘The sequence 1s monotonically decreasing. To see this note that35 SERIES 89 and 80 dy, < dq. Moreover this sequence is unbounded since for every K > 0, no ‘matter how large, Ligand? daenayy se ‘That is, this sequence is ot bounded below. Therefore the sequenc: divergent ‘We can see from these two examples that, forthe case of amonotonic sequence, itcan be much easier to check for convergence or diveryence using theorem 2.3, than by using definitions 3 and 3.4. If a sequence js not monotonic, then theorem 3.3 is not of any use. The following two sequences illustrate this fac. Both the sequence y" sand the sequence 42 (yer metas are bounded and neither is monotonic, yet the first is not convergent while the second one is, esas 1, Use theorem 3.3 to show that the sequence PY, = V/(I +r)! is convergent when r > Oand divergent when —1 1. Lis also easy to see that if Jo] = 1 We got ¢; = a and sy = na, which diverges for any a #0 For the case With [o| < 1, itis fairly easy to derive the limit of the geometric series, lim 5, a = ‘This sone by noting that upon mutiplying each term in the expression fr sy by. p.we get Pin = ap an? bap’ ++ bap"! tap" where tap + apap +++ apt! We can sce from the above two expressions that Se = PS =a —ap" ‘This allows us to write the sum 5, as % (=) Bai Since for |p| <1 we get p” — O.as n + 00, it follows that G3) Both equation (3.4), the formula for the sum of a finite geometric series, and ‘equation (3.5), the formula for the sum of an infinite geometric series, have mat | uses in economics. Before moving on to applications, a few general remarks about series are in ‘order. It may seem counterintuitive that a series such as the geometric series (with (

0,1 = 1, 2,3: in swhich family B ties to catch up to family A but fails to do s0, the sum of theseD, D, + miles = ri z traveled (wy ‘Stage 1 (aticr initial 60 minutes) a Dy les traveled miles traveled mH) CHOSH Dy Dy + + rites + traveled, 0 P, mR, (60) (90) (Ws) ct2.3) Stage 4 (after further t, = 7.5 minutes) * Dy 2D, Lu miles a . a traveled Stage i+ | (after further +, minutes) Figure 3.8 Relative location ofthe families in the Achilles Paradox story35 SERIES 95 Example 3.18 nite series which converges: Hea ele For the simple example above we know that the limit of this infinite series ts 460 (minutes), which is the time it takes for Family B to overtake family A.To see this formally, note that the series 1; has tems) = 30, to = 15.79 =7.5.-.-,.0F = ap! witha = 30and p= 0.5. Thus s; = Sot a iva geometri series and lion 5 Having resolved the Achilles Paradox by recognizing that an infinite sum of positive numbers may be finite should not lead one to claim oo much. Inthe geometric series, ¢, =a" with [p| < L-themth term approaches zero us > 20. However, it is ot generally correct that for any sequence ty With liMy-.:. the associated series s, 1; converges. ‘The series constricted from the sequence ay = 1/n, called the harmonic series, «does nol converge even though litt .2. dy = 0. (This is left as an exercise.) The intuition isthat if a seriesis toconverge, the nth term (a,) of tsussociated sequence ‘must approach zero “quickly enough’ that the sum of the terms ts finite even. as nn 6, This i the rationale of the condition stated in theorem 3.4, that ‘aya ‘which ensures that a series is convergent. Note that for the harmonic sequence Present Value of a Stream of Payments Earlier we saw how the sequence PV; = V/(1 +r’ (see equation 3.3) represents the present value of an amount of money V received ¢ periods into the future Im many economic setinss we need! (0 compute the equivalent present value of a seties (ie. the sum total) of such amounts, For example, a morgage or other long-term Joan represents & current sum of money loaned to an individual or96 CHAPTERS SEQUENCES, SERIES, AND LIMITS insttation in seturn for a stream of future payments. ‘Thus, {fan individual makes annual payments atthe end of exch year in amount V for 7 years, with the interest ‘ate being r, then the present value of this Stream of payments is e=y v See Oe NS rie ae Oe 36) “The relationships among the variablesin equation (3,6) te worked out in mort sage tables. They are generally computed on a monthly basis, in which case the appropriate interest rate isr/12, where isthe annual rate and T refers tothe num ber of monthly rather bun yearly payments. However, let us consider the following example based on annval payments, The yearly payment required to compensale {lender for a loan of amount $100,000 at an interest rate of 8% (» = 0.08) spread ver 25 years is V = $9,367.88, while if payments are spread over SO years the annual payments would te $8,174.28. Note that if the payments were to be made in perptity (ie, T —> 9c), we could Use the formal fran nfnte geometric sees with d= V/(L-+N. p = 1/(1-+rhsince Sy vito ov ity Fis Se a IN) 7 te = Dia Tiana 7 Thus we get V = rP = $8,000 for our example, which is Tasty close tothe valle when payments are made for 50 years. The reson fr this is iMustrated by the fact that the present value of $8.000 received 50 years from now, when the ieverest rate is 8¢, is omly $8.000/¢1 +008)" = $170.57, The present value of all payments of amknnt V = $8,000 received after $0 years ws tin So = Ji Py ~ tin ey A Dae which is only $2,132.13 in our example (100,000 — $97,867.87), «difference of only 2.1% (approximately), "Thus we see that using the formula for an infinite | series is often & good approximation for evaluating the present value of 3 finite series, provided that the number of periods or the interest rate isnot too small. The reason for the later requiresnent is that if i close to zero, the discount factor, = 1/(1 +9), is close to one, and so future payments are not discounted very ‘nvich and thus should wot be ignored. In fact, if the interest rate is only 1/2 of 1%. then we find that the present value of an infinite stream of payments of SK.000 per year is $1.6 million and the present value of the payments received afes the |Example 3.19 35 SERIES 97 ‘50th year is z Vv ie eae cad $1,246,858 which is 78% of the entire present value, compared to the error of 2.1% if the interest rate were 8% (rom the calculation above), Suppose that a stream of equal pay:nents of amount $10,000 per year is to continue in perpetuity. AL the interest rate of 6% compute (i) the present value of this entre stream of benefits (ii) the present value of che benefits beginning atthe end of the SOth year (ii) the present value of the first 30 years of benetits Solution oy $F Sica00 _ sto000 lim Pr mF (1.06 ~~ 0.06 $166,666.67 (ii) as of the beginning of the 50k year the present value of $10,000 per year in perpetuity is $166,666.67, as computed in part (). Since this isin effect eceived atthe end of the SOth year. its current (ie..8 of now) present value ‘must be discounted so that it becomes $166,666.67 (o6ys7 = $048.06 ‘The present value ofthe firs 50 years’ Worth of payments is simply the answer im i) Less that in Ci $3166 666.67 ~ $9,048.06 = $157,618.61 . “The examples above all dea! with the problem of determining the present value ‘of @ series of equal payments. In general, however, one can evaluate the present value of any pattern of payments. Suppose, for example, that a business firm is ‘considering the possibility of making acurrent (and immediate) investment of $C, the payatf of which will be the sules revenue af a product whose sales will increase lover time. Let us assume that the production process will begin at the end of one98 CHAPTERS SEQUENCES, SERIES, AND LIMITS. Example 3.20 {year and that net profit from sales of the product is Sr(1 + g) the first year and ‘will grow at a rate of g each subsequent year. Thus the profit for period ¢ will bea, = 711 +g, and the (undiscounted) valve of the stream of benefits (gross benefits) will be ‘which isa divengent series if and g are positive. The discounted or present value ‘of the stream of benefits is 3a) which is just geometric series, with @=(h +g)/(+r) and p=(14+8)/ (+2), $0 that PVB = m(l + g)/(r ~ g) and is finite valued if and only if C or PVB- ere Lease PY of costs PY of revenues ‘The tight side of this equation represents the amount $70,000 every year in per petuity beginning five years from now. As of the beginning of year 5, this has 4 present value of $72,000/r, and so discounting this number to account fora Five-Year delay before it begins means that it has a current value of (870,000/r) ae } Tis not easy to solve analytically for i this refaionship, which can be written $50,000 __($70,000/r) $100,000 + r Cr PV of costs PY of benefits By using a computer to ty several values for, we find the solution to be r = 0.05 Values less shave r = 0.05 give a higher present value for benefits than costs, while ‘values greater than r = 0.08 give a higher present value for costs than for benefits ‘The reason for this is that the benefits of this project accrue relatively further i the future and so are reduced to a greater extent than are costs as the interest rate rises. Table 3.1 illustrates this poim, Table 3.1 Interest rate (¢) PY of benefits 0.04 $1,350,000 $1,438,000 0.05 $1,100,000 $1,100,000 0.06 $933,300 $871,80035 SERIES 103 ‘The Keynesian Multiplier An important component of the traditional Keynesian macroeconomic model used 1 explain the importance of government fiscal policy isthe multiplier. The basic idea is that if there is an increase in exogenous expenditure in the economy say Bovernment spending, then # multiplier effect ensues so that the ultimate impact ‘on economic activity (GNP) is greater than the initial expenditure. For example, suppose that the government initiates additional expenditure of $100 million for increased road repair. This expenditure then becomes additional income for fms and houscholds. Although we would expect these individuals to save a certain fraction of this extra income, pay part of it as taxes, ane perhaps use some to purchase imported goods, we would nonetheless also expect that a certain fraction \wouild be subsequently spent on domestically produced goods and services. Ifthe fraction of this income spent domestically is 60%, then the increased goverment expenditure will have a second-round impact on domestic incomes of $60 million {ie.. $100 million 0.6). The individuals receiving this additional income of ‘$60 million will also spend a certain fraction domestically. If hi also 60%, then the third-round effect is equal 10 $36 million ie, $60 million x0.6), Continuation of this provess is described in table 3.2: Table 3.2 Ist round effect (initial) 100,00 million 2nd round effect 60.00 million (100. 0.6) 3rd round effect 36,00 million (60 « 0.6) 4th round effect 21.60 million (86 x06) Sth round effect 12.96 million (21.6 x 0.6) and soon Wecan seein the table that the overall impact can be described asthe geometic series 100 + 1010.6) + 100(0.6}? + 100(0.6)° + += which, from equation (3.5), has the value (a = 100, » = 0.6) 00 _ 100 06 04 250 million ‘The fact that even if we allow for an infinite number of rourids in this problem, the overall increase in national income is finite because of the same intition that resolves the Achilles Paradox. Summing an infinite numberof terms, each positive. imay give rise toa fini value ifthe rerms become small sufficiently fast.Example 3.24 Suppose that there isan initial increase in government spending of $100 billion tnd (hat individuals spend 80% of any extra income on domestically produced goods. Use the Keynesian multiplier model to determine the overall impact ofthis $100 billion injected inte the economy. Also compute the fist five rounds of the process as was done in table 3.2. Solution ‘The first five rounds of effects are described in table 3.3. The overall impact is 100 100 + 1000.8) + 100(0.8)° + 100(0.8)" + 3 = 5M" billion Table 3.3, {st round effect (initial) 