Multivariate

UNIT 2 MULTIVARIATE CALCULUS-II Calculus-II

Structure
2.0 Aims and Objectives
2.1 Introduction
2.2 Applications of Level Curves and Partial Derivatives in Economics
2.3 Applications of Total Differentials, Total Derivatives and Chain Rule
in Economics
2.4 Applications of Implicit Functions in Economics
2.5 Applications of Homogeneous Functions and Euler’s Theorem in
Economics
2.6 Let Us Sum Up
2.7 Answers to Check Your Progress Exercises

2.0 AIMS AND OBJECTIVES

In the previous Unit, you were introduced to the mathematics of multivariate
calculus. In this unit, we shall discuss some applications of multivariate
calculus in economics. After going through the unit, you will be able to:

• State some important curves in economic theory that are level curves;
• Apply partial derivatives to areas in microeconomic and macroeconomic
theory;

• Describe some applications of total differentials and total derivatives in

economics;
• Examine how implicit functions may be used in economic theory; and

• Discuss how homogeneous functions and Euler’s theorem can be

applied in economic analysis.

2.1 INTRODUCTION
In the previous Unit, you were introduced to multivariate functions, and also
differential calculus applicable to multivariate functions. There you learnt
about partial derivatives, about total differentials and total derivatives, about
implicit functions and differentiation of implicit functions, and about
homogeneous and homothetic functions and Euler’s theorem. In unit 1, you
learnt about the mathematics of these concepts. Here, we intend to discuss
elements of economic theory to which these concepts are applied. While the
applications presented here are certainly not exhaustive, we hope you will get
a flavor of how multivariate calculus is applied in economics. Reading the
present unit together with unit 1, you will gain an understanding about which
mathematical concept to invoke to make clear specific economic ideas. For
instance, from your microeconomics course, you learnt about the importance
35
Functions of Several
Variables
of marginal utility, marginal costs, marginal revenue etc. In this unit, you will
learn that partial derivatives are the appropriate device for expressing the idea
of marginal units in multivariate functions. For each concept that you learnt
in the previous unit, we present some suitable economics examples. In this
unit, you shall be getting acquainted with these progressively.

The unit is organized as follows. In the next section, section 2.2 we discuss
applications in economics of partial derivatives and level curves.. We mainly
take examples from microeconomics, specifically from consumer theory and
theory of the firm; we discuss some macroeconomic examples as well. In the
section after that, section 2.3 we discuss how total differentials, total
derivatives and chain rule find applications in economics. Following this, the
discussion moves to a discussion of applications of implicit functions in
economics. In the final section, section 2.5, the unit discusses some
homogeneous functions found in economics, and discusses an important
application of Euler’s theorem. As you study the unit, you will discover that
many concepts that you have and will encounter in your study of
microeconomics and macroeconomics are approached from a mathematical
point of view. You will gain an insight into the structure of microeconomic
and macroeconomic theory, a structure which is mathematical in nature. You
will also realise that mathematical concepts are such as to lend themselves
easily into a language for communicating ideas of economics.

We strongly urge you to have unit 1 open along with this, the present unit, so
that you can immediately refresh your learning of the corresponding
mathematical concept for each economic application we deal with in this
unit.

2.2 APPLICATIONS OF LEVEL CURVES AND

PARTIAL DERIVATIVES IN ECONOMICS
Recall your study of multivariate functions and level curves in unit 1. We
saw multivariate functions can be written as Z = f ( X , Y )

If the function has n arguments we can write it as

z = f ( x1 , x2 ,..., xn )

To understand the applications of such functions in economics, what you

have to do is think of a situation where a variable depends on more than one
variable.

For example, demand of a good x depends upon a variety of factors like its
own price ��� �, the prices of related goods ��� �, money income of the
consumer (M), his tastes, habits and fashion (i.e. consumer preferences-I) and
so on. We can represent a demand function as,
�� = ���� , ��, �, � … �,

36
 Multivariate
Similarly, we have production function: � = ���, �� where � stands for Calculus-II
production/output, L for labour and K for capital.
Economic situations typically depicted using multivariate functions. For
simplicity we consider only two-variable analysis. For example in a
production function, p f L, K , we assume and capital (K) used in the
process of production. Similarly, in a utility function, u f x, y , we assume
utility (u) depending upon the quantity of two goods x and y consumed.
With the use of partial derivatives we can identify whether two goods are
competitive or complementary.

