"Introductory" Lecture

Orest V. Iftime
University of Groningen, The Netherlands
March 2013
1

Outline

Organization of the course

Functions and Elasticities

Matrices and The Leontief Model

On Ranking (Google Page Rank)

Forward Contracts and Itos Lemma

Systems of differential equations

Contents

March 2013

Organization of the course

Introductory Lecture

Review of basics: self study (March 1-31)

Review of basics + new topics (April 1-5)

Activity in class: 20% (April 1-2)

Written exam: 30% (Wednesday, April 3,

15.00-18.00)

Oral exam: 50% (April 29)

Reexamination only next year.

March 2013

Functions and Elasticities

Functions

Elasticity

Partial Elasticity

Elasticity of substitution

March 2013

Functions

What is a function?

Is f (x) = x2 a function?

See the definition on page 80 of the book.

Is f (K, L) = K 2 L3 , K > 0, L > 0 a function?

March 2013

Elasticity
D(K) the demand of a given asset at price K.
Price elasticity of the demand of a given asset:
ElK D(K) =

D
(K)
D(K)

For example ElK D(K) = 1 means that

an increase with 1% in the price will lead to a
decrease of 1% in the demand.
Elx f (x) =

f
f (x) (x)

Example: f (x) = x2 , D(f ) = R. What is Elx f (x)?

March 2013

Partial Elasticities
D(K, r) the demand of a given asset at price K
and interest rate r. Price elasticity of the demand
of a given asset:
ElK D(K, r) =

D
D(K,r) K (K, r)

For example ElK D(K, r) = 1 means that

an increase with 1% in the price will lead to a
decrease of 1% in the demand.
Elx f (x, y) =

f
f (x,y) x (x, y)

Example: f (x, y) = x2 y 3 , D(f ) = R. Elx f (x, y) =?

March 2013

Elasticity of substitution
Consider a level curve which defines y implicitly
as a function of x
F (x, y) = constant
The marginal rate of substitution of y for x is
Ryx =

Fx (x,y)
Fy (x,y)

= y (x)

Ryx is the quantity of y one must substitute (add)

per unit of x removed, if one would stay on the
same level curve.
March 2013

Elasticity of substitution
Consider a level curve which defines y implicitly
as a function of x
F (x, y) = 5x2 y 3 = c
The marginal rate of substitution of y for x is
Ryx =

Fx (x,y)
Fy (x,y)

52xy 3
53x2 y 2

2y
3x

Ryx is the quantity of y one must substitute (add)

per unit of x removed, if one would stay on the
same level curve.
March 2013

Elasticity of substitution
Consider a level curve which defines y implicitly
as a function of x
F (x, y) = 5x2 y 3 = c
The marginal rate of substitution of y for x is
Ryx =

Fx (x,y)
Fy (x,y)

52xy 3
53x2 y 2

2y
3x

x0 = 2 x1 = 1 then
y0 = 3 y1 = 3 + Ry0 x0 = 3 + 1 to compensate.
March 2013

10

Elasticity of substitution (page 420)

Consider a level curve F (x, y) = c.
The elasticity of substitution between y and x is


y
yx = ElRyx x
yx is the elasticity of the fraction
El f () =

y
x

w.r.t. Ryx .

f
f () ()

f () = xy (Ryx ) where = Ryx .

ElRyx

March 2013

y
x

Ryx
y
x (Ryx )

y
x (Ryx )
11

Elasticity of substitution
Consider the level curve F (x, y) = 5x2 y 3 = c.
The elasticity of substitution between y and x is


y
yx = ElRyx x
yx is the elasticity of the fraction
Ryx =
y (Ryx )
x

52xy 3
53x2 y 2

w.r.t. Ryx .
2y
3x

= 32 Ryx and yx = 1?
ElRyx

March 2013

Fx (x,y)
Fy (x,y)

y
x

y
x

Ryx
y
x (Ryx )

y
x (Ryx )
12

Elasticity of substitution: example

p

q
p p

Consider F (x, y) = (ax + by )

where a, b > 0, q 6= 0, p > 1 and x, y > 0.


y
yx = ElRyx x
yx is the elasticity of the fraction
Ryx =
Ryx =

w.r.t. Ryx .

q
p 1
q
p
p
p (ax +by )
a(p)xp1
Fx (x,y)
q
p 1
q
Fy (x,y)
p
p
p (ax +by )
b(p)y p1
p1
1
y
a x
b
1+p

 
y

ElRyx
March 2013

y
x

so x (Ryx ) = a Ryx




Ryx
y
y
x = y (Ryx ) x (Ryx )

13

Elasticity of substitution: example

Ryx =

a
b

 p1
x
y

yx = ElRyx

so


y
x =

y
x (Ryx )
Ryx
y
x (Ryx )

b
a Ryx

1

1+p

y
x (Ryx )

The computation:
yx =

March 2013

Ryx

( ab Ryx )

1
1+p

1
p+1

b
a Ryx

1

1+p
1

b
a

=?