100.00 billion 2nd round elfect 80,00 billion (100 x 0.8) 3rd round effect 64.00 billion (80 x08) 4th round effect 51.20 billion (64 08) ‘Sth round effect 4096 billion (51.2 « 0.8) In general, if we let c be the feaction of extra income that each individual \would spend on domesticaliy produced goods (0 ° () me G10) Which tums out to be a series that converges (1e., has a finite-valued limit). We ‘can see this immediately by using theorem 3,4, Thetis, = tg Leno a Ten tim 2 tet In Ln Sa wy lim‘which is fess than J, and so the series represented by equation (3.10) converges, (Note that the second fine follows from In(2"*")=(n-+1)In2 and In(2") ‘min2.) Thus, by using the function In(y) 10 represent the utility of $y and pre- suming that individuals rank risky alternatives by comparing the expected value of the utility they generate, rather than the expected monetary value, we avoid the problem of concluding thatthe St. Petersburg gamble is worth more than any certain amount of money. no matter how large in value. ‘Examining this issue further is worthwhile as itbrings out some ofthe intuition bout infinite series involving terms that tend to zero or infinity. Let pg be the sequence that represents the probability that the first head occurs after 1108508 G.e., py =1/2") and let ey = (5) be the utility Bain upon receiving the winnings Of ip (i Yq =2" and w(-) = In(-) forthe example above, Thus represents she expected utility of the gamble. The limit ts the sum of the product of the terms from two sequences, one that tends fo zero (p,)-and another that tends {0 infinity (up) a8 n —> 00. The series converges if the ui. ferms do not approach infinity 200 quickly relative to howe quickly the py terms approach zero. We saw above that if Ye = 2" and we use iy = Yq (Or any linear. increasing function of y,, then the series does not converge, while if we use x. = n(y,), the series does converge. The problem with this resolution of the St. Petershurg Paradox is that fone can construct a sequence of prizes. such 8s jy =e”, such that the series will no longer converge even if u(+) = In(:). This follows since i which isa divergent series (recall that In¢e) = 1). Thus. by altering the prize sinu ture, we see that adopting the utility function u(y) = Inty) will nol always resolve the type of paradox raised by the St. Petersburg gamble. A suflicient condition for resolving this paradox is to assume that the utility {function is bounded, f(y) is bounded above by the value u* as illustrated ir108 CHAPTERS SEQUENCES, SERIES, AND LIMITS wy) ou is) Figure 3.10 A beundod wilty Function figure 3.10, then the series Eu am ‘An alternative way out of the St, Petersburg Paradox is to assume that the prize values are bounded, say because of a budget constraint. aaa 1, Consider the trivial sequence a, = c, ¢> 0.8 constant. Show that this is aa example of a sequence for which and the ries generated by it diverges (see theorem 3.4), 2. Show that the harmonic series diverges. (Hint: Group terms from i = 2 +1102", k = 12,3... aand note that the sum in each group is greater than 1/2.] Show that this ix an example of a sequence for which lity last /in] = 1 and the series | generated by it diverges. By writing out and expanding expressions for sy and p’ ll 0, however smalt, there exists some 5 > 0, such that | fic) —L#| 1/6) tn fact, ifthe left-hand limitis L", then the sequen of values f= (4s) must converge (0 the value L for, =u ~ (I/n) ‘This example of «sequence of values xy that approaches. x =a from the left illustrates the relationship between limits of functions and limits of sequences (see chapter 3) and also explains why the notation x > a is used to denote a left-hand limit (x =a minus some small positive value). One must realize, however, tha {or the left-hand limit ofthe function to exist and equal L, jtmust be the case ‘any Sequence of ty values approaching a from the left must induce a sequence o function-ealues fy = fq), which converges to the limit L!. ‘A similar definition applies for the right-hand limit, namely that if there i always some (possibly very small) range of values of x to the right of a (iss strictly greater than a) for which the function values f(x) can be made ar trary close to some value L®, then we say that the right-hand limit of (1) a x=u exists and is equal 10". An example of a sequence of x-values that proaches.x = a fromthe rightis.xy=a-+1/n. n= 1.2, 3,.... Hence we have rotation lin, Fes‘The right-hand limit of a function f(x) which is defined to the right of x the point x =a, exists and is equal to L®, written lim, f(x) = 1" iffor any € > 0, however small, there exists some 5 > 0, such that |/(c) — L*) < e.¥ x, satisfying a 0 such that |f(x) — /(a)| <« whenever |x ~ a <4 forany € > 0, A funetion that is not continuous is said to be discontinuous. Definition 4.3 is the more useful definition when trying to show that a function is discontinuous at ‘acertain point. This will become clear when discussing why the examples of the118 CHAPTER 4 CONTINUITY OF FUNCTIONS: Example 4.2 fa) 646, 6 6-4 383335 ¢ Figure 4.1 Function y ~ 2x (with demonstration hit iis Continuous at r=3) Example 4.3 functions illustrated in figures 4.3 104.6 are discontinuous. Each case demonstrates «distinct property that i the cause of the discontinuity. Together the cases exhaust the reasons why a funtion miay be discontinuous. Itis often simpler, however, to use definition 4.4 to show that a function is continuous, as will be seen forthe examples of continuous functions illustrated in figures 4.1 and 4.2, Definition 4.4 illustrates the similarity between the definition ‘of continuity of a function and that of the limit of a sequence (definition 3.2), Ac cording to detinition 4.4, a fmetion f(x) is continaous at the point x = a if (1) is arbitrarily close 10 f(a) forall values of x close fo x =a (ie.,for \x—a) <8) While a sequence f(r) has limit value Lif f(n) is arbitrarity