MATHEMATICAL ECON OM ICS

ECON6042

:':::;';,
emai I address

Office

: iosephwu(decon.hku. hk

hours:

6:15

- 6:45pm Thursdays

Room 904 KKL Building

Or by appointment Telephone: 2&50-6905

ECONOMICS 6042
M ATH EM

DR.

ATICAL ECON OM ICS

J.

WU

/ Jan/2010

This course aims to show the interconnection between mathematics and economics.
The cornerstone of modem economic theory is general equilibrium theory based on
optimization. Static and dynamic optimal models will be presented for studying
microeconomic and macroeconomic topics. In particular classical welfare economic
theorems will be covered within nonlinear programming framework in the Euclidean
space R". Such analysis will be extended to more abstract spaces as a lead-in to the
study of topological foundation for static and dynamic equilibrium and optimization
models. Rehrning to the Euclidean space, application of these abstact concepts in the
form of Ponfyagin optimal contol theory and recursive methods based on Bellman
stochastic dynamic programming will be used for analyzing the all-important macro
topics of economic growth and employmen! illustating the importance and relevance of
these advanced theories.

Textbook: Lecture notes for the whole course will be available at my WebCT, HKU
Portal
Reference textbooks:

Olq E.A., Real analysis with Economic Applications, Princeton Univ. Press , Princeton
2007
Stokey, N.L.
E conom ics,

& Lucas, R.E. (with Prescott, E.C,), Recursive Methods in Dynamic

Ilarvard University Press, Canrbridge 1 989

Hoy, M., Livernois, J., McKenna, C., Rees, R., Stengos,T., Mathematics for Economics
2ed. Cambridge, Massachusetts. The

MT

Press 2001

Ljungqvist, L, and Sargent, T.J., Recursive Macroeconomic, MIT Press, Cambridge 2000
Romer, D.,Advanced Macroeconomics 2ed. , McGraw-Hill, New York 2000
Takayama, A-, Mathematical Economics 2ed, Cambridge U. Press, Cambridge 1985

Reference Bibliography:

Akerlof, G. "The Ivlarket for 'Lemons': Quality Uncertainty and the Market Mechanism" , Quarterly
Journal of Economics 1970
Arrow, K. J., "The Role of Securities in the Optimal Allocations of Risk-Bearing," Reiew of Economic
Studies

3l (April l96a)

Bellman,

kE,

Dynamic Programming, Princeton University Press, Princeton 1957

Bellman, RE., Dreyfus,S.E.,Applied Dlmamic Programming,Princeton U. Press, Princeton N.J 1962

Border, K.,Fixed Point Theoremswth application to konomics and Game Theory, Cambridge Univenity
Press, Cambridge Reprinted 2003
Bouabdallah, K., Jellal, M., Wolff, F. "Unemployment and work sharing in an efiiciency wage model"
Economics Bul/ear, Vo.' 0,No.3 pp.l -7, 20[,4

Browning, M., I{ansen, L.P. & Heckman, J.J., "Micro Data and General Equilibrium Models"
& Woodford, M. (eds/ Handbook of Macroeconomics, Norlir Holland, Amsterdam 2000

in Tayloq

Capinski, N., Kopp, P.,Measurc,Integral & Probability 2ed Springer-Verlag London 2004
Cass, D., Optimum Growth in an Aggregative Model of Capital Accumulation, Reiew of Economic
Sndies 1965

Chiang, A., Wainwrigh\K, Fundamenal Methods ofMathematical Economics 4ed, McGraw Hill
International Edition 2005
Chow, G. C.,D)mamic fuonomics: Optimization by the Iagrange Merhd, Oxford U. Press, Oxford 1997
Debreu, G., Theory of Value,, Wiley, New York I 95 I
De La Croix, D., Mchel, P.A Theory of Economic Growth, Dynamics and Policy in Overlapping
Generations, Cambridge University Press, Cambridge 2002

Dixig

A K.,Optimimtion

in Economic Theory,2ed, Oxford, OxfordUnivenitypress 1990

Dreyfus, S.E., Law, A.M., The Art and Theory of Dynamic Programming,Academic Press, N.y. 1977
Farmer, R.E. A.,Macroeconomics, South-Westem College Publishing Cincinnati 1999

R E. Hall, "Tumover
Heathfiel4

in the Labor Forcn". Brookings Papers on konomic Activity 3 ,1972

(Ed ), Topics inApplied Macroeconomics. MacMillan Press Ltd., London 1976

Hillier, F.S., Lieberman, G.J., Introduction

to

Mathematical Progmmming,McGraw-Hill, N.Y. 1990

Hoy, M., Livemois, J., McKenna, C., Rees, R., Stengos, T.,Mathematicsfor Economics 2ed. The MIT
Press, Cambridge, IMassachusetts 200 I

Huang, T., Ilallam., 4., Arazem, P., Patemo, E. "Empirical Tests of Efficiency Wage Models", Economica
vol.65, ppl25-43 1998

Intriligator, M.D., Mathematical Optimimtion & Economic Theory, Prentice Hall , New Jen ey

l97l

J.

Kamien,

and Schwartz, N., Dynamic Optimization 2ed Elsevier North Holland, Amsterdam 2003

Knight, F., Risks, Uncertainty &Proft,Houghton Mifflin, Boston

l92l

Kubrusky , C., Measure Theory A First Course, Elsevier Academic Press lvfass, 2007
Kusuoka" S., and Maruyama, T. @ds.) Advances in Mathemqtical konomics, Springer, Tokyo 1999
Layard, R, Nickell, S., Jackman R,(Jnemployment Macroeconomic Performance and the Inbour Market,
2ed.,Oxford U. Press, Oxford 2005

Leslie,

D, Advwnced

Macroeoconomlcs, Beyond IS/LIvI, McC'raw-Hill Book Co. London 1993

Ljungqvist, L, and Sargent,T.J.,Recarsive Macroecanomic Theory, MIT Press, Cambridge 2000

Lucas, R. E. Jr..,

*On the Mechanics

of Economic Development

", J of Monetary Economics

22 (1988\

Luenberger, D.G., Microeconomic Theory, McGraw-Hill Inc., New York1997

I\{ankiq

N .G.,

Macrceconomics 5ed, Worth Publishers, New York 2003

ilfinford, P, and Peel, D, Advanced Macroeconomics, A Primer,Edward Elgar, Chelterham,UK.2002

Muth, J. F., Rational Expectations and the Theory of Price Movements, Econometrica 29:315-335 (1961)
Negishi, T., General
Amsterdam 1972

fuuilibium

Theory & International Trade,North Holland Publishing Co.,

Oh E.A., Real Analysis with Economic Applications, Princeton University Press, Princeton, 2007
Pissarides, C.A., Equilibrium Unemployment

Theory,2d MIT

Press 2000

Radner, R, Paths of Economic C'rowttr that are Optimal with regard only to Final States,.Review
Economic Sudies 196l

of

Ramsey, F.P., Al\4athematical Theory of Saving. Economic Joumal3S:543-559 (1928)

Romer, D ., Advanced Macraeconomics

2d,

McGraw-Hill, New York 2000

Romer, P.M., "Increasing Retums and Iong-Run Growth", Joumal of Political Economy 94 (Oct 1986)
Samuelson, P. A., Foundations of konomic Analysis, Harvard University Press, Cambridge, IVIass. 1947

Simon, C.P., and Blume, L.,Mathematicsfor Economislr, New York,

W W. Norton

1994

*A Closed Form Solution to the Ramsey Model" Contributions to Macroeconomics: Yol.6:

No. I Article 3, 2006 (http://www.bepress.com/bejm/contributions/vol6/issl /art3)
Smith, W. T.,

Silbe6erg, E. & Suen, Wing,The Structure of Economics, AMa*tematical Analysis,, Irwin McGraw-Hill
Intemational Edition, Boston 2001
Stiglitz, J.E. & Weiss,
Review

l98l

"Credit Rationing in lzlarkets with Imperfect Information"

merican

konomic

Stokey, N.L. & Lucas, RE. (with Prescotl E.C.), Recursive Methods in Dynamic konomics,I{arvard
University Press, Cambridge 1989

Sun, W., Yuan, Y. Optimization

MediaIIC, U.S.A.2006

Theory &Methods: Nonlinear Programming, Springer Science-Business

Takayama, 4., Analytical Methods in Economics,, University ofMichigan Press, Ann Arbor 1993
Takayama, 4., Mathematical honomics 2ed , cambridge univenity Press, cambridge 1985

Tobin, James, (selected by) Landmark Papers in Macroeconombs,E dward Edgar Publishing Ltd.
Northampton, Ndass. 2002
Tobin, James, "On the Efficiency of the Financial System", trloyds Bank Reiew July l9B4
Tinbergen, J. and Bos, H.C., ,Mathematical Models of Economic Growth,McGraw
Uz"awa,

Hill , New York

1962

H., Optiimal Growth in a Two-sector Model of Capital Accumulation, Review of Economic Swdies

1964

Van, C.L., Dana, R, Dynamic Programming in Economics,Kluwer Academic Publishers, Dordrecht 2003

Vohrq

k,

Advanced Mathematical konomics,Routledge, Oxon 2005

Von Neumann, John,

*Model

of General Equilibrium', Review of Economic Studies 1945

Von Neumann,Joln,The Mathematical Foundation of QuanumMechanics, tanslated by R. Beyer,

Princeton, Princeton Univenify Press 1955

Von Neumann, John, & Morgentstem,O., Theory of Games & Economic Behawor, Princeton, New York,
1955

Wan, F.Y.M. ,Introduction to the Calcalus ofYariations and its Applications,Chapman &

Ilall, New York

t995
Weinstock,

Calailus of Vaiations, Dover, NewYork 1974

Whinston, A, Moore, J., Wu, J. 'Resource Allocation in a Non-Convex Economy'', Review of Economic
Sudies 1973

Chapter L A.

What is Economics?

Tvpical definitions:

./\
Study of resource allocation,
production and distribution.

branch of social science.

studies human behaviour.

-/

Actually want

most efficie nt (Opti m al)

way to allocate resources,
to produce & to distribute.
(if do not want to optimize, not necessary to study econ)

most

efficient(Optimal)

way to behave/do things.

IU

optimization,

but scarce resources constaints

(ifno scarcity, not necessary to study econ)

constrained optimization:

max/min some goals

subject to some constaints

Prof. StevenN.S. Cheung FffitHtU ,\!llE

Arcadia Press 2000 page24-25
(to paraphrase Prof. Cheung, only 2 basic principles in Econ.
constained optimization (by varying constaints, can predicVobserve behavioral

l.

changes)

2.

downward sloping demand function D.

Microeconomics:
Study of individual
Producers and consumers in markets

Macroeconomics:
study of the economy
as a whole

constrained optimization by economic agents

economy made up of economic

agents' actions and reactions and
these economic agents (macro jargon:
households and firms) all constained

optimizing
macro

micro foundation of

Remark:

But optimization as the main principle to study economics went through stages of
opposition and refinement.

Adam Smith's main theme of individuals pursuing seliinterest (optimaation) and

invisible hand (prices and markets) will lead the situation to a social optimality (result of
optimization).
Social writers like

Karl Man

reiected this idea as economics manv times do not

alleviate poverty.

J. M. Keynes wrote the General Theory because of unemployment during the Great
Depression in 1930s which ran contrary to the full employment predicted by
microeconomics theory. The attention shifted from optimnationto aggregate concepts in
the economy.
All the while, classical economics, especially the Ghicago School, went through
refinements and modification. In 1990s, the tide seems to shift back towards
optimization by rational (self-interest) economic agents and the resultant market
equilibrium (G.E. models). Macroeconomics also was swept towards this general
equilibrium framework.

1. Static optimization is used to explain economic behavior at a given instance of time.

2. Dynarnic optimization, dlmamic programming or Lagranglan methods are used to

3.

explain economic behavior througb time.

Stochastic features are added to include risks.

ECONOMIC

-.

OPTIMIZATION OR CONSTRAINED OPTIMIZATION

In Math, constrained optimization is called mathematical programming.

A) i)

Static equilibrium models:

When

set of simultaneous math equations.

the

functions

t
"*

solution for this set of simultaneous equations,

model has an equilibrium point x*)

e.g. the familiar supply S@) and demand D(P)

But what is behind S and D?

S - derived from constrained profit-optimizing behavior and
D - derived from utility-optimizing behavior under budget constraints.

q*

In other words, there are optimal models underlying the equilibrium models.

ii)

Static optimization models: Optimize (Max

sometimes s.t. some constraint function g
e.g. Linear Programming

orMin) objective function f

LP- if objective & constraint fi,rnctions are all linear.

Nonlinear Programming NLP - when functions involved are not linear.

e.g. concave programming: when objective F and consfaint G are concave
functions over convex set
Max F (x,y,z) s.t. G (x, y, z) S K

(Soln: (**, y*,

B) i) Dynamic

,*))

equilibrium models:

If time is discrete, math models described by difference equations.

If time is continuous, model uses differential equations.
(solutions are family of functions or curves over time).
Underlyrng such dynamic equilibrium models are optimal dpamic models.

iD Dynamic optimization models: if objective function is an integral of differential

functions s. t. consfaints that are differential equations. (solutions are optimal
time paths f*(t))

Calculus of variations @uler's equation)

I
a,

More general theory

J,
Pontryagin's Optimal Contol Theory

Bellman Dynamic Pro gramming

.,

Find time sheam of Xnnol vble u

s.t. constaints on state variable x
-solution is opt control path u*(t)
& opt state vble path x*(t)

basically a multi-stage decision

process based op recursive methods
\.\

--L/

stocl-rastic adaptive Bayesian

II

certainty

with

risk

O..irion Theory
(dual contol)
risks can be J by
learning

(p d. fcn)

Since this is a gadmath econ course, we will also cover general analysis, topology
and set theory to provide a math foundation of such consfiained optimization as well as
most general cases for optimization and existence of solutions. This is typical coverage
of advanced grad math econ]

[C)

MATHEMATICS

- OPTIMIZATION

OR CONSTRAINED OPTIMIZATION

17ft century: pre calculus

18tr century:

CONTINENT
Leibniz (1646

ENGLAND

- 1714)

Newton (1642- 1727)

Developed calculus independently

Newton,

of

developed calculus to handle

motion (based on Fermat's idea)
and used for Newtonian & celestial
mechanics (laws of motion)

argued withNewton for calculus primacy.

LaGrange, Poisson, Johann & Jakob Bernoulli
tied to find general principle underlying
Newtonian mechanics so that calculus will onlv
be a special case ofthis general theory.

t0)=o

of brachistochroneproblem
(minimum time of sliding object from 0
p under Savlty g
(which is a dyn opt problem)

Based on Galileo 1630 discussion

in 1696 solved by Johann &

,*?
I

Jakob Bernoulli, Leibniz and Newton

P. Mauperfuis, Euler noticed that many phenomena in Nature occur in the most efficient
and most economical (no waste) way. Based on this metaphysical realization, Euler
established general principle to study all these simplifying, economizing phenomena in
Nature
developed into a branch of math in1744 called Calculus of Variations.

E.g. In optics: Fermat's

Principle

I
I
I

bubbles
Water droplets
Geodesics
Hamilton's Principle
Soap

calculus of variations is a

unifyrng theory for these

problems

t
I

Fields of elecbicity magnetism, relativity theory J

Nature economizing and optimizing

people subconsciously or conscious_ly mimicking nature and optimize?

And since people optimizing before 17h century
in-bred into human nature??
Optimization is necessity for sustained Survival???

NATURE - OPTIMIZATION

INTERCONNECTED

MATH

ECON

Chapter L

B. Historical Development of Math

Econ within general econ

'T*
16m

Century

-max Exportl

*"

Mercantilism

precious metals (gold, silver)

Econ activities by state

planning & control

-min Import.[

-Classical Economics
Adam Smith
1776 nu rNeulRy tNTo rHE NATURE AND cAUSEs oF THE wEALTH oF NATIoNS

Invisible hand will bring

lffil*
l(nade)

social optimum
I

& growth

David Ricardo
1817 Principles of Political Econ

the
Rent

"{.'

& Taxation

",
\

mparative Advantage
@. Krugman 2008 trade pattems basod on econ of
scalg location. But still compamtive advantage?)

Thomas Malthus
John Stuart Mill (state as "civilizer", forerunner of macro),
Edgeworth, Pareto, Wicksell, Walras

Karl Marx
Das Kapital

-Neoclassical Econ

Alfred Marshall
1890 Principles of Economics
-Util max and profit fi max

-Demand function D(P), +MU

-Cambridge cash-balance D Theory
- thouglr his writing mostly in plain English yet used math analysis
including phase diagram

/
A. C.

Pisou

,/\
tvt*uritd"ti"
of all i's

util

*l\

J. M. Keynes

Robbins

vs. L.
1936 General Theory of Employment,
I
(Pigou incorrect : as cannot'
Interest & Monev
have interpersonal util
comparison
MACRO _

Pareto Optimality

P.O.:

from whole economy's viewpoin!

using aggregate variables like GNP,
National Income, agg consumption C,
, agg Investrnent l, agg savings S,
I G (Gov expenditure), T (Tax overall)

\
situation where no one can be made better off
without somebody else beingmade worse off.
Thus avoiding problem of interpersonal

utility comparison

MICRO _
view from each market and then add
up to whole economy.
I
I

Micro Development
I

1937 Von Neumann, J "Ueber Ein Oeknomisches Gleichungs-System und eine

Verallgemeinerung des Brouwerschen Fixpunktsatzes" in Ergebnisse eines
Mathematischen Kolloquiums edited by K.Menger 1937
franslated inl945-46 REStudies "A Model of General Equilibrium"
1930-40 Hicks, RGD Allen, A. Lerner, O. Lange, Samuelson using Calculus
(marginal concepts like MU,

MCrl\
r/\

Theory of Consumer
Given:

Theory of Firm

ofgivenprices (pr, pz, p:, ......., p$) =Pvector

consumption bundle of consumer i (*t,, xa, xi3,
withconsumptionmafixX: [xr, X2, X3, ......., xr]
a set

production bundle of produceri (yir, !iz, yit,

with productionmafix y: [yr, yz, yz, ......., yil

yrN)

yj vector

each consumer

tvlax

each producerj

tI, (xi )

Max

s.t. budget constaint

Vi

rc1

= Max

s.t. production

pnyjo

lonstaints Vj

s.t P**in(Incomei
constained optimization
I

from ls order conditions of optimization, can derive solutions x io*(P), yj"*(P)

which are

i's demand fcns x-*(P) of good n

j's

in terms of price vector P

Law of D to assume I sloping D fcn

& demand firnctions of inputs in

supply fcns y;"*(P) of good n

terms of given P

Define competition = all consumers and producers take prices as given.

(Price taking behavior using atomism as rationale: all economic agents are too
small to affect prices and everyone will take prices as given).
I
I

pN-) s.t. in each nft market

If can find price vector P* : (pr*, pz*, p3*,
Total Demand D" (P*) =I p,,* xin * : Total Supply S" [P*) = I pr,*y;,,*

ri

then P* is the market clearing

[P*, x*,

y*]

price AND we note

solves Max Ui s.t. budget constaint Vi

Max
and

ri

s.t. production

P* clears nft

sst

market

Vj
V nft markets

Then [P*, x*, y*] is called a General Equilibrium GE under Perfect Competition
OR a Competitive Equilibrium C. E.
I

Fundamental Theorem of Welfare Economics

Hand):
Under perfect competition assumptions

(:

Theorem of Invisible

a) perfect information (no information cost, no risks)

b) perfect exchange (no tansaction cost TC)
c) no externalities (a11 econ agents consumption/production are independent)
d) perfect knowledge (no risks)
[P*, x*,y*] is C.E.
(i.e. Equilibrium

t
t

[x*, y*] is P.O.

Efficiency)

1ra

1'6f-0

Policy implication: explains why laissez faire (each agent left to pursue
his own constrained maximization) leads to social optimality; why
decentalized (as opposed centralized planned economy) is "good"
because it is Pareto optimal.

Pure Price Theory

|4ko20

Applied Price Theory

(Chicago School)

(Welfare Economics)

1930-60 Keynesian Macro popular but U. of

Chicago maintained Micro discipline with its
policy implication of laissez faire/market econ
I

Viner, Hotelling, Simon (1978;no full information,

decision based on bounded rationality), Douglas,
I

Frank Knight (risks & uncertainty)

if market
Coase

rrotp.reri

(1991)

G. Stigler (1982)

M. Friedman
A. Director, Coase
no perfect exchange no perfect information properfy rights to
:) Transaction cost in real life
clarifu 1) incentive to
:> information cos! use Price system
Coase Thm: if TC:0
CE t P.O.
search cost to set
(laissez faire &
Properfy rights to
information
decenfralized market)
clarifu externality problems
2) externality (Coase
Theorem)
F.Oshom (2009) common propty
Rb can be managed by group
O. Williamson (2009)firm as
structure to rcsolve conllicts

if no atomism

not price taking behavior

e.g. duopoly (2 sellers)

oligopsony (few buyers)

oligopoly (few sellers) monopsony (1 buyer)
monopoly (single seller)

facing J sloping D

facing fsloping

sc

not P-taking

?
PX

,/

b.Aa..6

6^df ir^/l*t U44f\

e,

P-searching (Stigler's search cost)

\-rent-seeking behavior (Buchanan I 986)

consumer surplus exfraction

pncmg

non-pricing behavior

e.g. cut prices

to compete

packaging
- sales promotion

real life competition

(Industial Organization topics)

incl. design of econ

institution: Hurwicz,
E. Maskin, R.Myerson

u
Generalized Neoclassical Micro Model (incorporating real life features)

How about risks?

Via information cost; incur information costJ risks
until at the margin, additional info cost: benefit
from additional risk reduction. (But unsatisfactory)

Pure Price Theory (main model GE: C.E.

P.O.)
Lemer and Lange proved converse in 1930-40

P.O.+C.E.
But calculus proof

I
I

small neighbourhood ('.' derivatives use limit concepts)

results only local and not global

1950 K. Arrow (1972) and G. Debreu (1983) (teacher M. Allais) independently

extended to global results, using mathematical programming over sets (convex
production set and concave utility functions);
Hurwicz (2007), Uzawa ; Takayama, Whinston

Given perfect competition (perfect information, exchange, no externality

and price-takers) and certainty (no risks) assumptions:

C.E.

P. O. globally

General analysis & set theory in math used to extend results from Euclidean
o
space R to more general topological spaces & provide proof of solution
existence.

il

rtft.A.0

t4 6cQo
How about risks?

/_

Theory

Game

=_\_-*_

Decision Theory
(esp. B-School)

Von Neumann-

@ayesian, adaptive
Model )

Expected

Morgenstern VN-M

VonNeumann 1928
Zur Theorie der
Gesellschaflspiele

Utility

VN-M 1947 Theory

of Games &
Economic Behavior
(M. Allais 1988)

action <+ reaction

I

Radner, Shubik, Scart Shapley

Nash (1994, Nash Equilibrium
Harsanyi (1994), Selten (1994)
I
Generafrzed reaction function

&

Best response fi.rnctions

D. KahnemnQ0A2)
strategic pricing and market models
V. Smith Q002)
core, coalition,
cooperative & noncooperative g:rmes
bargaining, agency problems
stochastic games

R. Aumann, T. Schelling (2005)

Arrow-Debreu State-contingent
Commodities Model (Full Insurance Model)
based on VltlM expected utility theorem

proved: given convexif5r assumptions and

with risk-free assumption relaxed, if I a full
insurance market (or full state-of-nature)

then

C.E. still + P. O.
even under risky situations.

Qualifications :

asymmetrical information
Stiglitz, Spence, Akerlof(all 2001)

in fact, insurance market and other financial product markets

(e.g. swaps, derivatives, options, stocks ...
: all markets for efficient risk re-allocation. )
Note: risks cannot be eliminated, it can be reduced by
informational activities until at the margin, benefit = cost;
and then the remaining risks are re-allocated efficiently,
again resulting in a P.O.

other a comPuter. If the qJrestioner cannot determine bY

the responses to queries Posed
to theri which is the human
and which the comPuter, then
the computer can be said to
be "thinicing" as weU as
the human.

Ttrring remains

hero to

DroDonents of afificial intelligence ln part because ofhis

Etithe aszumption of a rosy fuhrre: "One day ladies will take
their computers for walks in
the oark and tell each other,
'tvty little comprrter said such a

funny thing this morning!'"

Unfor' tunatelY,. realitY

causht up with Turing well before-his vision would, if ever, be

realized. tn Manchester, he told
police investigating a robbery

at his house that he was having

"an affair" with a man who

was probablyloown to the

burdar. AluraYs frank about

his iexual orientation, lirring
this time got himself into real
houble. Homosexual relations
were still a felonY ia Britain,
and Thring was tried and
convicted-of "gross indecenql
in 1959. He was sPared Prison
but subjected to injections
of female bormones intended
to dampen his lust 'fm

orow1rriq,breasts!" TLrring told a

f,iend. bn June 7, 1954, he
committed zuicide bY

eating an apPle laced with

cyanide. He was 4I.

Ttue setuior uniter ?utl GraY

arites on o Turing manhinn

By NATIIAN ilfYHR\rOtD
irtually all comPuterstodaY, from

$l0million supercomputers to the tiny

chips that Power cell Phones and

Furbies. have one thing in'common:
they are all "Von Neumann.maehines,"
variations on the basic comPuter
architecture that John von Neumann' - ..
building on the work of Alaii Turing, laid out
in the 1940s: Men have become famous tor-''-'
less. But-in'the lifetima of.tbislHungarian- '
born mathematician whorhad;.his handin: "
everything from quantum physics to U'S'
policy during the cold waq the Von
fu"uriunn m-achine was almost the least of
his accomplishments.

WORLD WAR II
HtS COLOSSUS CRUNCHED NUMBERS FOR BRITAIN IN

such as numbers ortext, also

the University oi aud"pesi ai'ttre age -ot zei'' iliilldiiis,
held the stepby-step instructions that would
After. immigrating to the U'S. in 1933'
allow the machine to be programmed to
von'tieum"nn ias hired, along vi'ith Albert
oerform any task Von Neumann persuaded
;-'
formed'lnstitute'for
newly
'
6nstein" by the
'ih.
t.n s.'t Jomewhat skeptical board of
a
NJ"
Advanced StudY in Princeton,
trustees to allocate $1O0,OOO-quite a sum in
nonprofit research institute set up by the
1945-to buitd the trnNnc, the first in a series
Barirbergei famity.with profits'lrom their
'of'earlv Von Neumann machines that
deoartmlnt'stores. The l-Ls- proved to be
the JoHNNIAc (at Argonne National
the -oerfect intellectual playgtrould for'Von - . : ' inctua6a
and the IBM 70L one of the
Laboratory)
genius:-He;threw
;
Neumannts.boundless
progenitors of IBM's enormously profitable'
into"bneiintractabie*
i,irit"i?
i' mainft ame lihes.
after another;ranging-'fror* the'' :
oroblem"iiin-a"{trusiast
' . I recently visited the i.A-s. archives
abstractrnathematics:ofiguanturn.. ) . paged
'nd
throu!h Von Neumann's handwritten
mechanics to. the practical problems of
construction
the
describing
iaf,notebooks
weatherprediction' hydrology and'the'
and testing of his primitive computer
svstems. Interspersed with technical data
a?e,comments such as; "5 a.m.: l've been at
this all night, and I still can't find the
problem.J'm disgusted and I'm going to
bedl"-a sentiment anY computer
. programmer will recognize..Von'Neumann
bian't just design the stored'program
comouter; he was the first hacker.
economic's and.'evolutionary
.

.: a!.

'

ffiffi

j:

*'

:!E5
:l-\

'
theorv: The 1997 Nobel Prize in
to'
Economics was awarded
eame theorists, the seventh
iobel Prize that grew out of Von
Neumann'b ideas:.

With theonset of World

War ll, Von Neumann was
recruited tor the Manhattan
Project and PlaYed a role in

:l**'d:'fllfJ',i:;f

*HT"'"",JI:

ONE OF SEVERAL SEMINAL"VON NEUTJANN:MACru!-'IES* bution was supervising the vast

iL'Euni lr'iAE tNsrtrurE FoR ADVANcED
ind comptex mathematical

sruoY

BorntoprosperousJewishparentsincalcu|ations_donefirstbyhandand|aterby
primitive electronic computers-required to
vun N"u."ni w"i a

Budaoest in 1g03,
ittiiJiroaiey who could divide eight-digit design,the bombs'
After the war, he returned to the l^.s.
age iix,-lEarned'
nur"Ulri in'[,is f,eaa by
jndamuiea
became obsessed with computing' von
and
nis
;;i;;ilt-;; "LL "igt t
vision for the machines went
phone
Neumann's
at
a
parents' friends by glanclng
tasks for which
book and reciting wnote pales verbatim. beyond the rote arithmetic
d::g!:9:.L}t idealized
Mathematics quickly oecanie the {ocus of they were o1iginally
computer, thJsaml memory units that held
his studies, culminating in a Ph.D. from

104

TIlvlE, lvlARCH 29'

1999

hs rivatry with the Soviet Union heated

uo, Von Neumann became a strategic adviser
on defense policy. He was appointed by
President Dwight O. Eisenhower to the
Atomic Energy Commissioni which oversaw
the oostwar LuitOup ot the U.S. nuclear
arsenal. Von Neurnann's game theory became
a tool to analyze the unthinkable-glob^al
nuclear war-and led t6 the doctrine of
;mutu"tty assured destruction'" which would
shape U.S. strategy for the next two decades'
Von Neumann also became an icon of the
*"t. Oit"Uled with pancreatic cancer' he
"oiO
stoicallv continued to attend AEc meetings
,ntii nii death in 1957. The wheelchair:b'ound
scientist with the Hungarian accent who
mathematically analyzed doomsday is
said to have bien a model for Stanley
Kubrick's Dr.

Strangelove.

Nothan Muhnold., chief technologg ofrctt

Jor Micrositft, colbcts old ntpercornputers

MACRO
Agg concepts C,I, G, T

Samuelson

(1

970), Robinson

Stone (1984)

parallel development

GNP as measurement of
national income, measurement
of C, I, G, Y, L, M etc
ECONOMETRICS
(Econ + statistics)
Tinberger (19 69), R.Frisch( I 969)
Klein ( I 980),Kuznets( I 97 I )
Haavelmo(l 989 Identification Problem)
Samuelson' s Keynesian Crgss

lz +5U Lts+kl
ctt th

(,r,Q t

+*

1 ,EW
;

u-{4*r*(
Y.

Tac;{

if replace G by net gciv expenditure g: G - T

get lhcal policy AG and AT

letg:0 )equilibriumYe:C + I

t Y- C : I

defineS=Y-C butY-C:I

I I: S

get IS curve

But how about monev:

money supply: M exogenous (e.g. cenfal bank conrol)
get monetary policy AM

demand: liquidity preference (prefer to hold money) L

various theories: 1) Quantity Theory of Money
2) Marshall Cambridge equation
3) Keynesian monetary theory (using consols)
4) Tobin (1981) LP as Behavior towards Risks
REStudieslgsS - (laid partial foundation of
modem Finance)
5) Baumol's Inventory Approach
6) Friedman (1976) New Quantity Theory ofMoney
get LM curve

ws

1950-60

IS-LMfremework

Aggregate D

But how about labour, production

(i.e. supply side, e.g. Cobb-Douglas
aggregateprod funotion, Solow (1937)
education for labour force; Becker(1992)
human resources for productivity

i Aggregate S

{}

IMarschak-Brownlee Aggregate S - Aggregate D Macro model

(analogous but different from GE built up from individual econ agents)

u
1960 Growth Theory (=tper capita Y &lor Yfrr".ploym*t by
technological advances and labour productivity increase education/fraining)
Inflation, unemployment issues (esp. Phillips Curve and later
Friedman-Phelps (2006) expectations-augmented Phillips Curve)
Friedman Permanent Income Hypothesis (expectation)
U

r970-94

Rational Expectation Theory

I\{arschak (1953 Economeffic Measurements for Policy & Prediction)
Robert Lucas (1995)
Micro level - individuals max obj
s.t. various consfraints AND
s.t. rational expectation of prices (both present & future like
infl ation/deflation - macro), of intertemporal consumption
pattern and of actions of other economic agents, thus
linking macro with micro foundation.

Equilibrium now just steady state in decision rules space

fiust like Micro ArrowDebreu State-contingent GE model)
So far most models are static models (one period instantaneous models)

1930-60

Dynamic l\dodels (with time dimension) for both macro (e.g. growth
models) and micro intertemporal models, mostly using difference &
differential equations and calculus of variations.

tTIff TYALI }I'ITUS'I firu$T[AL

\ I$focn

OPIMON

DECEMBER 3,2008

Economists Have Abandoned Principle

Twelve months ago nobody could have imagined government
interventions we now take for granted'
By OLIVER HART and LIIIGI ZINGALES
history, but also as
This year wili be remembered not just for one of ttre worst financiai crises in American
to be a consensus that selective
the moment when economists abandoned. their principles. There used
shattered.
intervention in the economy was bad. In the iast 12 months ttris belief has been

to solve the problems

hacticaliy every day the government launches a massively expensive new initiative
pnncrples behind these actions. The lack of a
that the last dav s initiativi.did not It is hard to discern any
public's perception of the govemment's
has increased uncertainty and undenained the
coherent strategy

coropetence and trustworthiness.

a golden opportu:rity to put the
The obama administation, with its highly able team of economists, has
government to adopt two key
counfry on a better path. We believe that the way forward is for the
failure. The
principles. The first is that it shouid intervene only when there is a clearly identified market
ta,tpayers.
to
out at minimum cost
second is that government intervention should be carried

provides mechanisms for

How do these principles apply to the present crisis? First, ttre market economy
death, but this is misleadine.
dealing with difficult fi11195: Take bankruptcy. It is often viewed as a kind of
start. A company in financial
Bankuptcy is an oppornr:rity for a company (or individlal) to make a fresh
gives it some respite. It also
distess faces the aungrr thai creditotr *itt ffy to seize its assets. Bani<ruptcy
trouble was the result
provides
oppormrlty for claimants to figure out whetherthe company's financiai
process ttrrough a
of bad luck or bad management, and to decide what should be done. Short-cuuing this
saved?
govemment baiiout is digerour. Do.r the government really know whettrer a company should be

further than the FDiC procedure

As an exampie of an effective bankruptcy mechanism, one need look no
to flnd a buyer. Every
for banls. when a bank gets into touble the EDiC puts it into receivership and ties
paid in futt and had access to their money at all
time this procedure has bien invoked the,depositors were
times. The system works we1i.
about letting Bear Stearns, AIG and
From this penpective, one must ask what would have been so bad
11 banlcruptcy? One
Citigroup (and in tire iuture, General Motors) go into receivership or Chapter

71u2009

Lia4

Page 2

of2

',,
.

argument often made is that these institutions had huge numbers of complicated ciaims, and that the
bankruptcy of any one of them would have 1ed to contagion and systemic failure, causing scores of further
banh-uptcies. 41G had to be saved, the argument goes, because it had rillions of dollars of credit default
swaps wrth J.p. Morgan. These credit default swaps acted as hedges for tillions of dollars of credit default
swaps ttrat J.p. Morgan had wi*r other parties. If AIG had gone bankrupt, J.P. Morgan would have found
itself unhedged, putting its sAbiliry and that of others at risk.
parties rather
This argument has some validity, but it suggests that the best way to proceed is to help third
than the disftessed company itself. In other words, instead of bailing out AIG and its creditors, it would
have been better for the goyernment to guarantee AIG's obligations to J.P. Morgan and those who bought
probably at much
insurance frorn AIG. Such an action would have nipped the contagion in the bud,
smaller cost to ta:cpayers than tire cost of bailing out the whole of AIG. It would also have saved ttre
govemment from having to tnke a position on AIG's viabiliW as a business, which could have been left to
i Uuot *prcy court Filally,'it would have minimized concerns about moral hazwd. AIG may be
responsible for its financial problems, but the culpabiliW of those who do business with AIG is less clear,
and so hetpile them out does not reward bad behavior.
prices
Similar principies apply !c the housing market. It appean that many people thought that house
premise.
The adjusunent tc the
would never fali nationaily, and made financial decisions based on this
new reality is painful. But past mistakes do not constitute a market failure. Thus it makes tro sense for the
govemment to support house prices, aS Some economists have suggested.

Where there is arguably a market tailure is in mortgage renegotiations. Many mortgages are secwitized,
and the lenders are dispersed and cannot easily alter ttre terms of the mortgage. It is unlikely ttrat the
prcsent situation was anticipated when the loan contacts were written. Government initiatives at

facilitatine renegotiation therefore make a lot of sense.

Our desire for a principled approach to this crisis does not arise from an academic need for intellectuai
pressue.
coherence. Without principles, policy maken ineviably make mistakes and succumb to lobbying
This is what haBpened with the Bush administation. The Obama adminisfation can do better.

Mr. Hat is a professor of economics at Harvard. Mr. Zingales is a professo: of finance at tle Chicago
Booth School of Business.
Hanlon's Razor: Never attribute to nalice that which can be adequately explained by stupidity.
dscott,s corollary: The line between malice and stupidity is called depraved indifference'

?6J

'- ----4'

- /r ,^nnn

Dynamic econ

multiperiod objective function (of variables)

in different time periods
s.t. resource confraints of these variables over time

- optimize

1960- present

Dynamic optimization under uncertainty (explain econ behavior

through time, under risky situations)

Remark: most analysis relies on function differentiability, hence opt are local results;
with present-day powerful computers, computational iterations &/or approximation
algorithms are employed to estimate functions, whether differentiable or not.
Pontryagin Optimal Confrol Theory
(for both continuous & discrete cases,
mostly m4thematical econ)

-l

Dynamic opt + stochastic assumptions

-LaGrangian method
(continuous optimization under risks)
Discrete Models (mostly Macro, esp. growth models)
F. Kydland (2004) E.?rescott (2004)
I

Bellman's dynamic programming

{Dynamic programming is a way to approach certain types of dynamic problems and
many time solutions limited by dimensionality)
In particular, graduate Macroecon theory course: study dynamic macro models based
on GE and using dynamic programming

under

ce@inty

Principle of optimality

tlll

recursive

models

stochastic models

Markovian process to add risks

Markov process: measure theory & integration

I

Basicdlly sequence of probty distribution functions

converging to an invariant distribution = stochastic
equivalent of detenninistic steady state.

just frnd steady state dynamic system (equilibrium) but theoretical models
with equil described by stochastic processes over different periods fiust like real life
economic behavior). But many times, such problems are analytically insoluble or
have no evident closed form solutions, or can only be solved by common sense, or no
standard solving procedure, &lor can only be approximated by some algorithm
So now not

sometimes.

Hist development of Econ

Summarv:

Mercantilism
I

Adam Smith Invisible Hand

I

Marshall

Pigout

-Keyn"s

MICRO
Theory of Cons. D Theory of Firm

MACRO

GE model
-r

compet and perfect mkt asstrmption

Thm: Inv Hand: CE

Pure Micro P Theory

CE +

PO globally

PO locallv

Applied P Theory
esp. Chicago School
realJife features by relaxing
compet and perf mkt assumptions
Generalized Neoclassical Micro Model

RISKS???
Stochastic models
Game theory

Decision

Theory Arrow-Debreu full insurance

(VNM Exp Util Thm)
C+I+G

+LM

(usual undergrad)

+AggS

Agg D

1960 growth, risks???

Dynamic systems - Simple descriptive dynamic systems

1
I

(difference:tions: Harrod Growth Model; stochastic 2-dim

difference +ions: companies growdr, Hall Employment model )

to*l

Rational Exp
Towards GE model (Op$
Dyna mic optimizationrnodels
Discrete time

,/\
case

continuous time case

non*urlo opt control theory

Belknan dyn prog

and multi-stage opt

RISKS???

Stochasticdynamicoptimization

Chapter I.

C. Unconstained

REF: Silberberg &

and Constrained Optimization

Suen (2001) Chapter 4

Takayama (1985) Chapler

Takayama (1993) Part2

This section and optimization in general, in skeletal form:

Unconstrained
functionwith I
indep variable

-/

\-'-{

multivariate function

_/\ -/\

y: (x)

n indep
vbles
y : f(x1. x2,

2 indep
vbles

Y: (xI, x2)

I
max

Optimization

y:

f(x)

max

II

y : (xr, x2)

y:

f(x1, x2,
max
(without matrix)
(with mahix)

consfrained
,1,

multivariate function with n indep

variables

----4\

equality
constaint

2 indep vbles
max
f(x1, xz)
s.t. g(x1, x2): k

y:

(without matrix)
(with mafrix)

m inequalify
constramts

vbles
max y (xt, x2,
s.t. g(x1, x2, "', xo)

'.. , xn)
:k

(with mafix)
max y

S.t.

f(xr, X2, ... , .,)

jg(xr,xz, "', x,1;2ki

xi20

i:1,2,
j:1,2,
(The most general case
programming section)

will

be covered in the nonlinear

i)

Unconstained optimization

How to optimize (max or min)??

Assumption: In this section, we assume functions are differentiable.