For example think of production, where output of a good depends on two

factors labor and capital. Let labor be denoted by L and capital by K. let the
output be denoted by Q. Then we have a production function
Q = f (L , K )

Now suppose we have several inputs, not just two. Let the number of inputs
be n. Let us denote the collection of n inputs by an n-tuple ( x1 , x2 ,...xn )

We can then write the production function as

Q = f (x1 , x2 ,..., xn )

Similarly, we can think of a utility function which shows the utility U that a
consumer derives from the consumption of two goods X and Y. We can show
this as
U = f (X ,Y )

Again, suppose there are n goods Y1,Y2…Yn and the amount consumed of
these goods are denoted by
( y1 , y 2 ,... y n )
In this case, we can depict the utility function as
U = f ( y1 , y 2 ,..., y n )

As a final example, this time from macroeconomics, let the money demand
Md be a function of the interest rate r and income. We can show this as
Md = g (r, Y )
So you understand that in all these functions a dependent variable depends on
more than one variable. In the rest of the unit, we study how changes in the
independent variable induce changes in the dependent variable. Sometimes
we consider the change in one independent variable keeping the others
constant, and sometimes we consider changes in all the independent variables
together.

Now we turn to a discussion of level curves in economics. At this point you

must remember the discussion in section 1.2.2 of unit 1. You know from that
37
Functions of Several
Variables
discussion that a level curve shows the curve where the dependent variable is
fixed at a certain level. If we have a function Z = f(X,Y), the graph of this
function in three-dimensional space can be visualized as being cut by
horizontal planes that are parallel to the x y – plane. The intersections
between the planes and the graph can be projected onto the x y – plane. If the
intersecting plane is at z = k then the projection onto the x y – plane is known
as the level curve or contour at height k for the function f. The contour or
level will consist of points that satisfy the equation
f (x , y ) = k

To understand the economic application, think of the simple production

function that we just considered
Q = f (L , K )

If we were to depict this graphically, we can show L and K in the x-y plane
and the output Q vertically on the z –axis. Then the graph of the production
function Q will be like a ‘hill’ or dome. To think of level curves suppose the
value of Q is fixed at a level say k. Then the production function will be k = f
(L, K ). Here k is a constant. The graph of the production function will be a
‘slice’ on the hill or dome at a height k. If we were to take a different fixed
value of k, then there will be a ‘slice’ at different height on the dome. To put
this slightly differently, a level curve for the production function above is the
locus of all points showing combinations of labour and capital that yield an
output equal to k. All the combinations of labour and capital that result in the
same specific output level will be on the same level curve. In
microeconomics, in the theory, you have come across level curves under the
name ‘isoquant’. So for a production function (with two factors) each
isoquant is a different level curve.
Similarly, consider the simple utility function U = f ( X , Y )

If the level of utility were to be fixed at a given level say U then a level
curve would be produced as the locus of all combinations of X and Y that
give the same level of utility equal to U . In the context of the theory of the
consumer that you studied in microeconomic theory, you were familiarized
with level curves under the name ‘indifference curves’. So for a utility
function (of two goods), each indifference curve is a different level curve,
showing a different level of utility.

Let us now discuss applications of partial derivatives in economics. Recall

the discussion on partial derivatives in section 1.3 in unit1. Now we take
some functions in economics and see where partial derivatives can be
applied. If we take the production function above and see by how much the
output increases if we were to increase labour input by one unit while holding
capital constant, we will get the marginal product of labour. So if we have
∂Q
Q = f (L , K ) , the marginal product of labour will be
∂L
38
 Multivariate
Calculus-II
∂Q
Similarly we can have
∂K
Now consider the utility function
U = f (X ,Y )

Here, if we increase X by one unit while holding Y constant, the change in

∂U
utility that would result is the marginal utility of X: ∂X

∂U
In a similar manner, we can have the marginal utility of Y: ∂Y

Let us consider simple solved example from basic microeconomic theory.

Given the demand function of two goods X 1 and X 2 , as x1 8 p1 3 p2 11
and x2 2 p1 3 p2 17 , find the effect of change in prices of two goods on
their demand. Interpret the results.
Alternatively, this example could be thought of being about finding, what is
called, partial marginal demands (PMD). There are four possibilities.
1) PMD of X1 , when price of X1 changes (holding other variables
x1
constant) 8
p1

x1
2) PMD of X1 , when price of X 2 changes 3
p2

x2
3) PMD of X 2 , when price of X 2 changes 3
p2

x2
4) PMD of X 2 , when price of X1 changes 2
p1

Interpretation:
x1
1) 8 , shows that when the price of X 2 is held constant, a rise in
p1
price of X1 , by one unit decreases X1 s demand by 8 units

x1
2) 3 , shows that when the price of X1 is held constant, a rise in price
p2
of X 2 , by one unit increases the demand of X1 by 3 units

x2
3) 3 , shows that when the price of X1 is held constant, a rise in
p2
price of X 2 , by one unit decreases X 2 s demand by 3 units

39
Functions of Several x2
Variables 4) 2 , shows that when the price of X1 is held constant, a rise in price
p1
of X1 , increases demand for X 2 by 2 units.

