Optimization in Economic Theory

PD Dr. Johannes Paha

University of Hohenheim

winter term 2021/22

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 Chapter 1 – Introduction and Linear Algebra

Chapter 1
Introduction and Linear Algebra

Oct 19-26, 2021

Optimization in Economic Theory

PD Dr. Johannes Paha
winter term 2021/22

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 Chapter 1 – Introduction and Linear Algebra

Organization – Lecturer

PD Dr. Johannes Paha

Office: 31/022
Office hours: By appointment
Email: johannes.paha@uni-hohenheim.de

Privatdozent at University of Gießen

PhD in Economics, Gießen, 2011
Research interests: Industrial Organization, competition economics
(mergers, cartels, dominance, state aid), development economics

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 Chapter 1 – Introduction and Linear Algebra Double click here for audio contents

Organization – Schedule (Lecture)

Tue, Oct 19, Chapter 1.1 – Introduction and Linear Algebra

What is economics about?
Why do we need mathematical tools to solve, for example, problems of
consumer choice?
Wed, Oct 20, Chapter 1.2 – Solving Linear Systems
Economic policy often pursues several objectives at the same time, using
multiple instruments?
How can such a system of equations be solved for the optimal policies?
Wed, Oct 27, Chapter 1.3 – Matrix Algebra
Under what circumstances does a system of equations have a (unique)
solution at all?
How can matrix methods be used to facilitate solving the system of
equations?

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Organization – Schedule (Lecture)

Wed, Nov 03, Chapter 2 – Derivatives and Differentials

How are derivatives defined?
How can derivatives and total differentials be used to solve economic
problems such as the consumer choice problem?
Wed, Nov 10, Chapter 3 – Derivatives: Further Insights
What is a gradient vector? How can it be used to solve multivariate
optimization problems?
What role does the Hessian matrix play in economic optimization?
Wed, Nov 17, Chapter 4 – Derivatives: Concavity and Convexity
Use the Hessian matrix to determine under what circumstances a
multivariate function is convex or concave.
This requires defining the definiteness of a matrix.
Perform an unconstrained optimization.

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Organization – Schedule (Lecture)

Wed, Nov 24, Chapter 5 – Constrained Optimization I

Perform an optimization with one constraint (such as utility maximization).
Introduction of the Lagrangian function.
Wed, Dec 01, Chapter 6 – Constrained Optimization II
Perform an optimization with several constraints, using the Hessian matrix.
Determine under what conditions the constraints are satisfied and how they
affect the optimum.
Wed, Dec 08, Chapter 7 – Constrained Optimization III
Analyze optimization problems with non-negativity and inequality constraints.
Introduce the concept of complementary slackness.
Tue, Dec 14, Chapters 7 and 8

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Organization – Schedule (Lecture)

Wed, Dec 22, Chapter 8 – Interpreting the Lagrange Multiplier

The Lagrange multiplier can be interpreted as a shadow price.
Show what effects marginal changes in the constraints have on the value of
the objective function.
Compare the free market equilibrium to an optimal allocation chosen by a
social planner.
Wed, Jan 12, Chapter 9 – The Envelope Theorem
Demonstrate the concept of an maximum value function.
Show how changes in parameters affect the optimal value even if they also
affect decisionmakers’ best responses.

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 Chapter 1 – Introduction and Linear Algebra Double click here for audio contents

Organization – Schedule (Lecture)

Wed, Jan 19, Chapter 10 – Maximum Value Functions

Apply the envelope theorem to microeconomic problems.
Derive Roy’s identity, Shepherd’s lemma, and the Slutzky-Hicks
decomposition.
Wed, Jan 26, Chapter 11 – Decision Making Under Uncertainty
Introduce the concepts of risk, risk aversion, insurance, and moral hazard.
Show how risk affects decisionmakers’ choices.

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Organization – Schedule (Tutorial)

Tue, Oct 19, lecture instead of tutorial
Tue, Oct 26, Assignment 1, Mathematical Basics
Tue, Nov 02, Assignment 2, Linear Systems
Tue, Nov 09, Assignment 3
Tue, Nov 16, Assignment 4
Tue, Nov 23, Assignment 5
Tue, Nov 30, Assignment 6
Tue, Dec 07, Assignment 7
Tue, Dec 14, Assignment 8
Tue, Dec 21, Assignment 9
Tue, Jan 11, Assignment 10
Tue, Jan 18, Assignment 11
Tue, Jan 25, Assignment 12
Tue, Feb 01, Assignment 13
Wed, Feb 02, Recap
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 Chapter 1 – Introduction and Linear Algebra Double click here for audio contents

Organization

Course organization
Lecture (basic concepts), Tue 12-2pm
Tutorial (exercises), Wed 10-12

Organization of studies
1 Physical presence in class (30% of work load) – Active participation in
lectures and exercise classes is highly welcome!
2 Self-study (70% of work load)
Going through lecture slides, reading, and other material before and
after lectures
Working on problem sets before and after exercise class
Preparation for final exam

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Organization

Material on ILIAS: https://bit.ly/3ah91iQ

Textbook
We follow several textbooks.
Especially: Simon & Blume (1994) “Mathematics for Economists”
(Norton & Company)

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Organization

Final Exam
End-term written exams, 90min
100% of final grade
Organized by the examination office

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 Chapter 1 – Introduction and Linear Algebra

Overview 1.1

Organizational details and introduction (week 1)

Why do we need mathematical tools?
A two-dimensional model of consumer choice
Linear systems (week 2)
Linear systems
Solving linear systems
Linear algebra (week 3)
When does a linear system have a solution?
How many solutions does it have?
Matrix algebra

Background reading:
Simon & Blume, Mathematics for Economists, Ch. 1
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Learning goals

Students
Know the organizational details of this course
Can discuss the importance of mathematical tools
for economic analysis
Can solve a two-dimensional consumer choice problem graphically
and discuss the shortcomings of the geometric framework
Know how to solve linear systems
Know how to express and solve linear systems in matrix notation

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Introduction – What is Economics about?