close ro 1. forall values n heyond some value that is sufficiently large (ie.. > Show that the Tineas function f(c) = 2c is continuous, Solution ‘Take the function f(x) = 2x. This function is continuous at every point x & R, To see this, consider the point x = 3 in figure 4,1. The function value at x is (3) = 6. According to definition 4.4, this function is continuous at this poiat if, no matter how small a number e > 0 we choose, there is some value 8 > 0 (possibly very small) such that all the function values defined on the set of x values (3 ~6, 3 +8) lie within the set 6 ~¢, 6+) Intuitively this means that the function values defined at points near.x = 3 are all clase to /(3). For example if we choose € = WAL then by choosing = 0.002, we find that all funetica values f(x) defined on the set x & (3 — 0.002, 3 + 0.002) lie within distanae € of f(3). That is. fx) © (PG — 0.002), 3 + 0.002)), which implies F(x) € (6 — 0.04, 6 + 0,004). All of these values are within distance € = 0.0 if (3) = 6. This would be true for any choice of § < 0.005. More generay. see that at any valve « = a we can be assured that / (x) will lie within distances ‘of f(a) as tong as we choose 3 < €/2. Thatis for s € (a ~ €/2,a+€/2),We fly € Qa—e,2a +6), Infortwally then, a funetion is continuous at a point x = a if the function defined at that point (i. F(a) exists) and you can meet the following challenge. matter how smal value € > Dis chosen. its always possible to find suficie ‘small but positive 6 such that forall the x-values -ithin distance 4 of the pois x =a, the function values fall within distance € of f(a), ‘Show that the polynomial function (x) =x? ~ 2x? +1 is continuous atthe x=1/2.Example 4.4 Jia) Ta=reo “isso Figure 4.3 Function in twample 4.4 (which is discontinuous ur=0) 4:1 CONTINUITY OF A FUNCTION OF ONE VARIABLE 119 Solution ‘The graph for the polynomial function f(x) =x*—2x?+ 1 is drawn in figure 4.2. At c= 1/2, we see that the function takes on the value. f(1/2) = 5/8, tis clear from the diagram that if for any € > O wean find a value 8 such that for xe (1/2— 5, 1/2-+8), the function values will ie within the set f(x) € (5/8 —€.5/8 +) In this case the actual choice for for any given ¢ is not s0 easy to ascertain, Some reasonably straightforward cases are given in the exercises following this section Figure 42 Function = 244 | (with demonstration that its continuous at r= 172) . Show that the function below is discontinuous: soo = Solution ‘This function is graphed in figure 43. Notice that the function has an obvious “break” or “jump” at the point x = 0. AS one approaches the point x = 0 from the left, the value of the function is +1, while as one approaches x. = 0 from the right, the value of the function is —1. In other words, the left-hand timit, lim, .o- f(2) = +1y is not equal to the right-hand limit, fim, .o- f(x) = —L. ‘Thus condition (i) of definition 4.3 is not satisfied atthe point x = 0, and so the function is not continuous at « = 0. ‘We can also use definition 4.4 to see that this function is discontinuous at the point x = 0. Suppose that we try to find an interval (open set) of x-values including the point x = 0 such that for all x-values in this interval, the function value is within distance ¢ = 0.5 of (0), We will fail, No matter how small a value 8 > 0 ‘we choose, we will aways find that f(r) will take on both the values +1 and —1 for some x € (—8, 8). .Before considering further examples of functions which are discontinuous, its useful to introduce the concept of the asymptote of # function Ifthe value of a function /(x)..x € R, becomes unbounded! as x approaches some ‘value x=a either from the left or the right, then we say the line x = a is any asymptote of the function, In such cases the funetion is nor continuous. If any one or more of the following possibilities holds, we say that the line x = q isa vertical asymptote, lim, f@) = +00, im fod Jim for) = 00. of tim fee 1 /x? has the same left-hand and right: = 0, itis not continuous, Example 4.5 Show that although the function fx; hhand asymptotic limits atthe point Solution fay ‘The line x = Gis 2 vertical asymptote for the function f(x) = 1/4 because the left-hand and right-hand limits of f (x) at x = © are bath +90: fay =e Jim fe) = Jim f(x) = 48 ‘We say that the asymptotic limit ofthe funetion-at x = (is +20, This possibiiy is similar to the idea of @ sequence being definitely divergent, as discussed in chapter 3. Although the left- and right-hand limits of the function are equal, the fanction is not continuous because f(@) is not defined. Thus condition (i) Figure 4.4. The function definition 4.3 is violated. The same holds true for definition 4.4 which seq) F(x) = Ve" Oohich is discontionsns that (Gr) must be defined on some open interval including the point x = 0 fori atx =Osinee 1/1 isundefined there) to be continuous at x = 0 (see figure 4.4) Example 4.8 Findanexample ofa functionthathas diferent eft-hand and right-hand asymptote limits at a point and so is not continuous a that point Solution ‘The function f(x) = |/(x — 1) has different left-hand and right-hand asym limitsatthe point. x = 1 Fors sghtlylessthan 1. itfollowsthat x ~ 1 isasmall ative number, and se L/(x ~ 1) isnegative but large in absolute value. For x sighExample 4.7 fis) =3x.982 : 322 | Fgure 4.6 Function in example AF (which is discontinuous at x = 2) cater than 1. it follows that (x ~ 1) isa small postive number, and so 1/(x ~1) isa large positive number, Thus lim,...\- f(x) = —oo, while lim, .)