14

Elasticity of substitution: example

Ryx =

a
b

 p1
x
y

yx = ElRyx

1

1+p

so xy (Ryx ) = ab Ryx
.




Ryx
y
y
x = y (Ryx ) x (Ryx )
x

The computation:
yx =

Ryx
1
1+p

1
p+1

b
a Ryx

1

1+p
1

b
a

1
p+1

(
)
Constant elasticity of substitution.
yx is the percentage change in the fraction
Note that
Rxy = R1yx and xy = yx .
March 2013

b
a Ryx

y
x

15

Outline

Organization of the course

Functions and Elasticities

Matrices and The Leontief Model

On Ranking (Google Page Rank)

Forward Contracts and Itos Lemma

Systems of differential equations

Contents

March 2013

16

Matrices

What is a matrix?

Matrix operations

Vectors

Systems of Linear Equations

Gaussian Elimination

Determinants

Inverse of a Matrix

Eigenvalues and Eigenvectors

March 2013

17

On Ranking

A set of firms N = {1, 2, ..., n};

Question: which firm is "the best"?

= {ij }i,j : a link between firms i and j;

i j: firm i (looser) to firm j (winner);

wi,j is a weight to be chosen;

Pn
Assume that j=1 wi,j 6= 0 for all i N ;

Define the matrix P = {pi,j }i,j=1..n ;

wi,j
Entries of P : pi,j = Pn
j=1 wi,j

March 2013

18

On Ranking

A set of firms N = {1, 2, ..., n};

Question: which firm is "the best"?

Define the matrix P = {pi,j }i,j=1..n ;

Answer: The solution is the normalized

dominant left-eigenvector of P corresponding
to the dominant eigenvalue = 1.

Amy N. Langville and Carl D. Meyer, Googles

PageRank and Beyond: The Science of
Search Engine Rankings, Princeton
University Press, 2006.

March 2013

19

On Ranking

Add links between every two firms (no extra

profit)
(1)
G() = P + (1 )E,
1
E is a matrix which has all entries equal to
n
Answer: The solution is the normalized
dominant left-eigenvector of P corresponding
to the dominant eigenvalue = 1.

Robust with respect to .

Case study with 8 firms.

March 2013

20

Case Study Ranking Firms: varying

Firm 2
Firm 7
Firm 3
Firm 4
Firm 5
Firm 6
Firm 8
Firm 1
March 2013

= .05
1(0.1308)
2(0.1303)
3(0.1246)
4(0.1242)
5(0.1233)
6(0.1232)
7-8(0.1218)
7-8(0.1218)

= .3
1(0.1622)
2(0.1568)
3(0.1225)
4(0.1190)
6(0.1125)
5(0.1150)
8(0.1049)
7(0.1071)

= .6
2(0.1891)
1(0.2048)
3(0.1199)
4(0.1107)
6(0.0951)
5(0.1066)
8(0.0818)
7(0.0921)
21

Eigenvalues and Eigenvectors

If G is an n n matrix, then a scalar is an
eigenvalue of G if there is a nonzero vector v in
Rn such that
Gv = v
Then v is an eigenvector of G associated with .

How to find eigenvalues?

pG () = det(I G) - the characteristic

polynomial.

pG () = 0 - the characteristic equation.

How to find the eigenvectors?

For each eigenvalue , solve Gv = v for v.

March 2013

22

Outline

Organization of the course

Functions and Elasticities

Matrices and The Leontief Model

On Ranking (Google Page Rank)

Forward Contracts and Itos Lemma

Systems of differential equations

Contents

March 2013

23

Forward contract
A forward contract is an agreement to buy or sell
an asset at a certain future time for a certain price.
One of the parties assumes a long position and
agrees to buy the underlying asset on a certain
specified future date and for a certain specified
future price. The other party assumes a short position and agrees to sell the asset on the same
date and at the same price (delivery price).
March 2013

24

Forward contract
K - the delivery price
ST - the price of the asset at the maturity of the
contract

ST K is the payoff from the long position

K ST is the payoff from the short position

What is the value of the a forward contract?

The easiest forward contract to value is one

written on a security that provides the holder
no income.

Example: non-divident-paying stocks.

March 2013

25

Forward contract
For there to be no arbitrage opportunities the
forward price should be
F = Ser(T t)

F - the forward price

S - the spot price

r - the risk free rate of interest per year

March 2013

26

Forward contract
If, for example:
F > Ser(T t)

Borrow S euro for T t at rate r.

Take a short position in the forward contract.

Sell the asset for F at time T .