Since differentiation deals with small neighborhood around a point, the max or min we obtain
will be called local or relative max (or min) and not necessarily global max (or min).
Case a) unconstrained optimization of function

Optimizef(x) x

with

1 independent variable

solution x*

l$ order condition (necessary condition):

f ' 1x*; : 0 (critical point)

2d order condition (sufficient condition):

if f "1x*; < 0, then x* is a relative max
if f "1x*; > 0, then x* is a relative min

[r-21

In case f " 1x*; : 0 at critical point x*, then we need to have successive derivative test,
We must keep taking derivative at x* until we get a nonzero higher-order derivative.

lf

such nonzero higher-order derivative is

t'\

--\

odd-numbered

(3t, 5", 7*,

... .)

even'numbered (4ft, o*,

g*, ...)

then

I
I

x* is an inflection point.

and

<0 / -&- -\"

ll

>0

x*isa

x*isa

relative max

relative min

RMK: For a rigorous derivation of the l't and 2od order condition using Taylor's
please see Silberberg & Suen or Takayama [985].

series,

o
a

Y,t

IE 'oc

-E

'-qq

$,

o
@
o
o
o
O'iN

u 'ri:
o>
ERF
wdU
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:.8
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@::l

d x:-

=I

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#tE

atl

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x.5
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Economic application (unconsfrained opt of univariate ftrnction):

A firm wishes to max profit n(Q) defined as Revenue R(O - Cost C(0, & given
R(Q) : 407Q - Q' ; C(Q) :Q' -lQ'- 50 where Q: outputquantrtyofthe firm.

-Qt - (Qt-3Q2-s0)

Maxn(Q):407Q

:
1o order

4o7Q +2Q2

-Q' + 5o)

condition to get critical point Q*:

set

dn(Q/dQ:407 +4Q-3Q' :

3Q'- 4Q-407
Q*

{ l6-4(3x-407)l t 2(3) : [4 r .l+roo1r0

,.:i):
_:

or -

66 / 6 (we rule out this soln

'.'

assune output not

Can check critical point condition at Q*:

da(Q)

/ d Q :407

2od order

Tt"

+4 Q-3Q'

407 +

4(37/3)-3(378)2

:0

condition at Q*:

(Q):4*6Q- 4-6(3713):-70<0 )

localmaximum

-ve)

o-;'6

ko)
c

ll

5Cg
H.
.R
-^
qr
X
C

^l.dl

{gl"
>,1 A
"t' I'o

o
.
.{
6-E-g
tr-a/

>,1

,/

,/

6
;\
:-)

ctt

"l lE

!av

d
->F<
FHH\ I

agAo
oAftr'd

'ct()c
o>;d
-

*)l c>.1l'oal

@AV

H-v

u
c)

el

()

(!

q.{
u)

cr

q$
^()

q
N

t+i

+)
c)

'a

iN

bI)

x
X .tse

---+

.{

^Pd

(n

.q
-H

^6

N
U)

u)
q)

bI)

qr

c.t

q-i

i(t)
(H

,g)

* d

i.!'l

i.-

t{x

{)

I'

C-l
(H

h.5
!.,

,:=

v
cs

u)

rn

()
(n

(It

iEt

r-r-|
lo
>u.#x

FlIjl
,d
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6l
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qixH

;lNl

?'+
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qi
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qi

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EX

cg .^.

qr
-

aa

,t,

6i

xn
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(u
u)

(ri

D.

tl

HTN
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X
6 x

rCLO
/^\

SU

9':

6'TFF

?H^

,f

tr

liO

n!)tr
EIiJX

a\
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t- ^9F 'CJ.=
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at

:r )cr
f!*,,-,)

lu/afr,R-

--\,

\'I

6,.-)

c1,,*;

ft=o
\
n-nJo'lr't<.

)narta

\t/

An example of unconstrained optimization of functions with 2 independent variables:

z(x,y) :x3 + y3 -18x2 + 6y'

1" order

+81

x -36y +

condition:
set

zx

:3*-36x+81 :0 t *-tzx+27:0

t
zy:3t'+l2y-36:0
t

23

4 critical

x*:3

points (3,2)

(3,

l2(l)

or9

y'+4y-12:0

+'{Wnt
: {12+ 6} 12: 3 or 9l

[x:{+12

-6) (9,2)

[y:{-4+{

16

{-4+ 8\ /

2:

4(rX-12)| t2(1)
2 or -61

(9, -6)

2"d order condition

zw :

z,u<:6x-36

**(3,2) : 6 (3) - 36: -18 < 0

z *" (3,-6) : 6 (3) - 36: -18 < 0
z**(9,2) :6(9)-36: 18> 0
z**(9,-6) :6(9)-36:18> 0

n (3,2): 6 (2) * 12: 24

z r, (3,-6) :6 (-6) + 12: - 24
z

*y:

y* :

0 for all critical

for (3, -6)

z*"

(3,-6)<0

zr,

points

6y+12

zn(9,2):6(2)* 12: 24 >0

zn(9,-6):6 ('6) r 12: -24 <0

("

*)' :

(3,-6)<0 and z xxzw: (-1SX-24): +432> 0 : ("r)'

relative maximum

for (9,2)

z,*(9,2)>0 zn(9,2)>0 and zxxzw :(1SX24):+432>0 :(z*y)'

relative minimum

for (3, 2)

z*"(3,2)<A

zo (3,2)> 0 (different

signs)

&2"*zw:(-1SX24)

-432<0 :

("*)'

@)

saddle point

for ( 9, -6)
z *" (9,-6) >

n (9,-6) < 0 (different signs) & z **z

w:

(18X-24)

-432

( 0 : (r r)'

saddle point

Economic application example :

Afirm's

revenue function depends on its two products a and b and is given as:

z(a,b):32a-a2 +2ab -2bz + 16b -9

Find a*, b* to max the firm's revenue function.

l't order condition to find critical point:

za :32-2a+2b :0

26 :2a -4b+16:0

a*:40

b*:24

2d order condition at (a*, b*):

zaa :
zab :

-2

26 : 2 t

("ua )' :4

zM zbb:G2)(-4): 8 > 4:
Hence revenue is maximized at a*

revenue z

(40,24):

32(40)

(zuo )'
40

*:

24 and

- 402 + 2(40)(24) -2Q4\ + 16(24) -9 :823

Case c -1) unconstrained optimization of multivariate functions with

without using mafix algebra (generalae from

n:2

p2

independent variables,
independent variables case):

Assumption: below multivariate function f has continuous partial derivatives to any order.

Optimize f(x1(a), xz(a), ... , xi(a), ... , xn(a))

ls

order condition: set following

fi

(xr (a),x2(a),... , xi(a), ... , xo(a))

2nd

at solution (x1*(a), x2*(a),

... , xi*(a), ... , xn*(a))

0 to get critical point

: 0

Vi

order condition: (using Taylor series and sign definiteness of quadratic forms)

IlfiitFl:o
r-r

t-r

dxi

d":

da

da

if [F] < 0 then negative definite (f stictly concave) and we obtain local maximum.
and ltr] > 0 then positive definite (f strictly convex) and we obtain local minimum.
We can see with the many combinations of i, j when n gets large, the terms becomes very
unwieldy. One way to overcome this is to use linear (matrix) algebra.

Remark: A formal derivation of the l" and 2d order condition can be found in Silberbere &
Suen [2001] and Chiang & Wainwright [2005].

Case c-2) (alternative method) unconsfrained optimization of multivafiate functions

n independent variables.

optimize

f(xr,xr,...,xn) )

atsolution

f* =(x,,*1,...*l)

1$ order condition:

vector

x' = (xi,*!,...*l)

i=1,2,...,n

.f,(7')=0
2od order

is such that

critical point x.

condition:

matix

H:

a'f a'f
ax? &r&,
azf

azf

&,&o
a2f

*,7'

&r.&"

a2f

a2f
..--;

&n&,

Ax;

Remark Note H is symmetrical

Hessian lHl alternates in signs starting

lH,l .0,lHrl ) 0,...
=+ lHl is negative definite (itrf is stictly concave) and

2d order condition for x'being

a local maximum is satisfied

Hessian fHl with principal minors lH,lt

V, = 1,...n
lHl is positive definite (itrf is srrictly convex) and

2oo order

condition forx'being a local minimum is satisfied

with

Chapter I. C.

ii) Constrained Optimization

We mentioned at the start of the course that resources in the economy are scarce. We also
cannot do anything that is technologically impossible &lor we are bound by existing sociefy's
property right structure. So when we optimize we will be constrained by resource scarcity &/or
tecbnology &/or some other conditions (like private property rights consfaints whereby you
cannot just take other people's resources without making proper payment).

constrained optimization, called mathematical programming (;rcomputer programming).

In particular, if optimize linear functions subject to (s.t.) linear constaints, the math
programming is oalled Linear Programming (LP). The most general case is Nonlinear
Programming where both objective and consfaint ftinctions are nonlinear.

Familiar examples in Econ:

(a) Aconsumermaximizeshisutility U(x)

x
s.t. his budget constraint p . x < his income I
(b) A firm maximizes profit

zc(y)

Rn

Rn

s.t. production is feasible within the existing technological set.

(c) A flrm minimizes cost C(y)

ft n
s.t. technological level and inputs/labor availability.

How to do constrained optimization???

When we are given a consfained optimization problem, we just convert it into an unconstrained
one (using a Lagrangian equation), because we know how to do unconstrained optimization.
For instance, given a function f(*, y) with 2 independent variables and
(univariate functions is a special case of the following, just set y :0)

Max f(x, y)
s.t. g(x, y) :

equality constraint:

f is called objective function

called constraint, this case is an equality consfiaint

- g(x,y) : 0

can write alternatively as k

[Remark: to minimize an objective function h(x, y) is just the same as max

only show constrained maximization.]

h(x, y) so we will

We set up a new objective function Q called Lagrangian, consisting of both f and g:

Original objective firnction

(x, y,

rl:

(r,lv)

constraint

(k-

* t t k - Jf*, ,ll
t

g)

l. called Lagrangian multiplier

IAA) tk - Bl :0
[k - g] :0 so optimizing Lagrangian = opt original
BB) The Lagrangian is unconsfained
we can apply the unconstained

CC)

maximization which we covered previously

constraint will automatically be satisfied when we are solving 1s order cond]:

Max O (x, y,

I) : (x, y) + l,

Ik

g(x, y)]

ls order condition: to get critical point with 3 variables x, y and l,

@" :0
@v :0

@r

:0 (= k-g(t,y):.0

whichisjusttheconstraint laftersolvingforx,y,l,fromthese

3 simultaneous 1o order condition equations, the consfaint is automatically satisfied).

Interpretation of the Lagrangian multiplier l. : at the optimal level, l.* shows the approximate
change in the objective function when the constraint is changed by I unit.
We can derive the 2"d order condition for oonsfained optimization but this again involves many
different combinations of partiats and cross derivatives like (Dii , (Dtj as well as solving for
simultaneous equations in the 1$ order optimization condition, all of which can be handled more
easily with mafix algebra.
Usual econ examples:

Max utility function U (x, y)

s.t, prx+pzy: t

x , y commodities

Ot:priceofx; p2:priceofy; I:income

If U(x,y):x2 + 5xy + y2 and (pr, p z ): Q,1) and I:100

1o order

condition: (critical point)

Q*:2x+5y-21,:0
@r

: 5x + 2y - l" -0

@l -100-Zx-y:0

(rfiiohisjusttheoonstraintlaftersolvingforx,y, l,fromthesimultaneousl$order
condition equations, the constraint is automatically satisfied at the critical point)

) x*: 10 Y*:80 l* :5x+2y:210

atthecriticalpoint(x*,y*):(10,80)

5(10X80) + (80)2 : 10,500

s.t. 2(10) + (80) : 100 and the constraint is satisfied

{J*:(10)2 +

2d order conditions can be checked to

see

this is indeed a maximum.

Now if we change the constraint by a small unit, say 1 unit

(should be arbitrarily small unit but this is just for ease of calculation)

constraint

2x+y = 100 changedto

from l" order condition, we get

and(D1 :101 -2x - y

y:

x+ y

191

8x

:0 t 101 -2x- 8 x:0 t

t x* : 10.1
t Y*:80'8
) U* now: (10.1)2 + 5(10,1X80.8) + (80.8)2 : 10,711.05
compared with the previous U*, the difference is (10,711.05

101

:10x

10,500)

:211.05 = 210 :

,F

Optimal Lagrangian multiplier /' x tells us if we relax the consffaint by one unit, the optimal value
of the objective function will change by L x units.
For programming (constained optimization) problems, we often times use a value function V (x, o)
where x is the endogenous variable and o the parameter. Value firnction is defined as the optimal
value of the objective function given the parameter. Hence in the above example, O is the
objective function, x,y are the endogenous variables and consfiaint amount 100 is the parameter.
Then

:
V(x*, Y*, 101) :
V(xn, Y*, 100)

10,500

10,7I1.05

In this context, the Lagrangian multiplier 2 * is the imputed value of the consfiaint.
It is the maximum amount that the optimizsr is willing to pay to change one unit of constraint (i.e.
the shadowprice of the consfaint).

ln the above example, we used equality consfraints (in the budget conshaint case, flris means
the consumer will use up all his income). We will extend the case to inequality consfraints.

Alternatively,
Constrained optimization
in terms of linear algebra.

Optimize

of 2-independent-variable functions with

I equality constaint,

f(x,,xr)

s,t. $(xr,xr) =

k:

constant

we form the Lagrangian

O(x,, x2, X) = f(x, , X, ) * l,(k

- gix,, xr;)

note = 0

ls

order condition:
-)

set Or=0

0
@r=0
Oz =

to get critical point

(xi,x])

fNote:O^=0 )

+g("rr,xr)-k=0
=+ constraint is satisfied when solving simultaneous

equations]

2n

order condition:

setupborderedHessian

7,: i;l "' fl, ;'*

ll
lg, Ez o I le, (D,, Qn

1o1=13,,

andcheckat

(xi,xi)

if

o =ltrl is positive definite + (xi,xl;

llt-rJ=1"-l

\
if

"

is a locat min.

(-O uS3+ 2Q ngg z - A ,rS? )

lFrl>O *lHl isnegativedefinite

=+(xi,xi)

is alocatmax.

if 2"d order not met, need firther test.

t )l
\
\ J() /

.-o
dH
oo
6.o
adl
o6
Ec

.eI

6E
3
&;- bo

'D

e'
_b6
.*oo

,>,
trEq
o=

r0

.9
R

#E
r tx

h,
i

EE

6==

e
6
e

-6d

EH
Eg

n.:-^ 9!
nS!';E
"lp
EF

E
h

;XF EE
8E
JJ;
^
>
6lio
r*
'-'??Al qtgF
r{
;Y-; & ,$,
?
p:
\\rl
e--,^
e
t s$e T
rR*s

-? c.8lPa.O ,8*r-. -E."

>e

'-lt ra
:

:3

=F'6
aa

E ed"edd ;;;

:,S
H;

'Et

'e*

rtsi

R
.H;ti
EE
tr .9 " E: o
#3E

rEf

5H#.E.EF
g

g H5

j s iEs I
E Eg i:
E!gH:E

P
0

"

;E*H,q {
EgEEEi : ^g
sflsse-$ * (}E
JS
9lPPFoo:
;
EE$TsE rg
.8.6;PE ,: !
s.EE*,a'f , 3.-E
FFi{: { SrE
*$qf!" s*: $E
E EE;#:*
E#
E'q.eiE .R
E E6;EEB
"E R
'H 5
H
i gcEsF E iE
-

ls

&

m\

> -Jl

tr
3

60

bo\\
^

:*-qe,e

ry
< d ,. ,. bo v
{a

dd dd

|t'lJ"

::
ge
\:t

lJ

Ag
''

^"

J<

dll

6a
t

Ix

,Og

;d"
+

e*

ll

c.5E
bo,Og

.:
'st
s 6 s..
-d
u- A a.'...]t/
c>6So

tl

rf

;
II

1i

x
.ta

..9
'F
x6
o5

.o=

E=
tr:r
o..

6$o
n rl

'rj:?

EF s'o T

We extend to constained optimization of multivariate function with one equality

consfrain! using linear algebra:
optimize f(x,, xr,...,xo ) s.t. g(xr ,x2," ',Xr ) = k

k:

form Lagrangian (D=

xo

f(xr , X2 2..-, X1) + l"(t - g(x,, xr,...,

orn

-12

l3::
Bordered HessianlHi=

orn

9r

or=

lo"t

lt,

8z

o-

g
9n

o
|'n

ls,

ls,

l'tolon

))

8r

lo

8z

constant

Ez

8n

@,,
Q^

@rt

orn

Ort

":

@rn

o*

lo order condition:
set O,

2"o order

if

-Oz =@r...@o -@r. =0 togetcriticalpoint x. =(xi,xl,...,x;)

condition: check at

lH-,1,1H,1,...1tr,1<0

x.

=lHi

nositivedefinite

+ tocatmin

order of principal minor

if ltrrl t

O,lFrl

.0,ltrrl > 0...

alternating in

sign+ lHl

local max

if

negative definite

2"d order condition not met, we need further test.

c)

*{

uzt$*M+refe {*u Jf'

wl

u4, f(*,rfIr-'-'r-i)
(;l', iX C*, ,*r, "', x.) e ft't

l.r\

*n

f,{r,,-*, -- ,y^}+

({
Lxl
i=t

+g

(x,,

--,*"))

ral :
gp

't,'to"*-"'1,^
'8, *0, - -- '$"

(3

o1
,tl

lt+

b o '-o iE'*f,"---.$n
-'g,"X, --ry, ![,, [,o fl,.

'?"

',-'1

'x^ 'e^

9" '_':

-'h* i*, *'---

{o^

?ffr

h;4*t

l-r
t:T
I
tu I
l"-"tr4' Lt,**t I .,It-,^+"\ -- -

>d ur{t-

tia*t{

\ f,l"tn^*r \ gr-*.
\\
\

(r'.t*-g *3

Gl,"s a.I*at<--

6"^'. I

tS b*oi=4 'f

"

frl

5*- *

k, f *

,t,i-u'&6rt

4;

#'{lc."r&
-- 1"

Kt*

.d?t.ag-q &nefr* u-1,-<-,

Lrs-{'af

Econornic application

Derivation of Marshallian Demand function D for economic agent

fu\A.

y) : 5 xy s.t. budgetconstraint g(x, y): I

whereg(x,y) : prx + pzy and I:constant- A\rA\r{'sincome.

fuAu\ MaxutilityfunctionU (x,

l,[I-(p1x + pzy)]

Formlagrangian@andmax: Max@: Max 5xy +

1$ order condition

(to get critical point):

O":5y -Ipr :0

l,:5ylpt:Sxlpz

@v:5x -l"pr:6

@r:I-(pr" +pzy):O

t I-prx -pzx(prlpz):0

(tlrisisjusttheconstaint)

) x: I / 2pt -

* y: x(p1lp2)
\

I -2prX

Dfunction forx dependentonpricepl andhis income I

check 2"d order condition using bordered Hessian:

(note partia derivatives

l4,l:lu-l: lorr en er | : lo r
0
l@r, Qzz Ez
I
15 pz
o
| *' Ez I lp'

I r = pr , s: = p: )

o,
pz
o

Laplace expansion along l$ row

|u" u"

dzt urrl

"l u,, u,,

l*

: 0

ua
I
at'
dtt ullll+
lu,t

( -1) arz

5Pt
Cl)5

+Pr

Pr0

zzz

dtz

50
Pr

Pz
ll

- PtPz

:5prpz

+ 5prpz

: l0 prpz >0

lFl negative definite

5Pz

'.'

prices

Pr>o

pz>o

local maximum.

Chapter I. C.

iii)

Constrained optimization with inequality constraints.

So far we used equaliry in the constraint. For example in the budget constraint case, equality
means consumer will use up all his income. How about the case when he doesn't spend all his
income and save some of it? Then we need to look at inequality constraints. How can we handle

inequality constraints? Answer: convert the inequality constraint into an equality constaint
('.' we know howto solve opt s.t. equality constraint):

Max

f(x)

4-

x>0

s.t.

inequality consfaint

Note we can convert inequality x > 0 into equality - s'

where s : slack variable, squared to get a +ve sin; s"e R

equalitv constraint

tr

x> 0 meansx)0 or x:0

x:

X,
x>0case
whens * 0

0 case

when

Noteifs#0

w)

s:0

: s' > 0 *

interior solution (not corner soln)

u!\Ny {b0

{e>
X-

*x7O
:
:
Noteifs:0) x st 0 t corner solution and constraint is bindine.
Subcase I

)turtv.&*)
4 u4 Arfr:afr'^
ah

subcase 2

te)

r
\

MM fC*>

(!,

>(..7_9

xtso
:

Max Lagrangian O

l't

order condition (to get critical point):

Max f +

?,

[r - r'

O": f' +]" - 0

(Dr: -2)"s :0

........n u
.........12.21

ol,: x-s2 -o

[3.3.]

(interiorsolution.
Casel) if s l0 from 12.2) + t : 0 I

@:f+1,[x-s2]
:f+0[x_s,]:f

constraint not binding

2"o order condition (bordered Hessian)

i@z

: lo

@"* O*, g^l

?: ?: %'l

f**

-2 ?,,
-2s

+l

must > 0

(if we want

maximum)

tf *(0-4r')-o+1(2 r)
-4

s2

fx*+27,

>o

.. ..

t4.41

: 0 ) corner solution x* : 0
('.' from [3.3])
and , 2?,, >0 ('.' from[a.a])
) l. >0 t f'< 0 ('.'fromll.l] f'--1.)

Case 2)

if

I function f is falling and not critical point (i.e. f ' + 0 )

p'*{u\ *x. . {8}
) x*:0 is the maximum.

(Nwd4,.f(*) #xAo

-rr

x*

;c(:o

:+

we get the following conditions:

max

(x)

s.t. x )

generalized,l'1 order

condition: f'(*) <0 and if f,<0:+ x = 0 max

Note above principle was derived using the 2nd order condition
ws are saying if we want
(i.e.
the max
set (H)t o ) then the principle is hue, but this does not tell us how to find the max.

Similarly for
min

f(x) s.t.

x>0

generalized l'tordercondition:

f'(x) Z 0; if

f'>0+ x=0 min

we can generalize to multivariate function

max

f(x,,...,xo)

s.t.

generalized 1" order condition:

1)

For those variables x,

+ fi <0 andif f, <0 then Xi =0 ismax

2)

For those variables

x,

not restricted

to

>0

*fi=0

(-)

Analogously, c&r add slack variables and do the same derivation to get optimum

max f(xl,

X2 ,. . ., X1

)
s.t. tg(*,,'"x,,)>0

of

any n, m

jg(*,,".,Xn)=fi.rnctions

'g(xr,...x")>0
I,(*,,'"x")>o
xi

>0

i=l,"',n

we form the Lagrangian

r( )+ir,,ie
j=l

1$ order condition:

(also known

as

*t

O, = fi

f, j g' s 0

j=t

KUHN-TUCKER

and

if

(D,

<0,

Xi:0

condition)
(D^ =jg 2 0

andif

*r,t0, =

For min

f(

1$ order

condition 0, = f; *if, jg, ) 0

) s.t. 'g( )< 0 x, )

fu,=0

j=l

and

if

>0, then

x;:

0r, =rg 2 o
and

if *r, t O,then I: = 0

Remark: again these conditions only describe max/min but cannot be used to find the

max/mn.

Show Kuhn-Tucker K-T condition for constained maximization can be rewritten as:

(B) :[Qi:

fi+ I I: jg, . 0

(Bl):[@rj:'g]
Pf:

l.i

0 ;

K-T condition is stated

as

and x'
@i1

frst part (A)

Or:0]
:ol
and second part

at tfre optimal point

(Al) below:

I f i'g, = 0 andif (Di<0flrenxi:0]

(A):[@r:fi+ f l:'gt'0 and if @i<0then xi =0]
t [xi (Di:0&ofcoursestillOi:fi+ I Lj'gt < 0]:(B)
(B):[@i:fr+ I l.i 'gt'0 andxl @i:o]
t [if (Di< 0 then x1 must: 0 to make xi (Di : 0 & of course
still (Dt: f i+ f L: t g, s 0l : (A)

K-Tconditionfirstpart: (A)[@1:f1+

Hence

(A)

+ (B)

or

(A)

(B)

Similarly for second part of K-T condition:

(A1): [@r::'g ] 0 ; I: ] 0 & if Oij >Othen l; :01

t (Bt;:[@rj:'g ] 0; I: > 0 & li @ri =01:(81)

And

(A1)

(81)

K-T condition which is (A) + (Al) is

(B) + (Bl)

x*

L*

Economic Application of Kuhn-Tucker (K-T) condition:

John minimizes cost C(a, b) under the following conditions:

Min

C:

Pu

a +

Pu

Pu: price of apples

P6

s.t. his

>K

utility function U(a,b)

price ofbread b

a,b

assuming goods are not free so Pu, Pu > 0

Question: in minimizing his cost, what is John's utility level?

We note Min

C =

Max

-C

above minimization problem

Max-Pua - Pub

becomes

s.t.U(a,b)-K>

[Let U(a*,b*) be denoted by U*]

)Lagrangian@: -Pua - Prb +1.[U(a,b)-K]

K-T condition:
- Pa + 1* 16U*/ D a) S

]">

and

and a* (-Pu

),* (AU*i d a)):0

[K-T-l]

L*(AU*/db)):0

[K-T-2]

-Pr + 1r*(?U*lab)< 0 and b*GPo +

u*_K> 0
If we assume

from

I*> 0

[K_T_3]

John wants to consume both a and b, then a, b > 0

[K-T-l]

(-Pu

?u*

(AF*/d a) :9

t l.* ;e 0 and since l,* > 0 )

i

I*(U*_K):O

ot l* (aF*/ d a): Pu > 0

l.* > 0

from [K-T-3] ( U* - K):0

'U*:K
Economic interpretation: to min cost, John is at the same time "maximizing" his utility level
by consuming up to his constraint level K.

il4

Chapter I. C. iv) Nonlinear Programming

The most general optirnization problem is when multivariate objective function f and

conshaints rg are nonlinear functions.

(again we look at maimizattonbeoause minirnization is just maximizing the negative f)

Max f

(x1, x2,X3,

jg(x1.

s.t.

... Xn)

xz,x...

.. "") ) 0

I :(xr,

xz,

xr, ... xr,) e XcR"

j --1,2,...

,J

all functions are nonlinear.

We notice

1)

tle following points:

Our analysis so far are characterization of optimum using calculus, there is no known
algorithm for finding the optimum (except in Linear Programming LP - we have the
simplex algorithm based on extreme point theorem.)
Usual method for nonlinear case is to find feasible points (points that satisfy the
constraints) and check Af when A x i ; and keep changing x 1 to hopefully max/min f
There are many approximation algorithms using computers but these are not closed
form solutions. This brings up the question of
Existence ofa feasible point that is optimal? and
Can we characterize constrained optimum for general firnction case?

2)
3)

ln fact, in math eoon, questions 2) & 3) occupy the bulk ofdiscussion.

For example, concave programming with saddle point characterization.
Given

f, .

jg

are concave functions then the nonlinear programming problems

of

f(x )
jg(x) > 0 V j ( constraints)
s.t.

Max

is called concave programming.

Remark: f

and

jg

need not be differentiable; hence the analysis is very general.

We show we can characterize the optimality of this concave programming with saddle point
and tle optimal result is global.

Defu: Given any two points x1 and x2 in

a set X: o x1 + (1 - d,) x2 is called the linear

combination of points x1 , x2 and is the equation of the straight line joining these two points.
fNote: xl , x2 can be vectors.]

Defn: in particular if
xl ,x2

< a < l,thencr xl + (l -o)x2

is called a convex combination

Definition: asetCisconvexif x1, x2 e C then convex combination cr x,+ (1

(for any 0< cr < l).
[i.e. ifxl and x2e C) line joining these 2 points alsoe C, the C is convex]

of

-cr)x2 e C

[hence relationship: convex functions requires convex set for its domain]
My teacher the late Prof. Takayama used the Chinese character for convex
a set is convex

if A

(protruding) everywhere

Below set S also not convex

Concave function: f is a concave function over a convex set C

ifV x,ye Cand0<

<

I
f(ct x1 + (1 -cr)xr) > a f(x1 ) + (1 - c.) (x, )
[Geometrically, line joining any 2 points on f
lies on/below the function f l
cr

also concave
(but not strictly
concave) finction

If strict inequaiity

{e;

f(c x1 +(1 -c)x2)> af(x1

0< o <1 x + y

strictly concave lirnction

(no shaight lin
segmetrts allowed)

*,

:"
o,,!,{-{)xt

$,t;U tn't a'*

'(a,.'

Definition: fis (strictly ) convex function

if - f

is (shictly) concave.

convex function

/r

L'l

Not strictly convex function

Generalized defi nition:

f(cr1

x1

6s2

x2 +

f is concave over

a convex set

f(x1

cra,Xn

)>

cr1

L,U

strictly convex function

X g R.' iff Vintegers rn > I

)+crzf(xz)+.... + o.f (x.)

with cr1 >

and

0j

We first state a theorem in linear programming (which is a special case of concave

programming because linear functions are both concave and convex functions but not
conversely. i.e. concave (convex) functions are not necessarily linear).

Defii: Given a function O(x,l.) = f G) + Itrg(x)1, (x *, l*; is a saddle point Sp of O (x, ),)
if@ (x,l"t) S @(x *,2,*) S @(x *,2,) V_x
V& in the domain.
[Remark: SP means if viewed fiom one cross section, the fiinction
if viewed from another cross section, it's a relative minimuml

is a relative maximum anc

Theorem (Goldman - Tucker):

convex setc cRl , then

If i'g ,Vj:1,2,...

J, are linear functions defrned over a

x * is a global maximum over the domain C solving

Max
(i.e. x

f(l ) s.t.rg(x) >0 j:1,2,....,J

*

is a solution for the linear programming problem)

iff
3

o(x,D:f(x

> 0 s.t. (*

*,

l*) is a saddle point ofthe Lagrangian

) + l['g(x )] with ]":(],r. ),r. l"r)

Lagrangian multiplier l"*

[Tfus tleorem actually points out the important primal-dual result in Linear Programming. For
proof, please see Takayama [985]1.

Before proceeding to more general concave programming theorems, we will look at KuhnTucker Theorem. As a simple illustration, we will only prove the theorem for the case of 2variable differentiable concave functions and one inequality constraint. We will also state the
more general case theorem for n-variable concave firnctions (not necessarily differentiable) and
j inequality constraints and its proofcan be found in Takayama [1985].
Lemma:
For concave firnctions f (x1. x2) and g(xl, x2) with

xl.

xz

2 0; (xr. x2 ) e C c R2

thera dos not exist

(A)

If /

(x1#, x2#) e C s.t. f(x1#. x2#) > 0 and g(x1#. x2#) > 0
(i.e. no points in the domain for f and g to be simultaneously positive),
then 3 nonnegative weights po.

pr- )

s.t. p6- f (x1, x2)+pr- g(x1, x2) <

@) firthermore if I

(xrO, x20)

0, not both zero,

(xr, xz)e C gR2

e C s.t.g(x10. x20)

>0

[Slater's condition]

then p6- > 0

Proof:
(A) WLOG, let f be +ve then g must be -ve so can choose pr. very largo to make weighted
negative p1. g to at least offset the weighted positive p6- f;
and hence po. f (xr, x2)+pr. g(xr. x2) < 0.

(B) Ifp6- not> 0, then p6- :0

) (0[(x1. x2)+pt- g(x1. x2) <

('.'

po. > 0)
(x1.

x2)e C gR2

g(*r,

*r) . 0

(x1,

x2)e C

Hence ps* > 0.

-cRz

contradicting Slater's condition

Theorem: (Kuhn-Tucker)
Given f (x1. x2) and g(xr, x2) are real-valued differentiable concave functions defined over a
convex set C c Fi and

If f

(xr0. xz0)e C s.t.g(xr0, x20)

>0

[ Slater's condition]

then (x1*, x2* ) is a solution for the concave programming problem:

Max f (x1, x2)s.t. g(x1,

x2)) 0 xr,xzZ0

),* : pr- / po. ) 0

iff

Lagrangian multipliers
(x1. x2, l")

f(xr.

x2

+ l" I g (xr.

xz

for the Lagangian

satisfu.ing following Kuhn-Tucker conditions:

0@/0x;_

f i(xl*, x2*)

xi+ (d@/dx-i-)

+ l,* gi(xr*. x2*) < 0

xr*. x2*

>

=Q i:1,2

A@/A),.: g(xr*.xz*) 2 0

l"*>0

l,* (ao/a).) -0
Proof: If(x1*, x2*

is a solution for the concave programmirrg,

f (x1*. x2*)

I /

any (xr,

f (x1.

x2)e C

f(x1*. x2*)<f(x1,

x2)

with g(x1.

*r) > 0 V (x1, x2)e C

s.t.

x2) withg(xi, x2) including g (x1,

meaning

any (x1,

x2)e C

f(xr. xz)- f(x1*, x2*)

It,

(concave

numoer,

sl

concave

then by above lemma:

s.t.

>0 with

g(x1. x2) >0

concave

xr) >0

3 nonnegative weights

s.t. p0.[f(x1,

ps- f (x1.

po-

po.,

pr. i

0, notboth zero.

x2)- f(x1*, xz*)]+

xz)-

f("r. x2)+

<

In particular, ifwe insert (x1*. x2*

we
pr. g(xr*.

get

*r*) s 0

po,

and

[I-L-9]

po. f (xr,

x2)+

tl-L-gj

g(xr

*, x2*)

> 0 [-L-11]

pr. g(x1*. x2*)=0

p1- g(xl,

Furthermore, for any pz

[-L-10]

[-L-10]
from

x2) S

po-

O, g(x1*.

x2*)

/,=o

f(xr*. x2*)

p1* g(x1*. x2*) [I-L_12]

/r=o

into [I-L-9]

2 0 and g(x1*, xz*) Z 0 ) pr

V (xr. x2)e

x2*)

f(x1*,

but pr-

[I-L-l1]

+ pr. g(xr. x2) s

po. f(x1*. x2*)

p1" g(xr, x2)

pr- g(x1, x2) <

p6. f(x1*. x2*) * p1* g(xr*. x2* ) < p6- f(x1*. xz*
)

.z>o

pz g(x1*, x2*

) [I-L-13]

iI-L-121 [I-L-13] combined give the follow Saddle poinr Sp:

p0*

f (xr,x2)+pr" g(xr.xz)

po. f(x1*,x2*

)rpy. g(x,*,

xr*f

pn.

f(x1*,x2*)+prg(x,*.x2*) [Sp]

and slater's condition, po- > 0, so we can divide throughout

[Sp] by p6.
getting following for all p2, x1, x2 ) Q
and by above lemma

(x1,

and

x, )+(p,., p6, )g(x1. x2 )3f(x1*. x2*)+(p1.7 po. )g(x, *,x2*)<

{xy

if we define l.: fu27p6)

(x1.

x2)+ l"tg(x1,

x2

and given

l.* :pr.

+.

xr*)+(prpn)g(x1*. xr* )[Sp1]

/po- >

0 tsplj

becomes

)<f(x1*. x2*)+l.*g(xr *.xz*)3 (xr *. x2*)+l.g(xr *, xrr XSp2l

[SP2] means (x1i. x2*) maxim izes Lagrangian (D (x1. x2, L) while l+ mifimizes the same
Lagrangian (D. And since f and g are differentiable functions then l't and 2nd order condition
for max and min are the same as those depicted by the Kuhn-Tucker conditions (i.e. thev both

state: (xr *, x2*) maxirnizes and l,* minimizes Lagrangian @).

I (*r \

\7

if(x1*. x2*) , l"*

Conversely,

[SP2]

f(x1, x2) + l.* g(xr. x: )

i) ifl"* >0

Case

satisfy Kuhn-Tucker conditiols

:0

[r-L-15]

g(x1*, x2+)

< f(x1*,

x2*) +

and from Kuhn-Tucker

Ir

g(x1*,x2*) Vxr.xz

0 tI-L_141

condition ),* (6 @ I 6l,) ( which

: l.* g(x1*. x2*))

[-L-l4l

+
t

l"t )

But

) 0<

0 and when s.t. constraint

f(xr

f(x1*,

=
=

f (x1.x2)+1"*g(x1.x2)< f(x'*, x2*) vxr,xz

l*g(x1,x2)S f(x1*. x2*)- f(x1.x2)

*,

xz*)- f(xr,xz)

x2*)2 f(xl,x2)

g(xl, x2)>0&Vx1,x2)

s.t. constraint

s.t. constraint

& vxr.x:)

& vxr,xz

solves concave progrzrmming problem

Case

ii) ifg(x1*. x2*)>0thenby[I-L-15] ,,*

[-L-14]

(xr*,

xz*)

>

f(x1, x2) Vxr,xz

g(xi *,

x2*):0

0 V g (x1. x2)

t ],* -0

There are two more general and useful theorems covering conoave programmmg.

Theorem (Kuhn-Tucker-Uzawa): Given t rg

functions defined over a convex set C g Rn

,Vj:1,2,... I,are real-valued ooncave

;1* is a solution for the concave programming problem:

jg(x) > 0 Vj:t,2,....,1
Max f(x )
s.t.

i f

coefficients p0,, pr*, p2..

..., pr. all > 0

(x) + pr' tg(x) +pr"g(x )+

and p1. tg(X*) +p2.2g(x*
po-

)+

s.t.

jg(x)
.. *prspo- ({*)
*pr. ig(d):0

Proof of this theorem uses Minkowski separation Theorem and the details can be found in
Takayama [985].

The following theorem requires Slater,s condition assumption:

x0 e

C s.t. ig(x0 )> 0 j:1,2,....,J

Theorem: if
convex set C

[Slater's condition]

f(a ), jg(x ) j:1,2,....,J

c R.'

are all concave functions defined over a

and suppose Slater's condition is satisfied, then

x * is a global solution (global maximum) for the concave programming problem:

Max f(x )
s.t.rg(x ) > 0 v j:1,2,....,J

iff

)"*> 0

s.t. (x *,

i,*) is a saddle point of the Lagrangian

with I:(?q. 1'2,.

.l.i):

O(x,1.*) 5 @(x*, l*) < O(x*,

l)

Vxe

(x,l) : f(x ) + lt je(x )l

V),>

Proof of the above treorem follows from the above Kuhn-Tucker-Uzawa Theorem and can be
found in Takayama [1985]

The above theorems form the basis for showing existence of competitive equilibrium, pareto
optimality and other issues in welfare economic theory which occupied thJ main part of math
eoon development in 1950-1980.

Above analysis is also extended to more absfact level using fourdations of math (set Theory
and math logic, general analysis) to provide foundation of math econ.

We

will

study all these topics in the following chapters.

Chapter II.

A. Main Micro Econ Issues within

Math Framework

Microeconomics: principal theory is price Theory and main theme is Adam Smith's
Invisible Hand Theorem (= Qlassical Welfare Theorems)
Adam Smith's Invisible Hand rheorem Iinks equiribrium and efficiencv concepts.
Competitive Equil C E.

i)

Pareto Opt P.O. globally under weakest assumptions.

I

untler PerGct Competition

efficient in

Equilibriun

Pareio Optimal sonse

Importance of market vs. planned economy

significance ofprope(y rights.

Given: scarce resources (if resources are not scarce, no need to study economics)

)
A1.

two questions A1, A2

-.---

resource allocation

A 2. income/wealth disaibution

we

need

mechanism to allocate resources

Planned

(: s6p6-6;

mechanism to distribute income

Market econ (: decentralized

price system)

econ I

Central Planning Board CPB

decides resource (including human resources)

allocation, production, distribution.

1) To properly gauge D, S of everything:
Transaction cost TC (incl contracting, actual transaction
& enforcement cost) and information cost incredibly high
-- resources utilized for nonproductive activities

like monitoring reporting, enforcing.

2) if CPB gauging incorrect, further wastage ofresources
unwanted goods (S > D), or shortage (D >S) means long
queues for products (waiting time opportunity cost), black
markets, bribery
all employing resources, but for nonproductive activities, i.e. not for production of goods & services.

allocation by
decenfr alized price system
(Micro hice Theory)

A&
\
m slmplest sense

ifS>Dforsomething
* supplier will supply

pJ

less and demander

will

demand more

) Pf and S & D change until at certain P*,

S(P* ) : D(P*) ) P* called equilibrium price
S for something t pf
* supplier will supply more and demander will
demand less
) P I and S & D change until at certain p*,
S(P* ) - np*; ) P* called equilibrium price

if D>

decision (for allocation) deoentralized and nobody has

to gauge what other people want. All they need to do
is to optimize according to the changing prices. (e.g.
max utility s.t. budget constraint or max rr s.t.
production). TC for gauging limited to own self
which much less than gauging by CpB.

We can show such price system at equilibrium is

efficient in the sense of Pareto Ootimalitv p.O.
We now proceed to studv this.

Adam Smith (1776):

Invisible hand will brins

maln

tleme

ii)

propensity to work

Classical Welfare Econ Thms within NLp framework in Euclidean Spare R":
Economists for the next 200 years formulated his concepts oflaissez faire, invisible hands,
sooial optimality etc., culminating in the classical welfare Theorems with two imDortant
modern day concepts:

Competitive Equilibrium C.E.: General Equilibrium under perfect competition

AND

\]v

Pareto Optimality P.O.: an economic state (equilibrium or allocation) is p.O. if no one can
be made better off without somebody else being made worse off. (This is to avoid
interpersonal utility comparison which is impossible)
Remarks on P. O.:
1
P. O. is a static efficiency conoept for question A1. Welfare Econ looks at the
equilibrium to see whether it is socially desirable in terms of efficiency.
2.
P. O. is not concerned with the (other) question 42. of income/wealth distribution
(which depends on subjective value judgment). e.g. a dictator may own 98% of the
wealth of his country while the people only own 2%, this situation may still be p.O.
because any re-distribution will make the dictator worse off -- objection to this

involves value judgment.