[Note that Price of X1 is p1 and price of X2 is p2

Demand of X1 is x1 and demand of X 2 is x1 ]

Two goods x and y are complementary when, other things being held
constant, rise in the price of one (say petrol), decreases the demand for the
other (say cars). In this case both the cross partial derivatives should be
negative i.e.
x1 x2
0; 0
p2 p1

On the other hand, two goods X and Y are competitive (or substitute
goods), when other things being held constant, if the increase in the price of
one (say coffee) increases the demand for the other (say tea). In this case both
the order partial derivatives should be positive i.e.
x1 x2
0; 0
p2 p1

Example.
The demand for functions of two goods x1 and x2 , find whether the goods
are complementary or competitive? The functions are:
10 150
x1 ; x2 where p1 and p2 are the prices of x1 and x2
p12 p2 p1 p22
respectively

x1 10 1 10
From the first function: 0
p2 p12 p2 p2 p p22
2
1

x2 150 1 15
From the second function: 0
p1 p22 p1 p1 p p22
2
1

x1 x2
Since both and are negative, therefore, the goods are
p2 p1
complementary.

Example.
Find are nature of goods x1 and x2 when

x1 p1 0.4 e0.2 p2 and x2 p2 0.6 e0.5 p1

where p1 and p2 represent their respective prices.

x1
p1 0.4 e0.2 p2 0.2 0.2 x1 0
p2
40
 x2 Multivariate
p2 0.6 e0.5 p1 0.5 0.5 p2 0.6 e0.5 p1 .5 x2 0 Calculus-II
p1

Since both the partial derivatives are positive, therefore, the goods x1 and x2
are competitive.

Application to Partial Elasticities (PE)

Keeping in mind the formula for point elasticity of demand, we can calculate
four partial elasticities, for the two demand functions,

x1 f1 p1 , p2 and x2 f 2 p1 , p2 where x1 and x2 represent demand for

two goods X1 & X 2 and p1 & p2 are their prices. These elasticities are as
follows.
x1 p1
a) PE of demand for x1 w.r.t p1 e11 ∗
p1 x1

x1 p2
b) PE of demand for x1 w.r.t p2 e12
p2 x1

x2 p2
c) PE of demand for x2 w.r.t p2 e22
p2 x2

x2 p1
d) PE of demand for x2 w.r.t p1 e21
p1 x2

Note: Where as e11 and e22 are direct PEs of demand, but e12 and e21 are
cross PEs of demand.
Let us take some examples to illustrate
Example 1. Given the demand functions x1 p1 1.5 p2.4 and x2 p1.6 p2 .7 , find
the direct as well as cross partial elasticities. ( x1 and x2 are demands p1 , p2
are the prices of two goods X1 and X 2 respectively)

Sol. a) Direct PEs

x1 p1 p1 1.5 p 1.5 p2.4

e11 1.5 p1 2.5 p2.4 1.5
p1 x1 p1 1.5 p2.4 p 1.5 p2.4

x2 p2 p2 .7 p1.6 p2.7
e22 .7 p1.6 p2 1.7 .6 0.7
.7
p2 x2 p1 p2 p1.6 p2.7

b) Cross PEs

x1 p2 .4 p1 1.5 p2 .6 p2 .4 p1 1.5 p2.4

e12 .4
p2 x1 p1 1.5 p2.4 p1 1.5 p2.4

∗
1) In e11 , the LHS 1 stands for x1 and the RHS 1 stands for p1
2) First write PD to avoid mistakes (only suggestive) 41
Functions of Several
Variables
Example 2. Demand for a goods x is given as a function of money income
(M) and price p x as x .9 M 1.1 p 0.7 . Find price elasticity and income
elasticity of demand.

Sol. Given x .9M 1.1 px 0.7 x f M , px

x px
a) Price elasticity of demand
px x
p
.7 .9M 1.1 px 1.7 x
.7
.9M px 0.7
1.1

x M
b) Income elasticity of demand
M x
M
.9 M .1 1.1 p x 0.7 1.1
.9 M 1.1 p x 0.7

Example 3. From the following demand function, find income and cross
elasticity of demand when consumer income (m) = Rs.500, price of
x px 10 and price of z pz 15 .

px2 pz m
x 800 .
5 60 10
x pz
a) Cross elasticity of demand
pz x

x 1 1
when 0 0 0 .
pz 60 60

10 15 500
x 800 (For m =500, px 10, pz 15 )
5 60 10
1
800 2 50 848.25
4
1
1 15 1
is cross
4 60 848.25 3393

x m
b) Income elasticity of demand , where
m x
x 1 1
0 0 ,m 500 and
m 10 10
x 848.25 (already calculated)
1 50 0 50
is em .0589
10 848.25 848.25

42
 Multivariate
Application to Utility Function Calculus-II

We know any marginal function is first derivative of total function. Thus

d
Marginal = (Total). Since it is a care of partial derivative dealing with
dx
functions of two variables, therefore, we will find partial derivatives like
u u
, etc. Let us take some examples.
x j

Example 1. Let the utility function be u x 7 y 2 . Find the marginal

utilities with respect to the two goods x and y when 5 units of x and 3 units
of y are consumed.

