Differentiation in Economics – Objectives 1 Understand that differentiation lets us identify marginal relationships in economics Measure the rate of change along a line or curve Find dy/dx for power functions and practise the basic rules of differentiation Apply differentiation notation to economics examples

Differentiation in Economics – Objectives 2 Differentiate a total utility function to find marginal utility Obtain a marginal revenue function as the derivative of the total revenue function Differentiate a short-run production function to find the marginal product of labour

Differentiation in Economics – Objectives 3 Understand the relationship between total cost and marginal cost Measure point elasticity of demand and supply Find the investment multiplier in a simple macroeconomic model

Differentiation Differentiation provides a technique of measuring the rate at which one variable alters in response to changes in another

Changes for a Linear Function For a linear function The rate of change of y with respect to x is measured by The slope of the line =

Differentiation Terminology Differentiation: finding the derivative of a function Tangent: a line that just touches a curve at a point Derivative of a function: the rate at which a function is changing with respect to an independent variable, measured at any point on the function by the slope of the tangent to the function at that point

Derivatives The derivative of y with respect to x is denoted The expression should be regarded as a single symbol and you should not try to work separately with parts of it

Using Derivatives The derivative is an expression that measures the slope of the tangent to the curve at any point on the function y = f(x) A derivative measures the rate of change of y with respect to x and can only be found for smooth curves To be differentiable, a function must be continuous in the relevant range

Tangents at points A, B and C The slope of the tangent at A is steeper than that at B; the tangent at C has a negative slope

Working with Derivatives The derivative is itself a function of x If we wish we can evaluate for any particular x value by substituting that value of x

Small Increments Formula For small changes  x it is approximately true that  y =  x. We can use this formula to predict the effect on y,  y, of a small change in x,  x This method is approximate and is valid only for small changes in x

Rules of Differentiation for Functions of the Form y = f(x) The Constant Rule Constants differentiate to zero, i.e. if y = c where c is a constant = 0

If y = ax n where a and n are constants = n.ax n –1 Multiply by the power, then subtract 1 from the power Power-Function Rule

Another way of handling the constant a in the function y = a.f(x) is to write it down as you begin differentiating and multiply it by the derivative of f(x) = The derivative of a constant times a function is the constant times the derivative of the function Constant Times a Function Rule

Indices in Differentiation When differentiating power functions, remember the following from the rules of indices x 1 = x x 0 = 1 = x – n  x = x 0.5 = x 1/2

If y = f(x) + g(x) = If y = f(x) – g(x) = The derivative of a sum (difference) is the sum (difference) of the derivatives Sum – Difference Rule

If y = c + mx = m The derivative of a linear function is the slope of the line Linear – Function Rule 1

If y = mx = m The derivative of a constant times the variable with respect to which we are differentiating is the constant Linear – Function Rule 2

To find dy/dx, we may obtain dx/dy and turn it upside down, i.e. = There must be just one y value corresponding to each x value so that the inverse function exists Inverse Function Rule

When Differentiating Ascertain which letters represent constants Identify the variable with respect to which you are differentiating and use it as x in the rules

Utility Functions To find an expression for marginal utility, differentiate the total utility function If total utility is given by U = f(x) MU =

Revenue Functions To find marginal revenue, MR, differentiate total revenue, TR, with respect to quantity, Q If TR = f(Q) MR =

Short-run Production Functions The marginal product of labour is found by differentiating the production function with respect to labour If output produced, Q, is a function of the quantity of labour employed, L, then Q = f(L) MPL =

Total and Marginal Cost Marginal cost is the derivative of total cost, TC, with respect to Q, the quantity of output, i.e. MC = When MC is falling, TC bends downwards When MC is rising, TC bends upwards

Variable and Marginal Cost Marginal cost is also the derivative of variable cost, VC, with respect to Q, i.e. MC =

Point Elasticity of Demand and of Supply Point price elasticity = For price elasticity of demand use the equation for the demand curve Differentiate it to find dQ/dP then substitute as appropriate Supply elasticity is found from the supply equation in a similar way

Finding Point Elasticities Point price elasticity = If the demand or supply function is given in the form P = f(Q), use the inverse function rule = For downward sloping demand curves, dQ/dP is negative, so point elasticity is negative  as price falls the quantity demanded increases

Elasticity Values Demand elasticities are negative, but we ignore the negative sign in discussion of their size As you move along a demand or supply curve, elasticity usually changes Functions with constant elasticity:  Demand: Q = k/P where k is a constant has E = – 1 at all prices  Supply: Q = kP where k is a constant has E = 1 at all prices

Elasticity at Different Points on Linear Demand Curves Elasticity varies from –  to 0 as you move down a linear demand curve Two demand curves with the same intercept on the P axis have the same elasticity at every price For two demand curves with different intercepts on the P axis, the one with the lower intercept has the greater elasticity at every price

Finding the Investment Multiplier 1 1. Write down the equilibrium condition for the economy Y = AD Income = Aggregate Demand 2. Write an expression for AD AD = C + I + G + X – Z Substitute into this, but do not substitute a numerical value for the autonomous expenditure I so AD = f(Y, I)