42.

income/wealth distribution

involves subjective value judgment

e.g. in pure communism and socialism,
theoretioally there should be absolute equalif
in income/wealth distribution and all capital
goods are owned by everybody (common
property rights).
Under private property rights systerns,
income/wealth distribution depends on
endowments and capability of individuals.
Which distribution is better depends on
subjective value judgment which is outside
our realm.

Main point on .A2.: property right stucture

if private property rights, then people

have materialistic incentive to produce; while
is

common properry rights system channels

effort towards non-production endeavors like
climbing the hierarchical ladder of the ruling

party

More importantly, private property right is

essential for people to have incentrve to use
price system./market econ.
Without private property rights, allocation is
by CPB or CPB-controlled price system.

fiL

\,
47,

CPB bureaucrats are not disciplined nor

rewarded by changes in the market
value ofresources they control
no incentive to adjust price
according to market value changes.
222. matket players cannot compete for
resources by paying higher prices when
III

optimizing
no incentive to use price system.
333. Also no incentive to preserve resources
without private property rights

(these are Industrial Organization topics).

Back to C.E. and P. O. in question A1.

.

The historical development starts from

Theory of consumer D: Marginal Utility MU, Marginal Rate of Substitution MRS

& equilibrium occurs when ratio of MRS for any two goods ofany two persons are equal.

i-I)

Then use Edgeworth box of two persons' jndifference curve to prove P.O.
D functions from 1$ order conditions of utility maximization subject to budget constraint.

iII)

Theory of firm: equilibrium will occur when ratios of Marginal Rate of

Transformation MRT for any two inputs of any two producers will be equal. This
equilibrium can be shown to be P.O.
S frrnctions from l" order conditions of maximization ofprofit subject to production.

i-III)

Theory of General Equilibrium : Combine theory of consumer D and theory of firm

and D & S ofeach market and find prioe vector p* such that all D: S.
This type of coverage is common in all micro price theory course (e.g.: Luenberger

textbook [1997] )
We will cover the above subjects ftom the viewpoint of the Classical Welfare theorems
n
n
the Euclidean space R (R is a vector space)
Assume perfect competition
1

2.

(l

perfect defined by perfect information

no risks, no uncertainty), perfect
exchange (no TC), no externality, property rights perfectly defined.
competition defined as all econ agents are price-takers.
fRationale is atomism which states that all econ agents are too small to affect
market prices so just take market prices as given when optimizing.l

in

i-I)

Theory of consumer

D:

each individual i maximizes his

L li S Wi. :

budget constraint:

utilif'

fti) s.t.
his incorne * endowment
U;

[we assume his utility depends on his consumption ofgoods bundle represented by
vectorl i: (xir, xi:, xi:, ...,xiv) : say (apples, ioranges, 1clothes, 1watch,.....,ipen)

vector p
market price vector (p1, p2. ...,pv),assumeditakesthisgivengandput
into his budget constraint when he is optimizing;
in our example (price of apples, price of oranges, price of clothes, ... , price ofpen).
Since i can only afford bundles x I within his budget, we call these feasible bundles.l

Max utility s.t. budget constraint is constrained optimization, so we set up Lagrangian

each individual

Max

Oi:Max Ui(x;r. xiz,

(D

xi:, .xiv)+l(Wi - ,- p* xi,,,)

and from this consfained maximization problem we can get demand function of the
individual, in terms ofprice vector.

) -- i's demand for good

,Pv) - i's demand for good2

x1* (pr. Pz, . . . ,pv

}t-ftt,
x

pr,

l"r. Gr. pz.

...,pu)-

i's demand for goodM

i's demand depends on tle given prices and his optimization behavior; and
feasible (i.e. within his budget constraint)

x* will

be

We defrre individual i's preference ordering Fi between two goods bundles x

(represented by veotor 1) and y (represented by vector y)
.

x >i y
x -i y
ifbodr

for: i prefers goods bundle x over goods bundle y

stands for: i is indifferent between x and y.
stands

above two cases, we use the syrnbol

fNote: b; represents preference reflecting emotionaVpsychological factors and is

different from > which compares real numbers.
We assume that i's preference ordering can be represented by his real-value utility
firnction U; (hence can use >) . We will study the necessary conditions for existence of
such utility function in real space and in metric spaoel.
We assume i's preference ordering can be represented by his utility function as follows:
x tsi y if & only if U, (l) > U, (y)

r -i )L if & only if
x li y if&onlyif

(x) : U, (y)
UrG) >U,(y)

U,

irl'ilrii[
!i
it
rIftil

'

t: t;i+
ai
t- l" t-

li

ti

iiifi!i
ili r

iiiiir
,
r!

tn

al

i!l

;t
II

i'

il
irt

.F

ii!l

I
?fl$ I

:iis
rl

IT
I
!

I
I

a;

t'

rf rl

tt

i i

,r,
5rl

a;iF

:T

i;i:

tl

:f

I
f

I
I

I
I

i f

I
f
t I

$Er

iF

EE

5$ i$
f
!

i{

!BX{

I
t

.;l

i
I
I f t r
r9;

;r

f {t

iti
llr
lI

i ii

iFF

After i solved the above constrained maximization problem given price p the solution
bundle x* (feasible) will be preferred over all other feasible bundles x (i.e. x* L; x
)

i-II)

Theory of firm: Forj's production vector

yi:

(y1t, yj2, ...,y;rvr), positive entry

enfy 0 means he is not

stands for his ouQu(s), negative entry stands for his input(s) and

producing that good nor using that good as input.

j's production vector maybe

(apples, .ioranges, ;clothes, . . . ,1bee{ .;hides, .;homs, . , . .,lcattle feed, 11and ,1labor,.. .,
lpen )
:( -3003, -60
-36 , -.. ,9 ton,3 ton, .1 ton, ... , -18tons ,-3 acres, -18, ...,-5)
e.g.

6 ,

Given price p, each produoer j maximizes profit: p (yjr. y.i2....,y:r,,a)inj,sproduction

set Y . We denote solution of this math programming problem by y1
[Since price p> 0, when we multiply the two vectors p and y!, 1le +ve ]jn (outputs)
multiplied by p- will be the revenue and the -ve yt* (inputs) multiplied by p. will be the
cost and we automatically get the profit function.l

i-trI)

Theory of General Equilibrium under perfect competition C.E.

We combine the above Theory of consumer D and Theory of fum by first confining
total consumption by all i in good m must be < total production by all j + initial
endowment of all i and j in that good rn, for all goods m 1,2, ...,M.
i.e. feasible consumption s.t. x < y+xo, where x u = initial endowment goods vector.

Market is cleared at certain price vector p! means: g!( y + x0 - I ) : 0,

[i.e. at price pl , total supply = total demand for each and all goods.]
We can frame above in terms of nonlinear programming:
Assume no externalities
goods
m:1,2,...,M
consumers i with consumption vector xj:(xil, xo,
producers j with production vector yi: (y;1, yJ2. . .

m:

. .,xir) i:1,2,...,1
j:1,2, ...,J
..yjM),

initial endowment vector held by i orj

utility firnction for i :

letx

=i=lLxi

U1 (x11, xi2 , xB

y= IJi
j-l

xl

or

.x

\a

x$,

nf
) continuous and real-valued fimction

"o= Ixoi+di
i.j

Definition: An array ofconsumption vectors { 1 } is feasible if3 array ofproduction

vector{yi} s.t. y+ X0 ) x
1e consumption setX g RM
Definition: given U(1) = [rU (x),
and r g(x),

,g(x)

vector X* e

if

rult;, ..

.rU(X) ]is a vector-valued function

MgG) are real-valued functions; 4

is called a vector

maximum ofU(a)

e consumption set

RM

s.t. *g(D>0 m:1,2,...,M

(l) '" g(l*))o vm

(2) / a s.t. rU(x)2 rU(x*) k= 1,2, ...,K
wrth 1U(d> ru(><|) at least one k
and '.g(dZ0 m:1,2,...,M x e X
n particular if u(:r) represents utility vector for all economic agents and constraints are
the feasibility consfiaints, then this vector maximum definition is actually equivalent to
the following P.O. definition.

Definition: Feasible {

1 *}

is

.} s.t.
feasible {
for all i, widr strict inequality for at least one i

Pmeto Optimal if

Ur (l ') > Ui (X_i *)

Remark:

Vector Max -ve definition

P.O. -ve definition

U(x):[rU(x),zU($.,rU(x)]

U(x): [lU(5),:U(x). . ,ru(x)]

,7

2nd person

constraints ,,g (x) > 0

consfaint g(l) =

4* vector max ofU s.t. g(a)> 0

,v
feasible 1

X*

yi

util firnctiol

y + ><o -21 >0

vector max of U s.t. g(g

,v
feasible

$ )0

I y

IT

l) 1+ feasible (i.e. g(x*)) 0 )

1) x* y* feasible (i.e. g(x*. y*)

)0)

2)

cannot furd any feasible xr s.t.

hu (ro)

ru(xr),

.*U

2)

cannot find any feasible

1t

y# s.t.

LU(x),rUG#r. ...U(xu)l

(x#) I
with sbict inequality
for at last one i

hu(x.),zu(r"). ..xu(x')l
i.e.

atleastsoms,uftl

' ruG) "/

/\

[ru(x').zU(x-), .ru(x-)]
| \

,.".

",,*"tsode

iu6') > iuG)

I x+ y*] is P.O.
means when feasible

x*

sav

[rU (x-) , :u (x*.1. 3u 6*

:1r,2,3,41

cannot furd feasible some

y."

.g

xt

1*r';1

s.t.

(xt , rg1t*;, ,U<xnl. rUtllt

:1r,2,3.0r,41
LU

11,

2,

3.01,

4l

lr,

2,

3,

4)

('.' if can find such 5", then x* not p.O.)

Definition: Array ofvectors [p*,{ xi *},{ yi*}] withp!>Q

lJLi *e X, =
consumptlon set, yi+e Yj: j's production set V i, j,
is a

i',

Competitive Equilibrium ifi

(CEl) U, (x.l*) >Ui(xi ) with p*_x_i Sp*x;*

V1i e X;
(cE2) p*Ij* > p*& v_y, e Y; vj
(CE3) l*S(y++Ie)and
p*(y.+ xo-x,*1 -6

Vi

Econ interpretation:

(CEl) means each i will max his utility at x* according to p* s.t. his budget consfaint.
(CE2) means eachj will max his profit at y* according to p* s.t. his proJuction
set
(CE3) means feasibility ofconsumption and market clearing for each market.

e)

....rU(x);

Theorem (Vector Maximum): ru(d, zU($.

rg($, zg(x),...,Mg(x) are
concave real-valued functions defined on a convex set X c RM
and that Slater's condition holds i.e.
rg(X,)>0 Vj

f x' s.t.

ff 4* is a vector maximum for U(x) s.t.

and define (D( x , &) = Q U(s) +l"g(x) , then

f 9>0 but+q and?,*>0

[i.e. O( 1, ],*) S O( x*
Proof: Please

such that (

!*)

see Takayama

(a) >

19

x*, i"*) is Saddle point of@(1,1")

S O( x*

l")

for all

1e X and i" ]

QJ

[1985].

Now we are ready to proceed to prove P. O.

C.E. globally

We note the following:

l)PO
I 2;

equivalant definition

::)

vector rnax

* 8t*n slat"t"

"-a
Q>8but+ 0; l,*>0
"*T-.,_,*^:*)*_l

l
Max Q U(a)

3)SP

1*r

sr"t

',si

s.t.

(s*, l"+) is Spof O(5, ),) =

U(1) +l,g(x)

x* is global max for following concave programming problem:

s.t. g(x) > 0
[ConProg 16]

[by NLP theorem in Chapter I. L. which states given concave functions over a
convex set and Slater's condition, SP ( x* ,l,*) of Lagrangian O(
is
global max for conoave prograrnming problem]

l,l,)

4) If

above U(x) = utility vector function

and g(a) to be the feasibility oonsraintf + x0 - x
Q
Then [ConProg 16] becomes following concave prog problem;
x*, y! is the global max for [ConProg 16-1]:

Max Q U(a) s.t. feasibility C(x, y, r0) >

5)

same x*, y! is the global max for the following

Max U(x) s.t. feasibility g(x, y, x') > Q

[16-A]
concave prog problem:

[Conprog 16-16]

d,l is NOT &e global max I : i ..t. U1i 1t U(!*) s.t. feasibility.
Butg>g,q+0 t CU(i) > 0 UG1) s.t feasibility + contradicting [16-A']
i d, y! is the global Irra\imrn for [CorProg 16-16]l
[Pf

Assume

6) By Kuhn-Tucker-Uzawa
concave programming

I,

theorem in Chapter

x*,

3po*,p1 :(pr*, pz*.

U(x) 1plfu + ro - d s po* U(d) anp

-p10i+ r'- rIJ=0 s.t.feasibility(yl+ x"-

y!

..

is a solution of the

.,py* ) >0

s.t.

po*

x'))0

U(g +pj(y+ x0- dS ps* U(f) &we justadd

pl e(i!) to RHS of above inequality:
pq*U(g+ Ll (y + r0 - x) s ps* U(f) + pl (y1 + 40 - rI) [18-18]

7) from[17-17]

pe*

a zero temr

In addition, if we have following assunptions, we can show [P.O.

(A-1)

lSUefs conaftionl

(A-2) Y

117-17)

x#

C.E]

X;y# eYs.t.y#rao-1# >g(if s0 )some i may not survive atr#)

convex set

(A-3)

U,(x_r ) oontinuous and concave function V

(A-4)

*,
*> p*x3 # , V
[Cheaper Point Assumption] given 41 p*: 1 4_; # a X; s.t. p*Li
[without this assumption, i may only be minimizing his expenditure but not
necessarily maximizing his utility s.t. budget constraint].

Theorem [P.O.

if

[{rli*},

C.E]: Under assumptions (A-1)

y_*] isP.O. thenl p*

(A-4)

>0 and{yr*}s.t.[p*,{t*},{yi*}]

isaC.E.

Proof: We know [{xt*}, y*] isP.O. andby above steps 1)-7)wehave

AA) from |7-l7l1po* , tr*. : (pr*. pz*. ...,pl,a*) 20 s.t.
po* U(x) + pl fu + x" - E) S ps* U(d) and

pI(yl+ r0- r:):0 s.t.feasibility(yl+ru-xI)>0 t

and

BB)

(CE3)

from [18-18] pq*U(r+ pj (y + :0 - x) 5 ps* U(rj) + pj (y! + r0 - E)

we
andy:y1 except some arbifary producer q then [18-18]
becomes pl (yn)s pi(yn1 )

letx:*

since q arbitary from

1,2, ... , J

tp1(vi)<p1(vi1)
similarly we let

x: xi &V:C

vj

t(cE2)

except some arbifary consumer h then [18-18]

becomes

Bixul-pl*u s ps*uu(xf) - ps*uu(xh)

vxr',e

Xi anvi=1,2,...,r

[19-191

2 cases:

ifpq*>0,

then [19-19] means

Uu(xrJ) >UlGr.)

with.Blu* )plxa Vhfromi:1,2,...1+ (CEt)

ifps*:0,

)plxl*

then [19-19] means pl xb

Vxr contradicting (A_4) cheaper
point, )po* must > 0 (and above p6* > 0 case works) t (CEl).

This also brings out the following lemma_

Definition: consumer i is satiated at4-;#

Lemma:

If I

ifu,(4#) > U,(xr )

one consumer i who is not satiated at

* then

p*

Vx-.; e X;
+

Proof: assumep*:0 then from [19-19] p6* Q(d < ps* Ui (Xt)

i is satiated

[C.E.

at x_;

@eductio ad absurdum

proof by contradiction)_

P.O. Theorem is almost trivial]

Theorem: [p*, { :r i *}, { yr-*}] is a C.E.

I{

x_,

*}, {g*}l

Proof: from (CEl)

Ur (x..i * ) >Ur(I, ) with p*3 Sp*xi*
Vx3e X;
) cri Ui (l * ) ) oi Ui (x_i ) with feasibiliry oi > 0

x o; Ui (x i *
ll

now if [{

)3

) >:

1*}, {1i*}]

iii)

U1(3_1

[{

x-;

*}, {;vi*}]

with

feasibility

Vi

120-201

notp.O.

feasiblefu')s.t. U, (X,')>IJi

)X cr,1 U1 (l') > !

ri

is p.O.

o.;

(a_1*)

Ui(1 * )

for all i, with strict inequaliry for at least one i

with feasibility conhadicting [20_20].

must be P.o.

Existence of C.E. using Brouwer's and Kakutani,s Fixed point theorems:

p.O.
[193040 Hicks, Samuelson, studying C.E.
(Ref: Econ of Control Ny MacMillan 1944) were
studying the converse P.O.
p* s.t. C.E.l
and Oskar Lange and A. Lerner

) f

A1. Allocation problem: From the above welfare

thms we know ! an equilibrium price

vector at which supply equals demand in each market. But then a cpB can also achieve
this by rationing demand & supply of everything. what is different is this perfect market
price allocation is PO efficient as shown by the welfare theorem.

A 2. Income/wealth distribution problem: As we mentioned, the above perfect market

equilibrium allocation may be Pareto but it may not be "equitable', by some subjective
value judgment. In fact, within a static model, any distribution of benefit is paretol
One possibility is to distribute aggregaie income p*(y* + x0 ) by giving p*lr., * to each
and then we also get C.E. and P.O. But this is artificial, contrived and controlled.

We want to show the "real" existence of C. E. with math.

Existence ofCE using Fixed Point Theorem

Definition: Ii(p* , y*)

where

03

is

i's

:p*

share of

1;u + max { 0, X,0ti !* $*}

profit from

e.g. income distribution as

X

01i

- I ('s profit completely distributed to a1l i)

(CEl) now becomes Ui

(ti*) > U, (X_, ) V-x.i e X1 Vi with p*1

Need additional assumptions:

(A"5)

Z:

{(xr.

xz.

,xr,y): x

y*+

x0

y_e

4ie X;

Vi}

<

11

iscompact {in

real spaoe = closed (including all boundary points) and bounded (does not go to infinite))

(A-6) Nonsatiation: Vlae

l3

X;

[{

xi'e X1 s.t. xr' bi &_

(A-7) Inaotion allowed:

(48) Suwival: 3

0eYi

x1m e

X1

I }, y] e Z

Vi

Vj (togerp)0)
s.t. &oo. *,0 Vr

(oonesponding to cheaper point. -- to guarantee i's dernand function upper semi

continuous. Also implication xf is an interior point of Y + X0 in a C.E. and not be
below subsistence level. We will study the concept of semicontinuity in the following
sections)

(^

[Existence of C.E.]
Theorem Ee: Under assumptions (A-1)

(A-8)

p* >0 butpg*+Q s.t. [p*,{x_r*},{g*}] isaC.E.

Proof

use Kuhn-Tucker Theorem and

Kakutani's Fixed Point FP Theorem. Please see

Takayama [1985]page289. (Kakutani's FP Thm is normally used when utility functior
is concave. In case of strictly concave utility functions, we can use Brouwer,s Fixed

Point Thm.)

In the above analysis, we are concentrating on the theory and making all kinds of
assurnptions necessary for the theory to work. e.g.. we assume I utility function; swvival
and semi-continuiry in above theorem etc.
In order to explain the rationale behind all these assumptions, go into details of some of
our proofs and extend our results, we need proper math econ foundation. Ald we also
need various FP theorems. The next section on general math analysis and topology is
typical grad school coverage for such purpose.

lRemark: For students who want to see a preview of the next section
A) Brouwer's FP Thm
s nonemp4" convex, compact c R" and continuous
s
S
- fixed point xx S s.t. f(x*) : x*.

f: )

Every continuous function f from closed unit ball B "

B o has at least one fixed
pomt.
o
o
[closed unit ball B & closed unit simplexes A are homeomorphic].

Application of Brouwer's FP Thm: Proof of C.E. existence in an exchange economy

where utili|., functions are strictly concave.
Sketch ofproof: Assumptions 1) existence ofa continuous, strictly concave and locally
insatiable utility function u;(xi): non-negative quadrants R" +
Vi

)R

and 2) feasible set closed and

bdd (i.e. compact).

Since budget constaints remain unchanged when price vector p is scaled by any constanl
we can normalize p by scaling to get p A ".
Construot use excess demand funotion E(p) to construct a mapping f (p)
p + E(p) .
Such that
and satisfying all Brouwer's Thm assumptions

f: A' ) A'

i by Brouwer FP Thm 3 fixed point p* s.t. f (p*): p* but f(p*) ulro: p*+E(p*)
I p* : p* + E(p*)
) I p* s.t. E(p*) = 0 [i.e. p* will make aggregate excess demand function:01
I - p* s.t. supply = demand resulting in C.E.

B) Kakutani's

FP Thm
X nonempty compact, convex set

R.'

:X 3 X is upper semicontinuous (u.s.c.) s.t.

fixed point x* S with x* | (x*).

and conespondence

valued, then

(x) is convex_

Note above f in Brouwer's FP Thm is a point-to-point function. Kakutani's Fp Thm

generalizes Brouwer's FP Thm in a slightly different direction. We stay in Euclidean
space R " , + compagtness + convexrry, but now look at set-valued (-mu1ti-valued
point-to-set = multifunction) functions
called correspondences, in particular semiand hemi-continuous oorrespondences

Application: Proof of existence ofNash Equitibrium in Game Theory and above

Takayama's proof of C.E. existence. We shall cover all these topics in detail.]

Chapter II. B. Generalization of math econ concepts using general math analysis

i)

Set theory and short review

ofreal analysis

In previous seotion, we have all these assumptions on preference (emotional aspect),

nonsatiation, compactness of feasible sets Z, semi-continuity of functions etc. which
basically are assumptions necessary to do the math parts. To understand this we need to
study the axiomatic foundation of math.
General topology is used in virtually all branches of modem matl. Together with set
theory topology provide the axiomatic foundation of math and hence foundation of math
econ.

For undergrad math econ courses we mainly do problems in Euclidean space R.'. @lease
see footnote below). But not all econ problems are Euclidean. Something as
fundamental as preference is not really Euclidean. Hence in grad level math econ, we
move up to a more abstact and more basic level to work in general topological spaces (of
which R' is a special case) and theory of functions in general (not just real-valued
functions). For instance, we work in a space of bundles of goods (not real numbers) in
which cons'rmers will have a preference ordering (psychological, emotional rather than
real numbers).
Topological spaces .ne math structues drat allow the formalization of concepts such as
convergence, connectedness and continuity. The three main structures we are interested
in are
1. order structure (ordering things so we can talk about finding higher/highest (or
lower/lowest) order for maximization (or minimization)).
metic struohre (concept of "distance" for measurement purpose, i.e. how much
higher or how much lower, how near. We also need metric spaces with arbitrary set X
to show preference ordering can be represented by real-valued functions).
3. linear structure (to add vectors and do scalar multiplication. This is necessary to have
proper consumption and production sets consisting of vectors.)

2.

And of course, when we move from our abstract level back down to the Euclidean level,
we get the usual undergrad defrnition of convergence, continuity of real sequences/series
and real analysis.

6ncttt^l

Footnote:
e.g.

typical undergrad courses use Edgewortl.r Box in

RP space

to show PO. and CE.

br'C--,a / E
In advanced undergrad and grad courses, we use vector maximum in R:'space for PO. [x*, y*], CE [x*, y+,

p*] concept.
In proper grad coursies, we can start widl any space like a commodities space - not Rl- and preference
ordering. Then modi$ the space (make it compact etc) so that preference can be represented by utility
function etc., making the analysis both realistic and general.

(;-'

''-'

Terminology and basic notions.

Given arbitary sets X and Yboth

* O; set of natural numbers N: {0, 1,2,....,n,

.....}

FtINCfiON fis a binary relation X x Y Cartesian product:

1)VxX,3yeYs.t.xE/
y,z Y, xS and xfz )

2)V

Notation: f

y:"

X
domail

codomaio

ffi
Notation:

yx:1f :X ) y)

X is COUNTABLY INFINITI, if 3 bijection (1-i conespondence) f : X

X is countable if it is 1) finite or 2) countably infinite.

Cardinality of a set : number of elements in the set.

[example : N is countable but set of real numbers R is not countable
Countable set has cadinality : cardinaiity of some subset of N]
[X, Y countable

Cartesian product X x Y a]so countable.l

fintuitively if (x, y) Cartesiaa product X x Ymeans we caa find a way

(namely, a tunction g: {X,Y}) U{X,Y} s.t. g(D Xandg(Y) Y VX,Ye{X,Y})
to pick one element x fron X and one element of y from Y. For finite and countably
infi:ritely many Xx\xZ ..,., we can find such a function gJ
For Cartesian products of infinite number of nonempty sets Xx YxZ ........, we need
Axiom of Choice:
V nonempty class Y

={Y

Y is a set}, 3 a function g: Y

uY s.t. g(Yl

VY

we just rely on this axiom that we can pick one element from each of the
inffnitely rnany sets in the Cartesian product. This is equivalent to :
1. every n-nary relation conteins a function.
2. Zorn's Lemma which we will cover after introducing order structurel

[ntuitively:

Given set X
The list(X,

if

Q, binmy operations + and .

) is a FIELD F:

+,.

on

X ; x, y,

zX.

x+y:y+x ; x.y:y.x
2) associative: (x+y)+z:x+(y+z) ; (x. y) .z:x.(y.z)
3) distributive: x(y+z):x.y * x.z
1) commutative:

4) 3 identity elements 0 and 1: 0+x:x+0:x ; 1.x:x.1=x

5) 3 inverse elements -x and.x-r : x+ -x : -x +x :0,
VxK{0} x .x-t : x-r .x = I
[Intuitively: A field is an algebraic structure for doing arithmetic. x X is called a scalar
Example: set ofreal numbers R; set of complex numbers Z]
VECTOR SPACE V overthe freld F:

i)

1-/T

set V with two binary operafions:

Vu,v,wV;

veotor addition v +

x,yF
w: Vx !-+V

ii) scalar multiplication

xv:

---+

satisfuing axioms below:

associative: u + (v +

2.

commutative: v + w=w + v.

4.

inverse elements

L>l

A,

l.

3. 3 identity element

w):

(u + v) + w.

zero vector

.t1o

V: v+0:v

-v Vwith v+-y:$.

5. Distributive: x (v + w) :

1v

to.

6. Distributive: (x + y) v : x v + y v.

7. x (y
8.

v):

(xy) v.

Soalar multiplication identity element 1: 1 v

flntuitively: Vector space is a set of objeots called vectors that can be scaled (scalar
multiplication) and added (vector addition)
Examples: real vector spaces R ' , R ', ... ; in particular R n is n-dim real vector space]

: { br , bz , .... , bn } s.t. for any v V )

linear combination a1 b1 * azbz+ .... * aoln : y
Ordered BASIS B for vector space V

a'l
U,

lvls: : I
:l
a.l

.J

Coorcmate

1!

[e.g.forR3: b1 : (1,0,0) br:(0,1,0)

b3 -(0,0,1)and all vjn rlat vector space can be

(1,0,0) (0,1,0) (0,0,1)

expressed as linear combinations of

Now we add order structure into a field to set ordered field:

Order: Defrne a binary relation

E : X) X

as:

(Vx,y,zX)
1. Transitive

(T)

ifx E yandy E z )xD

2. Reflexive (R) if

xE

E y and y E x
4. Symmetical (S) if x E y I y E *
5. Antisymmetrical (A) if xE y& yE xl x=y
3.

Complete (C)

if

either

called preorder

ifTR

andthe list (X, E ) ca[ed preordered set

called partial order

if TRA

called linear order

if TRAC and

and the list (X,

E called poset
)

the list (X,

E ) cailed loset

Boundedness (Bddness): S c poset P is bdd from above

bbd frombelow

If

if 3 b Ps.t.

pE

Vp

if

p s.t. a P p Vp p;

and

p.

S is bdd both from above and below then

it's called bounded fbdd).

[intuitively, it means S is contained in an intervall

E i. u generalization of all "greater or equal,' Spe ordering, ilcluding

subset ordering I in math, preference ordering ) in econ, 5 ) 4 in real number Rl
[intuitively,

Application to Theory of choice in Econ: preference relation on a set x of arbitrary

objects is usually assumed to be TR, so list (X, )) is a preordered set. A preordered set

(X, P ) is just a generalization of (X, >). From tlere we can extend to utility function
expressing such preference ordering.

Szpilrajn Theorem: Every poset can be extended to a loset

[krtuitively: we

can extend the TRA to TRAC with a more general

Define an equivalence relationship

EI

if it is TRS

Define equivalence class of x with respect to

::

{y X ; y = x} denoted by [x]=
Application to Theory of Choice in Eoon: [x]= is just a generalization of indifference
curve going though the point x.
[f we move back down to the Euclidean space R.', we get the familiar indifference curve]

Given preordered set (X, E

),

+Y

y>

y*

y* E-minimalifiyYs.t. y* >

Y*

E-maximalif/yYs.t.

Ey V ye Y I
if yEy* V yY )
ify*

and

y* Y

y* called E-maximum of Y.
y* called E-minimum of Y

(X, E ), ** is an upper bound for poset if x* E

Given a poset (X, E ), ** is an lower bound for poset if x E

Gven

x
x*

a poset

VxX

VxX

The supremum of X, denoted by sup(X), is the least upper bound. i.e. sup(X) is the Eminimum of {upper bounds xi of X}
lnfimum of X, inf(X), is the geatest lower bound: the biggest of all lower bounds of X.

A sequence in a nonempty set X, denoted as

(xt,xz, ....

{x.},

is an ordered array of elements

,x.,....) x. X
So basically it's a function f: N) Xwithf(m):x. mN

Given seq(x1
, x-, ... .), take the seq m1 (rrlz (m:
{x * "} is a subsequence of {x,n}

,x2,....

<..

< m.

<....

ofX,

and the seq

Z!

space which has a dlstance measure

[Example: a Cauchy sequence in metric space - its elements becomes closer and closer
together as it progresses. i.e. after n terms of the sequence, the maxirnum ilistance
between any two elements becomes smaller than an arbitrary e > 0.

{xJ = 0, v,, 1/3,....1&, 1/m,...) and l1& - l/ml < l1&l + l1/ml ;
as k, m ) co Iim l1&l + ll/ml = 0l tlistance between l/k & l/m squeezed
) no "holes". But since we are talking about distance, we can do this only in metric
spaces which we will cover.
e.g.

Later on, we will look at comptrete metric space M (where all such Cauchy sequences
converge to a limit, i.e. evely Cauchy seq of points in M has limit also il M). And we can
always complete the space by fflling in all the "holes". E.g. given Q which is incomplete
because there are "holes" of irrational numbers like .f,2 and z ..., we can make it
complete by filling in all the irrational numbers.
Metric space l1{ js sorn.pact ifr M is complete and totally bdd (versus S C R " is compact
iff S is closed and bdd so we see compactness in metric spaces works like the abstract
generalization of finiteness due to the bdilness.l
Zorn's Lemma: If all loset in a given poset has an upper bound

poset has a maximal

elgment-

[Zorn's Lemma is equivalent to Axiom of Choice]

Hausdorff maximal principle: f a f -maximal loset in all posets.
ordering defmed in terms of subsa (inclusion) relation.

ORDERED FIELD (X, + ,

s.t.x

. , 2)

is a freld with partial ordering on

2 y) x+z2y+"aod if z2 0thenxz2yz

Notation: X. = {x

} 0l

X ={x <0}

X--: {x<0}

Note in any ordered freld (X , + ,

llx+vll s llxlr -

X*n: {x > 0}

. , ]),

the triangular inequality holds:

lyll t";a.pl.' f.]r". 'utr*riXii>rx-g l{,,tl+llYrl-11xtJll

tt1tt/ \$/ t
'
"oZ
-,K

#;+#

..n>

[example: rational numbers Q form an ordered field, R is an ordered field but

difference is the following completeness axiom:
Every nonempty, bounded from above S

R has a sup@)

a real number

Intuitively: R is complete (no "holes" between its elements) while

(irrational numbers slots between its elements)]

thl

r*.

Q has "holes"

ii)

Topological spaces

In modern math foundation, the concept oftopological space is essential.

We study topological spaces to see the foundation structure of math econ. These include
1. order structure, part of whioh is covered in the above analysis, for optimization
2. mefric sfucture used for measurement and optimization
3. linear structure for vector operation.

We start with the concept of space.

In any discussion, we have a universe ofdiscourse (the universal set).
We call this a space: a collection ofobjects (= points).

Deft:
let r
1.

a collection

of sets Oi

can be anrthing, e.g. X can

= {oonsumption bundles for

c X s.t.

@er, Xer

i: 1,2, ..., m )
Ooer aeA )

2. Oi
3.

Given an arbitrary nonempty set X (x

John) );

fli=r Oie

Uo66 Ooe

then the pair ofobjects (X, t) is a topological space with topology r.

A member 01 of t is called an open set.
Collection t is called the topology on the underlying set X.

ln addition, if the topological space (X, r) has a distance (= metric) frrnction d for its
points, then it's called metric space, denoted by (X, d).
Defn: (X, dx) is a metric space if X is any nonempty set and has a distance firnction
d: XxX) Rs.t.
l) d1 (x,Y)=A |ff1:t x,Y e X
2) dx (x,y) + d(v, z) > d(z,x) tiangular inequality
3) d;(x,y) Z 0
a) d1 (x,y): d(y,x) slmmetry
flntuitively, with the distance firncfion, we can talk about how near (the distance
between) any point xo is to another point x in the space; hence we can have notions of
length between 2 points - used to define open/closed intervals ; and

l.

t\

.'.?Lo
, ''-n-lt,
2.

neighborhood of xe - used for function continuity ( A function f(x) is continuous at x6

maps points nearby to x0 to points that are nearby to f(x o)) I
[n analysis, we study metic spaces for connectedness, separability, compactness and
completeness concepts.
e.g. Econ Application: connededness + separability + Richter-Peleg
utility
Rader's Utility Tluu
Debreu's Utility Thml

if f

The real line R is a topological space @, t), associated with the metric space (R,
real number system with a distance function (called Euclidean mefic) d(x1, x)

:lxr*xzl(i.e.

length ofthe interval (x1

,x2))

between any two points x1 .x2

If

d) of

eR

interval does not include endpoints x and y, then it's an open interval.
includes the endpoints x and y, then it's a closed intenal.

If

interval

CIASt+ tilfe&,A,

o?6t l'^je*lh|-.

P.
On the real line, neighborhood is in terms ofopen intervals, namely,
given any xs,r e R" r>0,the set B"(x6) = {x eR:d(xs,x)< r}
{open intervals around about xo with radius r}.
Open sets in this metric space can then be characterized as a union of open intervals.

l-dimensional @, d) metric space

fl
I

p.ta',co

tu -+F

tu

nedr*il^;L
We can extend to Cartesian products

6"-(xn)

ofR. namely, R "

@ , r) topological

space:

space associated with the metric space

(R.' , d) with a distance firnction called

Euclidean metric d(x,y)

: .,/l (.r, - y, )'?

I

i=1

and open intervals are conespondingly generalized to n-dim open balls

B. (x o) {x e Ro: d(xo, x) < r}

Example:

(*,y):{G:;:Gfl

2-dim (R'z, d; ig.a metric space Euclidean metric d

denoted also by ll . ll . Not" open interval generalized to an open circle (2-dim ball)

K';'l--" *ut,v\

,rc

l'''"

6.tx'\={tt f:a{'";)arJ
(.

3-dim

(R',

d) metric space

u&,>4."t
R-

ebbrc)<ltJ

[We note in the (Rl, d) space, points can be expressed in terms ofvectors.

VECTOR: Ordered n-tuples ofreal numbers is called

x.= (x1,x2,....,xi,

a vector, denoted

by

...,xo) xi e set of real numbersl

Analogously, in a general metric space (X, d), an Open BalI around a point x
B,(xo): { xeX: d(x,xs) <r} and xois called the cenfe and r the radius.

Defit: nonempty S c (X, dx) is an open set if for

s.t. B' (x ) c $.

any x

S,

e (X, d) :

+ve real number r

[example: all open balls are open sets, collection of all open sets in X is open. Note open
ball are nonempty because it at least contains the oenhe]
[Intuitively, since we have d in metic space (X, dx), we can define open balls and hence
define open sets. We let t be the collection of open sets defrned in terms of open balls,
then we get a topological space (X, t )l
Since a metric space have these open (and closed set) set properties, we can leverage on
these to move to even more abstract topological spaces. @lease see below)

In addition, in metic

space, we have idea

of one element being "close to" anotler

element in terms of distance metric d in an abstract space. Using this "close-to-ness" we

can talk about convergence of seq in metric space because convergence intuitively is just
elements in the seq getting arbitrarily close to the limit.

Given mehic space (X, d1), x 6 e X andS C X, a sequence

any real number e> 0 I n* e N++ (+ve natural number) s.t.

Vne

N++

We write

If

lim

n*

) dx(x6,xsr)<e

{x-}: x o or {x-})

S, then

x6
seq {xo'} is a convergent sequence in

{x.}convergestoxoiffor

iii) Generalization ofecon

ideas in abstract topological spaces

'Y
Defir: Given topological

spaoe

open set. In other words, S "

[examples:

sets.

(a,

bl

(X,

),S

Xis

a closed set

if its complement

S " is an

in R,

a, b are finite rea] numbers: intervals [f,A], [a,

and [a,b) are neither closed nor open sets.]

.), (-*,

a] are closed

Given topologioal space fi, T ), sequence {x,o} in X is convergent in X if I x o X s.t.

xn Y.
for any open set Y containing xe 3 n* N++ where Vn N*+ 2 n*

In an arbitrary topological space, such a limit x o need not be

In particular, for real seq {x,n} R, it is bdd from above if

And bdd ftom below if inf{x* : m N} > - co
And bdd if bbd from both above and from below
[ntuitively, bdd from above means all the terms

x'o in the

1 t

sup

seq

{x.

:m

N}

<

co

some real number

B]

Every convergent real seq is bdd and we have

Bolzano-Weierstrass Thm
Every bdd real seq has a convergent subsequence.

Defo: (X, fi) and S c X is closed iff

point s S.

Sisbddinxif I

sequences in S convergent in

X converges to a

>0s.t. Se neighborhood N.,1(x)

{y X: fi(x,y)< e

Continuity of single-valued function f.

) (!

spaces (X, dx) (Y dv) and function f: (X, dy)

dv),
>
point
x0
if
for
any
real
number
e
0,
I
real
number
6
s.t.
foranyx
fis continuous at
e
Iffis continuous at all points ofX, then
X , d1( x, ro). 6
dv( f(x), (xo))
is continuous in X.

Defir: Given metic

< .

flntuitively, continuity means for points x close to x6, (x) will be close to f(x6) in the
space.l

Since R is also a metric space with the usual Euclidean

down to this R spaoe, then

f:

metric ll . ll , we can move back

R and we get the familiar Bolzano-Cauchy epsilon

delta 6 definition for continuity:

Areal function f;

XqR) YcRis

continuous at a e X

ifve )0, =6>0s.t.vxX lx-al < 6 t I{6d-(d1.,

This is the neighborhood idea we mentioned previously. f is continuous means: iJ we

want to restrict flJ values in any arbitrarily small r -neighborhood, we only need to
choose small enough neighborhood ofx values around a. In other words, if we can do
this regarclless ofhow small the neighborhood offld then fis continuous.
Alternatively, we can also define continuiry in terms of seq. Letx V c
if X seq (x-) in V\{x} withx-) x or if such a seq & lim u-* f(v):
continuous at point x.

R, I V ) R;
(x), then f is

Third way is to define continuity by open sets. This approach is most general and easiest
to gxtend to more abstract sDacs:
-. .- ^-1^:*
f is continuous rn X
ifff -'(W) is open in X whenever W is open in Y
continuity definition is extended to topological spaces as:

f: (X, Tx

)) G Tv ) is continuous if frflID T* whenever W T'

We know continuity is a local concept because we define continuity of f at a point. lf f is

continuous at each point on an iatervayset, we say fis continuous on an intervaVset. But
ws still have the "each point" local concept.

To extend this local into a global concept, we need to extend continuif based on
uniformity:

) (l

Given f: (X, dx)

dv), f is uniformly continuous
if for every real number e > 0, I6>0 such that for all x, xo
we have that dr( f(x), f(a)) < e

X with dx(

x, xo)< 6,

fintuitively, funiformly continuous means fnstly srnall changes in x I small change in

f(x) (continuif part); secondly the size of change in f(x) depends solely on size of change
in x but not on the porn I x itself (uniformity part).

In other words, uniform continuity is a global concept.l

s9

Note:

Uniformly continuous functions are continuous but not conversely. (e.g. (x) : 1 I x, x
0, changes in f(x) become unbounded, hence not
uniformly continuous).
2. A function f that is continuous on a closed bdd interval is also uniformlv continuous

l.

R*' is continuous. But as x )

on that interval.

[f

we move back to real space R2 with Euclidean distance function ll . ll , then denr of
uniformly continuity becomes the familiar: if for any e > 0, f 6 > 0 such that for all x, xo
Rwith llx- xo) ll l< O
ll (") -("o) ll< t

[Concept of uniformly

continuif

'

can be generalized into topological vector space.]