Sol. Given utility function u x 7 y 2 or

u
a) MU with respect to x y 2.
x
For x 5, y 3, Mu x y 2 3 2 5

u
b) MU with respect to y x 7.
y
For x 5, y 3, Mu y x 7 5 7 12

Example 2. If the utility function is u ax by c xy , find the ratio of

marginal utilities of the two goods x and y .
1
Sol. Given: u ax by c xy 2

u cy 2a xy cy
Mu x a
x 2 xy 2 xy

u cx 2b xy cx
Mu y b
y 2 xy 2 xy

Mu x 2a xy cx 2b xy cx
Therefore, ratio of Mus
Mu y 2 xy 2 xy

2a xy cy
2b xy cx

Application to Production Function

A production function represent total product (TP). Therefore, marginal
product will be the 1st partial derivative of TP with respect to one of the
factors, keeping other factor constant. Therefore,

a) Marginal Product of Labour (L) TP

L

43
Functions of Several
Variables b) Marginal Product of Capital (K) TP
K
Euler Theorem can also be stated in terms of partial derivatives. If
P f L, K is the production function of two factors, labour (L) and capital
(K), then the Euler Theorem states that
P P
L K P
L K
L MPL K MPK P

This is also called product exhaustion theorem or the adding-up problem. It

states that:
If all factors are paid according to their marginal product then the total
product is exhausted.

That is P L MPL KMPK 0

Let us now take some illustrations

Example 1.
1
Given the production function P 2 LK 2
, where P is total product, L is
labour and K is capital as factors of production
1) Find the marginal product of the two factors
2) Show that Euler Theorem is satisfied

3) What shall be the payment to labour is 5 units of labour are used, when
capit remains fired at 20
1 1
Sol. Given TP : P 2.L 2 K 2

1
1 1
P 1 K 2
i) MPL 2 L 2
K 2
L 2 L
1
P 1 12 1
L 2
and MPL 2 LK 2
K 2 K

ii) Euler Theorem states that: L MPL KMPK P

1 1
1 1 1 1 1 1
K 2 L 2
or L K L2 K 2 K 2 L2 2 L2 K 2 P
L K
The Euler Theorem is satisfied.
1 1
K 2 20 2 1
iii) When L 5 and K 20 , then MPL 4 2 2
L 5

44
 Multivariate
Example 2. Calculus-II
1 1
A production function is given by Ax 3 y 3
where x stands for labour and y
stands for capital. Answer the following questions

a) What is the behaviour of each factor?

b) What is the nature of returns to scale?

c) Find whether total product is exhausted or not?

1 1
Sol. Given PF : P Ax 3
y 3

a) Behaviour of factor's MP means nature of rate of change of MP of that

factor i.e.

MPx and MPy

x y

P 1 23 13 1 2 1
i) MPx A x y Ax 3 y 3
x 3 3
2 1
1
Rate of change of MPx MPx Ax 3 y 3
x x 3
5 1 5 1
1 2 2
A x3 y3 Ax 3 y 3 0
3 3 9
This shows that as amount of factor x in creases, its MP decreases,
when y is held constant

P 1 13 2
1 1 2
ii) MPy A x y 3
Ax 3 y 3
y 3 3
1 13 32
Rate of change of MPy MPy Ax y
y y 3
1 5
1 2 2 13 35
A x y 3 3
Ax y 0
3 3 9
This shows that as amount of factor y increase, its MP decreases, when x
is held constant.

b) To show the nature of returns to scale, we increase both the factors by a

2 1 1 2
∗
fixed proportion say . Then the PF becomes P̂ 3
Ax 3 y 3 3
P
2
Since power of is
1 , therefore, a 20% increase in both the factors
3
bring about less than proportionate (i.e. less then 20%) increase in total

∗
read as Lamda is a proportion. If we increase every factor by, say, 20%, than
20 1
.2
100 5 45
Functions of Several
Variables
product P. That is the production function shows decreasing returns to
scale.
c) Let us see if Euler theorem holds good not if x and y factors are paid
according to their MP, then TP should be exhausted i.e.
or TP – (Payment to factor x + Payment to factor) zero

1 13 32
Now payment to y y MPy y Ax y
3
1 13 32
Similarly payment to y y MPy y Ax y
3
1 13 13 1
Ax y P.
3 3
1 1 2
is total payment P P P P
3 3 3
Hence total product is not exhausted. Euler Theorem is not exhausted.

Example 3.
Let the production function by Q ALa K b . Find the elasticity of production
with respect to labour (L) and capital (K).
Sol. Given: Production function: Q ALa K b

Q L
i) Labour elasticity of Production eL
L Q
L a A La K b
A a La 1 K 6 a.
ALa K b ALa K b
(which is the exponent of the factor L)
Q K
ii) Capital elasticity of Production eK
K Q
K b A La K b
A bLa K b 1
b.
ALa K b ALa K b

Check Your Progress 1

1) Given the utility function U = x2y3, find the marginal utilities. Determine
if the marginal functions are increasing or decreasing.
…………………………………………………………………………….