Finding the Investment Multiplier 2 Substituting AD in the equilibrium condition gives an equation where Y occurs on both sides 3. Collect terms in Y on the left-hand side and solve for Y 4. Now differentiate If Y = income and I = investment dY/dI is the investment multiplier

Maximum and Minimum Values – Objectives 1 Appreciate that economic objectives involve optimization Identify maximum and minimum turning points by differentiating and then finding the second derivative Find maximum revenue Show which output maximizes profit and whether it changes if taxation is imposed

Maximum and Minimum Values – Objectives 2 Identify minimum turning points on cost curves Find the level of employment at which the average product of labour is maximized Choose the per unit tax which maximizes tax revenue Identify the economic order quantity which minimizes total inventory costs

Derivatives and Turning Points Sign of around a turning point: before at critical value after Maximum+0– Minimum– 0+

Second Derivative of a Function After obtaining the first derivative of the function we differentiate that and the result is called the second derivative of the original function = Second derivative: is obtained by differentiating a derivative

To Identify Possible Turning Points: Differentiate, set equal to zero and solve for x Find and look at its sign to distinguish a maximum from a minimum The first and second order conditions are: MaximumMinimum 0 0 – ve+ve

Point of Inflexion There is also the possibility that d 2 y/dx 2 may be zero In this case we have neither a maximum nor a minimum Here the curve changes its shape, bending in the opposite direction This is called a point of inflexion

Maximum Total Revenue For maximum total revenue Differentiate the TR function with respect to output, Q Set the derivative equal to zero and solve for Q Find the second derivative and check that it is negative

Maximum Profit For maximum profit,  = TR – TC Substitute the expressions for TR and TC in the profit function so  = f(Q) Differentiate the profit function with respect to output, Q Set the derivative equal to zero and solve for Q Find the second derivative and check that it is negative

Indirect taxation 1 A lump sum tax, T, increases fixed cost but does not affect marginal cost or average variable cost Price and quantity are unchanged Profit falls by the amount of the lump sum tax The effect of the tax falls on the producer

Indirect taxation 2 A per unit tax, t, shifts the average and marginal cost curves up by the amount of the tax and total cost increases by t.Q, where Q is the quantity of output sold Price rises and quantity falls Profit is reduced The effect of a per unit tax is shared between the producer and buyers of the good

Minimum Average Cost At the minimum point of AC AC = MC Marginal Cost intersects Average Cost at the minimum point of the AC curve

Average and Marginal Product of Labour When average product is maximized, APL=MPL The MPL curve intersects the APL curve at that point MPL reaches a maximum at a lower value of L than that where APL is a maximum After the maximum of MPL there are diminishing marginal returns, since the marginal product of labour is falling

Tax Rate which Maximizes Tax Revenue To find the per unit rate of tax, t, which maximizes tax revenue Write the supply and demand equations in the form P = f(Q) Equate these and solve for Q in terms of t, finding an equilibrium expression for Q Multiply by t to find tax revenue tQ Differentiate with respect to t and set = 0 for a maximum

Minimizing Total Inventory Costs To find economic order quantity EOQ, choose Q to minimize Total Inventory Cost = Differentiate with respect to Q and set = 0 for a minimum

Further Rules of Differentiation – Mathematics Objectives Appreciate when further rules of differentiation are needed Differentiate composite functions using the chain rule Use the product rule of differentiation Apply the quotient rule

Further Rules of Differentiation – Economics Objectives Show the relationship between marginal revenue, elasticity and maximum total revenue Analyse optimal production and cost relationships Differentiate natural logarithmic and exponential functions Use logarithmic and exponential relationships in economic analysis

Chain Rule If y = f(u) where u = g(x) = Chain rule: multiply the derivative of the outer function by the derivative of the inner function

Product Rule If y = f(x)g(x) u = f(x), v = g(x) = v. + u. Product rule: the derivative of the first term times the second plus the derivative of the second term times the first

Quotient rule If y = f(x)/g(x) u = f(x), v = g(x) Quotient rule: the derivative of the first term times the second minus the derivative of the second term times the first, all divided by the square of the second term

Marginal Revenue, Price Elasticity and Maximum Total Revenue For any demand curve, given that E is point price elasticity of demand and is negative and maximum total revenue occurs when E = – 1

Optimal Production and Cost Relationships Maximum output occurs where dQ/dL = 0 A firm operating in perfectly competitive product and labour markets:  has short-run marginal cost curve MC = W/MPL where MPL is the marginal product of labour and W is the wage rate  to maximize profits, it employs labour until MVP = W where P is the price of its product and MVP = P.MPL is the marginal value product of labour

Marginal and average cost MC is below AC before a minimum turning point of AC At the turning point of AC, MC intersects AC from below

Exponential Functions For the exponential function y = e x = e x More generally we can write the rule as shown below: For the exponential function y = ae mx = mae mx

Natural Logarithmic Functions 1 If y = log e x = x –1

Natural Logarithmic Functions 2 More generally: if y = log e mx = x –1 and if y = log e ax m