MATHEMATICAL ECON OM ICS

ECON6042

:':::;';,
emai I address

: iosephwu(decon.hku. hk
6:15

Office

hours:

- 6:45pm Thursdays

Room 904 KKL Building

Or by appointment Telephone: 2&50-6905

ECONOMICS 6042
M ATH EM

ATICAL ECON OM ICS

DR.

J.

WU

/ Jan/2010

This course aims to show the interconnection between mathematics and economics.
The cornerstone of modem economic theory is general equilibrium theory based on optimization. Static and dynamic optimal models will be presented for studying microeconomic and macroeconomic topics. In particular classical welfare economic theorems will be covered within nonlinear programming framework in the Euclidean space R". Such analysis will be extended to more abstract spaces as a lead-in to the study of topological foundation for static and dynamic equilibrium and optimization models. Rehrning to the Euclidean space, application of these abstact concepts in the form of Ponfyagin optimal contol theory and recursive methods based on Bellman stochastic dynamic programming will be used for analyzing the all-important macro topics of economic growth and employmen! illustating the importance and relevance of these advanced theories.

Textbook: Lecture notes for the whole course will be available at my WebCT, HKU Portal
Reference textbooks:

Olq E.A., Real analysis with Economic Applications, Princeton Univ. Press , Princeton 2007
Stokey, N.L.
E conom ics,

& Lucas, R.E. (with Prescott, E.C,), Recursive Methods in Dynamic

Ilarvard University Press, Canrbridge 1 989

Hoy, M., Livernois, J., McKenna, C., Rees, R., Stengos,T., Mathematics for Economics
2ed. Cambridge, Massachusetts. The

MT

Press 2001

Ljungqvist, L, and Sargent, T.J., Recursive Macroeconomic, MIT Press, Cambridge 2000
Romer, D.,Advanced Macroeconomics 2ed. , McGraw-Hill, New York 2000 Takayama, A-, Mathematical Economics 2ed, Cambridge U. Press, Cambridge 1985

Reference Bibliography:

Akerlof, G. "The Ivlarket for 'Lemons': Quality Uncertainty and the Market Mechanism" , Quarterly Journal of Economics 1970
Arrow, K. J., "The Role of Securities in the Optimal Allocations of Risk-Bearing," Reiew of Economic
Studies

3l (April l96a)

Bellman,

kE,

Dynamic Programming, Princeton University Press, Princeton 1957

Bellman, RE., Dreyfus,S.E.,Applied Dlmamic Programming,Princeton U. Press, Princeton N.J 1962

Border, K.,Fixed Point Theoremswth application to konomics and Game Theory, Cambridge Univenity Press, Cambridge Reprinted 2003 Bouabdallah, K., Jellal, M., Wolff, F. "Unemployment and work sharing in an efiiciency wage model" Economics Bul/ear, Vo.' 0,No.3 pp.l -7, 20[,4

Browning, M., I{ansen, L.P. & Heckman, J.J., "Micro Data and General Equilibrium Models" & Woodford, M. (eds/ Handbook of Macroeconomics, Norlir Holland, Amsterdam 2000
Capinski, N., Kopp, P.,Measurc,Integral & Probability 2ed Springer-Verlag London 2004

in Tayloq

J.

Cass, D., Optimum Growth in an Aggregative Model of Capital Accumulation, Reiew of Economic Sndies 1965

Chiang, A., Wainwrigh\K, Fundamenal Methods ofMathematical Economics 4ed, McGraw Hill International Edition 2005 Chow, G. C.,D)mamic fuonomics: Optimization by the Iagrange Merhd, Oxford U. Press, Oxford 1997 Debreu, G., Theory of Value,, Wiley, New York I 95 I De La Croix, D., Mchel, P.A Theory of Economic Growth, Dynamics and Policy in Overlapping Generations, Cambridge University Press, Cambridge 2002

Dixig

A K.,Optimimtion

in Economic Theory,2ed, Oxford, OxfordUnivenitypress 1990

Dreyfus, S.E., Law, A.M., The Art and Theory of Dynamic Programming,Academic Press, N.y. 1977
Farmer, R.E. A.,Macroeconomics, South-Westem College Publishing Cincinnati 1999

R E. Hall, "Tumover
Heathfiel4

in the Labor Forcn". Brookings Papers on konomic Activity 3 ,1972

(Ed ), Topics inApplied Macroeconomics. MacMillan Press Ltd., London 1976

to

Hillier, F.S., Lieberman, G.J., Introduction

Mathematical Progmmming,McGraw-Hill, N.Y. 1990

Hoy, M., Livemois, J., McKenna, C., Rees, R., Stengos, T.,Mathematicsfor Economics 2ed. The MIT
Press, Cambridge, IMassachusetts 200 I

Huang, T., Ilallam., 4., Arazem, P., Patemo, E. "Empirical Tests of Efficiency Wage Models", Economica vol.65, ppl25-43 1998

Intriligator, M.D., Mathematical Optimimtion & Economic Theory, Prentice Hall , New Jen ey

l97l

Kamien,

and Schwartz, N., Dynamic Optimization 2ed Elsevier North Holland, Amsterdam 2003

Knight, F., Risks, Uncertainty &Proft,Houghton Mifflin, Boston

l92l

Kubrusky , C., Measure Theory A First Course, Elsevier Academic Press lvfass, 2007 Kusuoka" S., and Maruyama, T. @ds.) Advances in Mathemqtical konomics, Springer, Tokyo 1999
Layard, R, Nickell, S., Jackman R,(Jnemployment Macroeconomic Performance and the Inbour Market, 2ed.,Oxford U. Press, Oxford 2005

Leslie,

D, Advwnced

Macroeoconomlcs, Beyond IS/LIvI, McC'raw-Hill Book Co. London 1993

Ljungqvist, L, and Sargent,T.J.,Recarsive Macroecanomic Theory, MIT Press, Cambridge 2000

Lucas, R. E. Jr..,

*On the Mechanics of Economic Development

", J of Monetary Economics

22 (1988\

Luenberger, D.G., Microeconomic Theory, McGraw-Hill Inc., New York1997

I\{ankiq

N .G.,

Macrceconomics 5ed, Worth Publishers, New York 2003

ilfinford, P, and Peel, D, Advanced Macroeconomics, A Primer,Edward Elgar, Chelterham,UK.2002

Muth, J. F., Rational Expectations and the Theory of Price Movements, Econometrica 29:315-335 (1961) Negishi, T., General Amsterdam 1972

fuuilibium

Theory & International Trade,North Holland Publishing Co.,

Oh E.A., Real Analysis with Economic Applications, Princeton University Press, Princeton, 2007
Pissarides, C.A., Equilibrium Unemployment

Theory,2d MIT

Press 2000

Radner, R, Paths of Economic C'rowttr that are Optimal with regard only to Final States,.Review Economic Sudies 196l
Ramsey, F.P., Al\4athematical Theory of Saving. Economic Joumal3S:543-559 (1928)

of

Romer, D ., Advanced Macraeconomics

2d,

McGraw-Hill, New York 2000

Romer, P.M., "Increasing Retums and Iong-Run Growth", Joumal of Political Economy 94 (Oct 1986)
Samuelson, P. A., Foundations of konomic Analysis, Harvard University Press, Cambridge, IVIass. 1947

Simon, C.P., and Blume, L.,Mathematicsfor Economislr, New York, Smith, W. T.,

W W. Norton

1994

*A Closed Form Solution to the Ramsey Model" Contributions to Macroeconomics: Yol.6: No. I Article 3, 2006 (http://www.bepress.com/bejm/contributions/vol6/issl /art3)
Silbe6erg, E. & Suen, Wing,The Structure of Economics, AMa*tematical Analysis,, Irwin McGraw-Hill Intemational Edition, Boston 2001 Stiglitz, J.E. & Weiss,
Review

"Credit Rationing in lzlarkets with Imperfect Information"

l98l

merican

konomic

Stokey, N.L. & Lucas, RE. (with Prescotl E.C.), Recursive Methods in Dynamic konomics,I{arvard University Press, Cambridge 1989

Sun, W., Yuan, Y. Optimization MediaIIC, U.S.A.2006

Theory &Methods: Nonlinear Programming, Springer Science-Business

Takayama, 4., Analytical Methods in Economics,, University ofMichigan Press, Ann Arbor 1993 Takayama, 4., Mathematical honomics 2ed , cambridge univenity Press, cambridge 1985

Tobin, James, (selected by) Landmark Papers in Macroeconombs,E dward Edgar Publishing Ltd. Northampton, Ndass. 2002 Tobin, James, "On the Efficiency of the Financial System", trloyds Bank Reiew July l9B4
Tinbergen, J. and Bos, H.C., ,Mathematical Models of Economic Growth,McGraw
Uz"awa,

Hill , New York

1962

H., Optiimal Growth in a Two-sector Model of Capital Accumulation, Review of Economic Swdies

1964

Van, C.L., Dana, R, Dynamic Programming in Economics,Kluwer Academic Publishers, Dordrecht 2003

Vohrq

k,

Advanced Mathematical konomics,Routledge, Oxon 2005

Von Neumann, John,

*Model

of General Equilibrium', Review of Economic Studies 1945

Von Neumann,Joln,The Mathematical Foundation of QuanumMechanics, tanslated by R. Beyer,

Princeton, Princeton Univenify Press 1955

Von Neumann, John, & Morgentstem,O., Theory of Games & Economic Behawor, Princeton, New York,
1955

Wan, F.Y.M. ,Introduction to the Calcalus ofYariations and its Applications,Chapman &

Ilall, New York

t995
Weinstock,

Calailus of Vaiations, Dover, NewYork 1974

Whinston, A, Moore, J., Wu, J. 'Resource Allocation in a Non-Convex Economy'', Review of Economic Sudies 1973

Chapter L A.

What is Economics?

Tvpical definitions:

./\
Study of resource allocation, production and distribution. branch of social science. studies human behaviour.

Actually want

-/
most

most efficie nt (Opti m al) way to allocate resources, to produce & to distribute. (if do not want to optimize, not necessary to study econ)

efficient(Optimal)

way to behave/do things.

IU

optimization,

but scarce resources constaints

constrained optimization:

(ifno scarcity, not necessary to study econ)

max/min some goals subject to some constaints

Prof. StevenN.S. Cheung FffitHtU ,\!llE Arcadia Press 2000 page24-25 (to paraphrase Prof. Cheung, only 2 basic principles in Econ. constained optimization (by varying constaints, can predicVobserve behavioral

l.

changes)

2.

downward sloping demand function D.

Microeconomics: Study of individual Producers and consumers in markets

constrained optimization by economic agents

Macroeconomics: study of the economy as a whole

economy made up of economic agents' actions and reactions and these economic agents (macro jargon: households and firms) all constained

optimizing
macro

micro foundation of

Remark:

But optimization as the main principle to study economics went through stages of opposition and refinement.

Adam Smith's main theme of individuals pursuing seliinterest (optimaation) and invisible hand (prices and markets) will lead the situation to a social optimality (result of
optimization).
Social writers like

Karl Man

reiected this idea as economics manv times do not

alleviate poverty.

J. M. Keynes wrote the General Theory because of unemployment during the Great Depression in 1930s which ran contrary to the full employment predicted by microeconomics theory. The attention shifted from optimnationto aggregate concepts in the economy.
All the while, classical economics, especially the Ghicago School, went through refinements and modification. In 1990s, the tide seems to shift back towards optimization by rational (self-interest) economic agents and the resultant market equilibrium (G.E. models). Macroeconomics also was swept towards this general equilibrium framework.

1. Static optimization is used to explain economic behavior at a given instance of time. 2. Dynarnic optimization, dlmamic programming or Lagranglan methods are used to

3.

explain economic behavior througb time. Stochastic features are added to include risks.

ECONOMIC

-.

OPTIMIZATION OR CONSTRAINED OPTIMIZATION

In Math, constrained optimization is called mathematical programming.

A) i)

Static equilibrium models:

set of simultaneous math equations.

When

solution for this set of simultaneous equations, model has an equilibrium point x*)

the

e.g. the familiar supply S@) and demand D(P)

functions

t "*

But what is behind S and D? S - derived from constrained profit-optimizing behavior and D - derived from utility-optimizing behavior under budget constraints.

q*

In other words, there are optimal models underlying the equilibrium models.

ii)

Static optimization models: Optimize (Max sometimes s.t. some constraint function g
e.g. Linear Programming

orMin) objective function f

LP- if objective & constraint fi,rnctions are all linear.

Nonlinear Programming NLP - when functions involved are not linear. e.g. concave programming: when objective F and consfaint G are concave functions over convex set Max F (x,y,z) s.t. G (x, y, z) S K

(Soln: (**, y*,

,*))

B) i) Dynamic

equilibrium models:

If time is discrete, math models described by difference equations.

If time is continuous, model uses differential equations. (solutions are family of functions or curves over time).
Underlyrng such dynamic equilibrium models are optimal dpamic models.

iD Dynamic optimization models: if objective function is an integral of differential functions s. t. consfaints that are differential equations. (solutions are optimal time paths f*(t))

Calculus of variations @uler's equation)

I a,

More general theory

J,
Pontryagin's Optimal Contol Theory Find time sheam of Xnnol vble u s.t. constaints on state variable x -solution is opt control path u*(t) & opt state vble path x*(t)
Bellman Dynamic Pro gramming

.,
basically a multi-stage decision process based op recursive methods
--L/ \.\

stocl-rastic adaptive Bayesian

I I
with

certainty

risk

O..irion Theory (dual contol) risks can be J by learning

(p d. fcn)

Since this is a gadmath econ course, we will also cover general analysis, topology and set theory to provide a math foundation of such consfiained optimization as well as most general cases for optimization and existence of solutions. This is typical coverage of advanced grad math econ]

[C)

MATHEMATICS

- OPTIMIZATION

OR CONSTRAINED OPTIMIZATION

17ft century: pre calculus

18tr century:

CONTINENT Leibniz (1646

ENGLAND
Newton (1642- 1727)

- 1714)
of

Developed calculus independently Newton,

developed calculus to handle motion (based on Fermat's idea) and used for Newtonian & celestial mechanics (laws of motion)

argued withNewton for calculus primacy. LaGrange, Poisson, Johann & Jakob Bernoulli tied to find general principle underlying Newtonian mechanics so that calculus will onlv be a special case ofthis general theory. Based on Galileo 1630 discussion

t0)=o

,*?
I

of brachistochroneproblem (minimum time of sliding object from 0 p under Savlty g (which is a dyn opt problem)

in 1696 solved by Johann &

Jakob Bernoulli, Leibniz and Newton

P. Mauperfuis, Euler noticed that many phenomena in Nature occur in the most efficient and most economical (no waste) way. Based on this metaphysical realization, Euler established general principle to study all these simplifying, economizing phenomena in Nature developed into a branch of math in1744 called Calculus of Variations.

E.g. In optics: Fermat's

Soap

bubbles Water droplets Geodesics Hamilton's Principle

Principle

I I I
t
I

calculus of variations is a

unifyrng theory for these problems

Fields of elecbicity magnetism, relativity theory J

Nature economizing and optimizing

people subconsciously or conscious_ly mimicking nature and optimize? And since people optimizing before 17h century in-bred into human nature?? Optimization is necessity for sustained Survival???

NATURE - OPTIMIZATION

INTERCONNECTED

MATH

ECON

Chapter L

B. Historical Development of Math

Econ within general econ

'T*
16m

Century
F
I

Mercantilism

-max Exportl

*"

precious metals (gold, silver)

Econ activities by state planning & control

-min Import.[

-Classical Economics
Adam Smith
1776 nu rNeulRy tNTo rHE NATURE AND cAUSEs oF THE wEALTH oF NATIoNS

Invisible hand will bring

lffil* l(nade)
David Ricardo
1817 Principles of Political Econ

social optimum
I

& growth

& Taxation

the Rent

"{.'

", \
mparative Advantage
@. Krugman 2008 trade pattems basod on econ of scalg location. But still compamtive advantage?)

Thomas Malthus John Stuart Mill (state as "civilizer", forerunner of macro), Edgeworth, Pareto, Wicksell, Walras

Karl Marx
Das Kapital

-Neoclassical Econ

Alfred Marshall
1890 Principles of Economics -Util max and profit fi max

-Demand function D(P), +MU -Cambridge cash-balance D Theory - thouglr his writing mostly in plain English yet used math analysis including phase diagram

/
A. C.

/
J. M. Keynes

,/\ tvt*uritd"ti"
of all i's

Pisou
util

*l\

vs. L. 1936 General Theory of Employment, I (Pigou incorrect : as cannot' Interest & Monev have interpersonal util comparison MACRO _

Robbins

\ situation where no one can be made better off without somebody else beingmade worse off.
Thus avoiding problem of interpersonal

Pareto Optimality

P.O.:

from whole economy's viewpoin! using aggregate variables like GNP, National Income, agg consumption C, , agg Investrnent l, agg savings S, I G (Gov expenditure), T (Tax overall)

utility comparison

MICRO _
view from each market and then add up to whole economy.
I
I

Micro Development
I

1937 Von Neumann, J "Ueber Ein Oeknomisches Gleichungs-System und eine Verallgemeinerung des Brouwerschen Fixpunktsatzes" in Ergebnisse eines Mathematischen Kolloquiums edited by K.Menger 1937 franslated inl945-46 REStudies "A Model of General Equilibrium" 1930-40 Hicks, RGD Allen, A. Lerner, O. Lange, Samuelson using Calculus (marginal concepts like MU,

MCrl\ r/\

Theory of Consumer Given:

a set

Theory of Firm

ofgivenprices (pr, pz, p:, ......., p$) =Pvector consumption bundle of consumer i (*t,, xa, xi3, withconsumptionmafixX: [xr, X2, X3, ......., xr]
production bundle of produceri (yir, !iz, yit, with productionmafix y: [yr, yz, yz, ......., yil
yrN)

yj vector

each consumer

i
Vi

each producerj

tvlax

tI, (xi )

Max

rc1

= Max

pnyjo

1ra

1'6f-0

s.t. budget constaint

s.t. production

lonstaints Vj

s.t P**in(Incomei
constained optimization
I

from ls order conditions of optimization, can derive solutions x io*(P), yj"*(P) which are

i's demand fcns x-*(P) of good n

in terms of price vector P Law of D to assume I sloping D fcn

j's

supply fcns y;"*(P) of good n

& demand firnctions of inputs in

terms of given P

Define competition = all consumers and producers take prices as given. (Price taking behavior using atomism as rationale: all economic agents are too small to affect prices and everyone will take prices as given).
I

pN-) s.t. in each nft market If can find price vector P* : (pr*, pz*, p3*, Total Demand D" (P*) =I p,,* xin * : Total Supply S" [P*) = I pr,*y;,,*

ri

then P* is the market clearing

price AND we note

[P*, x*,

y*]

solves Max Ui s.t. budget constaint Vi

Max
and

ri

s.t. production

sst

Vj
V nft markets

P* clears nft

market
I

Then [P*, x*, y*] is called a General Equilibrium GE under Perfect Competition OR a Competitive Equilibrium C. E.

Fundamental Theorem of Welfare Economics Hand):

Under perfect competition assumptions
:

(:

Theorem of Invisible

a) perfect information (no information cost, no risks) b) perfect exchange (no tansaction cost TC) c) no externalities (a11 econ agents consumption/production are independent) d) perfect knowledge (no risks)
[P*, x*,y*] is C.E. (i.e. Equilibrium

t t

[x*, y*] is P.O. Efficiency)

Policy implication: explains why laissez faire (each agent left to pursue his own constrained maximization) leads to social optimality; why decentalized (as opposed centralized planned economy) is "good" because it is Pareto optimal.

|4ko20

Pure Price Theory

(Welfare Economics)

Applied Price Theory (Chicago School)

1930-60 Keynesian Macro popular but U. of Chicago maintained Micro discipline with its policy implication of laissez faire/market econ
I

Viner, Hotelling, Simon (1978;no full information, decision based on bounded rationality), Douglas,
I

Frank Knight (risks & uncertainty)

if market
Coase

rrotp.reri
G. Stigler (1982)

M. Friedman A. Director, Coase no perfect exchange no perfect information properfy rights to :) Transaction cost in real life clarifu 1) incentive to :> information cos! use Price system Coase Thm: if TC:0 CE t P.O. search cost to set (laissez faire & Properfy rights to information decenfralized market) clarifu externality problems 2) externality (Coase
Theorem)
F.Oshom (2009) common propty Rb can be managed by group O. Williamson (2009)firm as structure to rcsolve conllicts

(1991)

if no atomism

not price taking behavior

e.g. duopoly (2 sellers)

oligopsony (few buyers) oligopoly (few sellers) monopsony (1 buyer) monopoly (single seller) facing fsloping
S

facing J sloping D

not P-taking

sc ,/

?
PX

b.Aa..6

6^df ir^/l*t U44f\

e,

P-searching (Stigler's search cost)

\-rent-seeking behavior (Buchanan I 986) consumer surplus exfraction real life competition
(Industial Organization topics)
il

rtft.A.0

pncmg
e.g. cut prices

non-pricing behavior

to compete

packaging - sales promotion

incl. design of econ institution: Hurwicz, E. Maskin, R.Myerson

u
Generalized Neoclassical Micro Model (incorporating real life features)

How about risks? Via information cost; incur information costJ risks until at the margin, additional info cost: benefit from additional risk reduction. (But unsatisfactory)

Pure Price Theory (main model GE: C.E. P.O.) Lemer and Lange proved converse in 1930-40

P.O.+C.E.
But calculus proof

I I

small neighbourhood ('.' derivatives use limit concepts) results only local and not global

1950 K. Arrow (1972) and G. Debreu (1983) (teacher M. Allais) independently

extended to global results, using mathematical programming over sets (convex production set and concave utility functions); Hurwicz (2007), Uzawa ; Takayama, Whinston

Given perfect competition (perfect information, exchange, no externality and price-takers) and certainty (no risks) assumptions:

C.E.

P. O. globally

General analysis & set theory in math used to extend results from Euclidean o space R to more general topological spaces & provide proof of solution existence.

t4 6cQo
How about risks?

/_

Game

Theory

=_\_-*_

Decision Theory (esp. B-School) @ayesian, adaptive Model )

\
Von Neumann-

Morgenstern VN-M
Expected

Utility

VonNeumann 1928 Zur Theorie der Gesellschaflspiele

I

VN-M 1947 Theory of Games &

Economic Behavior (M. Allais 1988)

action <+ reaction

I

Radner, Shubik, Scart Shapley Nash (1994, Nash Equilibrium Harsanyi (1994), Selten (1994)
I Generafrzed reaction function

&

Best response fi.rnctions D. KahnemnQ0A2) strategic pricing and market models V. Smith Q002) core, coalition, cooperative & noncooperative g:rmes bargaining, agency problems stochastic games

R. Aumann, T. Schelling (2005) Arrow-Debreu State-contingent Commodities Model (Full Insurance Model) based on VltlM expected utility theorem

proved: given convexif5r assumptions and with risk-free assumption relaxed, if I a full insurance market (or full state-of-nature)

then

C.E. still + P. O. even under risky situations.

I

Qualifications :

asymmetrical information Stiglitz, Spence, Akerlof(all 2001)

in fact, insurance market and other financial product markets (e.g. swaps, derivatives, options, stocks ... : all markets for efficient risk re-allocation. ) Note: risks cannot be eliminated, it can be reduced by informational activities until at the margin, benefit = cost; and then the remaining risks are re-allocated efficiently, again resulting in a P.O.

other a comPuter. If the qJrestioner cannot determine bY the responses to queries Posed to theri which is the human and which the comPuter, then the computer can be said to
be "thinicing" as weU as the human.

at his house that he was having

"an affair" with a man who was probablyloown to the

Ttrring remains

hero to

burdar. AluraYs frank about his iexual orientation, lirring this time got himself into real houble. Homosexual relations were still a felonY ia Britain, and Thring was tried and
convicted-of "gross indecenql in 1959. He was sPared Prison but subjected to injections of female bormones intended to dampen his lust 'fm

DroDonents of afificial intelligence ln part because ofhis Etithe aszumption of a rosy fuhrre: "One day ladies will take their computers for walks in the oark and tell each other, 'tvty little comprrter said such a

funny thing this morning!'"

Unfor' tunatelY,. realitY

orow1rriq,breasts!" TLrring told a f,iend. bn June 7, 1954, he committed zuicide bY

causht up with Turing well before-his vision would, if ever, be realized. tn Manchester, he told police investigating a robbery

eating an apPle laced with cyanide. He was 4I.

Ttue setuior uniter ?utl GraY

arites on o Turing manhinn

WORLD WAR II HtS COLOSSUS CRUNCHED NUMBERS FOR BRITAIN IN

By NATIIAN ilfYHR\rOtD irtually all comPuterstodaY, from

chips that Power cell Phones and Furbies. have one thing in'common: they are all "Von Neumann.maehines," variations on the basic comPuter architecture that John von Neumann' - .. building on the work of Alaii Turing, laid out in the 1940s: Men have become famous tor-'' -' less. But-in'the lifetima of.tbislHungarian- ' handin: born mathematician whorhad;.his " everything from quantum physics to U'S' policy during the cold waq the Von fu"uriunn m-achine was almost the least of his accomplishments.

$l0million supercomputers to the tiny

such as numbers ortext, also the University oi aud"pesi ai'ttre age -ot zei'' iliilldiiis, held the stepby-step instructions that would After. immigrating to the U'S. in 1933' allow the machine to be programmed to von'tieum"nn ias hired, along vi'ith Albert oerform any task Von Neumann persuaded newly formed'lnstitute'for ;-' ' 'ih. 6nstein" by the t.n s.'t Jomewhat skeptical board of NJ" a Advanced StudY in Princeton, trustees to allocate $1O0,OOO-quite a sum in nonprofit research institute set up by the 1945-to buitd the trnNnc, the first in a series Barirbergei famity.with profits'lrom their 'of'earlv Von Neumann machines that deoartmlnt'stores. The l-Ls- proved to be the JoHNNIAc (at Argonne National the -oerfect intellectual playgtrould for'Von - . : ' inctua6a genius:-He;threw - ; Laboratory) and the IBM 70L one of the Neumannts.boundless profitable' into"bneiintractabie* progenitors of IBM's enormously i,irit"i? "iiin-a"{trusiast the'' : i' mainft ame lihes. oroblem after another;ranging-'fror* archives '. I abstractrnathematics:ofiguanturn.. ) . pagedrecently visited the i.A-s. handwritten 'nd throu!h Von Neumann's mechanics to. the practical problems of describing the construction iaf,notebooks weatherprediction' hydrology and'the' and testing of his primitive computer svstems. Interspersed with technical data a?e,comments such as; "5 a.m.: l've been at this all night, and I still can't find the problem.J'm disgusted and I'm going to bedl"-a sentiment anY computer . programmer will recognize..Von'Neumann bian't just design the stored'program comouter; he was the first hacker. economic's and.'evolutionary
.

.: a!.

'

' theorv: The 1997 Nobel Prize in to' Economics was awarded eame theorists, the seventh iobel Prize that grew out of Von Neumann'b ideas:.

ffiffi

j:

*'

:l**'d:'fllfJ',i:;f
sruoY

:!E5 :l-\

With theonset of World War ll, Von Neumann was recruited tor the Manhattan Project and PlaYed a role in

*HT"'"",JI:

ONE OF SEVERAL SEMINAL"VON NEUTJANN:MACru!-'IES* bution was supervising the vast iL'Euni lr'iAE tNsrtrurE FoR ADVANcED ind comptex mathematical

Budaoest in 1g03, ittiiJiroaiey who could divide eight-digit design,the bombs' he returned to the l^.s. After the war, nur"Ulri in'[,is f,eaa by age iix,-lEarned' obsessed with computing' von nis ;;i;;ilt-;; "LL "igt t jndamuieaphone and becamevision for the machines went Neumann's at a parents' friends by glanclng tasks for which book and reciting wnote pales verbatim. beyond the rote arithmetic d::g!:9:.L}t idealized Mathematics quickly oecanie the {ocus of they were o1iginally computer, thJsaml memory units that held his studies, culminating in a Ph.D. from
TIlvlE, lvlARCH 29'
1999

BorntoprosperousJewishparentsincalcu|ations_donefirstbyhandand|aterby to primitive electronic computers-required vun N"u."ni w"i a

hs rivatry with the Soviet Union heated uo, Von Neumann became a strategic adviser on defense policy. He was appointed by President Dwight O. Eisenhower to the Atomic Energy Commissioni which oversaw the oostwar LuitOup ot the U.S. nuclear arsenal. Von Neurnann's game theory became a tool to analyze the unthinkable-glob^al nuclear war-and led t6 the doctrine of ;mutu"tty assured destruction'" which would shape U.S. strategy for the next two decades' Von Neumann also became an icon of the *"t. Oit"Uled with pancreatic cancer' he "oiO stoicallv continued to attend AEc meetings ,ntii nii death in 1957. The wheelchair:b'ound scientist with the Hungarian accent who mathematically analyzed doomsday is said to have bien a model for Stanley Kubrick's Dr.

Strangelove.

Nothan Muhnold., chief technologg ofrctt Jor Micrositft, colbcts old ntpercornputers

104

MACRO
Agg concepts C,I, G, T

Samuelson

(1

970), Robinson

Stone (1984)

parallel development

GNP as measurement of national income, measurement of C, I, G, Y, L, M etc ECONOMETRICS (Econ + statistics) Tinberger (19 69), R.Frisch( I 969) Klein ( I 980),Kuznets( I 97 I ) Haavelmo(l 989 Identification Problem)

(,r,Q t

Samuelson' s Keynesian Crgss

lz +5U Lts+kl ctt th

1 ,EW
;

+*

u-{4*r*(
Y.

if replace G by net gciv expenditure g: G - T

get lhcal policy AG and AT

Tac;{

letg:0 )equilibriumYe:C + I
defineS=Y-C butY-C:I

t Y- C : I

I I: S

get IS curve

But how about monev: money supply: M exogenous (e.g. cenfal bank conrol) get monetary policy AM

demand: liquidity preference (prefer to hold money) L various theories: 1) Quantity Theory of Money 2) Marshall Cambridge equation 3) Keynesian monetary theory (using consols) 4) Tobin (1981) LP as Behavior towards Risks REStudieslgsS - (laid partial foundation of modem Finance) 5) Baumol's Inventory Approach 6) Friedman (1976) New Quantity Theory ofMoney
get LM curve

ws
I
Aggregate D

1950-60

IS-LMfremework

But how about labour, production (i.e. supply side, e.g. Cobb-Douglas aggregateprod funotion, Solow (1937) education for labour force; Becker(1992) human resources for productivity
{}

i Aggregate S

IMarschak-Brownlee Aggregate S - Aggregate D Macro model (analogous but different from GE built up from individual econ agents)

u
1960 Growth Theory (=tper capita Y &lor Yfrr".ploym*t by technological advances and labour productivity increase education/fraining) Inflation, unemployment issues (esp. Phillips Curve and later Friedman-Phelps (2006) expectations-augmented Phillips Curve) Friedman Permanent Income Hypothesis (expectation)
U

r970-94

Rational Expectation Theory I\{arschak (1953 Economeffic Measurements for Policy & Prediction) Robert Lucas (1995) Micro level - individuals max obj s.t. various consfraints AND s.t. rational expectation of prices (both present & future like infl ation/deflation - macro), of intertemporal consumption pattern and of actions of other economic agents, thus linking macro with micro foundation.

Equilibrium now just steady state in decision rules space fiust like Micro ArrowDebreu State-contingent GE model)
So far most models are static models (one period instantaneous models)

1930-60

Dynamic l\dodels (with time dimension) for both macro (e.g. growth models) and micro intertemporal models, mostly using difference & differential equations and calculus of variations.

tTIff TYALI }I'ITUS'I firu$T[AL

\ I$focn

OPIMON

DECEMBER 3,2008

Economists Have Abandoned Principle

Twelve months ago nobody could have imagined government interventions we now take for granted'
By OLIVER HART and LIIIGI ZINGALES
history, but also as This year wili be remembered not just for one of ttre worst financiai crises in American to be a consensus that selective the moment when economists abandoned. their principles. There used shattered. intervention in the economy was bad. In the iast 12 months ttris belief has been

to solve the problems hacticaliy every day the government launches a massively expensive new initiative pnncrples behind these actions. The lack of a that the last dav s initiativi.did not It is hard to discern any public's perception of the govemment's has increased uncertainty and undenained the
coherent strategy coropetence and trustworthiness.
a golden opportu:rity to put the The obama administation, with its highly able team of economists, has government to adopt two key counfry on a better path. We believe that the way forward is for the failure. The principles. The first is that it shouid intervene only when there is a clearly identified market to ta,tpayers. out at minimum cost second is that government intervention should be carried

provides mechanisms for How do these principles apply to the present crisis? First, ttre market economy death, but this is misleadine. dealing with difficult fi11195: Take bankruptcy. It is often viewed as a kind of start. A company in financial Bankuptcy is an oppornr:rity for a company (or individlal) to make a fresh gives it some respite. It also distess faces the aungrr thai creditotr *itt ffy to seize its assets. Bani<ruptcy trouble was the result provides oppormrlty for claimants to figure out whetherthe company's financiai process ttrrough a of bad luck or bad management, and to decide what should be done. Short-cuuing this saved? govemment baiiout is digerour. Do.r the government really know whettrer a company should be

further than the FDiC procedure As an exampie of an effective bankruptcy mechanism, one need look no to flnd a buyer. Every for banls. when a bank gets into touble the EDiC puts it into receivership and ties paid in futt and had access to their money at all time this procedure has bien invoked the,depositors were times. The system works we1i.
about letting Bear Stearns, AIG and From this penpective, one must ask what would have been so bad 11 banlcruptcy? One Citigroup (and in tire iuture, General Motors) go into receivership or Chapter

71u2009

Lia4

Page 2
',,
.

of2

argument often made is that these institutions had huge numbers of complicated ciaims, and that the bankruptcy of any one of them would have 1ed to contagion and systemic failure, causing scores of further banh-uptcies. 41G had to be saved, the argument goes, because it had rillions of dollars of credit default swaps wrth J.p. Morgan. These credit default swaps acted as hedges for tillions of dollars of credit default swaps ttrat J.p. Morgan had wi*r other parties. If AIG had gone bankrupt, J.P. Morgan would have found itself unhedged, putting its sAbiliry and that of others at risk. parties rather This argument has some validity, but it suggests that the best way to proceed is to help third than the disftessed company itself. In other words, instead of bailing out AIG and its creditors, it would have been better for the goyernment to guarantee AIG's obligations to J.P. Morgan and those who bought probably at much insurance frorn AIG. Such an action would have nipped the contagion in the bud, smaller cost to ta:cpayers than tire cost of bailing out the whole of AIG. It would also have saved ttre govemment from having to tnke a position on AIG's viabiliW as a business, which could have been left to i Uuot *prcy court Filally,'it would have minimized concerns about moral hazwd. AIG may be responsible for its financial problems, but the culpabiliW of those who do business with AIG is less clear, and so hetpile them out does not reward bad behavior. prices Similar principies apply !c the housing market. It appean that many people thought that house premise. The adjusunent tc the would never fali nationaily, and made financial decisions based on this new reality is painful. But past mistakes do not constitute a market failure. Thus it makes tro sense for the govemment to support house prices, aS Some economists have suggested.

Where there is arguably a market tailure is in mortgage renegotiations. Many mortgages are secwitized, and the lenders are dispersed and cannot easily alter ttre terms of the mortgage. It is unlikely ttrat the prcsent situation was anticipated when the loan contacts were written. Government initiatives at

facilitatine renegotiation therefore make a lot of sense.

Our desire for a principled approach to this crisis does not arise from an academic need for intellectuai pressue. coherence. Without principles, policy maken ineviably make mistakes and succumb to lobbying This is what haBpened with the Bush administation. The Obama adminisfation can do better.

Mr. Hat is a professor of economics at Harvard. Mr. Zingales is a professo: of finance at tle Chicago Booth School of Business.
Hanlon's Razor: Never attribute to nalice that which can be adequately explained by stupidity. dscott,s corollary: The line between malice and stupidity is called depraved indifference'

?6J

'- ----4'

- /r ,^nnn

Dynamic econ

- optimize

multiperiod objective function (of variables) in different time periods s.t. resource confraints of these variables over time

1960- present

Dynamic optimization under uncertainty (explain econ behavior through time, under risky situations)

Remark: most analysis relies on function differentiability, hence opt are local results; with present-day powerful computers, computational iterations &/or approximation algorithms are employed to estimate functions, whether differentiable or not.
Pontryagin Optimal Confrol Theory (for both continuous & discrete cases, mostly m4thematical econ)

-l

Dynamic opt + stochastic assumptions -LaGrangian method (continuous optimization under risks)
Discrete Models (mostly Macro, esp. growth models) F. Kydland (2004) E.?rescott (2004)
I

Bellman's dynamic programming {Dynamic programming is a way to approach certain types of dynamic problems and many time solutions limited by dimensionality) In particular, graduate Macroecon theory course: study dynamic macro models based on GE and using dynamic programming

under

ce@inty

stochastic models

Principle of optimality

tl ll

Markovian process to add risks

recursive

models

Markov process: measure theory & integration Basicdlly sequence of probty distribution functions converging to an invariant distribution = stochastic equivalent of detenninistic steady state.
I

just frnd steady state dynamic system (equilibrium) but theoretical models with equil described by stochastic processes over different periods fiust like real life economic behavior). But many times, such problems are analytically insoluble or have no evident closed form solutions, or can only be solved by common sense, or no standard solving procedure, &lor can only be approximated by some algorithm
So now not

sometimes.

Summarv:

Hist development of Econ Mercantilism

I

Adam Smith Invisible Hand

I

Marshall

Pigout
MICRO Theory of Cons. D Theory of Firm
GE model
-r

-Keyn"s

MACRO

compet and perfect mkt asstrmption

Thm: Inv Hand: CE

Pure Micro P Theory

PO locallv

CE +

PO globally

Applied P Theory esp. Chicago School realJife features by relaxing compet and perf mkt assumptions Generalized Neoclassical Micro Model

RISKS???
Stochastic models Game theory

Decision

Theory Arrow-Debreu full insurance

(VNM Exp Util Thm)
C+I+G

+LM
Agg D

(usual undergrad)

+AggS

1960 growth, risks??? Dynamic systems - Simple descriptive dynamic systems

1 I

Rational Exp Towards GE model (Op$ Dyna mic optimizationrnodels Discrete time

(difference:tions: Harrod Growth Model; stochastic 2-dim difference +ions: companies growdr, Hall Employment model )

to*l

,/\ case

continuous time case

I
Belknan dyn prog and multi-stage opt

non*urlo opt control theory

RISKS???

Stochasticdynamicoptimization

Chapter I.

C. Unconstained

and Constrained Optimization

REF: Silberberg &

Suen (2001) Chapter 4

Takayama (1985) Chapler Takayama (1993) Part2

This section and optimization in general, in skeletal form:

Unconstrained
functionwith I indep variable

-/

\-'-{

4
_/\ -/\

Optimization

multivariate function

y: (x)
I
max

2 indep vbles

Y: (xI, x2)

y:

f(x)

max

y : (xr, x2)

II

n indep vbles y : f(x1. x2,

f(x1, x2, max (without matrix) (with mahix)

y:

consfrained
,1,

multivariate function with n indep variables

1

equality constaint

----4\
:
'.. , xn) :k

m inequalify constramts

2 indep vbles max f(x1, xz) s.t. g(x1, x2): k

y:

vbles max y (xt, x2, s.t. g(x1, x2, "', xo)

(without matrix) (with mafrix)

(with mafix)
max y

S.t.

f(xr, X2, ... , .,) jg(xr,xz, "', x,1;2ki

i:1,2, j:1,2,
(The most general case programming section)

xi20
will

be covered in the nonlinear

i)

Unconstained optimization

How to optimize (max or min)??

Assumption: In this section, we assume functions are differentiable. Since differentiation deals with small neighborhood around a point, the max or min we obtain will be called local or relative max (or min) and not necessarily global max (or min).
Case a) unconstrained optimization of function

with

1 independent variable

Optimizef(x) x

solution x*

l$ order condition (necessary condition): f ' 1x*; : 0 (critical point)

2d order condition (sufficient condition): if f "1x*; < 0, then x* is a relative max if f "1x*; > 0, then x* is a relative min

[r-21

In case f " 1x*; : 0 at critical point x*, then we need to have successive derivative test, We must keep taking derivative at x* until we get a nonzero higher-order derivative.

lf

such nonzero higher-order derivative is

odd-numbered then

(3t, 5", 7*,

I

t'\

--\
even'numbered (4ft, o*,
I I

... .)

g*, ...)

x* is an inflection point.

and

<0 / -&- -\" x*isa

relative max

ll

>0

x*isa
relative min

RMK: For a rigorous derivation of the l't and 2od order condition using Taylor's please see Silberberg & Suen or Takayama [985].

series,

o a
d
@

a -E

I 'oc E
'qq

Y,t

E
@

I
o @ o o o
O'iN

$,

u 'ri: o> ERF wdU ou!

^a a

:.8
Q' @::l

Aa vq qo!

,>
a

A.E :

.o

vt Bi -a,fi) H.'E
=I

'l

,tfr XE ; x.5 Et I
E

e* rcq xo ,39
a4

atl

e
C) tl

rio ;._ :!H .x

Hl

a
R

rR o;
i

tl x
!

ll

#tE

d x:-

^ae:ll o .--!

+r

i36

-E
HOvq

t)

gx
{
T
,9
f

I
ll

Ga

t : s ?v EEgoo
* H ;:: x;
6' q i qq

49i6

{ { {
.{a

6 a
H

a= EO

EE
.!

f'
na Ui;
o

E
a o o
c-t

rl

?t 9"'
X5
QA tt

F6 i?

)l

SR

9^ z,E
rJ

J?
V B

-t F
E ':

ra
.U
tl

c aE
d6

fr xE -g rn {=
Z o O
Fe

B Ea 6 oo 9c O -: O rr tH 'oo R oo Its';. ll f E
-LL
AY

;r
to rl

oo ko

a E

\)

5r

oj
o

4,i
>o
tsB

*I
E=

-3 sE o -ri Or'=

E E?

do-

L
d

F:<

a
tl

R LN d =<

; 5t E ^=

s)

s r

4a t-E== '.r -Si rf 5=

.ig
-.

R.E

E6

CE\
Ao .:v
^o iv

3 z t; S tr h Ei-

\.-+3

u d! I i;

g.

Economic application (unconsfrained opt of univariate ftrnction):

A firm wishes to max profit n(Q) defined as Revenue R(O - Cost C(0, & given R(Q) : 407Q - Q' ; C(Q) :Q' -lQ'- 50 where Q: outputquantrtyofthe firm.

Maxn(Q):407Q

-Qt - (Qt-3Q2-s0)

:
1o order

4o7Q +2Q2

-Q' + 5o)
set
0

condition to get critical point Q*:

dn(Q/dQ:407 +4Q-3Q' :

3Q'- 4Q-407
Q*
or -

,.:i): { l6-4(3x-407)l t 2(3) : [4 r .l+roo1r0 _:

66 / 6 (we rule out this soln

'.'

assune output not

-ve)

Can check critical point condition at Q*:

da(Q)

/ d Q :407

+4 Q-3Q'

407 +

4(37/3)-3(378)2

:0

2od order

condition at Q*:

Tt"

(Q):4*6Q- 4-6(3713):-70<0 )

localmaximum

5Cg .R H. -^ qr X C

?H^
ll

k o)

n!)tr EIiJX
6'TFF
l

liO

tr

o-;'6

9':
HTN 'E X 6 x

,f

o . 6-E-g .{ tr-a/
@AV

{gl"A >,1 " I'o t'

^l .dl

agAo oAftr'd
SU
d d

d I ->F< FHH\

,/

,/

" lE l

>,1

ctt

6 ;\ :-)
!av

(ri

6i
L

rCLO

*)l -al >.1 c l'o

(u u)

/^\

'ct()c o>;d -

.t

D.
H-v

xn r --2 ;';
EX
g

tl
d

u
c)
aa

cg .^.
at

qr
-

el

()

(!

q.{
u)

,t,

q N

+)
c)
u) q)

t+i
N

q$ ^()

cr

'a
(n

bI)

iN

---+

x X .tse
^Pd

.{
t d

.q
-H

^6

U)

bI)

qr
q-i

c.t

i(t) (H

,g)

t- ^9F 'CJ.= 63O X \/ V) L4

a\ X **

* d

I'

{)
*

t{x

i.!'l i.-

h.5 !.,

v
cs

C-l
(H

= ,:
u)

rn

iEt
,d \J 6l Hl

r-r-| lou.#x >-

qixH
qi

?'+ ,S +.8 v'E

qi
o .t> cg r\

()
(It
(n

FlIjl
;l Nl

:r )cr f!*,,-,)

lu/afr,Rf

)narta

--\,

\'I

6,.-)

c1,,*;

ft=o
\
n-nJo'lr't<.

\t/

An example of unconstrained optimization of functions with 2 independent variables:

z(x,y) :x3 + y3 -18x2 + 6y'

1" order

+81

x -36y +

23

condition:
set

zx

:3*-36x+81 :0 t *-tzx+27:0

[x:{+12

t
zy:3t'+l2y-36:0 t
4 critical

+'{Wnt : {12+ 6} 12: 3 or 9l

l2(l)

x*:3

or9

t
(3,

y'+4y-12:0
-6) (9,2)
(9, -6)

[y:{-4+{

16

{-4+ 8\ /

2:

4(rX-12)| t2(1) 2 or -61

points (3,2)

2"d order condition

z,u<:6x-36
**(3,2) : 6 (3) - 36: -18 < 0 z *" (3,-6) : 6 (3) - 36: -18 < 0 z**(9,2) :6(9)-36: 18> 0 z**(9,-6) :6(9)-36:18> 0
z z

zw :
z

6y+12

n (3,2): 6 (2) * 12: 24 z r, (3,-6) :6 (-6) + 12: - 24

zn(9,2):6(2)* 12: 24 >0

zn(9,-6):6 ('6) r 12: -24 <0

*y:

y* :

0 for all critical

points

("

*)' :

for (3, -6)

z*"

(3,-6)<0

zr,

(3,-6)<0 and z xxzw: (-1SX-24): +432> 0 : ("r)'

relative maximum

for (9,2)

z,*(9,2)>0 zn(9,2)>0 and zxxzw :(1SX24):+432>0 :(z*y)'

relative minimum

for (3, 2)

z*"(3,2)<A

zo (3,2)> 0 (different

signs)

&2"*zw:(-1SX24)

-432<0 :

("*)'

@)

saddle point

for ( 9, -6)
z *" (9,-6) >

n (9,-6) < 0 (different signs) & z **z

w:

(18X-24)

-432

( 0 : (r r)'

saddle point

Economic application example :

Afirm's

revenue function depends on its two products a and b and is given as:

z(a,b):32a-a2 +2ab -2bz + 16b -9

Find a*, b* to max the firm's revenue function.

l't order condition to find critical point:

za :32-2a+2b :0 26 :2a -4b+16:0

2d order condition at (a*, b*):

a*:40

b*:24

zaa : zab :

-2

26 : 2 t

("ua )' :4
(zuo )'
40

zM zbb:G2)(-4): 8 > 4:
Hence revenue is maximized at a*

*:

24 and

revenue z

(40,24):

32(40)

- 402 + 2(40)(24) -2Q4\ + 16(24) -9 :823

Case c -1) unconstrained optimization of multivariate functions with

without using mafix algebra (generalae from

n:2

independent variables, independent variables case):

p2

Assumption: below multivariate function f has continuous partial derivatives to any order.