…………………………………………………………………………….

…………………………………………………………………………….

…………………………………………………………………………….

…………………………………………………………………………….

46
 Multivariate
2) Given the production function Q = 10L0.7K0.3, find the marginal Calculus-II
products. Determine if the marginal functions are increasing or
decreasing.

…………………………………………………………………………….

…………………………………………………………………………….
…………………………………………………………………………….

…………………………………………………………………………….

…………………………………………………………………………….

2.3 APPLICATIONS OF TOTAL DIFFERENTIALS,

TOTAL DERIVATIVES AND CHAIN RULE IN
ECONOMICS
In the previous section, you got a lengthy discussion of partial derivatives in
economics. In this section we shall look at economic applications of total
differentials as well as total derivatives in economics. Before we begin, let us
introduce two notational points. The first one is that about functions. Suppose
we have a function z = f (x, y). We can denote it by z =z (x, y ). So the
function itself we can denote by z instead of by f. This says that there is a
variable which depends on x and y. We can sometimes talk of the relation
between z, and x and y without using the equality sign. If we have z (x, y )
you can think of it immediately as being about some variable z which
depends on x and y. Thus we can talk about money demand Md as Md (r, Y )
where r is interest rate and Y is income. This says money demand depends on
the interest rate and income. We shall be using this notation intermittently in
the rest of the unit.
The second point about notation concerns partial derivatives. Take a function
∂U
U = f (x, y). The partial derivative of U with respect to x, can also be
∂x
written Ux. Similarly the partial derivative of U with respect to y can be
written Uy. The partial derivatives are also sometimes denoted fx and fy.
Another notation is sometimes used. Suppose we have a function denoted U
= (x1, x2 ). Then the partial derivative of U with respect to x1 and x2 is
sometimes denoted U1 and U2 respectively, or even as f1 and f2 respectively.
So, having made these basic comments about notation, let us discuss some
applications of differentials and derivatives to economics. For this section
too, as for all sections of this unit, you just have to recall the basic concept
that you learned in Unit 1.

Consider a saving function

S = S (Y , i ) where S is saving, Y is income, and i is interest rate. We assume
that the function is continuous and has partial derivatives. In this saving
47
Functions of Several ∂S
Variables function, is the marginal propensity to save. If there is a change in Y, dY,
∂Y
∂S
the resulting change in S will be approximately dY . Similarly, given a
∂Y
∂S
change in i, di, we can say that the resultant change in S will be di . Thus
∂i
the total change in S due to the change in Y and in i is
∂S ∂S
dS = dY + di . In the notation we had mentioned above, we can write
∂Y ∂i
this as
dS = S Y dY + S i di

Here dS is the total differential of the saving function. The process of

obtaining the total differential of a function is called total differentiation.
In the saving function mentioned above, it is possible that only income
changes; the interest rate stays constant. In that case, di = 0. So the total
∂S ∂S
differential of the saving function becomes dS = dY + 0 = dY
∂Y ∂Y
Dividing both sides by dY we get

 dS  ∂S
  =
 dY  i =i ∂Y
∂S
We can interpret the partial derivative as the ratio of two differentials dS
∂Y
and dY, with the condition that the other variable in the saving function, I,
remains constant. We could have also had a situation where Y did not
change, only I did, and obtained

 dS  ∂S
  =
 di Y =Y ∂i

Now let us consider a function with n arguments. Think of the following

utility function
U = f ( x1 , x2 ,..., xn ) . Note that we can also write this also as

U = U (x1 , x 2 ,..., xn ) in the notation that we mentioned at the beginning of this

section.
Differentiating U totally, we will get the total differential of U as:
∂U ∂U ∂U
dU = dx1 + dx2 +  + dxn
∂x1 ∂x 2 ∂xn

We can also write this as

n
dU = U 1dx1 + U 2 dx2 + U n dxn = ∑U i dxi
i =1
48
 Multivariate
As a final application of total differential, we will make use of one of the Calculus-II
rules involving total differentials that you had studied in the previous unit
which says
d (u ± v ) = du ± dv

As an illustration of this, consider the basic macroeconomic national income

equation for a closed economy: Y = C + I + G , where Y is income, C is
aggregate private consumption, I is investment and G is government
expenditure. Then the total differential of Y will be dY = dC + dI + dG

Now suppose private investment I was a function of the interest rate r. Then
we would have
∂I
dY = dC + dr + dG
∂r
After this discussion of application of total differentials in economics, let us
discuss the application of total derivatives. To do this, think of the saving
function S = S (Y , i )