- f(x) = +00, asillustited in figure 4.5. As was the case for example 45, tis Fonction is not de fined at the point in question (x = 1) and so is not continuous at. = 1. In this case there isthe additional problera that the left-and right-hand lint are not the same. soa fo) = Merb Figure 4.5 Function fx) = /(x — L) (which is discontinuous atx = since 1/1) is undefined there) 2 Show that a function with a hole init is not continuous. Solution Consider the function ax, WreRa #2 no=ts” ¢ ‘which is graphed in figure 4.6. Despite the fact that this function is defined at (2) and its left- and right-hand fimits are equal atx = 2, the function is not continuous here because condition (ii) of definition 4.3 is not satisfied ‘We can also see formally that this function is not continuous by using defi- nition 4.4. At the point x = 2 we have f(x) = 3. However. consider the value Itis not possible to find an interval of x-values, (2 — 8,2 + 8), for which the function values are within distance € of /(2) for every x in this interval, This is true no matter how small a value for 8(8 > 0) is chasen, . ‘The following results, which summarize some useful properties of continuous functions, ae intuitively straightforward. We provide a proof for only one of them, which should give the Havor of the rest ofthe results,Proof (part @) only) Since itis assumed that /(2) is continuous, we know from, nition 4.3 that for any x = a. limp F(x) exists and is equal to ja). That Himy a> f(x) = Vimy o- F(4) = Fla). Thus, letting Aix) = cf Cx), we get =cfla) lim Ce) = tim ef (e) =e tim fe Similarly tim, 9: A(x) = ef (a) and h(a) = ef (a). Thus al ofthe conditions continity are satisfied forthe function Mx) = ef U9. ‘There are many instances jn economies in which the domain of a function ‘not the entre real line but isa proper subset of it For example, in considering amount of labor Z. fora fim to employ. it does not make sense to consider neg ‘values. Thus the relevant domain of a production function g = Q(Z) inv a lower bound or boundary, and we would write L > 0 or L € [0,ce). ‘considering continuity of the function Q(L) atthe point L = 0, it does aot sense to think about an open interval containing that point. In other instances domain may have an upper bound or both a lower and upper bound. For exampl in the short run a firm is constrained by its existing capital stock, say K < Ky so the relevant set of values for capital to choose from would be K€ (0, R]. ‘To deal with eases where the domain has boundary points, we make use the concepts of right-hand and lefi-hand limits as giver in definitions 4.1 4.2. Thus suppose that the function f(x) is defined enly om the closed in xa, b], a a~, and since x cannot be greater than b, we cannot def the right-hand limit of f(c) as.x —> b*. However, as long as (x) is continu al every point strictly within the interval [a.6], meaning for w a (from the right) andr + b~ (from the let), we say the fuaction (x) is continuous on the closed interval [a,bLet f(x) be defined on the closed interval [ 6) £2) is continuous from the right at the point x fa) exists, and lim, 9s f(x) = Fla, (ii) (2) is continuous from the left at the point x = 6 if lim, .y- f(x) exists, F(b) exists, and Lim, i> F189 = £16). Gli) C4) Is continuous on the closed interval [a,b] if it is continuous at every point x strictly within the interval (i.e., 0, x € R)? In the frst place, ro assume that f(x) is continuous ‘ata point x = a implies that J (x) is defined on some open interval of real numbers containing the point u. This means that must be infinitely divisible. That is, one ccan choose x to he a value that deviates even by infinitesimal amounts from ¥ =a. ‘An example of an input (and in output) that would not be infinitely divisible ‘would be bolts used in the production of an automobile. Since one would net use a faction like a half of a bolt. it Would only make literal sense to treat bots ay integer valued, Therefore it does not make sense to conterapate an open interval ‘of points including some value x = « bolts. However, if « manufacturer produces 20.000 vehicles per year using 1,050 hols in each vehicle, it seems reasonable to Simply treat bolts and vehicles as infinitely divisible and represent the relationship hetween them as y = /1,050, where.» is the number of bolts used and y is the number of vehicles produced. (Of course, we have ignored all he other inputs.)126 CHAPTER CONTINUITY OF FUNCTIONS Figure 4.7 illustrates this function white the true relationship would inchide ‘only the points (1,050, 1), (2,100, 2) (3.150, 3), ete. IF one ses the continuous funetion y = (1/1.050)x in the proves of solving some decision problem forthe firm and discovers the solution invalves some value of tht is not a multiple of f 1,050, then using the elosest value that is « multiple of 1,050 would probably he i reasonably uacurate. Thus, even if a commodity is not infinitely divisible, we may i often assume that i is, witht «storting reality very much, 1,080 2,100 31507 A Salary Schedule with a Bonus Payment Figure 4.7 Ye Cunction ‘Suppose that a salesperson receives a salary according toa contract that establishes y= (1/1.080 4 celationship between pay and the level of sales nade by the salesperson. Ia particular, suppose thatthe contrat stipalates thatthe salesperson's monthly salary will be composed of three parts: (i) abasic amount of S800, (ii) a commission ol 10%, and (if) & lump-sum bonus of $50) if the salespersons sales for the month reach or exceed $20,000, From this description, one can see that her salary will jump by $500 if the critical level of $20,000 worth of sales is achieved. This implies a discontinuity in her salary schedule, Letting $ represent sales per month and P cepresent the salesperson’s pay for the month. it follows that the function) describing her salazy-saes celationship is $8000.15, 5 = $20.000 $1,300-40.18, § > $20,000 Which is ilustrated in figure: 4.8 - 3,200 2,400 1.000 P= 400+ 0.15; s< 20.000 20,000 Figure 4.8 A salary schedule with s bonus paymentFigure 4.9 A discontinuous jnsme support function ‘The fact that the bonus of $500 is achieved once S reaches the critical value ‘of $20,000 leads to the result that the left-hand limit of the salary function at 5 = $20,000 is $2,800 while the right-hand limit is $3,300. The existence of this