Optimize f(x1(a), xz(a), ... , xi(a), ... , xn(a))

at solution (x1*(a), x2*(a),

... , xi*(a), ... , xn*(a))

ls

order condition: set following

0 to get critical point

fi
2nd

(xr (a),x2(a),... , xi(a), ... , xo(a))

: 0

Vi

order condition: (using Taylor series and sign definiteness of quadratic forms)

t-r

IlfiitFl:o r-r

dxi
da

d":
da

if [F] < 0 then negative definite (f stictly concave) and we obtain local maximum. and ltr] > 0 then positive definite (f strictly convex) and we obtain local minimum.
We can see with the many combinations of i, j when n gets large, the terms becomes very unwieldy. One way to overcome this is to use linear (matrix) algebra.

Remark: A formal derivation of the l" and 2d order condition can be found in Silberbere & Suen [2001] and Chiang & Wainwright [2005].

Case c-2) (alternative method) unconsfrained optimization of multivafiate functions

with

n independent variables.

optimize

f(xr,xr,...,xn) )

atsolution

f* =(x,,*1,...*l)

1$ order condition:

vector

x' = (xi,*!,...*l)

is such that

.f,(7')=0
2od order

i=1,2,...,n

critical point x.

condition:

matix

H:

*,7'
a2f

a'f a'f ax? &r&, azf

azf

&,&o
a2f

&r.&"
a2f ..--;
Ax;

&n&,
Remark Note H is symmetrical

Hessian lHl alternates in signs starting lH,l .0,lHrl ) 0,... =+ lHl is negative definite (itrf is stictly concave) and

2d order condition for x'being

a local maximum is satisfied

Hessian fHl with principal minors lH,lt V, = 1,...n lHl is positive definite (itrf is srrictly convex) and

2oo order

condition forx'being a local minimum is satisfied

Chapter I. C.

ii) Constrained Optimization

We mentioned at the start of the course that resources in the economy are scarce. We also cannot do anything that is technologically impossible &lor we are bound by existing sociefy's property right structure. So when we optimize we will be constrained by resource scarcity &/or tecbnology &/or some other conditions (like private property rights consfaints whereby you cannot just take other people's resources without making proper payment).

constrained optimization, called mathematical programming (;rcomputer programming).

In particular, if optimize linear functions subject to (s.t.) linear constaints, the math programming is oalled Linear Programming (LP). The most general case is Nonlinear Programming where both objective and consfaint ftinctions are nonlinear.

Familiar examples in Econ:

(a) Aconsumermaximizeshisutility U(x) x s.t. his budget constraint p . x < his income I (b) A firm maximizes profit

Rn

Rn

zc(y)

s.t. production is feasible within the existing technological set.

(c) A flrm minimizes cost C(y)

ft n s.t. technological level and inputs/labor availability.

How to do constrained optimization??? When we are given a consfained optimization problem, we just convert it into an unconstrained one (using a Lagrangian equation), because we know how to do unconstrained optimization.
For instance, given a function f(*, y) with 2 independent variables and (univariate functions is a special case of the following, just set y :0)

equality constraint:

Max f(x, y)
s.t. g(x, y) :

f is called objective function

can write alternatively as k

called constraint, this case is an equality consfiaint - g(x,y) : 0

[Remark: to minimize an objective function h(x, y) is just the same as max only show constrained maximization.]

h(x, y) so we will

We set up a new objective function Q called Lagrangian, consisting of both f and g:

Original objective firnction

constraint

(k-

g)

(x, y,

rl:

(r,lv)

* t t k - Jf*, ,ll
f
t

l. called Lagrangian multiplier

IAA) tk - Bl :0 [k - g] :0 so optimizing Lagrangian = opt original BB) The Lagrangian is unconsfained we can apply the unconstained

CC)

maximization which we covered previously constraint will automatically be satisfied when we are solving 1s order cond]:

Max O (x, y,

I) : (x, y) + l,

Ik

g(x, y)]

ls order condition: to get critical point with 3 variables x, y and l,

@" :0 @v :0

@r

:0 (= k-g(t,y):.0

whichisjusttheconstraint laftersolvingforx,y,l,fromthese

3 simultaneous 1o order condition equations, the consfaint is automatically satisfied).

Interpretation of the Lagrangian multiplier l. : at the optimal level, l.* shows the approximate change in the objective function when the constraint is changed by I unit. We can derive the 2"d order condition for oonsfained optimization but this again involves many different combinations of partiats and cross derivatives like (Dii , (Dtj as well as solving for simultaneous equations in the 1$ order optimization condition, all of which can be handled more easily with mafix algebra.
Usual econ examples:

Max utility function U (x, y)

Ot:priceofx; p2:priceofy; I:income If U(x,y):x2 + 5xy + y2 and (pr, p z ): Q,1) and I:100

s.t, prx+pzy: t

x , y commodities

1o order

condition: (critical point)

Q*:2x+5y-21,:0
@r

: 5x + 2y - l" -0
(rfiiohisjusttheoonstraintlaftersolvingforx,y, l,fromthesimultaneousl$order
condition equations, the constraint is automatically satisfied at the critical point)

@l -100-Zx-y:0

) x*: 10 Y*:80 l* :5x+2y:210

atthecriticalpoint(x*,y*):(10,80)

{J*:(10)2 +

5(10X80) + (80)2 : 10,500 s.t. 2(10) + (80) : 100 and the constraint is satisfied
see

2d order conditions can be checked to

this is indeed a maximum.

Now if we change the constraint by a small unit, say 1 unit (should be arbitrarily small unit but this is just for ease of calculation)

constraint

2x+y = 100 changedto

x+ y

191

:0 t 101 -2x- 8 x:0 t t x* : 10.1 t Y*:80'8 ) U* now: (10.1)2 + 5(10,1X80.8) + (80.8)2 : 10,711.05
compared with the previous U*, the difference is (10,711.05

from l" order condition, we get and(D1 :101 -2x - y

y:

8x

101

:10x

10,500)

:211.05 = 210 :

,F

Optimal Lagrangian multiplier /' x tells us if we relax the consffaint by one unit, the optimal value of the objective function will change by L x units. For programming (constained optimization) problems, we often times use a value function V (x, o) where x is the endogenous variable and o the parameter. Value firnction is defined as the optimal value of the objective function given the parameter. Hence in the above example, O is the objective function, x,y are the endogenous variables and consfiaint amount 100 is the parameter. Then

: V(x*, Y*, 101) :

V(xn, Y*, 100)

10,500

10,7I1.05

In this context, the Lagrangian multiplier 2 * is the imputed value of the consfiaint. It is the maximum amount that the optimizsr is willing to pay to change one unit of constraint (i.e. the shadowprice of the consfaint).

ln the above example, we used equality consfraints (in the budget conshaint case, flris means the consumer will use up all his income). We will extend the case to inequality consfraints.

Alternatively,
Constrained optimization in terms of linear algebra.

of 2-independent-variable functions with

I equality constaint,

Optimize

f(x,,xr)

s,t. $(xr,xr) = we form the Lagrangian

k:

constant

O(x,, x2, X) = f(x, , X, ) * l,(k

\
ls
order condition:

- gix,, xr;)

note = 0

set Or=0

-)

0 @r=0
Oz =

fNote:O^=0 )
equations]

to get critical point

(xi,x])

+g("rr,xr)-k=0
=+ constraint is satisfied when solving simultaneous

2n

order condition:

setupborderedHessian

1o1=13,,

7,: i;l "' fl, ;'* ll lg, Ez o I le, (D,, Qn

is a locat min.

andcheckat

(xi,xi)

if

llt-rJ=1"-l

\
if

"

o =ltrl is positive definite + (xi,xl;

(-O uS3+ 2Q ngg z - A ,rS? )

lFrl>O *lHl isnegativedefinite

=+(xi,xi)

is alocatmax.

if 2"d order not met, need firther test.

t )l \ \ J() /

.-o dH oo 6.o adl o6 Ec

e' _b6 .*oo

r0
,>, trEq o=

6E 3 &;- bo

.eI

'D
.9
R

a
h

h, i

;XF EE 8E ^ & ,$, JJ; Al > F r* 6lio '-'?? r{ ;Y-; qtg ? e--,^ p: e \\rl rR*s t s$e T -? c.8lPa.O ,8*r-. -E."
>e

e 6 e
6

#E r tx

EE
EH Eg

E h

n.:-^ 9! nS!';E EF "lp

-6d

6==

:3

E ed"edd ;;;

'-lt ra :
-

=F'6 aa

:,S H;

'Et

'e*

R .H;ti EE tr .9 " E: o #3E

rtsi
g

rEf
E

5H#.E.EF

ls
J
o

;E*H,q { EgEEEi : ^g sflsse-$ * JS 9lPPFoo: ; (}E EE$TsE rg .8.6;PE ,: ! s.EE*,a'f , 3.-E FFi{: { SrE *: *$qf!" s $E # E EE;#:* E'q.eiE 'H E E E6;EEB .R "E R H 5 gcEsF E iE i
m\ > -Jl
tr 3

j s iEs I E Eg i:
&

g H5 E!gH:E

"

bo\\ ^

60
ry v < {a d ,. ,. bo

:*-qe,e
|t'lJ"

c.5E bo,Og

dd dd
Ag
'' ^"
J<

6a
6
t
Ix

:: ge
\:t
ll

.: 'st s 6 s..
-d u A a.'...]t/ c>6So

s
E

1i

o x

,Og

dll

.ta

lJ

;d" +
II

e*

..9
.o=
'F x6 o5

6$o
n rl

tl

rf

EF s'o T

E= tr:r o..

'rj:?

We extend to constained optimization of multivariate function with one equality

consfrain! using linear algebra: optimize f(x,, xr,...,xo ) s.t. g(xr ,x2," ',Xr ) = k
form Lagrangian (D=

k:
xo

constant

f(xr , X2 2..-, X1) + l"(t - g(x,, xr,...,

orn

))

-12

9r 8z

l3::
Bordered HessianlHi=

orn

lo

8r
@,, Q^ Ort

Ez

8n

lo"t

or=

ls,

@rt

orn
@rn

o8z
o |'n

g 9n

ls,

lt,
lo order condition:
set O,

l' to lon

":

o*

-Oz =@r...@o -@r. =0 togetcriticalpoint x. =(xi,xl,...,x;)

condition: check at

2"o order

x.
nositivedefinite

if

lH-,1,1H,1,...1tr,1<0

=lHi

+ tocatmin

order of principal minor

if ltrrl t

O,lFrl

.0,ltrrl > 0...

alternating in

sign+ lHl

negative definite

local max

if

2"d order condition not met, we need further test.

c)

*{

uzt$*M+refe {*u Jf'

wl

u4, f(*,rfIr-'-'r-i) (;l', iX C*, ,*r, "', x.) e ft't

*n

f,{r,,-*, -- ,y^}+

Lxl ({ i=t
v

l.r\

+g

(x,,

--,*"))

ral :
gp
,tl

(3

o1

't,'to"*-"'1,^ '8, *0, - -- '$"

t
lt+

'?"

b o '-o iE'*f,"---.$n -'g,"X, --ry, ![,, [,o fl,.

',-'1

9" '_':

'x^ 'e^

-'h* i*, *'--tia*t{

{o^

?ffr

h;4*t
>d ur{t-

t:T I l-r I -- tu l"-"tr4' Lt,**t I .,It-,^+"\

frl
,t,i-u'&6rt

;
(r'.t*-g *3
"

5*- *

\ f, \ gr-*. \\ l"tn^*r \
!

k, f *
Kt*

4;

#'{lc."r&
-- 1"

Gl,"s a.I*at<--

tS b*oi=4 'f

Lrs-{'af

6"^'. I

.d?t.ag-q &nefr* u-1,-<-,

Econornic application

Derivation of Marshallian Demand function D for economic agent

fu\A.

fuAu\ MaxutilityfunctionU (x,

y) : 5 xy s.t. budgetconstraint g(x, y): I whereg(x,y) : prx + pzy and I:constant- A\rA\r{'sincome. l,[I-(p1x + pzy)]

Formlagrangian@andmax: Max@: Max 5xy +

1$ order condition

(to get critical point):

O":5y -Ipr :0
@v:5x -l"pr:6
(tlrisisjusttheconstaint)

l,:5ylpt:Sxlpz

* y: x(p1lp2) \

@r:I-(pr" +pzy):O ) x: I / 2pt -

t I-prx -pzx(prlpz):0
) I -2prX
Dfunction forx dependentonpricepl andhis income I

check 2"d order condition using bordered Hessian:

(note partia derivatives

I r = pr , s: = p: )

l4,l:lu-l: lorr en er | : lo r 0 l@r, Qzz Ez I 15 pz o | *' Ez I lp'

Laplace expansion along l$ row

o,
pz o

|u" u"

dzt urrl
( -1) arz

"l u,, u,, l*

ua at' I dtt ullll+ lu,t

I

zzz

dtz

: 0

5Pt
Cl)5

+Pr

50 Pr
ll

Pr0
- PtPz

Pz

5Pz

:5prpz

+ 5prpz

: l0 prpz >0 I
local maximum.

'.'

prices

Pr>o

pz>o

lFl negative definite

Chapter I. C.

iii)

Constrained optimization with inequality constraints.

So far we used equaliry in the constraint. For example in the budget constraint case, equality means consumer will use up all his income. How about the case when he doesn't spend all his income and save some of it? Then we need to look at inequality constraints. How can we handle

inequality constraints? Answer: convert the inequality constraint into an equality constaint ('.' we know howto solve opt s.t. equality constraint):

Max

f(x)

s.t.

x>0

4-

inequality consfaint

Note we can convert inequality x > 0 into equality - s' where s : slack variable, squared to get a +ve sin; s"e R

tr

equalitv constraint

x> 0 meansx)0 or x:0

x:

X,
0 case

when

s:0

x>0case whens * 0

Noteifs#0

w)

: s' > 0 *

interior solution (not corner soln)

u!\Ny {b0

{e>
*x7O : st : 0 t corner solution and constraint is bindine. Noteifs:0) x
Subcase I

X-

subcase 2

)turtv.&*) 4 u4 Arfr:afr'^
ah

te)

r \

MM fC*>

(!,

>(..7_9

xtso
)
l't
Max Lagrangian O

Max f +

?,

[r - r'

order condition (to get critical point):

O": f' +]" - 0 (Dr: -2)"s :0 ol,: x-s2 -o

4

........n u
.........12.21 [3.3.]

(interiorsolution. Casel) if s l0 from 12.2) + t : 0 I

*
constraint not binding

@:f+1,[x-s2] :f+0[x_s,]:f

2"o order condition (bordered Hessian) i@z

: lo

@"* O*, g^l

f**
0

?: ?: %'l
tf *(0-4r')-o+1(2 r)
-4
s2

-2 ?,, -2s

+l

must > 0

(if we want
maximum)

fx*+27,

>o

.. ..

t4.41

Case 2)

: 0 ) corner solution x* : 0 ('.' from [3.3]) and , 2?,, >0 ('.' from[a.a]) ) l. >0 t f'< 0 ('.'fromll.l] f'--1.)
if
s

I function f is falling and not critical point (i.e. f ' + 0 ) p'*{u\ *x. . {8} ) x*:0 is the maximum.

(Nwd4,.f(*) #xAo

-rr

x*

;c(:o

:+

we get the following conditions:

max

(x)

s.t. x )

generalized,l'1 order

condition: f'(*) <0 and if f,<0:+ x = 0 max

Note above principle was derived using the 2nd order condition ws are saying if we want (i.e. set (H)t o ) then the principle is hue, but this does not tell us how to find the max. the max

Similarly for min

f(x) s.t.

x>0

generalized l'tordercondition:

f'(x) Z 0; if

f'>0+ x=0 min

we can generalize to multivariate function

max

f(x,,...,xo)

s.t.

generalized 1" order condition:

1)

For those variables x,

+ fi <0 andif f, <0 then Xi =0 ismax 2)

For those variables

x,

not restricted

to

>0

*fi=0

(-)

Analogously, c&r add slack variables and do the same derivation to get optimum

of

max f(xl,

) s.t. tg(*,,'"x,,)>0

X2 ,. . ., X1

any n, m

'g(xr,...x")>0
I,(*,,'"x")>o
xi
we form the Lagrangian

jg(*,,".,Xn)=fi.rnctions

>0

i=l,"',n

r( )+ir,,ie j=l

1$ order condition:

(also known

as

O, = fi
and

*t
j=t

f, j g' s 0
<0,

KUHN-TUCKER
condition)

if

(D,

Xi:0

(D^ =jg 2 0

andif
For min
1$ order

*r,t0, =
0

fu,=0

f(

) s.t. 'g( )< 0 x, )

condition 0, = f; *if, jg, ) 0

j=l

and

if

>0, then

x;:

0r, =rg 2 o
and

if *r, t O,then I: = 0

Remark: again these conditions only describe max/min but cannot be used to find the

max/mn.

Show Kuhn-Tucker K-T condition for constained maximization can be rewritten as:

(B) :[Qi:

fi+ I I: jg, . 0 0 ;
as

and x'
@i1

Or:0] :ol
and second part

(Bl):[@rj:'g]
Pf:

l.i

at tfre optimal point

x*

L*

K-T condition is stated

frst part (A)

(Al) below:

K-Tconditionfirstpart: (A)[@1:f1+

I f i'g, = 0 andif (Di<0flrenxi:0] (A):[@r:fi+ f l:'gt'0 and if @i<0then xi =0] t [xi (Di:0&ofcoursestillOi:fi+ I Lj'gt < 0]:(B) (B):[@i:fr+ I l.i 'gt'0 andxl @i:o] t [if (Di< 0 then x1 must: 0 to make xi (Di : 0 & of course still (Dt: f i+ f L: t g, s 0l : (A)
(A)

Hence

+ (B)

or

(A)

(B)

(A1): [@r::'g ] 0 ; I: ] 0 & if Oij >Othen l; :01 t (Bt;:[@rj:'g ] 0; I: > 0 & li @ri =01:(81)
And

Similarly for second part of K-T condition:

(A1)

(81)

K-T condition which is (A) + (Al) is

(B) + (Bl)

Economic Application of Kuhn-Tucker (K-T) condition:

John minimizes cost C(a, b) under the following conditions:

Min

C:

Pu

a +

Pu

b >K

Pu: price of apples

P6

price ofbread b

s.t. his

utility function U(a,b)

a,b

assuming goods are not free so Pu, Pu > 0

Question: in minimizing his cost, what is John's utility level?

We note Min

C =

Max

-C

above minimization problem

becomes
0

Max-Pua - Pub

s.t.U(a,b)-K>

[Let U(a*,b*) be denoted by U*]

)Lagrangian@: -Pua - Prb +1.[U(a,b)-K]

and

]">

K-T condition: - Pa + 1* 16U*/ D a) S

and a* (-Pu

),* (AU*i d a)):0

[K-T-l]
[K-T-2]
[K_T_3]

-Pr + 1r*(?U*lab)< 0 and b*GPo +

L*(AU*/db)):0

u*_K> 0
If we assume

I*> 0
(-Pu

I*(U*_K):O

John wants to consume both a and b, then a, b > 0

I i

from

[K-T-l]

?u*

(AF*/d a) :9

ot l* (aF*/ d a): Pu > 0

t l.* ;e 0 and since l,* > 0 )

from [K-T-3] ( U* - K):0

l.* > 0

'U*:K
Economic interpretation: to min cost, John is at the same time "maximizing" his utility level by consuming up to his constraint level K.

il4

Chapter I. C. iv) Nonlinear Programming The most general optirnization problem is when multivariate objective function f and

conshaints rg are nonlinear functions. (again we look at maimizattonbeoause minirnization is just maximizing the negative f)

Max f

(x1, x2,X3,

... Xn)

I :(xr,

xz,

xr, ... xr,) e XcR"

,J

s.t.

jg(x1.

xz,x...

.. "") ) 0

j --1,2,...

all functions are nonlinear.

We notice

tle following points:

1)

2) 3)

Our analysis so far are characterization of optimum using calculus, there is no known algorithm for finding the optimum (except in Linear Programming LP - we have the simplex algorithm based on extreme point theorem.) Usual method for nonlinear case is to find feasible points (points that satisfy the constraints) and check Af when A x i ; and keep changing x 1 to hopefully max/min f There are many approximation algorithms using computers but these are not closed form solutions. This brings up the question of Existence ofa feasible point that is optimal? and Can we characterize constrained optimum for general firnction case?

ln fact, in math eoon, questions 2) & 3) occupy the bulk ofdiscussion. For example, concave programming with saddle point characterization.
Given

f, .

jg

are concave functions then the nonlinear programming problems

of

Max

f(x ) jg(x) > 0 V j ( constraints) s.t.

is called concave programming.

Remark: f

and

jg

need not be differentiable; hence the analysis is very general.

We show we can characterize the optimality of this concave programming with saddle point and tle optimal result is global.

Defu: Given any two points x1 and x2 in

a set X: o x1 + (1 - d,) x2 is called the linear combination of points x1 , x2 and is the equation of the straight line joining these two points. fNote: xl , x2 can be vectors.]

Defn: in particular if xl ,x2

< a < l,thencr xl + (l -o)x2

is called a convex combination

of

Definition: asetCisconvexif x1, x2 e C then convex combination cr x,+ (1 (for any 0< cr < l). [i.e. ifxl and x2e C) line joining these 2 points alsoe C, the C is convex]
[hence relationship: convex functions requires convex set for its domain] My teacher the late Prof. Takayama used the Chinese character for convex
a set is convex

-cr)x2 e C

if A

(protruding) everywhere

Below set S also not convex

ifV x,ye Cand0<

Concave function: f is a concave function over a convex set C

I f(ct x1 + (1 -cr)xr) > a f(x1 ) + (1 - c.) (x, ) [Geometrically, line joining any 2 points on f lies on/below the function f l
cr

<

also concave (but not strictly concave) finction

{e;

*, o,,!,{-{)xt

:"

If strict inequaiity

f(c x1 +(1 -c)x2)> af(x1 0< o <1 x + y

strictly concave lirnction (no shaight lin

segmetrts allowed)

$,t;U tn't a'*

'(a,.'

Definition: fis (strictly ) convex function

if - f

is (shictly) concave.

convex function

/r
Not strictly convex function

L'l

L,U

strictly convex function

Generalized defi nition:

f is concave over

a convex set

X g R.' iff Vintegers rn > I

f(cr1

x1

6s2

x2 +
m

*
0j

cra,Xn

)>

cr1

f(x1

)+crzf(xz)+.... + o.f (x.)

with cr1 >

and

We first state a theorem in linear programming (which is a special case of concave programming because linear functions are both concave and convex functions but not conversely. i.e. concave (convex) functions are not necessarily linear).

Defii: Given a function O(x,l.) = f G) + Itrg(x)1, (x *, l*; is a saddle point Sp of O (x, ),) if@ (x,l"t) S @(x *,2,*) S @(x *,2,) V_x V& in the domain.
[Remark: SP means if viewed fiom one cross section, the fiinction if viewed from another cross section, it's a relative minimuml
is a relative maximum anc

Theorem (Goldman - Tucker): convex setc cRl , then

If i'g ,Vj:1,2,...

J, are linear functions defrned over a

x * is a global maximum over the domain C solving

Max
(i.e. x

f(l ) s.t.rg(x) >0 j:1,2,....,J *

> 0 s.t. (*
*,

is a solution for the linear programming problem)

iff
3

o(x,D:f(x

Lagrangian multiplier l"*

l*) is a saddle point ofthe Lagrangian ) + l['g(x )] with ]":(],r. ),r. l"r)

[Tfus tleorem actually points out the important primal-dual result in Linear Programming. For proof, please see Takayama [985]1.

Before proceeding to more general concave programming theorems, we will look at KuhnTucker Theorem. As a simple illustration, we will only prove the theorem for the case of 2variable differentiable concave functions and one inequality constraint. We will also state the more general case theorem for n-variable concave firnctions (not necessarily differentiable) and j inequality constraints and its proofcan be found in Takayama [1985].
Lemma: For concave firnctions f (x1. x2) and g(xl, x2) with
thera dos not exist

xl.

xz

2 0; (xr. x2 ) e C c R2

(A)

(x1#, x2#) e C s.t. f(x1#. x2#) > 0 and g(x1#. x2#) > 0 (i.e. no points in the domain for f and g to be simultaneously positive), then 3 nonnegative weights po.

If /

pr- )

0, not both zero,

s.t. p6- f (x1, x2)+pr- g(x1, x2) <

(xr, xz)e C gR2

@) firthermore if I

(xrO, x20)

e C s.t.g(x10. x20)

>0

[Slater's condition]

then p6- > 0 Proof: (A) WLOG, let f be +ve then g must be -ve so can choose pr. very largo to make weighted negative p1. g to at least offset the weighted positive p6- f; and hence po. f (xr, x2)+pr. g(xr. x2) < 0.

(B) Ifp6- not> 0, then p6- :0 ) (0[(x1. x2)+pt- g(x1. x2) <

('.'

po. > 0) (x1.

x2)e C gR2

g(*r,

*r) . 0

(x1,

x2)e C

Hence ps* > 0.

-cRz

contradicting Slater's condition

Theorem: (Kuhn-Tucker) Given f (x1. x2) and g(xr, x2) are real-valued differentiable concave functions defined over a convex set C c Fi and

If f

(xr0. xz0)e C s.t.g(xr0, x20)

>0

[ Slater's condition]

then (x1*, x2* ) is a solution for the concave programming problem:

Max f (x1, x2)s.t. g(x1,

x2)) 0 xr,xzZ0
),* : pr- / po. ) 0
xz

iff

I
o

Lagrangian multipliers
(x1. x2, l")

for the Lagangian

f(xr.

x2

+ l" I g (xr.

satisfu.ing following Kuhn-Tucker conditions:

0@/0x;_

f i(xl*, x2*)

+ l,* gi(xr*. x2*) < 0

xr*. x2*

>

xi+ (d@/dx-i-)

=Q i:1,2
l"*>0

A@/A),.: g(xr*.xz*) 2 0
l,* (ao/a).) -0
Proof: If(x1*, x2*

is a solution for the concave programmirrg,

f (x1*. x2*)
any (xr,

f (x1.

x2)

with g(x1.

*r) > 0 V (x1, x2)e C

I /
meaning

x2)e C

s.t.

f(x1*. x2*)<f(x1,

x2) withg(xi, x2) including g (x1,

xr) >0

any (x1,

x2)e C

s.t.

f(xr. xz)- f(x1*, x2*)

(concave

It,
-

>0 with

g(x1. x2) >0

numoer,

sl

concave

concave

then by above lemma:

3 nonnegative weights

po.,

pr. i

0, notboth zero.

s.t. p0.[f(x1,

x2)- f(x1*, xz*)]+

po. f(x1*. x2*) p1" g(xr, x2)

pr- g(x1, x2) <

0
0

V (xr. x2)e

i )

ps- f (x1.
po-

xz)-

+ pr. g(xr. x2) s

po,

f("r. x2)+

<
)

f(x1*,

x2*)
[-L-10]

tl-L-gj

In particular, ifwe insert (x1*. x2* we pr. g(xr*.

get

*r*) s 0 t

into [I-L-9]

but pr-

2 0 and g(x1*, xz*) Z 0 ) pr

and

g(xr

*, x2*)

> 0 [-L-11]

[-L-10]

[I-L-l1]

pr. g(x1*. x2*)=0

from

[I-L-9]
x2)+
p1- g(xl,

po. f (xr,

x2) S
O

po-

f(xr*. x2*)
x2*)

*
0

/,=o
p1* g(x1*. x2*) [I-L_12]

Furthermore, for any pz

O, g(x1*.

I
p0*

/r=o
p6. f(x1*. x2*) * p1* g(xr*. x2* ) < p6- f(x1*. xz* )

.z>o

pz g(x1*, x2*

) [I-L-13]

iI-L-121 [I-L-13] combined give the follow Saddle poinr Sp:

f (xr,x2)+pr" g(xr.xz)

po. f(x1*,x2*

)rpy. g(x,*,

xr*f

pn.

f(x1*,x2*)+prg(x,*.x2*) [Sp]

and slater's condition, po- > 0, so we can divide throughout [Sp] by p6. getting following for all p2, x1, x2 ) Q
and by above lemma

(x1,

x, )+(p,., p6, )g(x1. x2 )3f(x1*. x2*)+(p1.7 po. )g(x, *,x2*)< {xy

+.

xr*)+(prpn)g(x1*. xr* )[Sp1]

and

if we define l.: fu27p6)

x2)+ l"tg(x1,
x2

and given

l.* :pr.

/po- >

0 tsplj

becomes

(x1.

)<f(x1*. x2*)+l.*g(xr *.xz*)3 (xr *. x2*)+l.g(xr *, xrr XSp2l

[SP2] means (x1i. x2*) maxim izes Lagrangian (D (x1. x2, L) while l+ mifimizes the same Lagrangian (D. And since f and g are differentiable functions then l't and 2nd order condition for max and min are the same as those depicted by the Kuhn-Tucker conditions (i.e. thev both

state: (xr *, x2*) maxirnizes and l,* minimizes Lagrangian @).

I (*r \

\7

Conversely,

if(x1*. x2*) , l"*

satisfy Kuhn-Tucker conditiols

* :0
) + t

f(x1, x2) + l.* g(xr. x: )

[SP2]

< f(x1*,

x2*) +

Ir

g(x1*,x2*) Vxr.xz

0 tI-L_141

Case

i) ifl"* >0
:
6

and from Kuhn-Tucker

condition ),* (6 @ I 6l,) ( which

: l.* g(x1*. x2*))

[r-L-15]
g(x1*, x2+)

[-L-l4l

f (x1.x2)+1"*g(x1.x2)< f(x'*, x2*) vxr,xz l*g(x1,x2)S f(x1*. x2*)- f(x1.x2)

But

) 0< = =

l"t )

0 and when s.t. constraint

f(xr

*,

g(xl, x2)>0&Vx1,x2)

xz*)- f(xr,xz)

s.t. constraint

& vxr.x:)

f(x1*,

x2*)2 f(xl,x2)

s.t. constraint

& vxr,xz

solves concave progrzrmming problem

Case

ii) ifg(x1*. x2*)>0thenby[I-L-15] ,,*

(xr*,
xz*)

g(xi *,

x2*):0

t ],* -0

[-L-14]

>

f(x1, x2) Vxr,xz

0 V g (x1. x2)

There are two more general and useful theorems covering conoave programmmg.

Theorem (Kuhn-Tucker-Uzawa): Given t rg functions defined over a convex set C g Rn

,Vj:1,2,... I,are real-valued ooncave

;1* is a solution for the concave programming problem: jg(x) > 0 Vj:t,2,....,1 Max f(x ) s.t.

i f
po-

coefficients p0,, pr*, p2..

..., pr. all > 0

s.t.

(x) + pr' tg(x) +pr"g(x )+ and p1. tg(X*) +p2.2g(x*

)+

jg(x) .. *prspo- ({*) *pr. ig(d):0

Proof of this theorem uses Minkowski separation Theorem and the details can be found in Takayama [985].

The following theorem requires Slater,s condition assumption:

x0 e

C s.t. ig(x0 )> 0 j:1,2,....,J

c R.'

[Slater's condition]

Theorem: if convex set C

f(a ), jg(x ) j:1,2,....,J

are all concave functions defined over a and suppose Slater's condition is satisfied, then

x * is a global solution (global maximum) for the concave programming problem: Max f(x ) s.t.rg(x ) > 0 v j:1,2,....,J

iff with I:(?q. 1'2,.

)"*> 0

s.t. (x *,

i,*) is a saddle point of the Lagrangian

.l.i):

(x,l) : f(x ) + lt je(x )l

0

O(x,1.*) 5 @(x*, l*) < O(x*,

l)

Vxe

V),>

Proof of the above treorem follows from the above Kuhn-Tucker-Uzawa Theorem and can be found in Takayama [1985]

The above theorems form the basis for showing existence of competitive equilibrium, pareto optimality and other issues in welfare economic theory which occupied thJ main part of math eoon development in 1950-1980.

Above analysis is also extended to more absfact level using fourdations of math (set Theory and math logic, general analysis) to provide foundation of math econ.

We

will

study all these topics in the following chapters.

Chapter II.

A. Main Micro Econ Issues within

Math Framework

Microeconomics: principal theory is price Theory and main theme is Adam Smith's Invisible Hand Theorem (= Qlassical Welfare Theorems)
Adam Smith's Invisible Hand rheorem Iinks equiribrium and efficiencv concepts. Competitive Equil C E.
untler PerGct Competition

Pareto Opt P.O. globally under weakest assumptions.

efficient in
Pareio Optimal sonse
I

Equilibriun

i)

Importance of market vs. planned economy

significance ofprope(y rights.

Given: scarce resources (if resources are not scarce, no need to study economics)

)
A1.
resource allocation

two questions A1, A2

-.---

A 2. income/wealth disaibution

we
mechanism to allocate resources

need

mechanism to distribute income

Planned

econ I

(: s6p6-6;

Market econ (: decentralized price system)

Central Planning Board CPB decides resource (including human resources)

allocation, production, distribution.

1) To properly gauge D, S of everything: Transaction cost TC (incl contracting, actual transaction & enforcement cost) and information cost incredibly high -- resources utilized for nonproductive activities

like monitoring reporting, enforcing. 2) if CPB gauging incorrect, further wastage ofresources unwanted goods (S > D), or shortage (D >S) means long queues for products (waiting time opportunity cost), black markets, bribery all employing resources, but for nonproductive activities, i.e. not for production of goods & services.

allocation by decenfr alized price system (Micro hice Theory)

A&
\
m slmplest sense

ifS>Dforsomething * supplier will supply

demand more

pJ
will

less and demander

) Pf and S & D change until at certain P*, S(P* ) : D(P*) ) P* called equilibrium price
S for something t pf * supplier will supply more and demander will demand less ) P I and S & D change until at certain p*, S(P* ) - np*; ) P* called equilibrium price

if D>

decision (for allocation) deoentralized and nobody has to gauge what other people want. All they need to do is to optimize according to the changing prices. (e.g. max utility s.t. budget constraint or max rr s.t. production). TC for gauging limited to own self which much less than gauging by CpB.

We can show such price system at equilibrium is efficient in the sense of Pareto Ootimalitv p.O.
We now proceed to studv this.

Adam Smith (1776):

Invisible hand will brins

maln

tleme

propensity to work

ii)

Classical Welfare Econ Thms within NLp framework in Euclidean Spare R": Economists for the next 200 years formulated his concepts oflaissez faire, invisible hands, sooial optimality etc., culminating in the classical welfare Theorems with two imDortant modern day concepts:

Competitive Equilibrium C.E.: General Equilibrium under perfect competition

AND

\]v

Pareto Optimality P.O.: an economic state (equilibrium or allocation) is p.O. if no one can be made better off without somebody else being made worse off. (This is to avoid interpersonal utility comparison which is impossible) Remarks on P. O.: 1 P. O. is a static efficiency conoept for question A1. Welfare Econ looks at the equilibrium to see whether it is socially desirable in terms of efficiency. 2. P. O. is not concerned with the (other) question 42. of income/wealth distribution (which depends on subjective value judgment). e.g. a dictator may own 98% of the wealth of his country while the people only own 2%, this situation may still be p.O. because any re-distribution will make the dictator worse off -- objection to this

fiL

involves value judgment.

42.

income/wealth distribution

involves subjective value judgment e.g. in pure communism and socialism, theoretioally there should be absolute equalif in income/wealth distribution and all capital goods are owned by everybody (common property rights). Under private property rights systerns, income/wealth distribution depends on endowments and capability of individuals. Which distribution is better depends on subjective value judgment which is outside our realm.

Main point on .A2.: property right stucture

if private property rights, then people have materialistic incentive to produce; while
is common properry rights system channels effort towards non-production endeavors like climbing the hierarchical ladder of the ruling

party

More importantly, private property right is

essential for people to have incentrve to use price system./market econ. Without private property rights, allocation is by CPB or CPB-controlled price system.

\,
47,

CPB bureaucrats are not disciplined nor rewarded by changes in the market value ofresources they control no incentive to adjust price according to market value changes. 222. matket players cannot compete for resources by paying higher prices when
III

optimizing no incentive to use price system. 333. Also no incentive to preserve resources without private property rights

(these are Industrial Organization topics).

Back to C.E. and P. O. in question A1.

.

The historical development starts from

i-I)

Theory of consumer D: Marginal Utility MU, Marginal Rate of Substitution MRS & equilibrium occurs when ratio of MRS for any two goods ofany two persons are equal.

Then use Edgeworth box of two persons' jndifference curve to prove P.O. D functions from 1$ order conditions of utility maximization subject to budget constraint.

Theory of firm: equilibrium will occur when ratios of Marginal Rate of Transformation MRT for any two inputs of any two producers will be equal. This equilibrium can be shown to be P.O. S frrnctions from l" order conditions of maximization ofprofit subject to production.
Theory of General Equilibrium : Combine theory of consumer D and theory of firm and D & S ofeach market and find prioe vector p* such that all D: S.
This type of coverage is common in all micro price theory course (e.g.: Luenberger

iII)

i-III)

textbook [1997] )
We will cover the above subjects ftom the viewpoint of the Classical Welfare theorems n n the Euclidean space R (R is a vector space) Assume perfect competition
1
:

in

2.

perfect defined by perfect information no risks, no uncertainty), perfect exchange (no TC), no externality, property rights perfectly defined. competition defined as all econ agents are price-takers. fRationale is atomism which states that all econ agents are too small to affect market prices so just take market prices as given when optimizing.l

(l

i-I)

Theory of consumer

D:

each individual i maximizes his

budget constraint:

L li S Wi. :

utilif'

fti) s.t. his incorne * endowment

U;

[we assume his utility depends on his consumption ofgoods bundle represented by vectorl i: (xir, xi:, xi:, ...,xiv) : say (apples, ioranges, 1clothes, 1watch,.....,ipen)
vector p market price vector (p1, p2. ...,pv),assumeditakesthisgivengandput into his budget constraint when he is optimizing; in our example (price of apples, price of oranges, price of clothes, ... , price ofpen). Since i can only afford bundles x I within his budget, we call these feasible bundles.l

Max utility s.t. budget constraint is constrained optimization, so we set up Lagrangian

(D

each individual

Max

Oi:Max Ui(x;r. xiz,

xi:, .xiv)+l(Wi - ,- p* xi,,,)

and from this consfained maximization problem we can get demand function of the individual, in terms ofprice vector.

x1* (pr. Pz, . . . ,pv

}t-ftt,
x

pr,

) -- i's demand for good ,Pv) - i's demand for good2

1

l"r. Gr. pz.

...,pu)-

i's demand for goodM

i's demand depends on tle given prices and his optimization behavior; and feasible (i.e. within his budget constraint)

x* will

be

We defrre individual i's preference ordering Fi between two goods bundles x (represented by veotor 1) and y (represented by vector y)
.

x >i y x -i y
ifbodr

for: i prefers goods bundle x over goods bundle y stands for: i is indifferent between x and y.
stands

above two cases, we use the syrnbol

fNote: b; represents preference reflecting emotionaVpsychological factors and is different from > which compares real numbers. We assume that i's preference ordering can be represented by his real-value utility firnction U; (hence can use >) . We will study the necessary conditions for existence of such utility function in real space and in metric spaoel. We assume i's preference ordering can be represented by his utility function as follows: x tsi y if & only if U, (l) > U, (y)

r -i )L if & only if x li y if&onlyif

U,

(x) : U, (y) UrG) >U,(y)

irl'ilrii[

it il !i rIft
'
il
ti

.F

i'

;t II

tn

i+ t: t; ai t- l" t-

li
i

al

irt

I
t

I ?fl$ I

ii!l

iiifi!i ili r

:iis
IT I ! I I

i ii
tt
I

i
?

rl

rf rl
$

f {t

$Er

i!l
iti llr lI
,r, 5rl

iiiiir ,
r!

I I

I
a;

i i
7

I I

iF

EE

t'

i I I f t r
r9;
E

5$ i$
f
!

iFF

;r

.;l
I

!BX{

i{
t I
?

a;iF

t
J

:f

tl
t

i;i:
N

:T

I f

I f
t I

i f

After i solved the above constrained maximization problem given price p the solution bundle x* (feasible) will be preferred over all other feasible bundles x (i.e. x* L; x )

i-II)

Theory of firm: Forj's production vector

yi:

stands for his ouQu(s), negative entry stands for his input(s) and

(y1t, yj2, ...,y;rvr), positive entry enfy 0 means he is not

producing that good nor using that good as input.

j's production vector maybe (apples, .ioranges, ;clothes, . . . ,1bee{ .;hides, .;homs, . , . .,lcattle feed, 11and ,1labor,.. ., lpen ) :( -3003, -60 -36 , -.. ,9 ton,3 ton, .1 ton, ... , -18tons ,-3 acres, -18, ...,-5)
e.g.

6 ,

Given price p, each produoer j maximizes profit: p (yjr. y.i2....,y:r,,a)inj,sproduction set Y . We denote solution of this math programming problem by y1
[Since price p> 0, when we multiply the two vectors p and y!, 1le +ve ]jn (outputs) multiplied by p- will be the revenue and the -ve yt* (inputs) multiplied by p. will be the cost and we automatically get the profit function.l

i-trI)

Theory of General Equilibrium under perfect competition C.E.

We combine the above Theory of consumer D and Theory of fum by first confining total consumption by all i in good m must be < total production by all j + initial endowment of all i and j in that good rn, for all goods m 1,2, ...,M. i.e. feasible consumption s.t. x < y+xo, where x u = initial endowment goods vector.

Market is cleared at certain price vector p! means: g!( y + x0 - I ) : 0, [i.e. at price pl , total supply = total demand for each and all goods.] We can frame above in terms of nonlinear programming:
Assume no externalities goods m:1,2,...,M consumers i with consumption vector xj:(xil, xo, producers j with production vector yi: (y;1, yJ2. . .

m:

. .,xir) i:1,2,...,1 j:1,2, ...,J ..yjM),

x$,

initial endowment vector held by i orj utility firnction for i :

U1 (x11, xi2 , xB

xl

or
\a

nf
) continuous and real-valued fimction

.x

letx

Lxi =i=l

y= IJi j-l

"o= Ixoi+di i.j

Definition: An array ofconsumption vectors { 1 } is feasible if3 array ofproduction vector{yi} s.t. y+ X0 ) x 1e consumption setX g RM
Definition: given U(1) = [rU (x), and r g(x),

rult;, ..

.rU(X) ]is a vector-valued function

e consumption set

,g(x)
X

MgG) are real-valued functions; 4

RM

vector X* e

(l) '" g(l*))o vm (2) / a s.t. rU(x)2 rU(x*) k= 1,2, ...,K wrth 1U(d> ru(><|) at least one k and '.g(dZ0 m:1,2,...,M x e X
n particular if u(:r) represents utility vector for all economic agents and constraints are the feasibility consfiaints, then this vector maximum definition is actually equivalent to the following P.O. definition.

if

is called a vector

maximum ofU(a)

s.t. *g(D>0 m:1,2,...,M

Definition: Feasible {

Ur (l ') > Ui (X_i *)

1 *}

is

Pmeto Optimal if

.} s.t. feasible { for all i, widr strict inequality for at least one i

Remark:

Vector Max -ve definition

P.O. -ve definition

U(x):[rU(x),zU($.,rU(x)]
constraints ,,g (x) > 0

U(x): [lU(5),:U(x). . ,ru(x)]

,7
2nd person

util firnctiol

consfaint g(l) =

y + ><o -21 >0

4* vector max ofU s.t. g(a)> 0

X*

yi

vector max of U s.t. g(g

,v
feasible 1

,v
feasible

$ )0

I y

IT

l) 1+ feasible (i.e. g(x*)) 0 )

1) x* y* feasible (i.e. g(x*. y*)

)0)

2)

cannot furd any feasible xr s.t.

,

2)

cannot find any feasible

1t

y# s.t.

hu (ro)

ru(xr),

.*U

(x#) I
with sbict inequality
for at last one i

LU(x),rUG#r. ...U(xu)l

hu(x.),zu(r"). ..xu(x')l
i.e.

/\

[ru(x').zU(x-), .ru(x-)]
| \
,.".

atleastsoms,uftl

' ruG) "/

",,*"tsode

iu6') > iuG)

I x+ y*] is P.O. means when feasible

x*

sav
y."

:
.g
1*r';1
s.t.

:1r,2,3,41
LU

[rU (x-) , :u (x*.1. 3u 6*

(xt , rg1t*;, ,U<xnl. rUtllt :1r,2,3.0r,41

cannot furd feasible some

xt

11,

2, 2,

3.01,

4l
4)

lr,

3,

('.' if can find such 5", then x* not p.O.)

Definition: Array ofvectors [p*,{ xi *},{ yi*}] withp!>Q lJLi *e X, = consumptlon set, yi+e Yj: j's production set V i, j, is a

i',

Competitive Equilibrium ifi

(CEl) U, (x.l*) >Ui(xi ) with p*_x_i Sp*x;* V1i e X; (cE2) p*Ij* > p*& v_y, e Y; vj (CE3) l*S(y++Ie)and p*(y.+ xo-x,*1 -6
Econ interpretation:

Vi

(CEl) means each i will max his utility at x* according to p* s.t. his budget consfaint. (CE2) means eachj will max his profit at y* according to p* s.t. his proJuction set (CE3) means feasibility ofconsumption and market clearing for each market.

e)

Theorem (Vector Maximum): ru(d, zU($. rg($, zg(x),...,Mg(x) are concave real-valued functions defined on a convex set X c RM and that Slater's condition holds i.e. rg(X,)>0 Vj

....rU(x); 0

f x' s.t.
19

ff 4* is a vector maximum for U(x) s.t. and define (D( x , &) = Q U(s) +l"g(x) , then

(a) >

f 9>0 but+q and?,*>0

[i.e. O( 1, ],*) S O( x*
Proof: Please
,

such that (

x*, i"*) is Saddle point of@(1,1")

,

!*)

S O( x*

l")

for all

1e X and i" ]

QJ

see Takayama

[1985].

Now we are ready to proceed to prove P. O.

We note the following:

C.E. globally

l)PO
I 2;

::)

equivalant definition

vector rnax

"-a Q>8but+ 0; l,*>0 "*T-.,_,*^:*)*_l

3)SP

* 8t*n slat"t"

s.t.

(s*, l"+) is Spof O(5, ),) =

U(1) +l,g(x)

l Max Q U(a)
1*r
sr"t

',si

x* is global max for following concave programming problem: s.t. g(x) > 0 [ConProg 16]

[by NLP theorem in Chapter I. L. which states given concave functions over a convex set and Slater's condition, SP ( x* ,l,*) of Lagrangian O( is global max for conoave prograrnming problem]

l,l,)

4) If

above U(x) = utility vector function and g(a) to be the feasibility oonsraintf + x0 - x Q Then [ConProg 16] becomes following concave prog problem; x*, y! is the global max for [ConProg 16-1]:

Max Q U(a) s.t. feasibility C(x, y, r0) >

[16-A]
concave prog problem:

5)

same x*, y! is the global max for the following Max U(x) s.t. feasibility g(x, y, x') > Q

[Conprog 16-16]

d,l is NOT &e global max I : i ..t. U1i 1t U(!*) s.t. feasibility. Butg>g,q+0 t CU(i) > 0 UG1) s.t feasibility + contradicting [16-A'] i d, y! is the global Irra\imrn for [CorProg 16-16]l
[Pf

Assume

6) By Kuhn-Tucker-Uzawa
concave programming po*

theorem in Chapter

3po*,p1 :(pr*, pz*.