We had considered this function above. Earlier, in this function we had

assumed that income Y and interest rate i are independent variables. But
suppose that both these variables somehow depend on the money supply M.
So now we can write the saving function as S = S(Y(M),i(M)).
Now suppose we would like to see how savings change as a result of the
money supply. Then we take the total derivative of S with respect to M. We
get:
dS ∂S dY ∂S di
= +
dM ∂Y dM ∂i dM
In the above, we assume that the only channels through which M affects S are
through its influence on Y and i, and that M does not independently
influence S. However, there may be cases where in a function the arguments
themselves depend on a variable, and that this variable independently
influences the dependent variable. For an example, we consider a production
function, but in a dynamic long-run sense:
Q = Q(L, K , t )

This says that output depends not only on inputs capital and labour but on a
third argument in the function, time, denoted by t. The presence of time in the
production function suggests that production of the good is affected over time
by technology, increase in skills, etc. This factor shifts the production
function. Thus the production function is dynamic and not static. Now capital
and labour can also change over time, and so we have K = K (t ) and
L = L(t ) . So the production function can be written

Q = Q(L(t ), K (t ), t )
49
Functions of Several
Variables
We can use total derivative of Q with respect to t to show the rate of change
of output over time. This will be
dQ ∂Q dL ∂Q dK ∂Q
= + +
dt ∂L dt ∂K dt ∂t
Using an alternative notation, we can depict this as
dQ
= QL L′(t ) + QK K ′(t ) + Qt
dt
The above can be considered as an application of chain rule also, although we
had mentioned in unit 1 that for chain rule to apply, each of the arguments in
the function should itself be a function of two variables. Say you have a
function

Z = f ( x, y ) and x and y each is a function of r and s. So we have

z = f ( x(r , s ), y (r , s ))

We can construct examples from economics. Say a person gets utility by

being happy when his two children A and B get utility from consumption of
food, denoted by F, and clothes denoted by C. Let UA be the utility function
of A and UB be the utility function of B. Let U be the utility of this person.
Then we can write:
[
U = f U A (F , C ),U B (F , C ) ]
Notice that we have not made a distinction between the quantities of food and
clothes consumed by the two children.

Suppose we want to see how the utility of this person changes when the
dU
consumption of clothes changes. This we can find by getting . This will
dC
be equal to
dU U dU A U dU B
dC U A dC U B dC
dU
We can similarly obtain to see the change in utility of this person when
dF
the consumption of food by his children.

2.4 APPLICATIONS OF IMPLICIT FUNCTIONS

IN ECONOMICS
We have till now seen the application of partial derivatives, total differentials
and total derivatives in economics. In this section, we look at the
differentiation of implicit functions. For this we would again urge you to read
the corresponding section on implicit functions in Unit 1, which is section
1.6.3.
50
 Multivariate
If we have a function f ( x, y ), we find that x and y are related implicitly. To Calculus-II
proceed further with this implicit function, we can introduce a third variable
z, which is related as a single valued function of x and y: z = g (x, y ). For z =
k (a constant ) we get a level curve. So level curves (like indifference curves
and isoquants in economics) are implicit functions.

As x and y vary (not necessarily independent of each other), the change in z

is obtained from the total differential:
dz = g x dx + g y dy , where g x is the partial derivative of z with respect to x;
you understand what g y is

If the values of x and y are such that the value of z is 0, then

dz = g x dx + g y dy = 0

dy g
Hence, =− x
dx gy

Let us apply this idea of differentiating implicit functions to economics.

Consider a production function Q = f (L, K ) . This gives rise to a family of
isoquants. A specific isoquant will have the equation f (L, K ) = c , where c is
a constant. Differentiating this with totally we get
f L dL + f K = 0 .

This is the approximate relation between changes dL and dK in the inputs

along the isoquant through ( L, K ). This relation holds at all points on the
isoquant. Hence the tangent gradient of the isoquant through ( L, K ) is
dK f
=− L
dL fK

dK
The left-hand side is called the marginal rate of technical substitution. It
dL
shows the marginal rate of substitution of capital for labour.

On the right-hand side, fL and fK are the marginal products of labour and
capital respectively.

Thus the marginal rate of technical substitution between capital and labour is
equal to the negative of the ratio of the marginal product of labour and that of
capital.

We can do a similar exercise in the case of consumer theory. Take an

indifference curve U = f ( x, y ) . Now along each indifference curve, the
utility remains constant. Thus, for a specific indifference curve, let utility be
fixed at a level U

Then, the total differential of this function would be dU = f x dx + f y dy = 0

51
Functions of Several dy f
Variables From this we get =− x
dx fy

The left-hand side is called the marginal rate of substitution of y for x. The
right-hand side is the ratio of the marginal utility of x to that of y.
Let us now consider an application of implicit functions in macroeconomics.
Consider a closed economy. Its basic accounting equation shows that total
income is a sum of total private consumption, total private spending, and
government expenditure:

Y = C + I + G.
Let consumption be an increasing function of income, and investment be an
increasing function of income, and a decreasing function of the interest rate,
r. Government spending is assumed to be exogenous. Then we can write the
above equations as
Y = C (Y ) + I (Y , r ) + G
0 < C′ < 1
IY > 0
Ir < 0

We can also consider a money market in which the exogenous supply of

money, M, is equal to the demand for money, L, where L is an increasing
function of income Y, and a decreasing function of the interest rate, r.