Econ application: Ordinal utility theory

Deftr: Given set g

x|

Z-dense in X.

2 y, then S

is

preordered set (X,

>)

(TR). If

Vx,y Xwithx>y,

!z

Ss,!

represent preference relation as we know it in Econ; and X as

econ agent views altemative x to be
{ outcomes} or {conunodities} or {alternatives}
at least as good as alternative y ifx 2 y
including strict preference relation ) and

kr particular, let

---

indifference relation

on X.

We let preference relation on X to mean preordered set (X, >)

Reflexivity: x ) x is easily acceptable as rational behavior

Transitivity: is usually accepted as a rationality hypothesis. i.e. if you prefer x over y and
y over z, then you will prefer x over z.

Vx,y

Note for Completeness: you must know x )y or y

1
X. There will be
objections that this be included as rational behavior since many times we don't know.
For instance, trying to decide whether to go to Chinese U to study Chinese literature or to
HKU to study madr. Unless there is complete ordering in such n-dim choice set, we may
be indecisive.

Defir: Given

(X, )) where ) is the above preference

U.(x) ofx is defined as:

preordered set

weak upper --contour sets

U.(x):{yeX:y)x}
Analogous defo for stict upper )-contour sets U, (x) ofx:

U,(x):{yX: y>x}

reln.

Vx

And weak/stict lower )-contour sets L.(x) / L, (x) of x:

L.(x):{yX: x)y}
I-,(x):{yX:x>y}
In order, to do utility theory in Econ, we need to find the class of preference relations that
can be described by a utility function and then maximize the utility function.

* Sc

Defir: Given 0
Function u:

x.y

S)

itr

any arbitrary set X and preference relation

R represents

u(x)

on X.

onSif

- u(y) Vx,yS.

If I

such function u, then u is called a

representable.

utility function and preference relation

is

Note such a utility function is not 1! As any strictly increasing self-map f(u): u(X)
R
can also be a utility function.
.Hence this is an ordinal (order only, noi for calculations,
not cardinal utility function) utility concept.
U

^r-p^.-t--*

Hg) -t'l/'7L

ithei x > y or

T\nt: 0 #

y>x

X is a countable set and ) isa complete preference relation onX

representable.

BirkhoffTlvn:0
countable

X is a set and

l-dense S c X, then

I )

is

is a complete preference relation on X. If

representable by a utility function u: X ) t0,11.

[A lexicographic preference reln on R2 is not representable by a utility function.]

A preorder which is not

complete cannot be representable. In 1960-70 people (M.

Richter, B. Peleg) were trying to relax the completeness assumption. They modified the
utility function u: X ) Rto:

x>y

u(x)

>u(y) AND

x=y i

u(x) = u(y)

called a fuchter-Peleg utility function.

Lemma [Richter]: Given 0

X and is a preference relation on X.
X contains a countable )-dense subset
3 a Richter-Peleg utility ftnction.

range R is
fRichter-Peleg utility firnction: domain X is not completely ordered
completely ordered. Hence there will be cases of indecisiveness or agent cannot compare
the altematives.
Shortcoming: (information contained in Richter-Peleg u) is < (information contained in

>\
Because uG)

> u(y) only tells

us

y is not strictly prefened over x but does not say econ

agent actually prefer x over y.

One possible way out is to use a set of real-valued functions as

preference:

SetU: X

R represents

[e.g.: givenR",n

) iff

>

itr

> u(y) Vu U Vx,y

2.

We represent the partial ordering

Thus

u(x)

utility index to represent

ui(x) 2

by a setof utility frrnctions u i(x)

ui(v) i:1,2,,....,n

=xi

V x R"

We now move the above analysis up to the metric space level.

Defu: Metic space (X, dx) and ) is a preference relation on X. ) is upper

senicontinuous if strict lower contour set L> (*) :{ V X: x ) y}is an open subset of X;
and is lower semicontinuous if U, (x): {y X: y> x} is an opel subset of X, Vx
X; and is continuous if ) is both upper and lower semicontinuous.]
[Intuitively, for upper semicontinuous preference relation,

if

altemative

over y, then x is also prefened over alternative z which is very close to y.

x is preferred

Alternatively upper semicontinuous preference reln means:

Seq{y''}inX)y t:BR

Thus linking emotion

with math metric

closue of

Defu: (X,dx)andS
x).

s.t.

x)y.VmZB.
through semicontinuity.l

wrt to X is tlre smallest closed set in X contai[ing

c X. if cl x(S) = X, the S is dense in X (or S is a dense subset of

[Intuitively, S is dense in X
f. if any point in X can be "approximated" by points in S,
2. any nghd ofx N .,x(*) contains at least l point from S.l
4

{y X: dx(x,y)<.

Defu: (X, d1) is a separable metric

space

if X contails

a countable dense set.

fExample: R is separable metric space '.' Q is a countable dense subset in R]

R} is a separable Hausdorff Space with cardinality
try9*uct 19e9l9ey on {functions: R
of 2' (called beth-two, with c as cardinality of R)
separable spaces can be ..not
small".
But in general, when we talk about separable space, we think of it as not very .,large,'
because there's a countable set in this space almost the size of the space itself.
AIso intuitively, separability means the metric space has few open sets.]

We wish to have metric spaces which are "nice". Separability is .hice". (please see
below Rader's Thn.). Also all open sets can be described as countable sets oi open sets
know all open subsets of (X, dx)
know all its closed &/or connected set
know
all seq convergent in that space
know about upper and lower semicon and continuity.
other properties making a metric space "nice" are compaotness and connectednes;.
@lease see below after Rader's Thm).

Thm: Rader's Utility Representation

(X, d1) is a separable metic space and

is upper semicontinuous

it can

is a complete preference relation on X.

be represented by a

utility firnction u: X

tO,ll

Before covering compact sets in topological spaces, we need to remark on class of sets.
Gven a set X, its power set denoted by 2x :{S: S c X} ('.' if I n elements in
f 2'
elements in 2x e.g.-X: {a, b, c} with 3 elts, then 2x has lA, fu\, lb}, {c},
b},
{a,
{a, c},
cardinality of2x > cardinalig, of X. S
{b, c}, {a, b, c}} 23 8 elts.

Xt

X:

[Cantor's Paradox]:
{S: S isa set} cannotbe a set.
Assume @: {S: S is a set} is a set
[VeltSin2@:> S g @ andisasett S@jmeans2@c @
cardinality
2@ < cardinality of contradicting
So @ = {S: s is a set} cannot
be considered as a set. we can just call it a (proper) class which is a collection
oi

)
I

of

s.

sets.

Defo: (X, dy) and S c X:

Cantor's Paradox (Also Russll,s peadox a set ofan sets.)

AclassC of subsets of X is said to cover S if S c u C.

If all such subsets in C are open in X, then C is an open cover of S.
lAlternatively: class c of open sets {c 1 } with i I (an index set). c is a open cover of
S if each point in S belongs to at least one C 1l

Defu: (X, d1) is compact if every open cover of X has a finite subset also coverins X.
S e X is a compact subset of X if every open cover of S has a finite subit atso
covering S.

[Lrtuitively, compactness provides a finite strucf,re for the infinite concepts we are

dealing with.

compactness helps to extend-results {iom metric spaces into more general topological
space settings Examples are function spaces that are not metric spaoe;. For
ourpurfose,
it is very important for optimization.l
In oase of R

space, we have the

following thm.

Thm [Heine-Borel]: Every subset S G R n is compact iff S is closed and bdd.

Note this is only valid for R o space and not for any metric space because there are closed
& bdd nenic spacas that are not compact. In other *o.ds,
is a broader
concept than closed & bddness. In fact, compactness iff closed "o,npactness
+
& bdd equicontinuous.
6 collection.of functions is equicontinuous if ar the functions are continuous and have
equal vairation over a given neighborhood.)

And the important thm:

Thm [Weierstrass]: (X, T ) and continuous funotion f: X

R.
Compact S g X
f achieves a maximum and a minimum in S

Thm A closed subset ofa compact metric space (X, dJ is compact.

Econ application:

(x, dx) with x = {choices of econ agent} with

of econ agents) assumed

We

will

C(ry

+O

case

lyFwithy

2) if F is Nor

AND )

x* s.t. feasibilitv.

and it is compact.

case 1) ifF finite and since we have transitivity

findthex*Fs.t.

X where F :{feasibre choices

* Z

@ thenwe have a optimal choice solution

show that

Fc

setC(F): { xF: /yFs.t. y > x}

Define optimal choice

If C(F)

subset

>

of)

x ) C(g +

, we can always order all elts

x and

finite (e.g. infinite-dimensional commodities space)BUT compact

is upper semicontinuous:
is upper semioontinuous
L,

(x):{ y X: x )

y}is an open subset ofX for Vx in X

{L, (x): xF} is anopen

t AlleltsxF c X also u[open subsets L, (x)j )u

cover of F
At the same time we know C(F)

- {xF: XyFs.t.y ) x}= n{F\!(x*) :xF}

Suppose C(F): n {F\L, (x*) :xeF} -A
t F:F\Z:F\ n{F\L,(x*): xF}:u {F\ F\ L, (x*) : x F}: u{ L, (x*) :xF}

is an open cover

ofF.

Since F compact

) f finite subsetFF c F (F is a cover) ) Since FF finite and by transitivity of>

) I )-maxim:rl elt x* in FF and note x* F\ L, (x*) (..' x* ) ;x)
I x* must L, (x+) for some x+ e FF\{x*} (defn ofcover) ) means x* is in strict
lower contour set in FF\{x*}

FF) C(D+ o
To show C(ry + A

with

x+

x+, contradicting x* being the )-maximal elt in

is compact:

Pf: L, (x) is open set in F ) F\ L, (x) is closed subset ofF V x F

) n {F\ L, (x) : x e F} is a closed subset ofF which is compact
and [r {F\ L, (x) : x F}: C(F)
C(F) compact. (closed subset of a compact metric space is compact,t

O> opt (most preferred )-maximal) elt in feasible set; and

[Above means C(D
explains why we needed semicont and compact set as ass'mptions for Thrn Ee. To fully
prove that thm and also its counterpart thm in more abstaot spaces, we need to cover
fixed point theorems below.

Completeness properly of space

Deft: A Cauchy

sequence is a sequence in a

)B

mefic

space (X, d*)

lBRs.t.

d"

[Intuitively:

the later terms beoome arbitrarily close to eaoh other]

(x-, xn) <e forallm,n

Thm. A

seq in metric space is convergent

Thm. If
X

a Cauchy seq has a subseq that converges in

if for any e > 0,

it is Cauchy.

X, then the seq itself converges in

Deft: (X, da) is complete if every

Cauchy seq in X converges to a point in X

[Intuitively, completeness means there are no points missing either in the interior or the
boundary.
Q is not complete (points like irrationals are missing) but R is complete.l

Thm. Metric subspace

Compactness

S of complete

(X, d1) is complete iffS is closed in X.

completeness but converse not true (e.g. R is complete but not compact

because not bdd).

(X, d1) is compact iff it's complete and totally bdd.

Sc

CK, dx)

totaily bdd if any

> 0, I fuite T

T}
hfrnite
is
discrete
space
bdd
but
not
totally]
[e.g.

s.t.

Sc u {neighborhood N .,;(x): x

Reason we want completeness is because contactive self-map (contraction) on a

complete metric space has fixed point.

Defii:

map

d: X)

X on a metric space (X, d") is a contraction (= contraction

mapping) if 3 real number 0 < r < 1 s.t. d,.(d(x), 0 (V)) < r d"(x,y) V ayX.
[Intuitively, g shortens the distance between two points. S is uniformly continuous.]
a self

K
.1,--

d[e),4@)

rd'"t)

La(x-,t) > az(\eYdtas)

sn..,e

X_

| -- -aQ&)
t,@,4611

--

-cg,
\8'7

Gven

a self-map

&

f :X

X, f(x) = x is a fixed point

4()
i.|

EO

1{

In a complete (X, dv) a contraction mapping has a Mxed point. such a fixed point is
the limit of the convergent (cauchy) sequence defined by the recursive equation x
,*,
6(xJ, n=0, 1,2, ....... This is formulated in the thm below:

Fixed Poitrt FP Thm [Banach]:

Given complete (X, gs), contaction d

x*ex.

) X' l1!

fixed

point d(x*)=**

4en
4@t't)
dtrorlD))

+r,ft

l*t{

t) Qk)

r.

x-1

[The Banach FP Thm does not hold for a metic space that is not complete. The Thm can
also be used to prove existence ofordinary differantial equation solutions]

d: X)

Defo: Gven any nonempry setX and self map

X, define 6r=
0(O'),n:1,2,3,.... The self map0n is called the nth iteration of d.

Thm: Given complete (X, dx),

has a fixed

point

(x*): **,

d'

"*

(nth iteration of self map

21d 6n+r=

) is a contaction

".

[Intuitively, if the iteration results in a smaller and smaller interval (confaction), then it

converges to a fixed point. ]

flteration is the starting point of recursive methods, difference equation and its phase
diagrams.l
Derivation ofgenera.l solution formula for l$-order linear autonomous difference equation:

xt = bxt.r *
We

a, b constants

start iteration for t = 0, l, 2, ....,t

xr= bxo + a
x:= bxr + a = b(bxo + d + a
=b2xo+ba+a

[2

1s+a(b+f)

xe= bxz + a = b(bsxo + a(b +1))+a

= b3xo +bza +ba +a

a:
a,

bsx

= bixo

a( bz +

a(bfr

b+

1)

bt2 + ... + b+1)

But geometric progress of t terms of sum

1-bt
1-

(bt.r +bt.s

ifb l1

+ ... + b+ t) {

ifb=l
)

General solution (when no

initial condition is specified and we get family

by varying initial condition x o ):

{xo - [a/(1-b)]]b'+
xr

ia /(1

= {t

b* 1

-b)]

l,-

xo + at
Ifinitial condition is specified

get specific solution.

Phase diagram of nonlinear difference equation: y

tt

+-*tt

[6-6]

1r

(y

t_r)2

of solutions

[Importance of FP theorems in Math Econ:

If

.)

we wish to specifi conditions for existence of a solution x* ro a sysrem

of simultaneous equations, where the solution is in the form off(x*) 0.
ifwe can express d(x)=(x)*xwhere
Xis aself-map

d: X)

and introduce the same conditions required by some Fp theorem

t
)
t

on

(x)

into the system

there will exist some fixed point x* by this FP Thm
FP means d (xx) = x,r
f(xi) d (xx) - x* : 0 and we have accomplished what we set out to do.

E.g.

Given an exchange economy with consumer

endowment Wi :
we define an excess demand function

'.'

equil in tle market

demand :

f(p)

: ),

i's

demand D; (p) and his initial

@, (p) - W;

(when f(p)

0 means

supply).

we define o (p) = (p) + p and impose some conditions (like some continuity conditions
on f(p) and on concave utility functions, compact convex feasible set) to ensure bv
Brouwer's EP Thm I a fxed point p* (: price vector) where d(p*): p*
+ d (p*) = f(p*) + p* = p*
t f(p*) = 0
This is the FP part ofthe proof of Thm

2. For

if

game theory,

S_

I is

Es

a mixed strategy for all n players except for player i.

Define a best response correspondence g 1(S_i )toS_1

opponent players profiles ) to { i' s strategies}.

Define

(S):

O,

(S_r)x O2(S_2)t

...,

{all prob distrib over

d"(S_")

If3 a fixedpoint S* s.t. S* e O (S*) = I stratgy set which is a best response

= no player can I by deviating from that strategy

to itself

= Nash equilibrium

set up the conditions for Kakutani Fp Thm so that

existence of Nash Eouil.

d (S) has a fixed point and we get

[It is said that when in 1949 Johr Nash presented his (-Nobel-prize-winning) theory to
von Neumann. Von Neumann's response: "That's trivial, you know. Thafs just a fixed

point theorem".]

3.

Suppose we are given

an:tio1;

If f is a contraction, then we

;: (x) + c where fis a vector and c is a real number

can define self map

g(y): (y)

t g(y) also a contraction

) by Banach FP Thm f a I ! fixed point y* s.t. y* : g(y*)
I y*:f(y*)+c
I y* is a solution for x: f(x) + c.l

+c

In general, any topologioal space in which any continuous self-mapping must have

fixed point to said to possess a fixed point property. Note not all topological spaces have
point property, e.g. a continuous self-map rotating the annulus of dougbnut
this
_!xed
(or disc) has no fixed point. If annulus is filled in, then the centre will be the fixed point.

since Banach FP

Tlm

Programming DP, we
theorems.

will

provides the theoretic foundation of Bellman Dvnamic

cover this subject first before rehrning to various other Fp

ffi'#ifi;3,Hf*i"ffffi.i,
I

Lemma: S a nonempty set and 0 +X c

closed under addition by +ve constant function

B(S)

Gven increasing self map @-. X

and

0<5<l

s.t.

oeaosf

meansfext f+aX

r'

,gXandf

-g)

O(f) > O(g)

@(f+a) <O(f)+6a

is a contaction

Given following functional equation (note fon both sides of equation):

(("):

max

(x, y) + 6 f(v)}

o<x,y <

0<6<1

with d (x, y) being any continuous mappilg: [0,1] x [0,1]) [0,1J x [0,1]
Note:

1) d
2) 0

(x, V) obviously bdd real function (hence complete).

(x, V) is closed under +ve constant function addition
'.'@ (x, y) continuous
O (x,y)+a with a> 0 also continuous

Note: rD: C[0,1]

{[0,1] x [0,1]]

\set of continuous

real functions on [0,1]

And O maps a continuous function to a continuous function

(D

is a self map on C[0,1]

Iff(y) -g(y) t d (4v)+6(y) > d (x,y)+s g(y)

) max{ O 1",y;+6f(v)} ) max {O (x,y)+Og1y;;

O(D

>

(D

(g)

@ is an increasing self map

Furthermore

@(f(x)+a):max { O (x, y)+ 6 ((y)+ a)}

: max{ g (x,y)+d6(f(y)}+6a
< O (f ) + 6 a
Then all hypothesis of above lemma is satisfied and @(f) is a contraction.

) l ll
=f

fixedpoint

O(f*)=f*

fC[0,1]

* solves the functional equatior f(x)

max{ g (x, y) +

f(y)} with

which is called Bellman's functional equation.

<x, y< I

0<6<1

One other property of metric space is comectedness.

Deft: (X, dx) is connected if /

X1u X2 :X

2 nonempty and disjoint open subsets

X:, X:c

s.t.

[tntuitively, metric spaoe is connected if cannot be written as union of two or more

disjoint open sets; so pizza is connected brt two separate pizzas each representing a space
!s not connected. As an aside, douftnut is not path-connectedl

We shall return to our discussion on Bellman Dynamic Programming later. First let us go
through the other fixed point FP theorems so that we can wrap up our discussion on
classical welfare tleorems and game theory.

Observation: Connected sets 6

a:

{all intervals

on

R}.

Lemma: Given metric spaces (X, d,.), (Y, dy) and continuous function
Xconnected

X)

Y.

fOO cormected c Y.

Pf: Assume f(X) not connected

s't' Or U Oz= fCXl)'

Foraayxe f -t(Or), f(x)

f:

3 2 nonempty & disjoint open subsets Or , Oz of f(X)

) -

>0s.t.N .,y(f(x)) cO1

Furthermore fcontatx + f 6>0s.t.f(N 0,1(x)) cN .,y(f(x)) butN .,v(f(x)) eOr
) f(N a,1(x)) c Or. Alternatively, N o.;1x) cf-r(Or).
-r(O1)
-t(Or)
Since x is any arbitrary x e f
nonempty open qX.
,t f
Or whichis open

,, . ^-t-^,
^.
Smllarly 1'-'(O2)
nonempty open

cX.

nonempty open f 't(Or) , f -t(Or) must be disjoint (if they are not disjoint
Or anp 02 with
(x) Or and (x) 02 contradicting Or and 02 are disjoint,
-'(Oz)
-'(O1)
hence f
must be disjoint.)
,f
Moreover f -1(O1) U f -t(Or):f -r(Or U Or):X, contradicring X connected
must be connected.
These

) !

) ffi

Actually the simplest FP thm is the lntermediate Value Thm IVT. (= l-dimensional
Brouwer's FP Thm)
Version I of Intermediate Value Thm IVT
(K, d") connected and continuous function f:
R.
(x) <c < (y) anyx,y
latleastonez X s.t.

X)

X)

f(z):c.

above lemma (X) connected

(X) interval in R and on this interval,
R
every point is : to some f(x).
any c in the interval (x)<cSf(y) must: to some f(z) ,

Pf: From

tf
,Tl
JI

)l
sl

z X.

llol
f cont & X, f(X) connected
) no break in fgraph and [x, y]
) f going from f(x) to (y) must
go tlrough e : (z) and cannot skip
over it.

fq-)
fG)="
!e>

v
x-

c*__

*3-o^

IVT Corollary
Case 3) f(0) > 0,

ftt<
x*,

f(i) < 1

from (0) to (1)

must cut 45o line
'.'no break in f graph and
Cannot skip over 45o line

fcont

J&*)

Real life example inciudes: continuous water evaporation over time, temperature change
or fever over time:
Or lost 30 lbs weight over 15 day

sometime

-w
l.a*

3olh l--

lo t+

l0

t5 )4

withil the 15 days must have lose 9 lbs.

Version 2 of IVT (Bolzano)

[a,b] nonempty, compaot, convex QR, f continuous: [a,b]
3xx [a,b] s.t. f(x*):0.

Corollary: f continuous

[0,1])

3fxed point xx [0,1]

Pl

Case

1)

(0):0 )

Case 2) f(1): I )

s.t.

R and f(a).(b) < 0

[0,1]

(x*) = y*.

done.
done.

f(0)>0; f(1) + 1t f(1) < 0 @lease see diag on previous page)

Define F(x) = f(x) - x. Note F : [0,1] ) R and continuous
And F(0) = f(0) - 0 = f(0) > 0 and F(1) = (1) - I < 0 t F(0).F(1) < 0 and by above IVT
Case

3) f(0) +

3x*

0t

[0,1] s.t. F(x*):g also =

f(x*)-x*

I (x*;:t*

frxed point.

Converse of IVT does not hold. E.g. f reai-valued function on interval

and Vu ((a), (b), 3c (a, b) s.t. f(c) =u
fcont?
No! e.g. (x) = sin
x *O and f(0) = 0. f has FP but not cont.

llx

I.

Any a, b

Above corollary is a special case of a more general FP thm called Brouwer's FP Thm.
Where cont f: S ) S and S no longer: [0, 1].

Retraction: (S, ds) metric spaces c metric space (X, d*)

continuous function f: X) S is a retraction if f(x) = x Vx
(x, d,.).

S and (S, ds) is a

retract of

[Intuitively, every point of the codomain is a fixed point of the function f. Note R can be
condensed continuously by the foliowing cont f into [0,1] in a way to leave each point in
gr"
[0,1] intact (x) 0 for all x < 0 and f(x) = 1 for all x > 1; for 0 < x < 1, f (x)
"
identify map.
Note [0,1] cannot be condensed into (0,1).1

Metric space (X, dJ has FP property (every continuous self-map f on X has a fxed
point) does not guarantee its mekic subspace also has FP property. E.g. [0,1] has FP
property but (0,1) does not.

If

Lemma @orsuk)
(S, ds) is a retract of iX, d"). (X, dJ has FP property
also has FP properly.

Brouwer's FP Thm: S nonempty, convex, compact

Rn aad continuous

fxed Point x* S s.t. (x*) :

f: S )

(S, ds)

1*.

a0

Pf:

Please see Border (uses Sperner's Lemma

in combinatorial topology).

[sketch of an altemative pf:

unit sphere So in a normed vector space V = {v
ll v ll = 1} a closed unit ball
n
Bn in a normed vector space y= {v
ll vll < 1} and in case of Ro, 5 =1112 +
x22+... + x"'?= 11 andBD:{x12+ xz2 + ...+xn2< 1}. Note the borurdary of Bois a
sphere S o'1 (e.g. projecting a ball in 3-dim space onto 2-dim spaoe we get a circle).
'.' B n is nonempty, convex, compact G Rn , we can rc-state:
a

V:

V:

Brouwer's FP Thm: Every continuous function f from closed unit ball B "
B n has at
least one fxed point.
Lemma @orsuk) fl any retraction fiom B n onto S n't n = 1,2,3, .....
[Intuitively, there is no oontinuous mapping from all the interior poinls of a disk onto the circle
forming the boundary ofthe disk.l

I
Take any x in B and f(x) #x
caa draw a straight line
-r
joining x
f(x) and extend the straight line to cut S " (at the boundary) at g(x). g is a
continuous function: B o
S'-1 and is a retraction, violating above Lemma @orsuk)
must 3 FP x* f(x*). l
Suppose X FP

x*

--

f(x*).

fNotes:
1. Generalization of Brouwer's FP Thm into infinite dimension by extending unit ball in
a Euclidean space to one in a Hilbert space is not true '.' uait ball in infrnite-dim Hilbert
space is not compact. So such generalization require additional compactless and many
li-nres convexity assumptions on the space.
2. Above Thm does not hold for open balls.
Brouwer's FP Thm is used to show existence of solution to differential =.tions,
existence of CE and existence of equilibrium in Game Theory.]

3.

Examples in real life application of FP Thm:

Directory map of HKU campus, airport, subway etc and point "you are here" is a fxed
point. Map of the world on the floor--some pt in the map lying directly over the point it
represents. But if you are haveling in a space ship, drop world map on space ship floor
will not result in a FP because you are outside &e set S.

Application of Brouwer's FP Thm: to prove existence of

a C.E.

in an exchange economy

(no producti on).

Consumers

i:

1,2,

.....,I

commodities

i's consumption bundle vector x;

=(

x1 , xiz,

& his initial endowment c; : ( c;r, c;2,

1,2, ..., J

...,x;:)

xi

rt'* n

. . .. c.ts)

x3, . . ., x1)
pricevectorp: (pr, pz, p:, . . ., pr)
allocation x

(x1, x2,

Ary

*' e R.'*)3 yi Rn*

neighborhood of x;
.s.t.

u ;(y;)

in

> u i(x1)

Assuming existence of a continuous, strictly concave and locally insatiable utility

frnction u i(xi): non-negative quadrants R: o ) R Vi. And assume X q < Q,
making the feasible set closed and bdd (i.e.compact).
So we have a set of utility functions {ui(x)}

[f

utility function is concave but not strictly

concave, we need Kakutani's FP Thm to

prove.l

f: X ) Y, argument of the max

argmax(x)={x X: f(x)}(y) Vy X}

For a function

Define C.E. (x*, p*) as

x;* arg max{u r(xi): s.t. px;

2. lxi *: Ii

ci

Define function

difu):

<pc;(budget)&0<x<Q(feasibility)Vi}

arg max{u r(x): s.t. px; -< pc;(budget)

& Ixi S Ici < e

Vx R.'* )
This is the most preferred bundle in the feasible budget set : demand by i (analogous to
derivation of demand function ftom the l'r order condition in utility max).
Since u(x) continuous, stictly concave ) d 1(p) well defrned and single-valued V p.
(feasibility)

ITerminology:
the standard (=

6it)

N:

n-simplex denoted by
{(r,, Xz, X:, .. ., *t)
Ii xt-1) ( Intuitively it is the n-dimension analogue of a triangle)
0-simplex is a point
1-simplex is a line segment plus all interior points.
2-simplex is a triangle plus all interior points.

R.':

x1

} 6 66

3-simplex is a py'ramid tetrahedron plus all interior points. (viewed from above X )
4-simplex
Given a regular (n-1)-simplex, pick a new vertex and join it to all original vertices by a
common length edge to form a regular n-simplex.
In topology, simpiexes are the simplest convex sets.
Note: all balls and simplexes
the same dimension are homeomoryhic,
(homeomorphism = topological isomorphism = isomorphism between topological spaces
which preserve topological properties. Hence homeomorphic spaces can be considered
as same topological spaces)
balls and simplexes are same in topological spaces.]

of

l)

For any a> 0,px; < pci E apxi < apci which means dro) = d(a p) because the
budget constraints remain unchanged in the optimization problem when p is scaled by a
in our optimizatlon, we can scale any price vectorp'by letting a: |
p;' s.t.p;.)
newpricep:'/E pi' and summation of all these new prices
(pj' / p; '
1 (i.e.
normalize the price vector) F-9
for the following analysis, we can just use normalized price vector which means our
price vector p {p R" * and p: =1 }
p unit simplex N in Euclidean space.

/\
Ij

):

2)'.'dr(p)generatesmaxutilityinfeasiblebudgetsetsoforanyui(x')>ui(di(p))then
such \'must be outside the feasible budget region with px i ' > p d ;(p)

3) if x;* solves max{u 1(x): s.t. px;3 pc; (budget) & 0S x s Q (feasibility) V i} aad
suppose px1* < pci) by local insatiability assumption 3x;'in neighborhood of x1* s.t.
px 1' < pci and u i(xi')> u 1(x;*) conhadicting x* optimal ) pX i* = pci conshaint
binding.

Lemma (Walras Law)

Pf: by3)px1*:pcr

p Ri*and p. [}(dr(p)

pxi* -pci

:0*

- ci)l =0

p(x;* -ci

summing over all iwe Betp.[Ii (d;(p) - q)] :0

Lemma:
t)

Pf:

lim

sequence {

p, } in A'=p,

then

d;(p;

oo

Please see Vohra.

We defme an aggregate excess demand fimction

says

d;(p)

)=0 V i

p.E(p):0

B(p)

XrI (d

iO,

ci

) so Walras Law

Standard procedure to prove existence as we mentioned is to let function p + E(p) to have

a frxed point i.e. let -p*
p* + E(p*)
E(p*) = 0 or p* will make aggregate excess
demand function to be zero and supply demand for the equilibrium.

We use a variant of the E(p) function, call it g(p), for the proof:

Defrne g

(p):

(gr (p), crb), ...,g1 fu) ) on An

- crj)} i (Lr(p.+max{0, |1(di*b) - ci.)})

c,.;)} / (l+I'r max{0, Ii (di,(p) - ci.)})

CjO) = p;+max{O, L(dt(p)

:p;+max{0, |i(dii(p) -

Note this is a variant of normalization of price F-9, modified to have nonnegative excess
demand of all p.

t
l.

g (p): (er (p), crfu), ...,sr (p) ) is a continuous function by above lemma and also
g,(p) = 1 so g:
)
^^"

^^"

By Brouwer's FP Thm f fixed point p Ao s.t. p=

(unit balls and unit simplexes are homeomorphic).

O)

p.i = g:

b)

pj:pj+max{0, }(d,;(p) - c,t)} / (1+I",'max{0, Ii(di-1p) )p: (1lX-'max{0"L(dr.6) - ci"')}): p;+max{0, }(d,:(p) -"-)})
c,:)}
lp;,' max{0, Ii(di.b) - ci,)}):max{O , l(d,:(p) - c;1)} [ff-10]
rib) - c i)} > 0; and we only need to look at cases where
pi > 0 (we restricted ourselves topl > 0andifp; = 0, commodity j is afree good and all
We know that max

{0,

tr

(d

consumers will consume j up to tl-re constraint

supply ofj = demand ofj in market j).
case

1) max {0,

(d,:(n)

c ,,:)}

and

(d ri(O)

c11

):0

and we have

p; > 0

) (:,'max{0, !; (di.G) "r)}):0

) each max {0, } (d ^(p) - ci-)}:0
) X, (d;-(p) - c;') < 0
Again we only need o look atp,n >
demand in market m):
Subcase
Subcase

l-1) ifXr (di,(p) - ci.)

1-2) if

Ii

(d

m(p)

0 ( if p,n:01m

is free commodity and supply =

- c i-)

0 we have supply = demand in market m< 0 and p- > 0

>

)p* Oi(d^G) - ci.)<0 Vm

) Lp. Oi (di.(p) - ci.) )<0 violating Walras Law Lemma
) we can only have Ii (di,(p) - cin) = 0 and supply = demand in market m

case

2) max {0,

[F-10]

) (tr

and for p;

max {0,

(d,:(p)

,p. >0

(d",(p)

ci.i)}

- ci-)}) > 0

I some m s.t. l; (d *(p) - c;-) > 0

* p ^(Xi (d'-(p) - c,-)) > o
t t* p'" {x; (d l"b) - c *) ) > 0 contradicting Wal ras Law Lemma
) can only have Ii (d,-(p) - ci-):0 and supply = demand in market m
So in ;'all cases, we have sunnlv: dernand in eech msr!.et and the f;xed poini p is.uhc
equilibrium price guaranteed by Brouwer's FP Thm.

Kakutani's FP Thm generalizes Blouwer's FP Thm in a slightly different direction. We

stay in Euclidean space R n , * compactness + convexity, but now look at set-valued
(:multi-valued
point-to-set
multifunction) functions called correspondences, in
particular semi- and hemi-continuous conespondences.

Terminology:

Correspondence
: eachp point ofa setX 3 subset ofthe setX.
3 for multi-valued functions). So now f(x) is a set c X.

(use notation

l:x32r/{a}
If f

(X)

X then it's

For correspondence
Correspondence

xX = f (x)c

a self correspondence on

X.

(x) , a fixed point x* means xt

l(x)is:

convex-valued
2) closed-valued

1)

For both firnctions (point-point)

the graph, denoted by Gr is:

>

(x*).

if I.(x) is a convex set, VxX.

if | {x) is a closed subset c Y

Y and conespondences (poinfset) I-: X

Grf:{(,{,y) Xx Y y=f(x)}

Gr

| :{(x,y) Xx Y y |

3!

(x)}

Since now we are dealing with correspondences, we wish to have the concep of
continuity to be consistent with continuity in the single-valued function case: i.e.
if we collapse a multlvalued correspondence continuity to that of a single-valued
correspondence, we should get the ordinary continuity notion. [Intuitively, ordinary
frrnction continuity is a graph showing no breakl. We can do this either by upper
semi/hemi continuity or by lower semi.&emi continuity of correspondence.

('jeuwa.r

\a^ f

+&,t

.?
tl.a!\

$.@q)

(*vt-<{-o..J.a^<t

Ytr-t

*D

And we know that to understand Kakutani's Thm properly, we need to clarify the
analogous concepts of continuif for both single-valued functions and multi-valued
conespondences.

For single-valued function

.-.. f
Defir: Given G, dx): f: X) R is upper semicontinuous
Topqlggrg{l qpace

ifforanye>0 3

6 > 0 s.t.

d1(x*,y)<

(u.s.c.)

atx* X

6 )f(y)<(x*)+

e Vyd;(x*,y)

f is u.s.c. if it is u.s.c. Vx X.

[Intuitively, fis u.s.c. at x* means points ppp nearby x* )

1. (ppp) not > f(x*) by too much but can be much lower; or
2. f(ppp) very close to or < f(x+)l

Example:

x' foro<x<1
f(x): { 15 forx:1
1-x for I <x

is not continuous but is u.s.c.

Ofct)

l.>

$ ,r-s.c.

0,5

atx-

,F{
z5=t

aE x!=

X
J.'

t
Given

(X dx): f: X) R is lower si:micontinuous (l.s.c.) at x* X

ifforany+g f 6>0s.t.dx(x*,y)<6t(V) l (**)- Vydx(xn,y)

f is l.s.c. if it is I.s.c. Vx X.

flntuitively: (ppp) very

close to or >

f(x*)]

t;,n*

fc*:

v,s.c .
Y\q
F,Of uJ. C,

t)

cert)

'.'

L.s.c.

tcrit)J

(a

In real space:
Altemative defir:

f: X c R') R is u.s.c. on X
if VrR {xX: (x) 2 r} isclosedinX.
= {x X: f(x) ( r} is open in X.
Alternative defu: f X c R.') R is l.s.c. on X
if Vr R {x X: f(x) ( r} is closed in X.
= {x X: f(x)

>

r) is open in X.

u.s.c. and l.s.c. is a weaker notion of continuity.

Above f(x) is continuous on
f(x) is both upper and lower semicontinuous.

X iff

The reason we split the definition of continuity into u.s.c. and l.s.c.:

Most students lmow that real-valued function over a compact set X assumes its max/min
in X if f is continuous by the following theorem:

Weirstrass Thm: (X, da) compact and continuous f: X

J x, y X s.t. (x): sup fCX) aad (y): inf fCX)

,v7

bound

supremum = least upper

foraselS & if a bouod s.t. set S is
=
bdd fiom above. then
tie smallest ofthese
upper bounds is sup

infimum:

greatest lower bound

But actually f only needs to be u.s.c. to get the max and l.s.c. to get the min:
Lemma @aire) (X, d1) compact and continuous f: X
1)fu.s.c.
s.t. (x):sup f(X)

2)fl.s.c.

) I xX
) I xX s.t.(x):inf f(X)

Application: we only need

u.

s.

continuity for preference to be representable by utility

function.

Rader's Utility Representation Thm II

(X, d1) separable aad ) complete preference relation on X. Then
) u.s.c. ) ) representable by a u.s.c. utility frrnction u: X) R.
Debreu's Utility Representation Thm
d;) separable and ) complete preference relation on X. Then
) continuous
representable by a continuous utility function u:

([

In fact

I )

continuous (/u.s.c.) utility representation

for> iff

X)

R.

is continuous (/u.s.c.)

We now look at meaning

ofcontinuity ofa multi-valued correspondence

Terminology:

[CAUTION: In the literature, especially in earlier textbooks (e.g. Tatayama [1985j),

semicontinuity (s.c.) is sometimes used both for single-valued functions and for multivalued corespondence. More recent publications us-e semicontinuity for frrnctions and
hemicontinuity (h.c.)for correspondences. However, we can usually distinguish between
the two by looking at the function/conespondence in question.
Confusion will oniy arise if we are discussing real-valued single-valued correspondence
because a semicontinuous real-valued frmction f (single'valued function) is not a
hemicontinuous cortespondence (multi-valued function) unless fis continuous.]

Defn: given (X, dx) , (Y dy)

correspondence f:X 3 Yis compact-valued
(i.e. if image is compact subset of Y).

if l(x) c Y

is compact

xX.

[We leamed the following 2 definitions already. Here we just state them again but this
time in terms of metric spaces:
dv), correspondence f :X 3 Yis closed-valued if f (x)c
Deftr: given (X, dx) ,
Y is closed.
fis convex-valuedl
AND Defn: ifY
and l(x)convex V

(l

c R'

xX,

is not standard and is defined differently by different writers.

E.g. Berge required compact-valuedness in his defu of upper henicontinuity (u.h.c.)
The general defrr ofu.h.c. is dfferent from Berge's definition ifimage set Y is not
compact. When compact-valuedness is absent, Berge definition becomes the definition

[CAUTION: Defn of h.c.

of closedness of at x. However in most econ writings and applications, and also in

our notes, compactness of image set Y is usually assumed so this normally will not
is mapped into a compact
present any problems. Specifically, when closed-valued
space, Berge's and the general definition of u.h.c. coincide.
u.h.c
Observations: Y is compact and I is closed
is closed.l
AND is u.h.c. & closed-valued

) f

Thm: Topological

spaces

I f

X and X correspondence

l: X 3l I is u.s.c- inXiff |

closed in X and Y is compact.

To extend continuity concept from single-valued fimction to multi-valued

correspondence, we define hemicontinuity.

General Deftr:
Correspondence
a neighborhood

isu.h.c.atx ifwhenever x is in the upper inverse ofan

ofx also in the upper inverse of that open set.

I.

Conespondence
Y
V open O

-'(o)- { xexs.L F(x) co} voc

|:X 3Y isu.h.c,atx iff upper inverse image f-l(O)isopeninX

(Y dv)
correspondence f: X 3 Yis u.h.c. at x X
if Vopen subset Or c Y with f (x) c6r, I
Given (X, dx)

open set

6 > 0 s.t.

O{o,x(x)) qOr

Alternative Defn:
from
from X and seq{y
: X 3 Y is u.h.c. at x X if any two sequences seq{x
"}
"}
Y compact, with:

x,,)x; y"f(x,) Vn; and y,) yY

) y f (x) (i.e. seq {y"} f (x") ) some end point y, if endpointy l(x)
then u.h.c. at x)1.

Alternative Deftr: Correspondence

Gr

={(x,y)

Xx Y y |

Defn: If u.h.c. V x

then

X e Rl

X (compact) is u.h.c.

if

(x)}isclosed.

is u.h.c. on

[When u.h.c. (and similarly for l.h.c.) concept is reduced from set-valued conespondence
to single-valued correspondence (essentially like a single-valued function), then
fis a continuous function
single-valued correspondence fis u.h.c.
(similarly
Every u.h.c.
for l.h.c.) single-valued correspondence is a continuous
frrnction and conversely.
AND a semicont real-valued function is NOT a hemi-cont correspondence unless it is
also continuous.]

itr

[Intuitively,
u.h.c. at x means small change in x

image set

(x) to suddenly becomes larger.