I,

x*,

y!

..

.,py* ) >0

is a solution of the
s.t.

U(x) 1plfu + ro - d s po* U(d) anp -p10i+ r'- rIJ=0 s.t.feasibility(yl+ x"-

x'))0

117-17)

7) from[17-17]

)
(A-1)

a zero temr

U(g +pj(y+ x0- dS ps* U(f) &we justadd pl e(i!) to RHS of above inequality: pq*U(g+ Ll (y + r0 - x) s ps* U(f) + pl (y1 + 40 - rI) [18-18]

pe*

In addition, if we have following assunptions, we can show [P.O.

lSUefs conaftionl

C.E]

x#

X;y# eYs.t.y#rao-1# >g(if s0 )some i may not survive atr#)

(A-2) Y

convex set

(A-3)
(A-4)

U,(x_r ) oontinuous and concave function V

i
i

*, *> p*x3 # , V [Cheaper Point Assumption] given 41 p*: 1 4_; # a X; s.t. p*Li [without this assumption, i may only be minimizing his expenditure but not necessarily maximizing his utility s.t. budget constraint].

Theorem [P.O.

C.E]: Under assumptions (A-1)

(A-4) isaC.E.

if

[{rli*},

y_*] isP.O. thenl p*

>0 and{yr*}s.t.[p*,{t*},{yi*}]

Proof: We know [{xt*}, y*] isP.O. andby above steps 1)-7)wehave AA) from |7-l7l1po* , tr*. : (pr*. pz*. ...,pl,a*) 20 s.t. po* U(x) + pl fu + x" - E) S ps* U(d) and

pI(yl+ r0- r:):0 s.t.feasibility(yl+ru-xI)>0 t

(CE3)

and

BB)

from [18-18] pq*U(r+ pj (y + :0 - x) 5 ps* U(rj) + pj (y! + r0 - E) we andy:y1 except some arbifary producer q then [18-18] becomes pl (yn)s pi(yn1 )

letx:*

since q arbitary from

1,2, ... , J

tp1(vi)<p1(vi1)
similarly we let
becomes

vj

t(cE2)

x: xi &V:C

except some arbifary consumer h then [18-18]

Bixul-pl*u s ps*uu(xf) - ps*uu(xh)

vxr',e

Xi anvi=1,2,...,r

[19-191

2 cases:

ifpq*>0,

then [19-19] means

Uu(xrJ) >UlGr.)

with.Blu* )plxa Vhfromi:1,2,...1+ (CEt)

ifps*:0,

then [19-19] means pl xb Vxr contradicting (A_4) cheaper point, )po* must > 0 (and above p6* > 0 case works) t (CEl).

)plxl*

This also brings out the following lemma_

Definition: consumer i is satiated at4-;#

Lemma:

ifu,(4#) > U,(xr ) 6

* then

Vx-.; e X;
+
Q

If I

one consumer i who is not satiated at

p*

Proof: assumep*:0 then from [19-19] p6* Q(d < ps* Ui (Xt)

i is satiated

at x_;

@eductio ad absurdum

proof by contradiction)_

[C.E.

P.O. Theorem is almost trivial]

Theorem: [p*, { :r i *}, { yr-*}] is a C.E.

I{

x_,

*}, {g*}l

is p.O.

Proof: from (CEl) Ur (x..i * ) >Ur(I, ) with p*3 Sp*xi* Vx3e X; ) cri Ui (l * ) ) oi Ui (x_i ) with feasibiliry oi > 0

Vi

x o; Ui (x i *
ll

) >:

U1(3_1

with

feasibility

120-201

now if [{

1*}, {1i*}]

notp.O.
(a_1*)

)3

feasiblefu')s.t. U, (X,')>IJi
o.;

for all i, with strict inequaliry for at least one i

)X cr,1 U1 (l') > ! ri

Ui(1 * )

with feasibility conhadicting [20_20].

t iii)

[{

x-;

*}, {;vi*}]

must be P.o.

Existence of C.E. using Brouwer's and Kakutani,s Fixed point theorems: p.O. [193040 Hicks, Samuelson, studying C.E. (Ref: Econ of Control Ny MacMillan 1944) were studying the converse P.O. p* s.t. C.E.l
and Oskar Lange and A. Lerner

) f

A1. Allocation problem: From the above welfare

thms we know ! an equilibrium price vector at which supply equals demand in each market. But then a cpB can also achieve this by rationing demand & supply of everything. what is different is this perfect market price allocation is PO efficient as shown by the welfare theorem.

A 2. Income/wealth distribution problem: As we mentioned, the above perfect market equilibrium allocation may be Pareto but it may not be "equitable', by some subjective value judgment. In fact, within a static model, any distribution of benefit is paretol
One possibility is to distribute aggregaie income p*(y* + x0 ) by giving p*lr., * to each and then we also get C.E. and P.O. But this is artificial, contrived and controlled.

We want to show the "real" existence of C. E. with math.

Existence ofCE using Fixed Point Theorem

Definition: Ii(p* , y*)

where
03

:p*

1;u + max { 0, X,0ti !* $*}

is

i's

share of

profit from

e.g. income distribution as X

01i

- I ('s profit completely distributed to a1l i) (ti*) > U, (X_, ) V-x.i e X1 Vi with p*1 ,xr,y): x X;
V

(CEl) now becomes Ui (A"5)

<

11

Need additional assumptions:

Z:

{(xr.

xz.

y*+

x0
[{

y_e

4ie X;

Vi}

real spaoe = closed (including all boundary points) and bounded (does not go to infinite))

iscompact {in

(A-6) Nonsatiation: Vlae

i
Vi

I }, y] e Z

l3

xi'e X1 s.t. xr' bi &_

(A-7) Inaotion allowed:

0eYi X1

Vj (togerp)0) s.t. &oo. *,0 Vr

(48) Suwival: 3

x1m e

(oonesponding to cheaper point. -- to guarantee i's dernand function upper semi continuous. Also implication xf is an interior point of Y + X0 in a C.E. and not be below subsistence level. We will study the concept of semicontinuity in the following sections)

(^

[Existence of C.E.] Theorem Ee: Under assumptions (A-1)

(A-8)

p* >0 butpg*+Q s.t. [p*,{x_r*},{g*}] isaC.E.

use Kuhn-Tucker Theorem and

Proof

Kakutani's Fixed Point FP Theorem. Please see Takayama [1985]page289. (Kakutani's FP Thm is normally used when utility functior is concave. In case of strictly concave utility functions, we can use Brouwer,s Fixed

Point Thm.)

In the above analysis, we are concentrating on the theory and making all kinds of assurnptions necessary for the theory to work. e.g.. we assume I utility function; swvival and semi-continuiry in above theorem etc. In order to explain the rationale behind all these assumptions, go into details of some of our proofs and extend our results, we need proper math econ foundation. Ald we also need various FP theorems. The next section on general math analysis and topology is typical grad school coverage for such purpose.

lRemark: For students who want to see a preview of the next section A) Brouwer's FP Thm s nonemp4" convex, compact c R" and continuous s S - fixed point xx S s.t. f(x*) : x*.

f: ) )

Every continuous function f from closed unit ball B " B o has at least one fixed pomt. o o [closed unit ball B & closed unit simplexes A are homeomorphic].

Application of Brouwer's FP Thm: Proof of C.E. existence in an exchange economy where utili|., functions are strictly concave.
Sketch ofproof: Assumptions 1) existence ofa continuous, strictly concave and locally insatiable utility function u;(xi): non-negative quadrants R" + Vi

)R

and 2) feasible set closed and

bdd (i.e. compact).

Since budget constaints remain unchanged when price vector p is scaled by any constanl we can normalize p by scaling to get p A ". Construot use excess demand funotion E(p) to construct a mapping f (p) p + E(p) . Such that and satisfying all Brouwer's Thm assumptions

i by Brouwer FP Thm 3 fixed point p* s.t. f (p*): p* but f(p*) ulro: p*+E(p*) I p* : p* + E(p*) ) I p* s.t. E(p*) = 0 [i.e. p* will make aggregate excess demand function:01 I - p* s.t. supply = demand resulting in C.E.

f: A' ) A'

B) Kakutani's

FP Thm X nonempty compact, convex set

and conespondence

R.'

valued, then

:X 3 X is upper semicontinuous (u.s.c.) s.t. fixed point x* S with x* | (x*).

(x) is convex_

Note above f in Brouwer's FP Thm is a point-to-point function. Kakutani's Fp Thm generalizes Brouwer's FP Thm in a slightly different direction. We stay in Euclidean space R " , + compagtness + convexrry, but now look at set-valued (-mu1ti-valued point-to-set = multifunction) functions called correspondences, in particular semiand hemi-continuous oorrespondences

Application: Proof of existence ofNash Equitibrium in Game Theory and above Takayama's proof of C.E. existence. We shall cover all these topics in detail.]

Chapter II. B. Generalization of math econ concepts using general math analysis

i)

Set theory and short review

ofreal analysis

In previous seotion, we have all these assumptions on preference (emotional aspect), nonsatiation, compactness of feasible sets Z, semi-continuity of functions etc. which
basically are assumptions necessary to do the math parts. To understand this we need to study the axiomatic foundation of math.
General topology is used in virtually all branches of modem matl. Together with set theory topology provide the axiomatic foundation of math and hence foundation of math
econ.

For undergrad math econ courses we mainly do problems in Euclidean space R.'. @lease see footnote below). But not all econ problems are Euclidean. Something as fundamental as preference is not really Euclidean. Hence in grad level math econ, we move up to a more abstact and more basic level to work in general topological spaces (of which R' is a special case) and theory of functions in general (not just real-valued functions). For instance, we work in a space of bundles of goods (not real numbers) in which cons'rmers will have a preference ordering (psychological, emotional rather than real numbers). Topological spaces .ne math structues drat allow the formalization of concepts such as convergence, connectedness and continuity. The three main structures we are interested in are 1. order structure (ordering things so we can talk about finding higher/highest (or lower/lowest) order for maximization (or minimization)). metic struohre (concept of "distance" for measurement purpose, i.e. how much higher or how much lower, how near. We also need metric spaces with arbitrary set X to show preference ordering can be represented by real-valued functions). 3. linear structure (to add vectors and do scalar multiplication. This is necessary to have proper consumption and production sets consisting of vectors.)

2.

And of course, when we move from our abstract level back down to the Euclidean level, we get the usual undergrad defrnition of convergence, continuity of real sequences/series
and real analysis.

6ncttt^l

Footnote:
e.g.

typical undergrad courses use Edgewortl.r Box in

RP space

to show PO. and CE.

br'C--,a / E
In advanced undergrad and grad courses, we use vector maximum in R:'space for PO. [x*, y*], CE [x*, y+,

p*] concept. In proper grad coursies, we can start widl any space like a commodities space - not Rl- and preference ordering. Then modi$ the space (make it compact etc) so that preference can be represented by utility
function etc., making the analysis both realistic and general.

(;-'

''-'

Terminology and basic notions. Given arbitary sets X and Yboth

* O; set of natural numbers N: {0, 1,2,....,n,

.....}

FtINCfiON fis a binary relation X x Y Cartesian product:

2)V

1)VxX,3yeYs.t.xE/ y,z Y, xS and xfz )

y:"

Notation: f

X domail

codomaio

ffi
Notation:

yx:1f :X ) y) )
N

X is COUNTABLY INFINITI, if 3 bijection (1-i conespondence) f : X X is countable if it is 1) finite or 2) countably infinite.

Cardinality of a set : number of elements in the set. [example : N is countable but set of real numbers R is not countable Countable set has cadinality : cardinaiity of some subset of N]
[X, Y countable

Cartesian product X x Y a]so countable.l

fintuitively if (x, y) Cartesiaa product X x Ymeans we caa find a way (namely, a tunction g: {X,Y}) U{X,Y} s.t. g(D Xandg(Y) Y VX,Ye{X,Y}) to pick one element x fron X and one element of y from Y. For finite and countably infi:ritely many Xx\xZ ..,., we can find such a function gJ For Cartesian products of infinite number of nonempty sets Xx YxZ ........, we need Axiom of Choice:
V nonempty class Y

={Y

Y is a set}, 3 a function g: Y

uY s.t. g(Yl

VY

we just rely on this axiom that we can pick one element from each of the inffnitely rnany sets in the Cartesian product. This is equivalent to : 1. every n-nary relation conteins a function. 2. Zorn's Lemma which we will cover after introducing order structurel

[ntuitively:

Given set X The list(X,

+,.

Q, binmy operations + and . ) is a FIELD F:

on

X ; x, y,

zX.

if

x+y:y+x ; x.y:y.x 2) associative: (x+y)+z:x+(y+z) ; (x. y) .z:x.(y.z) 3) distributive: x(y+z):x.y * x.z

1) commutative:

4) 3 identity elements 0 and 1: 0+x:x+0:x ; 1.x:x.1=x 5) 3 inverse elements -x and.x-r : x+ -x : -x +x :0, VxK{0} x .x-t : x-r .x = I
[Intuitively: A field is an algebraic structure for doing arithmetic. x X is called a scalar Example: set ofreal numbers R; set of complex numbers Z]
VECTOR SPACE V overthe freld F:

Vu,v,wV;

set V with two binary operafions:

x,yF
w: Vx !-+V
xv:
V
---+

1-/T
v
A,

i)

veotor addition v +

ii) scalar multiplication

L>l

satisfuing axioms below:

l.
2.

associative: u + (v +

w):

(u + v) + w.

.t1o

commutative: v + w=w + v.
zero vector

3. 3 identity element 4.

V: v+0:v

inverse elements

-v Vwith v+-y:$.
1v

5. Distributive: x (v + w) :

to.

6. Distributive: (x + y) v : x v + y v.

7. x (y 8.

v):

(xy) v.

Soalar multiplication identity element 1: 1 v

flntuitively: Vector space is a set of objeots called vectors that can be scaled (scalar multiplication) and added (vector addition) Examples: real vector spaces R ' , R ', ... ; in particular R n is n-dim real vector space]

: { br , bz , .... , bn } s.t. for any v V ) linear combination a1 b1 * azbz+ .... * aoln : y

Ordered BASIS B for vector space V

1!

a'l
U,
I

lvls: : I :l
.J
a.l

Coorcmate

[e.g.forR3: b1 : (1,0,0) br:(0,1,0)

expressed as linear combinations of

b3 -(0,0,1)and all vjn rlat vector space can be (1,0,0) (0,1,0) (0,0,1)

Now we add order structure into a field to set ordered field: Order: Defrne a binary relation

E : X) X

as:

(Vx,y,zX)
1. Transitive

(T)

ifx E yandy E z )xD

xE
either

2. Reflexive (R) if

E y and y E x 4. Symmetical (S) if x E y I y E * 5. Antisymmetrical (A) if xE y& yE xl x=y

3.
Complete (C)

if

P E E

called preorder

ifTR

andthe list (X, E ) ca[ed preordered set

and the list (X,

called partial order

if TRA

E called poset ) E ) cailed loset

called linear order

if TRAC and

the list (X,

Boundedness (Bddness): S c poset P is bdd from above bbd frombelow

if

p s.t. a P p Vp p;

and

if 3 b Ps.t.

pE

Vp

p.

If

it's called bounded fbdd). [intuitively, it means S is contained in an intervall

S is bdd both from above and below then

E i. u generalization of all "greater or equal,' Spe ordering, ilcluding subset ordering I in math, preference ordering ) in econ, 5 ) 4 in real number Rl
[intuitively,
Application to Theory of choice in Econ: preference relation on a set x of arbitrary objects is usually assumed to be TR, so list (X, )) is a preordered set. A preordered set

(X, P ) is just a generalization of (X, >). From tlere we can extend to utility function
expressing such preference ordering.

Szpilrajn Theorem: Every poset can be extended to a loset

[krtuitively: we

can extend the TRA to TRAC with a more general

EI

Define an equivalence relationship

if it is TRS

Define equivalence class of x with respect to

{y X ; y = x} denoted by [x]= Application to Theory of Choice in Eoon: [x]= is just a generalization of indifference curve going though the point x. [f we move back down to the Euclidean space R.', we get the familiar indifference curve]

::

Given preordered set (X, E

),

+Y

and

y* Y

Y*

E-maximalif/yYs.t.

y>

y* y

y* E-minimalifiyYs.t. y* >
Ey V ye Y I if yEy* V yY )
ify*
Gven
a poset

y* called E-maximum of Y. y* called E-minimum of Y

(X, E ), ** is an upper bound for poset if x* E Given a poset (X, E ), ** is an lower bound for poset if x E

x x*

VxX

VxX

The supremum of X, denoted by sup(X), is the least upper bound. i.e. sup(X) is the Eminimum of {upper bounds xi of X} lnfimum of X, inf(X), is the geatest lower bound: the biggest of all lower bounds of X.

(xt,xz, ....

A sequence in a nonempty set X, denoted as

Given seq(x1 , x-, ... .), take the seq m1 (rrlz (m: {x * "} is a subsequence of {x,n}

,x.,....) x. X So basically it's a function f: N) Xwithf(m):x. mN

,x2,....

{x.},

is an ordered array of elements

ofX,

<..

< m.

<....

and the seq

Z!

space which has a dlstance measure

[Example: a Cauchy sequence in metric space - its elements becomes closer and closer together as it progresses. i.e. after n terms of the sequence, the maxirnum ilistance between any two elements becomes smaller than an arbitrary e > 0.

{xJ = 0, v,, 1/3,....1&, 1/m,...) and l1& - l/ml < l1&l + l1/ml ; as k, m ) co Iim l1&l + ll/ml = 0l tlistance between l/k & l/m squeezed ) no "holes". But since we are talking about distance, we can do this only in metric spaces which we will cover.
e.g.
Later on, we will look at comptrete metric space M (where all such Cauchy sequences converge to a limit, i.e. evely Cauchy seq of points in M has limit also il M). And we can always complete the space by fflling in all the "holes". E.g. given Q which is incomplete because there are "holes" of irrational numbers like .f,2 and z ..., we can make it complete by filling in all the irrational numbers.

Metric space l1{ js sorn.pact ifr M is complete and totally bdd (versus S C R " is compact iff S is closed and bdd so we see compactness in metric spaces works like the abstract generalization of finiteness due to the bdilness.l
Zorn's Lemma: If all loset in a given poset has an upper bound
elgment-

poset has a maximal

[Zorn's Lemma is equivalent to Axiom of Choice] Hausdorff maximal principle: f a f -maximal loset in all posets.
ordering defmed in terms of subsa (inclusion) relation.

ORDERED FIELD (X, + ,

s.t.x

2 y) x+z2y+"aod if z2 0thenxz2yz

. , 2)

is a freld with partial ordering on

Notation: X. = {x

} 0l

X*n: {x > 0}

X ={x <0}

X--: {x<0}

Note in any ordered freld (X , + ,

llx+vll s llxlr -

lyll t";a.pl.' f.]r". 'utr*riXii>rx-g l{,,tl+llYrl-11xtJll tt1tt/ ' "oZ \$/ t -,K

. , ]),

the triangular inequality holds:

[example: rational numbers Q form an ordered field, R is an ordered field but difference is the following completeness axiom:
Every nonempty, bounded from above S

..n>

#;+#
r*.

thl

R has a sup@)

a real number

Intuitively: R is complete (no "holes" between its elements) while (irrational numbers slots between its elements)]

Q has "holes"

ii)

Topological spaces

In modern math foundation, the concept oftopological space is essential. We study topological spaces to see the foundation structure of math econ. These include 1. order structure, part of whioh is covered in the above analysis, for optimization 2. mefric sfucture used for measurement and optimization 3. linear structure for vector operation.

We start with the concept of space. In any discussion, we have a universe ofdiscourse (the universal set). We call this a space: a collection ofobjects (= points).

Deft:
let r
1.

Given an arbitrary nonempty set X (x John) );

a collection

can be anrthing, e.g. X can

= {oonsumption bundles for

of sets Oi

c X s.t.

@er, Xer

2. Oi 3.

i: 1,2, ..., m ) Ooer aeA )

e

fli=r Oie

t t

Uo66 Ooe

then the pair ofobjects (X, t) is a topological space with topology r. A member 01 of t is called an open set. Collection t is called the topology on the underlying set X.

ln addition, if the topological space (X, r) has a distance (= metric) frrnction d for its points, then it's called metric space, denoted by (X, d).
Defn: (X, dx) is a metric space if X is any nonempty set and has a distance firnction d: XxX) Rs.t. l) d1 (x,Y)=A |ff1:t x,Y e X 2) dx (x,y) + d(v, z) > d(z,x) tiangular inequality 3) d;(x,y) Z 0 a) d1 (x,y): d(y,x) slmmetry flntuitively, with the distance firncfion, we can talk about how near (the distance between) any point xo is to another point x in the space; hence we can have notions of length between 2 points - used to define open/closed intervals ; and

l.

t\

.'.?Lo , ''-n-lt,
neighborhood of xe - used for function continuity ( A function f(x) is continuous at x6 maps points nearby to x0 to points that are nearby to f(x o)) I [n analysis, we study metic spaces for connectedness, separability, compactness and completeness concepts. e.g. Econ Application: connededness + separability + Richter-Peleg utility Rader's Utility Tluu Debreu's Utility Thml

2.

if f

The real line R is a topological space @, t), associated with the metric space (R, real number system with a distance function (called Euclidean mefic) d(x1, x)

d) of

:lxr*xzl(i.e.

length ofthe interval (x1

,x2))

between any two points x1 .x2

eR

If

interval does not include endpoints x and y, then it's an open interval. includes the endpoints x and y, then it's a closed intenal.

If

interval

o?6t l'^je*lh|-.

CIASt+ tilfe&,A,
P.

On the real line, neighborhood is in terms ofopen intervals, namely, given any xs,r e R" r>0,the set B"(x6) = {x eR:d(xs,x)< r} {open intervals around about xo with radius r}. Open sets in this metric space can then be characterized as a union of open intervals.

l-dimensional @, d) metric space

fl
I

p.ta',co

tu -+F

tu

nedr*il^;L
We can extend to Cartesian products

6"-(xn)
space:

ofR. namely, R "

@ , r) topological

space associated with the metric space (R.' , d) with a distance firnction called

Euclidean metric d(x,y)

: .,/l (.r, - y, )'?

I
i=1

and open intervals are conespondingly generalized to n-dim open balls B. (x o) {x e Ro: d(xo, x) < r}

Example:

2-dim (R'z, d; ig.a metric space Euclidean metric d denoted also by ll . ll . Not" open interval generalized to an open circle (2-dim ball)

(*,y):{G:;:Gfl

K';'l--" *ut,v\
l'''"
(.

,rc
6.tx'\={tt f:a{'";)arJ

3-dim

(R',

d) metric space

u&,>4."t
R-

ebbrc)<ltJ

[We note in the (Rl, d) space, points can be expressed in terms ofvectors.

VECTOR: Ordered n-tuples ofreal numbers is called

a vector, denoted

by

x.= (x1,x2,....,xi,

...,xo) xi e set of real numbersl

0

Analogously, in a general metric space (X, d), an Open BalI around a point x B,(xo): { xeX: d(x,xs) <r} and xois called the cenfe and r the radius.

e (X, d) :

Defit: nonempty S c (X, dx) is an open set if for s.t. B' (x ) c $.

any x

S,

+ve real number r

[example: all open balls are open sets, collection of all open sets in X is open. Note open ball are nonempty because it at least contains the oenhe] [Intuitively, since we have d in metic space (X, dx), we can define open balls and hence define open sets. We let t be the collection of open sets defrned in terms of open balls, then we get a topological space (X, t )l
Since a metric space have these open (and closed set) set properties, we can leverage on these to move to even more abstract topological spaces. @lease see below)

In addition, in metic

space, we have idea

of one element being "close to" anotler

element in terms of distance metric d in an abstract space. Using this "close-to-ness" we can talk about convergence of seq in metric space because convergence intuitively is just elements in the seq getting arbitrarily close to the limit.

Given mehic space (X, d1), x 6 e X andS C X, a sequence any real number e> 0 I n* e N++ (+ve natural number) s.t.

{x.}convergestoxoiffor

Vne

N++

n*

) dx(x6,xsr)<e
S

If

We write

lim

{x-}: x o or {x-})

S, then

x6 seq {xo'} is a convergent sequence in

iii) Generalization ofecon

ideas in abstract topological spaces

'Y
Defir: Given topological
spaoe

(X,

),S

Xis

a closed set

if its complement

S " is an

open set. In other words, S " [examples:

T
.), (-*,
a] are closed

in R,

sets.

(a,

bl

a, b are finite rea] numbers: intervals [f,A], [a, and [a,b) are neither closed nor open sets.]

Given topologioal space fi, T ), sequence {x,o} in X is convergent in X if I x o X s.t. xn Y. for any open set Y containing xe 3 n* N++ where Vn N*+ 2 n*

In an arbitrary topological space, such a limit x o need not be

1 t

In particular, for real seq {x,n} R, it is bdd from above if And bdd ftom below if inf{x* : m N} > - co And bdd if bbd from both above and from below [ntuitively, bdd from above means all the terms
Every convergent real seq is bdd and we have
Bolzano-Weierstrass Thm Every bdd real seq has a convergent subsequence.
x'o in the

sup

{x.

:m

N}

<

co

seq

some real number

B]

Defo: (X, fi) and S c X is closed iff point s S.

sequences in S convergent in

X converges to a

Sisbddinxif I

>0s.t. Se neighborhood N.,1(x)

{y X: fi(x,y)< e
Continuity of single-valued function f.

spaces (X, dx) (Y dv) and function f: (X, dy) dv), point x0 if for any real number e > 0, I real number 6 s.t. foranyx fis continuous at e Iffis continuous at all points ofX, then X , d1( x, ro). 6 dv( f(x), (xo)) is continuous in X.

Defir: Given metic

) (!

< .

flntuitively, continuity means for points x close to x6, (x) will be close to f(x6) in the
space.l

Since R is also a metric space with the usual Euclidean

metric ll . ll , we can move back

down to this R spaoe, then

f:

R and we get the familiar Bolzano-Cauchy epsilon

delta 6 definition for continuity:

Areal function f;

ifve )0, =6>0s.t.vxX lx-al < 6 t I{6d-(d1.,

XqR) YcRis

continuous at a e X

This is the neighborhood idea we mentioned previously. f is continuous means: iJ we want to restrict flJ values in any arbitrarily small r -neighborhood, we only need to choose small enough neighborhood ofx values around a. In other words, if we can do this regarclless ofhow small the neighborhood offld then fis continuous. Alternatively, we can also define continuiry in terms of seq. Letx V c if X seq (x-) in V\{x} withx-) x or if such a seq & lim u-* f(v): continuous at point x.

R, I V ) R; (x), then f is

Third way is to define continuity by open sets. This approach is most general and easiest to gxtend to more abstract sDacs: -'(W) -. .f is continuous rn X ifff^-1^:* is open in X whenever W is open in Y continuity definition is extended to topological spaces as:

f: (X, Tx

)) G Tv ) is continuous if frflID T* whenever W T'

We know continuity is a local concept because we define continuity of f at a point. lf f is continuous at each point on an iatervayset, we say fis continuous on an intervaVset. But ws still have the "each point" local concept.

To extend this local into a global concept, we need to extend continuif based on uniformity:

Given f: (X, dx) dv), f is uniformly continuous if for every real number e > 0, I6>0 such that for all x, xo we have that dr( f(x), f(a)) < e

) (l

X with dx(

x, xo)< 6,

fintuitively, funiformly continuous means fnstly srnall changes in x I small change in f(x) (continuif part); secondly the size of change in f(x) depends solely on size of change
in x but not on the porn I x itself (uniformity part).

In other words, uniform continuity is a global concept.l

s9

Note:

Uniformly continuous functions are continuous but not conversely. (e.g. (x) : 1 I x, x 0, changes in f(x) become unbounded, hence not uniformly continuous). 2. A function f that is continuous on a closed bdd interval is also uniformlv continuous

R*' is continuous. But as x )

l.

on that interval.

we move back to real space R2 with Euclidean distance function ll . ll , then denr of uniformly continuity becomes the familiar: if for any e > 0, f 6 > 0 such that for all x, xo Rwith llx- xo) ll l< O ll (") -("o) ll< t

[f

'

[Concept of uniformly

continuif

can be generalized into topological vector space.]

Econ application: Ordinal utility theory

Deftr: Given set g

preordered set (X,

>)

(TR). If

Vx,y Xwithx>y,

!z

Ss,!

x|

2 y, then S

is

Z-dense in X.

represent preference relation as we know it in Econ; and X as econ agent views altemative x to be { outcomes} or {conunodities} or {alternatives} at least as good as alternative y ifx 2 y including strict preference relation ) and

kr particular, let

---

indifference relation

on X.

We let preference relation on X to mean preordered set (X, >)

Reflexivity: x ) x is easily acceptable as rational behavior Transitivity: is usually accepted as a rationality hypothesis. i.e. if you prefer x over y and y over z, then you will prefer x over z.
Note for Completeness: you must know x )y or y 1 X. There will be objections that this be included as rational behavior since many times we don't know. For instance, trying to decide whether to go to Chinese U to study Chinese literature or to HKU to study madr. Unless there is complete ordering in such n-dim choice set, we may be indecisive.

Vx,y

Defir: Given

preordered set

weak upper --contour sets

(X, )) where ) is the above preference U.(x) ofx is defined as:

reln.

Vx

U.(x):{yeX:y)x}
Analogous defo for stict upper )-contour sets U, (x) ofx:

U,(x):{yX: y>x}

And weak/stict lower )-contour sets L.(x) / L, (x) of x:

L.(x):{yX: x)y} I-,(x):{yX:x>y}

In order, to do utility theory in Econ, we need to find the class of preference relations that can be described by a utility function and then maximize the utility function.

Defir: Given 0
Function u:

* Sc
u(x)

any arbitrary set X and preference relation

S)

R represents

on X.

onSif

x.y If I

itr

- u(y) Vx,yS.
utility function and preference relation

such function u, then u is called a representable.

) )

is

Note such a utility function is not 1! As any strictly increasing self-map f(u): u(X) R can also be a utility function. .Hence this is an ordinal (order only, noi for calculations, not cardinal utility function) utility concept. U

^r-p^.-t--*

Hg) -t'l/'7L

ithei x > y or

y>x

T\nt: 0 #

X is a countable set and ) isa complete preference relation onX

representable.

I ) f

is

BirkhoffTlvn:0
countable

l-dense S c X, then

X is a set and

is a complete preference relation on X. If representable by a utility function u: X ) t0,11.

[A lexicographic preference reln on R2 is not representable by a utility function.]

A preorder which is not

complete cannot be representable. In 1960-70 people (M. Richter, B. Peleg) were trying to relax the completeness assumption. They modified the utility function u: X ) Rto:

x>y

u(x)

>u(y) AND

x=y i

u(x) = u(y)

called a fuchter-Peleg utility function.

Lemma [Richter]: Given 0 X and is a preference relation on X. X contains a countable )-dense subset 3 a Richter-Peleg utility ftnction.

range R is fRichter-Peleg utility firnction: domain X is not completely ordered completely ordered. Hence there will be cases of indecisiveness or agent cannot compare the altematives. Shortcoming: (information contained in Richter-Peleg u) is < (information contained in

>\
Because uG)

> u(y) only tells

us

y is not strictly prefened over x but does not say econ

agent actually prefer x over y.

One possible way out is to use a set of real-valued functions as preference:

utility index to represent

SetU: X

* y

R represents

) iff
2

u(x)

> u(y) Vu U Vx,y

[e.g.: givenR",n
Thus

2.

We represent the partial ordering

>

itr

ui(x) 2

ui(v) i:1,2,,....,n

by a setof utility frrnctions u i(x)

=xi

V x R"

We now move the above analysis up to the metric space level.

Defu: Metic space (X, dx) and ) is a preference relation on X. ) is upper senicontinuous if strict lower contour set L> (*) :{ V X: x ) y}is an open subset of X; and is lower semicontinuous if U, (x): {y X: y> x} is an opel subset of X, Vx X; and is continuous if ) is both upper and lower semicontinuous.]
[Intuitively, for upper semicontinuous preference relation,

if

altemative

x is preferred

over y, then x is also prefened over alternative z which is very close to y.

Alternatively upper semicontinuous preference reln means:

Seq{y''}inX)y t:BR
)

s.t.

Thus linking emotion

with math metric

x)y.VmZB.
through semicontinuity.l

closue of

wrt to X is tlre smallest closed set in X contai[ing

Defu: (X,dx)andS x).

c X. if cl x(S) = X, the S is dense in X (or S is a dense subset of

[Intuitively, S is dense in X f. if any point in X can be "approximated" by points in S, 2. any nghd ofx N .,x(*) contains at least l point from S.l 4

{y X: dx(x,y)<.

Defu: (X, d1) is a separable metric

space

if X contails

a countable dense set.

fExample: R is separable metric space '.' Q is a countable dense subset in R] R} is a separable Hausdorff Space with cardinality try9*uct 19e9l9ey on {functions: R of 2' (called beth-two, with c as cardinality of R) separable spaces can be ..not small". But in general, when we talk about separable space, we think of it as not very .,large,' because there's a countable set in this space almost the size of the space itself. AIso intuitively, separability means the metric space has few open sets.]

We wish to have metric spaces which are "nice". Separability is .hice". (please see below Rader's Thn.). Also all open sets can be described as countable sets oi open sets know all open subsets of (X, dx) know all its closed &/or connected set know all seq convergent in that space know about upper and lower semicon and continuity. other properties making a metric space "nice" are compaotness and connectednes;. @lease see below after Rader's Thm).

Thm: Rader's Utility Representation (X, d1) is a separable metic space and

is a complete preference relation on X.

is upper semicontinuous

it can

be represented by a

utility firnction u: X

tO,ll

Before covering compact sets in topological spaces, we need to remark on class of sets. Gven a set X, its power set denoted by 2x :{S: S c X} ('.' if I n elements in f 2' elements in 2x e.g.-X: {a, b, c} with 3 elts, then 2x has lA, fu\, lb}, {c}, b}, {a, c}, {a, cardinality of2x > cardinalig, of X. S {b, c}, {a, b, c}} 23 8 elts.

Xt

[Cantor's Paradox]: {S: S isa set} cannotbe a set. Assume @: {S: S is a set} is a set [VeltSin2@:> S g @ andisasett S@jmeans2@c @ cardinality 2@ < cardinality of contradicting So @ = {S: s is a set} cannot be considered as a set. we can just call it a (proper) class which is a collection oi

X:

) I

of

s.

sets.

Defo: (X, dy) and S c X:

Cantor's Paradox (Also Russll,s peadox a set ofan sets.)

AclassC of subsets of X is said to cover S if S c u C. If all such subsets in C are open in X, then C is an open cover of S. lAlternatively: class c of open sets {c 1 } with i I (an index set). c is a open cover of S if each point in S belongs to at least one C 1l

Defu: (X, d1) is compact if every open cover of X has a finite subset also coverins X. S e X is a compact subset of X if every open cover of S has a finite subit atso
covering S.

dealing with.

[Lrtuitively, compactness provides a finite strucf,re for the infinite concepts we are

compactness helps to extend-results {iom metric spaces into more general topological space settings Examples are function spaces that are not metric spaoe;. For ourpurfose, it is very important for optimization.l In oase of R
o

space, we have the

following thm.

Thm [Heine-Borel]: Every subset S G R n is compact iff S is closed and bdd. Note this is only valid for R o space and not for any metric space because there are closed & bdd nenic spacas that are not compact. In other *o.ds, is a broader concept than closed & bddness. In fact, compactness iff closed "o,npactness + equicontinuous. & bdd 6 collection.of functions is equicontinuous if ar the functions are continuous and have equal vairation over a given neighborhood.)

And the important thm: Thm [Weierstrass]: (X, T ) and continuous funotion f: X R. Compact S g X f achieves a maximum and a minimum in S

Thm A closed subset ofa compact metric space (X, dJ is compact.

Econ application:

(x, dx) with x = {choices of econ agent} with

of econ agents) assumed Define optimal choice

subset

Fc

X where F :{feasibre choices

* Z

setC(F): { xF: /yFs.t. y > x}

x* s.t. feasibilitv.

If C(F)
We

@ thenwe have a optimal choice solution

will

show that

C(ry

+O

and it is compact.

case 1) ifF finite and since we have transitivity

of)

, we can always order all elts

x and

findthex*Fs.t.
case

lyFwithy

>

x ) C(g +

2) if F is Nor

AND )

finite (e.g. infinite-dimensional commodities space)BUT compact

t AlleltsxF c X also u[open subsets L, (x)j )u

is upper semicontinuous: is upper semioontinuous L,

(x):{ y X: x )

cover of F At the same time we know C(F)

y}is an open subset ofX for Vx in X {L, (x): xF} is anopen

- {xF: XyFs.t.y ) x}= n{F\!(x*) :xF} Suppose C(F): n {F\L, (x*) :xeF} -A t F:F\Z:F\ n{F\L,(x*): xF}:u {F\ F\ L, (x*) : x F}: u{ L, (x*) :xF}
ofF.

is an open cover

Since F compact

) f finite subsetFF c F (F is a cover) ) Since FF finite and by transitivity of> ) I )-maxim:rl elt x* in FF and note x* F\ L, (x*) (..' x* ) ;x) I x* must L, (x+) for some x+ e FF\{x*} (defn ofcover) ) means x* is in strict
lower contour set in FF\{x*}

with

x+

x+, contradicting x* being the )-maximal elt in

FF) C(D+ o To show C(ry + A t

is compact:

Pf: L, (x) is open set in F ) F\ L, (x) is closed subset ofF V x F ) n {F\ L, (x) : x e F} is a closed subset ofF which is compact
and [r {F\ L, (x) : x F}: C(F) C(F) compact. (closed subset of a compact metric space is compact,t

O> opt (most preferred )-maximal) elt in feasible set; and [Above means C(D explains why we needed semicont and compact set as ass'mptions for Thrn Ee. To fully prove that thm and also its counterpart thm in more abstaot spaces, we need to cover fixed point theorems below.

Completeness properly of space

Deft: A Cauchy

sequence is a sequence in a

lBRs.t.
[Intuitively:
Thm. A

d"

(x-, xn) <e forallm,n

)B t

mefic

space (X, d*)

if for any e > 0,

the later terms beoome arbitrarily close to eaoh other]

seq in metric space is convergent

it is Cauchy.

Thm. If X

a Cauchy seq has a subseq that converges in

X, then the seq itself converges in

Deft: (X, da) is complete if every

Cauchy seq in X converges to a point in X [Intuitively, completeness means there are no points missing either in the interior or the boundary. Q is not complete (points like irrationals are missing) but R is complete.l

Thm. Metric subspace

Compactness

S of complete

(X, d1) is complete iffS is closed in X.

completeness but converse not true (e.g. R is complete but not compact

because not bdd).

(X, d1) is compact iff it's complete and totally bdd.

Sc

CK, dx)

totaily bdd if any

> 0, I fuite T

s.t.

T} hfrnite discrete space is bdd but not totally] [e.g.

Sc u {neighborhood N .,;(x): x

Reason we want completeness is because contactive self-map (contraction) on a complete metric space has fixed point.

Defii:

X on a metric space (X, d") is a contraction (= contraction mapping) if 3 real number 0 < r < 1 s.t. d,.(d(x), 0 (V)) < r d"(x,y) V ayX. [Intuitively, g shortens the distance between two points. S is uniformly continuous.]
a self

map

d: X)

K
.1,--

sn..,e

X_

d[e),4@)

| -- -aQ&)
t,@,4611

rd'"t)

--

-cg,
\8'7

La(x-,t) > az(\eYdtas)

Gven

a self-map

&

f :X

X, f(x) = x is a fixed point

4()
i.|
EO

In a complete (X, dv) a contraction mapping has a Mxed point. such a fixed point is the limit of the convergent (cauchy) sequence defined by the recursive equation x ,*, 6(xJ, n=0, 1,2, ....... This is formulated in the thm below:

1{

L
:

x*ex.

Fixed Poitrt FP Thm [Banach]: Given complete (X, gs), contaction d

) X' l1!
/

fixed

point d(x*)=**

4en
4@t't)
dtrorlD))

+r,ft

l*t{

r.

t) Qk)

x-1

[The Banach FP Thm does not hold for a metic space that is not complete. The Thm can also be used to prove existence ofordinary differantial equation solutions]

Defo: Gven any nonempry setX and self map X, define 6r= 0(O'),n:1,2,3,.... The self map0n is called the nth iteration of d.

d: X)

21d 6n+r=

Thm: Given complete (X, dx),

has a fixed

point

(x*): **,

d'
a

(nth iteration of self map

) is a contaction

"*

".

converges to a fixed point. ]

[Intuitively, if the iteration results in a smaller and smaller interval (confaction), then it

flteration is the starting point of recursive methods, difference equation and its phase diagrams.l
Derivation ofgenera.l solution formula for l$-order linear autonomous difference equation:

xt = bxt.r *
We

a, b constants

start iteration for t = 0, l, 2, ....,t

xr= bxo + a x:= bxr + a = b(bxo + d + a =b2xo+ba+a

[2

1s+a(b+f)
+
+

xe= bxz + a = b(bsxo + a(b +1))+a = b3xo +bza +ba +a

a: a,
But geometric progress of t terms of sum

bsx

a( bz +

b+

1)

= bixo

a(bfr

bt2 + ... + b+1)

1-bt
1b

ifb l1

(bt.r +bt.s

+ ... + b+ t) {

ifb=l )
General solution (when no

by varying initial condition x o ):

initial condition is specified and we get family

ia /(1

of solutions

{xo - [a/(1-b)]]b'+
xr

= { t
xo + at

-b)]

b* 1
l,r

[6-6]

Ifinitial condition is specified

get specific solution.

Phase diagram of nonlinear difference equation: y

(y

t_r)2

tt

+-*tt

1r

[Importance of FP theorems in Math Econ:

If

.)

we wish to specifi conditions for existence of a solution x* ro a sysrem of simultaneous equations, where the solution is in the form off(x*) 0. ifwe can express d(x)=(x)*xwhere Xis aself-map

d: X)

and introduce the same conditions required by some Fp theorem

on

(x)

t ) t

into the system there will exist some fixed point x* by this FP Thm FP means d (xx) = x,r f(xi) d (xx) - x* : 0 and we have accomplished what we set out to do.

E.g.

Given an exchange economy with consumer

i's

demand D; (p) and his initial

endowment Wi : we define an excess demand function

equil in tle market

'.'

demand :

f(p)

: ),

@, (p) - W;

(when f(p)

0 means

supply).

we define o (p) = (p) + p and impose some conditions (like some continuity conditions on f(p) and on concave utility functions, compact convex feasible set) to ensure bv Brouwer's EP Thm I a fxed point p* (: price vector) where d(p*): p* + d (p*) = f(p*) + p* = p* t f(p*) = 0
This is the FP part ofthe proof of Thm
Es

2. For

game theory,

if

S_

I is

a mixed strategy for all n players except for player i.

Define a best response correspondence g 1(S_i )toS_1 opponent players profiles ) to { i' s strategies}.

{all prob distrib over

Define

(S):

O,

(S_r)x O2(S_2)t

...,

d"(S_")
to itself

If3 a fixedpoint S* s.t. S* e O (S*) = I stratgy set which is a best response = no player can I by deviating from that strategy
= Nash equilibrium

set up the conditions for Kakutani Fp Thm so that existence of Nash Eouil.

d (S) has a fixed point and we get

point theorem".]

[It is said that when in 1949 Johr Nash presented his (-Nobel-prize-winning) theory to von Neumann. Von Neumann's response: "That's trivial, you know. Thafs just a fixed

3.

Suppose we are given

an:tio1;

If f is a contraction, then we

;: (x) + c where fis a vector and c is a real number

g(y): (y)
+c

t g(y) also a contraction ) by Banach FP Thm f a I ! fixed point y* s.t. y* : g(y*) I y*:f(y*)+c I y* is a solution for x: f(x) + c.l

can define self map

fixed point to said to possess a fixed point property. Note not all topological spaces have point property, e.g. a continuous self-map rotating the annulus of dougbnut this _!xed (or disc) has no fixed point. If annulus is filled in, then the centre will be the fixed point.

In general, any topologioal space in which any continuous self-mapping must have

since Banach FP

Tlm
will

Programming DP, we theorems.

provides the theoretic foundation of Bellman Dvnamic cover this subject first before rehrning to various other Fp

ffi'#ifi;3,Hf*i"ffffi.i,
Lemma: S a nonempty set and 0 +X c closed under addition by +ve constant function

B(S)
r'

meansfext f+aX

Gven increasing self map @-. X

oeaosf

,gXandf

-g)

O(f) > O(g)

and

0<5<l
@

s.t.

@(f+a) <O(f)+6a

is a contaction

Given following functional equation (note fon both sides of equation):

(("):

max

(x, y) + 6 f(v)}

o<x,y <

0<6<1

with d (x, y) being any continuous mappilg: [0,1] x [0,1]) [0,1J x [0,1]
Note:

1) d 2) 0

(x, V) obviously bdd real function (hence complete). (x, V) is closed under +ve constant function addition '.'@ (x, y) continuous O (x,y)+a with a> 0 also continuous

Note: rD: C[0,1]

{[0,1] x [0,1]]
real functions on [0,1]

\set of continuous

And O maps a continuous function to a continuous function

(D

is a self map on C[0,1]

Iff(y) -g(y) t d (4v)+6(y) > d (x,y)+s g(y) ) max{ O 1",y;+6f(v)} ) max {O (x,y)+Og1y;;

O(D

>

(D

(g)

@ is an increasing self map

Furthermore

@(f(x)+a):max { O (x, y)+ 6 ((y)+ a)} : max{ g (x,y)+d6(f(y)}+6a

< O (f ) + 6 a Then all hypothesis of above lemma is satisfied and @(f) is a contraction.

) l ll
=f

fixedpoint

O(f*)=f*

fC[0,1]

* solves the functional equatior f(x)

max{ g (x, y) +

f(y)} with

<x, y< I

which is called Bellman's functional equation.

0<6<1

Deft: (X, dx) is connected if / X1u X2 :X

One other property of metric space is comectedness.

2 nonempty and disjoint open subsets

X:, X:c

s.t.

[tntuitively, metric spaoe is connected if cannot be written as union of two or more disjoint open sets; so pizza is connected brt two separate pizzas each representing a space !s not connected. As an aside, douftnut is not path-connectedl

We shall return to our discussion on Bellman Dynamic Programming later. First let us go through the other fixed point FP theorems so that we can wrap up our discussion on classical welfare tleorems and game theory.

Observation: Connected sets 6

a:

{all intervals

on

R}.

Lemma: Given metric spaces (X, d,.), (Y, dy) and continuous function
Xconnected

f:

X)

Y.

fOO cormected c Y.