We can write for the money market the following equilibrium condition
M = L(Y , r )

We have now two equations: one for the goods market, and one for the
money market. Leaving aside the government expenditure, we can consider
the money supply as the only actual exogenous variable. We can take total
differentials and get:
dY = CY dY + IY dY − I r dr + dG
And for the money market
dM Ly dY + Lr dr
=

If we take government spending and money supply to be fixed, then dG and

dM will be zero, and the model can be solved.

Check Your Progress 2

1) Given a production function

= ( K , L ) K 0.3 L0.5 , find the marginal rate of technical substitution.

Y f=

……………………………………………………………………………

……………………………………………………………………………
52
 Multivariate
1) A firm finds that its production function is of the form Calculus-II

Q =100K0.25L0.75
Where Q is output and K and L are capital and labour, respectively.

i) Show that the equation of the isoquant for Q = 100 is given by

K = 1/L3
ii) Show that this isoquant is negatively sloped.

…………………………………………………………………………….
…………………………………………………………………………….

…………………………………………………………………………….

…………………………………………………………………………….

…………………………………………………………………………….

2) Consider the utility function

U = XY, where X and Y are two goods consumed

i) Show that the indifference curves are downward sloping and

convex.

ii) Give an economic interpretation to the slope and curvature of the

indifference curve
……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………

2.5 APPLICATIONS OF HOMOGENEOUS

FUNCTIONS AND EULER’S THEOREM IN
ECONOMICS
In this final section of the unit, we look at some applications of homogeneous
functions in economics. For this section in this unit, you must read the
corresponding section on homogeneous functions and their differentiation in
unit 1.

Let us consider a production function F where output Q is a function of two

inputs labour (L) and capital (K), that is, Q = F(L, K). This production
function is said to be homogeneous of degree r, if for all Land K in the
domain,
F (λL, λK ) ≡ λr F (L, K ) .
53
Functions of Several
Variables
We can extend this definition to a production function of n-inputs x1., x2
,…,xn (Q is a function not just of labour and capital but of n inputs denoted
as above. Suppose
z = f ( x1 , x2 ,..., x n ) . Then f is said to be homogeneous of degree r if

f (λx1 , λx2 ,..., λxn ) ≡ λr f ( x1 , x2 ,..., x n ) . Here r determines the returns to scale
of the production function. If
F ( x, y ) is linearly homogeneous (homogeneous of degree 1) if and only if
x x x 
F ( x, y) = yf   ,where f   = F  ,1
 y  y y 
How do we show this? Let us begin by showing the ‘if’ (sufficiency) part.
Given:
x
F ( x, y ) = yf   ,we have
 y
 λx  x
=F (= λ x, λ y ) λ yf=
 yf   λ F ( x, y )
 λ=
 λy   y

Now let us show the only if (necessary condition) part:

Given F(x,y) is linearly homogeneous (homogeneous of degree 1). Then

F ( λ x, λ y ) = λ F ( x, y ) , for any λ

1
Put λ = . The we have
y

x  1
F  ,1 = F ( x, y )
y  y
x 
Thus yF  ,1 = F ( x, y )
y 
x  x
But F  ,1 = f   .
y   y
 x
Hence, F ( x, y ) = yf  
 y
Differentiation of a Homogeneous Function
A very important property of homogeneous functions is with regard to the
differentiation of homogeneous functions.

Let us have a homogeneous function f(x, y) of degree r. then we have:

f (λx, λy ) ≡ λr f ( x, y )

54 Differentiating with respect to x we have:

 ∂f Multivariate
λf x (λx, λy ) = λr f x ( x, y ) , where f x = Calculus-II
∂x
If we divide by λ we get:
f x (λx, λy ) = λr −1 f x ( x, y )

If you notice carefully, the above equation shows that the function f x is
homogeneous of degree r – 1. The above holds for the function fy too, where
fy is the partial derivative with respect to y. the above holds in the case of any
multivariate homogeneous function.
This result says that if a function is homogeneous of degree r, then each of its
partial derivatives is homogeneous of degree r – 1.

Euler’s equation
This is a very important property displayed by homogeneous equations. Let
z f x, y

be a homogeneous function of degree r. then the following relation holds as

an identity:
∂z ∂z
x + y = rz
∂x ∂y

We repeat the proof that that was provided in unit 1. We prove Euler’s
equation using implicit differentiation and the chain rule:
Let us have the homogeneous function
f (λx, λy ) ≡ λr f ( x, y ) (a)

Let us partially differentiate the left-hand side of equation (a) with respect to
λ. We get:
∂f (λx, λy ) ∂λx ∂f (λx, λy ) ∂λy
+
∂λx ∂λ ∂λy ∂λ

= xfλx + yfλy (b)

Now let us obtain the partial derivative of the right-hand side of equation (a)
with respect to λ. We now get:

∂λr ∂f ( x, y )
f ( x, y ) + λr
∂λ ∂λ

rλr −1 f (x, y ) + 0
= (c)
= rλr −1 f (x, y )

Since for equation (a), left-hand side = right hand side, therefore equation (b)
= equation (c). Hence we have
55
Functions of Several
Variables
xfλx + yfλy = rλr −1 f ( x, y )

Now λ can be any number. Let λ be 1. Then, we get Euler’s theorem:

∂z ∂z
xf x + yf y = rf ( x, y ) , i.e. x + y = rz `
∂x ∂y

The above can be generalised for functions of more than two variables. Let us
discuss an important application in economics of Euler’s theorem.