discontinuity has interesting economic implications. Consider the following scenario, There are three salespersons, called A, B, and C. Their cumulative sales for the month, not inclusing the last day, are $26,000 for A, $18,500 for B, and 36,000 for C. The 10% commission on sales will give each a similar incemive to inake extra sales onthe last day af the month, But will the $500 bonus possibility have a different effect on the three salespersons? Assuming that it is plausible Renerate a few thousand dollars worth of sales in a day but vinually impossible to Cereate more than $10,000 worth of sales. one woul expect that salesperson B will try harder onthe last day to increase sales than will the other 10. A Discontinuous Income Support Program Many welfare programs or “income support programs” offer individuals who are not employed a fixed or lump-sum monthly payment that is made only if the individual does not earn any income, Once ar individu earns any income whal- soever, the payments stopped. Corser te following hypothetical example. Sup- pose a single parent of zwo preschool-sged children can collect a monthly welfare ‘payment of $750 provided she doesn't work. However, once she earns any positive miount of income, the welfare payment stops. Assume that she could earn $15 per hhour at some job for which the number of hours Worked per month is entirely flexi- ble. The income ofthis person, asa function of hours worked, i. is given below: vay = [7 h=0 = Tish, hoo ‘The graph depicting this person'sincome asa function of hours workedis provided in figure 4.9. Its clearly discontinuous at /i = 0 hours worked. ‘Thistype of discontiauity, which isa property of many “all ornothing” income support programs, has been he subject of a great deal of debate. One ean see that a ‘person in sucha program would have to work 50 hours per month just vo match the income earned from the support payments. Since the person Would face childcare and other costs of working, the “all or nothing” property of this program presents a serious deterreot to the incentive to work. An altemative scheme would be to allow a person in this situation to keep) 4 certain fraction of income earned in addition to the $750 monthly payment Suppose. for example, thatthe person were allowed to retain 530% of any earnings. with the other 50% representing a payback of the income Support up fo the level ‘where the entire $750 is paid back. A person facing & Wage rate of $15 per hour ‘ill have paid back the full $750 only after working 100 hours oF more per month (0.5 x 100 x 15= 750). For 0 << 100, the effective wage rate is 50% of $15 (0F $7.50), and so net income for this range of hours worked is ¥ (1) = 7.5h. AfterCHAPTER 4 _ CONTINUITY OF FUNCTIONS this amount of earnings, the individual would keep any excess. Therefore undet this program the person’s income schedule would be the following: 750+75h, 0 100 ‘The graph for this income schedule is provided in figure 4.10, Notice that it is continuous. [Check that limp. ¥(h) = limy..,oy- ¥(h) = ¥(100).) vu) ry (2s 7s a0 15h h> 100, 750 100 D Figure 4.10 continnoys income-sipport function | Many economists prefer this second plan because it avoids the discontinuityl) the first plan. tn the first plan there is effectively large penalty for working a il since income drops from $750 per manth to almost zero ifthe individual ch ‘only a few hours of work. Under the second plan the person always earns moe) income by choosing work more. The resus that he person will be more lke choose some positive hours of work under the second plan making himsellhersl better off and slso reducing the cost ofthe program (o the governmet Continuous Marginal-Product Functions ‘The marginal product of an input is Ue amount by Which oxtput increases a result of an addtional uoit of that input being used, given fixed amounts ‘other inputs available. This concept is useful in economies when analyzing Accision-making problem of firms in the short run when the level of some in can be altered (variable inputs) but sther input levels are fixed (xed inputAull reatment of the marginal product of an input will be taken up inthe following chapter on derivatives. However, there are some interesting problems concerning the continuity of marginal-product funetions that are useful to consider here. For example, suppose thatthe function y = 10L-relatesthe anhount of output produced, +, the amount of labor input employed, L, for given fixed levels of other inputs. ‘ne can then see that an increase in L of one unit always leads to an increase in output of 10 units. Thus the marginal product of labor function is the constant function y = 10 and so is continaous on the interval (0, 20) Notice that this marginal-product function has the rather unrealistic property tha more output is generated by using more laber even for very large values oF labor, Since the amounts of all other inputs are fixed, one might anticipate that ‘makes more sense to imagine that as Z inczeases, the added output generated begins to fall and may even become zer0 oF negative. The following discussion shows that this phenomenon may occur in such a way tha the marginal-product function should be modeled as adi Marginal-Product Function with a Capacity Constraint In many production processes the maximum output that can be produced by in- creasing the amount of a variable input depends on the amount ofthe other (xed) inputs available. A good example is a coal-fired electricity generating station. ‘There will always be some absolute maximum amount of power that can be gen- crated from a single station. This maximum is generally referred to as the expac- ity of the station. For example, if station has & 1,500-megawatt capacity, 1 means that no matter how much coal or other inputs ate ayailable, the maximum. amount of energy that can be generated in a twenty-four hour period (per day) is 36,000 megawati-hours (i., 24 x 1,500) Suppose chat we want to determine the marginal product of coal for a ease in which there is enough of all inputs other than coal to keep a 1.500-megawatt power plant operating at capacity. Assume that it takes 250 pounds of coal to zeneratz one megawatt-hour of energy. and so one ton of coal will generate eight megavatt-hoursof energy. Therefore the marginal product (per day’ of coals eight megawatt-hours (per ton) as long as capacity has not been reached, Once capacity has been reached, however, the marginal product of coal draps to zero, Thus, once 4,500 tons of coal have been used in a day to generate electricity, the generating station will have reached capacity (4.500 x 8 = 36,000), If we let. represent ions of coal used per day and y the manginal product of coal in megawatt-hours, then the marginal product of coal is given by the funetion 8, 051 =4.500 0. 