Applications of Derivatives in Economics

B.Prahalathan
Senior Lecturer
Department of Commerce
Faculty of Management Studies & Commerce
University of Jaffna

1. Introduction
This article provides a simple introduction to the general topic of calculus. Calculus is
concerned with the mathematical study of change - The techniques of calculus actually
provide a quick way of performing calculations.

In the last half of the 18th century Isaac Newton [1642-1727] and G.W. Leibniz [1646-1716]
lay the foundations for what was to become known as “calculus.” This was a powerful tool to
deal with infinitesimal problems of arc lengths, tangents to curves, area and volumes. The
Bernoulli brothers, Jackob [1654-1705] and Johann [1667-1748] extended the tool to deal
with the processes of change. During the mid 19th century (from about 1825 to 1875) a
growing number of writers applied calculus to the problems of changes in the realm of
economics. Johann Heinrich von Thünen [1783-1850], Hermann Heinrich Gossen [1810-
1858], Jules Dupuit [1804-1866] and Augustin Cournot [1801-1877] applied mathematical
tools to economic problems. In the 1870’s W.S. Jevons [1835-1882], Carl Menger [1840-
1921] and Léon Walras [1834-1910] initiated what has come to be known as the “Marginalist
Revolution” in economics. The Marginalist Revolution established the importance of calculus
in economic analysis. During the 19th and 20th centuries the role of mathematics in
economics has expanded.

This article will show how differentiation can be used to find out the maximum and minimum
values of a function. Since, the derivative provides information about the gradient or slope of
the graph of a function. In many applications, a scientist, engineer, or economist for example,
will be interested in such points for obvious reasons such as maximising power, or profit, or
minimising losses or costs.

2.0 Functions & Economic Relationships

Models of economic relationships are abstractions that explain many of the forces that shape
economic behaviour. Models can be in a narrative or mathematical format. In a mathematical
format, the variables may be quantified or measured.

A function is a relationship (or mapping) between two or more variables whereby the value
of one variable (the dependent variable) is determined by the values taken by the other
variables (the independent variables).

1
The general notation for a function is a follows:

Y = f ( X , Z)

Where

Y : dependent variable
X, Z : independent variables
f() : means “is a function of”

This is the most general form of a function. It simply states that the variable Y is a function of
the variables X and Z.

Economic Examples
The following are examples of commonly used functions in economic models.

QD = f (P) : Demand function

C = f (YD) : Consumption function

U = f (X, Y) : Utility function

Q = f (L, K) : Production function

C = f (Q) : Total Cost function

2.1 Linear Function

A two variable linear function can be written as follows:

Y = a +bX

Where, a and b are two parameters which can be assigned fixed values. The values of a and b
determine the exact form of the linear function.

Example:
Assume a = 10, b = 2. Thus
Y
we have the following specific linear function;

Y = 10 + 2 X Y=10+2X
2
We can now construct a table 5
and then graph this function.
2
0
1
5
1
0 2
5

1
2 4 6 8
0 X
 X Y

0 10 Figure - 1
2 14 To draw the graph of a linear function we only need to calculate and plot
4 18 two points and then simply join them up with a straight line.

6 22 Economic Examples
Some common examples of linear functions used in economic analysis
8 26
are:
10 30
Q D = a − bP + cY Demand function
Q S = g + hP Supply function
C = a + cYD Keynesian consumption function
M =αY −βr Demand for money function

Note the common use of upper case letters for variables and lower case English or Greek
letters for parameters.

2.2 Polynomial Functions

A two variable general polynomial function is shown below:

Y = a + b1 X + b2 X 2 + b3 X 3 + ......+ bn X n

This is often referred to as polynomial of degree n. The most commonly used polynomial
functions are those of degree n = 2 (the quadratic function), and degree n = 3 (the cubic
function).

2.3 Quadratic Function

A quadratic function is a polynomial of degree 2; i.e. Y = a + b1 X + b2 X 2

It has three parameters a, b1 and b2 - values for these determine the specific form and graph of
the function.

The graph of a quadratic function is either a U-shape (convex) or an inverted U-shape

(concave). Which shape the function has depends on the value of the parameter b2

− If b2 < 0 the function is concave

− If b2 > 0 the function is convex

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− A concave or convex function has only one turning point - a maximum if concave, a
minimum if convex.

Economic Example: Quadratic Function

Total Revenue function

Start with the linear demand function facing a price-taking firm (Perfect competitive firm)

Q = a − bP
Invert it to make price (P) a function of quantity sold (Q)

bp = a −Q
a Q
P= −
b b
Recall that Total Revenue = Price times Quantity, i.e. TR = PQ

So,

 a Q
TR = PQ =  −  Q
b b

Expanding the bracket gives us the quadratic total revenue function:

a Q2
TR = Q −
b b

3.0 Slope and Rate of Change

The slope of a line measures the change in the dependent variable associated with a change in
the independent variable.