Consider a production function that is homogeneous of degree 1. In other

words, this production function displays constant returns to scale. Consider
the following simple production function
Q = f (L, K )

If the Euler’s theorem holds for the function z f x, y

,then if z is homogeneous of degree 1, then Euler’s theorem would imply

∂z ∂z
x +y =z
∂x ∂y

Now let us merely substitute z with Q, x with L, and y with K. Then we

would have our production function above with constant returns to scale.
Euler’s theorem would imply:
∂Q ∂Q
L +K =Q
∂L ∂K
∂Q ∂Q
On the left hand side, is the marginal product of labour and is the
∂L ∂K
marginal product of capital. If each worker gets paid a wage equal to his or
her marginal product of labour, and each unit of capital gets paid a rental
∂Q
equl to its marginal product of capital, then L is the total earnings of all
∂L
∂Q
the workers (that is, of labour as a whole) and K is the total earnings of
∂K
capital. Thus the left-hand side of the above equation shows the total earnings
of all the factors of production (in this case, only labour and capital). This
equals the right-hand side , which is simply Q, or the total output. So we see
that if constant returns to scale prevail (which would, if the production
function is homogeneous of degree one), then the total earnings of the factors
of production is equal to the total output produced. Thus nothing is left over
and there are no extra-normal profits. The product is totally exhausted. This
is the famous product-exhaustion theorem which says that if there are
constant returns to scale and if each factor is paid its marginal product, then
the payments to the factors exhausts the entire output. Of course this holds
only in the case of constant returns to scale.

56
 Multivariate
Check Your Progress 3 Calculus-II

1) Suppose you have a utility function U = x α y β . Suppose U is fixed at the

level U = k. Find the marginal rate of substitution of the utility function

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………
……………………………………………………………………………

……………………………………………………………………………
2) Consider the production function Q = Lγ K η . Determine the degree of
homogeneity of this production function.

……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………

3) Show that if there are increasing returns to scale, the production

exhaustion theorem will not hold

……………………………………………………………………………
……………………………………………………………………………

……………………………………………………………………………

……………………………………………………………………………
……………………………………………………………………………

2.6 LET US SUM UP

This unit was devoted to presenting some economic applications of the
various concepts about multivariate functions and their differentiation. The
unit began by presenting some familiar multivariate functions that you come
across in economics, like utility function, production function, demand
function, money demand function, investment function and so on. Also, the
unit soon discussed a couple of examples of level curves in economics,
namely, indifference curves and isoquants. The unit then went on to discuss
partial derivatives in economics. We found that partial derivatives are
ubiquitous in economics. In a multivariate function, whenever we speak of a
marginal concept in economics, the corresponding mathematical concept is a
partial derivative. Marginal utility, marginal product of a factor, marginal

57
Functions of Several
Variables
cost, marginal revenue, and marginal propensity to consume are all examples
of partial derivatives,
The unit then went on to discuss the application of total differentials and total
derivatives in economics. The applications were drawn from utility theory,
production theory and macroeconomics. The application of the chain rule
with respect to derivative of multivariate functions, where each argument in
the original function is itself a function of two or more variables was also
discussed with the aid of a constructed example about utility as a function of
utility of others, with each utility in turn being functions of consumption of
two goods.

After this you were presented with some applications of implicit functions
and their differentiation. We saw that level curves are an important type of
implicit functions. In economics, using the function for indifference curves
and isoquants, we came across the concept of marginal rate of substitution,
and the marginal rate of technical substitution. We also came across an
example from macroeconomics.
Finally, the unit turned to a discussion of homogeneous functions and the
Euler’s theorem. We saw the homogeneity in utility functions, demand
functions and production functions, where the degree of homogeneity being
equal to, less than, or greater than one determines whether the production
function displays constant, decreasing, or increasing returns to scale. At the
end, the Euler’s theorem was applied to demonstrate the product exhaustion
theprem in the theory of production.

2.7 ANSWERS/HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) See section 2.3 and answer.
2) See section 2.3 and answer.
Check Your Progress 2
1) See section 2.4 and answer
2) See section 2.4 and answer
3) See section 2.4 and answer
Check Your Progress 3
1) See section 2.5 and answer.
2) See section 2.5 and answer.
3) See section 2.5 and answer.

58