4.500_y- meguatt-hours of electricity per ton of coal 8, 05554500 0, ¥>4.500 4500 ‘tons of 608 Figure 4.11 Marginal product of a input under a capacity constraint Revenue Function, Cost Function, and Profit Function for a Perfectly ‘Competitive Firm In the model of perfect competition it is assumed that each firm treats the market price as given. The firm does not believe its own choice of output level will influence the market price, and soit treats this value es fixed. This assumption is usually only ‘made to describe markets in which a large number of producers each produces & small amount of some homogeneous (identical) product. Letting 7 be the price of the product and y be the firm's output evel, we gt the revenue function R(y) = Py. Since this isa linear function in y. itis continuous. To show what must be tne in order that the cost function, C(v), be continous takes i lite effort. We begin ‘with the long-run situation. ‘The total cost of producing a given output level is simply the cost of all the inputs used in the production process. Suppose that there is only one input x wed to produce y and that the production function y = f(x) is used to describe the production relation. If we know how much output can be created from variows levels of input, then we can work backward to determine the level of input needed to produce a given level of output. This simply generates the inverse function y=fu) = x= sf as demonstrated in igure 412 for the ease y = x13, “Thus the cost of producing output level y is wie, where x is the amount of input required to produce output level and w is the persunit price ofthat inpyesay ‘ip msi Figure 4.12 A production function and is inverse Using the inverse function x = f-"y), we ean wrile Cl) = wf!(y). Now, if the production function f(s) is continuous, then, because of theorem 4.1(¥i), s0 is its inverse, f(y), and $0 €(y) is continuous. The profit function, (1) R(y)—C(y)isalso comtinusus by theorem 4, (ii, This is illustrated in figure 4.13, for a more general cost function. 12G)). RU CO) THO) = Ri) —Cy) Figute 4.13 Ifthe cost Function. C(y) is continuous, so js the profit function.) ‘i the short-run situation we usually model the firm’s decision in terms of a single (Variable) input. Again, let represent this imput and y= f() the (short- fun) production function, ‘The same analysis as in the above paragraph applies except that we need to recognize that if the firm produces. no output ia the short ‘un, itstill must pay its fixed costs. If we let fixed cost be SCy, then the cost function becomes C(,)) = wf “"y+Cp. Once again i follows that if f(x) isa continuous unetion, then so is the cost function and then so is the profit function. An example is illustrated in figure 4.14,12 CHAPTERS CONTINUITY OF FUNCTIONS Fy), RO}, CO) a Figure 4.14. cos function and profit function inthe presence of xed erst ‘Consider the following case in which the profit function is not contimuoes ‘Suppose that a firm cannot change from zero preduction to pesitive production ‘without expending resources to start he production process. Forexample, a smiet- ing furnace may have 16 he preheated before any steel can be produced. This type ‘of cost is called a serup cost and differs from the usual som of east in that it isa Jump-sum cost that must be incurred When going from zero to any positive ammount cof production, The amount prexiuced does not affect the size of this cost, The result 's thas the cost function, and hence the profit function, will be discontinuous at 1 = 0, Letting c(y) represent the cost of producing y. excluding the setup costs, ‘we cn write the cost function as 0 a Bey). y>0 cu) Where By is the setup cost. Then the profit function is, ayy = {° y=o TS | RO) = Bo et), yO ‘These Functions are illustrated in figure 4.15. {comparing the cost functions in figure 4.14 with that in figure 4.15, itis important to distinguish between fixed costs, a short-run phenomenon nil and ‘elup costs. The existence of fixed costs does not lead to # discontinuity of the short-run cost function because. if the firm chooses to produce zero output, itisCO). ROTA oH Figure 4.15 A cost function and profi function in the presence of setup vats still the case that the firm must pay its fixed costs, Thus, for the cost function represented in figure 4.14, che right-hand limit of €(y) at y = Ois equal to Co; that {sto say, limy_g+ Cy) = Co, which is alsa equal to the value of the cost function at y = 0. For the cost function illustrated in figure 4.15, the setup costs, By, are incurred for any level of output no matter how small or large but are avoided when the firm chooses to produce zero output. Thus, the right-hand limit of C(p) al y = D for this cost function is equal to By, namely lim,-.o» C(y) = Boy but the value of the cost function at y = 0 is 0, Clearly dhis function is discontinuous 2: the point y = 0, ‘The Bertrand Model of Price Competition* I there is more than one produceriseller ina matket but nt So many as tor make the perfectly competitive model applicable, we say