Alternatively,
l) if move from point x to nearby point x' there will not be any point in | (x') that is not
nearby to some point | (x).
2) as we move from x to nearby x', | (x) will not suddenly contain new points.
3) image set | (x) can implode but not explode given small change in xl

Numerical example:
Conespondence:

f :R3R
:
x<0 f (x) {y: x-3<y<x-1}
x:0 I-(x):{y: ,3<y<3}
x>0 I.(x): {y: x+1<y<x+3}
fNote

Vx*

R I

is convex-valued

Vx: I- (x)

u.A...

u.at

ix *e

R,

is a convex set]

is u.h.c. at x*

Check:
any sequence seq{x
from R
"}
and seq{y,} from R with:

xo)x*;
andy")

y" f(x") Vn;

limit point

Is limit point y*

Ifyes, then

y*

(x *)

R
?

u.h.c. at x*)

<0
andseqxn)x*
WLOG let x*

ifseq
note y

{y"} r(x")
o) intewal (x*-3), (x* ,1)l

limit point y* must be

I- u.h.c.

x*-3<y*<x*-1
) y* | (x*)
at

xt

x*

Similarly for

can show seq {y

|
"}
some end point y*,

and y*

(x,)

(x *) then u.h.c. at x*

Double-check for the case x*:0:

I(0) contains all limit points of f(x)
in neighborhood of x*-0 so okay.

flntuitively;

x* means when x is approaching x*

in t]le domain with y in | (x) approaching its limit
pointy+, I will findy* in f (x*) set.l
is u.h.c. at

l-.A.c

d' f=o

*t *1fx"\ *

-:

t
rf

c1

f1-3 ,^.,r

1n-+

3.el-e<".)

o ere)

Numerical example:
Correspondence:

x<0 f (x) :
x:0 r(x) :

f :R3R

{y:
{0 }

x>0 l(x) = {y: x+ 1<ysx+ 3 }

Note I]

ris

-h... il z*1o

nt

R-

u,&.c,

aJ

z'x

=o

sfill cnnrrev-',ol"o.l

Vx*R x* *
'.'

x-3Sy<x- 1}

is u.h.c. at x*
same as above example.

But at x*

0 not u.h.c.:

WLOG, any seq{x

and

,}> 0 from R

seq{y"} from R with:

xn)0 ; yn e f (xn) V.,;

*d yo) y* >2
so

y* 4 |

I I

(0)
not u.h.c. at x* = 0

f
,:

v,c+

qt

L,l..c. or

r-x=o

&- o H 4f 1,3,,'v rF,,>

r$. g. -+ o (f@>

I'ell

xl
hct u.t.c.

ax

*t

Ye>

T,^
./'"
L.las.
at4o

ltt

I
6 zrz u,j,-c

wf u,Le,

ttat

tn.4,

t,t,c.

fu>

xtr-

t-.t

.c

"t

xg3

e:

hsd,*

t.h.

c"

a.-.* L.A.e.

u+

t
I

vl

fu'.]

"/,2

al

tl

x.>

/,,

el1

r.)tf,,
g

'4|
4xt-s.,-

I"rffi-{

7t

X'1,a

vEt

I [!^1e tTxn\ sf, t" *

t''+

v.\

1-

:ft-3eGc**)

'+

rt

>rR
,a.-+t

Defn: correspondence is l-h.c. at x if whenever x is in the lower inverse

of an open
set
a neighborhood ofx also in the lower inverse ofthat open
ser.

r -(O)= {xXs.t. f

(x)

nOl u } VOc y

f :X 3Yisl.h.c.atxX iff lowerinverseimagef_1{O)isopeninX

Given

VcpenO G

()i dx), (y, dv)

f: X :i Y is l.h.c. at x X if
VopensubsetOr c Ywith f (x) nor I @, I6>0s.t.

correspondence

Vx'N6.11x;.

[.h.c. means any element in

Altemative Defn:
compact, with:

l(x,)OO1

(x) can be approached from all directions]

f :X 3 yis l.h.c. atxX

ifany 2 sequences

inX

{x,}

andyis

x")x andanyy f (x)

I - seq {y " } in Y such that
y")yand y"e t(x") Vn
If l.h.c. V x X then

is l.h.c. on

X.

Deftr: given (X, dx), (X dv)

correspondence f: X 3 yis continuous at x X ifcorrespondence
is both u.h.c. and
r.n.c.
at x-

It

is continuous

[Intuitiyely;

if it

is continuous on whole set

is continuous at x means small change in

suddenly becomes larger upward or downward.]

image set

(x) to

]hile we are on the subject of correspondence continuity, we cover the following Berge
Maximum Thm.

Maximum
Given

Thm

@ergg Debreu)
space ofcontinuous real maps on

(l dv), CX, dx) and

compact-valued correspondence B:

Xxy

3 X; uC(XxY).

Define d(v): ar-g max{u(ay): x B(y))

VyY
and u*(y) = rn*{u(x,y): x e e(V)}
,'C\,
V .)er
continuous at some y y
1) d: Y 3X compact-yalued, u.h.c. and closed aty
2) u*: Y R is continuous at y

IfB

)
S

nonempty convex set

R", function f: S) Ris

x + (l_a)y) > min{f(x), f(y)) Vx,yS
f((l, x + (l_a)y)
min{f(x), (y)})

if(ct

stricdy qu|si.concrve
(quasi.concave

if

,v

[ifu

strictly quasi-concave

,0<cr<l

<-Y 4

d is continuous]

ha.,',r...,k J

fPlease note l.s.c. of u is necessary for Maximum Thm]

[when optimizing continuous real-valued firnction over compact set, and the compact set
is varying continuously with some parafteter vector, then opimal
*iution..tir ri ufp".
hemicontinuous correspondence with compact values
= optimal solution changes upper hemicontinuously when constraint set chanees

continuously.

knportance of Max Thm is that it tens us whenever constraint sets (rike

budget set) and
^maxrmands are continuous at x*, then the set of maximizers is u *"tt-u"t
uuJa u.t .'".
correspdence at x*. Thus letting us prove various important math
tlreoi"ms.

"cono-i"

From Berge Maxm Thm can

to Michaer Serection Thm for fhe suffcient condition for
selecting continuous ftrnction from the set of frrnctions in tlte correspondence

Brouwer's FP Thm

Kakutani Fp Thm.

Berge MaxmThm also provides foundation for one-sector optimal growh

model arrd
stationary Bellman DP and we will retum to this topic later.f

Application:
ln the above Maxm Thm:
Let price vector p R*n (strictly positive Euclidean space); w : wealth/income R.,*
Since budget constraint p xS w depends on both parameters p R++n and w R*and
w9 can lef Y: {(n w)} and q in the above theorem becomes a budget conespondence
B(p,w):
P*'*i 311

Y3X =

ln the above Thm, d(p, w) will then be the demand correspondence, is well-defined (bv
Weierstrass Thm), dependent on parameters (p, w)and d: R*n*l j R

ur in the Thm

can be

with u(x, (p,w))

utility function and is assumed to be confinuous with u,n: X x

y)

R.

Maxm Thm
B compact-valued & continuous correspondence at some (p, w)
1) demand correspondence d(p, w): R.,*"+1 3 R;
compact-valued, u.h.c. & closed at (p, w)
2) u* : {(p, w)}) R is continuous at (p, w)

y:

If X x Y is compact; and B, u are as in above Thm, then u* is continuous and bv

Weierstrass Thm, we can find (x*, (p, w)) to max u
we are ready to look at fixed point theorem involving concept of hemi-cont. we
firstly state different versions of Kakutani's Fp Thm as preview:

{ow

Kakutani's FP Thm: X nonempty compact, convex set c R.' and correspondence

:X 3 X is upper semicontinuous (u.s.c.) s.t. | (x) is convex-valued,
then 3 fixed point x* S with xr | (x*).

(here semicont means hemicont as

is a correspondence.)

Altemative Statement:
Kakutani's FP Thm
Let S be a nonempty, compact and convex subset of Euclidean space. Let | : S 3 2s
be
an uppr hemicontinuous set-valued function on s with the property that | (x) is
nonempty, closed and convex V x S. The I has a fixed point.

Pf:

Please see Border [1985 reprinted 2003]

chapter tr.

c.

Kakutani's fixed point theorem and application to Nash Equilibrium m

GameTheorv.

Kakutani's Fixed Point Theorem:

Graph of conespondence

Grft) is closed in product metric

X nonempty, closed, bdd, convex set G

If

G(b):

b:y+X={r;,, r)e yxXs,t.xe b(;)}

space

x X = b has a closed graph Cn@)

Ro.

b convex-valued self correspondence:

3 fixed point x* b(x*).

X)

X having a closed graph Gr(b)

fNote importance of convex-valued.

W$.

c,

cev'rS**a--'c"e*

**t Lm*gc'

+50

CotL*4-rn-lu*l*

e,"t 3 F**

?E

#F
l
(

tt>)

Application:
Game Theory: strategic interaction (action

reaction/response) of a group

of

players.

Action space ofplayer i Xi: {actions feasible to player i} V i=1,2,...'P

With game outcomesx=(xy, x2,......, xp) Xr x Xz x....... xXp:X
And payoff function of i: r;: X) Rs.t. n i (x) > r; (y) means i better offwithx:
(xr, x2,......, xp)thany=(y1 , y2.......,yp)
Action space of player j other than i: X-1 :
{ (w,, w, ...,wp_1 )s.t.w1 X.;

j<iandwl-r Xj V j>i) fori=1,2,...,P

(xi, x -J: i's action xl given a1l otherj I i players action x _i X-1
e.g. i: 5 , P*7 thenX-s: { (wt, w2. w3, w4, wo, w7 )
V

P-person sfiategic game

Defn: Given

G: { (Xi,

ri)

game G as above, outcome

i=r.2....,p }

x*

is a Nash Equilibrium NE

x* argnax { ri (*r, x-1*)s.t.x1X1 }

if

V i:1,2,....,P

and

NE(G)

{ Nash Equilibria of a game G}

If X i nonempty, compact c R.' , then G called a compact Euclidean Gane. If payoff

function zi is continuous real function: X)
R V i= 1,2,....,P then G is a
oontinuous and compact Euclidean Game. If each X i is convex and compact and each z
i(x;, x-i) is quasiconcave for any given x-i X-; , then G is called a convex and
compact Euclidean Game. A compact Euclidean Game that is compact and continuous is
called a regular Euclidean Game.

Thm (NasQ For a regular Euclidean Game

Pf: Definebi:X-t 3 Xi and b: X 3

n i) i=t,2,....p }, NE(G)
is a self-conespondence with

G: { (X1 ,

bi (x-i): argmax { ri (xi, x-;*) s.t. x; Xi }

b(x) =6r(x t) * b z (x- z)*....... x bp (x-p)
Weierstrass Thm

b is well defined

V xb(x) )

x1

t x

b;

(x-1) V i

NE(G).

Each Xi

compact and convex

X cornpact and convex (by thm).

O.

For xX and 0< cr < 1, andy,z b(x)

t
ni(y;, x-i): ni(zi, x-i)
Since ,ri

quasiconcave

z1(oy; +(l-a)zi, 11)

(all other strategies) V

I
)

>

best responses

t
min{ [ z i(yi ,x -j):nt(zi,x

wi Xi

linear combination
b convex-valued.

_;

)]

, zr

(z;,x-; ) ]

1)

)Q

b satisfies all condition ofKukutani FP Thm

bhasaFP

means

lx* b(x*): br(x-r*) x b2(x* 2*)x.......

i.e. x i * is best response action given all other players

x_

ay+(l-cr)z b(x)

By Berge Maxm Thm b has closed graph (and is self-correspondence: X

i
)

> r;(wi,

xbp (x_p*)

best response action x

_1

no incentive to change and reached a NE.

Direction of generalization of Kakutani's FP Thm:

Kakutani-Glicksberg-Fan FP
topological space:

Thm:

generalize Kakutani's Fp

rhm into infrnite-dim

Given S nonempty, compact and convex subset of a locally convex topolog.ical linear
space. Let
2x be a Kakuteni map (i.e. X, y topological spu""s; y coorre*;
X
2Yis upper hemicontinuous and (x) nonempty, compact and convex V xe

f:

x.)

) f

f :X)

has a fixed point.

Lefschetz FP Thm: applies to almost all arbinary compact topological spaces. Give
conditions in terms of singular homology (set of topological invariant of topological
space X) that guarantees
a fixed point.

III

chapter

A.

Continuous Time Dynamic Equ'ibrium

and optimal economic moders.

Review ofdifferential equations in dynamic

analysis.

Differential equations depict functions over

continuous time (any instant of time)
versus
difference equation over discrete time (points
i" tin," lirie iast rrour, this hour, next hour)
f differential

don

f difference

:tion
t

Review

differential

integral
indefinite

-variable

y = f(x)
1't order derivative

Y : (xr, Xz, x:, ...,

--""-."
r"- order partial

af af

2fr order denvative

dxr

d2y

dx

/ d.*:

f .. (x)

2od order

af
d

dxz

6xo

(xl

t"
af"-"ffi"?*il
af

.x2) = -----

dxr

dxr

+ ____-4",

oxz

I
partial derivative

a2f a2f
a xt2 a

.l
2*

totalderivatives\

(show 2-variable which easilv

'".t..a"u[

Xn)

derivative

dy/dx: f '(x)

l" r19ax

mulfivariale

d(dy/dx)

definite

,l

I
J(x)dx

\
l

----^------,_

x22

azf
o

xo2

order cross partials

a2f

a2f

dy0x2 dxrdx:

iip

^)^
o-r

a2f

6xzdxr
nth order derivative

b xz? xz

nth order partial derivatives

d\/ dx": f \x)

a"f
dxi"
nth order cross partials

6"f

dx1

dy dx called,
differentials

e.c.

(0:

8x; 6xr.......

-)

(df(t)/d0
where

-b

(t)

&

is a function

b is a

constant [f-D-9]

$olution of4 differential equation is a function (or an equation) without any

derivative or differential terms, defined over an interval and satisfies the differential
equation for values in that interval.
e.g. solution for above differential equation

(df(t)/d0 / f(t)

is: (reananging terms of [II-D-9])

= -b and integrating both sides of equation

i -t at
-bt+Cl

) f(t):

exp ( - bt +

tf(t)=ce-bt
(is

:.-bt
Cl _r1l\
"-J

Cl, C2
a

oonstants of integration

cl-cz

wherec=ecl-c2

function without ary derivative or differential terms.)

We can always check the solurio! by differentiating the solved f(t) irr
h'= -b f(l)
dfit)/dr = d(ce-"' ) / d r = c e - o , ( - b) = - b
"
and get back the original differential equatior [II-D-9].

[tr-D-10]
lll-D-l0l:

"

(O

when solutions contain unsoecified varue constant

c, the solutron is ca'ed a generar
solution (i.e' a famr.-ry of functions by varyin!
c,

When c is specified

.rtiffit

ffi..entiar

equation).

initial condition
or
solution called parti culzu or deftnite.
boundary conditions

by

+t;^14
g
e.g. spci& P as initial conditiol
lhen AB defurite solution

speci6, f(t) = 0 boundary cond ition

then AI' defrnit solution

For the above differential eouatign

tII_-D-gl, f(t) can be radioactrve erement at time t,
then the differentiar equation is d".".iuiog
il, ;onti";;;;"uy process of radioactive
element f(t) over time'rn phvsics:

Initially decay occurs faster because there is

more (radioactive) material, then slows
kss and tess (radioactive) material. 'So rate of
decay
*111*"u1.:to amount
proportlonal
of material f (t)

ifi(rfi;G-"

i.e.f(t)+ :
df (t)

rate of decay (d f

(t)

/ dt =-bf (t)

/ d0 J continuously over time. In other words

b = constant showing proportional change.

(a differcrrtjal

e{uaro! rvjft firr)ction (t) and ib derivatilie dtru

/ diJ

e g ln econ, suppose labour force L(t) grows

cnntinuously at 9% at any instant
of time t.
(i.e. at any instant of time percenfage growh
of labou,

fo.l"j

(d L(t) /

dt)

/ L(t) :

0.09 a dtfferential equation containing L &its

derivative.

We get solution by the same method as above:

Solufion: L(t)
(a!

equadon

wih I{t)

.ce 000,
but no

origiDEl difierntiat quation

check:

c rs any constant.

drivativydiffeftotials & such thar.

\\rhen we dilfej:ntiate the

dl(t) / dt = 0.09 L (t) )

solution we get bsck the

dLldt=d(ce 0.0e,1/dt: c e 0.0et(0.09)

o.ont

0.09

ce

0.09 119

The solution is a general solution.

Ifc is specified e.g.
5, then we get a particular solution

c:

L(t):

o.oet

( rt11

solving differential equations are not always simpte

Yjlf.l{ft1.:rtation,
srrargnuorward l hat is why we.have

and
different categorization ofiifferential equations,
each of which has different sorution methods.
ot"titi.o, r"r"tions are not knorm.

Remark: f can be a l-independent variable function

or a multivariate f'nction.
Following are some terminology for categorization.

Differenti al equation (oategorization )

f(x)

l-independent variable

called ordinar,v differential equations

i.e. differential equation is an

equation relating function
to its derivatives or differentials

e.g. above radioactive decay

df (t)/ dt =-bf(t)

f(x1, x2,

x:,

.,

x,r) multivariate

called pArti4l differential equatrons

(some total differential equations)
i.e. diflerential equation is an equation

relating function fto its partial/total

derivatives and/or its partiaVtotal differentials

e.g. 4+

(y-t)dy

+ (4

l+40

dt=

ot
e g. F(y, t)

and

---

dy

dy +

dt (partial

differential
equation)

Labour force gro*th functions

(dL(t)i dt)/L(t):0.0e

e.g.

dF(x, t)

(aF/ax) dx + (dFldt) dt
(total differential
equation)

e.g. in particular,

if d F (x, t) :

0 then
called exact differential ecuation
infactdF=0 FnoAg F constant
rn dynamics, F (x, t) called a stea<lv state

Terminology for firther categorization:

Order of differential equatior: order of tbe highest derivative

in the equation
e.g.

dy(t)/dt:ke et

l$ order (ordinary) differential equation

'.' highest is
e.g.

d'?r1x;

dy

x2

dx

d,

2no order

order derivative and l-independent variable

(ordinary) differential equation

'.' highest is 2nd order

derivative and l-independent variable
e.g.

2f(x1,

xr)

+ & :5

2N order partial difterenttal equation

a xl2

'.' highest is 2nd order derivative

and multivariate

e.g. n >9
aof

+
d xrn

aef
__-_____

* xt :5

nth order partial differential equation

6 *un

Degree of differential equations:

highest power to which the highest order of
derivative is raised.

e.g dy(0i dt=ke

d4f(x)
----------

ox

e1

+ x7 :5

^
{--:-}'r
dx'

a4r1xy
{-------- }t' r
dxo

ls order ordinary differential equation

l " degree 46 ord er ordirnry differential equation

x7- :)
d5r1x;

1"t degree

3d

*'=

degree 4h order ordinary differential equation

,
-rh
^tr qegree
v
)order ordrna.ry differential equation

Notation: when time dimension. is.involved as a

differential, we adopt Newton,s notation
-f and not Leibniz dy / dt t." : a j i'at

!,

t: ;;;;;t""

Definition: Autonomous (= time-independent)

differential equations
equations not specifically involving time.

e.C.

i(0
ji

=9

y+7

are differential

notrerm

(t) =ke5

Definition : Non-autonomous (= time-dependent)

differentiar equations are differential
equations specifically involving time.

e.g j,(t):9y2'
ii(t):kes(t+l)
Differential,equatio:r (categorization based
on order,
leading to Cauchy_peano Theorem
)

f(x) I -independent variable

- ordinary differential equations
1$ order

(only

I "t

order derivatrves,l

e.g. above radioactive decay

f (x1,

x2 , x:
.. xn) multivariate
- partial differential eauations

1$ order

(only I't order derivative/partials)

e.s. 4+6i

df(0/dt:_b f(r)

2d order

-r)dy +@f +4t)dt:A

2od order

e.g. Newtonian mechanics

a2 F

F(y,

m:massofy

y(t):
ji (t) :

A position

t): -:-

ofy

when A t
A_(A position of y when A t)
when A t
= acceleration a
( v(t)) ro.ce acting on y

|Law

of Motion

F(y(t!: n

2nd ordcr ordinary

a
:hit/+\

differ-rirr"

*/*\o'"

nth order (highest order is nth derivative)

nth order

af

dy + dt

4:t"

11119 see any

U)lease

Thegrem (= Fundamental Theorem for

differential equations)
math textbook for proof)

A system ofn ls order differential equations

with following 4 assumptions * )
3 function g (t) which is a solution of
ihe .y""..
o io ,atrsfies the iniriar condition,
then solution is unique.

lf

tf

assumprions for a system [ (t) = f

tl, u (r) , y(t) ]
frurction f is conrinuous
exist and are continuous
!e-]) nartials
(e-:)
V(t) at least piece-wise continuous
(A-4) (uo,
) grven
Application ofThm: nth order differential equations
can be converted to n
differential equations and then 3 solution by
Cauchy_peano Thm.

(A-l)

6fi/Oui

to

1",

order

D : flt,u(t),f (t) I n(f : du/dt n@= 6za6rz

convert to hvo 1$ order y :f t, u(t),y(t)
i
I and y(t)=f (r)
e.g. given2M

order

Tenninology for more categorization:

Differential equations are linear if 1$ degree
and no product ofy and

e.g.Y
e.c.

:cr y

+ c2 (1$ order linear)

ji (t) + 9iO

l9y(t):81

2od

order linear)

Nonlinear differential equation are >l"r

degree and,or with products ofy and derivatives
of y like jt.
e.c. Iy (0
e c.

l2

c y(t)

+k

3
bi (t)l :e1i, 1tly1tl1s

Remark: often times use linear-d-ifferential.equalions

(/system), which are easier to solve.
-ro approxlmate nonrinear differential
equations iisystem) and information from
linearization of the nonlinear systein tf," n"ighUo.hoo?JrL ,r.uay.ore. (e.g.
for
nonlinear linear tangent line is an uppro*i*ui.onj. '

"-"-'

that wg have categorized trre various differential

equations, we can start solving
to their catego(es.

)1w
them according

The first step is always to check to

see I'f the differential equahon can be
solved by
rntegration alone.

0.

Check

e.g.

if

can solve by integration or successive intesration

d2 y (t)

----------

l"tdegree 2nd order ordinary linear differential

equation

d t2

seeifcanJ[d2y(t)/dt2

d.

ldt

y(t)/dt

i sat
9t +c,

try integrate again (successive ntegratron)

itav(t)lat

lat

: j(st+cr)dt
:

,/Zl- + Crt *

C: is then the solution (no

derivative/partials)
check solution by differentiating:

dy(t)/dr

:9De)t + cr= 9r +

d2y (t) / d,t2

:d(gt + cr)/dr :

9 which is the

original differential equation.

Application:
Simple Endogenous Growth Model (Let

y:

nationai producvmcome; K

capital)

Prior to mid 1980s, almost alr gxowh moders (including

Solow tho*th Moder) assruned
1) technological changes are exodgenous, and
2) production functions exhibit diminishing returns to scale.
(i-e- the production with respect to each of the
inputs are concave firnctions).
This is lnown as Law of diminishing marginal productivity
= Law of
diminishing returns. It s.ays if we keep o"-" irrput
nt, say l0 workers, and I
machinery @apitar); initia y production with each"ooat
ex*a machine but after more and
f
more machines are added, such w l This is because
I
J
tle sarne 10 wJers
operate so many machines. Similarly if we hold machinery
constant and increase
-w-orkers, after a while, crowding and administration
of wtikers will J marginal
proouctlvltv.

";;i

In mid 1980s, economists started relaxing these two assumptions

which give rise to
Endogenous Growth Theory
Ref Romer, P. "Increasurg Returns

and Long_Run Crrowth,, JpE Oct/19g6

Endog Growth Theory assumes technological progress

is not exogenous.
In fact capital K should include knowledg".
to knowledge is plausibre
as knowledge is cumulative. Ifwe use knowledge
witt increasrng return to ofrbet
diminishing returns to other inputs, then it mightie
a"".ptuoi" ro u.r,r.e constant return
to scale (or even increasing return to scale if linowleage
i ;;fficiently;.

I"".;riog.";s

If we assume I rate of capital will be same as rate ofproduot y:

f

dK/K :

Y/Y

(interpretation, given % change inK,

case there is constant returnsJ

same % change, in which

above is a

l$ order differential equation and variabres are separabre, (different

variables
on different side ofequation). wi can sorve for
v:(integratJtoth sides of the quation)

t iarlr = jayly

t
t

lnK+sr: lnY+c,2 we let ca: h_b

ca: lnY-lnK
+ e"3 =A:y/K
note e c3
=[ >9

AK

is the production frnction

note: dY/dK = A > 0 and

dyrldk

= 0 not <u

This is ofcourse the production equation for the

AK Moder for Endogenous Growth.
Furthermore

then

if

we assume investment

dK : sY-6K

and

K is depreciated

at rate

of 6,

dKi K

:sY /K -AK/K
= sA

butdK/K=dY/Y (=sA - 6)

6t dy/y

as long as sA >
>0 which means national product will grow
persistently and there is no need for exogenous tech change assumptlon.

There are many forms of Endogenous Growth model with varying degree
sophistication. Please see for example Romer [2000].

of

Another macro econ application:

2-sector income determination model

Given: time t (instant of time, not a period)

aggregate consumption c(t)
aggregate Investnent I(t)
National Income Y (t)
and respective equilibrium levels C" I. %
and respective deviations from respective equilibriurn levels C

1 Iay6

c(t):c" +c^
I(0: Ie + I^

Y(t): Y. + Y^
Assume

Cr:

16: i
dY^

Yr

c:

mmgnal propensiS' to consume

Y6

/dt : k(Co+Ia -ya)

excess aggregate demand

Y grows

ocly to excess aggregate demand

0< i,c,k <

) dY^/dt : k(cya +iya -ya): k(c+i_I)y6
1

Ya

-:---

: k(c+i- l)dt

Y,1

isa ld order linear differential equafion

dYa

t I----- : Jt(c+i-1)dt
) In Yr : kt(c+i-1) +cl

cr:constantfrom integration

YA : ekt(c+i-l)+cl

att:0 Yr:ecr
J

Also: Y(0)-Y"
Since Y

ye

(t): Y" + y^

+ e kt(c+i-l) e c1

: ye+ ekt(c+i-t) (y(O)-%)

i ast+"o Y(t) will -+ Y" only if ekt(c+i-r) *
i.e. only if
i.e. only if

notek,t>0

(c+i-1)<0
(c+i)<1

So stability condition of2-sector income determination model is ( c + i ) < 1

That is, marginal propensity to consume and to invest must sum to less than l.
Altematively (c + i)
Y.

Y<

So far we only looked at 1'r order linear differential in the form

df (t) /dt:-bf(t)

= df(t)/dt

be solv-ed by integration.
"' order linear differential equalion:

w*hich_ can
|

df (t)
as

/dt

+b f (r)

:0

ftnown

of

as homogeneous

form)

we now proceed to cover the more general form of

b(0 : a (note a, b can be a(0, b(t) and a not necessarily:0)

well as other forms of differential equations.

The derivation of solutions can be found in nrany math econ books (e.g. Hoy, Livernois
et al). Here we will just state the solutions as rules based on a few categorizaiion. the
categotizafion is by no means exluustive. we remark again that often times, solutions of
differential equations are not known.

l.

order (highest derivative is 1 $ order) linear (no product of f, derivatives,

differentials nor > power of l,like f2)
I

dy(t)

/dt +by(t)-a

Rule: (must memorize)

(note a, b can be ao, b(t))

General

solution:

-lbat (c+
e -Jbdt
(

y(0=

t-<a

Ia"

Ioot

dt;

---

oalled complementary

function (arbitrary constant c)

= deviation ftom equilibrium

jlat
e -lbdt ( Jua
dt)

is called the particular integral

rntertemporal equilibrium level of y (t)

StabiliS, condition for this rype of

if lirn

t ---t a

"

-ftat

ifferential equation:

0
" = theny(t)dynamicallystable.

e.g.i+4y=16
tben solution by above formula

y(t) : e -J+dt (6+116e j4dt dt)

-ja at: -4t+cr

we lump cl to constant c so here
we just ignore it for the time berng

e -4r (c +J

16

4t dt)
there is constanl c2 of integration
which we lump to constant c as well

: e -4t(c+ (16/4)e4t)

- e

-4t -+ r
- c^ ^

ts the solution

dt : iO
t(t) =d(ce-4t+ 4)ldt: ce-4t(-4)+(0) :_4c
: 16-4ce -ot -16
check solution by differentiafing dy (I) /

e.4t

- 16-4(ce -o'+ 4) = 16-4y(t)

_
t i(t) +4y(t):16 which is t}le origiaai differential equation
and

lim e -Ibdt c:
t --) co

dynamically stable

tm e -l4dt c: lim e -ar c: lim c /(eat) :

t --+ oo
co
t
co
t
___+

-__+

2d

order bnear dif,ferential oquatrons

j(t)

+ br

j7

(t) +

b2

y(t)

: a

a, 6 ,bz

constants

2 parl

Particular integral

f: b,*o
jfit u, =o

complemertary function

!o=Jt+Yz

It' oo

v,

l;*

rr,

*o

b'1=b2=o

Yr =

Are"t

Yu = Azet"

rr,12

A1 4,2 constants

j
: - u, t.,,6 -16.
----i=----_'

br2

+ 4b"

(and

+
if
solution

y(t):

yn +

b12

4 b2 then

y"

Stability Condition for 2nd order linear differential equations

with distinct or
repeated real roots

complex roots

_h

___:! < 0

both

11,

r2<0

ri>0
U

convergent
il
(,. .- e--'--_+

U aS t__- oo)

not oonvergent

convergent

if

O12-4b2)<0

complex root)

-A.1 eft +,{2

t e(

Econ application:
Suppose market price P(t) of computers at time t is adjusted by hvo factors:

/\

1) excess Demand : D(t) - S(t)

with excess D(r) 1+ r19t

2)

unsold inventory for period [0,1]

p(rl
with unsold inventory | at time t
unsold inventory = total accumulated
past excss supply S(t) - D(t) represented by

(assume excess S(t)

tr.^.
)15\r)0
.

Given

>

0),

D(tlldt
"As

s(t):E +G P(t) ; D(t): H + J P(t)

E, G, H, J R ; assume G-J * 0

Find the price path P(t).

We nore: S(t1=
and we can

6P1r1o"46Q): JP()

write price adjustment differential equation as:

p(r)=atD(r)-s(t)l- pllsk)-

D(t)ldt

o, B

We differentiate [II]-D-321 wrt t:

p(r) alo(r) s(r)l
=
- Bts(r) - D(r)l
-

[Thm: function

P@ = zUPO - GP@) - BIE + Gp(t)

P{0 + gg_!y{t) + p(G - J )p(t) = p(H -

br

b:

- El

-El

\
\

\,7
t,.
\'.

.r
Pc:Ar e'

continuous on closed

interval[u,v]; V

te

F(t): ltfQptl

[u,v],
F

'(t):

f(t)l

- H - Jp(t)l

E)

nore B(G

- J )+

in solution formula

- alc - Jlx 1!(-a(G - J)),

plc-Jt :lHtG-Jr

pp -- PIH

>0 [rrr-D_32]

_ 4BlG _

Jl

Assume (-a(G-.I))t
+ Aze

A1 , 4,2

> lpyC-4>

real & disrinct rr, rz

arbifary constants

P(0: Pp +Pc

, \)\ -.\,i

3. Exact

l"order (1"'order derir.ative, multivariate) differential equations

[Remark: most economic books are confined to 2-variable difierential equations
e.g. ii(t) : fl t, u(t), ri(t)l

Given:

ls

d F (y,

steo: check

t):

(0F/0y) dy + GF/A|

&- 0

Find F(y, t).

ifexact differential <ion by checking

a2F _ a2F
dtdy dydt
2"o steo:

if exact, go to 3'd step. otherwise maybe able to _make exact by multipryine

by an integrating factor (a multiplier) then go to 3d step.

3d step: find solution by successively partial integrating

e.g.

given differential equation

dF(y,0

:4::_dv +$f

+qtJ at :o

[3_3_t]

2"d.: multiply whole equation by integrating factor t * *

[3-3-l] becomes 4ytz dy +@f t+4t )

I\

a-av^{
3d:

fr{+s,t')=ts,t fr{tfr)=ttt =

re-arrangeterm"

ff=+f

and partially integrate wrt

lar

dt:0

!+vtay

>

exact

OF=4ryz4

=lr',' *of,l

instead of
constant c
some t terms

lefl

After getting F, tale derivative of F wrt to t to e"t

dF
-'
ot

=4v't+G'(t\

which can now be equated with the given

ff

=G'(t)=4( + Jc'(t):c(r)=J+t'
tF(y,t)
cheok

ar

ff

+tt

at=

lt'

+ +rt

+c

= 2y2f +4Bf +c

4=4vt'?

fu'at

9l- =4w'

+4t'

: $ay * $a t = t|Gfi)dy + (4y' + +t;dt]=

av' a

sarne as [3-3-1]

** If3 integrating factor: Rule for finding integrating factor for

1$ order nonlinear

multivariate differential equation. *r--r

f"/ar)

"rdF))
I
/Ar ir
llql-1E11=rru)' aoo.,h.o .I',,,0, isintefuatine
(A)'lfaF)l-t---ry

(ait.)

^rart ^(ar't)
ol;i
"ltra
,I
_
,.
alone then tJst'xt t integratrngTactor
'-, - aFl ry
^,
a l=sttl
[

avl

r, llc2 J

i,l'

:,

''"
. .. l- .
++{ aompreviouspage

.:

'',,

chcck (A)

, raL%t _at*Ji

jJ'-A

/L. ____:__
|
|
t

4y-*
4*
'c

li-'

r^

/1.,

-|

_ .\6*s l= -+a u
|L r+q
(''r

a fimction not

t,,.L.,,
t-.-L
*tr

rf)tr1ut
'- ad )
-t
)+l
qtr

of y alone

but ofy, t

{y,t),

i.e.

not

{y)

I
I

It
,

- *t0 r| =

tl t)

.=4rr.Xt

=l{ -tr

-a

function of t alone
i.e. onlY involve t

vl
I

tien integrating factor =

^
C

.]

?ttt'lz

lJ- *
)i
lt
^

^ l.^t

(t) =

----

seoaration of variables

If

for solving I $ order

I "t

degree nonlinear differential equation

equation is separable s.t. M(x)dx + N(t)dt = 0 then can

just

dx
e8 -;=x-t

ot

*$=,0,
- J[{ =f,ar
xo
11
f
-;;*"' =tt",
xo

t2
+t+

l^ +c,

Sx5

-cr =u

solullon

d(t' * I *.,
* 17 5;
I
-+ t ----;1fdx)1=g
x.1.drl
-

cnecK Dy orllerentratrng

-_+

5.

-.,.]=,*J**(a)=e
')
5 \drl

dx
x"t
-dt =

Bernoullinonlineardifferential equations.

y +p(t)y=q(t)y"
manipulation: set s(t)

) ds(t)
dt

t V(t)

t-

dy

(l-n)y i;-nr-t ----- = (t-n)y-'

dt

ls

Solution: s(J) :

-J(r-')pdi[c+

i(t-o) q

[qy'

_py]

order linear difftial

Jo-n)pdt

(t_n) [q_ps]

don,

use formula

dt]

ll

lylt;1t'-";
in

particular, y = y (a- by)

1.e.

a, b >

called logistic or Verhulst or S-curve growth

f /y = a decreasing function
y(t):
Solution:
a/ [b+ke-"1 k oonstant

Before moving onto Solow Growth model, it will be helpful to have a

Recapitulation of Differential Equations:
-dimensional (single equation)
differential equations

-.../.--.-\
1

-independent variable

multivariate
: partial/total

ordinary

step 0: try integration or sucoessive integration

if unable to do, proceed to next step

first

e.g. Simple Endogenous Growth rnodel.

step

l:

solve according to different categorization ofthe differential equations

1"' order

(l$ derivative)

1't order

linear

nonlinear

product
linear
power
I
> l)
e.g. Solow
e.g. most simple
Growth

(no
terms, no

radioactivedecay Model
a: dy/dt + by

nonlinear
a. check

separation
variables
method

of

Io?'

ja;

e'Ibd( (c+

if

dt)

linear

in Solow, solve by
Bernoulli nonlinear

order

: a
Y(t):Yp + y"

5i1t)+brf(t) +
2

-part soln
a
b2

IA
t'=lu
'
4c
1

b2

y(t)

br*0
b,

=0

b,

=f,

+ stability conditions

!o=!t+Yz
br +0
=Q

sucoessive integration

by integrating factor

use Cobb-Douglas

+ stability conditions
2nd

differential
b. solution by
c. if not exact, make exact

I
General solution v (t)

if exact

Yr =
Jz

Are"'

= Aze"'

nth

order

nth order

Cauchy Peano Theorem converting nth order differential eqution to n

differential equations.

II.

1$ order

m-dimensional Differential Eouations

if we wish to have solutions, then we must

[m >l simultaneous differential equations
have m variables
always multivariate;
mostly study dynamic systems with steady states (stability conditions)l

2-dimensional
(2-simultaneous differential equations)

m-dimensional

linear-----\
I

2d order linear - trend

and momenfum modei
+ stability

stability using
eigenvalues

nonlinear
I

stability using
eigenvalues
& Jacobian

Remark: We repeat that unlike differentiation, solving differential equations are not
simple and not straightforward. That is why we have different categorization of
differential equations, each of which has different solution methods. Often times,
solutions zue not kno$'n even.

ri(1)

Chapter

III. B.

Neoclassical

Gro*th Model

Ref: Solow, R.M. "A Contribution to the Theory of Eoonomic Growth" eJE Feb/1956
Simple Solow Growth Model (1"'order 1" degree linear differential equation.)

Given

Y1

: F(Kt, Lt )

where Yt : aggegate output at time t [3-3-3]

F is the aggregate production function
K t : capital in economy at time t > 0
L 1 : labour in eoonomy at time t > 0

Assume F homogeneous ofdegree

AF AF

>
AKt OLt
-----

I, twice differentiable and

A2F

A2F

AK,,

6L,,

Kr:(:dKt/dt):sY,
Lt:Loe"
ietkt: Kt/Lt

0<s-savingsrate<1
L o : labour at time 0 and is given
r : labour growth rate

[3-34]
t3-3-51

capital: labour ratio

How to find the equilibrium growth path??

Implicit assumption of this model: since K1 and L l are the same in all model equations
) all Kt and L l are fully utilized
) full employment of both capital and labor are implicitly assumed.
[Standard manipulation of macro growth models: transfer the production function F with
two inputs in to production function f with k t: Kr / Lt ratio:

Define(kt)- [1 lLtl F(Kt, L1)

we multiply both sides of equation [3-3-3]

+ Yt lLt: F!Lt:
also ll

F(Kr

lLt, Lt/Lt):F(k,,1)

f ft 1) by definition of f

t Yr :L1 f (ki) :Lo e" f(kt)

alsoK, : kt Lr : k. L6 e'I
differentiate wrt t and get

by I / L I
since F homogeneous
degree I

of

)dKt/dt:
also

kt Loe't(r; + dki dt Loe't

ll

) ) ,k,* dk/dt =s[r(k,)]

sYr = sLoe" f(kt)

t dk/dt:s[fft1)] - rk1 )
is

l*

order

ln

k1 time path moves according to s, r rates

[3_3_6]

degree linear diffarentiar cquaron

[Given F is conoave, how about f?

Following two lemma show if F is concave, then f is also concave.]

Lemma:

f ' (k, )

= Marginal Physical product of Capital

MppK

Proof:

Knowl/L1[F@t,L)J =fGr)

aF al.tf(k)
:
MPPK:---dK. 6K,

Lemma: Kt

Lt > 0 t

Prgof

-> diminishing ftrum

<

t F:Lt(k)

a(Kt,Li)
a( K')
Ltf'(kt)-----------= L,f'G,)(1/L,) --- = f'(k,)
6K,
dK,

A?F

-ir,rto

ifandonlYiff

"(kt)

<o

ro tabour

a'F a aF a all4f(k,)l a
a(K,tL,)
: -:-[f(kt)+r,r f '(kr)-------------l
---. : --G--, : ---G------)
au, aLt aLt 6Lt 6L,
ar4
ua3-,
=

'(k,)

(K. lln

6L,

f'(k,X- K' /rnz) +

/^-4<--=-J

----

lLtf '(k1X- Kt /Lt2)l

tf'G,X- k, )l

a14

f'(k,X- K,/L,2 1" If'(k()(+K, /Lr2 )

f"(kt)(- KttI.:x-k,)
f"(k,)(- Kr t\' )(-K, /r-,)
: f"(kr)(k,2XliI4)
k,'> o
t +: .0 ifandontyif f "(kt)<0
dL,"

f"(ktx- Kr lLtz X-k,)l

(1/14)>

We see that [3-3-6] the equilibrium growth path d h / d

:s [f(k1)] - rks

a lsr order

or

diferntirl equation

To solve this differential equations:

if

f(k1)notknown

if weknowf

(():

or we don't want to

solvef(\):
use phase

diagram
and

to show the path

movements without

actually solving the

dilferential equation

use various rules according to

category

off

particular example

whenF(K1.