Pf: Assume f(X) not connected s't' Or U Oz= fCXl)'

3 2 nonempty & disjoint open subsets Or , Oz of f(X)

Foraayxe f -t(Or), f(x)

>0s.t.N .,y(f(x)) cO1 Furthermore fcontatx + f 6>0s.t.f(N 0,1(x)) cN .,y(f(x)) butN .,v(f(x)) eOr ) f(N a,1(x)) c Or. Alternatively, N o.;1x) cf-r(Or). -r(O1) -t(Or) Since x is any arbitrary x e f nonempty open qX. ,t f
Or whichis open
e

) -

^. ,, . 1'-'(O2) nonempty open Smllarly ^-t-^,

cX.

nonempty open f 't(Or) , f -t(Or) must be disjoint (if they are not disjoint Or anp 02 with (x) Or and (x) 02 contradicting Or and 02 are disjoint, -'(Oz) -'(O1) hence f must be disjoint.) ,f Moreover f -1(O1) U f -t(Or):f -r(Or U Or):X, contradicring X connected must be connected.
These

) ! ) ffi

Actually the simplest FP thm is the lntermediate Value Thm IVT. (= l-dimensional
Brouwer's FP Thm)
Version I of Intermediate Value Thm IVT (K, d") connected and continuous function f: R. (x) <c < (y) anyx,y latleastonez X s.t.

X)

X) t

f(z):c.

Pf: From

above lemma (X) connected (X) interval in R and on this interval, R every point is : to some f(x). any c in the interval (x)<cSf(y) must: to some f(z) ,

z X.

llol
f cont & X, f(X) connected ) no break in fgraph and [x, y] ) f going from f(x) to (y) must go tlrough e : (z) and cannot skip over it.

tf
,Tl

fq-) fG)=" !e>

)l sl

JI

v
x-

c*__

*3-o^

IVT Corollary
Case 3) f(0) > 0,

ftt< x*,
J&*)

from (0) to (1) must cut 45o line '.'no break in f graph and Cannot skip over 45o line

fcont

f(i) < 1

Real life example inciudes: continuous water evaporation over time, temperature change or fever over time: Or lost 30 lbs weight over 15 day

sometime

withil the 15 days must have lose 9 lbs.

-w
l.a*
3olh l--

lo t+

l0

t5 )4

Version 2 of IVT (Bolzano) [a,b] nonempty, compaot, convex QR, f continuous: [a,b] 3xx [a,b] s.t. f(x*):0.

) )

R and f(a).(b) < 0

Corollary: f continuous

[0,1])
s.t.

[0,1]

3fxed point xx [0,1]

Case 2) f(1): I )

(x*) = y*.

Pl

Case

1)

(0):0 )

done. done.

f(0)>0; f(1) + 1t f(1) < 0 @lease see diag on previous page) Define F(x) = f(x) - x. Note F : [0,1] ) R and continuous And F(0) = f(0) - 0 = f(0) > 0 and F(1) = (1) - I < 0 t F(0).F(1) < 0 and by above IVT
Case

3) f(0) +

0t

3x*

[0,1] s.t. F(x*):g also =

f(x*)-x*

I (x*;:t*

frxed point.

Converse of IVT does not hold. E.g. f reai-valued function on interval and Vu ((a), (b), 3c (a, b) s.t. f(c) =u fcont? No! e.g. (x) = sin x *O and f(0) = 0. f has FP but not cont.

llx

I.

Any a, b

Above corollary is a special case of a more general FP thm called Brouwer's FP Thm. Where cont f: S ) S and S no longer: [0, 1].

Retraction: (S, ds) metric spaces c metric space (X, d*) continuous function f: X) S is a retraction if f(x) = x Vx (x, d,.).

S and (S, ds) is a

retract of

[Intuitively, every point of the codomain is a fixed point of the function f. Note R can be condensed continuously by the foliowing cont f into [0,1] in a way to leave each point in gr" [0,1] intact (x) 0 for all x < 0 and f(x) = 1 for all x > 1; for 0 < x < 1, f (x) " identify map. Note [0,1] cannot be condensed into (0,1).1

Metric space (X, dJ has FP property (every continuous self-map f on X has a fxed point) does not guarantee its mekic subspace also has FP property. E.g. [0,1] has FP
property but (0,1) does not.

Lemma @orsuk) (S, ds) is a retract of iX, d"). (X, dJ has FP property also has FP properly.

If

(S, ds)

Brouwer's FP Thm: S nonempty, convex, compact

fxed Point x* S s.t. (x*) :

Rn aad continuous

f: S )

1*.

a0

Pf:

Please see Border (uses Sperner's Lemma

in combinatorial topology).

[sketch of an altemative pf: unit sphere So in a normed vector space V = {v ll v ll = 1} a closed unit ball n Bn in a normed vector space y= {v ll vll < 1} and in case of Ro, 5 =1112 + x22+... + x"'?= 11 andBD:{x12+ xz2 + ...+xn2< 1}. Note the borurdary of Bois a sphere S o'1 (e.g. projecting a ball in 3-dim space onto 2-dim spaoe we get a circle). '.' B n is nonempty, convex, compact G Rn , we can rc-state:
a

V:

V:

Brouwer's FP Thm: Every continuous function f from closed unit ball B " B n has at least one fxed point. Lemma @orsuk) fl any retraction fiom B n onto S n't n = 1,2,3, ..... [Intuitively, there is no oontinuous mapping from all the interior poinls of a disk onto the circle forming the boundary ofthe disk.l

I Take any x in B and f(x) #x caa draw a straight line -r joining x f(x) and extend the straight line to cut S " (at the boundary) at g(x). g is a continuous function: B o S'-1 and is a retraction, violating above Lemma @orsuk) must 3 FP x* f(x*). l
Suppose X FP

x*

f(x*).

--

fNotes: 1. Generalization of Brouwer's FP Thm into infinite dimension by extending unit ball in a Euclidean space to one in a Hilbert space is not true '.' uait ball in infrnite-dim Hilbert space is not compact. So such generalization require additional compactless and many li-nres convexity assumptions on the space. 2. Above Thm does not hold for open balls. Brouwer's FP Thm is used to show existence of solution to differential =.tions, existence of CE and existence of equilibrium in Game Theory.]

3.

Examples in real life application of FP Thm: Directory map of HKU campus, airport, subway etc and point "you are here" is a fxed point. Map of the world on the floor--some pt in the map lying directly over the point it represents. But if you are haveling in a space ship, drop world map on space ship floor will not result in a FP because you are outside &e set S.

Application of Brouwer's FP Thm: to prove existence of

(no producti on). Consumers

a C.E.

in an exchange economy

i:

1,2,

.....,I

commodities

1,2, ..., J

i's consumption bundle vector x;

=(

x1 , xiz,

...,x;:)

xi

rt'* n

& his initial endowment c; : ( c;r, c;2, x3, . . ., x1) pricevectorp: (pr, pz, p:, . . ., pr)
allocation x
(x1, x2,

. . .. c.ts)

Ary

*' e R.'*)3 yi Rn*

.s.t.
u ;(y;)

in

neighborhood of x;

> u i(x1)

Assuming existence of a continuous, strictly concave and locally insatiable utility frnction u i(xi): non-negative quadrants R: o ) R Vi. And assume X q < Q, making the feasible set closed and bdd (i.e.compact). So we have a set of utility functions {ui(x)}
prove.l
For a function

[f

utility function is concave but not strictly

concave, we need Kakutani's FP Thm to

f: X ) Y, argument of the max argmax(x)={x X: f(x)}(y) Vy X}

Define C.E. (x*, p*) as x;* arg max{u r(xi): s.t. px;

2. lxi *: Ii

<pc;(budget)&0<x<Q(feasibility)Vi}

ci

Define function

Vx R.'* ) This is the most preferred bundle in the feasible budget set : demand by i (analogous to derivation of demand function ftom the l'r order condition in utility max). Since u(x) continuous, stictly concave ) d 1(p) well defrned and single-valued V p.
(feasibility)
ITerminology: the standard (= n-simplex denoted by {(r,, Xz, X:, .. ., *t) Ii xt-1) ( Intuitively it is the n-dimension analogue of a triangle) 0-simplex is a point 1-simplex is a line segment plus all interior points. 2-simplex is a triangle plus all interior points.

difu):

arg max{u r(x): s.t. px; -< pc;(budget)

& Ixi S Ici < e

6it)

N:

R.':

x1

} 6 66

3-simplex is a py'ramid tetrahedron plus all interior points. (viewed from above X ) 4-simplex Given a regular (n-1)-simplex, pick a new vertex and join it to all original vertices by a common length edge to form a regular n-simplex. In topology, simpiexes are the simplest convex sets. Note: all balls and simplexes the same dimension are homeomoryhic, (homeomorphism = topological isomorphism = isomorphism between topological spaces which preserve topological properties. Hence homeomorphic spaces can be considered as same topological spaces) balls and simplexes are same in topological spaces.]

of

For any a> 0,px; < pci E apxi < apci which means dro) = d(a p) because the budget constraints remain unchanged in the optimization problem when p is scaled by a in our optimizatlon, we can scale any price vectorp'by letting a: | p;' s.t.p;.) newpricep:'/E pi' and summation of all these new prices (pj' / p; ' 1 (i.e. normalize the price vector) F-9 for the following analysis, we can just use normalized price vector which means our price vector p {p R" * and p: =1 } p unit simplex N in Euclidean space.

l)

/\ Ij

):

2)'.'dr(p)generatesmaxutilityinfeasiblebudgetsetsoforanyui(x')>ui(di(p))then such \'must be outside the feasible budget region with px i ' > p d ;(p)

3) if x;* solves max{u 1(x): s.t. px;3 pc; (budget) & 0S x s Q (feasibility) V i} aad suppose px1* < pci) by local insatiability assumption 3x;'in neighborhood of x1* s.t. px 1' < pci and u i(xi')> u 1(x;*) conhadicting x* optimal ) pX i* = pci conshaint
binding. Lemma (Walras Law)

p Ri*and p. [}(dr(p)

- ci)l =0
)=0 V i

Pf: by3)px1*:pcr

summing over all iwe Betp.[Ii (d;(p) - q)] :0

pxi* -pci

:0*

p(x;* -ci

Lemma:
t)

lim
oo

sequence {

p, } in A'=p,

then

d;(p)

d;(p;

Pf:
says

Please see Vohra.

We defme an aggregate excess demand fimction

p.E(p):0

B(p)

XrI (d

iO,

ci

) so Walras Law

Standard procedure to prove existence as we mentioned is to let function p + E(p) to have a frxed point i.e. let -p* p* + E(p*) E(p*) = 0 or p* will make aggregate excess demand function to be zero and supply demand for the equilibrium.

We use a variant of the E(p) function, call it g(p), for the proof:

Defrne g

(p):

(gr (p), crb), ...,g1 fu) ) on An

CjO) = p;+max{O, L(dt(p)

:p;+max{0, |i(dii(p) -

- crj)} i (Lr(p.+max{0, |1(di*b) - ci.)}) c,.;)} / (l+I'r max{0, Ii (di,(p) - ci.)})

Note this is a variant of normalization of price F-9, modified to have nonnegative excess demand of all p.

t l.

g (p): (er (p), crfu), ...,sr (p) ) is a continuous function by above lemma and also g,(p) = 1 so g: )
^^"
^^"

By Brouwer's FP Thm f fixed point p Ao s.t. p= (unit balls and unit simplexes are homeomorphic).

O)

p.i = g:

b)

pj:pj+max{0, }(d,;(p) - c,t)} / (1+I",'max{0, Ii(di-1p) "-)}) )p: (1lX-'max{0"L(dr.6) - ci"')}): p;+max{0, }(d,:(p) - c,:)} lp;,' max{0, Ii(di.b) - ci,)}):max{O , l(d,:(p) - c;1)} [ff-10]
rib) - c i)} > 0; and we only need to look at cases where pi > 0 (we restricted ourselves topl > 0andifp; = 0, commodity j is afree good and all
We know that max

{0,

tr

(d

consumers will consume j up to tl-re constraint supply ofj = demand ofj in market j).
case

(d ri(O)

c11

):0

and we have

1) max {0,

(d,:(n)

c ,,:)}

and

p; > 0

) (:,'max{0, !; (di.G) "r)}):0 ) each max {0, } (d ^(p) - ci-)}:0 ) X, (d;-(p) - c;') < 0
Again we only need o look atp,n > demand in market m):
Subcase Subcase

0 ( if p,n:01m

is free commodity and supply =

l-1) ifXr (di,(p) - ci.)

1-2) if

)p* Oi(d^G) - ci.)<0 Vm ) Lp. Oi (di.(p) - ci.) )<0 violating Walras Law Lemma ) we can only have Ii (di,(p) - cin) = 0 and supply = demand in market m
2) max {0,
max {0,

Ii

(d

m(p)

- c i-)

0 we have supply = demand in market m< 0 and p- > 0

case

} }

(d,:(p)

ci.i)}

>

[F-10]

) (tr

and for p;

,p. >0
(d",(p)

- ci-)}) > 0

I some m s.t. l; (d *(p) - c;-) > 0 * p ^(Xi (d'-(p) - c,-)) > o t t* p'" {x; (d l"b) - c *) ) > 0 contradicting Wal ras Law Lemma ) can only have Ii (d,-(p) - ci-):0 and supply = demand in market m
So in ;'all cases, we have sunnlv: dernand in eech msr!.et and the f;xed poini p is.uhc equilibrium price guaranteed by Brouwer's FP Thm.

Kakutani's FP Thm generalizes Blouwer's FP Thm in a slightly different direction. We stay in Euclidean space R n , * compactness + convexity, but now look at set-valued (:multi-valued point-to-set multifunction) functions called correspondences, in particular semi- and hemi-continuous conespondences.

Terminology:

(use notation

Correspondence : eachp point ofa setX 3 subset ofthe setX. 3 for multi-valued functions). So now f(x) is a set c X.

l:x32r/{a}
If f
(X)

X then it's

a self correspondence on

xX = f (x)c
X.

For correspondence Correspondence

(x) , a fixed point x* means xt

1)

(x*).

l(x)is:

convex-valued 2) closed-valued

if I.(x) is a convex set, VxX. if | {x) is a closed subset c Y

3!

For both firnctions (point-point) the graph, denoted by Gr is:

>

Y and conespondences (poinfset) I-: X

Grf:{(,{,y) Xx Y y=f(x)}

Gr

| :{(x,y) Xx Y y |

(x)}

Since now we are dealing with correspondences, we wish to have the concep of continuity to be consistent with continuity in the single-valued function case: i.e. if we collapse a multlvalued correspondence continuity to that of a single-valued correspondence, we should get the ordinary continuity notion. [Intuitively, ordinary frrnction continuity is a graph showing no breakl. We can do this either by upper semi/hemi continuity or by lower semi.&emi continuity of correspondence.

('jeuwa.r

+&,t

.? tl.a!\

\a^ f

$.@q)

(*vt-<{-o..J.a^<t

Ytr-t

*D

And we know that to understand Kakutani's Thm properly, we need to clarify the analogous concepts of continuif for both single-valued functions and multi-valued
conespondences.

For single-valued function

i
(u.s.c.)

.-.. f Defir: Given G, dx): f: X) R is upper semicontinuous

Topqlggrg{l qpace

ifforanye>0 3

6 > 0 s.t.

d1(x*,y)<

6 )f(y)<(x*)+

atx* X

e Vyd;(x*,y)

f is u.s.c. if it is u.s.c. Vx X.

[Intuitively, fis u.s.c. at x* means points ppp nearby x* ) 1. (ppp) not > f(x*) by too much but can be much lower; or 2. f(ppp) very close to or < f(x+)l

Example:

x' foro<x<1 f(x): { 15 forx:1 1-x for I <x

is not continuous but is u.s.c.

atx-

l.>
I

Ofct)
$ ,r-s.c.

aE x!=

0,5

,F{
z5=t
J.'

t
Given

(X dx): f: X) R is lower si:micontinuous (l.s.c.) at x* X ifforany+g f 6>0s.t.dx(x*,y)<6t(V) l (**)- Vydx(xn,y)

f is l.s.c. if it is I.s.c. Vx X.

flntuitively: (ppp) very

close to or >

f(x*)]

fc*:
F,Of uJ. C,

t;,n*
v,s.c . Y\q

t)

cert)

'.'

L.s.c.

tcrit)J

(a

In real space: Altemative defir:

f: X c R') R is u.s.c. on X if VrR {xX: (x) 2 r} isclosedinX. = {x X: f(x) ( r} is open in X. Alternative defu: f X c R.') R is l.s.c. on X if Vr R {x X: f(x) ( r} is closed in X.
= {x X: f(x)
>

r) is open in X.

u.s.c. and l.s.c. is a weaker notion of continuity. Above f(x) is continuous on f(x) is both upper and lower semicontinuous.

X iff

The reason we split the definition of continuity into u.s.c. and l.s.c.:

Most students lmow that real-valued function over a compact set X assumes its max/min in X if f is continuous by the following theorem: Weirstrass Thm: (X, da) compact and continuous f: X J x, y X s.t. (x): sup fCX) aad (y): inf fCX)

supremum = least upper foraselS & if a bouod s.t. set S is = bdd fiom above. then tie smallest ofthese upper bounds is sup

bound

,v7

infimum:

greatest lower bound

But actually f only needs to be u.s.c. to get the max and l.s.c. to get the min:
Lemma @aire) (X, d1) compact and continuous f: X 1)fu.s.c. s.t. (x):sup f(X)

2)fl.s.c.

) I xX ) I xX s.t.(x):inf f(X)
u.
s.

Application: we only need

function.

continuity for preference to be representable by utility

Rader's Utility Representation Thm II (X, d1) separable aad ) complete preference relation on X. Then ) u.s.c. ) ) representable by a u.s.c. utility frrnction u: X) R.
Debreu's Utility Representation Thm d;) separable and ) complete preference relation on X. Then ) continuous representable by a continuous utility function u:

([

I )

X)

R.

In fact

continuous (/u.s.c.) utility representation

for> iff

is continuous (/u.s.c.)

We now look at meaning

ofcontinuity ofa multi-valued correspondence

Terminology:

[CAUTION: In the literature, especially in earlier textbooks (e.g. Tatayama [1985j), semicontinuity (s.c.) is sometimes used both for single-valued functions and for multivalued corespondence. More recent publications us-e semicontinuity for frrnctions and
hemicontinuity (h.c.)for correspondences. However, we can usually distinguish between the two by looking at the function/conespondence in question.
Confusion will oniy arise if we are discussing real-valued single-valued correspondence because a semicontinuous real-valued frmction f (single'valued function) is not a hemicontinuous cortespondence (multi-valued function) unless fis continuous.]

Defn: given (X, dx) , (Y dy) correspondence f:X 3 Yis compact-valued (i.e. if image is compact subset of Y).

if l(x) c Y

is compact

xX.

[We leamed the following 2 definitions already. Here we just state them again but this time in terms of metric spaces: dv), correspondence f :X 3 Yis closed-valued if f (x)c Deftr: given (X, dx) , Y is closed. fis convex-valuedl AND Defn: ifY and l(x)convex V

(l

c R'

xX,

is not standard and is defined differently by different writers. E.g. Berge required compact-valuedness in his defu of upper henicontinuity (u.h.c.) The general defrr ofu.h.c. is dfferent from Berge's definition ifimage set Y is not compact. When compact-valuedness is absent, Berge definition becomes the definition

[CAUTION: Defn of h.c.

of closedness of at x. However in most econ writings and applications, and also in our notes, compactness of image set Y is usually assumed so this normally will not is mapped into a compact present any problems. Specifically, when closed-valued space, Berge's and the general definition of u.h.c. coincide. u.h.c Observations: Y is compact and I is closed is closed.l AND is u.h.c. & closed-valued

) f

I f

Thm: Topological

spaces

X and X correspondence

l: X 3l I is u.s.c- inXiff |

closed in X and Y is compact.

To extend continuity concept from single-valued fimction to multi-valued correspondence, we define hemicontinuity.

General Deftr: Correspondence a neighborhood

isu.h.c.atx ifwhenever x is in the upper inverse ofan ofx also in the upper inverse of that open set.
I.

open set

=
Conespondence Y V open O

-'(o)- { xexs.L F(x) co} voc

|:X 3Y isu.h.c,atx iff upper inverse image f-l(O)isopeninX

(Y dv) correspondence f: X 3 Yis u.h.c. at x X if Vopen subset Or c Y with f (x) c6r, I

Given (X, dx)

6 > 0 s.t.

O{o,x(x)) qOr

Alternative Defn: from from X and seq{y : X 3 Y is u.h.c. at x X if any two sequences seq{x "} "} Y compact, with:

x,,)x; y"f(x,) Vn; and y,) yY ) y f (x) (i.e. seq {y"} f (x") ) some end point y, if endpointy l(x)
then u.h.c. at x)1.

Alternative Deftr: Correspondence

Gr

={(x,y)

Xx Y y |
X
then

X e Rl

X (compact) is u.h.c.

if

(x)}isclosed.

Defn: If u.h.c. V x

is u.h.c. on

[When u.h.c. (and similarly for l.h.c.) concept is reduced from set-valued conespondence to single-valued correspondence (essentially like a single-valued function), then fis a continuous function single-valued correspondence fis u.h.c. (similarly for l.h.c.) single-valued correspondence is a continuous Every u.h.c. frrnction and conversely. AND a semicont real-valued function is NOT a hemi-cont correspondence unless it is also continuous.]

itr

[Intuitively,
u.h.c. at x means small change in x

image set

(x) to suddenly becomes larger.

Alternatively, l) if move from point x to nearby point x' there will not be any point in | (x') that is not nearby to some point | (x). 2) as we move from x to nearby x', | (x) will not suddenly contain new points. 3) image set | (x) can implode but not explode given small change in xl

Numerical example: Conespondence:

f :R3R : {y: x-3<y<x-1} x<0 f (x) x:0 I-(x):{y: ,3<y<3} x>0 I.(x): {y: x+1<y<x+3}
fNote

(
is a convex set]

u.A...

ix *e

R,

is convex-valued

Vx: I- (x)

Vx*

R I

is u.h.c. at x*

Check: any sequence seq{x from R "}with: and seq{y,} from R

xo)x*;
andy")

y" f(x") Vn;

y*
R
?

limit point

Is limit point y*

Ifyes, then

(x *)

u.h.c. at x*)

<0 andseqxn)x*
WLOG let x*

ifseq
note y

) )

x*-3<y*<x*-1 ) y* | (x*)
I- u.h.c.
at

limit point y* must be

{y"} r(x") o) intewal (x*-3), (x* ,1)l

xt

Similarly for

x*

can show seq {y "} | some end point y*,

(x,)

and y*

(x *) then u.h.c. at x*

Double-check for the case x*:0: I(0) contains all limit points of f(x) in neighborhood of x*-0 so okay.

Y
-:

u.at

l-.A.c

d' f=o
o

flntuitively;

x* means when x is approaching x* in t]le domain with y in | (x) approaching its limit pointy+, I will findy* in f (x*) set.l
is u.h.c. at

*t *1fx"\ *
c1

t
rf

f1-3 ,^.,r

3.el-e<".)

1n-+

o ere)

Numerical example: Correspondence:

Note I]

x>0 l(x) = {y: x+ 1<ysx+ 3 }

ris

x<0 f (x) : x:0 r(x) :

f :R3R

{y:
{0 }

x-3Sy<x- 1}
R-

-h... il z*1o
u,&.c,

nt

aJ

z'x

=o

sfill cnnrrev-',ol"o.l
0

Vx*R x* *
'.'

is u.h.c. at x* same as above example.

But at x*

0 not u.h.c.:

WLOG, any seq{x

and

xn)0 ; yn e f (xn) V.,; *d yo) y* >2

so

seq{y"} from R with:

,}> 0 from R

I I

y* 4 |

(0) not u.h.c. at x* = 0

f
,:

v,c+

qt

L,l..c. or

r-x=o

&- o H 4f 1,3,,'v rF,,>

r$. g. -+ o (f@>

I'ell

xl
hct u.t.c.

ax

*t

Ye>

T,^ ./'" L.las. at4o

I 6 zrz u,j,-c
ttat

ltt

tn.4,

e:

wf u,Le,

t,t,c.

a.-.* L.A.e.

hsd,*

t.h.

c"

fu>

xtrt-.t

.c

"t

xg3

u+

t
I

"/,2

al

tl
/,,

vl

x.>

fu'.]

el1

r.)tf,,
g

'4|
4x7t vEt 1X'1,a

'+

>rR
,a.-+t

I [!^1e tTxn\ sf, t" *

t-s.,-

I"rffi-{

:ft-3eGc**)

rt

t''+

v.\

Defn: correspondence is l-h.c. at x if whenever x is in the lower inverse of an open set a neighborhood ofx also in the lower inverse ofthat open ser.

r -(O)= {xXs.t. f

(x)

nOl u } VOc y
VcpenO G

f :X 3Yisl.h.c.atxX iff lowerinverseimagef_1{O)isopeninX

()i dx), (y, dv)
l(x,)OO1

Given

correspondence

Vx'N6.11x;.

f: X :i Y is l.h.c. at x X if VopensubsetOr c Ywith f (x) nor I @, I6>0s.t.

f

[.h.c. means any element in

Altemative Defn: compact, with:

(x) can be approached from all directions]

f :X 3 yis l.h.c. atxX

ifany 2 sequences

{x,}

inX

andyis

x")x andanyy f (x) I - seq {y " } in Y such that y")yand y"e t(x") Vn
If l.h.c. V x X then

is l.h.c. on

X.

Deftr: given (X, dx), (X dv) correspondence f: X 3 yis continuous at x X ifcorrespondence is both u.h.c. and r.n.c.
at x-

It

is continuous

if it

is continuous on whole set

X
x

is continuous at x means small change in suddenly becomes larger upward or downward.]

[Intuitiyely;

image set

(x) to

]hile we are on the subject of correspondence continuity, we cover the following Berge Maximum Thm.

Maximum Given

Thm

@ergg Debreu)
space ofcontinuous real maps on

(l dv), CX, dx) and

Xxy

compact-valued correspondence B:

3 X; uC(XxY).

Define d(v): ar-g max{u(ay): x B(y)) VyY and u*(y) = rn*{u(x,y): x e e(V)} ,'C\, V .)er
continuous at some y y 1) d: Y 3X compact-yalued, u.h.c. and closed aty 2) u*: Y R is continuous at y

IfB

)
S

nonempty convex set (quasi.concave

q
if

stricdy qu|si.concrve

if(ct

R", function f: S) Ris x + (l_a)y) > min{f(x), f(y)) Vx,yS f((l, x + (l_a)y) min{f(x), (y)})

,0<cr<l

,v

[ifu

strictly quasi-concave

d is continuous]

ha.,',r...,k J

<-Y 4

fPlease note l.s.c. of u is necessary for Maximum Thm]

continuously.

[when optimizing continuous real-valued firnction over compact set, and the compact set is varying continuously with some parafteter vector, then opimal *iution..tir ri ufp". hemicontinuous correspondence with compact values = optimal solution changes upper hemicontinuously when constraint set chanees

knportance of Max Thm is that it tens us whenever constraint sets (rike budget set) and ^maxrmands are continuous at x*, then the set of maximizers is u *"tt-u"t uuJa u.t .'". correspdence at x*. Thus letting us prove various important math tlreoi"ms.

"cono-i"

From Berge Maxm Thm can to Michaer Serection Thm for fhe suffcient condition for selecting continuous ftrnction from the set of frrnctions in tlte correspondence

Brouwer's FP Thm

Kakutani Fp Thm.

Berge MaxmThm also provides foundation for one-sector optimal growh model arrd stationary Bellman DP and we will retum to this topic later.f

Application: ln the above Maxm Thm: Let price vector p R*n (strictly positive Euclidean space); w : wealth/income R.,* Since budget constraint p xS w depends on both parameters p R++n and w R*and w9 can lef Y: {(n w)} and q in the above theorem becomes a budget conespondence B(p,w): P*'*i 311

Y3X =

ln the above Thm, d(p, w) will then be the demand correspondence, is well-defined (bv Weierstrass Thm), dependent on parameters (p, w)and d: R*n*l j R

ur in the Thm

can be

with u(x, (p,w))

utility function and is assumed to be confinuous with u,n: X x

R.

y)

Maxm Thm B compact-valued & continuous correspondence at some (p, w) 1) demand correspondence d(p, w): R.,*"+1 3 R; compact-valued, u.h.c. & closed at (p, w) 2) u* : {(p, w)}) R is continuous at (p, w)

y:

If X x Y is compact; and B, u are as in above Thm, then u* is continuous and bv Weierstrass Thm, we can find (x*, (p, w)) to max u
we are ready to look at fixed point theorem involving concept of hemi-cont. we firstly state different versions of Kakutani's Fp Thm as preview:

{ow

Kakutani's FP Thm: X nonempty compact, convex set c R.' and correspondence :X 3 X is upper semicontinuous (u.s.c.) s.t. | (x) is convex-valued, then 3 fixed point x* S with xr | (x*).

(here semicont means hemicont as

is a correspondence.)

Altemative Statement: Kakutani's FP Thm Let S be a nonempty, compact and convex subset of Euclidean space. Let | : S 3 2s be an uppr hemicontinuous set-valued function on s with the property that | (x) is nonempty, closed and convex V x S. The I has a fixed point.

Pf:

Please see Border [1985 reprinted 2003]

chapter tr.

c.

Kakutani's fixed point theorem and application to Nash Equilibrium m

GameTheorv.

Kakutani's Fixed Point Theorem:

.
X nonempty, closed, bdd, convex set G

Graph of conespondence

b:y+X={r;,, r)e yxXs,t.xe b(;)}

space

G(b):

Grft) is closed in product metric Ro.

x X = b has a closed graph Cn@)

If

b convex-valued self correspondence: 3 fixed point x* b(x*).

X)

X having a closed graph Gr(b)

fNote importance of convex-valued.

W$.

c,

cev'rS**a--'c"e*

**t Lm*gc'

+50

CotL*4-rn-lu*l*

e,"t 3 F**

?E

#F
l
(

tt>)

Application:
Game Theory: strategic interaction (action
players.

reaction/response) of a group

of

Action space ofplayer i Xi: {actions feasible to player i} V i=1,2,...'P With game outcomesx=(xy, x2,......, xp) Xr x Xz x....... xXp:X And payoff function of i: r;: X) Rs.t. n i (x) > r; (y) means i better offwithx: (xr, x2,......, xp)thany=(y1 , y2.......,yp) Action space of player j other than i: X-1 : { (w,, w, ...,wp_1 )s.t.w1 X.;

j<iandwl-r Xj V j>i) fori=1,2,...,P (xi, x -J: i's action xl given a1l otherj I i players action x _i X-1 e.g. i: 5 , P*7 thenX-s: { (wt, w2. w3, w4, wo, w7 )
V
P-person sfiategic game

G: { (Xi,

ri)

i=r.2....,p }

Defn: Given

game G as above, outcome

x*

is a Nash Equilibrium NE

if

x* argnax { ri (*r, x-1*)s.t.x1X1 }

and

V i:1,2,....,P

NE(G)

{ Nash Equilibria of a game G}

If X i nonempty, compact c R.' , then G called a compact Euclidean Gane. If payoff function zi is continuous real function: X) R V i= 1,2,....,P then G is a oontinuous and compact Euclidean Game. If each X i is convex and compact and each z i(x;, x-i) is quasiconcave for any given x-i X-; , then G is called a convex and
compact Euclidean Game. A compact Euclidean Game that is compact and continuous is called a regular Euclidean Game.

Thm (NasQ For a regular Euclidean Game Pf: Definebi:X-t 3 Xi and b: X 3

G: { (X1 ,

n i) i=t,2,....p }, NE(G) is a self-conespondence with

O.

bi (x-i): argmax { ri (xi, x-;*) s.t. x; Xi } b(x) =6r(x t) * b z (x- z)*....... x bp (x-p)
Weierstrass Thm

I
x1

b is well defined

V xb(x) ) t x
NE(G).

b;

(x-1) V i )

Each Xi

compact and convex

X cornpact and convex (by thm).

For xX and 0< cr < 1, andy,z b(x) t ni(y;, x-i): ni(zi, x-i)
Since ,ri
quasiconcave

best responses

z1(oy; +(l-a)zi, 11) (all other strategies) V

>

t
min{ [ z i(yi ,x -j):nt(zi,x
_;

wi Xi

)]

, zr

(z;,x-; ) ]

> r;(wi,

x_

1)

I ) i )

linear combination b convex-valued.

ay+(l-cr)z b(x)

By Berge Maxm Thm b has closed graph (and is self-correspondence: X

b satisfies all condition ofKukutani FP Thm

)Q

bhasaFP

means

lx* b(x*): br(x-r*) x b2(x* 2*)x.......

xbp (x_p*)
_1

i.e. x i * is best response action given all other players

best response action x

no incentive to change and reached a NE.

Direction of generalization of Kakutani's FP Thm:

Kakutani-Glicksberg-Fan FP topological space:

Thm:

generalize Kakutani's Fp

rhm into infrnite-dim

x.)

Given S nonempty, compact and convex subset of a locally convex topolog.ical linear space. Let 2x be a Kakuteni map (i.e. X, y topological spu""s; y coorre*; X 2Yis upper hemicontinuous and (x) nonempty, compact and convex V xe

f:

f :X)

) f

has a fixed point.

Lefschetz FP Thm: applies to almost all arbinary compact topological spaces. Give conditions in terms of singular homology (set of topological invariant of topological space X) that guarantees a fixed point.

chapter

III

Continuous Time Dynamic Equ'ibrium and optimal economic moders.

A.

Review ofdifferential equations in dynamic analysis.

Differential equations depict functions over continuous time (any instant of time) versus difference equation over discrete time (points i" tin," lirie iast rrour, this hour, next hour) f differential

don

f difference

:tion
t

Review

differential indefinite

integral

----^------,_

\
l

I J(x)dx

l" r19ax

,l

definite

-variable

I
y = f(x)
1't order derivative

mulfivariale

Y : (xr, Xz, x:, ..., --""-." r"- order partial

derivative

Xn)

totalderivatives\
t" af"-"ffi"?*il af

dy/dx: f '(x)
l
2fr order denvative
I

af af
dxr
2od order

(show 2-variable which easilv '".t..a"u[

af
d

dxz

(xl

6xo

.x2) = -----

dxr

+ ____-4",

dxr

oxz

d(dy/dx)

dx

I partial derivative

d2y

/ d.*:

f .. (x)

a2f a2f

azf
o
xo2

.l 2*

a xt2 a

x22

order cross partials

a2f

a2f

dy0x2 dxrdx:

iip

a2f

^)^ o-r
b xz? xz

6xzdxr
nth order derivative

d\/ dx": f \x)

nth order partial derivatives

a"f
dxi"
nth order cross partials

t
dy dx called,
differentials

6"f
dx1

8x; 6xr.......

-)

e.c.

(0:

(df(t)/d0
where

-b

(t)

is a function

&

b is a

constant [f-D-9]

$olution of4 differential equation is a function (or an equation) without any derivative or differential terms, defined over an interval and satisfies the differential equation for values in that interval.
e.g. solution for above differential equation

is: (reananging terms of [II-D-9])

(df(t)/d0 / f(t)

= -b and integrating both sides of equation

i -t at
-bt+Cl
Cl, C2
a oonstants of integration

) f(t):
(is
a

exp ( - bt +

Cl _r1l\ :.-bt "-J

cl-cz
[tr-D-10]
lll-D-l0l:

tf(t)=ce-bt

wherec=ecl-c2

function without ary derivative or differential terms.)

We can always check the solurio! by differentiating the solved f(t) irr h'= -b f(l) dfit)/dr = d(ce-"' ) / d r = c e - o , ( - b) = - b " and get back the original differential equatior [II-D-9].

"

(O

when solutions contain unsoecified varue constant c, the solutron is ca'ed a generar solution (i.e' a famr.-ry of functions by varyin!
c,

.rtiffit

ffi..entiar

equation).

When c is specified

by

initial condition or solution called parti culzu or deftnite. boundary conditions

+t;^14 g
e.g. spci& P as initial conditiol lhen AB defurite solution

speci6, f(t) = 0 boundary cond ition then AI' defrnit solution

For the above differential eouatign tII_-D-gl, f(t) can be radioactrve erement at time t, then the differentiar equation is d".".iuiog il, ;onti";;;;"uy process of radioactive element f(t) over time'rn phvsics:

Initially decay occurs faster because there is more (radioactive) material, then slows kss and tess (radioactive) material. 'So rate of decay *111*"u1.: proportlonal to amount of material f (t)

ifi(rfi;G-"

i.e.f(t)+ :
df (t)

rate of decay (d f

(t)

/ d0 J continuously over time. In other words

b = constant showing proportional change.

/ dt =-bf (t)
(a differcrrtjal

e{uaro! rvjft firr)ction (t) and ib derivatilie dtru / diJ

e g ln econ, suppose labour force L(t) grows cnntinuously at 9% at any instant of time t. (i.e. at any instant of time percenfage growh of labou,

fo.l"j

(d L(t) /

dt)

/ L(t) :

0.09 a dtfferential equation containing L &its derivative.

We get solution by the same method as above:

Solufion: L(t)
(a!
equadon

.ce 000,
but no

c rs any constant.
\\rhen we dilfej:ntiate the

wih I{t)

drivativydiffeftotials & such thar.

origiDEl difierntiat quation

dl(t) / dt = 0.09 L (t) )

solution we get bsck the

check:

dLldt=d(ce 0.0e,1/dt: c e 0.0et(0.09) o.ont

0.09

ce

0.09 119

The solution is a general solution. Ifc is specified e.g. 5, then we get a particular solution

c:

L(t):

o.oet

( rt11

and different categorization ofiifferential equations, each of which has different sorution methods. ot"titi.o, r"r"tions are not knorm.

solving differential equations are not always simpte Yjlf.l{ft1.:rtation, is why we.have srrargnuorward l hat

Remark: f can be a l-independent variable function or a multivariate f'nction. Following are some terminology for categorization.

Differenti al equation (oategorization )

f(x)

l-independent variable

f(x1, x2,

x:,

.,

x,r) multivariate

called ordinar,v differential equations

called pArti4l differential equatrons (some total differential equations) i.e. diflerential equation is an equation

i.e. differential equation is an equation relating function to its derivatives or differentials

relating function fto its partial/total derivatives and/or its partiaVtotal differentials

df (t)/ dt =-bf(t)
and

e.g. above radioactive decay

e.g. 4+

(y-t)dy ot
=

+ (4

l+40

dt=

e g. F(y, t)

--:

dy

dy +

dt (partial

differential
equation)

Labour force gro*th functions

(dL(t)i dt)/L(t):0.0e

e.g.

dF(x, t)

(aF/ax) dx + (dFldt) dt
(total differential equation)

e.g. in particular,

0 then called exact differential ecuation infactdF=0 FnoAg F constant rn dynamics, F (x, t) called a stea<lv state

if d F (x, t) :

Terminology for firther categorization:

Order of differential equatior: order of tbe highest derivative in the equation

e.g.

dy(t)/dt:ke et

l$ order (ordinary) differential equation

'.' highest is
e.g.

order derivative and l-independent variable

d'?r1x;
d,

dy dx
2no order

x2

(ordinary) differential equation

'.' highest is 2nd order derivative and l-independent variable

e.g.

2f(x1,
a xl2

xr)

+ & :5

2N order partial difterenttal equation

'.' highest is 2nd order derivative and multivariate

e.g. n >9 aof

+ d xrn
aef
__-_____

* xt :5

nth order partial differential equation

6 *un

Degree of differential equations: highest power to which the highest order of derivative is raised.

e.g dy(0i dt=ke

d4f(x)
----------

e1

1"t degree

ls order ordinary differential equation

ox

+ x7 :5

l " degree 46 ord er ordirnry differential equation

x7- :)

3d

degree 4h order ordinary differential equation

^ {--:-}'r
dx'

d5r1x;

a4r1xy {-------- }t' r dxo

*'=

-rh ^tr qegree )- order ordrna.ry differential equation v ,

Notation: when time dimension. is.involved as a differential, we -f and not Leibniz dy / dt t." : a j i'at adopt Newton,s notation

!,

t: ;;;;;t""

Definition: Autonomous (= time-independent) differential equations

equations not specifically involving time. e.C.

are differential

i(0
ji

=9

y+7

notrerm

(t) =ke5

Definition : Non-autonomous (= time-dependent) differentiar equations are differential equations specifically involving time.

e.g j,(t):9y2'
ii(t):kes(t+l)
Differential,equatio:r (categorization based on order, leading to Cauchy_peano Theorem )

f(x) I -independent variable - ordinary differential equations

1$ order

f (x1,

x2 , x: .. xn) multivariate - partial differential eauations

(only

I "t

order derivatrves,l

1$ order

(only I't order derivative/partials)

e.g. above radioactive decay

df(0/dt:_b f(r)

e.s. 4+6i

-r)dy +@f +4t)dt:A

2d order
e.g. Newtonian mechanics

2od order

y(t): ji (t) : | Law

:

m:massofy
when A t A_(A position of y when A t) when A t = acceleration a ( v(t)) ro.ce acting on y
A position

F(y,

t): -:-

a2 F

ofy

af

dy + dt

of Motion

F(y(t!: n
differ-rirr"

a :hit/+\

2nd ordcr ordinary

*/*\o'"

nth order (highest order is nth derivative)

nth order

11119 see any

U)lease

4:t"

Thegrem (= Fundamental Theorem for differential equations) math textbook for proof)

A system ofn ls order differential equations with following 4 assumptions * ) 3 function g (t) which is a solution of ihe .y"".. o io ,atrsfies the iniriar condition, then solution is unique.

lf

assumprions for a system [ (t) = f tl, u (r) , y(t) ] frurction f is conrinuous exist and are continuous !e-]) nartials (e-:) V(t) at least piece-wise continuous (A-4) (uo, ) grven Application ofThm: nth order differential equations can be converted to n differential equations and then 3 solution by Cauchy_peano Thm.

tf

(A-l)

6fi/Oui

to

1",

order

D : flt,u(t),f (t) I n(f : du/dt n@= 6za6rz convert to hvo 1$ order y :f t, u(t),y(t) i I and y(t)=f (r)
e.g. given2M

order

Tenninology for more categorization: Differential equations are linear if 1$ degree and no product ofy and

e.g.Y
e.c.

:cr y

+ c2 (1$ order linear)

+

ji (t) + 9iO

l9y(t):81

2od

order linear)

Nonlinear differential equation are >l"r degree and,or with products ofy and derivatives of y like jt.
e.c. Iy (0
e c.

l2

c y(t)

+k

3 bi (t)l :e1i, 1tly1tl1s

Remark: often times use linear-d-ifferential.equalions (/system), which are easier to solve. -ro approxlmate nonrinear differential equations iisystem) and information from linearization of the nonlinear systein tf," n"ighUo.hoo?JrL ,r.uay.ore. (e.g. for nonlinear linear tangent line is an uppro*i*ui.onj. '

"-"-'

)1w according them

that wg have categorized trre various differential equations, we can start solving to their catego(es.

The first step is always to check to see I'f the differential equahon can be solved by rntegration alone.

0.

Check

if

can solve by integration or successive intesration

e.g.

d2 y (t)

---------d t2

l"tdegree 2nd order ordinary linear differential equation

seeifcanJ[d2y(t)/dt2

ldt

i sat
9t +c,

d.

y(t)/dt

try integrate again (successive ntegratron)

itav(t)lat

lat

: j(st+cr)dt
: ,/Zl- + Crt *
C: is then the solution (no

derivative/partials)
check solution by differentiating:

dy(t)/dr

:9De)t + cr= 9r +
:d(gt + cr)/dr :
9 which is the

d2y (t) / d,t2

original differential equation.

Application:
Simple Endogenous Growth Model (Let

y:

nationai producvmcome; K

capital)

Prior to mid 1980s, almost alr gxowh moders (including Solow tho*th Moder) assruned 1) technological changes are exodgenous, and 2) production functions exhibit diminishing returns to scale. (i-e- the production with respect to each of the inputs are concave firnctions). This is lnown as Law of diminishing marginal productivity = Law of diminishing returns. It s.ays if we keep o"-" irrput nt, say l0 workers, and I machinery @apitar); initia y production with each ex*a "ooat machine f but after more and more machines are added, such w l This is because I J tle sarne 10 wJers operate so many machines. Similarly if we hold machinery constant and increase -w-orkers, after a while, crowding and administration of wtikers will J marginal proouctlvltv.

";;i

In mid 1980s, economists started relaxing these two assumptions which give rise to
Endogenous Growth Theory Ref Romer, P. "Increasurg Returns
and Long_Run Crrowth,, JpE Oct/19g6

Endog Growth Theory assumes technological progress is not exogenous. In fact capital K should include knowledg". to knowledge is plausibre as knowledge is cumulative. Ifwe use knowledge witt increasrng return to ofrbet diminishing returns to other inputs, then it mightie a"".ptuoi" ro u.r,r.e constant return to scale (or even increasing return to scale if linowleage i ;;fficiently;.

I"".;riog.";s

If we assume I rate of capital will be same as rate ofproduot y: f

dK/K :
above is a

Y/Y

(interpretation, given % change inK, case there is constant returnsJ

same % change, in which

l$ order differential equation and variabres are separabre, (different variables on different side ofequation). wi can sorve for v:(integratJtoth sides of the quation)

lnK+sr: lnY+c,2 we let ca: h_b ca: lnY-lnK + e"3 =A:y/K note e c3 =[ >9

t t

t iarlr = jayly

AK
if

is the production frnction

note: dY/dK = A > 0 and

dyrldk

= 0 not <u

This is ofcourse the production equation for the AK Moder for Endogenous Growth. Furthermore

then

dK : sY-6K

we assume investment

and

K is depreciated

at rate

of 6,

dKi K

:sY /K -AK/K
= sA

butdK/K=dY/Y (=sA - 6)
as long as sA > >0 which means national product will grow persistently and there is no need for exogenous tech change assumptlon.

6t dy/y

There are many forms of Endogenous Growth model with varying degree sophistication. Please see for example Romer [2000].

of

Another macro econ application: 2-sector income determination model

Given: time t (instant of time, not a period) aggregate consumption c(t) aggregate Investnent I(t) National Income Y (t) and respective equilibrium levels C" I. % and respective deviations from respective equilibriurn levels C

1 Iay6

Y(t): Y. + Y^
Assume

c(t):c" +c^ I(0: Ie + I^

Cr:
dY^

Yr
Y6

c:

mmgnal propensiS' to consume

16: i

/dt : k(Co+Ia -ya)

1

excess aggregate demand

Y grows

ocly to excess aggregate demand

0< i,c,k < ) dY^/dt : k(cya +iya -ya): k(c+i_I)y6 +

d

Ya
Y,1

-:--dYa

: k(c+i- l)dt

isa ld order linear differential equafion

t I----- : Jt(c+i-1)dt ) In Yr : kt(c+i-1) +cl

cr:constantfrom integration

YA : ekt(c+i-l)+cl
J

att:0 Yr:ecr
Also: Y(0)-Y"
Since Y

(t): Y" + y^

ye

+ e kt(c+i-l) e c1

: ye+ ekt(c+i-t) (y(O)-%) i ast+"o Y(t) will -+ Y" only if ekt(c+i-r) *

i.e. only if i.e. only if
0

notek,t>0

(c+i-1)<0 (c+i)<1

So stability condition of2-sector income determination model is ( c + i ) < 1 That is, marginal propensity to consume and to invest must sum to less than l. Altematively (c + i) Y.