3.1 Slope of a Straight Line

When the function is linear, the slope can be calculated as

Change in the dependent variable ∆Y

=
Change in the independen t variable ∆X

4
 Slope of upward line Slope of downward line Slope of the horizontal line

Y
Y Y
Y Y
X
Y=
X X 0

X X X
Panel = A Panel = B Panel = C

Figure 2

Given a function P = 10 – 2Q both a table and a graph can be constructed in following table
and figure.

Quantity (Q) 0 1 2 3 4 5

Price (P) 10 8 6 4 2 0

The slope of the line in the graph is the change in price caused by a change in quantity, for
every one-unit change in Q, the value of price (P) will change by 2 units in the opposite
direction.

Price
1
0
8

1 2 3 4 5
Quantity
Figure – 3

It may be useful to notice that the function P = 10 – 2Q can be expressed where Q = f (P).
The equation would be Q = 5 - 0.5P. Notice that the slope of the function Q= f (P) is the
reciprocal of the slope of the equivalent function P = f (Q).
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3.2 Slope of the Nonlinear Function
Not all functions in economics are linear. The slope of the curves can be derived by
measuring the slope of the tangent.
When the function is nonlinear the slope can be imagined as the slope of an arc between two
∆Y
points on the function or as the slope of a tangent at a point on a function. Generally,
∆X
suggests the slope of a straight line or the slope of an arc between two points on a nonlinear
function.

In the following figure a nonlinear function Y= f(X) is graphed. If the value of X changes
from 4 to 10 then ΔX is +6. The change in Y (ΔY) is +3. The slope of the arc between points
∆Y +3
“a” and “b” is = = 0.5.
∆X +6

t’
Y
6 b
Y=f (X)

1
4 0 X
Figure - 4
Notice that as the change in X (ΔX) approaches 0, the tangent tt’ represents the change in Y
“caused” by a change in X. If the change in X (ΔX) approaches the limit of 0(ΔX→0), the
dy
notation for a derivative, is used. The slope of tt’ is calculated by taking the first
dx
∆Y
derivative of the function, Y =f(X). If you use , the slope is an estimate of the “average”
∆X
dy
slope between points a and b that lie on the function. The value of is the slope of the
dx
tangent at a point on the function. If there are several independent variables, each influencing
∂y
the value of the dependent variable, the notation for a partial derivative, is used.
∂x

4.0 Derivative of Function

6
The slope of the graph of a function is called the derivative of the function. This slope of
function is usually referred to as the derived function. An alternative notation for the derived
dy
function is . (dee y by dee x).
dx

4.1 Differentiation
The process of finding the derived function symbolically is known as differentiation.

4.2 Differential Coefficient

Consider the function.

Y = f (x)

x = independent variable.

Y = dependent variable.

By differentiate y with respect to x, we can get ‘first differential coefficient of y with respect
dy dy
to x’. This is denoted by . That is, is the first derivative of y with respect
dx dx
to x. By differentiate again with aspect to x, we can get the ‘second derivative of y with
d2y
respect to x’. This denoted by .
dx 2

Note:
Function is f (x)
1st derivative of f (x) is denoted by f’ (x)
2nd derivative of f (x) is denoted by f” (x)

4.3 A Simple Rule for a Derivative

Simple rule to calculate the first derivative for a function Y = aXb is

dy
=a (b) X (b – 1) .This is the equation for the tangent line at any value of X.
dx

For example
Applying this rule to the equation, Y = 2 + 1X - .05X2
The equation can be written as
Y = 2X0 + 1X1 - .05 X2,
This will make
dy
= 2(0) X (0-1) + 1(1) X (1-1) - .05(2) X (2-1) = 1 - .1X.
dx
If X is 10 the value of Y is 7. [Y = 2+1(10) - .05(10)2 = 12 - .05(100) = 12-5 = 7].

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That is, When X is 10 and Y is 7, the slope of the tangent to the function Y = 2 + 1X - .05X2
dy dy dy
will be = 1 - .1X or = 1 - .1X = 1 - .1(10) = 0. = is the change in Y caused
dx dx dx
by a very, very, small change in X (ΔX→0).

Where the slope is 0, the function has a maximum, a minimum or an inflection point. To
determine which, the second derivative (or second order condition) is used.

5. Stationary points
Any point at which the tangent to the graph is horizontal is called a stationary point.
dy
We can locate stationary points by looking for points at which = 0. Consider the graph
dx
of the function, Y(x), shown in the following figure.