Lt ): L, to K,o

0 <q, < I
which is a Cobb-Douglas funotion, homog ofdegree

t f(k,):1/LtlF(Kt, Lt )l :1/LrlL,lo
: Lt o Kt": Kt" / L,*: k,o

K," l

and [3-3-6] becomes

kt :slkt"l -rkt

13-3-jl

a nonlinear ( .' product k1 " ) differential equation Bernoulli differential eouation

can be solved by setting m(t) : k1 t
cL + 0,1

-"

+ dn(t)ldt : (1-o)\ tr-c''r-t dk,i dt

: ( 1-o)\-" k,
(1-a)
(s
1.d

Ikr"]

- r k.)

r\t

: (1-ct)[s -rk,{r-"1
: ( l-o)[s -r m(t)]
)

hansformed into a l"torder linear differential equation

in the form a : dy/dt + by

(1-cr,)s:
solution by formula:

--J--

m(t)/dt

m(t):e

+ r(1-o)

-Jrrr-u)dt

[c+

rn(t)

it f-a)se Ir(r-d)dt dt j

f ,rr

f(kt

f(kr)
s f(kt)

04s4I

f'>
f"<

aa.

n')

;J'

concave functi on

equilibrium

whererkr=sf(kt)
when i. = o
7t

<oLc|.J Aga.rll-l

FldD,L-

(@9e- .L.^+t'*

for thase

i agram

&.L

('*D

:e
:e
_

-lr(r-{r)dt

-Jr(r-c')dt

[. +

[c

j( t, cr; s e .(1*)t dt1

{(1-o,) s / (1-o)

r}

( e .(ro)t +c2)]

e -r(r{r)tc+ (e -L(tcltr, s/r(e r(r*)t,

+ c2

(l-o)s)

- . -r{t-c)t"+ {s/r} + e - .(1-")t{ c(l-cr)s)

: e - r(r-".)t (c+ (l-cr)sc2)+ {sir}
let

oonstant ca

m(t)

="

(c

- ro-c,)t

in particular at t =

I ca:
+

m(0)

(l-ct)s

ca+

c2

{s/r}

m(0)

:(1)ca+ {Vr}

{s/r}

t3-3-Sl m(t)=e-'('-a)t (m(0)-

since

m(t): k t-"

:;'

1r

r -ct

t3-3-Sl

- e '0-)t

{si4) + {sh}

1mi0;-1s/r)) +{s/r}is the solution (no derivative/partials)

0 < 1-ct andgivenr>O (population growth rate)

note 0 < cr. < I

>0 >0

and iim e-'(r-,,)t -

t-+co

-->

as

t-+

co, i.e. over time,

= k -+

l-"rl

s/r=

k t-" -+ 0+

{Vr}

(s/r1 r/(t-"1

Econ interpretation: Equilibrium gro*th path when capital: labour ratio-+ (s / r;

Bquilibrium level dependent on s savings rate (related to investment rate) and r

t r<t

"

population growth rate.l

Above is an equilibrium dynamic growth model. To extend it to an optimal growth
model where some objectives are optimized, we need to cover Calculus of Variations or
Pontryagin Optimal Control Theory or Bellman Dytamic programming and add in more
variables/equations to t}re above simple Solow Growth Model.

Chapter IIL C. Optimal Growth Models - Neoclassical Grow.th Model using Calculus
Variations

in 18s Century, Newton and Leibniz

of

were vying for calculus primacy.

Newtonian mechanics model:

Newton wanted new type of math for dealing with motion and forces (represented by
vectors) operating in physical system.
Approach: equations of motions (represented by differential equations). Simple cases
are solvable but typically coupled (i.e 2-dimensional) vector differential equations are
very formidable.
On the Continent,Leibniz, Bernoulli (farnily), Lagrange, Euler, Poisson, Jacobi (French,
Italian, Swiss, German mathematicians) tried to develop a more general theory such that
Newtonian mechanics becomes only a special case.
Such development actually stemmed from Galileo discussion in 1630 to find the
minimum sliding time of a particle moving from 0 -+ pby gravity. The problem (called
brachistocbrone problem) was solved by Joham & Jakob Bernoulli and also by Newton
and libniz in the early 18* Century.

P&e,tr)
Euler further deveioped this formulation into a branch of math in 1744 called Calculus
of Variations (to find extremals and form basis for Newtonian mechanics).
Euler and his fe1low mathematicians on the Continent noticed that Nature has certain
general properties that conform to principle ofeconomy or simplicity.
e.g. in optics: Fermat's Principle which as stated by Fermat was incomplete but basically
says that actual path between 2 points taken by a beam of light is one which is traversed

in the least time. (minimization)

e.g. geodesics : -- moving bodies seeking the shortest distance between two points on a
surface. (geodesics are actually cuwes in which distance between two points on a surface
is a local minimum -.- like Great Circle route when traveling the globe. Einstein used it
in his general theory ofrelativity where his curved space-time has geodesics --curves in
which the distance between 2 events is a local minimum).
e.g. soap bubbles: deformable thin

surface area.

film objects will take the shape that minimizes

e'g in electromagnetic and erectrodynamic theory: electromagnetic

phenomena also
follow similar minimum principle.
e'g'

mechanics: particles system organize themselves into equilibrium

-statistical that minimizes
configuration
their energy lHaiitton's rrincipre of reast action:
motion
of a system of particles explained by J
T = kinetic energy u : potential energy.)
-

i u

e'g' in thermodynamics, trre dissipative processes maximizes

the dissipation rate.
The- above approach is called I.agrangian dlmamics
and later Hamilton (rish
mathematician) focused on slightly different emphasis
calied Hamirtonian dynamics
establishing the most general formulation of mechanics.

Basic idea: look at the movement of a particle in a trajectory

from point A to poinf B.
We perturb the trajectory by a very smill amount ut
poirrt of time between A & B
and then minimize the perturbed trajectory to get
..rtubi"
th."ll".y
o. stationary,, trajectorl,.

Note above all extremum principles (least, min, shortest

etc) and can be formulated by

optimize

i..;,ft"::

called integral principle or variational principle

simplicity principles expressed some stationary path of

line integral (correct

path, stable path)

arbitrary variation about this correct path will lvaiue
the minimum.

of

rine integral and will not be

variational calculus - rook at relationship between corect

path and all arbitrary
path in neighborhood ofconect path in order to
get the coriect path solution.
c

coraect path

c' arbitrary path in

neighborhood of c
i.e.c'(x)=c(x)+

s
I

c(x)
\'a"t

l\+

variation pathvariation
parameter

c' continuously differentiable

o(x) goes to zero at end points

many c' possible

pl

p2

idea is extremizing arbitrary integral

tr

I = I Ftt,x(t),i(t)1dt

t6

(t):

(xr(t) ,

x2

(t), x3(t)

...

,x.(t)

ll

Letl(e) = J p(t,xG), x(e)) dt

g0

the stationary path has the property d

For I to have an extremum, its
Equation

AF

- ---

oxr

dt

f'st

AF

dxi

I/d

l_

-y

=0tomakeX(e)

differential dI must

0, solve and we get Euler,s

:0 i = r,2, ... ,m
a 2nd order

differential equation.

We state this as a theorem:

tr
f

Theorem:.In order that x(t) maximizes integral F x(r),

[t,
condition is Euler's
ta

AF

equation
daF

6xi

Oxi

)=0

,i

6y1

t,

the necessary

i=1,2,...,m

Proof: Please see Takayama [1993]

Altematively we can prove it by using the operator 6 similar to change, A, d,
called variation ofl s.t. (dI/del]rd.
= At

rtt)

Given F tt,

x(f, i1t)1

).

,(tJ + rl1t(t)

let

+l

i(,)

F - F t-t, x(tF mg(t),;(t)+mc(t)l

g x(t),
rn ariitrary constant, g(t; aruitrary
*function
. .F
but g(t6) : g(t r) :0 s.t. x1q:49 + mg(;) at to t r . By Taylor eifansion

x(t):

- to)

+ '"'(to ) (t

- to)t

io+mg@]

= F [t, x(t),

i(t)]

x(t)+ mg(t). x0)+mg(t)j -F[t, x(t), x(t)]

OF lA

x(t6 ) +

(to ) ( t

F [t, x(t)+ ms(t),

r'[1,

t,/
l\t,

/2!
r

+ ....

ra

* (mg) + d F /d i
x(mg) + a F ia

define

o1

(.g) * ....

i (-!., - ....

uu

I l+>)

IfF=x

6x =dx13x

(mg) +

A x /A1.

of 5x)

6i:ailax

IfF=;

@g) : mg (definition

a.
oxldx(mg)
=mg
.

1mg; +

01

6 F=(6Fldx) (5x )

+ (aFlai)(6i

Necessary condition for findi

page 4l4in Takayama

""o"tul

in dynamic optimization (please see Lemma

on

t1
'lggsf: tl
dt:0 r larp,"1t1,i611 ot:o
l.t,x(r),i(t)l
"o"+.,
) Jl(aF/dx)6x + (dF/Ai 1o)6il dr =0

: Llno
{(aF
=

+ (aFlai)nll dt:0 = I(6Flax)s + (aFlai)El dt

laisl dt + [116p 16i; !1 at

JftbFra$me

ll-(a

F /a x)gldt

@F

( inteention bv earts

/a\)

sf
o

f",

but g( t6)=C(tr)

tr

to

lpn' -prr-ltp')

rr,

1 (a F /d

)l ) dr

:0

i,{tdrlaxl - d/dr[ @F/ai)l] e dr =0

4n

il

0...
(dF

/0x)

d,/dtt (aFiai)

g arbitrary and need not =0

Euler's Equation

which gives.necessary condition for dynamic

optimization is
3]i-!y]"t.rto :n.ation
anatogous
first order condition in math piogramming problems.
The analogous sufficient t'2nd order) conditions
are known as Legendre, weierstrass,
Jacobi etc conditions. e.e. Leqendre condition
for suflicienf: for minimum F *,
2 0;
formaximum F-

,. <o iun"r"*l='J;ii";il'.'-''

*,

Most math econ coruses iust cover the.necessary

condition (Euler,s equation) and assume
the 2no order conditions are checked._
ett"-utiv"ty, iir ir-a'irr"r"rrtruule and concave in
x(t) and x (t), x(t) twice or*l:r]i9|":-"
= b' then Euler's equation becomes the necessary
"lor"d
and sulficient condition for x*(t) to

#;ii;bl *h";;i;t=ffi;i;;

M* j f (t, x(9, i1t.1y dt s.t. boundary conditions x(t6):aandx(11):S

(9

We employ Euler's equation to dynamic optimization involves

maximizing or
minimizing an integral which define an area under the curve
F, F being a-function
(time t, function x(t) and derivative function * (t) for
the time period [t 6, t 1]):
{r

Max (ormin)

Itto fr, *ft), i ttll a r

s.t.

of

boundaryconditionsx(re):aandx(r r ) =b

are. dealing in space of functions,

JF is called a functional. The solution of
lince 1ve
dyramic
optimization is*a funclion x*(t) without any derivativevpaniars
and which
opumrzes the mtegraI J F (t, x(t), i(t)) dt s.t. boundary
conditions. The funcrion x*(t_;
is caf fed an extremal.

'

to

,,

It now becomes very easy because we know if we wish to max

J Fftt, x(t). i(t)l dt
we.just substitute integrand F into Euler,s equarion form,
solve,ff" F
Euler's equation and the solution is the answlr.
"ii"iliiitr"*r"r
Hence:
static optimization

find point (x1, xz,

dynamic optimization

t;

x:, ...,x^)

frnd function x(t) max

which ma,x objective function

f(xy, x2,

.rIrd

F 1t, x,

iI

just plug F into Euler,s equation to get

possible extremal solution x*(t) (a
function)

x:, ...,x,n)

('.' Euler's equation only necessary but

not sufficient condition, unless F concave)
Math example of dynamic optimization

How to calculate length L of any curve

Pythagoras

theorem

dl z :

d.

t2 +

to
C

joining points

x,

+dL2 /d,t2 =l+dxz/d(

) dL / dl = V! d;./ dtT
=

add all d L with t

lustrate above discussion:

a

x (t 6 ) and b

x( t r)

.
>cct)

{r +l?tr

-+ o (i.e. smaller & smaller intervals)

... there,s no dr (width) in integ.alJ,

J dL Ike adding up
all points on C and not adding up all area urder the curve.

cet

:
f'dL
<o

: Itrr7T *;ioit

= lenglh of any Iine joining a and b

what is the shortest distance between a and b? (i.e. find a line joining a and b
that
shortest length).
We iust solve
'
"rn ;,,7- d t -minimize lengrh of line joining a and b
min L : min f.tt7-

ts

has the

"

we recognize this is a calculus ofvariations problem and now know how to

solve:
step 1. Just plug the integrand as F(t, x(t), x1i)) into Euler,s
equation:

F: {l + i (t )2, integrand

same math example as above:

AF
(as there are no

dx

d ,l'6Fr d
-t---l :--1"%

\ail

at

dt

t
Step

2: solve Euler's

terms)

(l+ i'z) % zi1 1"hain rule;

d/dtfk.,.............-/^,1 (t+ *')l

Euler's equation

i o at

J alat

) ct : \

0: d/dt[il./(f+ ir)]

equation which is a 2nd order differential equation.

t
=

x(t) terms, only

Jt'J-;?;-ar

-cr2:
lcr'
)

12

,,1

ti t.l tr*

1t+ ir,

ilt

el

at

constant orintegration

t1t+ *21 I cr2 +cr2Vt =

'*z

= |t-cr';2=11 -c,2;i2
/11- cr2) =i2
let ll

c12

) c=i

^2

i c dt = j i at

>,

c2 constant of intesration

t + c:-= x (t ) is a linear equation.

representing a straight line )

shortest distance between 2
points is a straight line.

So far all growth models we studied are equilibrium models

without

explicit

golimintion. (optimization being the cornerstone of modem econ). ts.g. sorow Growth
Model describes continuous equilibrium growh path based on ,uuirrgrlo.
we now study models with growth objeciive optimization, i.e. optimal
"oo.o-ption;.'
growth
-odels.

trf

Neoclassical Growth Model

Ref: solow' R'M' " A con*ibution to the Theory of

Economic Growfl,, eJE Feb/r956
(Using preliminaries we had in Chapter
III C. we look at a more elaborate solow,s Model
and then introduce optimization ofgrowth
objective.)
Assume at tlme t' economv orgluces a composite
product calred nationar product y,
with
2 factors ofproduction labour
populati
on) L 1 and capital K,
1:
Given aggregate production function:
where
= labour in economy at time t > 0
K 1 : capital in economy at time t > 0

Yt: F(Lt,Kt)

Lt

:Jffi

;i""$: A,x:ffif,1ffi#T'o

AF

AF

----- , ----dK, 0L,

>

a2F
0

; i;

'

t' = R2,
a2F
-;-;,-;-

'

[3D-1]

homogeneous ordegree 1 (constant

1ai'nini'hing."tm lvith

'espect

to each factor)

(Remark: an example of a fun;tjo_n th3t

satisfu all these assunptions is Cobb_Douglas
functionF(L,,Kr): A L,1-"
i,
fJ"'

K,"

let aggregate consumption at time

"

t: Xr ; aggegate investment at time t = I t

Equilibrium condition: yt = Xt * I
t (i.e. aggregate S: aggregate D)

t3D-21

let

= constart a depreciation of existing K

z gross tr = Kr +
new net

assume

Xt :

L1

(1

inveAent

UK,

[3D-3]

in K: *, o, \

: Loe't

.eplenish depreciated srock

Lo = labour

r :

-s)(Yt -pKt)

at time 0 and is siven

labour growth rate

o

f I ::

(oc savrns

behaviour)

[3D-4]

t3D-sl

average propensity to consume

This model has 5 variables L

s,

implicit assumption: full

K , I, , Xt, y,

and 5 equations.

e-ll!4nent of all factors, since use same K1

the equilibrium conditions and other equations.

L 1 in

forll >0

define

kr= K, /L,

capital: labour

l/ Lr {F(L,,Kt)} = F(1, Kt/

F(Lt,Kt)=Lt f(kr)

yt= yt / Lt

ratio

Lt)o"on"

= f(k,)

We recall the following 2 lemma in Chapter III.

B.

Lemma: f ' (k j )

Lemma: Kt

Marginal physical product of Capital

Mppr

a2F

Lt > 0 )

AL:

We can also easily show following 2 lemma:

Lemma: MPPL

AF / ALr =

f (k1) + f.(kt) (_k,

Proof: F (Lr, K,
f(k,)
:>aF /aLt: )=L,
f(k,) +L, f,(k,)(_Kt/Lt2):(k,)+

Lemma: K,
Proof:

Lemma:

a2F

Lr > 0 1

62Fl6K,2 = o

f,(kt)(_kr)

6K"

ff,(k,)l/dK,: f.,(k,)1r1il,; Lt >

L1/L1 =r

Proof: L.=dL,/dt=
NowYl = Xt * Ir

Assume L 1 ) 0 (atways
and(r/Lr ) [3D.6] get

need

Lee'tr =L1
X1

+(Ks + pK,)

labo*); we define

aa

f(k'): x, + Kt/Lt + pkt

note k1

t=Xt/Lt

t3D_6]

(per capita consumption;

: d(Kt/Lt)/dt :Kl(l/Lt)-Kr(LrrlLt
.a

: Kt(1/L, -Lt(Kr/Lt2)

2)

,1

A _:=lL
-.'- & Lt'

/'"
=:>Kt = Lt(kt +Lt(kr /Lt

:+(kr):

))

xt + Lt(kt +Ltkt /Lt))i L1+ pk1

kr, xt > 0

->kr:f(k1)-(r+p)k,-x,

[3D_7]

called the neoclassical aggregate feasible growth path.

Once initial condition ko
the attainable path_for (L1,

, x 0 specified, equations
Kt, It, Xt , yt )

Note only used 4 equations and3 variables

We add the other equations and variables.

[3D-7] will be

kt (Kt, L t )

x1

many paths possible.

from[3D-5] (l/Lt)JXtl = (1/Lr)l(1 .-s)(y1 -pK1)l

xr : (1 - s) [f(k1) - p k1 ] substituting into [3D_7]

-;

-1

kt: f(k,)- (r+p)k1 - (1 -s)[f(kt)-p kt]

: sf(kt)- rk1 -trrk,+pkr -sp kt
: sf(kt)- (r +sp)k,

If

we i.ntoduce the following assumprions:

(A-1) f'(k,)> 0 f..(k,)<0

v kt> 0
(A-2) f(0):0
(A-3) f '(0)> (r +sp)/s altematively (A_3') f ,(0):co
(A- ) f '(o )< (r +sp)/s altematively (A _a,) f .(oo):0

(A-5) 0<s <l

Theorem (Solow) Under assumptions (A

- I ) .-- (A

feasible and unique growth path (k sobw,

XSolow)

)
constants k s6bv', xs.q6w

s..t. any attainable gowth path with oc saving behaviour will

converge monotonically to
(k s"r"* , x sorow )
[i.e,. k1-+ k solo*, Xt -) X sotow ast-+oo regardless of initial k0 > 0]
and
(k soro*, xsor*) determined by sf(kso6*): (r +sp)*ks"6*
where kt:0

and

xs.l.*

:( l - s)[f(k s.lo*) - p ksolo,u]

such a (k sorow, x sorow) path is called Solow's path.

from [3D-5]

C**tffan

The following diagram depicts the proofofthe above theorem.

t(kc)
A;6.4)r<

.r

z4.b dg.Note Kt / Lt :

K sot"* rs constant

(et-=o)

K1 and L1 both grow at constant rate I

I Yt

and Xr

('. : L,

also both grow at constant rate

andXt/

Lt:

(1

I r aiso glow at constant rate

called abalanced growth path

s) [f(k

soro*

grow)ng attate r)

r (. Yri Lr=
)-

[i ksoro*]

f(k soro*): constant

constant)

r ('.'It:yt- X, , both y r,X r grow at constant rate r)

(L,, &,Ir, Xr, yr

If applied to a Cobb-Douglas production function F(L 1,

): L,t-o K," 0< cr <

f(k1)= l/L1 {F(Lr,K,)} = 7/Lt Q-t1'" K,") = (Li" K,") : k,"
I Solow's path s f(k solo*): (r +sp)ksor"*
I

k s.6*,"

: (r +sI)ks.,.*

t s/(r +sp):
)

K1

k.o,o*t-*

V- cooslanr ,
ksoroo= ''-''! s/(r

(analogous resull in Ch Ilt.B.. using Bemoullr

-sF)

L,>0.

diffrial lion

t3-lJ

':ttt

Econ interpretation: we see from above equation, an economy's savings rate s and labor
growth rate determine capital size and thence affect the production level.

Higher s &/or lower r

higher output level and highei per capita oueut.

Solow type growth model was used to explain why postwar Japan and Germany
experienced rapid growth (due to high savings and investment rates). It can also
be used
to explain why high population growth rate countries like India and china have lowerper
capital output growth. we caution that grouth determinants are more complicated than
as proposed by the Solow model and there are many other considerations.
We note above k soto*

) K,:

k soro*

Lt

constant

K1 ,{L I

-- ray fiom origin

(0,0) with slope d K1i

dL1

soto*

SoLod f*-q

(*t't- \*r;;

(+oF.>

Lt
[Ast-+"o kr-+ksoro*

but
Convefge tOk Solow fOY. lRefr

**> (Lv,K1) )kso6*

ray. In faot ca'show it cannot

Deardof, A. v. "Growth Path h rhe sotowNoclassical C,ro$rh Model

eJE

leb/t9ro]

Another econ interpretation: Solow type model is based on X consumption:

t
constant
ol. Y which means average propenslty to save ts constant regardless of inoome
idistribution
t
between L land K I owners.
Shortcomings: no money/finance, no tech progress, no intemational trade ... in the model.
In addition, solow fpe growth model cannot explain the sihution why most countries,
after reaching the steady state oueuf level, can siill grow persistently. To
do so, we need
to have exogenous technological progress to launch growth onto a niw equilibrium
paflr.

But in 1950-60 much discussion on growth models and more and more jargons.
For example:
Definition: Golden Age Path - is a ne oclassical feasible path ft i, x 1 ) with k 1, x I both
constant over time t .
) set ofall balanced grou.th paths of(L r, Kt,I,, Xt, Y1 ) satisfying [3D-l]
[3D-2] [3D-31 [3D-4].: set of golden age paths.
Sincekl= constant I kt: dkt/dt:0 on golden age path
) Xsoto* = fG s"r"* ) - (r + p) k s.1o* from [3D-7]
Growth theory was firrther extended to

Optimal Growth Theory (some growth objective is optimized)

Note from assumption f '> 0 f"< 0
) f t slowing whiie (r + p)kl tconstantly
I x; function bonding down
i can find k* which max x t globally.

find k* from 1't order condition:

dlf(kr)- (r+p)k1l / dk1 s"t:0

+
f'(k ): (r+ p) tosolve fork*
2nd

order condition

fconcavel fft1) - (r + p) k 1 also concave and 2od order condition satisfied. We have
both necessary and sufficient condition for

k* global max. Hence we get following:

Defn: Golden Rule Path: path maximizing per capita consumption

xi

at every

4
*tx

k+

Theorem: Under assumptions (A

- l), (A - 2), (A - 3 ,), (A _ 4 ' )

3 unique golden rule growth path (k*, x*)

where

f'(k*) :1+ p and

xr:fft*)-(r+p;k*

Econ interpretation: Golden Rule patl to max per capita consumption x, ) marginal
productivity ofcapital f' (k*) : labour growth rate + capital depreciation rate.

Problem: initial L,2, K,1 maynotbe on golden rule path of

ft 1, x1) ) need
additional assumption s.t. k e : L 6 / K 6 converges to goiden rule path as t _+ oo .
Policy implication: Note the appealing nature of the above various golden growth
path to a politician or social planner. For instance, he oan try to manipulate labour
growth rate and capital depreciation rate to equate them to marginal pioductivity
of
capital and tbus guide the econ to grow along an optimal path thaf maximizes
everybody's consumption. But note the limitations and the unrea.listic assumotions
of the_ model. More modern growth theory concenfiate on technological progr...,
including knowledge and labow productivity.

Macro optimal growth model using calculus of variations.

fGrowth models with time dimension are most suitable for dynamic optimization
applioation.l

Question: what is the necessary consumption X 1 to maximize certain tarset like

maximizing (stream of future consumption)
Xo

X.J
\

PV(X,)

l.-

PV(X,)

X2

n *.n-

s.t. feasibility oondition and given boundary condition.

obviously making choioe between X t and I (intertemporal resource allocation)

consume more (less) now invest less (more) now
=
= consume less (more) in the
future (unless technological/labour ohanges to increase (decrease; pioauciivity;.

xt

L^TgR

,lad-

aeqs s4 71-q

1..$

c'
&rt

tv1

We now start to build optimal gro*th theory based on previous

model. Assume:

; L,>0 Kt>0 [3D-l-ll

It=r(r,,K)
F homogeneous of degree I & ooncave
= Yr - X, (=I,)
{''.uK,
t3D-l-21
Lr / Lr : r

[3D_l_3]

From previous discussion we get the

feasibilif condition as summarized by the

neoclassical aggregate feasible growth path
[3D_7] :

kt: fG,)- (r+p)k, - x1

kt , Xr >

Question: Find optimal time path of per capita (divided by population) consumption x
1=
X I / L 1 that satisfies the target of
max

T
J x,

s.t. feasibility [3D-7] and boundary conditions k

6

{max total sum ofper capita consumption over planning period [0,
boundary condition.l

T]

,k

s.t. feasibility and

(We rccognize this as a d).oamic optimization problem)

Problematic points:
1) planning time horizon [0, T] is crucial because if the two cwves in above Figure
converges over certain time nterval, the height difference between
the 2 curies
have different econ interpretation. So who decides which plan, S_year,
tO_year,
50-year plan?
2) should population exhaust everything on or before T, if not, how much K1 Ia
should remain at T.
3) if r very far ahead, we wi have technorogical changes(computers, more efficient
--^'
production methods etc.), labour changes (better training
aod education; trr"i
affect the factors productivity; also soiio_political changes (from
common to
private property rights, from planned scon to decentraliied
market econ), as well
as X 1 pattern may change (taste, customs changes).
In the.literatwe, always igaore all these points and assume T_+ oo paliooule
.
being all
eligible paths closely approach fixed balanced growth paths
all paths root uuo,it ,u-"
for very long T horizon. obviously math is moie simpiified. Ifnew technology,
til"" ."do problern with new tecbnology incorporated in model and let T+ oo
again.

Broaden flre x 1by u(x 1) where.u is society's utility function,

maybe sum of all typical
individuals (e.g. all clones) utilib, functions to avoid interpersonai
utility comparison,
which are-very stong and unrealisfic assurnptions. But then whole
ri o"
strong ard unrealistic assrrmptions rike a "national product",
"r.u"."
""it,

function ... ..

aggregate production

Objective now becomes dynamic optimization problem:

max ir u(x,; g-ot dt

where u defined over [0,

st

e- pt

djscounting teru and p discount rate.

co

) strictiy concave and twice differentiable.

Lr= f(k,)- c.k1 -x1 ; cr: (r+ p) and boundary conditions

to feasib iry [3D-7]

Econ interpretation: p > 0 ) discounting utility ofour children

compared
) ethical and interpersonal oomparison issues involved.to utility
p:0 no problem. In the literature just assume p > 0

present generation

So dynamic optimization problem for Optimal

rnax Iru(x,1s'ot
o

dt

max

Grovth Theory now looks like:

p>o

s.t. i,: fG,)- crkl -x1

boundary condition

of

kr ,xt z

[3D-1-8]

k6>0 kr >0

[f(k,)- ak,-krJ s-ot dt

p>0
[3D_1_e]

k;,x1)0

ko>0 kr>0

How about convergence: ifassume satiation, then f bound from

above and if+
assumption *rat econ productivity 1 then bounded from
bel0w
convergence

ofpaths.

{e se.e t}at [3D-l-9] is a dynamic optimization problem which we can solve by calc'rus
of variations.
To apply Euler's equation, the integrand

O:

u [f(k1)

- gk1 _ir 1 s- ot

aodao

) set

--- ( --rdt 6k,

6kr

a@

'[f '(k,)- 0.]e-nt

0kt

d
;*
dt

ao

) : --6k, dt

( - -;-

[u

' ( - 1 ) e" et

] : [-u" i, s-0,+ u.(-l) e-o'(-p)]

e-pt

[_u..i, + u.pJ

' [f' (k,) - cr] e-

Euler's equation

''nf -e - ^t'[-u"x,-u'p.l

) [u'f '(k,) - u'cr - u. p] / -u,, :

)i, : (u'/ -o,,)lf.G,)- (a + p)l
Sinoe O strictly

concave

...

Xt

u shictly concave on finite T)

Euler's equation is both necessary and sufficient condition

kr xt

for x,

optimum.

solve for
from system of differential equation, i.,
-Euler's
to get the solution path (kt,xt
called feasible
path.
Assumptions

,i, at k6 , k1

)-

u'>0 u,.<0
(A-2)f.(k,)>0 f..(kt)<0 v k,>0
(A-3) f'(0): * f'(-):0
f(0)=0
(A-4) lim u(x)--+ -o osXt*)0 xq)0 (this is to guarantee
(A-1)

interior solution but note tlre extreme disutilitv

of low consumption period as x 1 -+ 0 )

+(&+)

eQt

({&+\

.&"t

&-A
f11maryis: Euler's

ollrerenuat eouatrons:

path is (k t, x t ) satisfuing following system of 2

simultaneous

kr: f(kr)- ok1 -x1

x1

: -(u'/u")[f '(k,)-

[3D-r-lt]
(o +

p)]

[3D_1-12]

If form offis given, we might be able to solve above simurtaneous differential

Ifno! or if we don't want to solve, we can use a technique called phase diaer.amequations.-

how the two solution curves behave, without actually solving for
k ,,

&

io

.".

Phase diagram 4ethod:

1) Set differential k , = g 1o get and plot steady-state line.
2) Determine which side of steady-state line
>0 lmeansk,

Iastt;.
3) Do the same for i 1 :

f,

(meanskl

tastt)andi,

of

0 steady-state line and determine sign

steady-state line.

4) combine various directions to get behaviour of the 2 differentiar

for our above two differential equations:

A. Form the k

1-

1 on eaoh side

constantly

dividesthekl-xl

eouations.

i ,: Og

xt

Spooe

from above figure, as t

k1l

tf(kt)-cr

into two regions.

i, : )

-+

"o, f 1 but tslowing while

following shape in figure and
bes.t. f(k") =61L,

has the

Letk.

g
C. -From [3D-1-12] set
and let k
f .(k"1
p). Note
is a vertical line in the k t - x 1 space in {igure and divides the k , _ x ipace into
,-

regions.

of

x 1 space. Get the two steady-state (when differential: 0) lines below.

B- From^[3D-l-l1] set

crks

<0

"1 s.t.

):(cr +

0<k,r S k. by(A-2)(A-3).

D. Now determine the signs of the differentiat,

i, i,

kt:

k.r

two

on either side of steady-state lines.

k.1 t f(k.2 ) < f(k", ) (...f .>0 )

and f '(ke ) > f '(k.r) ('.'f',<0)
)f'(k*)-(a+p)
> f .(k.r)-(a+p)

In figure,

lx,

t;,

fork,2 <

{<

IK sz: -Jy-:gltt'
>o
1

>o

(k e ) - (o +p)l > - (u, /u.. ) If . G

and

k"z

+ xtl <0

",

for k":)

) - (c[ + p)J

k.t

k"r

^i3

Similarly we can determine the signs of k 1

on either side of k 1: 0 graph.
>k"
e.g. af k5a
f(k"a)-ak"q: x"r <0 and - x1 <0 ('. x, >0 )t

k,l=f Gg)k"+

crk5a

'x1

<0

)forkl<k"

: i, I :

kr>0

ra

tt: t"r
(L; o srl',4 sIrr-)
*t7o

&tto

I
Jo

I+
ne6"3"cl
J

f-tt

&r*

&,

!_

L,,<a

{(tr). *(tal

(i.:o)+

i.

56,-c *4

xr:e \
i,."

QX 7+.ro

otl ,*1
<---;n

- (.o {::-:::.

f,a

t/

'*

I"est

,/.,

')o

f, x1l

,,,

V,,
(<.

&L

=o
i\
r.,lr!

iF;i|
,,

^\

12\

,
&,r

&,r

the
Depending on initial k o and boundary condition- .k ,' &e arrows will trace out
possible p-aths which describe shape oipath satisfying the simultaneous differentjal
equations [3D-l-l l] and [3D-l-12]

i,

=O

intersecting

k1= 0

steady states

= equilibrium

Chapter III. D. Growth model with nonlinear production and ininite horizon: RamseyCass-Koopmans Model.

Ref:

narnsey,

f. P., "A Mathematical Theory ofSavings"

Econ Journal Dc/1928

"Optimum Grorth in an Aggregate Model of Capital Accumulation: A Tumpike Theorem',
Ecorcmetrica Octl966
Koopmans, T.C., "On the concept of Optimal Economic Growth" in The Econometric Apprcach to
Deveiopment Planning, PASSV, Amsterdam, North-Holland 1965
Smith, W.
"A Closed Form Solution to the Ramsey Model", Contributions to Macroeconomics: Vol.6:
No. I Article 3. 2006
Cass,

D.,

T.,

The optimal savings rate in the previous section was originally studied by Cambridge
philosopher Frank Ramsey [1928] who did not solve the problem completely. In 1950s
the problem was revived when gro\4.th topic became popular in macro. ln 1960s Cass
and Koopmans formulated and solved the problem with nonlinear production function
and infinite time horizon. (Cass used Pontryagin Optimal Control Theory.) Basically we
wish to find optimal savings rate path s+ r that max per capita consumption (altematively
society's utility function) till eternity; noting however that more consumption (: less s 1 )
now
less capital now
less consumption in future, & vice versa.

Let us restate the problem with all the assumptions:

e- pt:

max J* u(",) e-Ptdt

discounti ng term, p discount rate.

[3-E-l]

s.t. feasibility and with following assumptions:

[A-1] u'(x,)>0 & u"(xt)<0 Vxr)0 (strictly monotonic & strictly concave frurction)
f"(k1)< 0
V k, ] 0 (saictly concave tuncrion)
[A-2] f' (k,)>0&

tA-31 f(0):0, f'(0):co, and

lA-41 lim u(x) )-co x>0

f'(o ):0

x-0

lA-51

xt>0 k,>0

Vt

To solve the problem, we start with the finite horizon problem that we solved in the
previous section, namely:

max J'u(x1)e-ot
0

dt

s.t. feasibility

I
aa

e- pt

discounting term and p discount rate.

[3-E-1-A]

and we get feasible Euler path solution from previous section as:

xt: (u'/ -u") [f '(k,) - (o + p)]

with feasibility

kt : f(kt) - ok1 -x1

together with the relative phas e diagam.

We define: f '(k*(p )) :(o + p) and from IA-21, tA-31
k rintercept and x*(p) is s.t. x * = f(k*(p)) - o k* ( p)

0< k*(p)< k#

where k# is

@)

u, fconcave by assumptions tA-UtA -21) integrand for Euler equation [3-D-1-9] in

previous section will be concave)l a global maximum & a 1! optimal savings path.
We now extend this finite analysis to infinite horizon by letting T--+ co in [3-E-t-A]:
get improper integral [3-E-1]. We need to check if this integral

1co
J u(xr)

e- P'

dt

converges (i.e.

not explode to infinity which

will

be meaningless)

In fact, when p = 0, the integral does not converge.

To overcome this divergence problem, Ramsey (and later Koopmans) used the following
ingenious method:
A bliss point is where economic agents ale satiated and society's utility function starts to
be non-increasing.
p=o
Assume ! same bliss level utility for all generations, denoted by u(x*(O))
) due to satiation, u(x*(0) = max utility achievable for generation t Vt :

utt&)

uLro)

uptor)

s (x*(e))

aO

-/"
,i@)
, Jo
' .,.
lj-L-l-bl

i,
i

Y_-

Ramsey then defined the following integral with a bliss

i
\
\
\

f@)
,l\

\
point: -\--\' .
, I
l:ou'alel'
otDeve'

t*.*. ri@ [u(x

t)-u(x*(O))] d t
L*\..,/-...-(u)udt
LJ-E:21
L3-E-21
\

....

which is equivalent to Min

\.

--'*-*----..*-=,?

rco
[u(x*(O)- u(x t)] d t [3-E-2-A]

....'"''

I
0

-...-"

"
Dt =---

tr"*'

---

-.,,-/

To ensure integral convergence (i.e. bounded from both above & below for optimal path):

1. We assume fiom some initial k s> 0, consumption path x, is always strictly positive
i u (x ) f shictly monotonically ) both integrals [3-E-1] & [3-E-2] are bounded from
below for the optimal path. LL

lx+ +
F-+

u(xt)f

V'e.>- 'i>lot)+

dt

2. A.lf

p > 0, [3-E-1] integral will converge as the integrand will tend to zero as t ---+
- Pt *
( since e
0 as t --I bounded fiom above)
"o
) f l! feasible Euler's path (given any positive initial k6) tending monotonically to
k*(p ) and x*(p ) as T --- o.
(ln

oo

ofdifferrtial equations, the point [k*(p), x*(p, is a saddle point SP. We can show by lineadzirg the fwo
Euler paths differential equations around SP, eigenvalues ofthe coefficient matrix will be real and of opposite signs.)
terms

B. If p = 0 the integral does not converge. We use above Ramsey's idea by

constructing a reference utility path u (x*(0)) and converting problem to [3-E-2]

Mar

*1u1x
J

00ll

,;-u(x*(O))l

dt

which = Ma* J-[,r(x, )-,r(x*(0))]e

ptdt withp= 0

[3-E-2-Bl
where u(x*(O)) is the utility level ofper capita satiated consumption for individuals.
From the above 2 diagrams [3-E-1-B] with bliss point, the integral l3-E-z-Al
is obviously bounded from above for both two possible cases (MU constant or falling).
Hence integral l3-E-21 is also bounded from above and convergent.

""Tfl'
pt]

while [3-E-2] integrand is [u(x s)-u(x*(0))]e

[u(x)ewithp:0(plssee[3-E-2-B]))[u(x*(0))]e-pr n P-E-21will drop out when we are
We note [3-E-1] integrand is

doing differentiation in Euler equation

the same.

-pt

Euler equation for both [3-E-1] & [3-E-2] are

Now we can analyze the Ramsey-Cass-Koopmans model:

When we solve [3-E-1]

M* j- u(x1) e-ptdt

with above assumptions

lThere

l:

are four types of Euler's paths in the phase diagrams [3-E-3] [3-E-4]:

xt:0

Type
if xo=0and
Vt
This is not eligible as optimal path because assumption [A-4] means utility will be -"o.
Similarly forko:0 and
V
V t means utility will
be -co; so again not eligible as optimal path.

kt:0

ttf(0):0)

xt:0

Type 2: if k, >k*(p) V t > T , given certain T > 0

We note such type path will eventually enter zone of kt > k*(p ) andxl < x*(p ) and
reach say kr2 at time T. We note from t> T, we can improve by consuming k I
(disinvesting k 1 and consuming it as additional x t )
towards k*(p)and fx1
- pt
towards x*(p ) and we will be moving towards the target of max
u( x,; e
dt.

) Ik,

it

And after we reached k*(p ) and x*(p ), we just maintain the path there and this will be a
better path than type 2. So type 2 is not eligible as optimal path.
Type 3: if k, < k*(p) V t> T, given certainT>0
x 1'[ and people will keep I x1 tomaxu(x1)
such type path will eventually move to k 1< 0 violating our assumption k
and hence is not eligible for optimal path.

)
)

t>

Type 4: if k1---+k*(p)and x1-'x*(p) V t---+ co This is the optimal path

maximizing either one of the integrals [3-E-1] or [3-E-2] s.t. feasibility and our other
assumptions.

Above can be summarized by the following Theorem:

Theorem: (Ramsey-Cass-Koopmans)
Given assumptions
p>

0:

[k*(p

[A-l],

IA-21,

[A-3], [A- ] and [A-5], from given any initial k o , if

3 1! eligible and feasible optimal path converging monotonically to path

x*(p )]. Such optimal path will max integral [3-E-1] and this integral will be

convergcnt for this optimal path.

p:0:

3 I ! eligible and feasible optimal path converging monotonically to path

x*(0
[k*(0 ),
)]. Such optimal path will max integral [3-E-2] and this integral will be
convergent for this optimal path. {Rmk: note this path is just the golden rule path}
Rmk:

if ko:

k*(p ), then feasible optimal path

is

just [k*(p), x*(p)] path

V t > 0.

Following is a phase diagram [3-E-5] for when p < 0 which has a funny interpretation of
a negative discount rate. Aoyway, for this case, / feasible, eligible Euler's path for the
infinite time horizon.

We note parenthetically that recently gro*th models use u (x 1) - ln x 1 which is a

special case of the following CRRA (Constant Relative Risk Aversion) utility function:

u(xr)

x,

t-o

0l l and>0

1-e

lnxt

0=1

And 1/ 0 = intertemporal substitution elasticity between xl and

x111

measure of willingness households substitute consumption over time periods.

The

larger I

/et

more

willing to substitute.

Ramsey model has also been modified to use above CRRA utility functions and that
firms are included to hire labor and rent capital from identical households. Yet
assumptions placed on firms make t}rem merely passive agents and not intertemporal
optimizing agents. e.g. firms maximize only instantaneous profit: at every instance of
time, frms employ production factors (labor and capital) by paying them respective
marginal products and then sell resulting output, thus generating zero profit. Hence even
though the modified model looks more like a G.E. structure, yet households still are the
only intertemporal optimizing agents.