Y<

So far we only looked at 1'r order linear differential in the form

of
form)

df (t) /dt:-bf(t)
w*hich_ can
|

= df(t)/dt

+b f (r)

:0

ftnown

as homogeneous

be solv-ed by integration. "' order linear differential equalion:

we now proceed to cover the more general form of

df (t)
as

/dt

b(0 : a (note a, b can be a(0, b(t) and a not necessarily:0)

well as other forms of differential equations.

The derivation of solutions can be found in nrany math econ books (e.g. Hoy, Livernois et al). Here we will just state the solutions as rules based on a few categorizaiion. the categotizafion is by no means exluustive. we remark again that often times, solutions of differential equations are not known.

l.

order (highest derivative is 1 $ order) linear (no product of f, derivatives, differentials nor > power of l,like f2)
I

dy(t)

/dt +by(t)-a

(note a, b can be ao, b(t))

Rule: (must memorize)

General

solution:

y(0= ---

t-<a

-lbat ( e -Jbdt (c+

Ia"

Ioot

dt;

oalled complementary

function (arbitrary constant c) = deviation ftom equilibrium

jlat e -lbdt ( Jua dt)

d

is called the particular integral rntertemporal equilibrium level of y (t)

StabiliS, condition for this rype of

ifferential equation:

if lirn

t ---t a

"

-ftat

0 " = theny(t)dynamicallystable.

e.g.i+4y=16
tben solution by above formula

y(t) : e -J+dt (6+116e j4dt dt)

-ja at: -4t+cr

we lump cl to constant c so here we just ignore it for the time berng

e -4r (c +J

16

4t dt)
there is constanl c2 of integration which we lump to constant c as well

: e -4t(c+ (16/4)e4t)
^ -4t -+ r - c ^

- e

ts the solution

dt : iO t(t) =d(ce-4t+ 4)ldt: ce-4t(-4)+(0) :_4c : 16-4ce -ot -16

check solution by differentiafing dy (I) /

e.4t

-o'+ 4) = 16-4y(t) _ - 16-4(ce t i(t) +4y(t):16 which is t}le origiaai differential equation
and

lim e -Ibdt c: t --) co

dynamically stable

tm e -l4dt c: lim e -ar c: lim c /(eat) : t --+ oo co t co t

___+

-__+

2d

order bnear dif,ferential oquatrons

j(t)

+ br

j7

(t) +

b2

y(t)

: a

a, 6 ,bz

constants

2 parl

Particular integral

v,

f: b,*o jfit u, =o
I oo t'

complemertary function

!o=Jt+Yz
rr,

*o

Yr =

Are"t
A1 4,2 constants

l;*

b'1=b2=o

Yu = Azet"

rr,12

j : - u, t.,,6 -16. ----i=----_'

+ 4b"
(and

br2

if

O12-4b2)<0

+
if
solution
b12

complex root)

4 b2 then

-A.1 eft +,{2

t e(

y(t):

yn +

y"

Stability Condition for 2nd order linear differential equations

with distinct or
repeated real roots

complex roots
___:! < 0

_h

both

11,

r2<0

ri>0
U U

convergent
,. il ( .- e--'--_+

not oonvergent

convergent

U aS t__- oo)

Econ application: Suppose market price P(t) of computers at time t is adjusted by hvo factors:
1) excess Demand : D(t) - S(t) with excess D(r) 1+ r19t

/\

2)

unsold inventory for period [0,1] p(rl with unsold inventory | at time t unsold inventory = total accumulated past excss supply S(t) - D(t) represented by

(assume excess S(t)

tr.^. )15\r)0
.

>

0),

D(tlldt
"As

Given

s(t):E +G P(t) ; D(t): H + J P(t) E, G, H, J R ; assume G-J * 0

Find the price path P(t).

We nore: S(t1=
and we can

6P1r1o"46Q): JP()

write price adjustment differential equation as:

p(r)=atD(r)-s(t)l- pllsk)-

D(t)ldt

o, B

>0 [rrr-D_32]
f
continuous on closed

We differentiate [II]-D-321 wrt t: p(r) alo(r) s(r)l = - Bts(r) - D(r)l -

[Thm: function

interval[u,v]; V

te

[u,v],
F

F(t): ltfQptl

'(t):

f(t)l

P@ = zUPO - GP@) - BIE + Gp(t)

- H - Jp(t)l

+
)

P{0 + gg_!y{t) + p(G - J )p(t) = p(H -

E)

nore B(G

- J )+

br
pp -- PIH

b:

in solution formula

\ \

plc-Jt :lH tG-Jr

- El

-El

- alc - Jlx 1!(-a(G - J)),

2

_ 4BlG _

Jl

\,7 t,. \'.

.r Pc:Ar e'

Assume (-a(G-.I))t
+ Aze

> lpyC-4>

real & disrinct rr, rz

A1 , 4,2

arbifary constants

P(0: Pp +Pc

, \)\ -.\,i

3. Exact

l"order (1"'order derir.ative, multivariate) differential equations [Remark: most economic books are confined to 2-variable difierential equations e.g. ii(t) : fl t, u(t), ri(t)l

Given:

d F (y,

t):

(0F/0y) dy + GF/A|

&- 0

Find F(y, t).

ls

steo: check

ifexact differential <ion by checking

a2F _ a2F dtdy dydt

2"o steo:

if exact, go to 3'd step. otherwise maybe able to _make exact by multipryine by an integrating factor (a multiplier) then go to 3d step.

3d step: find solution by successively partial integrating

e.g.
dF(y,0

given differential equation

:4::_dv +$f

+qtJ at :o

[3_3_t]

2"d.: multiply whole equation by integrating factor t * *

[3-3-l] becomes 4ytz dy +@f t+4t )

-av^{ a
3d:

I\

dt:0
exact

fr{+s,t')=ts,t fr{tfr)=ttt =

re-arrangeterm"

ff=+f
y

>

OF=4ryz4
instead of constant c
some t terms

and partially integrate wrt

lar

!+vtay

=lr',' *of,l

lefl

After getting F, tale derivative of F wrt to t to e"t dF -' ot

ff
+ +rt

=4v't+G'(t\

which can now be equated with the given

ff

+tt

=G'(t)=4( + Jc'(t):c(r)=J+t' tF(y,t)

cheok

at=

lt'

+c

= 2y2f +4Bf +c
9l- =4w'

4=4vt'?

fu'at

+4t'
o

ar

: $ay * $a t = t|Gfi)dy + (4y' + +t;dt]= av' a

sarne as [3-3-1]

** If3 integrating factor: Rule for finding integrating factor for

1$ order nonlinear

multivariate differential equation. *r--r

"rdF)) I llql-1E11=rru) aoo.,h.o .I',,,0, isintefuatine /Ar ir (A)'lfaF)l-t---ry '

f"/ar)

(ait.)
[

^rart ^(ar't) ol;i "ltr , - I '-, ,. aFl ry _ a a l=sttl alone then tJst'xt t integratrngTactor ^,
r

avl

r, llc2 J

i,l'

''" . .. l- . ++{ aompreviouspage

'',,
chcck (A)

.:

:,

, raL%t _at*Ji

/L. ____:__ | |
t .

jJ'-A

4y-* 4* 'c

.\ | r+q _ 6* ''r -+a u L s l= (-

li-'
-|

/1.,

r^

a fimction not

of y alone

t,,.L.,, L *tr t-.-

but ofy, t
i.e.

{y,t),

not

{y)

It

rf)tr1ut '- ad ) -t )+l

qtr

I
I

| - *t0 r =

.=4rr.Xt

tl t)

=l{ -tr

-a

function of t alone i.e. onlY involve t

vl
I

(t) =

----

tien integrating factor =

^ C

.]

?ttt'lz

lJ- )i lt * ^

^ l.^t

seoaration of variables

for solving I $ order

I "t

degree nonlinear differential equation

If

equation is separable s.t. M(x)dx + N(t)dt = 0 then can

just

dx e8 -;=x-t

ot

*$=,0, - J[{ =f,ar xo 11 f -;;*"' =tt",

xo

t2 +t+

Sx5

l^ +c,

-cr =u

solullon

cnecK Dy orllerentratrng

d(t' * I *., * 17 5; I fdx) -+ t ----;1 1=g x.1.drl dx x"t - = dt

-.,.]=,*J**(a)=e ') 5 \drl

-_+

5.

Bernoullinonlineardifferential equations.

y +p(t)y=q(t)y" ) ds(t) dt
manipulation: set s(t)

t V(t)

t-

(l-n)y i;-nr-t ----- = (t-n)y-'

dy

dt

[qy'

_py]

(t_n) [q_ps]

ls

order linear difftial

don,

use formula

Solution: s(J) :
ll

-J(r-')pdi[c+

i(t-o) q

Jo-n)pdt

dt]

lylt;1t'-";
in

particular, y = y (a- by)

a, b >

called logistic or Verhulst or S-curve growth

1.e.

f /y = a decreasing function y(t): a/ [b+ke-"1 k oonstant Solution:

Before moving onto Solow Growth model, it will be helpful to have a Recapitulation of Differential Equations:
I

-dimensional (single equation) differential equations

-.../.--.-\
1

-independent variable

ordinary

multivariate : partial/total

step 0: try integration or sucoessive integration if unable to do, proceed to next step

first

e.g. Simple Endogenous Growth rnodel. step

l:

solve according to different categorization ofthe differential equations

1"' order

(l$ derivative)

1't order

linear
(no terms, no

nonlinear nonlinear
I

product linear power I > l) e.g. Solow e.g. most simple Growth
radioactivedecay Model a: dy/dt + by

a. check

if exact

separation variables method I

of

differential
b. solution by
sucoessive integration

c. if not exact, make exact

General solution v (t)

e'Ibd( (c+

ja;

Io?'

by integrating factor

if

use Cobb-Douglas

dt)

in Solow, solve by Bernoulli nonlinear

+ stability conditions
2nd

order

linear
2

5i1t)+brf(t) +
-part soln
a b2

: a Y(t):Yp + y"
b2

y(t)

br*0
b,
b,

!o=!t+Yz
br +0
=Q
Yr =
Jz

IA t'=lu '
4c
1

=0 =f,

Are"'

= Aze"'

+ stability conditions

nth

order

nth order

Cauchy Peano Theorem converting nth order differential eqution to n differential equations.

1$ order

II.

m-dimensional Differential Eouations

if we wish to have solutions, then we must [m >l simultaneous differential equations have m variables always multivariate; mostly study dynamic systems with steady states (stability conditions)l

2-dimensional (2-simultaneous differential equations)

m-dimensional

-----\ linear
I

nonlinear
I

2d order linear - trend

and momenfum modei + stability

stability using eigenvalues

stability using
eigenvalues & Jacobian

Remark: We repeat that unlike differentiation, solving differential equations are not simple and not straightforward. That is why we have different categorization of differential equations, each of which has different solution methods. Often times, solutions zue not kno$'n even.

ri(1)

Chapter

III. B.

Neoclassical

Gro*th Model

Ref: Solow, R.M. "A Contribution to the Theory of Eoonomic Growth" eJE Feb/1956
Simple Solow Growth Model (1"'order 1" degree linear differential equation.)

Given

Y1

: F(Kt, Lt )

where Yt : aggegate output at time t [3-3-3] F is the aggregate production function K t : capital in economy at time t > 0 L 1 : labour in eoonomy at time t > 0

Assume F homogeneous ofdegree

I, twice differentiable and

A2F

> AKt OLt

-----

AF AF

A2F
0

AK,,

6L,,
[3-34]
t3-3-51

Kr:(:dKt/dt):sY, Lt:Loe" ietkt: Kt/Lt

0<s-savingsrate<1 L o : labour at time 0 and is given r : labour growth rate

capital: labour ratio

How to find the equilibrium growth path??

Implicit assumption of this model: since K1 and L l are the same in all model equations ) all Kt and L l are fully utilized ) full employment of both capital and labor are implicitly assumed.
[Standard manipulation of macro growth models: transfer the production function F with two inputs in to production function f with k t: Kr / Lt ratio:

Define(kt)- [1 lLtl F(Kt, L1)

we multiply both sides of equation [3-3-3]

by I / L I
since F homogeneous degree I

+ Yt lLt: F!Lt: also ll

F(Kr

lLt, Lt/Lt):F(k,,1)

of

f ft 1) by definition of f

t Yr :L1 f (ki) :Lo e" f(kt) alsoK, : kt Lr : k. L6 e'I

differentiate wrt t and get

)dKt/dt:
also

kt Loe't(r; + dki dt Loe't

sYr = sLoe" f(kt) t dk/dt:s[fft1)] - rk1 )

is

ll

) ) ,k,* dk/dt =s[r(k,)]

k1 time path moves according to s, r rates
[3_3_6]

l*

order

ln

degree linear diffarentiar cquaron

[Given F is conoave, how about f? Following two lemma show if F is concave, then f is also concave.]

Lemma:
Proof:

f ' (k, )

= Marginal Physical product of Capital

MppK

Knowl/L1[F@t,L)J =fGr)

t F:Lt(k)

aF al.tf(k) : MPPK:---dK. 6K,

a(Kt,Li) a( K') Ltf'(kt)-----------= L,f'G,)(1/L,) --- = f'(k,) 6K, dK,

Lemma: Kt Prgof
o

Lt > 0 t
-> diminishing ftrum

A?F

-ir,rto
ro tabour

ifandonlYiff

"(kt)

<o

a'F a aF a all4f(k,)l a a(K,tL,) : -:-[f(kt)+r,r f '(kr)-------------l ---. : --G--, : ---G------) au, aLt aLt 6Lt 6L, ar4 ua3-,
=
f

<

'(k,)

(K. lln

6L,

lLtf '(k1X- Kt /Lt2)l

/^-4<--=-J

f'(k,X- K' /rnz) +

----

a14

tf'G,X- k, )l
+

f'(k,X- K,/L,2 1" If'(k()(+K, /Lr2 ) f"(kt)(- KttI.:x-k,) f"(k,)(- Kr t\' )(-K, /r-,) : f"(kr)(k,2XliI4) k,'> o t +: .0 ifandontyif f "(kt)<0 dL,"

f"(ktx- Kr lLtz X-k,)l

(1/14)>
0

We see that [3-3-6] the equilibrium growth path d h / d

:s [f(k1)] - rks

or

a lsr order

diferntirl equation

To solve this differential equations:

if

f(k1)notknown diagram and

if weknowf

(():

or we don't want to

solvef(\):
use phase

to show the path movements without

use various rules according to category

off

actually solving the dilferential equation

particular example

whenF(K1.

0 <q, < I which is a Cobb-Douglas funotion, homog ofdegree

Lt ): L, to K,o

t f(k,):1/LtlF(Kt, Lt )l :1/LrlL,lo : Lt o Kt": Kt" / L,*: k,o

K," l

and [3-3-6] becomes

kt :slkt"l -rkt

13-3-jl

a nonlinear ( .' product k1 " ) differential equation Bernoulli differential eouation can be solved by setting m(t) : k1 t cL + 0,1

-"

+ dn(t)ldt : (1-o)\ tr-c''r-t dk,i dt : ( 1-o)\-" k,

(1-a)
(s
1.d

Ikr"]

- r k.)

r\t

: (1-ct)[s -rk,{r-"1 : ( l-o)[s -r m(t)] )

--J--

hansformed into a l"torder linear differential equation in the form a : dy/dt + by

(1-cr,)s:
solution by formula:

m(t)/dt

+ r(1-o)
[c+

rn(t)

m(t):e

-Jrrr-u)dt

it f-a)se Ir(r-d)dt dt j

f ,rr

f(kt

f(kr) s f(kt)

04s4I

f'> f"<

;J'

n')

concave functi on

equilibrium

aa.

whererkr=sf(kt) when i. = o
7t
<oLc|.J Aga.rll-l
FldD,L-

for thase

i agram

(@9e- .L.^+t'*

&.L

('*D

:e :e _

-lr(r-{r)dt

[. +

j( t, cr; s e .(1*)t dt1

r}

-Jr(r-c')dt

[c

{(1-o,) s / (1-o)

( e .(ro)t +c2)]
+ c2

e -r(r{r)tc+ (e -L(tcltr, s/r(e r(r*)t,

(l-o)s)

- . -r{t-c)t"+ {s/r} + e - .(1-")t{ c(l-cr)s) : e - r(r-".)t (c+ (l-cr)sc2)+ {sir}

let
oonstant ca

(c

(l-ct)s

c2

) t3-3-Sl

m(t)

="

- ro-c,)t

ca+

{s/r}

in particular at t =

m(0)

:(1)ca+ {Vr}

I ca: + :;'

m(0)

{s/r}

t3-3-Sl m(t)=e-'('-a)t (m(0)-

{si4) + {sh}

since

m(t): k t-"
1r
r -ct

- e '0-)t

1mi0;-1s/r)) +{s/r}is the solution (no derivative/partials)

note 0 < cr. < I

0 < 1-ct andgivenr>O (population growth rate)

0

and iim e-'(r-,,)t t-+co

>0 >0

-->

as

t-+

co, i.e. over time,

k t-" -+ 0+

{Vr}

= k -+

l-"rl

s/r=

(s/r1 r/(t-"1
t r<t
-

Econ interpretation: Equilibrium gro*th path when capital: labour ratio-+ (s / r; Bquilibrium level dependent on s savings rate (related to investment rate) and r

"

population growth rate.l Above is an equilibrium dynamic growth model. To extend it to an optimal growth model where some objectives are optimized, we need to cover Calculus of Variations or Pontryagin Optimal Control Theory or Bellman Dytamic programming and add in more variables/equations to t}re above simple Solow Growth Model.

Chapter IIL C. Optimal Growth Models - Neoclassical Grow.th Model using Calculus Variations

of

in 18s Century, Newton and Leibniz

were vying for calculus primacy.

Newtonian mechanics model: Newton wanted new type of math for dealing with motion and forces (represented by vectors) operating in physical system. Approach: equations of motions (represented by differential equations). Simple cases are solvable but typically coupled (i.e 2-dimensional) vector differential equations are very formidable.
On the Continent,Leibniz, Bernoulli (farnily), Lagrange, Euler, Poisson, Jacobi (French, Italian, Swiss, German mathematicians) tried to develop a more general theory such that Newtonian mechanics becomes only a special case. Such development actually stemmed from Galileo discussion in 1630 to find the minimum sliding time of a particle moving from 0 -+ pby gravity. The problem (called brachistocbrone problem) was solved by Joham & Jakob Bernoulli and also by Newton and libniz in the early 18* Century.

P&e,tr)
Euler further deveioped this formulation into a branch of math in 1744 called Calculus of Variations (to find extremals and form basis for Newtonian mechanics). Euler and his fe1low mathematicians on the Continent noticed that Nature has certain general properties that conform to principle ofeconomy or simplicity.
e.g. in optics: Fermat's Principle which as stated by Fermat was incomplete but basically says that actual path between 2 points taken by a beam of light is one which is traversed

in the least time. (minimization)

e.g. geodesics : -- moving bodies seeking the shortest distance between two points on a surface. (geodesics are actually cuwes in which distance between two points on a surface is a local minimum -.- like Great Circle route when traveling the globe. Einstein used it in his general theory ofrelativity where his curved space-time has geodesics --curves in which the distance between 2 events is a local minimum). e.g. soap bubbles: deformable thin

film objects will take the shape that minimizes

surface area.

e'g in electromagnetic and erectrodynamic theory: electromagnetic phenomena also follow similar minimum principle.
mechanics: particles system organize themselves into equilibrium -statistical configuration that minimizes their energy lHaiitton's rrincipre of reast action: motion of a system of particles explained by J T = kinetic energy u : potential energy.) e'g'

i u

e'g' in thermodynamics, trre dissipative processes maximizes the dissipation rate.

The- above approach is called I.agrangian dlmamics and later Hamilton (rish mathematician) focused on slightly different emphasis calied Hamirtonian dynamics establishing the most general formulation of mechanics.

Basic idea: look at the movement of a particle in a trajectory from point A to poinf B. We perturb the trajectory by a very smill amount ut poirrt of time between A & B and then minimize the perturbed trajectory to get ..rtubi" th."ll".y o. stationary,, trajectorl,.

Note above all extremum principles (least, min, shortest etc) and can be formulated by

optimize

called integral principle or variational principle

i..;,ft"::

path, stable path) arbitrary variation about this correct path will lvaiue the minimum.

simplicity principles expressed some stationary path of line integral (correct

of

rine integral and will not be

variational calculus - rook at relationship between corect path and all arbitrary path in neighborhood ofconect path in order to get the coriect path solution.
c

coraect path

c' arbitrary path in neighborhood of c

i.e.c'(x)=c(x)+
I

c(x)
\'a"t

variation pathvariation
parameter

l\+

c' continuously differentiable o(x) goes to zero at end points

pl

p2

many c' possible

idea is extremizing arbitrary integral

I = I Ftt,x(t),i(t)1dt
t6

tr

(t):

(xr(t) ,

x2

(t), x3(t)

...

,x.(t)

Letl(e) = J p(t,xG), x(e)) dt

g0

ll

the stationary path has the property d For I to have an extremum, its Equation

I/d

l_

=0tomakeX(e)

-y

f'st

differential dI must

0, solve and we get Euler,s

AF

oxr

- ---

AF

dt

dxi

:0 i = r,2, ... ,m
a 2nd order

differential equation.

We state this as a theorem:

Theorem:.In order that x(t) maximizes integral F x(r), [t, condition is Euler's ta

AF

equation daF
t
Oxi

tr f

,i

6y1

t,

the necessary

6xi

)=0

i=1,2,...,m

Proof: Please see Takayama [1993] Altematively we can prove it by using the operator 6 similar to change, A, d, called variation ofl s.t. (dI/del]rd. = At
Given F tt,

rtt)

).

x(f, i1t)1

let

,(tJ + rl1t(t)

rn ariitrary constant, g(t; aruitrary * F - F t-t, x(tF mg(t),;(t)+mc(t)l . .F g x(t), function but g(t6) : g(t r) :0 s.t. x1q:49 + mg(;) at to t r . By Taylor eifansion

i(,)

+l

x(t):

x(t6 ) +

(to ) ( t

- to)

+ '"'(to ) (t
= F [t, x(t),

- to)t
i(t)]

/2!
a

+ ....

F [t, x(t)+ ms(t),

io+mg@]

*
:

ra

* (mg) + d F /d i
x(mg) + a F ia

(.g) * ....

r'[1,

x(t)+ mg(t). x0)+mg(t)j -F[t, x(t), x(t)]

OF lA

t,/
l\t,

i (-!., - ....

define

o1

uu

I l+>)

IfF=x

6x =dx13x
I

(mg) +

A x /A1.

@g) : mg (definition

of 5x)

IfF=;

6i:ailax
01

1mg; +

a. oxldx(mg) =mg
.

6 F=(6Fldx) (5x )

+ (aFlai)(6i
""o"tul

t1 'lggsf: tl l.t,x(r),i(t)l dt:0 r larp,"1t1,i611 ot:o "o"+., ) Jl(aF/dx)6x + (dF/Ai 1o dr =0 )6il

JftbFra$me

Necessary condition for findi page 4l4in Takayama

in dynamic optimization (please see Lemma on

: Llno
{(aF
=
J

+ (aFlai)nll dt:0 = I(6Flax)s + (aFlai)El dt laisl dt + [116p 16i; !1 at

ll(a tr

F /a x)gldt

@F

/a\)

( inteention bv earts

lpn' -prr-ltp')

sf
o

f",

to

rr,

1 (a F /d

)l ) dr

but g( t6)=C(tr)

:0

4n

i,{tdrlaxl - d/dr[ @F/ai)l] e dr =0

il

0...
(dF

/0x)

d,/dtt (aFiai)

g arbitrary and need not =0

Euler's Equation

which gives.necessary condition for dynamic optimization is 3]i-!y]"t.r first order anatogous to :n.ation condition in math piogramming problems.
The analogous sufficient t'2nd order) conditions are known as Legendre, weierstrass, Jacobi etc conditions. e.e. Leqendre condition for suflicienf: for minimum F *, 2 0; formaximum F-

,. <o iun"r"*l='J;ii";il'.'-''

*,

M* j f (t, x(9, i1t.1y dt s.t. boundary conditions x(t6):aandx(11):S

Most math econ coruses iust cover the.necessary condition (Euler,s equation) and assume the 2no order conditions are checked._ ett"-utiv"ty, iir ir-a'irr"r"rrtruule and concave in x(t) and x (t), x(t) twice or*l:r]i9|":-" = b' then Euler's equation becomes the necessary "lor"d and sulficient condition for x*(t) to

#;ii;bl *h";;i;t=ffi;i;;

(9

We employ Euler's equation to dynamic optimization involves maximizing or minimizing an integral which define an area under the curve F, F being a-function (time t, function x(t) and derivative function * (t) for the time period [t 6, t 1]): {r

of

Max (ormin)

It fr, *ft), i ttll a r to

to

s.t.

boundaryconditionsx(re):aandx(r r ) =b

are. dealing in space of functions, JF is called a functional. The solution of lince 1ve dyramic optimization is*a funclion x*(t) without any derivativevpaniars and which opumrzes the mtegraI J F (t, x(t), i(t)) dt s.t. boundary conditions. The funcrion x*(t_; is caf fed an extremal.

'

It now becomes very easy because we know if we wish to max J Fftt, x(t). i(t)l dt we.just substitute integrand F into Euler,s equarion form, solve,ff" F Euler's equation and the solution is the answlr. "ii"iliiitr"*r"r
Hence: static optimization

,,

dynamic optimization frnd function x(t) max

find point (x1, xz,

x:, ...,x^)

which ma,x objective function f(xy, x2,

I .r rd

t;
F 1t, x,

iI

x:, ...,x,n)

just plug F into Euler,s equation to get possible extremal solution x*(t) (a function)

('.' Euler's equation only necessary but

not sufficient condition, unless F concave) Math example of dynamic optimization

to
C

lustrate above discussion:

a

How to calculate length L of any curve

Pythagoras

joining points

x (t 6 ) and b

x( t r)

theorem

dl z :

d.

t2 +

x,

+dL2 /d,t2 =l+dxz/d( ) dL / dl = V! d;./ dtT

=

>cct) .

{r +l?tr

add all d L with t

-+ o (i.e. smaller & smaller intervals)

J dL Ike adding up all points on C and not adding up all area urder the curve.

... there,s no dr (width) in integ.alJ,

cet

f'dL : <o

: Itrr7T *;ioit

= lenglh of any Iine joining a and b

what is the shortest distance between a and b? (i.e. find a line joining a and b that shortest length). We iust solve ' "rn ;,,7- d t -minimize lengrh of line joining a and b min L : min f.tt7-

has the

ts

"

we recognize this is a calculus ofvariations problem and now know how to solve: step 1. Just plug the integrand as F(t, x(t), x1i)) into Euler,s equation:
same math example as above:

F: {l + i (t )2, integrand
AF
(as there are no

dx

x(t) terms, only

terms)

at

d ,l d '6Fr :--1"% -t---l

\ail

dt

(l+ i'z) % zi1 1"hain rule;

.,.............-d/dtfk /^,1 (t+ *')l

t
Step

Euler's equation

0: d/dt[il./(f+ ir)]

2: solve Euler's

equation which is a 2nd order differential equation.

t
=

i o at

J alat t
,,1

ti t.l tr* 1

ilt
el

at

) ct : \

1t+ ir,

constant orintegration

Jt'J-;?;-ar

-cr2: lcr' )
c12

12

t1t+ *21 I cr2 +cr2Vt =

'*z

= |t-cr';2=11 -c,2;i2
/11- cr2) =i2 let ll
^2

) c=i

i c dt = j i at

>,

c2 constant of intesration

t + c:-= x (t ) is a linear equation.

representing a straight line ) shortest distance between 2 points is a straight line.

golimintion. (optimization being the cornerstone of modem econ). ts.g. sorow Growth Model describes continuous equilibrium growh path based on ,uuirrgrlo. we now study models with growth objeciive optimization, i.e. optimal "oo.o-ption;. growth -odels. '

So far all growth models we studied are equilibrium models without

explicit

trf

Neoclassical Growth Model

Ref: solow' R'M' " A con*ibution to the Theory of Economic Growfl,, eJE Feb/r956
(Using preliminaries we had in Chapter III C. we look at a more elaborate solow,s Model and then introduce optimization ofgrowth objective.) Assume at tlme t' economv orgluces a composite product calred nationar product y, with 2 factors ofproduction labour populati on) L 1 and capital K, 1:

Yt: F(Lt,Kt)
:Jffi

Given aggregate production function: where = labour in economy at time t > 0 K 1 : capital in economy at time t > 0

Lt

[3D-1]

;i""$: A,x:ffif,1ffi#T'o
AF

t' = R2,
a2F -;-;,-;' 0

homogeneous ordegree 1 (constant

AF

----- , ----dK, 0L,

>

a2F
0

; i;

'

1ai'nini'hing."tm lvith

'espect

to each factor)

(Remark: an example of a fun;tjo_n th3t satisfu all these assunptions is Cobb_Douglas functionF(L,,Kr): A L,1-" i, fJ"'

K,"

t: Xr ; aggegate investment at time t = I t Equilibrium condition: yt = Xt * I t (i.e. aggregate S: aggregate D)

let

let aggregate consumption at time

"

t3D-21

= constart a depreciation of existing K

t

z gross tr = Kr +
new net

UK,
.eplenish depreciated srock

inveAent

in K: *, o, \

[3D-3]

assume

L1

: Loe't

Lo = labour

r :

at time 0 and is siven

labour growth rate

o

[3D-4]

Xt :

(1

-s)(Yt -pKt)

f I ::

(oc savrns

behaviour)

t3D-sl

average propensity to consume

This model has 5 variables L s,

K , I, , Xt, y,

and 5 equations.

implicit assumption: full

e-ll!4nent of all factors, since use same K1 the equilibrium conditions and other equations.

L 1 in

forll >0 t t

define

kr= K, /L,

capital: labour

ratio

yt= yt / Lt

l/ Lr {F(L,,Kt)} = F(1, Kt/

Lt)o"on"

= f(k,)

F(Lt,Kt)=Lt f(kr) :

We recall the following 2 lemma in Chapter III. B.

Lemma: f ' (k j )

Marginal physical product of Capital

Mppr

Lemma: Kt

Lt > 0 )

a2F

AL:

We can also easily show following 2 lemma:

Lemma: MPPL

AF / ALr =

f (k1) + f.(kt) (_k, f,(kt)(_kr)

Proof: F (Lr, K, f(k,) :>aF /aLt: )=L, +L, f,(k,)(_Kt/Lt2):(k,)+ f(k,)

a2F

Lemma: K,
Proof:

Lr > 0 1

6K"
0

62Fl6K,2 = o

ff,(k,)l/dK,: f.,(k,)1r1il,; Lt >

Lemma:

L1/L1 =r Lee'tr =L1

X1

Proof: L.=dL,/dt=
NowYl = Xt * Ir

+(Ks + pK,)

t3D_6]

Assume L 1 ) 0 (atways and(r/Lr ) [3D.6] get aa

need

labo*); we define

t=Xt/Lt

(per capita consumption;

f(k'): x, + Kt/Lt + pkt

note k1

: d(Kt/Lt)/dt :Kl(l/Lt)-Kr(LrrlLt
: Kt(1/L, -Lt(Kr/Lt2)
.a

2)

/'" =:>Kt = Lt(kt +Lt(kr /Lt

A _:=lL -.'- & Lt'

))

,1

:+(kr):
a

xt + Lt(kt +Ltkt /Lt))i L1+ pk1

->kr:f(k1)-(r+p)k,-x,

kr, xt > 0 , x 0 specified, equations Kt, It, Xt , yt )

.

[3D_7]

called the neoclassical aggregate feasible growth path. Once initial condition ko the attainable path_for (L1,

[3D-7] will be

Note only used 4 equations and3 variables We add the other equations and variables.

kt (Kt, L t )

x1

many paths possible.

-;

from[3D-5] (l/Lt)JXtl = (1/Lr)l(1 .-s)(y1 -pK1)l xr : (1 - s) [f(k1) - p k1 ] substituting into [3D_7]

-1

kt: f(k,)- (r+p)k1 - (1 -s)[f(kt)-p kt] : sf(kt)- rk1 -trrk,+pkr -sp kt : sf(kt)- (r +sp)k,

If

we i.ntoduce the following assumprions:

(A-5) 0<s <l

I

(A-1) f'(k,)> 0 f..(k,)<0 v kt> 0 (A-2) f(0):0 (A-3) f '(0)> (r +sp)/s altematively (A_3') f ,(0):co (A- ) f '(o )< (r +sp)/s altematively (A _a,) f .(oo):0
- I ) .-- (A
5

Theorem (Solow) Under assumptions (A

)
constants k s6bv', xs.q6w

feasible and unique growth path (k sobw,

XSolow)

s..t. any attainable gowth path with oc saving behaviour will converge monotonically to (k s"r"* , x sorow ) [i.e,. k1-+ k solo*, Xt -) X sotow ast-+oo regardless of initial k0 > 0] and (k soro*, xsor*) determined by sf(kso6*): (r +sp)*ks"6* where kt:0

and

xs.l.*

:( l - s)[f(k s.lo*) - p ksolo,u]

from [3D-5]

such a (k sorow, x sorow) path is called Solow's path.

The following diagram depicts the proofofthe above theorem.

C**tffan

t(kc)
A;6.4)r<

.r

t3-lJ

':ttt

z4.b dg.Note Kt / Lt :
K sot"* rs constant

(et-=o)

K1 and L1 both grow at constant rate I and Xr

('. : L,
)-

grow)ng attate r)

I Yt )

also both grow at constant rate

andXt/

Lt:

r (. Yri Lr=
[i ksoro*]

(1

s) [f(k

soro*

f(k soro*): constant

constant)

I r aiso glow at constant rate

r ('.'It:yt- X, , both y r,X r grow at constant rate r)

called abalanced growth path

(L,, &,Ir, Xr, yr

K1

): L,t-o K," 0< cr < f(k1)= l/L1 {F(Lr,K,)} = 7/Lt Q-t1'" K,") = (Li" K,") : k," I Solow's path s f(k solo*): (r +sp)ksor"* I
)
s

If applied to a Cobb-Douglas production function F(L 1,

k s.6*,"

: (r +sI)ks.,.*
k.o,o*t-*
(analogous resull in Ch Ilt.B.. using Bemoullr

t s/(r +sp):

V- cooslanr , ksoroo= ''-''! s/(r

diffrial lion

-sF)

L,>0.

Higher s &/or lower r

Econ interpretation: we see from above equation, an economy's savings rate s and labor growth rate determine capital size and thence affect the production level.

higher output level and highei per capita oueut.

Solow type growth model was used to explain why postwar Japan and Germany experienced rapid growth (due to high savings and investment rates). It can also be used to explain why high population growth rate countries like India and china have lowerper capital output growth. we caution that grouth determinants are more complicated than as proposed by the Solow model and there are many other considerations.
We note above k soto*

) K,:

k soro*

Lt

constant

-- ray fiom origin

K1 ,{L I

(0,0) with slope d K1i

dL1

soto*

SoLod f*-q

(*t't- \*r;;

(+oF.>

Lt
but Convefge tOk Solow fOY. lRefr

[Ast-+"o kr-+ksoro*

**> (Lv,K1) )kso6*

ray. In faot ca'show it cannot

leb/t9ro]

Deardof, A. v. "Growth Path h rhe sotowNoclassical C,ro$rh Model eJE

Another econ interpretation: Solow type model is based on X consumption: t constant i ol. Y t which means average propenslty to save ts constant regardless of inoome distribution between L land K I owners. Shortcomings: no money/finance, no tech progress, no intemational trade ... in the model. In addition, solow fpe growth model cannot explain the sihution why most countries, after reaching the steady state oueuf level, can siill grow persistently. To do so, we need to have exogenous technological progress to launch growth onto a niw equilibrium paflr.

But in 1950-60 much discussion on growth models and more and more jargons. For example: Definition: Golden Age Path - is a ne oclassical feasible path ft i, x 1 ) with k 1, x I both constant over time t . ) set ofall balanced grou.th paths of(L r, Kt,I,, Xt, Y1 ) satisfying [3D-l] [3D-2] [3D-31 [3D-4].: set of golden age paths. Sincekl= constant I kt: dkt/dt:0 on golden age path ) Xsoto* = fG s"r"* ) - (r + p) k s.1o* from [3D-7]
Growth theory was firrther extended to

Optimal Growth Theory (some growth objective is optimized)

Note from assumption f '> 0 f"< 0 ) f t slowing whiie (r + p)kl tconstantly I x; function bonding down i can find k* which max x t globally.

find k* from 1't order condition:

dlf(kr)- (r+p)k1l / dk1 s"t:0 + f'(k ): (r+ p) tosolve fork*

2nd

order condition

fconcavel fft1) - (r + p) k 1 also concave and 2od order condition satisfied. We have
both necessary and sufficient condition for

k* global max. Hence we get following:

Defn: Golden Rule Path: path maximizing per capita consumption

xi

at every

4
*tx

k+

Theorem: Under assumptions (A

- l), (A - 2), (A - 3 ,), (A _ 4 ' )

where

3 unique golden rule growth path (k*, x*)

xr:fft*)-(r+p;k*

f'(k*) :1+ p and

Econ interpretation: Golden Rule patl to max per capita consumption x, ) marginal productivity ofcapital f' (k*) : labour growth rate + capital depreciation rate.

Problem: initial L,2, K,1 maynotbe on golden rule path of ft 1, x1) ) need additional assumption s.t. k e : L 6 / K 6 converges to goiden rule path as t _+ oo .
Policy implication: Note the appealing nature of the above various golden growth path to a politician or social planner. For instance, he oan try to manipulate labour growth rate and capital depreciation rate to equate them to marginal pioductivity of capital and tbus guide the econ to grow along an optimal path thaf maximizes everybody's consumption. But note the limitations and the unrea.listic assumotions of the_ model. More modern growth theory concenfiate on technological progr..., including knowledge and labow productivity.

Macro optimal growth model using calculus of variations.

fGrowth models with time dimension are most suitable for dynamic optimization applioation.l

Question: what is the necessary consumption X 1 to maximize certain tarset like maximizing (stream of future consumption)

X.J
\
PV(X,)
:

Xo

X2

n *.n-

l.xt

PV(X,)

s.t. feasibility oondition and given boundary condition.

obviously making choioe between X t and I (intertemporal resource allocation) consume more (less) now invest less (more) now = = consume less (more) in the future (unless technological/labour ohanges to increase (decrease; pioauciivity;.

L^TgR

,lad1..$

aeqs s4 71-q

c'
&rt

tv1

We now start to build optimal gro*th theory based on previous model. Assume:

; L,>0 It=r(r,,K) of degree Kt>0 [3D-l-ll F homogeneous I & ooncave = Yr - X, (=I,) {''.uK, r t3D-l-21 Lr / Lr :
From previous discussion we get the

[3D_l_3]

feasibilif condition as summarized by the neoclassical aggregate feasible growth path [3D_7] :

kt: fG,)- (r+p)k, - x1

kt , Xr >

Question: Find optimal time path of per capita (divided by population) consumption x 1= X I / L 1 that satisfies the target of max

T J x,

s.t. feasibility [3D-7] and boundary conditions k 6

,k

{max total sum ofper capita consumption over planning period [0, boundary condition.l
(We rccognize this as a d).oamic optimization problem)

T]

s.t. feasibility and

Problematic points: 1) planning time horizon [0, T] is crucial because if the two cwves in above Figure converges over certain time nterval, the height difference between the 2 curies have different econ interpretation. So who decides which plan, S_year, tO_year, 50-year plan? 2) should population exhaust everything on or before T, if not, how much K1 Ia should remain at T. 3) if r very far ahead, we wi have technorogical changes(computers, more efficient --^' production methods etc.), labour changes (better training aod education; trr"i affect the factors productivity; also soiio_political changes (from common to private property rights, from planned scon to decentraliied market econ), as well as X 1 pattern may change (taste, customs changes). In the.literatwe, always igaore all these points and assume T_+ oo paliooule . being all eligible paths closely approach fixed balanced growth paths all paths root uuo,it ,u-" for very long T horizon. obviously math is moie simpiified. Ifnew technology, til"" ."do problern with new tecbnology incorporated in model and let T+ oo again.

function ... ..

Broaden flre x 1by u(x 1) where.u is society's utility function, maybe sum of all typical individuals (e.g. all clones) utilib, functions to avoid interpersonai utility comparison, which are-very stong and unrealisfic assurnptions. But then whole ri o" strong ard unrealistic assrrmptions rike a "national product", "r.u"." ""it,

aggregate production

Objective now becomes dynamic optimization problem:

max ir u(x,; g-ot dt

st
where u defined over [0,
co

e- pt

djscounting teru and p discount rate.

to feasib iry [3D-7]

) strictiy concave and twice differentiable. Lr= f(k,)- c.k1 -x1 ; cr: (r+ p) and boundary conditions

present generation

Econ interpretation: p > 0 ) discounting utility ofour children compared ) ethical and interpersonal oomparison issues involved.to utility p:0 no problem. In the literature just assume p > 0

of

So dynamic optimization problem for Optimal

Grovth Theory now looks like:

rnax Iru(x,1s'ot o

dt

p>o

s.t. i,: fG,)- crkl -x1

boundary condition

kr ,xt z

[3D-1-8]

k6>0 kr >0
p>0
[3D_1_e]

max

[f(k,)- ak,-krJ s-ot dt

k;,x1)0

ko>0 kr>0 )
ofpaths.

How about convergence: ifassume satiation, then f bound from above and if+ assumption *rat econ productivity 1 then bounded from bel0w convergence

{e se.e t}at [3D-l-9] is a dynamic optimization problem which we can solve by calc'rus of variations.
To apply Euler's equation, the integrand

O:

u [f(k1)

- gk1 _ir 1 s- ot

) set
a@

aodao
6kr

--- ( --rdt 6k,

0kt

'[f '(k,)- 0.]e-nt ) : --6k, dt

d
;* dt

ao

( - -;-

[u

' ( - 1 ) e" et

] : [-u" i, s-0,+ u.(-l) e-o'(-p)]

:
Euler's equation

e-pt

[_u..i, + u.pJ
' [f' (k,) - cr] enf '' -e - ^t'[-u"x,-u'p.l

) [u'f '(k,) - u'cr - u. p] / -u,, : )i, : (u'/ -o,,)lf.G,)- (a + p)l

Sinoe O strictly
concave

Xt

...

u shictly concave on finite T)

Euler's equation is both necessary and sufficient condition

for x,

optimum.

solve for from system of differential equation, i., -Euler's to get the solution path (kt,xt called feasible path.

kr xt

)-

,i, at k6 , k1

Assumptions

u'>0 u,.<0 (A-2)f.(k,)>0 f..(kt)<0 v k,>0 (A-3) f'(0): * f'(-):0 f(0)=0 (A-4) lim u(x)--+ -o osXt*)0 xq)0 (this is to guarantee
(A-1)

+(&+)

interior solution but note tlre extreme disutilitv of low consumption period as x 1 -+ 0 )

eQt

({&+\

&-A
ollrerenuat eouatrons:
a

.&"t

f11maryis: Euler's

path is (k t, x t ) satisfuing following system of 2 simultaneous

kr: f(kr)- ok1 -x1

x1

[3D-r-lt] (o +

: -(u'/u")[f '(k,)-

p)]

[3D_1-12]

how the two solution curves behave, without actually solving for k ,,

If form offis given, we might be able to solve above simurtaneous differential equations. Ifno! or if we don't want to solve, we can use a technique called phase diaer.am

&

io

.".

Phase diagram 4ethod: 1) Set differential k , = g 1o get and plot steady-state line. 2) Determine which side of steady-state line >0 lmeansk,

Iastt;. 3) Do the same for i 1 :

(meanskl
steady-state line.

f,

tastt)andi,
i
1 on eaoh side

<0 of

0 steady-state line and determine sign

of

4) combine various directions to get behaviour of the 2 differentiar

for our above two differential equations:

1-

eouations.

A. Form the k

x 1 space. Get the two steady-state (when differential: 0) lines below.

B- From^[3D-l-l1] set

crks

constantly

dividesthekl-xl

i ,: Og
xt

from above figure, as t

tf(kt)-cr

k1l

has the

Spooe

into two regions.

Letk.

"o, f 1 but tslowing while following shape in figure and bes.t. f(k") =61L,

-+

g C. -From [3D-1-12] set and let k f .(k"1 p). Note is a vertical line in the k t - x 1 space in {igure and divides the k , _ x ipace into ,-

i, : )

"1 s.t.

):(cr +

kt:
two

k.r

regions.

0<k,r S k. by(A-2)(A-3).
fork,2 <

D. Now determine the signs of the differentiat,

In figure,

k.1 t f(k.2 ) < f(k", ) (...f .>0 ) and f '(ke ) > f '(k.r) ('.'f',<0) )f'(k*)-(a+p) > f .(k.r)-(a+p)

i, i,

on either side of steady-state lines.

lx,

: I sz -Jy-:gltt' >o K
1
k"z

{<

(k e ) - (o +p)l > - (u, /u.. ) If . G

",

) - (c[ + p)J

: i, I :

k.t

t;,

>o

and

+ xtl <0
^i3

for k":)

k"r

Similarly we can determine the signs of k 1 on either side of k 1: 0 graph. >k" f(k"a)-ak"q: x"r <0 and - x1 <0 ('. x, >0 )t e.g. af k5a

k,l=f Gg)k"+

crk5a

'x1

<0

)forkl<k"

kr>0

ra

tt: t"r
(L; o srl',4 sIrr-)
*t7o

&tto

I
Jo

I+ ne6"3"cl
J

&r*
L,,<a
i.

f-tt
{(tr). *(tal

&,

!_ (i.:o)+
56,-c *4
QX 7+.ro

xr:e \ i,."
L

')o

'*

f
o

otl ,*1
<---;n
f,a

- (.o {::-:::.

t/

I"est

f, x1l

,/.,

V,,
(<.

,,,

&L

=o
i\ r.,lr!

iF;i|
^\
,,

12\

,
&,r

&,r

the Depending on initial k o and boundary condition- .k ,' &e arrows will trace out possible p-aths which describe shape oipath satisfying the simultaneous differentjal equations [3D-l-l l] and [3D-l-12]

i,

=O

intersecting

k1= 0

steady states

= equilibrium

Chapter III. D. Growth model with nonlinear production and ininite horizon: RamseyCass-Koopmans Model.

Ref:

Econ Journal Dc/1928 "Optimum Grorth in an Aggregate Model of Capital Accumulation: A Tumpike Theorem', Ecorcmetrica Octl966 Koopmans, T.C., "On the concept of Optimal Economic Growth" in The Econometric Apprcach to Deveiopment Planning, PASSV, Amsterdam, North-Holland 1965 Smith, W. "A Closed Form Solution to the Ramsey Model", Contributions to Macroeconomics: Vol.6: No. I Article 3. 2006
Cass,

narnsey,

D.,

f. P., "A Mathematical Theory ofSavings"

T.,

The optimal savings rate in the previous section was originally studied by Cambridge philosopher Frank Ramsey [1928] who did not solve the problem completely. In 1950s the problem was revived when gro\4.th topic became popular in macro. ln 1960s Cass and Koopmans formulated and solved the problem with nonlinear production function and infinite time horizon. (Cass used Pontryagin Optimal Control Theory.) Basically we wish to find optimal savings rate path s+ r that max per capita consumption (altematively society's utility function) till eternity; noting however that more consumption (: less s 1 ) now less capital now less consumption in future, & vice versa.