Figure - 5

If, at the points marked A, B and C, we draw tangents to the graph; note that these are parallel
to the X axis. They are horizontal. This means that at each of the points A, B and C the
gradient of the graph is zero.
dy dy
The gradient of a graph is given by .Consequently, = 0 at points A, B and C. All of
dx dx
these points are known as stationary points.

6. Turning Points

In figure 6, Note that at points A and B the curve actually turns. These two stationary points
are referred to as turning points. Point C is not a turning point because, although the graph is
flat for a short time, the curve continues to go down as we look from left to right. So, all
turning points are stationary points. But not all stationary points are turning points (e.g. point
dy dy
C). At a turning point = 0. Not all points where = 0 are turning points, i.e. not all
dx dx
stationary points are turning points.
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7.0 Distinguishing Maximum Points from Minimum Points
7.1 Maxima

A function f (x) said to be maximum at points where it changes from an increasing to

decreasing function. Point A in Figure 6 is called a local maximum (maximum) because it is
the highest point, and so represents the greatest or maximum value of the function.

7.2 Minima

A function f (x) is said to be minimum at points where it changes from a decreasing to an

increasing function. Point B in Figure 7, is called a local minimum (minimum) because it is
the lowest point, and so represents the least, or minimum, value of the function.

Figure – 6
7.3 The Conditions for Minimum
dy
In figure – 7, goes from negative through zero to positive as x increases. In the left of
dx
dy
the minimum point is negative because the tangent has negative gradient. At the
dx
dy dy
minimum point, = 0. To the right of the minimum point is positive. Since here the
dx dx
dy
tangent has a positive gradient. So goes from negative, to zero, to positive as x increases.
dx

dy
If = 0 is increasing near the stationary point then that point must be minimum. That is, if
dx
dy dy
the derivative of is positive then the is increasing. So the stationary point is a
dx dx
dy d2y d2y
minimum. The derivative of called the second derivative, is written as . So, if
dx dx 2 dx 2
is positive at a stationary point, then that point must be a minimum turning point.

9
 Figure - 7

Conditions for a Minimum Value

dy
=0 : Necessary Condition
dx

d2 y
2
〉0 : Sufficient Condition
dx

7.4 The Conditions for Maximum

dy
Left of the maximum point is positive because the tangent has positive gradient. At the
dx
dy dy
maximum point, = 0 .To the right of the maximum point is negative because the
dx dx
dy
tangent has negative gradient. So when the function is positive goes from positive, to
dx
zero, to negative as x increases.

10
 Figure - 8

dy
If = 0 is decreasing near the stationary point then that point must be maximum. That is,
dx
dy dy
if the derivative of is negative then the is decreasing; so the stationary point is
dx dx
dy d2y
maximum. The derivative of called the second derivative, is written as . So, if
dx dx 2
d2y
is negative at a stationary point, then that point must be a maximum turning point.
dx 2

Conditions for a Maximum Value

dy
=0 : Necessary Condition
dx

d2y
2
〈0 : Sufficient Condition

dx

7.5 Testing a Function for Maximum and Minimum

Step (I)
dy
Find the First Derivative of the function – f’(x) OR. .
dx

Step (II)
11
Set the First Derivative Equal to Zero and find the real roots of the equation f ’(x) = 0 OR
dy
= 0 in order to find the stationary points of the independent variable (x).
dx

Step (III)
d2y
Find the Second Derivative of the function f” (x) OR .
dx 2

Step (IV)

Substitute each Stationary Point for the Independent Variable in the Second Derivative. If
2
d y ], then the function is a maximum for that stationery point, If the
result is negative [
2
〈0
dx
d2y
result is positive, [ > 0 ], then the function is a minimum for that stationary point.
dx 2

dy d2y Change of Stationary Point

dx dx 2

0 - Maximum Point

0 + Minimum Point

Example :-
Given a Y= x2 – 4x + 5, test the function whether it is minimum function or maximum
function.

Step (I)
dy
Find the First Derivative of the function – .
dx
dy
= 2x – 4
dx
12
Step (II)
Set the First Derivative Equal to Zero and find the real roots of the equation f ’(x) = 0 OR
dy
= 0 in order to find the stationary points of the independent variable (x).
dx

dy
=0
dx
2x – 4 = 0
x = 2.
If, x = 2, then
Y=1
Step (III)
d2y
Find the Second Derivative of the function - .
dx 2

dy
= 2x – 4
dx

d2y
=2
dx 2

d2 y
Here, 〉0
dx
Therefore the function is minimum function.