{'9

TY?E

rt

).q)

dBL-

T' "+#
&Q?

[u-*'.]

fieP

[s

-e-+1

,*;l;9-o

,t)

+{.f>

{p>
z''
xt" fdc) -"'kt

t l-e-sl

\_

.-+ +\
\*\
\t

chapter III. E. Alternative exposition of Neoclassical

Growth Model with
ponhyagin,s Optimal Control
Theory

In

1960s, Pontryagin's Optimal Control Theory replaced

Calculus
Variations as a tool for dynamic optimization.

of

Terminology:
Functional: an integral {*(t), u(t), tl dt whose numerical
value is
determined by each x(t) in the family of functions
of x(t).

For optimal control theory, solution are contror path u*(t)

and state path x*(t)
which optimize the functional s.t. constraints on state variable
x(t).
[calculus of variations is.a-speciar case of optimar control rheory, seeking
only the optimal state variable path x*(t).1

AAA) We first look

at univariate x(t) and u(t) functions;

First Case: Continuous finite time horizon and.fixed end point

T

Given: t = time ; T = fixed constant (finite time horizon)

x(t) real-valued function called the state vmiable

u(t) real-valued frmction calted the control variable

Find opt path of control function u(t) to max functional (or

some other target)
s.t. differential equation constraint on state variable x(t):
Max objective functional

s.t.

l't

order differentiat

fl*(tl, u(l). tJ dt

(or target

ix

itf

)t

i=I

equation

r-eal_valued firnction

(+partial

derivative)
xi:fi [x(t),u(t),t] i : 1,2,...,; p_tzl

where

x(t):[xr(t), x:(t), . ..,x"(t)]

u(t): Iu1(t), u2(t),

s.t.

..,

u,(r)]

boundaryconditions x1(t6)=x16

[3-13]

x1(T)=x;1 i: 1.2.....n

Solution: Optimal time path u*(t) for control variable and simultaneously
optimal path x*(t; xe, t 6) which solves differential equation(s) (containing
control variable u(t)), depicted bV l3-l2l and satisf,ing condition [3-13].
Note on optimal decision path x*(t), it is optimal at each time point t, not
just at initial time t = 0 or t 6 and ending time t : T.
Pontryagin formulated necessary condition for dynamic optimization called
Pontryagin Maximum Principle, involving a function called Hamiltonian H
which is analogous to Lagrangian function in math programming.

H is defined to be the integrand ofobjection function + a multiplier called

costate variable times the constraints.
i.e.

H:

f[x(t), u(t),

t] + Ioci(t) f i [x(t), u(t), t]

For sufficiency conditions, we need both the objective and constraint

functions to be differentiable and jointly concave in x and u; and costate

variable oc(t): 0 ifconstraint is nonlinear in x or u, otherwise oc(t) can take

on any sign.

Let us start with the objective function being a functional l-tl*t,1, u(t), tl dt
with fixed endpoints; x(t) and u(t) are l-dim, , and only I c'Bnstraint on x(t):
.T

Max

s.t.

J"

f[x(t), u(t), t] dt

i : g [x(t), u(t), t]

{derivative of state variable x(t) determines the

dynamics of the system)

s.t. boundary conditions

We define Hamiltonian

x (t s)

H:

: x6

f[x(t), u(t),

x(T):

t]

+ oc(t) g[x(t), u(t), t]

oc(t) is the costate variable (analogous to the Lagrangian multiplier) =

marginal value of state variable x(t) with respect to the objective function.

and strictly concave, then interior (not comer)

solution and Pontryagin's necessary conditions for max:

If H is differentiable in u(t)

A)

aH

0u
B)

-0
AH

0oc

Pontryagin's
Maximum
Principle

0t

C)

dx

AH

dt

0x.

boundary conditions x (t 6)

: x6 x(T):

Remark: If above f, gare differentiable and jointly concave in x(t) and u(t)

with oc(t)

0 when constraints

are nonlinear in

x(t) and u(t), then above

necessary conditions also are sufficient.

Let us look at an example:

{t x*[u(t)]'zdt

t*

IEll

s.t.

i(t)

:10u(r)

tE2l

s.t.

x(0):2 x(l): 5

tE3l

H: x - u ' + oc ( l0 u)
A) setO: a H I 0 u :-2u+10oc ) u:5oc [E4]

We set up the Hamiltonian

B)seti=-0H/Ox:-l

tE5l

BY IE4l

seti: 0 H / O x - constraint:rcu1ton

tE6l

\ t bt

[gs]+ a(t)

1*at:J(-1)dt

- -t +kr

kr:constantof integration

tE6lt x(t) = "f iot: i C50t+s0kr)dt

k2:constantofintegration
= -(50/2) 12 +50kr t+ k2
From [E3] x(0):2 : {-5012 (0)' + 50 kr (0) + k2 ) h : 2
From[E3]

x(1):5:-25Q)2 +50

kr

(1)+2

2 + 28 L+ 2
-25 t
optimal path x*(t)
- 5t+ 2.8 with u(0)
optimal control u*(t)

)
I

kl:28150:14125

2.8 andu(l)

-2.2

Second Case: continuous finite time case but with free endpoint:
T

tvtax

s.t.

f[x19, u(t), t] dt

i : g [x(t), u(t), t]

s.t. boundary conditions

if

{derivative of state variable x(t) determines the

dynamics of the system)

x (t6)

: xe

x(T) free

interior solution, then the maximum conditions remain the same except
for the boundary condition, namely:

A)

aH

:0

0u
Pontryagin's

B)

Ooc

0t

0x

at
c)

boundaryconditions x (to)

AH
Maximum

0x

Principle

AH
Doc

x6

oc

(T)

:0

oc (T) = 0 is called transversality condition for the free point. Since the
condition means value ofx at T is free. the relevant constraints is

nonbinding so the costate oc must be : 0.

In general, transversality condition means when there are various solutions

of optimal control problems (e.g. when solving 2no order differential
equations, there will be 2 constants of integration generating family of
solutions), we need endpoint transversality conditions to specif which
decision path should be our specific answer.
Example:
4

rrlal [ax-5
s.t. i:l0u
x(0):5

u21dt
x(4) free

We setupHamiltonianH:

A) set0: a H
B) set& =

H:4 x-5 u2 + oc(t; 10u

l0 u : -10u +10oc ) u:oc

- d H / 6 x -- -4

[E4-1]

tE5-11

n1[E+-11

seti= 0 HIO x=constraint:tOri-= tOo.

[E5-1])oc(t)- J;dt :JG4) dt -- 4t + kr

k1

tE6-11

constant of integration

lE6-11t x(t) = .i iat - i l0udt: "f to o. dt:J 10(-4t +kr)

k2: constant ofintegration
-(40/2) t2 + 10 k1 t + k2
From [E3-1]

x(0):5

=. {-4012

(0)'

From transversality condition oc

)k' :16

+ l0 kr (0) + k2

(T):0 )

)optimalpath x*(t):-20t" +1601+

optimal control

u*(t;:6. (T):

- 4t

oc
5

16

(4): 0:

k2

-4(4) + kr

Third Case: problems with endpoints s.t. inequality constraints

T

Max J flx(t), u(t), tl dt

t6

s.t.

=g

[x(t), u(t), t]

s.t.boundaryconditions

x(ts) : x6

x(T)>x1

r)

constraint nonbinding and the problem becomes an

ordinary free endpoint problem with oc (T):0 when x*(T) > x 1

Note if x*(T) > x

if x*(T) < x 1 then constraint is binding and problem becomes an ordinary

fixed endpoint problem with o. (T) > 0 when x*(T) : x 1
Thus when we have endpoints s.t. inequality constraints:
step 1: solve it like a free endpoint problem
step 2: if x*(T) Z x
, then we are done.
andsolve as afixedendpoint
Step 2a: ifx*(T)<x1 setx(T)=
problem.

xr

Example:
4

Maxi t4x-5u21dt
s.t.

i :10 u
x(0):5

x(4)>

225

We solve as if it is a free endpoint problem, from above, we know

)optimalpath x*(t):-20t" +1601+

optimal control u*(t) -oc

(T):

- 4t + 16

) x*(4): -2og)2 + 160(4) + 5=325 >225

) constraint nonbinding and solution is the right solution.

BBB) In cases where x and u are multivariate functions (> 1-dimensional):

x(t)

xd|,

(xr(t),

x3(t), ...,

x,(t))

u(t)

: (u1(t), u2(t), ..., u,(t)).

Optimize objective by finding x(t) n-dim real-valued function, time t, with

vector-valued firnction

nx

u(t)

r-dim

1" order differential equations

i'(t)=r'tx(t),u(t),tl i=1,...,n

(3-F-12)

7
\
,/
real-valued function

...,x(t)) I
u(t) = (ul(t), ur(t), ..., u(t))
tr-r-tr)
)|
i:1,...,n
boundaryconditions x'(t")=19
where x(t):(xl(t),xr(t),x3(t),

Again Pontryagin optimal control is used to find:

solution path x(t;x", t" ) satisSing path depicted by (3-F-12) and condition (3-F-13)
Remark: CAUCHy PEANO Theorem provides sufticient condition
local, unique solution x.

u(t) is called a control

= [ur(t), u2(t), , . . .,

If u(t) e U :

set

u(0]

for existence of

u1(t) called Control variable

of admissible controls
range

../

u(t)
domain

U ------+

range U called control resion

x(t)

path depends on control u(t) which is not specifred a

the set of u(t) that max a target.

priori, we just pick u(t) from

objective function

nt-

e.g.Max

S=l
i:l

u(t) e U
1*6;,

s.t. i i(0: r'

qx1

"1t1,

tl

(T)

T:fixedconstant

i:

1, . . . , n

o):

1u i:1,. .,n
o
with u(t) deiined on t < t <T
and x 1(t

Once found u*(t), can find state variables x*(t) (solution

satis$ing boundary condition)

of

differential equations

x i(t) assumed continuous fuaction on time t

f; assumed continuous in each x, t, u and continuously differentiable.

(x', t" )

s.t. x' e X

x(t" ) = x'

Theorem 1: If 3 continuous vector-valued function P(t) = [Pr(t), Pdt), ...,

vanishing simultaneously for each t such that

P(t)l not

1) H is maximized with respect to u(t)

i.e. H[x*(t), u*(t), t, P(t)] > Hlx*(t), u(t), t, P(t)l Vu(t) e U
fiom conslraints

where H[x(t), u(t), t, PC) =

2) P(t)

and x+(t), u*(t) solve

aPJ*.,u.

*-/

Ii=l P, (t)f, tx(t), u(t), t]

II.AMILTONIAN system:

P;:- dH*/dx; i:1,2,

i'-:aH*/ap,

aHl

i, - f;

4l

Pontryagin Maximum
Principle

3) TRANSVERSALITY Condition

RMK:

.' I

constants

ofintegr

get family

of solutions, so need trarsve.sality condition

to

P(r)

:q

From objective functions

4) x11t)=*o

i:
)

t,2,

determine sDecific solution

... , n

c; x1(T)

i:1,...,n

then

x*(t), u*(t)

solve

max

^+
S=)c,x,(T)

u(0u

T:

hxed constant

i=t

s.t.

xi(t)=fi

[x(t), u(t),

t]

i=1,...,n

xi(to):x o

i--l,...,n
iffl

Above is necessary condition, furthermore

are all concave functions in x and u, then
global
also
for
to
optimum.
above
suflicient condition
u* be

Analogy: H &

Lagangian

Pi

& Lagangian multiplier:

./

COSTATE variables
Rewrite (3-F-12) as

i,*:-

i,-(t):f;[x*(t),u*(t),t]

oH*

loxi

:-lPr (afl* / 6 x )+ P2(0f2* I 0 x )l

z --'
tsf.
=I-P,'&,
;
:+ 2n equations (lst order differential

ii:...

equations)

i Pi:....

i:1,.,.,n

2n variables

xi, Pi

i:1,...,n

2n boundary conditions

xi(to):x o

PiG):ci

i:1,...,n

transversality condition provides additional boundary condition

SolutionT* called optimal control, x* optunal trajectory

//

e.g. speed, direcfion ofthrult for

rocket

Above includes a special case

Ifwedefinex0(t) by
with

min time missile intercepts a plane

io(t) :fo [x(t),u(t),t]

u

x"(t')=o

x" = If" dt

k'
then t =
J'f. Ix(t), u(t), t]dt = x. (t)Ji

:
so

x"(T)

maxl:.l*j]tt

I dt = max

x.(T)

s.t. io(t) :

f6 [x(t),
xi(t):Ii
xi (t') = x: =0

=
=

x.(t):0

u(t), t]

define new Hamiltonian A[x(t), u(t), t, P. , P(t)]

{{[x,u,t] + lP,{
i=l

[x,u, t]

and conditions 1) 2) 3) a) ofTheorem 1 can be written as

f4**,u*,t,n,p(t)l> Hlx*,u,t,p.,p(t)l

vu

y'drop

P(t), x

*(t),

all other P; terms

P(T):0 i :0,1,...,n

P.(T):1
2

(3-F-1s)

u*

ii:afi*m,

(t)

(3-F-16)

solve rhe Hamilronian H

Pi:-AH */axi

i:0,1,2,...,n
(3-F-14)

): J)

b:q)

/r7f)

Since

P.(T):

1, by

Po: -dA */dxo

(3-F-I4)

:0)
N.

>P"(t)=l
:+ A witten

Vt

'.' Po:0

as

io:afi*/aPo:o
tr

tr,!(x,u,q ,/
p

= 1t;q1*1t;, o1t),9 +

is funotion of x, u, t,

,/

=Htx(t).u(t),t,P(t)l

,/
t/
Since P.(t) = 1 then AH */A Po : 0 '.'no P6 term in H
so can omit

0 case and rewrite as

1') H[x+(t), u*(0,

t, PC)] >

H[x*(t), u(t),

t,

P(t)] Vz(r)
no need 0

IJ *

2'\ x' =""

3P,

3) q(7)=0

6H*

i=1,2,...,n

necessary condition for max

I : max I q1*1t;,o1t1,tpt

ueU
s.t.

xt(t)=f,[x(t),u(t),t]
xi

(t')

Note 5 =
AS

s=

i = 1,...,

-t

,,--z r
I

(3-F-17)

(3-F-18)

can be converted to target as

-,t"
rtrt

ueU

x: i=1,...,n

I.c,x, (T)
J'

i=1,2,...,n

oxi

Ic;x;(t)

.T

llc,x,(t)
L i=l
Jr"
|

pt

"
+)c,x,tt"
'=,

& roic" rr"rru

nan
=

!c,x,
i=l

(T)

lcixi
i=l

(t")

Icixi(t")
i=l
/

Cancelled out so no need to include

in max process

+max S s.t. (3-F-17) (3-F-18)

=

.no

I r"l ]dt where f, =I",f,

s.t. (3-F-17)

(3-F-18)

Note above problem T is fixed a priori

but x(T) not fixed a priori
ftom equations we get i(t) and

once fi(t) obtained we get

i(t)

Various other cases:

Fixed T with fxed end points * need rnodifred theorem
Final T open with fixed end points - need modified theorem
Fixed T with variable RH end-point - need modified theorem
depending on x(T) a priori fixed for some coordinates ofx(T)
final time T a priori fxed

e.g. Final T not a priori fixed

(i) RH end-point x(T) partially fixed
i=1,2,"',m(n(frxed)
s.t. xr (T) = xJ

x,(T)

not

fixedfor i:m+1,"',n

then condition 3) transversality condition A to 3')

P'(T)=c'
P,

+Ii

(T) = c,

i=1,"',m
i=m+1,'..,n

1,, unknown variables constant over time

e.g. Fixed T with fxed end-point problem

max

(3-F-1e)

f" tx(t),u(t), tldt

s.r. i,(t): f'

t'=0
x, (0) =

[x1t1. u1t1.

xi

1]
x,(T) = x]

i=1,...,n
i=1,.",n

\\-,2
\\
T frxed and fixed

J]D

Define x.(t) by x 0 (t) =f

xo( 0:0

[x(t), u(t), t]

TT

)x6fi): 00
I ro at =J xo dt so

(3-F-19) =max

rv
xol = xo(T)
0

xo(T) s.t.xi:f i x0(t)=0 i:1,2,...,n

Now we apply Pontryagin Maximum to get following modified Ponfryagin Theorem

solving above (3-F-19) problem

2 [.ftl, tAil optimal for above (3-F-19) problem

nonzero (n+l) vector-valued continuous function P(t)=[P.C),P,(t),Pr(t),.r\,P,(tn

Theorem

if

which has piecewise continuous derivatives s.t.

i"O, i(t),0@ and P(t) solve
Hamiltonian fr

A = Hti( t), n(r), t, p(r)l =

(1) Hti, t, t, PI > H[i, u, t,

(z')

ii:

pt

P]

(t)fr ti(t), rD(t),

vu

with

aH rcPi

Pi: - aAlaxi

i:l,2,...,n

(3') P"(t) = c6m16r1 2g

Vt 0<t<T

(4')

x'(t")=xi

xi(T)=xI i=l,A,n

We have conesponding corollary theorems when T open and not fixed but we will not
cover as we only need above Pontryagin Theorem 2 for optimal growth theory.

Econ application: optimal gro*th theory again, using optimal control theory.

like

fo

maxJ u(x(t))e-e'dt

i,
I ike u
/ -_'rir"r
s.t.k(t):ftk(t) -ok(t) -x(t) k(0):k0>0
like

k(T) = ft' ;' p

x(t) > 0

p>0
Assumptions:

(A-1) u'(x)>0 u"(x)<0

Vx>0

(A-2) f(k)>O (k)<-

f(k)>O

(A-3)

f(0) > 0

f(0)

oo

f(o)

Vk>0

=6

Here per capita consumption x, control variable

k, state variable
control region f) S R nonnegative

>

closed set

Assume T final time fixed k(T) fixed

=+ apply Pontryagin Theorem 2

H [k (t ), x(t), t,

Po: constant

P @]

= P.u[x (t )]e

-P

/uno'
t

+ P @V Ik (t )l

Gk (t )

- x Ol

) 0 can show Po(0) > 0 and WLOG can assume Po:l

H[k, x, t, P] = u[x(t)]e-p' + P(t)[f[k]

from (1') u[i]e-at

pIi - ak -;l>

crk

- xl

u[x]e-ct * Ort'

r,

u[i]e-ot - u[x]e-oi > Pti - cri - xl - f1i - o[

= -P(x) - P(-i)

Vx(t)>0 0<t<T

=P(i)-Px
assume

liq

u(x)

- i1

-oo

u(x)= -oo
=i(t)=0
=
(boundary) lJ
not optimal

=*(r)>0 Vt 0<t<T

(i.e. interior solution)

/\
A
^n
(from dH /APi =) k(t) =r(k(t)) -ck(t) -x(t)

>0

(from - aA/a

:) i t = - p(t)tf 'G(O)- o l

since x is max in condition

afr

- dx
^ =0
+:
-

kO

afr
dx

(1') for H

critical point

=0 =u'(ile-o' +P(lX-l)=0

P(t.) = u'[i(t)] e-er > 0

>u >o >o

tdP(t)i dt:itt)

rittl:

:t"ie-p'+f,'

(Qt" -pt')

e-p' (-p)

""p' uuti(t) = -p(t)trit) -ol

=

)(it"

-pt') : -0'rtrlth

-t'

/1

1*1e*'gr'6y *

a1

-qr

t ?: -G'rirrrGt -ot-pt')rt/\.
UA

t :- -^-(f '(k) -(a+p)

same as in previous secton using calculus of variations
same phase diagram for x 1 and feasibility k t

G)

Now show calculus ofvariations, in particular Euler's equation, is a special case

of optimal control theory:
I=
J"

/
I
I
\

x(t) = {x, (t), x, (t),..., x" (r)}

rtx(t), x(t),tldt

Calculus of variations: choose x(t) to max

s.t.

x(a)=c {b)=p

like f, in theorem

if let ;t(t) = u(f,

then same as Pontryagin optimal control

\o'oJ'{*to,u(t),tldt

x(a)=g

x(b)=

final T time fixed, end points fixed

Hamiltonian:

'

+--

^
= P.f + /P,u,ftl

,=l

,arr

=x,' =-=u,
,p.

6:-drl:-pld
ox,
=max

crifical point

note

Vi
('.' u(t)

\ ox,

no

x,term) (3-F-20)

aH _
af = 0
= P. :+l -set
iou, ou, r---\

=constant>0; suppose

Po

=0+

i=1,".,n

P;

Vi

=0

contradicting

all P1

vanishing simultaneously.

= r-" > u

=)lf

ers

'

P
_at= ____
aui P.

P
.d(af\
_l _,1_ l= ___

and

dt[aa,

. af draf)

eouauon

ax, dt [ai(r)/
\

aui

( ar\
\ a,'/ I af
P. =-L0t,

'.\
(3-F-20)-plal

P.

i=1,...,n

not

chapter

A.

IV.

Discrete time dynamic equilibrium and optimal economic moders:

Discrete dynamic macro equil models:

i) Review of difference equations (dfce :tions)

Most undergrad models are static models with same-period instantaneous adjustment
and
without any time dimension. E.g. demand function ai present, suppry firnctiin as
ofnow,
equilibrium prices found instantaneously and hold for ihis moment.
In real life, we have intertemporal (between time periods, e.g. last month-this month-next
month, today-tomorrow etc. ) situations and adjustment processes. To handie such
situations, we need difference and differential equations.
when we are dealing with discrete trme change, we use difference equation and with
continuous time change, differential equations.
Difference equations are functions between time-lagged independent variables at
different time intervals and dependent variables.

Terminology: Order of difference equation

e.g. 1 period lagged

e.g. n periods lagged

greatest number

l'lorder

oftime period lagged.

nth-order

Symbol in difference equations:

A to measure discrete (not continuous) change over time period t.

Ax

Ax, = -------- - xr -t At

e.g. (last year

GDP

this vear GDp

$10 trillion
=$ 9 trillion
A x 1 $(10 - 9) trillion: $1 trillion )

Xr

solution of a difference equation yields values of x for every trme

ftrnctionl

t.

It is therefore a

Further categorization:

Linear (with respect to x t ) difference equation: one with x only raised to

l
l"r power (so
product terms like x, y 1 or-exponentiar terms like x
1
, m any real number, noi attowldy.
e.g.xr:bx1-1
a, b constants (note term araisedto nth power okayj

+ a"

Otherwise we have nonlinear difference equation.

e.g.
a, b constants

xr :b(x,-r )'*

Autonomous difference equation: one independent of time. i.e. without any

time t terms
in the function. Otherwise it is non-autonomous which is dependent on timi.
e.g. autonomous dfce
X, = bx,_t
a
e.g. non autonomous dfce -tion:
bXt_t
at

*tion:

xt :

In the previous chapter, we derived the general formula for l tt-order linear autonomous
difference equation as follows:

* &

xt:bXt-r

d,b constants

General solution (when no initial condition is specified):

We start iteration for t = 0, 7, 2,

..,

Xr: bxo + a
x:=bxr+a=b(bxo+a)+a
=b2xo+ba+a
x:: bxz + a:

b2xo+ a(b

+l)

I a(b +l))+a
+b'a
*ba *a
= b'xo
b(b2xo

X1

= iiiiiiii

b3xo + a(b2 +b+

: btxo + a(bt-l

:::::::::::::

+ bt-2

l)
+ ... + b+ l)

But geometric progress of t terms of sum

:
(St-1 ',r-6t-z

i__1_l-

Xt:

+... + b+l) {

:
)

ifbrl

ifb=l

General solution (when no initial condition is specified and we get family

solutions by varying initial condition x 6 ):

Ix s-(a/(l-b))] bt

[a/(1

_b)]

xs f !t

If initial condition

is specified

b+ 1
b=l

get specific solution.

tz_rl

of

We can re-write [2- 1] as

x1: Abj

?"

complementa.y
firnction =
deviation ftom equilibrium

If

deviation

.Cr
\

where

A=xo - (a/(l-b))

particular solution
= intertemporal equilibrium level

A bt + 0

ast-+ co

C=

a/(l

*b)

t22l

ofx

then solutionx,*

C = intertemporal equilibrium
also steady state of the system (= rest point, stationary value).

C is said to be dvnamicallv stable

stability depends on b (e.g. b = I/lrl , N a natural
oo, A b' -+ 0 )
number
as t

-)

Acfually Steady State x * means: as t-t oo, xt - xr+t: Xt+2 -- ...... =somex *
and we will retum to this subject later in our discussion of dynamics of the system.

Remark: We have to be very specific with the categorization of both difference and later
differential equations because there are different approaches and different solutions for
each categorization. Above system is single difference equation, i.e. one-dimensional.
Later we will look at simultaneous system of m difference equations i.e. m-dimensional.
Finance application as illusEation: deriving formula for Future Value FV using
difference equation:
Given present value P 1 for period t, interest rate per

) P,:

(1

period: i

+i)P, 1 in l't-order linear difference equation form

and

i >0 t(1+i) >1;6

so apply solution formula

P,= {Po - 0/[1 *(l+t]](1 +i)' + 0/tl -(t+i)i

: Po (l + i)t
which is the formula for FV.

(v=

?o

7,

=Qti,)f"

f,.(+i)(
-

Fv',=

Pr,=

[+e

Po

,.L ^

Q+t)

ro

( I rt

SIMPLE RI,CURSION:

we note in difference equations, x t is a function ofprevious period x 1_ 1 (for all t)

,
which means the problem is recursive. For linear reiursive problems, we use iteration
to
derive the solution, as we have done for the linear difference equation solution
formula.
In particular, if the linear difference equation is of the simple form as in the above FV
problem:
Ps+1

=a P1

(interpretation: principal P in t + 1 period = a times p in previous

period t ) deposit accumulating)

solution by iteration is much simpler & we can solve without using solution formula:

whent:0

Po*r=Pr=a

Po

t:l

Pr*r=P2:a

P1

t-*2

Pz*r = P: =

=a(aPe):
aPz

a2p6

a(a2po)= a.po

t=n-1

Pn

=a Pn-1:a(ao-tP6 )=

and this can be an alternative way to calculate

We

Iet P6

anP6

FV:

present value ofdeposit and interest rate is i, then

principal plus interest eaming per $ per period and

Pn: a"Po = ( 1+i)'po

a-1+i wi

bethe

wili be the future value after n periods and is the

same formula we derived above.

The reverse process ofcompounding is discounting.

i.e. given

FVn

and discount rate

From above equation we get P

i,

what is the

pV

6?

o : p,' /( l +i)'

) PV=FV"/(1+i)"
ln particular, we let 1/1+ i: B, then pV: B 'FV"
A formulation we will see in macro growth model lften.
E.g. social planner maximizing discounted society's utility stream Max

tS

tU( c,
).

OBSERVATIONS AS PREVIEW FOR RECURSIVE DYNAMIC PROGRAMMING:

l.

From above iteration, we get inkling ofusing recursive method to solve

a
dynamic problem with sequential relationship. We break up the dynamic problem
into sequence ofproblems, solve one ofthes- ,"qu"n"",
th"n use solution in
the sequential relationship to solve the whole dynamic problem.
2. Similarly, for dyramic programming where we are doing
multi_stage dynamic
optimization. We break up the problem into sequence oiproblems, solve
one
stage and then use this solution in sequbntial relationship io solve
the entire
dyramic problem.
J. To inhoduce risk, we use stochasric models which basically
consist of sequence
of probability distribution (p.d.) function for the sequentiairelationshio.
4. Regarding system equilibrium :
A) For deterministic models, when the sequential solutions converge to a
recurrent state, then we get an equilibrium.
B) _For stochastic models, it's the sequence ofp.d. converging to an invariant
distribution which is the equilibrium.

*i

Dynamics of a discrete system:

A discrete dynamic system reaches a steady

state when x

V t > some n.

A linear autonomous l't-order dfce =tion xs = bxt_r + a has the properfy

ofhaving
a steady state iff lbl < 1. Thismeansthatthetimepathxt,t:0,
1,2,.... traced out
from a difference equation x1 = bxt -r +a will
to a steady state iff lbl< t.

This is obvious ftom [2-2].

For b =+ve fraction 0<b<1

It is a monotonic path convergence

"onu".g"

b = -ve fiaction -l<b<0

It is an oscillating path convergence

For

Harrod Gro*th Model

a descripti.,r"

growh

.oa"tlGg

aiff".err""

-t-.

"q*ti_-_

will be st'dying gronth moders with dynamic optimization. As preparation,

we start
yith the simple deterministic macro Harrod growth moder using difference .dil;, ;;
we.

look at the dynamics and intertemporal equilibrium.

marginal propensit, to save

Given aggregate savings

aggregate investrnent I

St = sYt
= a(Yt - Yt-r

St:

) a>I

(this is Acceleration
Principle in Macro which
says aggfegate Investment
is proportional to rate of

AY

marginal capital: output ratio

equilibrium

-9
U<s<
l

Ir

i.e. rate

of

ly t )

I 1)

(IS curve over time)

sY1 = a(Y,- Y,-r

(a-s) Y1 =oYtr

t, : (a/ (a-s))Y, + 0

is in l'r-order difference equation form

I a
X1 :bXj-t

solution by formula

) Y, = 1Yo:

(a / (a-s.1)

) (ai (a-s))t+ ( ---------1-(ai

(a-s))

Ys {a/(a-s) }t

But

a>_1 s< 1)

non-oscillating.

(a-s) > 0 t

a/(a-s)

> 0 which means equilibrium

) a/(a-s) >1 (see below)

: 1.2)

Furthermore since 0<s<1anda>l

1.8 /(1.s-0.3)
@.c. a: 1.8, s-0.3

1 (non

oscillating), explodes without bound and not convergent to y e path.

Ya

t,

uv

Note in Harrod Model , in case

/ (a-s)

non oscillating

<1
<1

fboth these cases violate Harrod assumption of s > 0 ]

) a<a-s
) s<0

'a (a-s) *ve

) a:als

fraction
t*0

i (+ve fraction)
) convergent

as

t---

) s:0
Y,:

yo{1}, = yo

ast___} oo

oo

conversent
convergent

a1=Lo

One more case is when

a / (a-s) :0 [violates Harrod's assumption]

thenYt:Yo{0}':0

,>
is, yt :

or: yo

so depending on where Y6
0 maybe below
note the econ implication of a zero national income over time.

and

tg,

Corollary to Harrod Model: Y 1 in some cases explodes so change question to what

growth rate g will wanant St
I1 for each t -- warranted growth rate problem.

We know Y r =Yo

{ a /(a-s)}t

[Not: using solution of lst sequence to get equil for whole recursiv
probleml

= ( Y1- Y6)/ Y6
) g = ( Y6 {a / (a-s)}'- Yo)/ Yo= a/(a-s) : (a-a+s)i (a-s) : s/(a-s)

and definition

Econ policy

of growth rate g

implication:

s:

Suppose policy maker knows a = 115%o;

l5%o
investment at all time, then must try to get

and his objective is to ensure savings

= s/ (a-s; :
to ensure S t = I t foreacht.

growhatrate g

15% / (115-15)%

15o/o

/ 100%o:

15%

chapter I[. A. ii) Review of I't-order nonlinear difference

equation with phase diagram
(discrete growth model with nonlinear production

fu.;il;.

we

see how above l tt-order

rinear autonomous difference equations can be

sorved. In
fact, linear 1"-order and 2nd-order dfce
*"
uf*uf,
explicitly
solvable.
For nonlinear difference equations, *. =ion,
.un rot frJ roiuiioo'. ,or, or the time. However,
we can use phase diagram to study the characteristics
ofthe sorutions.
A dfcd +-ion phase diagram depicrs y , as a firnction y
of ,_1
.:t axes lor phase diagram will be y - y
,_1
,
where Y, = Y 1-1 will occur when the
ure uurer(,l
difference tuncrion crosses the
..o l,t-]:4n9"
,.
,,__A
?,
4)
rlne (+)- -trne equates the vertical with the horizontal axis).

It

For example, given nonlinear 1.t-order difference equation:

Yr: (Yr-r)"'
Find steady state:

y=(y)"
)

Y c-l
Yt =ytr :y:

y(y3-l)=o ) y:0

or

y = I are steady states

difference equation will cross 450 line (where vertical axis

Y 1=
axis) at Y = 0 and 1

Note: Y r-r

:0 )

Y, = 0

so the

1-1

horizontal

origin (0,0) is on dfce equation graph in phase diag.

check l"t and 2nd derivatives ofthe difference equation:

dY,

d Yt-r

(Ya)-%

>0(=slope)
,,

tfrl,r

d, Y,
=

dYu,'

(-3/4) (1/4) (y

-1-3la <
)

aaaa,

-9

L.-)

Y4

)function

is concave & we can draw phase diagram:

and from some arbitrary points like

Yr-r

0.1 and 1.5,

yt:1

the graph converges to Y1-1 =

is a locally stable steady state.

t(l,1)

Lo,

o.t=Io

Tt-l

6s7

The divergent cases are where ] r" order derivative

at steady state point l> 1. Hence we
have the following test for local stability for 1't-order
auton6mous nonlinear dfce =1ion:

given steady state y

If

d Y,

d Y,-r

< 0 then oscillation

l*,

> 0 then non oscillating

If

l-rl
Again using the example

aty:9
dY,

------------__l

ury-o

dY,-r

<

then y is locally stable

>

then y is locally unstable

of y t = (y .r ) ".

: %8 ,, )

t'ol

[steady states (0,0) and (1,1)'

ary-o ---+ +oo

non oscillatine

dY,

-----_-___l

d Y"l

I aty=0

co )

locally unstable

)0

non oscillating

: %<1

locally stable

.---+

atY=1

dY,
-----*-llatY=l
dYur

dYt
"-----*-lI

d Yt-r

atY= I

r/a

We can check similarly for the other three cases.

An economic application would be the following typical macro growth

model:

Given:

Yt

national product andkt capital (assuming unit

6 capital depreciation rate; s savings rate as "% ofy,labor) both at time

Aggregate

production:

Investment

yt = kto

kt >0 0< o <l

t e N set ofnatural numbers

function: kt*r = kt - 6kt +syt

) kt+r = kt

6<

1 0< s <l

dkt +skt"

= (1 -6)kt

+slt"

Ilgr.ordr nonlinear difi.erence equariotrI

steadJ states from solvi-ng following equation:

=ft'5k +sk
t k[6-sk"-1 ]-0
t k=0 or !=o-r.i(o I s)
l(

interpretation: equ'ibrium of the growth morlel depends

on depreciation rate 6
and savings rate s
Equi.librium olr*. *h"o
i"
the (o_ t)th root of
(depreciation/savings) ratio.
""0r1",
Econ

let order derivative:

d ktu
---.'.-...-..1latv

dkt

(1

'o) + cr s k," - t
v >0

>0

>0

>

>0

2"4 order derivai;ive:

d2kt+r

.........,.-......1

latr

kt

-concave

(o-1)
q s kr"-2
e <0 >0 >0 >O

<0

function and graph as follows and the non-zero

steady state is locally stable

ano converges m onotonically:

ft,t*

+50
r

llt=-rr-

-ar

arD

Remark: Some nonlinear autonomous dfce :tions like xt : bx1_1 (1 _xt_r

)has
parabolic-shape graphs its 1 't derivative changes sign - in the phase
diagram where x
converges monotonically at first but then oscillates as it nears the steady
itate. This leads
1

to chaos theorv..l

,.L

tb41r7;E-

Summary:

Difercnce equations

--t

Linear (with respect to y r )

- always explicitly solvable

nonlinear
- in general no explicit solutions
- use phase diagram to analyze

Solution
+ stability ofsieady states

i/

autonomous

nonautonomous

autonomous

nonautonomous

l"

order

*, = t1",., n

Solution by fomula
(recursive method)

bx, l+at

xl = blnxr-l+a

,/

some functions

xl - rxr-r(l-

xl_ r)

can lead to Chaos Theory

b, a are b, a i- or both
xl = br xr-l+ar_

Solution by recursive method

2nd

order

xr = bxr-l *axr-u *c
Solution by formula

&

eigenvalue/roots

(@

Chapter IV. A. iii) Briefreview of eigenvalue and eigenvectors for square matrices.
Stochastic descriptive dynamic model with Markov transition probability matrix:

fsurvival of firms)
In above two sections we studied single difference nions. How about n-dimension
difference equation models consisting ofn simultaneous difference equations?
To handle such n-dim difference models we need EIGENVAIUE in linear algebra.
We recall to solve a set of n simultaneous linear equations with n variables, we set it up
in matrix form A x : K , where A is a square matrix, x and K are vectors:
E.g. Given linear system:

x1* apx2 :
O2yXr* A22x2 :
311

k1

kr

LHS can be wriften as A

RHS

K:

:[:;r

lt

IKI

Ll

;i[:;]

rrJ
:

We then solve A x K using various methods in linear algebra.

For a square matrix A, we can calculate a number called determinant (to see
solution for the linear system),

if J

1 !

x:

(not K) where A is a square matrix.

For eigenvalues, we are solving A
cr
Also we can calculate another number called an eigenvalue ftom that square matrix.

[for eigenvalue, we first note if x is not null and given scalar ct,
..1
e.g. for 2x2 case.
-lr -!
f

If
0ll*, 1:
ax:lc x' l= rla 0lP,'l11
"
1l I x)
| 0 JL-J
L
L" *'l Lo "JL]'J
|

To derive the eigenvalue number:

given vector x
(xr, xz, x:. . . .,

and square matrix

[-a

',
lu:'

x,

o,,

a ,:

a22

a23

crx: crIx

a Ix
l

+0

l:
I

l'1.' u" u "

i_i9.;

If we can find reaVcomplex scalar cr

s.t. A x : cr x then a is called eigenvalue and
Note if a is an eigenvalue

is called eigenvector

t A l: s x : crl x
) (A- crl)x:0: null matrix

(A- crI)called
characteristic matrix

Lemma: for square matrix B, if Bx : 0 but x + 0 ) determinant

Pf: Assume lBl + 0, then B - I
given . B
we can multiply both sides of equation by B-1

x : 0
+
B-rBx
il * tIx:0
iltx
t
lBl:0
So by above lemma,

lBl:0

B-ro

il-

[-

confradicting x-+ 0

deteminant l(A

so we see that eigenvalue

a I )l :0

o is s.t. determinant l(A

o I )l : 0

and this suggests the method to calculate eigenvalue.

In fact $(cr)

l(A

o I )l

:0

Remark: we can write Q(cr) as

:crn+aroo-l +

is oalled the eigen equation (or characteristic equation).

a

polynomial

"'2 + a:ct"-3 +

arc

where a 1 are lirnctions

of

... + a,,-lctl+an

:0

a;i

Then by Fundamental Theorem

ofAlgebra, this polynomial has n (not necessarily

distinct, not necessarily real) roots and these are the eigenvalues.

- aI)issingular
matrix (A - cr I ) is linearly dependent
vector x can assume an infinite number of solutions.

Since (A

I
)

ln order to get

a unique vector solution, we normalize

To normalize means we choose the unique veotor

by

x i2

L=

( x 1 , x2 ) which has a length of 1.

Geometrically in Euclidjan space R2, u."Io. * cbe represented by an arrow fiom the origin to the point ( x 1 , x2 ) and has a unit length.
This implies that x12 * x22: l.

Eigenvalues analogy

eigenvalue : person's ID card

o. is not a mafix, but a number (analogous to ID card not a person but characterizing a
person).

Mafix

Person

Numerical example to show how to calculate eigenvalues:

:l
"= [-s
[: -e)
we know for eigenvalue

ct

butlA-"tt: [n^-*

L'

A-o,

Il=0
:

',

(-9-cr;2-f1:;

"]

=81 + 18 (t +ct' -9:72 + 18ct +ct2 :0

) ct : 1- rat./1tt'-+1t11tzy1y t z1t1
) cr: {-tst.[TFZEE]l7z
)

cr,

= {-9t3} : -12 or-6

*= {- ax,,[*G"11r zu

both eigenvalues (roots) are negative

We can use any one eigenvalue to calculate the eigenvector

substitutinginro

-3

(A-

, say use

ct)-r =[r-*-u, , I [-,.| :[,

., (_6lJ

xt +3xz=0

Ir

L.,J

o: -

L3

;lf; I

:|l,.il

and

xr - 3x2 = 6
x 1 : x2 and to normalize x 12 + 1r2 =

t
t

xt2

+xr2

=1

.) 2 x12 :1

xr ={-072

-r
f
'- andx =lfat72l
+ x2= xr ={(l/2)
I

lwz'l
L

Similarly using the other eigenvalue = -12, we get the conesponding eigenvector as:

=[l
=fsl
'''
,-',,,1
lfll
lt,]
['-

f'l
LOJ

t
)
t

3xr +3xz:0 and

3 xr + 3xz : 0
xi = -x2 and to normalize x1 ,
x12 +1-xy;2 :l 9, 2 xt2 _I

t *' ={@) t

*r, =l

Xz=-Xr : -./ ltlZ; andx :

[1.':?,,1

Another numerical example for illustration:

lu
Ll l

given square 2x2 (hence 2 eigenvalues) matrix A =

to frrd eigenvalues o sel 0

det lA - crtl

l-6 - o

Ir

ro

o-"1

= 6 s, +

check

az

-7

I & -7 are eisenvalues

",41,

l"i' ,.,1:,

l=,

There are many usages for eigenvalues:

1. to test for sign definiteness
2. to test for matrix singularity
3. for obtaining solutions of 2no order difference equations
4. for determining the stability of dynamic systems
5. for derivation of general solution for n-dimensional dynamic system etc.
_

In addition, if square matrix A is also symmetrical (i.e. A = Ar ) then we have the

following convenient properties regarding eigenvalues:
example of symmetrical

r-t
A lt t

4ll:
lz 6
4 5J

et

l:
We note symmehical mahi*

rri.t

U. square because a

ij

ji

in symmetrical matrix.