Let us restate the problem with all the assumptions:

max J* u(",) e-Ptdt

e- pt:

discounti ng term, p discount rate.

[3-E-l]

s.t. feasibility and with following assumptions:

tA-31 f(0):0, f'(0):co, and lA-41 lim u(x) )-co x>0

[A-1] u'(x,)>0 & u"(xt)<0 Vxr)0 (strictly monotonic & strictly concave frurction) f"(k1)< 0 V k, ] 0 (saictly concave tuncrion) [A-2] f' (k,)>0&

f'(o ):0

lA-51

xt>0 k,>0

x-0

Vt

To solve the problem, we start with the finite horizon problem that we solved in the previous section, namely:

max J'u(x1)e-ot 0
s.t. feasibility

dt

e- pt

discounting term and p discount rate.

[3-E-1-A]

I
aa

and we get feasible Euler path solution from previous section as:

xt: (u'/ -u") [f '(k,) - (o + p)]

with feasibility

kt : f(kt) - ok1 -x1 0< k*(p)< k#

where k# is

together with the relative phas e diagam. We define: f '(k*(p )) :(o + p) and from IA-21, tA-31 k rintercept and x*(p) is s.t. x * = f(k*(p)) - o k* ( p)

@)

u, fconcave by assumptions tA-UtA -21) integrand for Euler equation [3-D-1-9] in previous section will be concave)l a global maximum & a 1! optimal savings path. We now extend this finite analysis to infinite horizon by letting T--+ co in [3-E-t-A]: get improper integral [3-E-1]. We need to check if this integral

1co J u(xr)

e- P'

dt

converges (i.e.

not explode to infinity which

will

be meaningless)

In fact, when p = 0, the integral does not converge.

To overcome this divergence problem, Ramsey (and later Koopmans) used the following ingenious method: A bliss point is where economic agents ale satiated and society's utility function starts to be non-increasing. p=o Assume ! same bliss level utility for all generations, denoted by u(x*(O)) ) due to satiation, u(x*(0) = max utility achievable for generation t Vt :

utt&)
s (x*(e))

uLro)

uptor)

aO

i,
i

-/" ,i@) .,. , Jo ' lj-L-l-bl

t* r [u(x t)-u(x*(O))] d t LJ-E:21 .*. i@ L*\..,/-...-(u)udt L3-E-21 \
which is equivalent to Min

f@)
Y_-

i \ \
\ \.

Ramsey then defined the following integral with a bliss

\ point: -\--\ . , I ' l:ou'alel'

otDeve'

,l\

tr"*'
....'"''

....

I 0

rco [u(x*(O)- u(x t)] d t [3-E-2-A]

--'*-*----..*-=,?

"
Dt =-----

-...-"

-.,,-/

To ensure integral convergence (i.e. bounded from both above & below for optimal path):

1. We assume fiom some initial k s> 0, consumption path x, is always strictly positive i u (x ) f shictly monotonically ) both integrals [3-E-1] & [3-E-2] are bounded from below for the optimal path. LL

lx+ + F-+
I

u(xt)f

V'e.>- 'i>lot)+

dt
oo

p > 0, [3-E-1] integral will converge as the integrand will tend to zero as t ---+ - Pt * ( since e 0 as t --I bounded fiom above) "o ) f l! feasible Euler's path (given any positive initial k6) tending monotonically to k*(p ) and x*(p ) as T --- o.
ofdifferrtial equations, the point [k*(p), x*(p, is a saddle point SP. We can show by lineadzirg the fwo Euler paths differential equations around SP, eigenvalues ofthe coefficient matrix will be real and of opposite signs.)
terms

2. A.lf

(ln

B. If p = 0 the integral does not converge. We use above Ramsey's idea by constructing a reference utility path u (x*(0)) and converting problem to [3-E-2]

Mar

*1u1x

00ll

,;-u(x*(O))l

dt

which = Ma* J-[,r(x, )-,r(x*(0))]e

ptdt withp= 0

[3-E-2-Bl
where u(x*(O)) is the utility level ofper capita satiated consumption for individuals. From the above 2 diagrams [3-E-1-B] with bliss point, the integral l3-E-z-Al is obviously bounded from above for both two possible cases (MU constant or falling). Hence integral l3-E-21 is also bounded from above and convergent.

""Tfl'
while [3-E-2] integrand is [u(x s)-u(x*(0))]e [u(x)ewithp:0(plssee[3-E-2-B]))[u(x*(0))]e-pr n P-E-21will drop out when we are
We note [3-E-1] integrand is doing differentiation in Euler equation the same.

pt]

-pt

Euler equation for both [3-E-1] & [3-E-2] are

Now we can analyze the Ramsey-Cass-Koopmans model:

When we solve [3-E-1]
0

M* j- u(x1) e-ptdt

with above assumptions

lThere

are four types of Euler's paths in the phase diagrams [3-E-3] [3-E-4]:

Type if xo=0and Vt This is not eligible as optimal path because assumption [A-4] means utility will be -"o. Similarly forko:0 and V V t means utility will be -co; so again not eligible as optimal path.

l:

xt:0

kt:0

ttf(0):0)

xt:0

Type 2: if k, >k*(p) V t > T , given certain T > 0 We note such type path will eventually enter zone of kt > k*(p ) andxl < x*(p ) and reach say kr2 at time T. We note from t> T, we can improve by consuming k I (disinvesting k 1 and consuming it as additional x t ) towards k*(p)and fx1 - pt towards x*(p ) and we will be moving towards the target of max u( x,; e dt.

) Ik,

it

And after we reached k*(p ) and x*(p ), we just maintain the path there and this will be a better path than type 2. So type 2 is not eligible as optimal path.
Type 3: if k, < k*(p) V t> T, given certainT>0 x 1'[ and people will keep I x1 tomaxu(x1) such type path will eventually move to k 1< 0 violating our assumption k and hence is not eligible for optimal path.

) )

t>

Type 4: if k1---+k*(p)and x1-'x*(p) V t---+ co This is the optimal path maximizing either one of the integrals [3-E-1] or [3-E-2] s.t. feasibility and our other assumptions.

Above can be summarized by the following Theorem: Theorem: (Ramsey-Cass-Koopmans) Given assumptions
p>

[A-l],

IA-21,

[A-3], [A- ] and [A-5], from given any initial k o , if

0:
)

[k*(p

3 1! eligible and feasible optimal path converging monotonically to path x*(p )]. Such optimal path will max integral [3-E-1] and this integral will be

convergcnt for this optimal path.

3 I ! eligible and feasible optimal path converging monotonically to path x*(0 )]. Such optimal path will max integral [3-E-2] and this integral will be [k*(0 ), convergent for this optimal path. {Rmk: note this path is just the golden rule path} Rmk:

p:0:

if ko:

k*(p ), then feasible optimal path

is

just [k*(p), x*(p)] path

V t > 0.

Following is a phase diagram [3-E-5] for when p < 0 which has a funny interpretation of a negative discount rate. Aoyway, for this case, / feasible, eligible Euler's path for the infinite time horizon.

We note parenthetically that recently gro*th models use u (x 1) - ln x 1 which is a special case of the following CRRA (Constant Relative Risk Aversion) utility function:

u(xr)

x,
=

t-o

0l l and>0
0=1

1-e

lnxt

And 1/ 0 = intertemporal substitution elasticity between xl and

x111

measure of willingness households substitute consumption over time periods.

The

larger I

/et

more

willing to substitute.

Ramsey model has also been modified to use above CRRA utility functions and that firms are included to hire labor and rent capital from identical households. Yet assumptions placed on firms make t}rem merely passive agents and not intertemporal optimizing agents. e.g. firms maximize only instantaneous profit: at every instance of time, frms employ production factors (labor and capital) by paying them respective marginal products and then sell resulting output, thus generating zero profit. Hence even though the modified model looks more like a G.E. structure, yet households still are the only intertemporal optimizing agents.

{'9

).q)

rt

TY?E
dBL-

T' "+#
&Q?
|

,*;l;9-o

[u-*'.]

fieP

[s

-e-+1

,t)

+{.f>

{p>
z''
xt" fdc) -"'kt

t l-e-sl
\*\

.-+ +\
\t

\_

chapter III. E. Alternative exposition of Neoclassical Growth Model with ponhyagin,s Optimal Control Theory

In

1960s, Pontryagin's Optimal Control Theory replaced Calculus Variations as a tool for dynamic optimization.

of

Terminology: Functional: an integral {*(t), u(t), tl dt whose numerical value is determined by each x(t) in the family of functions of x(t).

For optimal control theory, solution are contror path u*(t) and state path x*(t) which optimize the functional s.t. constraints on state variable x(t). [calculus of variations is.a-speciar case of optimar control rheory, seeking only the optimal state variable path x*(t).1

AAA) We first look

at univariate x(t) and u(t) functions;

First Case: Continuous finite time horizon and.fixed end point T

u(t) real-valued frmction calted the control variable

Given: t = time ; T = fixed constant (finite time horizon) x(t) real-valued function called the state vmiable

Find opt path of control function u(t) to max functional (or some other target) s.t. differential equation constraint on state variable x(t): Max objective functional

fl*(tl, u(l). tJ dt

(or target

ix

itf

)t

s.t.

l't

order differentiat

equation

i=I

derivative) xi:fi [x(t),u(t),t] i : 1,2,...,; p_tzl

r-eal_valued firnction

(+partial

where

x(t):[xr(t), x:(t), . ..,x"(t)]

u(t): Iu1(t), u2(t),

..,

u,(r)]

[3-13]

s.t.

boundaryconditions x1(t6)=x16

x1(T)=x;1 i: 1.2.....n

Solution: Optimal time path u*(t) for control variable and simultaneously optimal path x*(t; xe, t 6) which solves differential equation(s) (containing control variable u(t)), depicted bV l3-l2l and satisf,ing condition [3-13].
Note on optimal decision path x*(t), it is optimal at each time point t, not just at initial time t = 0 or t 6 and ending time t : T.
Pontryagin formulated necessary condition for dynamic optimization called Pontryagin Maximum Principle, involving a function called Hamiltonian H which is analogous to Lagrangian function in math programming.

H is defined to be the integrand ofobjection function + a multiplier called

costate variable times the constraints. i.e.

H:

f[x(t), u(t),

t] + Ioci(t) f i [x(t), u(t), t]

For sufficiency conditions, we need both the objective and constraint functions to be differentiable and jointly concave in x and u; and costate

variable oc(t): 0 ifconstraint is nonlinear in x or u, otherwise oc(t) can take on any sign.

Let us start with the objective function being a functional l-tl*t,1, u(t), tl dt with fixed endpoints; x(t) and u(t) are l-dim, , and only I c'Bnstraint on x(t):
.T

Max

J"

f[x(t), u(t), t] dt
{derivative of state variable x(t) determines the dynamics of the system)

s.t.

i : g [x(t), u(t), t]

s.t. boundary conditions

x (t s)

: x6

x(T):

We define Hamiltonian

H:

f[x(t), u(t),

t]

+ oc(t) g[x(t), u(t), t]

oc(t) is the costate variable (analogous to the Lagrangian multiplier) = marginal value of state variable x(t) with respect to the objective function.

If H is differentiable in u(t)

and strictly concave, then interior (not comer) solution and Pontryagin's necessary conditions for max:

A)
B)

aH

0u
0oc

-0
AH
Pontryagin's Maximum Principle

0t

dx
dt

AH

0x.
: x6 x(T):
x
1

C)
with oc(t)

boundary conditions x (t 6)

Remark: If above f, gare differentiable and jointly concave in x(t) and u(t)

0 when constraints

are nonlinear in

x(t) and u(t), then above

necessary conditions also are sufficient.

Let us look at an example:

t*
s.t. s.t.

{t x*[u(t)]'zdt
i(t)

IEll
tE2l tE3l

:10u(r)

x(0):2 x(l): 5

We set up the Hamiltonian

H: x - u ' + oc ( l0 u) A) setO: a H I 0 u :-2u+10oc ) u:5oc [E4] B)seti=-0H/Ox:-l

tE5l

seti: 0 H / O x - constraint:rcu1ton

BY IE4l

tE6l

\ t bt

[gs]+ a(t)

1*at:J(-1)dt

- -t +kr

kr:constantof integration

tE6lt x(t) = "f iot: i C50t+s0kr)dt k2:constantofintegration = -(50/2) 12 +50kr t+ k2 From [E3] x(0):2 : {-5012 (0)' + 50 kr (0) + k2 ) h : 2
From[E3]

x(1):5:-25Q)2 +50

kr

(1)+2

)
:

kl:28150:14125
2.8 andu(l)

) I

2 + 28 L+ 2 -25 t optimal path x*(t) - 5t+ 2.8 with u(0) optimal control u*(t)

-2.2

Second Case: continuous finite time case but with free endpoint:

tvtax

f[x19, u(t), t] dt {derivative of state variable x(t) determines the dynamics of the system)

s.t.

i : g [x(t), u(t), t]

s.t. boundary conditions

x (t6)

: xe

x(T) free

if

interior solution, then the maximum conditions remain the same except for the boundary condition, namely:

A)
B)

aH

:0
Pontryagin's

0u
Ooc

AH

0t

0x
AH
Doc

Maximum Principle

0x

at
c)
boundaryconditions x (to)

x6

oc

(T)

:0

oc (T) = 0 is called transversality condition for the free point. Since the condition means value ofx at T is free. the relevant constraints is

nonbinding so the costate oc must be : 0.

In general, transversality condition means when there are various solutions of optimal control problems (e.g. when solving 2no order differential equations, there will be 2 constants of integration generating family of solutions), we need endpoint transversality conditions to specif which
decision path should be our specific answer. Example:

rrlal [ax-5 s.t. i:l0u x(0):5

u21dt
x(4) free

We setupHamiltonianH:

H:4 x-5 u2 + oc(t; 10u

[E4-1]

A) set0: a H B) set& =

l0 u : -10u +10oc ) u:oc

tE5-11

- d H / 6 x -- -4

n1[E+-11

seti= 0 HIO x=constraint:tOri-= tOo.

[E5-1])oc(t)- J;dt :JG4) dt -- 4t + kr
k1

tE6-11

constant of integration

lE6-11t x(t) = .i iat - i l0udt: "f to o. dt:J 10(-4t +kr) k2: constant ofintegration -(40/2) t2 + 10 k1 t + k2
From [E3-1]

x(0):5

=. {-4012

(0)'

+ l0 kr (0) + k2
oc
5

k2

From transversality condition oc

)k' :16 )

(T):0 )
- 4t

(4): 0:

-4(4) + kr

)optimalpath x*(t):-20t" +1601+

optimal control

u*(t;:6. (T):

16

Third Case: problems with endpoints s.t. inequality constraints

T

Max J flx(t), u(t), tl dt

t6
s.t.

=g

[x(t), u(t), t]

s.t.boundaryconditions
Note if x*(T) > x

x(ts) : x6

x(T)>x1

constraint nonbinding and the problem becomes an ordinary free endpoint problem with oc (T):0 when x*(T) > x 1

r)

if x*(T) < x 1 then constraint is binding and problem becomes an ordinary fixed endpoint problem with o. (T) > 0 when x*(T) : x 1
Thus when we have endpoints s.t. inequality constraints: step 1: solve it like a free endpoint problem step 2: if x*(T) Z x , then we are done. andsolve as afixedendpoint Step 2a: ifx*(T)<x1 setx(T)= problem.

xr

Example:

Maxi t4x-5u21dt
s.t.

i :10 u x(0):5

x(4)>

225

We solve as if it is a free endpoint problem, from above, we know

)optimalpath x*(t):-20t" +1601+

optimal control u*(t) -oc

(T):

- 4t + 16

) x*(4): -2og)2 + 160(4) + 5=325 >225 ) constraint nonbinding and solution is the right solution.

BBB) In cases where x and u are multivariate functions (> 1-dimensional):

x(t)

(xr(t),

xd|,

x3(t), ...,

x,(t))

u(t)

: (u1(t), u2(t), ..., u,(t)).

Optimize objective by finding x(t) n-dim real-valued function, time t, with vector-valued firnction

u(t)

r-dim

nx

1" order differential equations

i'(t)=r'tx(t),u(t),tl i=1,...,n
7 \ ,/
real-valued function

(3-F-12)

...,x(t)) I u(t) = (ul(t), ur(t), ..., u(t)) tr-r-tr) )| i:1,...,n boundaryconditions x'(t")=19
where x(t):(xl(t),xr(t),x3(t),
Again Pontryagin optimal control is used to find:
solution path x(t;x", t" ) satisSing path depicted by (3-F-12) and condition (3-F-13) Remark: CAUCHy PEANO Theorem provides sufticient condition local, unique solution x.

for existence of

u(t) is called a control = [ur(t), u2(t), , . . .,

u(0]
range

u1(t) called Control variable

If u(t) e U :

set

of admissible controls

u(t)
domain

../

U ------+

U
objective function

range U called control resion

x(t)

path depends on control u(t) which is not specifred a the set of u(t) that max a target.

priori, we just pick u(t) from

e.g.Max

S=l i:l

nt-

qx1

(T) i:

T:fixedconstant
1, . . . , n

s.t. i i(0: r'

u(t) e U 1*6;,

"1t1,

tl

1u i:1,. .,n o with u(t) deiined on t < t <T

and x 1(t
x

o):

Once found u*(t), can find state variables x*(t) (solution satis$ing boundary condition)

of

differential equations

x i(t) assumed continuous fuaction on time t f; assumed continuous in each x, t, u and continuously differentiable.

(x', t" )

s.t. x' e X

x(t" ) = x'

Theorem 1: If 3 continuous vector-valued function P(t) = [Pr(t), Pdt), ..., vanishing simultaneously for each t such that

P(t)l not

1) H is maximized with respect to u(t)

i.e. H[x*(t), u*(t), t, P(t)] > Hlx*(t), u(t), t, P(t)l Vu(t) e U
fiom conslraints

i, - f;

where H[x(t), u(t), t, PC) =

I P, (t)f, tx(t), u(t), t] i=l

2) P(t)

and x+(t), u*(t) solve

II.AMILTONIAN system:

i'-:aH*/ap,

P;:- dH*/dx; i:1,2,

aHl
aPJ*.,u.

*-/

4l

Pontryagin Maximum Principle

3) TRANSVERSALITY Condition

RMK: to

.' I

constants

ofintegr

get family

of solutions, so need trarsve.sality condition

determine sDecific solution

P(r)

:q
)

i:

t,2,

... , n

From objective functions

c; x1(T)

4) x11t)=*o

i:1,...,n

then

x*(t), u*(t)

solve

u(0u

max

^+ S=)c,x,(T)
i=t

T:

hxed constant

s.t.

xi(t)=fi

[x(t), u(t),

t]

i=1,...,n

xi(to):x o

i--l,...,n iffl

Above is necessary condition, furthermore are all concave functions in x and u, then also suflicient condition for u* to be global optimum. above

Analogy: H &

Lagangian

Pi

& Lagangian multiplier:

./
Rewrite (3-F-12) as

4
COSTATE variables

i,-(t):f;[x*(t),u*(t),t]

i,*:-

oH*

loxi

:-lPr (afl* / 6 x )+ P2(0f2* I 0 x )l

z --' tsf. =I-P,'&, ;

:+ 2n equations (lst order differential
equations)

ii:...
2n variables

i Pi:.... i:1,...,n PiG):ci

i:1,.,.,n

xi, Pi
2n boundary conditions

xi(to):x o

i:1,...,n

transversality condition provides additional boundary condition

SolutionT* called optimal control, x* optunal trajectory e.g. speed, direcfion ofthrult for
Above includes a special case

//

rocket

min time missile intercepts a plane

Ifwedefinex0(t) by
with

io(t) :fo [x(t),u(t),t]

u

x"(t')=o

k' then t = J'f. Ix(t), u(t), t]dt = x. (t)Ji

:
so x"(T)
I dt = max

x" = If" dt

x.(t):0

maxl:.l*j]tt

x.(T)
u(t), t]

s.t. io(t) :

f6 [x(t), xi(t):Ii xi (t') = x: =0

=
=

define new Hamiltonian A[x(t), u(t), t, P. , P(t)]

{{[x,u,t] + lP,{ i=l

[x,u, t]

and conditions 1) 2) 3) a) ofTheorem 1 can be written as

f4**,u*,t,n,p(t)l> Hlx*,u,t,p.,p(t)l

vu

(3-F-1s)
all other P; terms

P.(T):1
2

P(T):0 i :0,1,...,n
u*

y'drop

(3-F-16)

P(t), x

*(t),

(t)

solve rhe Hamilronian H

ii:afi*m,
3

Pi:-AH */axi
(3-F-14)

i:0,1,2,...,n

): J)

b:q)

/r7f)

Since

P.(T):

1, by

(3-F-I4)

Po: -dA */dxo

Vt
as

:0)
N.

>P"(t)=l
:+ A witten

'.' Po:0

io:afi*/aPo:o
tr
= 1t;q1*1t;, o1t),9 + is funotion of x, u, t,

tr,!(x,u,q ,/ p
,/

,/ t/ Since P.(t) = 1 then AH */A Po : 0 '.'no P6 term in H

so can omit

=Htx(t).u(t),t,P(t)l

0 case and rewrite as

t, PC)] >

1') H[x+(t), u*(0,

H[x*(t), u(t),

t,

P(t)] Vz(r)
no need 0

2'\ x' =""

IJ *

3P,

6H*
oxi

i=1,2,...,n

3) q(7)=0

i=1,2,...,n

necessary condition for max

I : max I q1*1t;,o1t1,tpt
ueU

ueU
s.t.

xt(t)=f,[x(t),u(t),t]
xi

i = 1,...,

(3-F-17)

(t')

x: i=1,...,n -t

(3-F-18)

Note 5 =
AS

I.c,x, (T)

can be converted to target as

" +)c,x,tt"
'=,

& roic" rr"rru

s=

-,t"
J'
r trt
I

,,--z r
Ic;x;(t)
.T
|

pt

llc,x,(t) Jr" L i=l

nan
=

!c,x, i=l

(T)

lcixi i=l

(t")

Icixi(t") i=l
/

Cancelled out so no need to include in max process

+max S s.t. (3-F-17) (3-F-18)

=

.no

I r"l ]dt where f, =I",f,

s.t. (3-F-17)

(3-F-18)

Note above problem T is fixed a priori but x(T) not fixed a priori ftom equations we get i(t) and

once fi(t) obtained we get

i(t)

Various other cases: Fixed T with fxed end points * need rnodifred theorem Final T open with fixed end points - need modified theorem Fixed T with variable RH end-point - need modified theorem
depending on x(T) a priori fixed for some coordinates ofx(T) final time T a priori fxed

e.g. Final T not a priori fixed

(i) RH end-point x(T) partially fixed i=1,2,"',m(n(frxed) s.t. xr (T) = xJ

x,(T)

not

fixedfor i:m+1,"',n

then condition 3) transversality condition A to 3')

P'(T)=c'
P,

+Ii

i=1,"',m
i=m+1,'..,n

(T) = c,

1,, unknown variables constant over time

e.g. Fixed T with fxed end-point problem max

f" tx(t),u(t), tldt

[x1t1. u1t1.

(3-F-1e)

s.r. i,(t): f' t'=0

x, (0) =

1]
x,(T) = x]

i=1,...,n
i=1,.",n

xi

\\-,2 \\
T frxed and fixed

J]D

Define x.(t) by x 0 (t) =f

[x(t), u(t), t]

xo( 0:0

)x6fi): 00 at =J xo dt I ro
so

TT

rv xol = xo(T)
0

(3-F-19) =max

xo(T) s.t.xi:f i x0(t)=0 i:1,2,...,n

2

Now we apply Pontryagin Maximum to get following modified Ponfryagin Theorem

solving above (3-F-19) problem
Theorem

if

2 [.ftl, tAil optimal for above (3-F-19) problem nonzero (n+l) vector-valued continuous function P(t)=[P.C),P,(t),Pr(t),.r\,P,(tn

which has piecewise continuous derivatives s.t. i"O, i(t),0@ and P(t) solve Hamiltonian fr

A = Hti( t), n(r), t, p(r)l =

pt

(t)fr ti(t), rD(t),

with

(1) Hti, t, t, PI > H[i, u, t,

P]

vu

(z')

ii:

aH rcPi i:l,2,...,n

Pi: - aAlaxi
(3') P"(t) = c6m16r1 2g

Vt 0<t<T

(4')

x'(t")=xi

xi(T)=xI i=l,A,n

We have conesponding corollary theorems when T open and not fixed but we will not cover as we only need above Pontryagin Theorem 2 for optimal growth theory.

Econ application: optimal gro*th theory again, using optimal control theory.

like
maxJ u(x(t))e-e'dt

fo

i, I ike u / -_'rir"r s.t.k(t):ftk(t) -ok(t) -x(t) k(0):k0>0

like

k(T) = ft' ;' p x(t) > 0

p>0
Assumptions:

(A-1) u'(x)>0 u"(x)<0 (A-2) f(k)>O (k)<(A-3)

f(0) > 0

Vx>0

f(k)>O
f(o)
=6

Vk>0

f(0)

oo

Here per capita consumption x, control variable

k, state variable
control region f) S R nonnegative

>

closed set

Assume T final time fixed k(T) fixed =+ apply Pontryagin Theorem 2

H [k (t ), x(t), t,

P @]

= P.u[x (t )]e

-P

/uno' t

+ P @V Ik (t )l

Gk (t )

- x Ol

Po: constant

) 0 can show Po(0) > 0 and WLOG can assume Po:l

crk

H[k, x, t, P] = u[x(t)]e-p' + P(t)[f[k]

+

- xl

from (1') u[i]e-at

pIi - ak -;l>

u[x]e-ct * Ort'

r,

u[i]e-ot - u[x]e-oi > Pti - cri - xl - f1i - o[ = -P(x) - P(-i)

- i1

=P(i)-Px
assume

Vx(t)>0 0<t<T
-oo

liq

u(x)

=i(t)=0 = u(x)= -oo (boundary) lJ

not optimal

=*(r)>0 Vt 0<t<T
/\ A ^n (from dH /APi =) k(t) =r(k(t)) -ck(t) -x(t)
(from - aA/a
a

(i.e. interior solution)

>0

kO

:) i t = - p(t)tf 'G(O)- o l
(1') for H

since x is max in condition

- dx =0 ^ +: afr
dx

afr

critical point

=0 =u'(ile-o' +P(lX-l)=0

P(t.) = u'[i(t)] e-er > 0 >u >o >o

tdP(t)i dt:itt)

:t"ie-p'+f,'

e-p' (-p)

rittl:

(Qt" -pt')

""p' uuti(t) = -p(t)trit) -ol

=

-t'

/1

1*1e*'gr'6y *

a1

)(it"

-pt') : -0'rtrlth
/\. UA

-qr

t ?: -G'rirrrGt -ot-pt')rtt :- -^-(f '(k) -(a+p)

same as in previous secton using calculus of variations same phase diagram for x 1 and feasibility k t

G)

Now show calculus ofvariations, in particular Euler's equation, is a special case of optimal control theory:
I= J"

rtx(t), x(t),tldt

x(t) = {x, (t), x, (t),..., x" (r)}

/ I I \

Calculus of variations: choose x(t) to max like f, in theorem

s.t.

x(a)=c {b)=p

if let ;t(t) = u(f,

then same as Pontryagin optimal control

\o'oJ'{*to,u(t),tldt

x(a)=g
final T time fixed, end points fixed Hamiltonian:

x(b)=

^ = P.f + /P,u,ftl
,=l

'

+--

=x,' =-=u, ,p.

,arr

Vi
('.' u(t)

6:-drl:-pld ox,
=max
crifical point

\ ox,

no

x,term) (3-F-20)

aH _ :+l -set af = i- = P. ou, r---\0 ou,

Po

i=1,".,n

note

=constant>0; suppose

=0+

P;

=0

Vi

contradicting

all P1

not

vanishing simultaneously.

= r- > u "

at P _ = ____
aui P.

and

P .d(af\l= ___ _l _,1_

-plal (3-F-20) '.\

-

dt[aa,

P.

( ar\ \ a, I af '/ P. =-L 0t,

=)lf

ers

eouauon

'

. af draf)
ax, dt [ai(r)/
\
aui

i=1,...,n

chapter

IV.

Discrete time dynamic equilibrium and optimal economic moders:

A.

Discrete dynamic macro equil models:

i) Review of difference equations (dfce :tions)

Most undergrad models are static models with same-period instantaneous adjustment and without any time dimension. E.g. demand function ai present, suppry firnctiin as ofnow, equilibrium prices found instantaneously and hold for ihis moment. In real life, we have intertemporal (between time periods, e.g. last month-this month-next month, today-tomorrow etc. ) situations and adjustment processes. To handie such situations, we need difference and differential equations. when we are dealing with discrete trme change, we use difference equation and with continuous time change, differential equations. Difference equations are functions between time-lagged independent variables at different time intervals and dependent variables.

Terminology: Order of difference equation

e.g. 1 period lagged e.g. n periods lagged

greatest number

l'lorder
nth-order

oftime period lagged.

Symbol in difference equations: A to measure discrete (not continuous) change over time period t.

Ax, = -------- - xr -t At

Ax

e.g. (last year Xr

this vear GDp $10 trillion =$ 9 trillion A x 1 $(10 - 9) trillion: $1 trillion )

GDP

solution of a difference equation yields values of x for every trme ftrnctionl

Further categorization:

t.

It is therefore a

Linear (with respect to x t ) difference equation: one with x only raised to l l"r power (so product terms like x, y 1 or-exponentiar terms like x 1 , m any real number, noi attowldy. e.g.xr:bx1-1 a, b constants (note term araisedto nth power okayj

+ a"

Otherwise we have nonlinear difference equation. e.g. a, b constants

xr :b(x,-r )'*

Autonomous difference equation: one independent of time. i.e. without any time t terms in the function. Otherwise it is non-autonomous which is dependent on timi. e.g. autonomous dfce X, = bx,_t a e.g. non autonomous dfce -tion: bXt_t at

*tion:

xt :

In the previous chapter, we derived the general formula for l tt-order linear autonomous difference equation as follows:

xt:bXt-r

* &

d,b constants

General solution (when no initial condition is specified): We start iteration for t = 0, 7, 2,

.

..,

Xr: bxo + a x:=bxr+a=b(bxo+a)+a =b2xo+ba+a x:: bxz + a:

b(b2xo

: :

b2xo+ a(b

+l)
l)
+ ... + b+ l)

I a(b +l))+a +b'a *ba *a = b'xo

b3xo + a(b2 +b+

X1

= iiiiiiii

:::::::::::::

: btxo + a(bt-l

+ bt-2

But geometric progress of t terms of sum

:
(St-1 ',r-6t-z

i__1_lb

ifbrl

+... + b+l) {

: )

ifb=l
of

General solution (when no initial condition is specified and we get family solutions by varying initial condition x 6 ):

Xt:

Ix s-(a/(l-b))] bt xs f !t
is specified

[a/(1

_b)]

b+ 1
b=l

tz_rl

If initial condition

get specific solution.

We can re-write [2- 1] as

x1: Abj

complementa.y firnction = deviation ftom equilibrium

?"

.Cr \

where

A=xo - (a/(l-b))
ofx

C=

a/(l

*b)

t22l

particular solution = intertemporal equilibrium level

If

deviation

A bt + 0

ast-+ co

then solutionx,*

C = intertemporal equilibrium also steady state of the system (= rest point, stationary value).

C is said to be dvnamicallv stable stability depends on b (e.g. b = I/lrl , N a natural oo, A b' -+ 0 ) number as t

-)

Acfually Steady State x * means: as t-t oo, xt - xr+t: Xt+2 -- ...... =somex * and we will retum to this subject later in our discussion of dynamics of the system.

Remark: We have to be very specific with the categorization of both difference and later differential equations because there are different approaches and different solutions for each categorization. Above system is single difference equation, i.e. one-dimensional. Later we will look at simultaneous system of m difference equations i.e. m-dimensional.
Finance application as illusEation: deriving formula for Future Value FV using difference equation: Given present value P 1 for period t, interest rate per

period: i

) P,:

(1

+i)P, 1 in l't-order linear difference equation form

and

i >0 t(1+i) >1;6

so apply solution formula

P,= {Po - 0/[1 *(l+t]](1 +i)' + 0/tl -(t+i)i : Po (l + i)t

which is the formula for FV.

(v=

?o

7,

=Qti,)f"

f,.(+i)(
Q+t)
,.L ^

Fv',=

Pr,=

[+e

Po

ro

( I rt

SIMPLE RI,CURSION:

we note in difference equations, x t is a function ofprevious period x 1_ 1 (for all t) , which means the problem is recursive. For linear reiursive problems, we use iteration to derive the solution, as we have done for the linear difference equation solution formula.
In particular, if the linear difference equation is of the simple form as in the above FV problem: Ps+1

=a P1

(interpretation: principal P in t + 1 period = a times p in previous period t ) deposit accumulating)

solution by iteration is much simpler & we can solve without using solution formula:

whent:0 t:l t-*2

:

Po*r=Pr=a Pr*r=P2:a

Po
P1

=a(aPe): aPz =

a2p6

Pz*r = P: =
Pn

a(a2po)= a.po

t=n-1
:

=a Pn-1:a(ao-tP6 )=
FV:

anP6

and this can be an alternative way to calculate

We

Iet P6

present value ofdeposit and interest rate is i, then principal plus interest eaming per $ per period and

a-1+i wi

bethe

Pn: a"Po = ( 1+i)'po

wili be the future value after n periods and is the same formula we derived above.

The reverse process ofcompounding is discounting. i.e. given

FVn

and discount rate

i,

what is the

pV

6?

From above equation we get P

o : p,' /( l +i)'

) PV=FV"/(1+i)"
ln particular, we let 1/1+ i: B, then pV: B 'FV" A formulation we will see in macro growth model lften.
E.g. social planner maximizing discounted society's utility stream Max

tS

tU( c, ).

OBSERVATIONS AS PREVIEW FOR RECURSIVE DYNAMIC PROGRAMMING: From above iteration, we get inkling ofusing recursive method to solve a dynamic problem with sequential relationship. We break up the dynamic problem into sequence ofproblems, solve one ofthes- ,"qu"n"", th"n use solution in the sequential relationship to solve the whole dynamic problem. 2. Similarly, for dyramic programming where we are doing multi_stage dynamic optimization. We break up the problem into sequence oiproblems, solve one stage and then use this solution in sequbntial relationship io solve the entire dyramic problem. J. To inhoduce risk, we use stochasric models which basically consist of sequence of probability distribution (p.d.) function for the sequentiairelationshio. 4. Regarding system equilibrium : A) For deterministic models, when the sequential solutions converge to a recurrent state, then we get an equilibrium. B) _For stochastic models, it's the sequence ofp.d. converging to an invariant distribution which is the equilibrium.

l.

*i

Dynamics of a discrete system:

A discrete dynamic system reaches a steady

state when x

V t > some n.

This is obvious ftom [2-2].

A linear autonomous l't-order dfce =tion xs = bxt_r + a has the properfy ofhaving a steady state iff lbl < 1. Thismeansthatthetimepathxt,t:0, 1,2,.... traced out from a difference equation x1 = bxt -r +a will to a steady state iff lbl< t.

For b =+ve fraction 0<b<1 It is a monotonic path convergence

"onu".g"

b = -ve fiaction -l<b<0 It is an oscillating path convergence

For

Harrod Gro*th Model

we.

a descripti.,r"

growh

.oa"tlGg

aiff".err""

-t-.

"q*ti_-_

will be st'dying gronth moders with dynamic optimization. As preparation, we start yith the simple deterministic macro Harrod growth moder using difference .dil;, ;;
look at the dynamics and intertemporal equilibrium.

marginal propensit, to save

Given aggregate savings aggregate investrnent I

St = sYt = a(Yt - Yt-r

) a>I
AY

-9 U<s< l

(this is Acceleration Principle in Macro which says aggfegate Investment is proportional to rate of
i.e. rate

marginal capital: output ratio

of

ly t )

I 1)

equilibrium

St:

Ir
)

(IS curve over time)

) t )

sY1 = a(Y,- Y,-r

(a-s) Y1 =oYtr

t, : (a/ (a-s))Y, + 0
1

is in l'r-order difference equation form I a X1 :bXj-t

solution by formula

) Y, = 1Yo:

(a / (a-s.1)

) (ai (a-s))t+ ( ---------1-(ai

(a-s))

Ys {a/(a-s) }t

But

a>_1 s< 1) t

non-oscillating.

(a-s) > 0 t

a/(a-s)

> 0 which means equilibrium

Furthermore since 0<s<1anda>l 1.8 /(1.s-0.3) @.c. a: 1.8, s-0.3

) a/(a-s) >1 (see below) : 1.2)

)
Ya

1 (non

oscillating), explodes without bound and not convergent to y e path.

t,

uv

Note in Harrod Model , in case

a
non oscillating

/ (a-s)
<1

<1

) a<a-s ) s<0

fboth these cases violate Harrod assumption of s > 0 ]

) a:als

i (+ve fraction) ) convergent

'a (a-s) *ve

fraction t*0
as

) s:0
Y,:

t---

yo{1}, = yo

ast___} oo

oo

convergent conversent

a1=Lo

thenYt:Yo{0}':0

One more case is when

a / (a-s) :0 [violates Harrod's assumption]

,>
so depending on where Y6 0 maybe below note the econ implication of a zero national income over time.

is, yt :

or: yo

and

tg,

Corollary to Harrod Model: Y 1 in some cases explodes so change question to what growth rate g will wanant St I1 for each t -- warranted growth rate problem.

We know Y r =Yo

{ a /(a-s)}t

[Not: using solution of lst sequence to get equil for whole recursiv
probleml

and definition

= ( Y1- Y6)/ Y6 ) g = ( Y6 {a / (a-s)}'- Yo)/ Yo= a/(a-s) : (a-a+s)i (a-s) : s/(a-s)

of growth rate g
implication:

Econ policy

and his objective is to ensure savings

growhatrate g

= s/ (a-s; : to ensure S t = I t foreacht.

Suppose policy maker knows a = 115%o; l5%o investment at all time, then must try to get

s:

15% / (115-15)%

15o/o

/ 100%o:

15%

chapter I[. A. ii) Review of I't-order nonlinear difference equation with phase diagram (discrete growth model with nonlinear production

fu.;il;.

rinear autonomous difference equations can be sorved. In fact, linear 1"-order and 2nd-order dfce *" uf*uf, explicitly solvable. For nonlinear difference equations, *. =ion, frJ .un rot roiuiioo'. ,or, or the time. However, we can use phase diagram to study the characteristics ofthe sorutions. A dfcd +-ion phase diagram depicrs y , as a firnction y of ,_1 .:t axes lor phase diagram will be y - y ,_1 , ure uurer(,l ..o ,. ,,__A ?, rlne (+)- -- where Y, = Y 1-1 will occur when the difference 4) l,t-]:4n9" equates the vertical with the horizontal axis). tuncrion crosses the trne

we

see how above l tt-order

It

For example, given nonlinear 1.t-order difference equation:

Yr: (Yr-r)"'
Find steady state:

Y c-l Yt =ytr :y:

y=(y)" )

y(y3-l)=o ) y:0

or

y = I are steady states

y
1-1

difference equation will cross 450 line (where vertical axis Y 1= axis) at Y = 0 and 1

horizontal

Note: Y r-r

:0 )

Y, = 0

so the

origin (0,0) is on dfce equation graph in phase diag.

check l"t and 2nd derivatives ofthe difference equation:

dY,
d Yt-r

(Ya)-%

>0(=slope)
,,

d, Y,

dYu,'

(-3/4) (1/4) (y

-1-3la < )

aaaa,

tfrl,r

L.-)

-9

Y4

)function
Yr-r

is concave & we can draw phase diagram: and from some arbitrary points like

0.1 and 1.5,

t(l,1)

the graph converges to Y1-1 = is a locally stable steady state.

yt:1

Lo,

o.t=Io

Tt-l

6s7

The divergent cases are where ] r" order derivative at steady state point l> 1. Hence we have the following test for local stability for 1't-order auton6mous nonlinear dfce =1ion:

given steady state y

If

d Y,

d Y,-r

l*,

< 0 then oscillation > 0 then non oscillating

If

<

l-rl
Again using the example

I I

then y is locally stable

then y is locally unstable

>

aty:9 dY,
dY,-r

of y t = (y .r ) ".

[steady states (0,0) and (1,1)'

------------__l

ury-o

: %8 ,, )

t'ol

ary-o ---+ +oo

non oscillatine

dY,

-----_-___l

d Y"l

I aty=0

.---+

co )

locally unstable

atY=1

dY, -----*-llatY=l
dYur

r/a

)0

non oscillating

d Yt-r

dYt "-----*-lI

atY= I

: %<1

locally stable

We can check similarly for the other three cases.

An economic application would be the following typical macro growth model:

Given:

Yt

national product andkt capital (assuming unit labor) both at time 6 capital depreciation rate; s savings rate as "% ofy,

Aggregate

production:

yt = kto

kt >0 0< o <l

t e N set ofnatural numbers

Investment

function: kt*r = kt - 6kt +syt

dkt +skt"
+slt"

6<

1 0< s <l

) kt+r = kt

= (1 -6)kt

Ilgr.ordr nonlinear difi.erence equariotrI

steadJ states from solvi-ng following equation:

=ft'5k +sk t k[6-sk"-1 ]-0 t k=0 or !=o-r.i(o I s)

l(
o

interpretation: equ'ibrium of the growth morlel depends on depreciation rate 6 and savings rate s Equi.librium olr*. *h"o i" the (o_ t)th root of (depreciation/savings) ratio. ""0r1",
Econ
let order derivative:

dkt

d ktu ---.'.-...-..1latv

(1

'o) + cr s k," - t
v >0
>0

>0

>

>0

2"4 order derivai;ive:

d2kt+r
d

.........,.-......1

kt

latr

(o-1) q s kr"-2 e <0 >0 >0 >O

<0

ano converges m onotonically:

-concave

function and graph as follows and the non-zero steady state is locally stable

ft,t*

+50
r

llt=rr-

-ar

arD

Remark: Some nonlinear autonomous dfce :tions like xt : bx1_1 (1 _xt_r )has parabolic-shape graphs its 1 't derivative changes sign - in the phase diagram where x converges monotonically at first but then oscillates as it nears the steady itate. This leads
1

to chaos theorv..l

,.L

Summary:

tb41r7;EDifercnce equations

Linear (with respect to y r ) - always explicitly solvable

--t

\
nonlinear
- in general no explicit solutions - use phase diagram to analyze

Solution
+ stability ofsieady states

autonomous
I

i/

nonautonomous

autonomous

nonautonomous

l"

order

I
u

*, = t1",., n

bx, l+at

xl = blnxr-l+a
some functions

Solution by fomula (recursive method)

,/

xl - rxr-r(l-

xl_ r)

can lead to Chaos Theory

b, a are b, a i- or both xl = br xr-l+ar_

Solution by recursive method

2nd

order

xr = bxr-l *axr-u *c
Solution by formula

&

eigenvalue/roots

(@

Chapter IV. A. iii) Briefreview of eigenvalue and eigenvectors for square matrices. Stochastic descriptive dynamic model with Markov transition probability matrix:

fsurvival of firms) In above two sections we studied single difference nions. How about n-dimension difference equation models consisting ofn simultaneous difference equations? To handle such n-dim difference models we need EIGENVAIUE in linear algebra.
We recall to solve a set of n simultaneous linear equations with n variables, we set it up in matrix form A x : K , where A is a square matrix, x and K are vectors: E.g. Given linear system:

x1* apx2 : O2yXr* A22x2 :

311

k1

kr

LHS can be wriften as A

:[:;r

RHS

K:

lt
Ll

;i[:;]
if J
1 !

IKI

rrJ
We then solve A x K using various methods in linear algebra. For a square matrix A, we can calculate a number called determinant (to see solution for the linear system),

(not K) where A is a square matrix. For eigenvalues, we are solving A cr Also we can calculate another number called an eigenvalue ftom that square matrix.

x:

If ax:lc x' l= r 0lP,'l- " 11 0ll*, 1: la *'l Lo "JL]'J L| 0 JL-Jx) 1l I L"

|

[for eigenvalue, we first note if x is not null and given scalar ct, ..1 e.g. for 2x2 case. -lr -! f

crx: crIx
l

a Ix

To derive the eigenvalue number: given vector x (xr, xz, x:. . . .,

x,

+0

and square matrix

[-a

', lu:'
I

o,,
a22

a ,:
a23

l:
I

l'1.' u" u "

i_i9.;

If we can find reaVcomplex scalar cr s.t. A x : cr x then a is called eigenvalue and

Note if a is an eigenvalue

is called eigenvector

t A l: s x : crl x ) (A- crl)x:0: null matrix I

(A- crI)called
characteristic matrix

Lemma: for square matrix B, if Bx : 0 but x + 0 ) determinant Pf: Assume lBl + 0, then B - I given . B we can multiply both sides of equation by B-1

lBl:0

x : 0 + B-rBx il * tIx:0 iltx t lBl:0

So by above lemma,

B-ro

il-

[-

confradicting x-+ 0

deteminant l(A

a I )l :0

so we see that eigenvalue

o is s.t. determinant l(A

o I )l : 0

and this suggests the method to calculate eigenvalue.

In fact $(cr)

l(A

o I )l

:0

is oalled the eigen equation (or characteristic equation).

a

Remark: we can write Q(cr) as

polynomial

:crn+aroo-l +

arc

"'2 + a:ct"-3 +
of
a;i

... + a,,-lctl+an

:0

where a 1 are lirnctions

Then by Fundamental Theorem

ofAlgebra, this polynomial has n (not necessarily distinct, not necessarily real) roots and these are the eigenvalues.
Since (A

I )

- aI)issingular matrix (A - cr I ) is linearly dependent vector x can assume an infinite number of solutions.
a unique vector solution, we normalize

ln order to get

by

x i2

To normalize means we choose the unique veotor

( x 1 , x2 ) which has a length of 1. Geometrically in Euclidjan space R2, u."Io. * cbe represented by an arrow fiom the origin to the point ( x 1 , x2 ) and has a unit length. This implies that x12 * x22: l.
eigenvalue : person's ID card o. is not a mafix, but a number (analogous to ID card not a person but characterizing a person).