that the market structure is ‘oligopolistic. The word oligopoly means “few sellers.” One model that describes the possible behavior of firms in this seting is the so-called Bertrand! model. To make matiers Simple, we assume that there are two firms in the market, although the qualitative nature of he outcome of the model is not altered if We assume that there are more thaa two firms, Tn the Bertrand mode! the twa firms ure assumed (o compete in prices. That ceack firm sets price and then meets whatever demand exists for its preduct a that price, Assuming thatthe firms produce identical commodities, fone firm charges. lower pre than the other, then all the consumers will purchase from that producer. Ifthe two firms charge the same price, then we assume that consumers194 CHAPTER 4 CONTINUITY OF FUNCTIONS purchases will be split evenly between the two producers. Thus we need to about how revenue for each firm changes as prices are altered, To see how firms will behave in this situation, consider the following simple numerical example: Lot the demand function be y = 20 — 2p, and let the marginal cost (i, the cost ‘of producing one more unit of output) be the constant value ¢ = 4 for each firm, ‘That is, Cy) = 4y is the cost function for each firm. Nowe that as long as the price exeeeds 4, each firm cant make an excess profit. If the price equals 4, each firm can only earn normal (or zero economic) profit, and ifthe price falls below &, either firm would incura loss iit produces any output. Therefore each firm would Produce zero output, We begin the analysis by determining how firm ’s revenue changes for alter: native prices given that a specific price has been set by firm %, Sty p> =7. Given that firm 2 is charging the price p2 = 7, it follows that if firm 1 charges a price “above 7, its sales will be zero and so will its revenue. If ic charges a price equal 07, it will share the market with fiem 2, To find total market demand, note that at a market price of 7 we have 20-217) =6 Since the wo firms share the market equally when they charge the Same price, we have yi mn 40 firm I'S revenue is RCP = iyi = 78) = 21 implying a profit level of ay = Rp) ~ Cul) = pss —4y1 = 78) — 43) =9 As noted, if firm 4 charges 2 price even slightly above 7. it loses alla its market hate to firm 2 and so its revenue and profit drop to 0. IF firm I charges a price even slighily less than 7, however, firm 1 will capture the entire market and so its revenue will jump accordingly. To see this, let p, = 7 —e, with « positive bat small, Since p is less than the price changed by the other firm, firm 1’s sales will be determined by the total market demand. Thus firm I sells output level ye =20— 2p, = 20-27) = 6 $2 sand so earns revenue Ri = Pry = (7 ~ EMG + 2c) = 42 + Re De? sand profit 4) —4(6 426) = 18-2 42 + Be m= RUPEECONOMIC APPLICATIONS OF CONTINUOUS AND DISCONTINUOUS FUNCTIONS 135 For e small (ie.,¢ — 0), We find that firm | earns revenue Ry m= 18 In fact, forany price p; <7, firm L captures the entire market and soits revenue and profit functions become that of a simple monopolist. We can therefore weite firm 1's revenue funetion as 12 and that profit 7(20—2py, pr <7 Rim = 421, m “aby 0 pot Firm 1°s profit funetion is i202) —A20—2p)). py <7 mip = {9 (ay 0, The revenue and profit functions are illustrated in figure 4.16, Looking at the revenue function and returning to the conditions for continuity given in defini tion 4.3, we see that this is a particularly interesting case mathematically. At the Point 7) = 7. the left-hand limitof the revenuie function is42, the right-hand limitis D.and the valve of the function itself is21. Thus we see that lim, .7- Ry(n) = 42, Him, .7» Ry(pu} = 0. and Ry(7) = 21. Since these are all differen, the function {is not continuous at this point. A similar result holds for the profit function. RP) Figure 4.16 Revenue and profit iu ceompetition tons of firm 1 for the model of Bertrand From an economic perspective this discontinuity i also extremely important, since what happens at the point of discontinuity drives the medel to its solution. To see this, consider any particular price, p>, that firm 2 may charge. As Jong as some profit can be male by charging the same price. firm I will never charge a higher priceas that would mean no sales and zero profit. IPfirm 1 charges the same price.136 CHAPTER 4 CONTINUITY OF FUNCTIONS. ary mye) = et Figure 417 eens and poi finsons fn | for aty price etby m2, >4 ‘P| = Pz then the firms share the market, However, if firm 1 charges a slightly lower price than firm 2, twill expture the entire market and its profits will jump ‘higher value. Thus, whatever price firm 2 charges, as long as it exceeds 4, firm will always undercut it in order 1o capture the entire market, It follows that the revenue and profit functions, which are drawn in figure 4.17, are PIM), m= Ps Ried = 4(4)P20- 2p), pi = Pr (43) 0, Pr > Py “The profit function is py(20 —2py) ~ 4202p), mh < Be mip) = 4 (2M20-2p)) —420=291)), ps aa 0. p> If firm 2 sets its price at p> 4, firm | will alway’ have an incentive to se price slightly below firm 2's price in order to capture the entire market, Of cours the same applies to fim 2, Tt will always have an incentive to undereut firm I prive slightly as long as firm 1 is charging a price above $4. Beginning at price above $4 charged by either firm, we will expect the two fiers fo engage in ‘process of undercutting each other's price until the price both fms are chai is S4.and they share the market equally. At this price both firms would eam economic profit and have na incentive to reduce the price further. ‘Thus, by concentrating on the discontinuity of the revenue or profit func Wwe can determine the final outcome of the model, OF course, one must reali that this type of competition will occur only under rather special assumiti Firs, the reselt requires that consumers would immediately switch to be