Summary
The “Marginalist Revolution” of the late 19th century was the result of the application of
calculus to economic phenomena. The word “marginal” refers to the rate of change in a
dependent variable “caused” by a change in an independent variable. Marginal can refer to
∆Y
the rate of change as the slope of a line or the slope of a tangent to a nonlinear function
∆X
dy
at a point .The concept of a “marginal” is fundamental to choosing among alternatives.
dx

References

1. Edward,T.D.(2004).Introduction to Mathematical Economics,3rd Edition,Tata

McGraw – Hill Publishing Company Ltd,NewDelhi,India.

13
 2. Jacques,I. (1994).Mathematics for Economics and Business,2nd Edition, Addition –
Wesley Publishing Company, United Kingdom.

3. Karunaratna,K.R.M.T.(2003).Business Economics: Mathematical Application, 1st

Edition, Tharanjee Printers,Maharagama,Colombo,SriLanka.

4. Soni,R.S. (1999).Business Mathematics with Applications in Business and Economics,

3rd Edition, Piyush Printers Publishers Pvt Ltd,New Delhi, India.

Marginal Functions

1. Marginal Revenue
Marginal Revenue is the derivative of total revenue with respect to demand.
d(TR)
MR = .
dQ

Example:-
If the total revenue function is TR = 100 Q - 2Q2

d(TR)
MR = = 100 – 4Q
d(Q)

MR = 100 – 4Q.

2. Marginal Cost

Marginal cost is the derivative of total cost with respect to input

d(TC)
MC =
d(Q)

Example:-
If the total cost function is TC = 2Q2 + 6Q + 13
d(TC)
MC = = 4Q + 6
d(Q)
MC = 4Q + 6.

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 3. Marginal Product

Marginal product of an input is the derivative of output with respect to that particular
input. For example, Marginal product of labor is
d(TP)
MPL =
d(L)
That is marginal product of labor is the derivative output with respect to labor.
Example:-
If the production function is Q = 300 L2 – 4L
d(Q)
MPL =
d(L)

MPL = 600 L – 4

4. Marginal Propensity to Consume

Marginal propensity to consume is the derivative of consumption with respect to

income.
d(C)
MPC =
d(Y)

Example:-
It the consumption function is C = 0.01Y2 + 0.2Y + 50
d(C)
MPC = = 0.02Y + 0.2
d(Y)

MPC = 0.02Y + 0.2

5. Marginal Propensity to Save

Marginal propensity to save is the derivative of savings with respect to income.

d(S)
MPS =
d(Y)

Example:-
If the saving function is S = 0.02Y2 – Y+ 100
d(S)
MPS = = 0.04 – 1.
d(Y)

MPS = 0.04Y – 1.

Practical Example
15
The demand equation of a commodity is given by P + Q = 30
The total cost function is given by TC = ½ Q2 + 6Q + 7
i. Find the level of output which maximizes total revenue.
ii. Find the level of output which maximizes profit. Calculate MR and MC at this value
of Q. What do you observe?

1. Find the level of output which maximizes total revenue.

Finding the Total Revenue Function

P + Q = 30
Rearranging price function as
P = 30 – Q
Total revenue is defined by
TR = PQ
Hence
TR = (30 – Q) Q
TR = 30Q – Q2

Find the level of output which maximizes total revenue

 At a stationary point
d(TR)
=0
dQ
30 – 2Q = 0
So,
Q = 15 Units

 Find the second derivative of the function

d 2 (TR)
= −2
dQ 2

The value is negative.

Conditions for a Maximum Value is

dy
= 0 : Necessary Condition
dx

d2y
2
〈0 : Sufficient Condition

dx
16
 Here the conditions are satisfied, therefore the total revenue is maximised at the
output level of 15 units.

2. Find the level of output which maximizes profit

Finding the Profit Function

The profit function is defined by

π = TR – TC

Here

TR = 30Q – Q2
TC = ½ Q2 + 6Q + 7

π = (30Q – Q2) – (½ Q2 + 6Q + 7)

3 2
π =- Q + 24Q – 7
2

 At a stationary point
d( π)
=0
dQ
- 3Q + 24 = 0

So,
Q = 8 Units

 Find the second derivative of the function

d 2 (π )
= −3
dQ 2

The value is negative.

Conditions for a Maximum Value is

dy
= 0 : Necessary Condition
dx

d2y
2
〈0 : Sufficient Condition

dx
17
 Here the conditions are satisfied, therefore the profit is maximised at the output
level of 8 units.

3. Calculation of MR and MC at the output level of 8 units which maximises the profit.

If

TR = 30Q – Q2
d(TR)
MR =
dQ
MR = 30 – 2Q

When Q = 8 Units

MR = 14

If
TC = ½ Q2 + 6Q + 7

d(TC)
MC =
d(Q)

MC = Q + 6

When Q = 8 Units

MC = 14

The observation is, when the Q = 8 the values of MR and MC are equal. That is at the
point of maximum profit MR = MC.

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