Economics is the study of how men and society choose, with or

without the use of money, to employ scarce productive resources
which could have alternative uses, to produce various commodities
over time and distribute them for consumption, now and in the
future among various people and groups of society.

Paul A. Samuelson, 1915-2009,

American economist, Nobel Laureate in 1970

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Introduction – What is Economics about?

Economists
Start with the premise that it is possible to understand the logic of
individual behavior and collective action as a result of scarcity
Try to understand how resources are used to alleviate scarcity

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Introduction – Definition: Scarcity

General definition:
Scarcity refers to situations where the wants exceed the means

In economics
Wants are typically restricted to human wants
Means include resources and goods that contribute to fulfilling these
wants
Economics is the study of how individuals and societies manage
resources and goods, which can be objectively and subjectively scarce

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Introduction – Levels of analysis

1 Individual level
Example: How does a person spend her or his income on
consumption?

2 Interaction level
Example: How much output does firm A produce, taking into
consideration that firm B produces for the same market.

3 Aggregate level
Example: What are the implications of individual labor market
decisions for aggregate labor supply in the economy?

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Introduction – Why do we rely on mathematical tools?

Models in Economics
“Logical backbones” of economic theories
Collection of assumptions and hypotheses linked by rules of
logic and mathematics
Hypotheses are derived from the assumptions in a logically
consistent way

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Introduction – Why do we rely on mathematical tools?

Mathematics
Forces the economist to define terms precisely
‘Visualizes’ assumptions in a parsimonious and universally
understandable way (mathematics as “language of economics”)
Helps to derive hypotheses that are logically consistent with all
assumptions
Helps to gain insights into models that cannot be solved with simple
geometric tools familiar from intermediate microeconomic theory

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Introduction – Discussion

We do not claim that consumers have utility functions or firms have profit
functions in their heads.

We only argue that individuals behave as if they

maximize utility subject to a budget constraint.
minimize costs subject to production function.

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Introduction – Optimal consumer choice with two goods

Notation: Let the pair (x1 , x2 ) denote a choice of an amount for both
goods (“commodity bundle”)

Simon and Blume (1994, Figure 1.1): Two commodity bundles in commodity space

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Introduction – Optimal consumer choice with two goods

Assumptions
Consumers have preferences about commodity bundles: they prefer
either one bundle to the other or are indifferent between the two
Under some conditions, preferences can be represented by a utility
function
Assigns a real number U(x1 , x2 ) to each bundle
If consumers prefer bundle (x1 , x2 ) to bundle (y1 , y2 ), the utility
function assigns a higher number to bundle (x1 , x2 ) than to bundle
(y1 , y2 )

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Introduction – Optimal consumer choice with two goods

Graphical illustration
Set of indifference curves
Commodity bundles on indifference curves farther away from the
origin are more preferred

Simon and Blume (1994, Figure 1.2): Indifference curves in commodity space

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Introduction – Optimal consumer choice with two goods

Further assumption: Assume that a consumer is confronted with a

set B of commodity bundles
Question: Which commodity bundle does the consumer choose?
This is a mathematical optimization problem.
Note: We abstract from many things, e.g.
How does the consumer learn about the products?
How does the consumer use this information in the consumption
decision?

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Introduction – Optimal consumer choice with two goods

To solve the problem graphically, we define the set of available commodity

bundles as

B = {(x1 , x2 ) : x1 ≥ 0, x2 ≥ 0, p1 x1 + p2 x2 ≤ I},

where p1 and p2 denote the prices of the commodities

and I available income

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Intro’n – Optimal consumer choice: Graphical solution

O ptirni zati o rt in E conorn i c Tht:oru

choicc

Fig. 1.1 The consumerrs optimum choicc

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Intro’n – Optimal consumer choice: Interpretation

1 Consumers will chose from the budget set so as to be on as high an

indifference curve as possible. (This implies that optimal bundle lies
on budget line.)

2 The optimal bundle lies on indifference curve that lies completely

outside the budget set except at the optimal bundle itself, where it is
tangent to the budget line

3 At the optimal bundle, the consumer’s marginal rate of substitution

(slope of the indifference curve through the optimal bundle) equals
the price ratio (slope of the budget line)

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Introduction – Further thought experiments

Comparative statics exercises

that can be solved using the graphical approach
1 What happens as income increases?

Simon and Blume (1994, Figure 1.4): Effects of increasing I

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Introduction – Further thought experiments

Comparative statics exercises

that can be solved using the graphical approach
2 What happens as the relative price of good 1 increases?

Simon and Blume (1994, Figure 1.5): Effects of increasing p1

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Introduction – Further thought experiments

Comparative statics exercises

that cannot be solved using the graphical approach
3 What happens if we relax the assumption that there are only two
goods?
Cannot be answered in geometric framework, but requires to solve the
following problem
maximize U(x1 , . . . , xn )
subject to
p1 x1 + p2 x2 + . . . + pn xn ≤ I,
x1 ≥ 0, . . . xn ≥ 0
We will discuss ideas and techniques of multivariable calculus and
linear algebra to answer this and similar questions

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 Chapter 1 – Introduction and Linear Algebra

Concluding remarks for 1.1

Mathematics
Is used by economists as a universal language to structure their
thinking
Helps to make the assumptions of economic models transparent
Allows for deriving logically consistent hypotheses
Is useful in higher dimensions where geometric approaches are limited
→ Economists do not do mathematics for the sake of doing
mathematics, but utilize mathematical tools for economic analysis

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