Pay back Ser(T t) .

Profit = ?

March 2013

27

Itos Lemma (Ito 1951)

A variable S follows the following process:
dS = a(S, t)dt + b(S, t)dz
Then F (S, t) follows the following process


2
F
1 F 2
F
dF = F
a
+
+
b
dt
+
S
t
2 S 2
S b dz

Take S the price of an asset;

a(S, t) = S (expected return) and

b(S, t) = S (volatility).

Take F (S, t) = Ser(T t)

What is the evolution of the forward price F ?

March 2013

28

Itos Lemma (Ito 1951)

A variable S follows the process:
dS = Sdt + Sdz
Then F (S, t) = Ser(T t) follows the process


2
F
1 F 2
F
dF = F
a
+
+
b
dt
+
S
t
2 S 2
S b dz


dF = Ser(T t) rSer(T t) dt + Ser(T t) dz
dF = ( r) F dt + F dz
The expected growth rate = r (rather than ).

March 2013

29

Systems of differential equations

Consider the system of nonlinear equation
(see pg 445) u2 + v = xy
uv = x2 + y 2

Find the differentials of u and v in terms of dx

and dy.

Find the partial derivatives of u and v w.r.t. x.

The point P = (x0 , y0 , u0 , v0 ) = (1, 0, 1, 1)

satisfies the system.

Calculate uxy at the point P .

March 2013

30

Systems of differential equations

Consider the system of nonlinear equation
(see pg 445) u2 + v = xy
uv = x2 + y 2

Find the differentials of u and v.

2udu + dv = ydx + xdy
vdu + udv = 2xdx + 2ydy

Adu + Bdv = b1 = ydx + xdy

Cdu + Ddv = b2 = 2xdx + 2ydy
Unique solution when: 2u2 v 6= 0.
March 2013

31

Systems of differential equations

Consider the system of nonlinear equation
(see pg 445) u2 + v = xy
uv = x2 + y 2

Find the differentials of u and v.

2udu + dv = ydx + xdy
vdu + udv = 2xdx + 2ydy
du =

March 2013

2x+yu
2u2 v dx

xu2y
2u2 v dy

32

Outline

Organization of the course

Functions and Elasticities

Matrices and The Leontief Model

On Ranking (Google Page Rank)

Forward Contracts and Itos Lemma

Systems of differential equations

Contents

March 2013

33

Part 1

Inverse Functions

Exponential Functions

Logarithmic Functions

Implicit Differentiation

Economic Examples

Differentiating the Inverse

Elasticities

March 2013

34

Part 2

Indefinite Integrals

Area and Definite Integrals

Properties of Definite Integrals

Economic Applications

Integration by Parts

Integration by Substitution

Infinite Intervals of Integration

March 2013

35

Part 3

Matrices

Systems of Linear Equations

Gaussian Elimination

Vectors

Determinants

The Inverse of a Matrix

Cramers Rule

The Leontief Model

Eigenvalues (and Eigenvectors)

March 2013

36

Part 4

A Simple Chain Rule for functions of two

variables.

Chain Rules for n variables

Implicit Differentiation

Elasticity of Substitution

The differential of a function

Homogeneous functions of two variables

Differentials

Differentiating Systems of Equations

March 2013

37

Part 5
Topics in integration

P1: Theorem 4.2.1 Leibnizs Formula and

how to use it.

P2: Theorem 4.2.2 and Example 5 page 162

FMEA

First order equations in one variable. (part I)

P3: Example 3 (Economic growth) page 196

FMEA

P4. Exercise 5.3.6

March 2013

38

Part 6
First order equations in one variable. (part II)

P5: Example 2 (Price adjustment

mechanism) page 201 FMEA.

P6: Example 3 (Economic growth) page 202

FMEA

Second order equations and systems in the

plane. (part I)

P7: Theory from Ch. 6 Section 2

P8: Theory from Ch. 6 Section 3

March 2013

39

Part 7
Second order equations and systems in the
plane. (part II)

P9: Exercise 6.3.4 page 234 FMEA

P10: Exercise 6.3.10 page 235 FMEA

P11: Linear systems with constant

coefficients, solutions based on eigenvalues
(page 241 FMEA)

P12: Theory from Ch. 6 Section 4

A TEST EXAM will be available.

March 2013

40

Written Exam

Discussion of the exercises

from the TEST EXAM

WRITTEN EXAM (30% of the grade)

Wednesday, April 3, 15.00-18.00

March 2013

41

Oral Exam
Monday, April 29

One of the topics P1-P12 (open notes)

(self study part 2: April 8-28)

One exercise.

ANSWER QUESTIONS RELATED TO THE

EXERCISES

ANSWER QUESTIONS RELATED TO

P1-P12
END

March 2013

42