L=

Eigenvalues analogy

Mafix

Person

Numerical example to show how to calculate eigenvalues:

"= [-s :l [: -e)

we know for eigenvalue

ct

A-o,

Il=0
:
(-9-cr;2-f1:;

butlA-"tt: [n^-*

L'

',

"]

=81 + 18 (t +ct' -9:72 + 18ct +ct2 :0

) ct : 1- rat./1tt'-+1t11tzy1y t z1t1 ) cr: {-tst.[TFZEE]l7z

)
cr,

*= {- ax,,[*G"11r zu

= {-9t3} : -12 or-6

both eigenvalues (roots) are negative

We can use any one eigenvalue to calculate the eigenvector

, say use

o: -

substitutinginro

(A-

ct)-r =[r-*-u, , I [-,.| :[, ., (_6lJ

Ir

L.,J

L3

;lf; I
:|l,.il

f'l
LOJ

t t t

-3 3

xt +3xz=0

and

xr - 3x2 = 6 x 1 : x2 and to normalize x 12 + 1r2 =

+xr2
=1

xt2

.) 2 x12 :1

xr ={-072

-r f '+ x2 xr ={(l/2) andx =lfat72l =

lwz'l L

Similarly using the other eigenvalue = -12, we get the conesponding eigenvector as:

''' ,-',,,1 lt,] =[l lfll =fsl ['-

t ) t

3xr +3xz:0 and 3 xr + 3xz : 0 xi = -x2 and to normalize x1 , x12 +1-xy;2 :l 9, 2 xt2 _I

*r, =l

t *' ={@) t

Xz=-Xr : -./ ltlZ; andx :

Another numerical example for illustration:

given square 2x2 (hence 2 eigenvalues) matrix A =
7

[1.':?,,1
l-6 - o

to frrd eigenvalues o sel 0

det lA - crtl

lu l Ll
o-"1
ro

Ir
I

= 6 s, +

az

-7

check

I & -7 are eisenvalues

",41,

l=,

l"i' ,.,1:,

There are many usages for eigenvalues: 1. to test for sign definiteness 2. to test for matrix singularity 3. for obtaining solutions of 2no order difference equations 4. for determining the stability of dynamic systems 5. for derivation of general solution for n-dimensional dynamic system etc.
_

In addition, if square matrix A is also symmetrical (i.e. A = Ar ) then we have the following convenient properties regarding eigenvalues:
example of symmetrical

r-t A lt t

lz 6 4ll: 4 5J

et

l:
We note symmehical mahi*

rri.t

U. square because a

ij

ji

in symmetrical matrix.

S)'rnmetrical matrices have 1) only real eigenvalues (no complex roots). 2) enough independent eigenvectors to diagonalize and not necessary to work with generalized eigenvectors. 3) eigenvectors that are orthogonal to each other

economists many time assume matrix symmetry when modeling for optimization or statistical (econometric) problems.
e ; denote

Numerical example: (let

givensymmetricalmaiixa f-s
set

eigenvalues)

12{
r

21

lA-eI | =9

->(_5__)2-

l;4: 0:>
J./tal

{-10

!1100 - 4(1)(2r)l} / 2 (r)

(-

10+ 116)

/2 : -7 or -3

all e < 0:> A negative definile and all e are real numbers.'.. A_symmehical can furd eigenvectors x-, from e, f.o. = -3 ar_

Lr'4

-7 ",

{'lltfl"
hi,oj

",

After frnding the eigenvectors x ! x I fiom the respective eigenvalues el group t}em into a Transformation Matrix T= [ xz- ]

e2

we can

lr

We now apply n-dim difference equation model to economics.

1-dimensional difference equation with single difference equation enables us to study e.g. how price of apple in period 1 will affect price and consumption of apple in period 2 etcl In real life, we require more complicated dynamic systems than those described by I equation. We need dynamic systems describing economic phenomena and their intertemporal relationship as well as their intenelationship. This necessitates a system of n simu^ltaneous difference equations. e.g. this month's price of apples and oranges will {fect ltue months'price and consumption ofapples, oranges, banana .... as described by difference equations; or present period R&D (research and development) will affect future technological level affect future production affect futuri supply, prices, demand etc.....

easily extended to n-dimensional first-order linear difference systems.

we illustrate with 2-dimensional first-order linear difference equations which can be

2-dimensional l"-order linear difference equation system (= fwo I st-order linear difference equation forming a dynamic system):
Xn+1

ott

Xn

Yn+l

ilz t Xn

* av Yn + a, v^

(still discrete & intertemporal n , n+l period )

We can rewrite in matrix form

-^il".
znr|n

*t+l
I

I n+l
I14',)

[-"-,.l tll
Z

LY",,J Lul urr) LtJ UUU

n+r = A
Zn

= [",, ",,"l [.".|

A solution to the system means Z n = ( x, , y n ) that solves all the difference equations
in the system simultaneously. To derive a solution, we need to assume that A has 2 distinct real eigenvalues (characteristic roots) e1 , and corresponding eigenvectors 11 v2.

e2

Review:

1) get eigenvalues by solving lA - e; I | = 6 2) get corresponding eigenvectors by solving (A

3) form transformation matrix T as matrix

[1

-e I )y 11: ]

:0

null vector

Following properties ofT are needed for the solution derivation.

Theorem: A is a m x m square matrix (not necessarily symmetrical) with m distinct real eigenvalues el ,e2, ....,em and corresponding eigenvectors v r , 1L2,..., v-!q.

is the transformation
.l

matrix:
0 0

v1

y_2

...

,n

] and

if

-r

exists,

Then T_'A

T =le1 0 [ 0 er
I

ol

t:
Proof: for

I'

:l
follows

lo o L
By defurition T
But

9rn I

sake of brevity, we prove the 2 x 2 case. The m x m case proof exactly the same steps but with i extended fiom 2, ..., to m.

Iv

I r:] ) AT: [A11 Av2]

by definition ofeigenvalues and eigenvectors

Av; : eillj

) AT = [e ryJ ezv z I

: r,r

..,,
1r,

0",]

:T
T-rA T :T-r
[' :,]
T

t'

ler
Lo

iJ 'f' :J

:
F'

:l

Qet

Corollary: if A is in addition

a symmetrical matrix, then T

-r: J r

Given a 2-dimensional linear dynamic system in matrix form:

: 'l : I.". ttl

L'' 'J
Zn+t

[,

UU

L"''

', ",,.I [.".l

^-J L'"J
AZ"

A is a square matrix eigenvectors y1 L2.

and

with 2 distinct real eigenvalues

and 2 conesponding

I't step: LetZ

useT:Ivr
Qt

v z ] to transform Z:
i.e.

i=T

Zn Zn+r

:TQ.
=TQ
o*r

UU
[t
[z
,,,,1 [0,,,,.l
rrrzJ

) q= T-t Z
m panlcular

[er;nJ
for

allz

Qn = T-rZn
including

Q o*1 = T-r Zo*t

Q nrt = I

LD*t

T-r (Az^)

r-'

A (rQ.)

(T-' A T)e"

[", ol q" e!
lo F,
ol

Lo

.,J p.,4

[0,",,-l

:
:
t q(n+l)t = : q (n + r) 2
er
g(n)r

l-l'

'*',,.*"]
= een

[:;n]
e2 q

(n)2 t2-31

are

two I -dimensional simultaneous difference equations

Recall from our discussion on finance application using iteration method

difference equations in the recursive form

ofQ n+t: eQ n

to

solve

the solution is

Q n = eo Qs

welet

now transform Q o backtoZ"

' t2.3r 1x';:',lN : [l ;;{ I |;$ =[:::;llJ ::i: :i

:rfo,",,l:rF,:.,1
Lo,",,J [:,".'J

f r f I Qo= lCrorrl:1c11 rorz-l L. ,l [o

where Q

is value of Q at period 0

where c

c 2 are constants

>2, :re"

=[rr

"r,[:;::J

:cl ern IL-! +c2 e2n y_2 )Zn : general solution form fora 2-dimensional dynamic model Zn+r : AZ" and the solution consists of constants c 1 c2 , eigenvalues el o e2 n and eigenvectors

The above can easily be extended to m-dimensional (i.e. m simultaneous I "t-order linear difference equations) system:

l':Ct,'

Zn+t

zn

j [i::lt;*
7 -^

z 6yr z 612
:

z6y^

Theorem: LetAbe the m x m matrix with m distinct real eigenvalues el e2 ... en with corresponding eigenvectors v r v 2 ... va : ) general solution form for a m-dimensional system ofm l't-order linear difference equations Zn+t = A Zn :

er' yt

+c2 e2" L2 +
1,2, ...,m

*cm emn llm

where c;

: constant i=

Economic application of m-dimensional difference equation system (discrete mdimensional d1'namic model) :
We construct a descripive dynamic model for growth of firms. To add more realism, we rntroduce risks into the model. This can be done through Markov process a stochastic dynamic model with Markov transition probability matrix. A model for firms growth can be stretched to imply econ growth with policy implications.

Some preliminaries: Markov matrix M is a mahix whose entries are > 0 and whose columns (or rows) each add up to l. This property means Markov matrices are suitable for handling probability dishibution (or density) p.d. functions. In other words for stochastic models:

row = 1(orl00%)
row = I (or100%)

=l
[Review: P is a p.d.

if

P1

>0

and

Pi = I ( like a Markov column)

iwk)

e.g. tossing of

coin 2 outcomes

H T

PH(H)=%> Pr(T)

:% > 0
1

IPi =l
Defir:
Sn+r

Stochastic process is a rule assigning probty that dynamic system will be in state attime n*1, givenprobty of system being in state Sn, Sn-r, Sn-2, .... So in

previous periods. In particular, ifprobty that system will be in state Sn+r at time n+1, is dependent only on the previous state Sn , then called Markov process (i.e. only immediate past state matte6).

Markov process Z n+ 1 =

M.,
ml1 m2l
:

Zn\
z61z

Z6+gr
Z 6+ r)2
:

Zrrrl
I

gt

+ r'sk

mkl

:l

column

zr"rkl

;l

M called hansition probability matrix or Markov

matrix.

Econ interpretation: if econ is in state j (e.g. good econ, bad econ, depression, recession, boom cycle etc ) at time n then m;.; is the probability of econ will be in state i at time n + I (i.e. probability ofintertemporal change in econ state).

Application: Let x n : 7o of companies in an economy growing at end of period

n t

! n :

%o

of

companies NOT growing at end of period

2 states of econ

periodn+l:90%

& let probability of growing

companies at end ofperiod n to continue to grow at end of (caa arrange Markov M to letthis be represented by mrr =.9)

probability of growing companies at end of period n to be NOT growing at end of period n + 1 : 10% (can arrange M to let this be represented by m u : .l)

:>

:>

column of M will add up to .9 + .1 =

Let probability

of NOT growing

periodn +

1=40%

companies end of period n to be growing at end of (can arrange Markov M to let this be represented by m rz :.4)

Q4)

probability of NOT growing companies at end of period n to continue NOT growing at end of period n + 1 : 600/o (can anange M to let mzz .6) column of M will add up to .4 + .6: I

:>

:)

Dynamic model describing above econ system

(2 dimensional)

Zn*r

Zn

Xn+r :0.9xn +0.4yn /n+r :0.1 xn * 0.-6 yn t\ ^rt note I column

-l-l

X column

Znn'L

Zn

:>

F,,l
|

one of Markov matrix M eigenvalues.: 1 and the other eigenvalue from solving

: [:

s{ FI

%i-, ,lf " l='

M-e;I v:0

:1 s, = [1.5+
:)

:>(0.9re)(0.6-e) -0.04 :0.54-0.6e*0.9e+e2 -0.04 :0.5 1.5e*e2 :0 1 /2(1) = [1.510.5]12= lor%

eigenvectors by solving

[on-' oo lf.,,l =iol t o.o-rJilluJ Lo.l t tl Lo.t

- 0.1 Vl + 0.4v2

[:
0.4 Vl +
0.1 VI +

',:1;
u
vz
v2

il []

= 0.1 vr - 0.4v2 : vl
u
v1

0.4 0.7

-0

u
v2
V2

:4
U

normalized

v12

+ vrz :

l'1){

[l fl,;;l
any vector 4:1 proportion

(4:1

cc

- i;] lil;J
any vector 1: -1 proportion

(1: -1

cc)

Alternatively

will work

will work

By Theorem, solutionofZn+r

= M Zn
e2n L2

: z^ :{:cr ein l4r +c2 "l

L'J

tl

- cr (t)' f+l

L'J

", 1rra"l 'l

"o

L 'I

As n ---

this term (1/2)

"

---, 0

llll
ct: l/(4+1): 1/ 5

['"J
:> z"=["".| =rnl+]:

L'l

We wish to get this term into p.d. form (i.e. % terms) which can be achieved by letting

lllrfrir

L'"J ['J I coldmn I l,;l

:1
Econ interpretation: over time (as n --r

loul=1aoxi = =L,yA
Jolumn

=l

80% of companies will continue to grow. 20% of companies will stay stagnant (no growth). Other possible economic scenarios:

In t}le above example, if we let gror'4h of companies in an economy be directly proportional to growth ofthe economy then above conclusion can represent the long run economic grouth picture. But note the conclusion figures depend entirely on our assumption of Markov probability mi.; . For instance, if we just change the above m 1r probability to 80% (probability of growing companies at end ofperiod n to continue to grow at end of period n + I now: 80% instead oforiginal 907o). This maybe due to business environment becomes nonaccommodative (e.g. govemment imposing higher taxes or new sales tax, extremely harsh environmental control, new labor legislations etc.) then conclusion becomes only 66.67Vo of companies will be growing and 33.33% of companies remaining stagnant in the long run and hence hindering economic growth. @lease check this as an exercise).

I.nA)

Chapter IV.A. iv). Discrete dynamic macro employment model to explain long run unemplol'rnent (R.8. Hall model for finding employment pattem).

Macro unemplolnnent rates are not useful for formulating macro policy because it does not give us information to which group our policy should be targeting.
We wish to know whether there are struchral or just short term reasons. E.g. low skill manufacturing workers in HK maybe unemployed for a long time because low-skill manufacturing jobs have moved to China (structural change in HK economy). During SARS and recent deflationary period in early 2000s, workers in all industries were losing jobs (short term reasons). 2005-2007 and 2008 saw some employment recovery and hints of inJlation. Therefore typical macro employrnent models are tamed as follows:

Hall's Employrnent model for finding pattems of unemployment over time. Hall, "Turnover in the Labor Force". Brookings Papers on Economic Activity 3 , @. 1972)
Let

) l-p: probty w remain unemployed.

:

p:

probability worker will find ajob (on average in the LR)

)
So

probty w remained employed next period l-q : probty w will be unemployed next period

) )

if let x : workers employed this period q x will rernain employed and ( i-q)x unemployed in next period.

Let y

py

will

workers unemployed this period be employed and (l-p)y will remain unemployed in next period.

next period average number employed qx + py next period average number unemployed (l-q)x + (1-p)y )dynamic system describing above average unemployment model for periods n & n+ I : Ln-l
(2 dimension&l)

I I

Ln

xr+l yn+r

: q xo + py" : (1-q) x'' + (l-p)y,

[Hall estimated for male (white) workers in U.S. in 1966:

Xn+l : yn+r :

0.998 0.002

x x

" + 0.136 yy " " + 0.864 "

We of course recogrize these p, q, using Markov.

(I

-q)

are transitional probty that can be formulated

Let

. = fraction of workforce employed at end of period n

fraction ofworkforce unemployed at end ofperiod

y n:

,;s
I

of econ

Assume probability ofemployed person at end ofperiod n to continue to be employed at end ofperiod n + | = 95% (e.g. can arrange Markov M to let this be represented by m 11 = .95)

:> :>

probability of employed person to be unemployed next period,= (100-95)% (e.g. can arrange Markov M to let this be represented by mzr = .05)
column of M will add up to .95 + .05

:5%

probability of unemployed person at end ofperiod n to be employed at end ofperiod n + (e.g. can arrange Markov M to let this be represented by mp .45)

: l:45% :> probty of unemployed person to remain unemployed at end of period n + 1= 55%
by
mzz

(e.g. can arrange Markov M to let this be represented column of M will add up to .45 + .55 = 1)

:>

.55

dl.namic system describing above econ model Z n * 1

(2 dimensional)

=
1

Zn

n+

n+ t

= 0.95 x n + 0.45 yo = 0.05 x " + 0.55y"

note

I column
-l-l

tr

X column

Zn+t

:MZN

:>

one of Markov matrix M eigenvalues: 1 and the other eigenvalue frorn solving 0.95 0.45

i::r : [;: tgL;{

:0 e 0.05 0.55 - e

:>(0.95 = :>
0

e) (0.55

- e) - 0.0225:0

0.5225

l.5e + e' -0.0225 = 0.5 - l.5e + e2 e i = tl.5 r / 20) : t1.5 r

\D75@3jf

{6:ttl

t2

= [r.s + 0.s1 t z

t or lz

17tO)

:>
I-rrr

eigenvectors by solving

lo.ss-r tttl O.ss llv, l -l -L-I v, I | 0.05 I

o.4s

:io 'rf

M-e 1I v:0

lol L.I
0.5

lo.es-% lo.ot L
u

,:;:;

=i'l
[;J
L'J

- 0.05 -v1 + 0.45

= 0 0.05 -v1 - 0.45 v2 = 0

vz
v
V1

0.45 v1 + 0.45

v2=0 v2:0

vr

+ 0.5

=9V2

vl:U

v
normalized
v12

+ yr2 :

U".l

"1:,1
Alternatively

:tl ie./ tl

vaz

uf",i
I

(9:1

cc

| {vaz I

=L

| 't uzl

(1: -1

c)

L.)

L"'l

"C
l: -l
proportion will work

any vector 9:1 proportion

will work

any vector

By Theorem, solution ofZ

n+r

: MZ"
+c2 ezlt y.J
il

=2"=l*"-i ="tet 'y-r

tl

L'".l
=

", rrr i-ql

+c,,112)n \ '\[

L'.I

{_ _i lt ,

tI
'
---+ 0

As n ---r oo this term (1/2)

:"'
We wish to get this term into p.d. form (i.e. % terms) which can be achieved by letting

tJ

|;]

cr=1/(9+1;:1719
Zn
=

:>

Ll
Policy implication:

"''[:]
=l

I column I o
)

vt r:r)
column

=1

Econ interpretation: over time (as n --+

907o of employed workers

will remain employed l0% ofunemployed workers stay unemployed (LR unemployment rate of

10%o)

there is a persistent LR unemployment rate of l0%, then this is not due to business cycles and policy must be geared toward frrding out the cause of this structural hend and relevant remedy. For example, we mentioned structural change of HK economy from manufacturing to service (banking & finance, entrepot and logistics, tourism) sector in the last twenty years. The cause is the loss ofHK comparative advantage (higher labor and other costs) to mainland in such manufacturing sector. HK Government policy seems to favor rekaining ofthe displaced manufacturing workers or outright subsidization. Effectiveness of such policy is hampered by reluctance ofdisplaced workers to switch, especially to low-paying jobs; &/or displaced worksrs cannot be re-trained for higher paying jobs; the usual mismanagement of bureaucrats includes wrong estimation ofpossiblejob vacancies and placements, increasing licensing requirement barriers preventing workers ability to switch jobs; waste due to bureaucratic rigidities (versus market allocation and discipline); abuse and sometimes fraud by subsidy recipients.

If

Chapter IV. B. Bellman's dynamic programming: Discrete dynamic multi-stage optimizati on models. Basic notions and terminology (optimal decision sequences examples)

Dynamic models can be continuous time

(t represented by real

x(t) or

discrete time x t

numbers)

(t by integers).

In pure math econ, most models are continuous time. Main analytical tools are differential equations and optimal control. However, most macro math models (e.g. macro growth, business cycles, employnent theory) are of discrete time. Hence difference equations and Bellman's dynamic programming are the main tools.
assume such discrete period to be points of time and differential equations and get useful result.l

fRmk: can actually

still use

Bellman's dynamic programming DP:

Defn: Bellman's DP is basically a way of solving dynamic optimization problems. It is a multi-stage

(: multi-period:

sequential) optimal decision process.

Given a multi-stage problem, we find an optimal decision policy. Based on this policy we generate a sequence of interrelated decisions that will optimize our objective at every stage and by following this decision policy, overall dynamic objective will also be optimized.

) )

A multi-stage optimization problem:

stagelperiod
policy

decision

3'd transfer transfer state-l A 51a1s-/ nr 51a1s-3

l

"

2"d

th

.. . .. ...

transfer
state-t

/}

Find opt decision s.t. transfer will contribute best value to state variable
at each

stage,

opt opt opt value-l value-2 value-3

opt value-t

and best to overall value of state variable

overall objective optimized

DP Terminology: there are two variables in DP. One is decision (= choice = control) variable and the other state variable. Every path decision at period affects value of state variable in all future periods t + 1,t+2, ......... hence affect overall value of state variable.

t)

How to do DP? Illustrate basic notions and terminology by an example of minimizing budgeted expense (abbreviated as exp) for economic development (growth): You are appointed as minister for economic development in country Planningland. You have to draft a 4-year plan to develop the countqr from economic state A (manufacturingbased) to economic state O (service-based). There are altemative ways to achieve this as given by the following graph. The numbers represent respective exp levels of altemative intermediate stages necessary to reach stage O.
stages/periods

I
Feb/2009

Feb/2010

Feb/2011

34

Feb/2012

)e
Objective: find optimal path to min overall exp to reach state O. A : manufacturing-based econ state 3 : gov build IT network for all office buildings downtoun C : gov build another theme park D = subsidize private IT companies E : increase funding of finance schools in universities F : special tax allowance for tourist and finance industries G : build east, west, north, south Kowloon cultural centres H : expand airport I : build additional shipping terminals
O service-based econ state One possible approach: grind out all possible paths, (in this case, all 18 paths) and compare overall exp for each path. Tedious, even for our simple problem.

@,

One possible approach: grind out all possible paths, (in this case, all 18 paths) and compare overall exp for each path. Tedious, even for our simple problem.

Another approach: pick min exp path every time:

A) B '.' 3 is smallest
then

B) F'.'5
then then

is smallest

F) I '.'3 is smallest I)A'.' only path (& exp:5) ) totalexp:3+5+3+5:16

Butthispathisnotminexppath'.' e.g.

A> C ) F ) I ) g 523s ) total exp: 15 < above 16

So need another approach: Bellman's DP.

DP Procedure: Bellman discovered the following technique, called Bellman's Principle of Optimality:
Various ways to state this Bellman's Principle of Optimality: optimal policy has following property: startiag from ANY initial and ANY optimal first decision, the remaining decisions constitute an optimal policy for the state resulting from the first decision.

A. Al

B. Optirdze {optimized objective of current period + optimized objective of all subsequent periods get the solution for the overall problem. using recursion- based on current period decision)

C. Starting from any point on an optirnal trajectory, remainder trajectory is optimal for the corresponding problm initiated from that point.

Above all mean that with Principle of Optimality, we can convert an n-period problem into an equivalent 2-period problem, namely current period and all-future periods (or all- previous periods). All-future (all-previous) period treated as one period. In addition, we assume that we have already optimized the objective for all-future period (or for all-previous period). Then we only need to optimize the current period and tag on the already-optimized all-future period. We repeat this process for each period (either forward or backward in time) recursively and the problem is solved.

t-r
'
2-peri od probl
em

+
COnVerI

't+t

lfconvert

optimize

[ (t-1

tl
&

lr

all

previous)

and t]
& al I futurel

optimize I

.ti:\

Now we solve your min-exp problem using DP:

Define

x1

decision variable, in this case: immediate next stage at period

)A=xo

xr )

x2 )x3)

xt:Q 5 immediate next

1

stage at penod 4

is @

current state means wg move from state S

state x

S+ /{

4.4.

(He)
-\/,2

,.4 tFt

(L, ) \/

Define: value function F t (S, x t ) for exp = total exp of already- minimized overall policy from stage t onward.

Define: f(

S,

1)

= exp of current period

F. (s,

zt)
denoted

Letx

= 6""i.ion variable minimizing F,(S, x,

):

by Fs*(S)

vt

Value function F 1 can be written in the following form called policy decision function:

Fr(S,xt) = min {f(S,x) + Ft*r *(xt

X1 min{ curent + alrcady-min t+l periods onward}

vtrich = for stages after S)

sFe

zt

DP terminology: an equation containing an unknown function is called a functional equation. (Above equation contains the unknown frrnction F p r * (x t))
Terminology: above equation is recursive

'.'

both F

and F tr r are in the same

-ion.

When working with time, we move backward stage by stage tbrough recursive equation until we get the first stage and we get the overall optimal solution for the whole problem.

(-D

We start from period 4 with destination state x a Q (S, x a) = min {exp cunent period 4 + already-min for stages 4+l onward} F4 =min{f(S,O) F4*1*(no stage afterxa=A)}:F a* (x:)

t )

E 0 '.' no stases 4*1 onward

can tabulate:

t=4
F+*(S)

X4*

t=

(t

2 more stages to go)

F3(S,x3):
min {f (S,x3)

+ F+*(x:)}
il

F:*(S)

X3 t

l+4=5 4+5=9 =10 3+5:8

min{5,9} = min{10,8}

:8
I

t7 min{7,8} I

l
t

: 2 ()

3 more stages to go)

Fz(S,xz) =
min

\t/
+ I

{f(

S,

2)

Fr *(x z)l
tl

F z* (s)

X2+

tl B

8+5:13 5+8:13 6+7=13

EElG

3+5:8

2+8=10 4+7=11

1+8=9

5+7=12

t=

| (t

4 more stages to go)

['

I (S, X r

rneans

optimized for period I onward (i-e. overall)

= min{f(s,x;) +

pr*(*v
F

Fr*(S)
S

Xt'

ll A

3+13:16

5+8:13

4+9=13

optimal path(s)

for min effort for

econ development

xo* )
5

x r*

)
J

x2r
E

) )
I

x 3*

)
4

xq*
iJ

t
4

)
A

)
n

orA

)
A

)
I

t
3

l3

)
5

l t
IJ

orA

)D

'F

'I

)a

Remark A: Above DP can have infinite staees

solution will be infurite sequence of interrelated decision variables {

f=

Remark B: Often times there are no solution or no closed form solution (only approximation). Remark C: Above DP require two pre-conditions: Principle of Optimality: At current stage, an optimal policy for the remaining stage is independent ofprevious stage policy. This is analogous to EfFrcient Market Hypothesis in Finance that current stock price reflects all relevant information of previous periods so we don't need to know tlle previous period information.

i)

ii)

3 recursive relationship: consecutive stages are related and such relationship is same for all consecutive stages.

Remark D: Many time solution by common sense, not by elegant deep math manipulations. Remark E.

Most soluble problems need differentiability

limited to local results.

Dynamic programming and macro growth models. As we mentioned, the latest development of grad level macro rely heavily on dynamic programming because it is employed to show rational eoonomic agents optimizing over time periods (with or without risks) - proper description ofeconomic agents observed behavior within GE (individuals optimizing to reach equitibrium) framework. Hence we get the micro (and concrete) foundation for macro. We also mentioned that macro GE models are different (not individual consumers or producers optimizing as in micro; but social planning maximizing some aggregate objective function subject to aggregate constraints).

Example: simplified macro dl,namio progranming model In an economy, 3 social planner elected by and always carrying out population wishes instantaneously. Let c , : qurr.rl oonsumption in period t and is controlled by population through the social planner. os control decision lariable ].

There is only one national product (a composite good) Y 1 in cunent period t which can be consumed or saved-invested, two inputs labor (assume: population) n 1 and capital k1. A production ftrnction F relating these 3 variables F( k1, nt Yt and F( k 1, n1) is homogeneous of degree l, differentiable and concave. Assume labor constant over time periods so can write n 1 = 1 unit .

):

) |

ln1 [F(k1,

n)] = F(kt/nt, n1/n1):F(k1,1) ) fcnof k1only.

and next period capital

production this period

dfined

consumption this period

) kt*r : F(kt,1) -ct = f(kr,ct) recursive equation [2-5] Note k t is then the state variable [we are looking at dyramic evolution (or equation of motion) of states k,, k,*r ]. State variables are the recursive ones in the constraint.

Assume economy's utility function U is a function

and U differentiable and concave.

ofbothkl and c1

U(k 1, c, )

Social planner's problem for population is to maximize this period's, next period's, and

all subsequent period's utility

Ifwe

are given constant discount rate

different future period utility period becomes:

end of each period t, then we can discount back one period to PV and problem for any particular

[l for

Max

IU(kt,cs) + [3U(k6r,

ct*r

)]

for all periods tand

t+l
T+l first and then

Suppose T + I is the last period, so we solve only for the periods T and solve recursively backward to I "t period:

1"' step: Max B U(k t*t , c r+r ) wrt decision variable c r+r to get the optimal decision function for c 1*1 in terms of a function h r+r of k r+r :
(by setting partial derivative = 0

DU(k r*r , c r*r )

:0

)get

cr*r * =hr*r (kr*r)

0"t-'t
V is analogous to F in previous

2nd

step: define a value function V r*r (k r*r

nothing after T+l pe.iod example Max {U(k r*r , c r*r ) * fl V r*z (k r*z )}

= U(k r*r , h

r*r (k r*r ))

all same

k r+t

(T+1 period variables)

3'd step: set up objective firnction for the consecutive period problem:

U(k1,c1) + [3U(kr+r,cr*r )

: U(kr,cr) + [3V r*r (kr*r )

from recursive equation [2-5]

: U(kr,cr) + BVr*r(f(kr,cr))
4d step:

Max

{U(kr,ct) + BVr*r((kr,cr)) } wrt

? Vr*r (krrr)

c1

Setting partial = 0

aUGr,cr) D(kr,cr)
+B
?

ct

c,

I :

)getcr*:hr(kr)

k r*r

i\J.u,

5m

repeat above procedure backward toward t

cr

step: after getting optimal decision function c 1*:h1(k 1) = I and we obtain which

*:hr(kr)

Max{U(k1,c1) + BVr*r(kr*r)
Cl

} = Vr(kr)

t2-61

[2-6] is called Bellman Equation.

Furthermore

if

V t Gt

converges to a steady state

ft1)

[2-6] becomes

v(k,) = Max{u(kt,c) + t3v(kt+r) } [2-7]

cl

[2-7] is a functional equation (i.e. same function V appearing on both sides ofthe equation) and when we solve this functional equation for V, we get solution for the dynamic optimization. This method is Bellman dynamic programming.
We see the parallel similarities of the previous example and above problem:

F1(S, x1) =Min {effs*1 +F1*1 *( x 1= L,n t+l onward )} - policy decision fcn p-4] "tae
X1

V(k,) : Max{U(k1,c) + BV(kp1)

C1

}-policydecisionfcn12-71

Economic application example: Planningland govemment now appoints you to be education minister. The govemment deems the best policy for economic growth is by investing in Planningland University but wants you to minimize the University expenditure. You did an econometric study and found: Whenever govemment budgets education expenditure E, in period t , the actual expenditure will be E . 2. When E is spent, "education capital" K1 consisting of camp^us building & infrastructure, library etc. will be I expanded/upgaded by 3. intertemporal relationship between Kt+r and K1 (dynamics of the system) is given by:

l.

&'

K*r-4Kt:E,

;: ri

4-^.0-A,L
You know at present K, represented by K6 = 5 (billions of $). You are glad the cost function is quadratic which means I a soln. Your appointment is only for 2 years (T = 2) so you only wish to solve the following problem:

rOl Min : (p,'+ K2) * E t=0 s.t. Kt*r-4Kt:& Ko:5

To solve: We start from T-1 period

T;L
K""

Kr2

lrrB-rl
[IIB-2]

*."1
bo

[IB-3]

t
K22

Min Fs.t.

p12
Kz

K1

2; + Er

lrrB-4I

- 4 Kr :

Kr

[IIB-5]

Kr

to be determined [118-6]

Min (Ett+ Kr2) +

zBt+ 2(Er+ 4K1)(l):0

1118-5-61

into [IIB-4]

@1

+4S)2
set to = 0)

I't order condition for min: (take derivative wrt E1 and

t:l equals to -2times state vble ValuetunctionVr(E^r)=Min(El 2+ &1^ + 1B1 +4&)2 =(_2Kt\. + K,,* (_2Kr+4K,\'
Eq

: -

K1_

[IIB-7]

control variable for

: Kl
e

4Ki1 q-+

4Kr

IrrB-81

) t:0 Min (Eo' + Ko') +

For T-2 period

Vr @r

IIIB-91

s.r.

&-

Ko:

aItu =
5

Eo
I

UrB-t0l
urB_31

I Min (E62 ) Min (Eo2

+ +

2s)
25)

gGko +Eo)2

9Kt2

I't order condition: ) 2Eo + 18 (4Ko +EoXl) =0

> ) I

2F4

18 (4(5)

+EoXl):0

Eo=-18 [IrB-11]
following
:

& : 4 Ko + E6 = 29 a 1-t*, -, Et: - 2Kr :-4 from[IIB-7]

Kz= 4Kr +

from [IIB-10]

\= 4(2)+(-4)= 4 from [IB-s] Vr@r)= 9k: :36 from [IIB-8]

Vo@o):Min(E02+Ko2)+Vr (Er ) =(-18)2+52 +

36: 385

fiom[IIB-3-8-9-11]

In other words, you will budget to cut initial expenditure Eo : -18 and next period cut expenditure Er = - 4 and the total minimized expenditure will be Vo(Eo 385.

):

Remark: We note that we did not discount the FV in the various periods. The implicit assumption is interest rate i in Planningland is zero, then there is not need to discount the FV to PV. (discounting factor B': I / (l+tt 1)

PLEASE READ STOKEY & LUCAS CIIAPTERS 1 AND 2 FOR FAMILIARIZATION OF DYNAMIC PROGRAMMING CONCEPTS.

Bellman's Principle of Optimality in metric spaces Given l. metric space (X, d1) called state space: 2. initial state x0 (x" if X is nth state) 3. transitioncorrespondencef:X3 f continuous and compact-valued self conespondence tells us that given state x , what will be all the possible [this " next state x 61] 4. discount factor for each period n 0<p<1 (assumed same for all periods) 5. one-period return (e.g. utility fimction ) function u: Gr( D R ( R including +oo); u continuous & bdd

X;

set

ofall

sequences in

X1

Feasible plan

(:

strategy) is represented by a seq(x")

Xsequences

s.t.

xl ef (x6)

and

xn+r

f (x") n:1,2,3,...:N++veintegers
ofthe system for period n+1]

fNote: x" in the

seq is the state

Typical DP can then be expressed as:

Max
seq(xJ

u(xo, x

r)

* Lx"11

p, u(x,,

x i+r

IDPU s.t.

xrf (x0) and

f (x") n:1,2,3,... =N*

Basic assumption for Bellman DP: (to avoid endless oscillation)

lim *)

XN po u1xn, x,,11) IR

for any feasible plan seq(x") Xsequences tA-DP-l] [This assumpion means we can find real number representing the PV of intertemporal returns stream offeasible policy decision.l
Define correspondence F p (x )

n=o

:XJ

Xt"au"n"""

:{seq(x")

Xsequences

: xrf (x)

and xo+rf (x.

nN+}

[= set of all feasible plans]

>zu)

Define new objection function H14 (seq (x"), x) : {F "1 aad look at altemative DP problem:

(x ) x {x}with x e X} )

Max
s.t.

H6.t(seq (x" ), x)

u(x,

" ')

* _l-l

pn u(x",

xo11)

seq(x")F1(x)

tDp2j

[this [DP2] is same as [DPl] except initial x6 in [Dpl] is replaced by any x e X in[Dp2] l [By assumption [A-DP-l], HE,1 (seq (x, ) , x) is well-defined real valued function. Since u is bdd, H1q ,1 also bdd.l Define value function V(x)

:X )
sup {

Hp,l(seq(x,),x) :

seq(xn)

eF1(x)}

[Dp3]

solution to [DP2] itr above sup : maxl [V(x) gives us the sup H s.t. feasibility]
I

Thm: (Bellman) Given any [DPl] problem with any initial state xo X and see x(n*) e F r (xo
V(x6)

)]

H6
"1

(seq

(x*

) , xo)

)
and

V(xo): u(xo*,xr*)+ FV(xr*)

V(xo*):
u (xn*,

xntr*)* 0V(x,*r*) V netl"

And conversely

ifu

is continuous and bdd.

Pf: Deft of V(x6)

o=l

means for any seq x(n*) e F r (xo )

u(x6*,x1*)+1,-p"u(xn*,xn11*)

u(*0,

x1)+xn=l

Fo u(xo, xo*r)

Vx(")eFr(xo)

Now due to recursive sfucture of the DP problem, for feasible (xz, x:, ...) eFp(x1*) (x 1*, x2, x3. ...) e F 1(x6) [if (x2, x3. ...)is feasible plan induced by initial state x1* implies(x1*,x2, x3. ...)is feasible plan induced by initial state xa with next state xr*l

u(*o*, x1*)

+t - pou(xn*, xo11*)
n=1

Z u(*o,xr*)+ F u(x1*,x2) *

:;

p'u(xo,x"+r)

H[-,.1(seq(x2*, x3*, x4'*,... ), xr*) ]H6ut(seq (x2, x3, V feasible seq(x2, x3 , & , ... ) F I (x1* )
V(x1*)

&,... ),xr*)

But

H1Il ut (seq

(x2*

, X:* , &* , ... ) , xr*)

xo)

V(xo)

Hrrq(seq (*"* ),

: u(xo,xr*)+ : :
u(x6,x1*)+
u(xo, x r*)

PIu(xr*,

*r*) * Xn=2

B"-r u(x"*, xo*1*)]

F lHrr,ul (seq

(xz*, x:*, &* , ... ), xr*) ]

p[V(xr* )]

And by iteration: V(xn*): u (xo*, xo*r*)

* 0V(x^*r*) V nell*

Conversely,

ifu

is continuous and bdd:

u(xo , x 1*)

We have V(xo)

fv(xt* )l

u(xo,

x1*)+

pu(x1*, x2*)+ p'V(*r* )

: u(x6,xr*)+ Bu(x1*, x2*)+ p2 u(x2*, x3*)+p3V(x3*)

u(xs,x1*)+

1!r

ju(x,*,
F

x1*r*)

+ F'*tv1"r*,*y V reN*

Since u is continuous and bdd by assumption

I t

Visbdd UB>0s.t. =

lVl <

UB

* t

the term p

r*lV(xr*r*)

) 0 as J) P,xo)

oo ('.' V bdd and p is a +ve fraction)

V(xo):
=

u(xo, x

r*)

p, u(x,*, x.;*r*)

(J)

co

H1q

't

(seq

(x'* ),

[The converse part of the Thm tells us in case u is continuous and bdd and if f solution (a set of maximizer sequences) to [DPl], tien we can go from the value firnction to the set of maximizer seq. In other words, we can use the value ftnction to solve Dp
problems, under the stated assumptions.]

Principle of Optimality: Optimal policy correspondence P: X X for DP problems: :argmax { u(x,x1)+ 0V(xr): x1 ef (x)} P(x)

[reminder: arg max stands for argument of the maximum e.g. given f(x), arg max: set of x* that maximizes (x).
so above P(x) gives the set of solutions maximizing the value function

V(x)l

Bellman [1957j: "an optimal policy has the property that, whatever the initial state aad decision are, the remaining decisions must constitute an optimal policy with regard to the state resulting from the first decision." policy, whatever initial [Means: policy function is opt for the infinite summation state and decision are, remaining decisions as per Bellman equation must be optimal policy with regards to resultant state from initial state/decision.l

Terminology: BtX)=

f(x): X) R :sup{ l(x)l withxeX} < -} : {{all bdd real firnctions defined on X}

Note: B(X)

space is metrized by the sup-metric

d-

i.e. B(X)

:a metric space (X, d-)

Thm: (Bellman, Prinoiple of Optimality)

Given any DP problem and frrnction Q(x) e

A(!:
[DP4]

Q(x):

max

{ u(x,x1)+ FQ(xr): xl ef (x)} V xeX

(seq

Q(x)

will:max { Hpol

(x"), x) : seq(xn) eF1(x)}

V xeX

Pf: For [DP4] Pick any arbitrary x X and for any arbitrary seq(x,) e F p (x), we have

Q(x) >u(x, 11)+

pe(xr) lZ-\
f
(x1

but Q(x 1) = max {u (x1, xu) + B Q(x2): x2 e so Q(x1) >u(xr,xz)+ lQGz) V-21

)}

incorporating

lz-2)inIo lZ-Il wegel

Q(x) >u(x,x1)+ BQ(x1)

-u(x,x1)+

F{

u(x,,x2)+ pe(x2)

tz-l-Al

but Q (x2) : max {u (x2, x3) + 9Q(xs): x3 so Q(x z) )u (xz, x:) + F Q (x:) [Z-3]

(x2

)}

incorporatin g lZ-21

into [Z-I-A] we get....

and by recursive iteration:

Q(x)

/Z (u(x,xr)+

j=1

xr gj u(*i,x1*r) ) * F'tte(*r*,) I:1,2,....

) asasJ) "o real seq (p t Q("t) converges to 0 ('.'p fraction) so lim p 'Q(x j) : 0 l : 1,2, ...
and since.Q is bdd
.

then asJ

Q(x)

> (u(x.xr)+ X- pj u(x;,x;*r)) -lim piQ(xr) J:1,2,....

oo

HEul (seq (xo ) , x)

By [DPa] we can pick a seq (xn* ) e F 1 (x ) with

Q(x):u(x,xr*)+ I

Q(x 1*) and Q(xn*) = u (x"*, x,,+r*)

F Q(x"*r*)

n:1,2,

...

)
:

foranyJ eN+

Q(x): u(x,x1*)+ p u(xr*, xz*) + ..... + pru(x;*,x:*r*)* 0'*t Q(*r.,*)

(u (x, x r*)

!r

Fr

u(x

j*,

x1*'*)

) +

p r+r

q1;,-'*;

As J

oo since Q bdd we get

Q(x): \u (x, x r*) +

X-

F, u(*;*,xi*r*) )

max { HEq (seq (x"), x)

seq(x,)

eFp(x)} V xeX

[Above thm says probleml

if

3 solution Q*(x) for [DP4], then

et

is the value function for our Dp

Chapter IV.

C.

Discrete Time Recursive Optimal Models

i)

Deterministic Optimal Gro'*'th Model: Finite horizon case

Indirect dgramic study using recursive methods: Model: function mapping state variables onto other variables, with intertemporal transition fimction on states variables to generate time series.
Mathematics for continuous time models are more elegant and better developed. However, economists often times use discrete models for various reasons, one being the empirical nature of economics. Most human (including economic) activities are discrete. For instance markets, factories, offices are open for certain hours everyday; hence are periodic and discrete. Economic data, mostly times series, are collected at discrete time intervals, e.g. GDP tabulated monthly, annually (hence growth rate of GDP also discrete). Commodities are discrete (however, we can look at the service attribute of a commodity to change it into a continuous case. For example,2.l566 hours of car service, instead of one car, two cars etc.).

In 1970s economists like Lucas (Nobe1 prize 1995: rational expectation) think if government policy changes (announced at discrete time point, applicabie to discrete
periods, e.g. increase in income tax for the fisca.l year 2008-2009, raising of benchmark interest rate between policy meetings), then rational economic agents will react accordingly by changing their decision rules for each period. econometricians cannot assume fixed behavioral equations for empirical work. More importantly, policy implication is that people's reaction based on expectation on govemment policy car render policymakers' effort useless.

Counter argument: 1. Such changes in behavioral equation parameters are either too smali or too slow to seriously affect the usefulness of optimal control calculations. 2. Sims [1980]: govemment policy rule can be framed in the form ofa reaction function (e.g. monetary policy as a function of observed state like differential between TIPS and straight treasurys, inflation rates, credit expansion . .. .).

With the above caveat, we will proceed with discrete growth models and re-visit Bellman's dynamic programming for applying to such models.

Let us start with some preliminaries of a deterministic (no risk) optimal growth model: Given: Time

ID'

Capital kt J
Product

Labor n, J
,t' h
y, J r

>

inputs

ouput

I J

linked by production function y t = F (k t , tt)

F(&,nt)
F: r:

I I I
I
|
I

I
I I

F(0,n)=0 nk,.Fn,>0; li. Fr, =o

*' *'
k'

uolllllluuusly ult.teterrlraurr continuouslY differentiable;! quasi-concave; strictly homogeneous ofdegree I

f;

kt,nt

lim Ft, =-'"

{/
allocated by

consumption-savings decision

ka
grossinvestments lg

to

/\,
currentconsumption
C1

-.--:'--"

assume s.t. constmints:

- cr * irS

Yt

and kr.r =kr - -6k,

machy

lfl

i,
new machy

0<6<1[N-0]
constant depreciation rate

depreciatedmchY

)c1+kt*r

-(1

- 6)k, S

Y,

Assume labor inelastic (fixed) each period Given society's util fcn U(co, and U additively seParable

n,=
,

(normalized) V

cr, c2' .""

= tllU(ct)
P.V.

0<[l<l
+

t=0

[!0

u(co

lL

) + [3'U(c1 )+t!'?u(cz)

[3'U(ct ) +

h",rG)
P'u(t'){"(tl

ul&,)

u(c.)

u(

U also bbd, cont diffble, strictly t

concave,
c

lim U ' (c r; t*0

: 5

To apply dynamic progamming:

Wenote

[IV-0] kt*r:kt - 6kt

1

+
)

it -

A recursive equation!!

And society's cunent utility function U(c

is given to depend only on c 1 , is separable

and is additive over discrete time period. Discount rate Bt for each period t are given so that we can discount different future period utility to PV

dynamic programming can be used to fmd optimal consumptive-investment allocative policy to Max society's utility over planning time horizon (finite or infinite) as follows:

r Social planner wishes: find sequence consumption and capital{c r , k t. n, }oo to:
@

Max IBtu(ct)
t=0 s.t. feasibility constraint

0<f3<1
ct

IIV-U

* kt*r -(l- 6)kt < F(k1,n1) at opt, assume output not wasted ) c1+ kt*r -(1 - 6)k, : F(kt,n,) ) F(kt,nt): F(kt'1) at opt, assume all labor employed ) nt= I ) (l- f(ktI )=F(kt,I )r capiial beginniDg-of-period tunction of k, filnrv ."rr"r. k
can defure fcn
=

6) k,

)c,:
Lemma:

f(kt) -

kt*r

flkt) is cont. diffble, strictly 1, concave, (0)=0, f '(k,) >0, lim f'(kt): oo lim f'(kr):1- 6 k r--' 0 kr-'Since

Pf:
(1

F continuously diffble, strictly 1, concave

- 6)kt cont diffble, stictly 1, linear (i.e. both concave and convex) ) f:F+(l - 6)kt also continuously diffble, strictly 1, concave f (0) : F(0,1 ) +(1- 6)0 : 0 f'(kt)= Ft,(kt'1)+
>0
(1

-6)>0
>0

er,

lim
kt-'co

'(k,)

lim Frt + lim

k,-- kt-.

(1
"o

- 6) =

(1

- 6)

lim
k, '0

'(k,)

rt + lim (1 - 6):o+ k,...'0 k,.-'0

lim F

(1

- 6 )=-

Note: similarity between above F & f and Solow Growth Model F & f.

can rewrite

[IV-l]

as

@ll
tIV-21 =MaxI[l' t=0
s.t. feasibility constraint 0

c, = f(k1) - k,*1 fiom

feasibility equality constaint

ulf(kt)-kr*rl
< f(k,) -{'.'

o<[!<1
0 < ct

<

k,*r

L
glven ko and

o< k.''

tk.r

:f(kt)-kt*r
S (k,)and

ko >

0.

J(et)

1*rr' #ft
&")=o
T

*.T

&-t

In particular, if [IV-2] frnite time horizon, stops at time T, we get

tIV-31

Max t
r=0

[3'ulf(k,)-k,*r]

0<B<1
0.

s.t. feasibility constraint 0 Note: at T, k r+t

< kt*r S f(kt)

given ko and ko >

0 (no more capital after T, all consumed)

"11\ '\-"

Since cont.

diflble

l"t order condition:

ak

--{tulf(ko) - k rFB' ulf(kr) - kzl + ... + BL'u[(k

t-r)

-kj+ Btut(k,)- k*1]+ ......1:6

k1

only these 2 terms have

t [3F'u' [(k ur) -k] Gt) + B' u'[f(k,)- k,*1] f '(k t) = 0 .) [rv-4] f3u'[f(kt)-kr*r]f'(k)= u' [(kt-r)-kd t:1,2,.....,7
)
from bdary condition

[IV-5] k t*t:6

given k 6 > 0
to determine specific solution

TD

t) :

-14,

-{t-

tI-'
-')
o(

6
l3ou'eult*

&

t
-t ) = l-

-6. kr*ttt= *-l-{

yr

9+-

t*

/ft-t

o(

a_ttca4 &
:- l- 4- +<
+
7=

ltt =a,t=&

t -ot$ * s61 =(-.tF) c -v + t- fi-*A)rr*6:o

-)T
o( p
,
-r-

( /t-.{
o<.lt +

,-

. +(F
r)
YP"+G

/+ <A+
/+a(p

+gpf- vg(r+

- o<6(,+*

rt <6 +("a6)'+for

+<p,t$cf)

Ig-c-r8-,rJ
+ - --- +(* 3+ - - -- t("crs)Ft +U

->

>A

(r-<F) ar

"<s(

t =l4C -:l

T-t+l

e9

<(\ /

/r,-"(F
=l 2 - -- -

Lg-t'

ff=1)

e.'+r"t*

q,*7.-*

fu {r"-c-}"EL

[o -t']
f r {"zF)r*t+rl

:k

Fr'-

:' -."F * Grp)'-'*"

u'( ft&tt - L*", ) *

oa a4

-K.

Cr-LqFf-LJ

r-QrPlT*trl

t-{Epf't*t -o{A +t<

'-Qcl3i*:*'

t- sF)
(t- *

: 421 T+A

p,,- 4&a:.<. U.arL&

SO

T+o
*7 L;

,-EF
=4.

lw-1-t

a*Lt- L /*r/t*.r

Dc A,*, (^,o.q, uq- L AM.e

a***dat

Chapter [V C. ii) infinite time horizon case usins

Lagrangian method

lReminder note: constrained optirnization is called mathematica] programming (lco,nputer progr:amming which is a branch of numericar anarysis). Lagrangiau is used tJhansform a constJained optimization problem into an unconstrained optimization one. Interpretation ofthe La,grangian multiFlier l, : at the optimal level, 2"* shows the approximate chaage in the objective function when there is marginal change in the constraint.l
Given cobb'Douglas production function f with unit labo! hclurring capital good depreciation:

f(kr)
aldkr*r

kf
ct

0< q < 1

=kf T

ko>

k t = capital good quantitry at beginning ofperiod t 0 andis given

We want to choose consumption c t (control variable) to:

Max
s.t.
Lagralgian:
T

I
t=0

B, In

Ct

0<B<l
k t state variable (','controlled by c J
+

kt+r =kto

- Cr \ kt*r - kto

ct=
cJ

O= : Bt ln cr

- Bi+l L

t*r (kt*r' kto

.L

ll

t*r is the Lagraagian multiplier +r is margina-l contribution of A k t*r to multi-period objective function at period t +1 ) I t+t must be discounted back to period t I B t*rtrt*r
Since

where

l"t order condition

lrv-91

ao
Act

Bt

[lt*r).tnr =0 )

I .-"-

Blt*r=0
t=0,
1, 2, ...,

llv-lol
I

a@

dkt

=
t

[3t].t .tr

Bt+l lt+1 ( ' o k to-1; =

B t ( - tr

t+

[3

t*r

o k 1o-1; = e

can solve for c

* ,

t*

We solve recursively backwards, starting from time T.

Wenotekr"r

is assumed to be not providing utiJity

) kr+r = 0

I and [rV-g]
Forperiod
Irv,10]

cr* =kr
1

" tomaxutility(U'
B.tr

> 0) (&om tie constraint equation when t = T)

r*r

t
t

).r +(1 / cr)( o kr'-')= -trr+(1 /kr") ( a kr'1) =-Ir + (o/kr) =0 Ir*= (a/kr)
1

And for period T -

trv-91 I
=
c
T.1

f3Lr = f3(o

/kr)= aB[1/(kr,," -cr.rrl

) (kr-r' / cr.t) ' I = aB t

cr-r

* = kr,t" / ( 1+ qB)

from

IIV.1ol

-|1.1 +B),r.r*ro kr'ro-1 =0 I hr = f3 ).ro k r.ro-1 =(tlcrJ cr kr-ro-1 = (r+crB)/ k r-1oo k r-r"-1

)rr.r* = q( 1 + cx[!) /kr.r

And for period T - 2

tw-el
c

=
T.2

fJ.Lr.r = f3(q(1+a13

) /kr.r)
ct

= qf3(1+qB) /[ kr,r" - crz] ) cr.z * = kr_2" /[1 + dB(1+qfl)]= kr-r" / lr +

[v.1ol

B+

tcrB)2

l\ r.z

* = [11+qf!1r+atl )) q] / krz
:: ;;

= [cr (1+crB + 1aB)z) J

/ kr2

And for period

T -t

Ir.'*=

cTr* = kr,.' /tt + cxB+ 1oB;z + .... + (a&)t I [a ( l+q B + (a [!)z a . . . + {qt!)r] / kr.t

try-ll]
tiv-i2l

ForT)co 1+o B + 1c t3)z + . . . + (cx B,)r + . . . . . = f /(1, crt3) lrv- il1 t crt* = (t- ot!) kr_t" tIV-lBl [IV-12] t lr,t* = o / t (1+crB) kr.tl tfv.l4l ) optirnal control consumption IIV.lgl = &action (1- oB) ofproduction k r,1"
And optimal

kt*r * = kt" = k,o

=

- ct - t(t-dt3)kt. l
_r(1-cB)l

kf

(1

= crBkf

whichis [V-g.r]

[Note in the^above approach, we erc letting T) o during the derivation of the solution. This is different from taking the l_imit of solutio"n as T) oI

This approach is also convenient for us to intooduce technologicar level into the model by adding a technology factor At in period t, assuming A, to be a glven parameter.

) )

kf above [fV-13] becomes c r., * = (1.q8)Ar kr_to

production function f (k t

)=

At

[V.lA-A]
IfV.t4-Al

above [V-14j becomes ]. tech A

r.t * = a /[11+at3) krt]

to allow technological progress (A or shock) we change At parameter into a variable.

stochastic model ) to introduce ri,"ks, we change At into a random variabre (with a probability distribution/density function attached) ind we will be -r*i_d;;l;;";;;;;; value of the above objective function

(e

To begin to answer this question, examine how the decision or control variables including consumption c,,, leisure W, demand jrrl for input in the 7 production of good I, and labor input L, in producing good r' behave, given the parameters 0, of the utility function, a, in the production functions, and
the derived paramelers y, from the former parameters through equation (3.1g). x,,, = (py,a/'l)Y 1,, p being the discount factor. Thus, consumption o[ sood i is proportional ro lhe out.put Y,r of good i, and so is the demand lor gooJ i in the

Cfrot/J

ousi t,ts

Lyctas

6J

Equation (3.22) srates thar c, equals (0,,{,)y,,, and equation (3.24) srates that

production of good k. Equations (3.23) and (3.25) state that leiiute W, and labor input l, used in producing good f are both given fractions of total hours H. If random shock 2,, is introduced in the production of Y,, output of each good i is subject to this shock. Consumption cu of each good i and the use of good i as input r^ir in rhe production of good /< will be affected proportionally,
because both are given fractions of Y/r. Because

Keynesians question the ability of these two basic mechanisms to do so satis_ factorily (see the discussions oi prose..lresljanJ r'r."ti* iis"8;), ,".,n", iepresenting an RBC viewpoint, and the f.ti", u i"yriisl"an vrewpoint;. As pointed out in section 5.1, Keynes did not, und ""r" rh" _;l;;;'ieynesians do not, believe that an equilibrium theory wittr full empklyment-of ,e.ou."es prevailing can explain observed economic fluciuaiions. 3l.ways l"-or example, Markiw (1989, p. 85) questions whether mosr ,"";;;;-;;;';, associated with some exogenous deteriorarion in the economy,s capabilities. f;;;";;; -simuttaneous the model of section 3.2 may be r.; *,;i;i. ;h; r, ltll:uch "bt" )menhof macroeconomic variables ro some exlent, it might be inad_

""

in the production of output y,r. The above dynamic characteristics of the economic variables generated by this multisector model are examined by Long and plosser (19g3) who emphasize the ;mplied comovements of economic variables:
2,,

multiplicative shock

H is fixed, and leiiure W. and labor input L,, are both given fractions of H, they will not be affected by the random shock z,i. Thus, the Cobb-Douglas utility and production functions impose very restrictive behavior on cn, xr*Wu and Lu if the only shock is a

other hand, such leadJag rllations.appear to be well "iii"U[r. captured, through tral analysis, by a simple linear multiplier_accelerato. fiquiJity_pr"f"r"n". consisting of .an aggregate consumption r"*ti.", i*"'r'gir"gri" i._ nt functions based on the ilves tment,accelerator, and a liquidity. 'erence relarion. See Chow and Leviran (19691, Cf,o* sl,

in explaining the leadJag relationships umong e.onomi"

O,

chow (1993b). The key question

T:"::::il"T"_11iables mooers ol optlmizing .Dy

"":wer red by the economics profession. The remainde,

productive employments will also be unexpectedly high at time ,, Assuming that the commodity has at least several alternative employments, this not only propagates the output shock forward in time, it also spread the future effects of the shock across sectors of the economy. At the most simplistic level of analysis, this is the primary explanation of persistence and comovement in the consumDtion. input, and output time series in our example. (p. 49)

If the output of commodity i is unexpectedly high at time, ldue to a stochastic shock on the production functionl, then inputs of commodity i in all of its

;h;;;;*_". the resulrs of some recent studies, \4,ith th" p".p;;;iili;ni "f so_e on this question.
thi,
optimization models are useful not only for studyinq .economic

:jl,,"g:il::

this questLn. No .onr"r,ru, or opi"ion

through business cyctes can be adequatety "r agen6 in equitibrium. Research is still

is whether the

dynamiJ"ir"r""t'-.lti*

ifS;,lh;t",

n".i""n

Esllmotlng Economlc Etfecls ot polllicot Evenls In Chlno

arso fo' :'-,:*:.!fi"-._1T:T"l b:tprovide studyinsec.l,.fir" .rrriei, counrries, To illustrate, I .;;;il;;;ii,o

aagveloniye Long and Plosser (1983) also examine the dynamic properties of pnce, wage rates, and interest rates. Prices and wages are studied by using ihe partLl derivatives of the value function with respect to the state variables output and leisure W,. Using the Lagrange method to solve the dynamic optimization problem for the centralplanner (or equivalently for the market economy), one can obtain prices and wages by the Lagrange multipliers themselves. The rate of interest is found as the ratio of prices of goods in I and , + 1, as discussed in section 4.4, 4.5, and 4.6. As the optimal decision functions for the control::

y!

:1,":j:.:nTJ:',l 9lT:*l to measure the economic-effeciJii poriticar inctuding the.creat Leap Forward *d rh"a;ft,";i ilf"i;r#:
serves as an introduction to sections 5.4 and 5.5. It araws,fJm 'and Chow (1996). Chinese economy is modeled as if there were central planners who ize, at any initial year zero,

"

.,rroy

!E,p,rnc, r-0

ln z,*, = ln z, + p+ e,.,

(s.4)

Per capita consumption or investment is determined by the social planners solving the dynamic optimization problem. One might object that this model is too simple, but it is useful in providing a crude answer to the question: If the Great Leap had not occurred, what would per capita output in 1992 be as compared with actual output? (By the way, the answer is, Twice as large.) To arrive at this answer, estimate the optimization model by using annual Chinese data from 1952 to 1993. The model consists of the random walk equation for ln z and an equation for lnk,,, derived from solving the dynamic optimization problem. Because the variables are nonstationary, first detrend by dividing by 2,, yielding k,.1= k,r1|2,,7,= z/zt and d,= c12,. The model in terms of the detrended variables consists of

rsso

re55 1950 re65

1970

FIcuRE,5.1 Observed and simulated residual

lnz, =p+e,
ln i<,.,

(s.5)
+ e,

=g+G,ln!

G"lnE,

(5.6)

'

with lnk,*, as the control variable, and lnZr and ln&, as two state variables. The coefficients (g, G,, Gr) are derived from optimization, given the structural parameters o, 0, and T = sp. The residual e, is added to the optimal control equation for ln k,.r to account for the fact that the simple model cannot explain the actual data on lnk4r cornpletely. Given the structural parameters, and time-series data on per capita output q, and per capita capital stock k, we can construct z, by solving q,= zf kl-) and derive the coefficients (9, G,, G) and hence the residuals q and e, in the above statistical model. Assuming (g, e,) to be jointly normal, we can evaluate the likelihood function and maximize it with respect to the parameters o, p, T and p. The results are, with standard errors in parenlheses,

smoothed residuals. The result is a tactor of 2.0 in per capita ootput in L992 I ,using the residuals free of the effects of the Great I-eap, and a factor of 1.2 :,using the residuals free of the effects of the Cultural Revolution. The latter estimate appears reasonable, because this estimate is concerned only with measured physical output and not with emotional sufferings.
E,| Esllmollng ond lestlng o Bose-llno Reol Buslness Cvcle Model

(a, 0,

l)=[o.zrs

(o.oroa),

o.wr

(o.ooor), o.ozrs (o.oozs)]

is

Returning to the study of economic fluctuations in the United States, I present in this section a base-line real business cycle model discussed in King, ilosser, and Rebelo (1988a,b). The model is slightly more complicated than the one presented in section 5.3, having another control variable, the number of working hours per capita ur,, in addition to investment t,r,,. The representative economic agent is assumed to maximize

The labor exponent 0.7495 in the Cobb-Douglas production function

reasonable. The large p = 0.9999 shows that the Chinese planners place great weight on future consumption as compared with current consumptiqn, thus devoting a large fraction of output to investment, which is in the neighborhood of 0.35 for most years from 1952 to 1993. The annual labor augmented technological progress of2 percent is reasonable if I include the years 1979-1993 after the economic reform. In Chow (1993c), a Cobb-Douglas production function with constant total factor productivity was shown to fit China data from 1952

eie,p,[tnr, _.
dt = (t

eln(l - a..)l
Jr,,

(s.7)

to the constraint on the evolution of capital stock

",.,_,

-6)r,, +r,,

(s.8)

a Cobb-Douglas production function for per capita output, per capita rDtion is
c,

to

1980, excluding certain abnormal yeari, but total factor productivity increased substantially after 1980. The current production function incorporates

= sr"(z,ur,)" -uu
s,,

(s.e)

total factor productivity and fits ihe data well enough for the entire sample from 1952 to 1993 to be included in estimating the parameters. Figure 5.1 shows the estimated residual0, in the log productivity equation. The impacts of the Great Leap and the Cultural Revolution on this residual is obvious. To estimate the economic effects of the Great Leap, smooth out the residuals , and e, in the Great [-eap period and simulate the model using the
a random

in.which the first state variable

117,

f6llows a random walk with drift y.

the,conslrainl on

..ot

::"::

cstcd in multisagc dccision

B.lltnrn died on Mcch 19, l! in his own wods sinc. be lft

inforiouivc autobiograpbt
publisher bas generously approvcd cxtjnsive excerpting. During tbc summer of 1949 Bellmen a Eourd associate profcssor of mathcmatics at Staniod Univcrii; wi6 a derclopilg intcrcst in analytic numbcr thcory, was consulting for the second suD-mf, at the RAND Ccooration in Santa Monica- Hc had rcceived his ph"D. from *nccton

(trd tDe nane, l95os wqc not gmd ycars for maitematical rcsegrcb- We had a very inErcsting gentlemal i! Washitrgton named wilson. He was

in

19,,16

at the agc of

5,

despite

vaiqr!

war-related

actiyitis during World War Il-inchrding being assigaed by tbe Arny to the Manhattan project in Irs Alamos. He had already xhibiEd ouBtanding ability both in pul matbematics and in solving applied problems arising ftom the physical world" Assured of a successfirl convcntional academic carecr, Beulca& dudng the period under consideratiorl cast his lot instead 'r'ith tbc kind of applied mathematics later to h hown as opcf,atioDs rar."t"i. to those days applied practitiooers wre regarded as distinctly second-class citizcns of the matbematical Aatcmity. Always one to enJoy conEoverst when invited to spea& at various univenity mat[ematics depdtmeft seminars, Bellman delighted in jusdfying his choice of applied over purc matheoatics as being motivaEd by the real world's greater challenges aDd mrtbematical dcmands.

of Defens, and he actually bad a pathological fea and hatrEd of thc wm4 rcsefich. I'm not using the term Iightly; I'm u$ng it precisely. His facc would sufttse, he would tum rcd, ard be would get violent if pecple used
Secretary tbc trm, rcsearcb. in his prcsencc. You can imagine how he

Following ar excerp6, takn cbjonologicaly ftom

Richard Bcllman's autobiogaphy. The page numbers arc giveu after cach. Th excerpt sction titles arc mine. These excrpts are far morc serious tban most of the book which is full of entcrtaining anccdotes and outraeous bchsviors by 80 exceptionally hunot bebg. Stuafi Drtlrls

fe& tbea about the term" matlenatical Tbe RAND Corpcration was cnployed by the Air Force, and the Air Force had Mlson as ia boss, essentirlly. Henc, I felt I hsd to do something to shield Tilson and tbe Air Force from the fact that I was rcally doing mathematics inside the RAND Ccrrpcration Wlat title, wbat name, could I choose? In the fust place I was intercsted in plaaning, in decision making, in thinking. But planning, is Dot a good word for vrious reasons. I decided therEfqe to use the wo4 programmiag.' I wanted to get adoss th idea that this was dynamic, this was multistage, tbis was time-varying-I tbought, let's kil two birds witb one storc. IJt's take a word that has an absolutely precise neaaing, namely dynamic, in tbe c.lassical physical sense. It also has a very interesting property as an adjcctive, and that is it's impossible to use the word, dynaEic, in a pejorative sense. Try tbinking of some combination that will possibly give it a pcjorative me3dn8. It's impossible. Thus, I thought dynadic pmgrarudng was
a nam. It was soEethirg not svcn a Congressman could objcct to. So I used it as al umbrella for my activi

gd

BELLI'AN'S INTRODUCTION TO MULTISTAGE

OECISION PROCESS PROBLEMS "I was vay eagf, to go to RAND in tbe sumrer of 1949 . . .I bcsse fricndly wir! Ed Paxson and asked him
Sbj.c, ctarri'rotb{: Dr!.ric For'tEEils: bindrr. prf..sbn t: coocrn o[.
Afra d!

ties" (p. 159). EARLY AI{ALYNCAL RESULTS -Ihe sumner of l95l was old-hooc-weekHaI Shqiro wer at IiAND.

Sam Kadin and

tukw: A,vxrvlr!^jry ItsJ! (SrEr^!I

Op.rdd n....rt
\,b1. 50. No.

l.

JllorFFhuq ?,rt\fr. a8-5t

O 2qn INFORMS

m3{!364xi12l5m104 t&t.@

48

152&J{d} clcdto.ic

[;sN

f>,rs)

i.:,fl-',*
nd to'solvc mber tbcory,
whicb
firDc-

doing tlis.
aay othrs whcn I found

se9n Pr

was clcar

THE MOOERN MAT}IEMAIICAL IMTELLECTUAL

Ivinq lngeD'ous

ClictrbrCl
mattrceaticirns-

trumber thetry, which I was sixteen. _ "Howevr, I had to face be fact that I could not do wbat I-laDted b do. Possibly the state of matheoratics did aot nad wa.nted

:",. T*_ ,*
IoT

'I !4d !o mrLe 1 6alor decision. Should I rctum to StaDford or. stay at RAND? I bad thought about this question in ttrDcton, but it was Dot an easy decisiotr !o makc sioce tierc were sbong arguments on each side. "At Stanfond, I bad I tenured positioq good for anotber , uury-lgbt yeas. Tbc retircment age at StaDftrd was sevcnty. I also had I good teaching position, with not too mucb teachtng, aDd a fine bouse, which I have described abovc. nor te importa considr.tiotrs. Ar Stan-

':me toot we uscd ias tbe calculus of yadations. Wlat we foud was that very simple problems rcquired grear ingeDuity. A sEall change in 6e problem caused a great change in thc solution. 'Clearly, something w8s wrong. Tber was an obvious lack of balancc. Reluctrntly, I was forced to the conclusion tbat the calculus of variations Eas not an efectivc tool for
obtaining a solution" (e,p. 174-175).

*T

chanc. to I b do sincedo analytic

FORMULANON OF TTIE MARKOV DECTSION PROCESS PROBLEM

to iL

allow this. CrtaiDly, ny state of howledge was not up

*.r a good deal of good analysis tbere. could see many applicatioDs. It was a clcar cDolce. I could either be a tradidoual iDte[ectual, or a mod_ cm. inElletua.I using 6e rcsults of foiO" problems of society. Thii a"rrgo*i -conemporary parn. Elther I could do too much rcsarch " and roo litrlc appligtion, or too littlc rcsealch and too tion. I had conEdencc that I could do &is aalcate "ppU"u^u"t aiivity, pic a la modc" (p. 173).
:o T" F.u1tbrTorc,

"I. _sfTt cnough timc in Los Angeles to know that I would_enjoy living there. I also knew th; Los Aagetes had many fiae bouses. although it was not undl 196g that I had one that was btr than lhc one up in Stanford. "I was htrigued by dynanic progasming. It was clear ^

"I spent a geat deal of tine and effort on the firnctional equations of dynanic Fogramning. I was able to solve somc equations and to dctermitre tbe propenies of the ftnction and &e policy for others. I devIoped sone new tbeories, Markovian dccision processcs, and was able to rcintrprf an old thecry like the calculus of variations, of which I will speat morc about below,' (p. 17g).
OYNAMIC PROGRAMIIING AilD OPTIMAL CONTROL THEORY

th:rc

.y ,"r"*l **

"A number of mathematical models of dynamic programning typ were analyzed using the calculus of variations.
The treatmeDt was not rortiae since we suffered cithcr Aom tbc prcsenc of constraiDts or from an excess of lincrity. Ar itrterBsting fact that cmerged ftom this detailed scrutiny was that tie way on utilized rcsourccs deprnded critically upon the levcl of these rcsources, and 6e tinc remaining in tbc process. Nanrrally this was surlnising only to soEone u rscd in ecoaooics such as mvself. But this was my condition wi6 rbe rcsult that the observation of rbis phenomenon came as quite a sbock" Again the indgling thoughe A solution is not mercly a sct of functions of time,

THE PRINCIPLE OF OPTIIIAUTY AND

ASSOCIATED FUNCTIONAL
'I,

EOUAIOIS

rrs

dcqided to itrvestigate tbrec areas: dyoamic program_ mrng, control tbcory, aad time-lag processes.

as a

p obdm closcty rctari 'As I result of a &tailcd i

over-involvd sincc all along I had

ously io the calqllus of variations. A corsc ir tbe sub. ject in college had grven me simultanously a rather low opinion of its intrinsic intrest and a healthyrcspect fd its inticacic.s. It ryFared to be [Ued with comDlicated xis-

Do desir to

wod

scri_

sEams, or at last

t:erman mathcmaticia4 concerning a crtain rypc of math_ ematician Wlen this iadividual discorms that he cal jump aqoss a streaE, he rcnuls to the otht sidc, ties a chair hit l"S, and sees if he can st'rll jump across the stream. lo lory T"y enjoy this spcq others, like myself, may feel lnat rt is &ce firn to see if you can jump across bigger

with self-imposcd rcstrictions, none pointbg ia any particular dirertion. This is Prtnent to a commeat made by Felir Klein, the great

teDce and uniqueness tbeorems

A SYST$'ANC METHODOLOGICAL
APPROACH TO MAIHEMAfICS
"As pointed out abovc, as of 1954 or so I had stumblcd into some importaat types of pmblems and had ben pushe4 willy-nilly, into answcring somc significant kinds of guestions. could handle deterministic conaol ptocesses to some extent and stochastic decision orocess in ecolomics and operations rcscarch as well Where next? At 6is point, .I began !o thiD& in a logical fashio4 using a systeEatic methodological approach. The point about th suitable ph.ilosophy Plcpaing ouc for the fortunate accident sbould bc kpt in nind. 'Thf,e are sevenl ways in which a mathmatician can Pmced to extend his rcsearch eforts, particularly one who is deeply intercsted in problems arising from the physicsl world He can, on onc hand, examine thc equations he has been vorking witb and modify thea in a vriety of ways. Or hc can ask questions tbat have not been asked beforc conceming the Datul! of the solution of the original cquations. This is basically a very dificult way to carry out rcscarch- It is very casy to cbaagc tbe form of at cquation in a largc number of ways. Th glEar orajorify of the ns, equatioDs ee not Eesningful, and, i-n conscgueoce, lcad to both difficult and unimporant problems. Similarly, &cre are many questions that are diffcult to answcr, but hardly worth asking. The weU-taincd mathematician docs not Ecasule tbe valuc of a problem solely by ia int-actability- The challenge is thec, but cnen very small boys do not

diftrcnt

ones.

"Despite Ey personal ;selings, tbe cballenge remaiaed-, trow drd one obtain the nurcrical solutions of ootimization problems? Were there reliable methods? As oointcd gut abov.e, I_ did not wish to gapple witb this thorny ques_ o:1 -d had ccrtainly rot contenplarcd tle appication J or.dynaEic progratnming to contsol processcs of determintsfic typcs. OriginaUy, I bad developed tbe thcory 8s a rool for stochatic_ decision processes. However, the thought was_ llruy torccd upon me that the &sired solution in a conEol Foccss was a. po.licy: .Do thus-and-thus if you 6nd' yourself in this portion of stare space wirh this s-mount of !m-_cJcft.''Cowenely, once it was realizcd tbat th coocpr was fi.6rrqmen6t in conrol tbeary, the natbipaticization of thc basic enghering concept of fecdback conBol,' tben the empbasis upon a state variable forDrulanatural. We s-iEE-ErEr,-irErBritrgEeracuotr bctweetr dyna.mic goga'nming and contol theory lDls gntorces tbc point tbar whcn working in tbc field of

of potcy

e": ry"."

acc?t all

dares.

uisc

df
q

!gF,'alt
qongo!
'

of tbc co ls tle assunptlon Uat ril

thc staE v{iableg caD bc

for dealing with these 'fuzzy' problems is being developci, but tbe path is not e.sy. 'Upon 6rst gaeing upoa thc complexities of tbe real wortr in temptation to rturn to nu-obf, thehowwer, does Dot seem to be rcwad-

'"In thc ibsl wcl4 n; fomly r4id Oftcn pa and comlltltss cannot problcns of society, as I' boondoggte ald high encrgr-ligl cost pt ues rn tE tict thal wc dont Lnow hdx, to plx systems of soci*y involving people, wc don't understa.nd cause and ctrcct, which is to say the consqucnccs of decisions, and we don't erren klow how to make our objcctives reasonably p{cise. Nooc of the rcquirements of classical scienc are met. Gradlally, a ncw -"thodology

it

of

tbe was

ical algorith'n".

this Sorccreds

dontinual e.ffon. The prcbleos are too difficult and &e victoris too few. Taking up the challenge of complexity, J felt ih'r the apprcpriate +t"g to do was to start with deterministic control prccesses and to modiS them stage by stage to obtain tbeories which could be usd to deal with basic uncrrtainties in a morc soohisti_

-*fo

catcd fashion. this end, we can begin by inroducing well-beiaved

sidrd thc last rsort of an incomptent mathcmaticia!. tue. Once working in the area, it is vqy quickly rcalized that far Eore ability and sophistication is rcqutd to obtain a numffical solution than b establish the usual *istcace and uniquaess theorems. It is far more difficult to obtaitr an efective algorirhm than one that stops with a denonstation of validity- A final goal of any scient'ric theory must be the derivation of nunbers. Theories stand or fall, ultimately, upon numbers. Thus I became intrestcd in computers, not as electronic toys but rathr because of whar tbey signified mathcmatica.lly ald scientifically. This interest led in oany uDexpcted directions, as I will indicate subsequendy. This is a significant pafi of the story of scietrtific methodology. It is usually, if
The opposirc, of course, is

wrcrtainty of the type exteasively treated by the classi_ caLllEo+f@iilitJFTbi{ leads to thc modern theory of stochastic contol processpwhere uncefiainry is rcpre_ sedltdbv-randnln v+eblefwith known probabitiry disributions, and where the objective is to maximize xDected values. This gives rise to an clegant 6eory with a good deal of alts'active analysis. It is a new part of pure matbematics-

not always, impossible to predict where a theoretical iavestigation will end onc started But wbat one can be certain of is that the investigation of a meaningfirl scientific area will lead to meaningfrl mathematics. Inevitably, as soon as

thcm ofobtaining numrical arswCs to numerical questions, one will be led to all kinds of
one pursues the basic

intercstiag and signifcant problems in purc mathematics" Crp. 182-185).

Chapter

IV

C.

ii)

b) infinite time horizon case using Bellman Functional Equation

In previous sections, we covered general principle of Bellman's Dp. we illustrated it with simple examples. ln discrete period growh analysis, we oan again use Dp. Now otll coverage is on more advanced level since we already have concept maturity in Dp.
For above optimal savings (= optimal consumption q) model, social planner is looking at the following problem: (c s control variable, k t state variable ... controlled by c

We want to choose infinite sequence

{c, , k,*r },=o- to:

Max { ct, kt*r},-6'

s.t.

,:o -ct

BtU(ct)

0<B<1

kt+r =g(ct,kt)=(k)

)
t3

r'u-trr

glven ko>0 k1e K1c R*

t2

t
$-y

1i'.'-'-

{o76 u(co)J
u

e"
I

&s

pu cct)
Q

(c")
Max Bb(c

f .r(c6;1
6)

BlU1c,;

B2U(c2)

+ ... + ntU1c,; + .. ..

s.t.kt*r=(k)-ct
If can find value fcn V(k J = max (all future utility) fmm time t = I onwards s.t. lerr=f(kJ-ct
then [IV-15] =

Itv-f6l ( uo T

u(co)- BV(kr) "'

o"?"oov(t
o)

\cr I s.t. co+>kr :f(ko) I\ stven ko o to

That is, we convert [IV-15] Max

[IV-16] MaxU + BV

Bt

U( c t )
without any

:(44,

But how do we solve for value function V:

First we notice above [v-16] reasoning applies to all periods (not just initial period 0). i.e. social planner actually max the following for EVERy period t (recursive):

Max U(c)+ BV(k*r) s.t. kt+r =f(kt) -ct

ko>

[v-17]
[ry-18]

o t 23

t &(

t+t
tt*t

t*z

ij-l,rax alL fuWe have two equations [IV-17] and need one more equation.

pz'"*aL+ uz-I^-z-

[V-18] but 3 variables c1,k1

and

k1a1

Social planner needs some policy function h(k = c 1 [V- I 9] to max in each period t by controlling the consumption c 1 , depending on k 1. We note again the recursive nature of the policy function which is same for EACH period t (called time-invariant policy).

[IV-I7-18-19] means

Max U(h(k) )+ BV(f(k) -h(kt))

given ka > 0 this functional equation all in terms of k can solve for k1 and then get kpq and q from [V-18-19]

) )

Dynamic Programming DP: frnd policy function h (state k1) then iterate following 2 equations from initial k0 ('.'recursive)

:
:

control

h(k) =c1 [V-19]

kt*r:

g(kt,

c1) (which
oo

=f

ft)

- c l in our example) [IV-18]

the iteration will generate

sequence {

}=o ""

which solves original problem [IV-l5].

The value functional equation linking value and policy functions:

Vft) :maxU(c) + B V(f (k) -c) [V-20] is called Bellman Equation

'-1..,

The fi:nction tl'at solves Max on RHS

satisfi es functional equation:

of [IV-20] is the policy function h(k)

which

u(h(k))

v(f (k)

h(k)

[rv-21]

There are 3 methods to solve the Bellman Equation, depending on U and g, namely: method (since value function V is recursive, we can use iteration as we did in previous - the recursive compound interest equation). 2) Guess-and-veriff (Guess-and-verify a solution V for the Bellmaa Equation) and 3) Howard's improvement algorithm (or policy improvement algorithm). We iterate the policy function for each successive period until h1 converges to the optimal policy function.

1) value function iteration

Here we will just cover method 1) value function iteration. (We have seen a crude version ofthis method in our min effort example in previous chapter):
From Vo , construct

V;*r (k)
s.t.

max {U (c)

+ B q G)}
k

for

j:

0,

r,2,

k-:

g (c, k), given

Iterate V.;tr until sequence of value functions converges and we solved the Dp problem. Retuming to our example (2 alternative approaches), we know by the Lagrangian approach, the optimal path for capital in the oo horizon planning case is

k+r: o0kt"

[IV-09-1]

We want to check

if this

is also correct by Bellmaa functional equation approach.

rr\

| ^ 04 t-+oz at-, = ol Bk,

*]2.fr-eJ,

st.

Ca+

k-,. =

s!,0!4r,t4@-

--) v&) - nax L t

L ^ rfl K+.,;

(--(+@D-

<A

t 'al {ii

r/-,-(kt.(,-<
,z Ltt+94t +1,

(t t-*(,-<
" /.- (L"

t-("p

+ <"/^.(Lo)

2 *il

A(+) r

+[E:-*]

,=

[g:"-a] >

lsf

P2AJ.v

z-aa*<';

h+,1u+

pV

t. .4- t -"a, V'= k.,

i;:

r' ((ct l (/-) =

ts'

tL&')

L,

t"
sK>

It

k' tt pKr
Kr

-- ot t',"L' l*(t+$p>: + Fk,+ fr. 4t)+ frr</-k - fr,t^{+*")

= (rrgr,)v t^-k, -(elr)L,Q+Akz)
rv:-r:- A]
u-'

+ gk,+

(r.
rc-,-

v-Lt)
a'.-

tn*-= l(>, l-r-lc-, t ?)K+

u:a-f el*&-k,

tlpEt-)4 =

k, = - [r+Ak,-)

tr{o 7-= \; r-<F

IAJ(l+pt!)tAt, --------s

? tt6k'= w *-J

+ F k, +Fkz
o

t1

= :- ./

-r-*F /

h!-!D +pr,+l*-[u*l - r^(,-<tt+ or,

t<l?
\7{ u.

= /-(r'<p)
...,.........-:--

+ kf

)2 s, = -+-l

- : ;

l^, Q'<F)

-F frl

=*P-

From above,

optimal savings policy function

g(k) (:

f(k)

-q=k1*1)which

maximizes value function

(k)

Max U(

(k) - g(k)

) + 0 V (g(k))

and we solved it and got optimal policy function:

FKz g(k) = ------- h" 1+ BK2

In fact when we substitute value
0[

q
where Kz

l-crF

of Kz into g function

we get

o/ (l -

cxp)]

cG,) =

Kt-

1+ BIo/(1-qF)]

F I cxl (1

cxp)]

(1-oF + Fcx) /(l-oF)

0B

k"

which

ktnr

In particular, if we assume

g(k):s

0<

s< I

(analogous to Solow Growth Model, constant c s of output is saved

and invested)
Since

fis continuously differentiable and strictly concave s f= gft) also cont. differentiable & strictly concave, get following

phase diagram:

(difference equation phase diagram)

{&tr

!(111

Aj&t)= 1Gt)
?6'

&t'

tx

ft.r,'
,

: .gi:'l

) ) I

stationary solutions (= steady states, rest points, fixed point, equilibdum) where gG,) k (wffie g crosses the 45o line)

steady states at kt = 0 and at k

but

k1

> 0 by model assumption

only k * steady

state

Stability: pick arbitrary kt point (e.g. kr , ka ) and trace out lines vertically to g, the horizontally to 45o line, vertically to g ..... to see if convergent or divergent.
From above phase diagram, ifka > or (note: divergent away from k1 :0)

<

k *, all
fraction

convergent to k * as t

) o

k,*r .\ In particular g (k)

fraction

cx B f (lq)

{{

0<o
ft)

B<1

optimal savings policy function g

has steady state and infinite sequence

{ k r}'=o

converges to that steady state .

Chapter IV.

D.

Stochastic Optimal Growth Models

We extend above deterministic (=certainty) model to include risks stochastic optimal growth models.

Brief review ofProbability Theory, Theory of statistics and dynamics of distributions.

Ref

Wu,

L,

Economics of Finance Academy Press 1990

Terminology: Random experiment / transaction: Given experimenVtransaction under identical conditions, if outcomes will not be the snme every time (: no certainty outcome), then experimenVtransaction is called random.

(= experimenVtransaction whose outcomes cannot be predicted with certainty before the experiment/transaction. )
Examples of random experiments

COINTOSSING (by same person, same coin) H, T, T, H, T, H, T,

ABC company STOCK PRICE RETURNS

(same management)

8......

z00r
3.6%

U 03 04 0s 06
4%
-5o/o 6%o

07 5%

-7% -2%

Since outcome are not certain, we wish to find a way to assign probability (chance) P each outcome occurring.

of

e.g. P(Hoccurs) :.4999 OR49.99% P(ABCRETURN2006: e.g. P(coin landing on edge):0%

P is called a

5%):

12.760/0

probability function. To define

P properly we need a random variable.

Definition: Random ( = stochastic) variable

certainty

outcome)

value offr known probabilistically (not outcome governed by a probability function.

t:

Random variables can be discrete fr; or continuous

t.

Population: complete

set of measwements to be analyzed.

,..,f*:tu

BASIC POSTULATE:

probability function P which govems outcomes of events in a

random experiment. P which assigrrs probability to each fl = q (a quantity or number) in population.

=l

Probability function: is a function ofrandom variable. Two types:

probability function for discrete random variable fl probability frrnction for continuous ranilom variable probability density function P with properties:

probability distribution function P with properties :

P(t;

Q: q e PoPulation)

>

P(fi) > 0

r P(fii):l
Vq
e.g. coin flipping experiment

I
-ao

1u;

dii :1

P(ii' : !I)

P(nz

T)

:'/z

e.s. normal (Gaussian) distribution z- f G:]

.-r' 'r eK A | Q. l \-Af-l )n P(0)= eJ2Ir --

*
-l
'.\

can check PGI) =

P(T) >

P1fi\=> '\-,/
@

Vfi

andX P(itt)=%+n
H,T
-@

J P(u)ou

by p'd' function and pick the We just denote all probability (distribution/density) function

ttt" ipptop.iut"

one according to which type of variables we are

working with'

,i.r1

) ;

1
t

(* t4\.*

Adr,,\

J.ote,-

a6t

Y) = ELzl
t

raTl utt-.LC-a-.

t-sP

zEc

t&.,...c.. = q(i)

i - g:!:\l

)/,1

rH

+6t

T-31

6-r

-o;-,

el.-

*sl

$o

{-{

t.rlif.

l-:"J 7t> =W

{l or7

q, *4.ao

N..#..-{

v*a,tbt

AIA-.-.&

+ b !_(ll:rl:

;- (r-r,-,.e)-=
e

a E+ql .
)

/llv.t

7.--t
*,-1t-lar- L-

l!e
i-c. a" T+@ ,
k

=l
{s l,Dt *
'

tl L. ,.e'Ea^1

el-',"c-

lA4)

t/J4.'L..-t

r-..--.- 4 I,*;

r l-

(t4

t-te
l.r-.)

n 6t*
Ltsll4

ar+tL A.

eLT a*lJ/il'rJ

\y

L\-

l"'L (Le4

t,c, t '^.."u-d,^. o".n T,*-,

Q^-51"

'L

1-

t{ut

= Yi t"p L)

(.=

v<J

_t

t>1

&,ta-Ll

+r,..

r\

at'|ltt'T
2

Above is a brief review of probability and statistics theory. Based on that we proceed to a short inhoductory note on stochastic models:
Recall Ramsey's Model on optimal savings (continuous, infinite horizon case):

Max J PV(society's utility U (c t ))

s.t. technology in the form of feasibility constraint'

We find the caPital stock k 1 level to U (c t) maximized. max consumption c t

tech is viewed as A production set

tr

represented by

Current cap stock k

given current state k I : k,*r is optimal investment policy B( k , )

J o=s)

optimal savings PolicY

recursive method based on curent cap stock k t find g and get next period opt cap stock k r*r
1

But if the model is stochastic (uncertain outcomes after action), k t*r depends on both k AND as-yet-to realize technology shock

we need Anow-Debreu state-contingent concept i.e. k. is expressed as

{k,itt',

k,*tt,

..., k,*"n}

and these states depends on history

oftech shocks'

Hence to extend a deterministic model

toa stochastic model, we introduce risks through

./

\\
B.

A.

technology affecting outPut function

some other factors affecting other variables in the mode..

1l-'

We look at approach A. by assuming y

1:

z1

f(k

where sequence \ z1 | arc independently & identically distributed (i'i'd) random variables, representing technological shocks.

Note: if z1 negative
output.

some damaging shocks' like machinery breakdown, reducing

Furthermore, assume households use expected values ofutility to rank stochastic consumption sequences (Von Neumann- Morgenstem Expected Utility Thm)

Finite time horizon case:

social planner
T

MaxE[

lt3'u(cs)]
t=0

o<B<1
ct, kt*t}

[Iv-24]

s.t.feasibilitykt*r*
Assume

ct S zt(kt)

Vt'V{ zt\AY-251

Begiruring

ofperiod

beginning of next period t+1

shock z t realized

t(k ), cs known

r+t

(k t, z t ) state of econ at time t

a
Social Planner

deterministic model

stochastic model

Maxbv tct , tt+t choosing

+--0

continsent on realization -T lct,L**,1+?o ofzrlz2,......,z1for each period

(i.e. a sequence of contingent plans for each period)

r'. lrl

P-- -

?n

v,t, u(ed= Fou

+?:t. h [t,G,
= !(Co
u[C1Car)

uQ(a;) ...u(c
(, u(c,@,D --. +?-u(Ci@"\

+z

3,,1. (, u3r?r>\+

,))+P

=2 dt

,'<-

t-.r4r*

P14*1

ft*,

A*

,:t,)

?, u(C, @i))

.T
pli.*4

Ri, ci ---x el
tr(ar) e &'i

c
0-

{4 e *+ c,(tt)e
eL+ , k,qt

c-t+-teK'i

'- {+,

e2,

kn(Zr) e

) L*t..-+a *A ,*.agr szf c(ko,1i ={c. ( ctgts an,,Lf,)e 9(kt ,6t), t--o. t,..-,t\
Lop

+ +r

C-^tyzf U^'z.f

ScS

. *o I'o+--

i { n7c,1a ;," )) +

Fl-

-)

td n^/.t-., Lt.4rfr;.

D+f

ItU4-

&rt-V-'

V+ 7E

|,il riJ ,.*

,"J

'- ' q

(cl

gvta

L on-

l,a-,,ar*, trool^--il--;

dt^L &-- t*

d-,Vl,-..-,

t^tLcl-, ttlt-S

G^l*e" 6

L,
:

ct +

FEV(LI*')

: , r)o y,+^E;
6.J/* ^

-r1..,.--

.F-f.^i

a^* 3 "^-fu*&, E hL; aaav<1a"5.;-. 711- A u*;4c4. .\ bt

2<,

k\

+4!bQ + ktLA+
# Lz/iF-,.--'l

vQt*,,

1.,,)= tq+ lcz d^' (&ll,,cr) +E,l^?t*,

k,

K:.

t*(l"i*r-cc)+
t tt"^<,*

P.

EI[-LI.*,

t*C* - l^(+fz*) +
a L^.L+ + bTt
*

A( rAk')
L,
+

Er*

= "t!^-L++L-\t - b(+fb'-) r

('t,

+frL)"/. L"

(tf f'L- )t .

- L-(

5c-1 + Se''

il_r,*

Fr:

l^ti;

'ir

5./

L
(r

* Er=L

E->1-t-

te-raa-r1

t.1 t^t"f+

bG-;tt *O

4,,4rt!.-c[ = A* 4 -L-"DE 6e

__

L:

j-?

4{-;L
-5 -t

2j-.. =
LoweLt -i

ltl/ al.ut

u' A+ t&+> - t(L+,y\ = F ELY 1c.,t.>, 6' >f

i1 u 1-ct\=
ItL
Lra

b (t

a-.A
- Ll

(4)=

d
t +., +Iy]

uo ua-t

ts v-'4-, v (kr,kt

A*'e+'" LE-sr7

=P!E)]i-;t.

-E'-;1;{'rtti;;i)

--

(.1"i-

y' I

o"{tv + l"Zn tr .i3. ? L '

-

co

o:l t-l

.
'

-t(,,v3)+t3

?l)"

1.

"1-lV*

+'L{J

n=
a ')o-:p

n=
-

t
I

'"-

).-

P-

4t-t-o^

,f4-ib
<+-r-, Ef

4,6'

.+-

n+ f e'

l- sa<-

(lB?. j

"\.17"*

dt"'tt>-'tn

o?tn>o
--.L

a+ F

3l-rl

1.r.-^-7-r-L

L'J baL frclqrc;

/.ft.--+

et'*t'g,'-'

a,,+. a,l'l.c<L tw- aLp Hft-epov 0aac'4 t /Jc l:

ca-tL

U'a+ {- . A frLtT'-L

?L'

14

atJ

9ntt4+

u;u

u ,^ fu-,

S a+

iz.^f t&\

t/./'.t

=/

EoLt^t+7

E,[t.tg\P)+

Lfu-yl

]LL
t&

tgr} L;-a 4gd]-+-ry'- L r "t W!

t+a+,.}t-..+J-',

b a:-r

frv-+c'\ )8t.1

,--f 14

-@'Y'l

!
l-.<E/

d.'

+J)

Jtz*

O<oa<,

*"1 .+e e

v*n^[

t-tr

*-L + i;.
h^-r-o

r.,&.*, +1+

1{

Lor

t+o

.ltO

cY

-+S -.rb

t+ o ,

0*

tnt'^ dzv tlaq. ,J( ; nr.uJ,

Au+U

Lo >o

a2 ulaf F-.^
tUtl-*"le-a;

kt fut^

vlr'|-a- u7t4-

c";"'t'*-t

r = t.t4 ( k, 4\

t#fL = f*t (uFtoa! La-

oL*,*)=a(*
pE-*-*:( a. E\

(,,ut

(L*",3 al Q=t')-= 6

$ a,6>o

.G

h,rrzr<-s

6 a- l'^'4

LcA: /r'-.1'* (

/u4 f A ruJ-L t^,.,a''"* d6fi)J2.<Jd C^rb^ h,-ci.*.; tl .+ V q^--, t^.ta*inz a-sr-+f-. a 4 rt*t-.*;rtt --=v- cl a.-2 4t4 *; *t ' r 4 ^vt+r--

d-;9: 4+<.

a-t+
.,aa.t,

Yp

4 (lr>

CIL>

951/^Lz;

=
-

tL-e
"t'rL

/.i-ZLr a,- l;A- 4

.^t 6'
1P z-ta-'"

Va al

t4<.r<-dr+--}L

,.:1.{j

ev&)

)-rl

+6EIv(qr't

E*^l-E;^