S)'rnmetrical matrices have

1) only real eigenvalues (no complex roots).
2) enough independent eigenvectors to diagonalize and not necessary to work with
generalized eigenvectors.
3) eigenvectors that are orthogonal to each other

economists many time assume matrix symmetry when modeling for optimization
or statistical (econometric) problems.

Numerical example: (let

e ; denote

eigenvalues)

givensymmetricalmaiixa f-s

12{

set

21

lA-eI | =9

->(_5__)2-

l;4: 0:>

{-10

(-

!1100 - 4(1)(2r)l} / 2 (r)

10+ 116)

/2 : -7 or -3

all e < 0:> A negative definile and all e are real numbers.'.. A_symmehical
can furd eigenvectors x-,
from e, f.o. = -3
ar_

J./tal

Lr'4

-7 ",

{'lltfl"
hi,oj

After frnding the eigenvectors x ! x I fiom the respective eigenvalues el

group t}em into a Transformation Matrix
T= [
xz- ]

",

e2

we can

lr

We now apply n-dim difference equation model to economics.

1-dimensional difference equation with single difference equation enables us to study e.g.
how price of apple in period 1 will affect price and consumption of apple in period 2 etcl
In real life, we require more complicated dynamic systems than those described by I
equation. We need dynamic systems describing economic phenomena and their
intertemporal relationship as well as their intenelationship. This necessitates a system of
n simu^ltaneous difference equations. e.g. this month's price of apples and oranges will
{fect ltue months'price and consumption ofapples, oranges, banana .... as described
by difference equations; or present period R&D (research and development) will affect
future technological level
affect future production
affect futuri supply, prices,
demand etc.....

we illustrate with 2-dimensional first-order linear difference equations which can be

easily extended to n-dimensional first-order linear difference systems.

2-dimensional l"-order linear difference equation system (= fwo I st-order linear

difference equation forming a dynamic system):
Xn+1

ott

Yn+l

ilz t Xn

Xn

* av Yn
+ a, v^

We can rewrite in matrix form

(still discrete & intertemporal

n , n+l period )

-^il".

*t+l
I

znr|n

I n+l
I14',-

[-"-,.l
tll

= [",, ",,"l [.".|

LY",,J Lul urr) LtJ

UUU
Z

n+r =

Zn

A solution to the system means Z n = ( x, , y n ) that solves all the difference equations
in the system simultaneously.
To derive a solution, we need to assume that A has 2 distinct real eigenvalues
(characteristic roots) e1 ,
and corresponding eigenvectors 11
v2.

e2

Review:

1) get eigenvalues by solving lA - e; I | = 6

2) get corresponding eigenvectors by solving (A

3) form transformation matrix T as matrix

[1

-e I )y
11: ]

:0

null vector

Following properties ofT are needed for the solution derivation.

Theorem: A is a m x m square matrix (not necessarily symmetrical) with m distinct real

eigenvalues el ,e2, ....,em and corresponding eigenvectors v r , 1L2,..., v-!q.

is the transformation
.l

Then T_'A

matrix:

T =le1 0
[ 0 er

0
0

I'

t:

o
lo
L

v1

y_2

...

,n

] and

if

-r

exists,

ol

:l

9rn I

Proof: for

sake of brevity, we prove the 2 x 2 case. The m x m case proof

exactly the same steps but with i extended fiom 2, ..., to m.

By defurition T
But

I r:] ) AT: [A11 Av2]

Iv

Av; : eillj

follows

by definition ofeigenvalues and eigenvectors

) AT = [e ryJ ezv z I

: r,r

..,,

0",]

1r,

:T
['

:,]

T-rA T :T-r

t'

ler
Lo

iJ 'f' :J

:
F'

:l

Qet

Corollary: if A is in addition

a symmetrical matrix, then T

-r: J r

Given a 2-dimensional linear dynamic system in matrix form:

:
'l
I.".
ttl :
L'' 'J

UU

[,

', ",,.I [.".l

L"''

AZ"

Zn+t

A is a square matrix
eigenvectors y1 L2.
and

I't step:
LetZ

useT:Ivr

i=T

^-J L'"J

with 2 distinct real eigenvalues

v z ] to transform Z:
i.e.

Qt

UU
[t
[z

and 2 conesponding

Zn

:TQ.

Zn+r

=TQ

o*r

,,,,1 [0,,,,.l
rrrzJ

[er;nJ

) q= T-t Z

for

allz

Qn = T-rZn
including

Q o*1 = T-r Zo*t

m panlcular

Q nrt = I

LD*t

T-r (Az^)

r-'

A (rQ.)

(T-' A T)e"

[", ole! q"

lo
F,

Lo

ol

[0,",,-l

.,J p.,4

:
:
t q(n+l)t =
:
q (n + r) 2

l-l'

'*',,.*"]
= een

[:;n]
er

g(n)r

e2 q

(n)2 t2-31

two I -dimensional simultaneous

difference equations

are

Recall from our discussion on finance application using iteration method

difference equations in the recursive form

Q n = eo Qs

welet

where Q

ofQ n+t: eQ n

to

solve

the solution is

is value of Q at period 0

f r f I
Qo= lCrorrl:1c11
rorz-l L. ,l
[o

where c

c 2 are constants

' t2.3r 1x';:',lN : [l ;;{ I |;$ =[:::;llJ ::i: :i

now transform Q o backtoZ"

>2, :re"

:rfo,",,l:rF,:.,1
Lo,",,J [:,".'J

=[rr

"r,[:;::J

:cl ern IL-! +c2 e2n y_2

)Zn
: general solution form fora 2-dimensional dynamic model Zn+r : AZ"
and the solution consists of constants c 1 c2 , eigenvalues el o e2 n and eigenvectors

The above can easily be extended to m-dimensional (i.e. m simultaneous I "t-order linear
difference equations) system:

l':Ct,'

Zn+t

zn

j
[i::lt;*

z 6yr
z 612
:

z6y^

Theorem: LetAbe the m x m matrix with m distinct real eigenvalues el e2 ... en

with corresponding eigenvectors v r v 2 ... va :
) general solution form for a m-dimensional system ofm l't-order linear difference
equations Zn+t = A Zn :
7

-^

where c;

er' yt

+c2 e2" L2 +

: constant i=

*cm emn llm

1,2, ...,m

Economic application of m-dimensional difference equation system (discrete mdimensional d1'namic model) :
We construct a descripive dynamic model for growth of firms. To add more realism, we
rntroduce risks into the model. This can be done through Markov process
a stochastic
dynamic model with Markov transition probability matrix. A model for firms growth can
be stretched to imply econ growth with policy implications.

Some preliminaries:
Markov matrix M is a mahix whose entries are > 0 and whose columns (or rows) each
add up to l. This property means Markov matrices are suitable for handling probability
dishibution (or density) p.d. functions. In other words for stochastic models:

row = 1(orl00%)
row = I (or100%)

=l
[Review: P is a p.d.

if

P1

>0

and

Pi = I ( like a Markov column)

iwk)

e.g. tossing of

coin 2 outcomes

PH(H)=%>

Pr(T)

:% > 0

IPi =l

Defir:
Sn+r

Stochastic process is a rule assigning probty that dynamic system will be in state
attime n*1, givenprobty of system being in state Sn, Sn-r, Sn-2, .... So in

previous periods.
In particular, ifprobty that system will be in state Sn+r at time n+1, is dependent only on
the previous state Sn , then called Markov process (i.e. only immediate past state matte6).

M.,

Markov process Z n+ 1 =

Z6+gr
:

gt

Zrrrl

ml1
m2l

Z 6+ r)2

Zn\
z61z

;l

zr"rkl

mkl

+ r'sk

column

:l

M called hansition probability matrix or Markov

matrix.

Econ interpretation: if econ is in state j (e.g. good econ, bad econ, depression, recession,
boom cycle etc ) at time n then m;.; is the probability of econ will be in state i at time n
+ I (i.e. probability ofintertemporal change in econ state).

Application:
Let x n : 7o of companies in an economy growing at end of period

! n :

%o

of

companies NOT growing at end of period

n t

2 states of econ

& let probability of growing

periodn+l:90%

companies at end ofperiod n to continue to grow at end of

(caa arrange Markov M to letthis be represented by mrr =.9)

:>

probability of growing companies at end of period n to be NOT growing at end of

period n + 1 : 10% (can arrange M to let this be represented by m u : .l)

:>

column of M will add up to .9 + .1 =

Let probability

periodn +

of NOT growing

1=40%

companies end of period n to be growing at end of

(can arrange Markov M to let this be represented by m rz :.4)

Q4)

:>

probability of NOT growing companies at end of period n to continue NOT

growing at end of period n + 1 : 600/o (can anange M to let mzz .6)
column of M will add up to .4 + .6: I

:)

Dynamic model describing above econ system

Zn*r

Zn

Xn+r :0.9xn +0.4yn

/n+r :0.1 xn * 0.-6 yn
t\
^rt
note I column

(2 dimensional)

X column

-l-l

Znn'L

:>

F,,l

: [:

Zn

s{ FI

one of Markov matrix M eigenvalues.: 1 and the other eigenvalue from solving

%i-, ,lf " l='

:>(0.9re)(0.6-e) -0.04 :0.54-0.6e*0.9e+e2 -0.04 :0.5 1.5e*e2 :0

1 /2(1) = [1.510.5]12= lor%

:1 s, = [1.5+
:)

eigenvectors by solving

M-e;I v:0

[on-' oo lf.,,l =iol

tLo.t o.o-rJilluJ
t Lo.l
tl

',:1;

[:

=
0.1 vr
vl - 0.4v2 :

- 0.1 Vl + 0.4v2

0.4 Vl +

0.4

vz

0.1 VI +

0.7

v2

u
v1

:4

il []

-0

u
v2

V2

normalized

v12

+ vrz :

l'1){

[l fl,;;l

(4:1

cc

- i;] lil;J

(1: -1

cc)

Alternatively

any vector 4:1 proportion

By Theorem, solutionofZn+r

will work

will work

= M Zn

: z^ :{:cr ein l4r +c2

"l

tl

L'J

any vector 1: -1 proportion

- cr (t)' f+l

e2n L2

", 1rra"l 'l

L'J

L 'I

As n ---

llll

['"J

"o

this term (1/2)

"

---, 0

L'l

We wish to get this term into p.d. form (i.e. % terms) which can be achieved by letting

ct: l/(4+1): 1/ 5

:> z"=["".| =rnl+]:

lllrfrir

loul=1aoxi
=
=L,yA

L'"J ['J I coldmn

l,;l
I
:1

Econ interpretation: over time (as n --r

=l

80% of companies will continue to grow.

20% of companies will stay stagnant (no growth).
Other possible economic scenarios:

Jolumn

In t}le above example, if we let gror'4h of companies in an economy be directly

proportional to growth ofthe economy then above conclusion can represent the long run
economic grouth picture.
But note the conclusion figures depend entirely on our assumption of Markov probability
mi.; . For instance, if we just change the above m 1r probability to 80% (probability of
growing companies at end ofperiod n to continue to grow at end of period n + I now:
80% instead oforiginal 907o). This maybe due to business environment becomes nonaccommodative (e.g. govemment imposing higher taxes or new sales tax, extremely
harsh environmental control, new labor legislations etc.) then conclusion becomes only
66.67Vo of companies will be growing and 33.33% of companies remaining stagnant in
the long run and hence hindering economic growth. @lease check this as an exercise).

I.nA)

Chapter IV.A. iv). Discrete dynamic macro employment model to explain long run
unemplol'rnent (R.8. Hall model for finding employment pattem).

Macro unemplolnnent rates are not useful for formulating macro policy because it does
not give us information to which group our policy should be targeting.
We wish to know whether there are struchral or just short term reasons. E.g. low skill
manufacturing workers in HK maybe unemployed for a long time because low-skill
manufacturing jobs have moved to China (structural change in HK economy). During
SARS and recent deflationary period in early 2000s, workers in all industries were losing
jobs (short term reasons). 2005-2007 and 2008 saw some employment recovery and hints
of inJlation. Therefore typical macro employrnent models are tamed as follows:

Hall's Employrnent model for finding pattems of unemployment over time.

Hall, "Turnover in the Labor Force". Brookings Papers on Economic Activity 3 ,

@.
1972)
Let

p:

probability worker will find ajob (on average in the LR)

) l-p: probty w remain unemployed.

)
So

probty w remained employed next period

l-q : probty w will be unemployed next period

if let x : workers employed this period

q x will rernain employed and ( i-q)x unemployed in next period.

Let y

py

workers unemployed this period

be employed and (l-p)y will remain unemployed in next period.

will

I
I

next period average number employed qx + py

next period average number unemployed (l-q)x + (1-p)y
)dynamic system describing above average unemployment model for periods n & n+ I :
*

Ln-l
(2 dimension&l)

xr+l
yn+r

Ln

:
q xo + py"
: (1-q) x'' + (l-p)y,

[Hall estimated for male (white) workers in U.S. in 1966:

Xn+l :
yn+r :

0.998
0.002

x
x

y
" ++ 0.136
"
0.864 y
"
"

We of course recogrize these p, q,

using Markov.

Let

(I

-q)

are transitional probty that can be formulated

. = fraction of workforce employed at end of period n

y n:

fraction ofworkforce unemployed at end ofperiod

,;s

of econ
I

Assume probability ofemployed person at end ofperiod n to continue to be employed at

end ofperiod n + | = 95% (e.g. can arrange Markov M to let this be represented by m 11
= .95)

:>

probability of employed person to be unemployed next period,= (100-95)%

(e.g. can arrange Markov M to let this be represented by mzr = .05)

:>

column of M will add up to .95 + .05

:5%

probability of unemployed person at end ofperiod n to be employed at end ofperiod n +

(e.g. can arrange Markov M to let this be represented by mp
.45)

:
l:45%
:> probty of unemployed person to remain unemployed at end of period n + 1= 55%
by

(e.g. can arrange Markov M to let this be represented

column of M will add up to .45 + .55 = 1)

:>

mzz

.55

dl.namic system describing above econ model Z n * 1

(2 dimensional)

n+

n+ t

Zn

= 0.95 x n + 0.45 yo
= 0.05 x " + 0.55y"

tr

I column

note

X column

-l-l

Zn+t

i::r : [;: tgL;{

:>

one of Markov matrix M eigenvalues: 1 and the other eigenvalue frorn solving
0.95 0.45

:0
e
0.05 0.55 - e

:>(0.95 -

:>=
0

:MZN

e) (0.55

- e) - 0.0225:0

l.5e + e' -0.0225 = 0.5 - l.5e + e2

e i = tl.5 r
/ 20) : t1.5 r

0.5225

\D75@3jf

{6:ttl

t2

= [r.s + 0.s1 t z

t or lz

17tO)

:>

eigenvectors by solving

I-rrr

lo.ss-r
llv, l
tttl
| 0.05 O.ss -l -LI I v, I

M-e 1I v:0

:io 'rf

o.4s

lo.es-%
lo.ot
L

lol
L.I

,:;:;

=i'l
[;J

L'J

= 0
0.05 -v1 - 0.45 v2 = 0

- 0.05 -v1 + 0.45

vz

0.45 v1 + 0.45
0.5

vr

+ 0.5

vl:-

=9V2

normalized

v12

+ yr2 :

uf",i

U".l

"1:,1

v2:0

v
V1

v2=0

:tl ie./
tl

vaz

(9:1

| {vaz I

cc

| 't uzl

=L

L"'l

L.)

(1: -1

c)

"C

Alternatively

any vector 9:1 proportion

By Theorem, solution ofZ

n+r

will work

tl

l: -l

proportion will work

: MZ"

=2"=l*"-i ="tet 'y-r

L'".l

any vector

", rrr i-ql

L'.I

+c2 ezlt y.J

il

+c,,112)n
'\[ \

tI

{_
lt_i
,

As n ---r oo this term (1/2)

'

---+ 0

:"'

|;]

tJ

We wish to get this term into p.d. form (i.e. % terms) which can be achieved by letting

cr=1/(9+1;:1719

:>

Zn

Ll

"''[:]

vt r:r)

I column I

=l

Econ interpretation: over time (as n --+

column

=1

will remain employed

l0% ofunemployed workers stay unemployed (LR unemployment rate of

907o of employed workers

10%o)

Policy implication:

If

there is a persistent LR unemployment rate of l0%, then this is not due to business
cycles and policy must be geared toward frrding out the cause of this structural hend and
relevant remedy.
For example, we mentioned structural change of HK economy from manufacturing to
service (banking & finance, entrepot and logistics, tourism) sector in the last twenty
years. The cause is the loss ofHK comparative advantage (higher labor and other costs)
to mainland in such manufacturing sector. HK Government policy seems to favor rekaining ofthe displaced manufacturing workers or outright subsidization. Effectiveness
of such policy is hampered by reluctance ofdisplaced workers to switch, especially to
low-paying jobs; &/or displaced worksrs cannot be re-trained for higher paying jobs; the
usual mismanagement of bureaucrats includes wrong estimation ofpossiblejob vacancies
and placements, increasing licensing requirement barriers preventing workers ability to
switch jobs; waste due to bureaucratic rigidities (versus market allocation and discipline);
abuse and sometimes fraud by subsidy recipients.

Chapter IV. B. Bellman's dynamic programming: Discrete dynamic multi-stage

optimizati on models.
Basic notions and terminology (optimal decision sequences examples)

Dynamic models can be continuous time

(t represented by real

x(t) or

numbers)

discrete time x t

(t by integers).

In pure math econ, most models are continuous time. Main analytical tools are
differential equations and optimal control.
However, most macro math models (e.g. macro growth, business cycles, employnent
theory) are of discrete time. Hence difference equations and Bellman's dynamic
programming are the main tools.
assume such discrete period to be points of time and
differential equations and get useful result.l

fRmk: can actually

still use

Bellman's dynamic programming DP:

Defn: Bellman's DP is basically a way of solving dynamic optimization problems.

It is a multi-stage

(: multi-period:

sequential) optimal decision process.

Given a multi-stage problem, we find an optimal decision policy.

Based on this policy we generate a sequence of interrelated decisions that will
optimize our objective at every stage
and by following this decision policy, overall dynamic objective will also be
optimized.

)
)

A multi-stage optimization problem:

stagelperiod
policy

decision

Find opt decision

s.t. transfer will contribute
best value to state variable
at each

stage,

2"d

3'd
transfer transfer
state-l A
51a1s-/ nr
51a1s-3
l

"

opt
opt
opt
value-l value-2 value-3

th

.. . .. ...

transfer
state-t

/}

opt
value-t

and best to overall value of state variable

overall objective optimized

DP Terminology: there are two variables in DP. One is decision (= choice = control)
variable and the other state variable. Every path decision at period
affects value of
state variable in all future periods t + 1,t+2, ......... hence affect overall value of state
variable.

t)

How to do DP?
Illustrate basic notions and terminology by an example of minimizing budgeted expense
(abbreviated as exp) for economic development (growth):
You are appointed as minister for economic development in country Planningland. You
have to draft a 4-year plan to develop the countqr from economic state A (manufacturingbased) to economic state O (service-based). There are altemative ways to achieve this as
given by the following graph. The numbers represent respective exp levels of altemative
intermediate stages necessary to reach stage O.
stages/periods

I
Feb/2009

Feb/2010

34

Feb/2011

Feb/2012

)e
Objective: find optimal path to min overall exp to reach state O.
A : manufacturing-based econ state
3 : gov build IT network for all office buildings downtoun
C : gov build another theme park
D = subsidize private IT companies
E : increase funding of finance schools in universities
F : special tax allowance for tourist and finance industries
G : build east, west, north, south Kowloon cultural centres
H : expand airport
I : build additional shipping terminals

O service-based econ state

One possible approach: grind out all possible paths, (in this case, all 18 paths) and
compare overall exp for each path. Tedious, even for our simple problem.

@,

One possible approach: grind out all possible paths, (in this case, all 18 paths) and
compare overall exp for each path. Tedious, even for our simple problem.

Another approach: pick min exp path every time:

A) B '.' 3 is smallest
then

B) F'.'5

is smallest

then

F) I '.'3 is smallest
then

I)A'.' only path (& exp:5)

) totalexp:3+5+3+5:16
Butthispathisnotminexppath'.' e.g.

A> C ) F ) I ) g
523s
) total exp: 15 < above 16

So need another approach: Bellman's DP.

DP Procedure:
Bellman discovered the following technique, called Bellman's Principle of Optimality:
Various ways to state this Bellman's Principle of Optimality:
optimal policy has following property: startiag from ANY initial and ANY optimal first decision,
the remaining decisions constitute an optimal policy for the state resulting from the first decision.

A. Al

B. Optirdze {optimized objective of current period + optimized objective of all subsequent periods
get the solution for the overall problem.
using recursion- based on current period decision)

C. Starting from any point on an optirnal trajectory, remainder trajectory is optimal for the
corresponding problm initiated from that point.

Above all mean that with Principle of Optimality, we can convert an n-period problem
into an equivalent 2-period problem, namely current period and all-future periods (or
all- previous periods). All-future (all-previous) period treated as one period. In
addition, we assume that we have already optimized the objective for all-future period
(or for all-previous period). Then we only need to optimize the current period and tag
on the already-optimized all-future period. We repeat this process for each period
(either forward or backward in time) recursively and the problem is solved.

t-r
'
2-peri od probl

't+t

COnVerI

lfconvert
lr

tl

em

optimize

[ (t-1

&

all

previous)

and t]

optimize I

& al I futurel

.ti:\

Now we solve your min-exp problem using DP:

Define

x1

)A=xo

decision variable, in this case: immediate next stage at period

xr )

x2 )x3)

current state
means wg move from state S

xt:Q
5
immediate next

state x

is @

S+ /{

4.4.

stage at penod 4

,.4
tFt

(He)
-\/,2

(L, )
\/

Define: value function F t (S, x t ) for exp = total exp of already- minimized overall
policy from stage t onward.

Define: f(

S,

1)

= exp of current period

zt)

F. (s,

Letx

= 6""i.ion variable minimizing F,(S, x,

):

denoted

by Fs*(S)

vt

Value function F 1 can be written in the following form called policy decision function:

Fr(S,xt) = min {f(S,x) + Ft*r *(xt

vtrich = for stages after S)

X1

sFe

min{ curent + alrcady-min t+l periods onward}

zt

DP terminology: an equation containing an unknown function is called a functional

equation. (Above equation contains the unknown frrnction F p r * (x t))
Terminology: above equation is recursive

'.'

both F

and F tr r are in the same

-ion.

When working with time, we move backward stage by stage tbrough recursive equation
until we get the first stage and we get the overall optimal solution for the whole problem.

(-D

We start from period 4 with destination state x a

Q
(S,
+
F4
x a) = min {exp cunent period 4 already-min for stages 4+l onward}
=min{f(S,O)
F4*1*(no stage afterxa=A)}:F a* (x:)

t
)

E 0 '.' no stases 4*1 onward

can tabulate:

t=4
F+*(S)

t=

(t

F3(S,x3):

2 more stages to go)

min {f (S,x3)

X4*

+ F+*(x:)}
il

X3 t

F:*(S)

l+4=5 4+5=9
=10 3+5:8

min{5,9} =
min{10,8}

:8

t7
min{7,8}
I

l
t

: 2 ()

3 more stages to go)

\t/

Fz(S,xz) =
min

{f(

S,

2)

+I

Fr *(x z)l
tl

F z* (s)

X2+

tl
B

8+5:13 5+8:13 6+7=13

3+5:8

2+8=10 4+7=11

1+8=9

5+7=12

EElG

t=

| (t

['

4 more stages to go)

I (S, X r

rneans

optimized for period I onward (i-e. overall)

= min{f(s,x;) +

pr*(*v

Fr*(S)

Xt'

ll
A

optimal path(s)

xo* )

x r*

orA

orA

)D

x2r

x 3*

'F

'I

xq*
iJ

4+9=13

econ development

for min effort for

5+8:13

3+13:16

l
t

l3

IJ

)a

Remark A:
Above DP can have infinite staees

solution will be infurite sequence of interrelated decision variables {

f=

Remark B:
Often times there are no solution or no closed form solution (only approximation).
Remark C:
Above DP require two pre-conditions:
Principle of Optimality: At current stage, an optimal policy for the remaining stage is
independent ofprevious stage policy. This is analogous to EfFrcient Market
Hypothesis in Finance that current stock price reflects all relevant information of
previous periods so we don't need to know tlle previous period information.

i)

ii)

3 recursive relationship: consecutive stages are related and such relationship is same
for all consecutive stages.

Remark D:
Many time solution by common sense, not by elegant deep math manipulations.
Remark E.

Most soluble problems need differentiability

limited to local results.

Dynamic programming and macro growth models.

As we mentioned, the latest development of grad level macro rely heavily on dynamic
programming because it is employed to show rational eoonomic agents optimizing over
time periods (with or without risks) - proper description ofeconomic agents observed
behavior within GE (individuals optimizing to reach equitibrium) framework. Hence we
get the micro (and concrete) foundation for macro. We also mentioned that macro GE
models are different (not individual consumers or producers optimizing as in micro; but
social planning maximizing some aggregate objective function subject to aggregate
constraints).

Example: simplified macro dl,namio progranming model

In an economy, 3 social planner elected by and always carrying out population wishes
instantaneously. Let c , : qurr.rl oonsumption in period t and is controlled by
population through the social planner.
os control decision lariable ].

There is only one national product (a composite good) Y 1 in cunent period t which can
be consumed or saved-invested, two inputs labor (assume: population) n 1 and capital
k1. A production ftrnction F relating these 3 variables F( k1, nt
Yt and F( k 1, n1) is
homogeneous of degree l, differentiable and concave.
Assume labor constant over time periods so can write n 1 = 1 unit .

):

) |

ln1 [F(k1,

n)] = F(kt/nt, n1/n1):F(k1,1) ) fcnof k1only.

and next period capital

production this period

consumption this period

dfined

) kt*r : F(kt,1) -ct = f(kr,ct)

recursive equation [2-5]
Note k t is then the state variable [we are looking at dyramic evolution (or equation of
motion) of states k,, k,*r ]. State variables are the recursive ones in the constraint.

Assume economy's utility function U is a function

ofbothkl and c1

U(k 1, c, )

and U differentiable and concave.

Social planner's problem for population is to maximize this period's, next period's, and

all subsequent period's utility

Ifwe

different future period utility

period becomes:

Max

[l for

end of each period t, then we can discount

back one period to PV and problem for any particular

are given constant discount rate

IU(kt,cs) + [3U(k6r,

)]

ct*r

for all periods tand

t+l

Suppose T + I is the last period, so we solve only for the periods T and
solve recursively backward to I "t period:

T+l first and then

1"' step: Max B U(k t*t , c r+r ) wrt decision variable c r+r to get the optimal decision
function for c 1*1 in terms of a function h r+r of k r+r :
(by setting partial derivative = 0

DU(k r*r , c r*r )

:0

)get

cr*r * =hr*r (kr*r)

0"t-'t
nothing after T+l pe.iod
example
Max {U(k r*r , c r*r ) * fl V r*z (k r*z )}

V is analogous to F in previous

2nd

step: define a value function V r*r (k r*r

= U(k r*r , h

r*r (k r*r ))

all same

k r+t

(T+1 period variables)

3'd step: set up objective firnction for the consecutive period problem:

U(k1,c1) + [3U(kr+r,cr*r )

: U(kr,cr) + [3V r*r (kr*r )

: U(kr,cr) + BVr*r(f(kr,cr))

from recursive equation [2-5]

4d step:

Max

{U(kr,ct) + BVr*r((kr,cr)) } wrt

c1

Setting partial = 0

aUGr,cr) D(kr,cr)

? Vr*r (krrr)

+B

ct

c,

I :

)getcr*:hr(kr)

k r*r

i\J.u,

step: after getting optimal decision function c 1*:h1(k 1)

= I and we obtain
which

5m

repeat above procedure backward toward t

*:hr(kr)

cr

Max{U(k1,c1) + BVr*r(kr*r)
Cl

} = Vr(kr)

t2-61

[2-6] is called Bellman Equation.

Furthermore

if

V t Gt

converges to a steady state

ft1)

[2-6] becomes

v(k,) = Max{u(kt,c) + t3v(kt+r) } [2-7]

cl

[2-7] is a functional equation (i.e. same function V appearing on both sides ofthe
equation) and when we solve this functional equation for V, we get solution for the
dynamic optimization. This method is Bellman dynamic programming.
We see the parallel similarities of the previous example and above problem:

F1(S, x1) =Min {effs*1 +F1*1 *( x 1= L,n

t+l onward )} - policy decision fcn p-4]
"tae
X1

V(k,) : Max{U(k1,c) + BV(kp1)

}-policydecisionfcn12-71

C1

Economic application example:

Planningland govemment now appoints you to be education minister. The govemment
deems the best policy for economic growth is by investing in Planningland University but
wants you to minimize the University expenditure. You did an econometric study and
found:
Whenever govemment budgets education expenditure E, in period t , the actual
expenditure will be E .
2. When E is spent, "education capital" K1 consisting of camp^us building &
infrastructure, library etc. will be I expanded/upgaded by
3. intertemporal relationship between Kt+r and K1 (dynamics of the system) is given by:

l.

&'

K*r-4Kt:E,

;: ri

4-^.0-A,L
You know at present K, represented by K6 = 5 (billions of $). You are glad the cost
function is quadratic which means I a soln. Your appointment is only for 2 years (T = 2)
so you only wish to solve the following problem:

rOl
Min : (p,'+ K2) *
E t=0

Kr2

s.t. Kt*r-4Kt:&

lrrB-rl

*."1

[IIB-2]

Ko:5

bo

[IB-3]

To solve:
We start from T-1 period

Min
F-

p12

s.t.

Kz

- 4 Kr :

Kr

Kr

1118-5-61

K1

2; +

t
K22

Er

lrrB-4I

[IIB-5]

to be determined [118-6]

into [IIB-4]

Min (Ett+ Kr2) +

@1

+4S)2

I't order condition for min: (take derivative wrt E1 and

zBt+ 2(Er+ 4K1)(l):0

: -

K1_

[IIB-7]

4Ki1 q-+

: Kl
e

control variable for

4Kr

IrrB-81

) t:0
Min (Eo' + Ko') +
For T-2 period

s.r.

set to = 0)

t:l equals to -2times state vble

ValuetunctionVr(E^r)=Min(El 2+ &1^ + 1B1 +4&)2
=(_2Kt\. + K,,* (_2Kr+4K,\'
Eq

&-

Ko:

I Min (E62
) Min (Eo2

aItu =

Eo

+
+

Vr @r

UrB-t0l
urB_31

2s)
25)

9Kt2

T;L

gGko +Eo)2

IIIB-91

K""

I't order condition:

) 2Eo + 18 (4Ko +EoXl) =0

>
)

Eo=-18 [IrB-11]

following

2F4

18 (4(5)

+EoXl):0

& : 4 Ko + E6 = 29 a 1-t*, -,
Et: - 2Kr :-4
from[IIB-7]

from [IIB-10]

\= 4(2)+(-4)= 4 from [IB-s]

Vr@r)= 9k: :36
from [IIB-8]
Kz= 4Kr +

Vo@o):Min(E02+Ko2)+Vr (Er ) =(-18)2+52 +

36: 385

fiom[IIB-3-8-9-11]

In other words, you will budget to cut initial expenditure Eo : -18 and next period cut
expenditure Er = - 4 and the total minimized expenditure will be Vo(Eo
385.

):

Remark:
We note that we did not discount the FV in the various periods. The implicit assumption
is interest rate i in Planningland is zero, then there is not need to discount the FV to PV.
(discounting factor B': I / (l+tt
1)

PLEASE READ STOKEY & LUCAS CIIAPTERS 1 AND 2 FOR

FAMILIARIZATION OF DYNAMIC PROGRAMMING CONCEPTS.

Bellman's Principle of Optimality in metric spaces

Given
l. metric space (X, d1) called state space:
2. initial state x0
(x" if X is nth state)
3. transitioncorrespondencef:X3
f continuous and compact-valued
self
conespondence
given
tells us that
state x , what will be all the possible
[this
"
next state x 61]
4. discount factor for each period n 0<p<1 (assumed same for all periods)
5. one-period return (e.g. utility fimction ) function u: Gr( D
R ( R including +oo);
u continuous & bdd

X;

set

Feasible plan

s.t.

(:

strategy) is represented by a seq(x")

xl ef (x6)

fNote: x" in the

and

xn+r

seq is the state

ofall

sequences in

X1

Xsequences

f (x") n:1,2,3,...:N++veintegers
ofthe system for period n+1]

Typical DP can then be expressed as:

Max

u(xo, x

r)

seq(xJ

* L-

p, u(x,,

x i+r

IDPU
s.t.

xrf (x0) and

x"11

f (x") n:1,2,3,... =N*

Basic assumption for Bellman DP:

(to avoid endless oscillation)

lim
*)

XN po u1xn, x,,11) IR

n=o

for any feasible plan seq(x") Xsequences tA-DP-l]

[This assumpion means we can find real number representing the PV of intertemporal
returns stream offeasible policy decision.l
Define correspondence F p (x )

:{seq(x")

:XJ

Xsequences

Xt"au"n"""

: xrf (x)

and xo+rf (x.

nN+}

[= set of all feasible plans]

>zu)

Define new objection function H14 (seq (x"), x) : {F

"1
aad look at altemative DP problem:

Max
s.t.

H6.t(seq (x" ), x)

u(x,

" ')

* _l-l

(x ) x {x}with x e X} )

pn u(x",

seq(x")F1(x)

xo11)

tDp2j

[this [DP2] is same as [DPl] except initial x6 in [Dpl] is replaced by any x e X in[Dp2] l
[By assumption [A-DP-l], HE,1 (seq (x, ) , x) is well-defined real valued function. Since
u is bdd, H1q ,1 also bdd.l
Define value function V(x)

:X )

sup {

Hp,l(seq(x,),x) :

seq(xn)

eF1(x)}

[Dp3]

solution to [DP2] itr above sup : maxl

[V(x) gives us the sup H s.t. feasibility]
I

Thm: (Bellman)
Given any [DPl] problem with any initial state xo X and see x(n*) e F r (xo
V(x6)

H6

(seq

(x*

"1

)]

) , xo)

V(xo): u(xo*,xr*)+ FV(xr*)

and

V(xo*):

And conversely

u (xn*,

ifu

Pf: Deft of V(x6)

xntr*)* 0V(x,*r*) V netl"

is continuous and bdd.

means for any seq x(n*) e F r (xo )

u(x6*,x1*)+1,-p"u(xn*,xn11*)
o=l

u(*0,

x1)+xn=l

Fo u(xo, xo*r)

Vx(")eFr(xo)

Now due to recursive sfucture of the DP problem, for feasible (xz, x:, ...) eFp(x1*)
(x 1*, x2, x3. ...) e F 1(x6)
[if (x2, x3. ...)is feasible plan induced by initial state x1* implies(x1*,x2, x3. ...)is
feasible plan induced by initial state xa with next state xr*l

u(*o*, x1*)

+t - pou(xn*, xo11*)
n=1

Z u(*o,xr*)+ F u(x1*,x2) *

V(x1*)

V(xo)

H1Il ut (seq

(x2*

Hrrq(seq (*"* ),

: u(xo,xr*)+
:

u(x6,x1*)+

u(xo, x r*)

And by iteration:
V(xn*): u (xo*, xo*r*)

Conversely,

ifu

We have V(xo)

p'u(xo,x"+r)

H[-,.1(seq(x2*, x3*, x4'*,... ), xr*) ]H6ut(seq (x2, x3,

V feasible seq(x2, x3 , & , ... ) F I (x1* )

But

:;

u(xo,

, X:* , &* , ... ) , xr*)

xo)

PIu(xr*,

*r*) * Xn=2

F lHrr,ul (seq

B"-r u(x"*, xo*1*)]

(xz*, x:*, &* , ... ), xr*) ]

p[V(xr* )]

* 0V(x^*r*) V nell*

is continuous and bdd:

x1*)+

&,... ),xr*)

u(xo , x 1*)

fv(xt* )l

pu(x1*, x2*)+ p'V(*r* )

: u(x6,xr*)+ Bu(x1*, x2*)+ p2 u(x2*, x3*)+p3V(x3*)

u(xs,x1*)+

1!r

ju(x,*,
F

x1*r*)

+ F'*tv1"r*,*y V reN*

Since u is continuous and bdd by assumption

I
t

Visbdd
UB>0s.t.
=

lVl <

UB

*
t

the term p

V(xo):
=

r*lV(xr*r*)

u(xo, x

H1q

't

r*)

(seq

) 0 as J)

p, u(x,*, x.;*r*)

P,-

(x'* ),

oo ('.' V bdd and p is a +ve fraction)

(J)

co

xo)

[The converse part of the Thm tells us in case u is continuous and bdd and if f solution
(a set of maximizer sequences) to [DPl], tien we can go from the value firnction to the
set of maximizer seq. In other words, we can use the value ftnction to solve Dp
problems, under the stated assumptions.]

Principle of Optimality:

Optimal policy correspondence P: X

X for DP problems:
:argmax
P(x)
{ u(x,x1)+ 0V(xr): x1 ef (x)}

[reminder: arg max stands for argument of the maximum

e.g. given f(x), arg max: set of x* that maximizes (x).
so above P(x) gives the set of solutions maximizing the value function

V(x)l

Bellman [1957j: "an optimal policy has the property that, whatever the initial state aad
decision are, the remaining decisions must constitute an optimal policy with regard to the
state resulting from the first decision."
policy, whatever initial
[Means: policy function is opt for the infinite summation
state and decision are, remaining decisions as per Bellman equation must be optimal
policy with regards to resultant state from initial state/decision.l

f(x): X) R :sup{ l(x)l withxeX} < -}

: {{all bdd real firnctions defined on X}

Terminology: BtX)=

Note: B(X)

space is metrized by the sup-metric

Thm: (Bellman, Prinoiple of Optimality)

Given any DP problem and frrnction Q(x) e

Q(x):

max

Q(x)

d-

i.e. B(X)

:a metric space (X, d-)

A(!:

{ u(x,x1)+ FQ(xr): xl ef (x)} V xeX

will:max { Hpol

(seq

(x"), x) : seq(xn) eF1(x)}

[DP4]

V xeX

Pf:
For [DP4] Pick any arbitrary x X and for any arbitrary seq(x,) e F p (x), we have

Q(x) >u(x, 11)+

pe(xr) lZ-\

but Q(x 1) = max {u (x1, xu) + B Q(x2): x2 e

so Q(x1) >u(xr,xz)+ lQGz) V-21

incorporating

-u(x,x1)+

F{

but Q (x2) : max {u (x2, x3) + 9Q(xs): x3

so Q(x z) )u (xz, x:) + F Q (x:) [Z-3]
incorporatin g lZ-21

Q(x)

(x1

)}

lz-2)inIo lZ-Il wegel

Q(x) >u(x,x1)+ BQ(x1)

/Z (u(x,xr)+

u(x,,x2)+ pe(x2)

(x2

into [Z-I-A] we get....

tz-l-Al

)}

and by recursive iteration:

xr gj u(*i,x1*r) ) * F'tte(*r*,) I:1,2,....

j=1

) asasJ) "o real seq (p t Q("t) converges to 0 ('.'p fraction)

so lim p 'Q(x j) : 0 l : 1,2, ...
and since.Q is bdd

then asJ

Q(x)

oo

> (u(x.xr)+ X- pj u(x;,x;*r)) -lim piQ(xr) J:1,2,....

HEul (seq (xo ) , x)

By [DPa] we can pick a seq (xn* ) e F 1 (x ) with

Q(x):u(x,xr*)+ I

Q(x 1*) and Q(xn*) = u (x"*, x,,+r*)

F Q(x"*r*)

n:1,2,

foranyJ eN+

Q(x): u(x,x1*)+ p u(xr*, xz*) + ..... + pru(x;*,x:*r*)* 0'*t Q(*r.,*)

(u (x, x r*)

!r

Fr

u(x

j*,

x1*'*)

) +

p r+r

q1;,-'*;

...

As J

oo since Q bdd we get

Q(x): \u (x, x r*) +

X-

F, u(*;*,xi*r*) )

max { HEq (seq (x"), x)

[Above thm says

probleml

if

seq(x,)

eFp(x)} V xeX

3 solution Q*(x) for [DP4], then

et

is the value function for our Dp

Chapter IV.

i)

C.

Discrete Time Recursive Optimal Models

Deterministic Optimal Gro'*'th Model: Finite horizon case

Indirect dgramic study using recursive methods:

Model: function mapping state variables onto other variables, with intertemporal
transition fimction on states variables to generate time series.
Mathematics for continuous time models are more elegant and better developed.
However, economists often times use discrete models for various reasons, one being the
empirical nature of economics. Most human (including economic) activities are discrete.
For instance markets, factories, offices are open for certain hours everyday; hence are
periodic and discrete. Economic data, mostly times series, are collected at discrete time
intervals, e.g. GDP tabulated monthly, annually (hence growth rate of GDP also discrete).
Commodities are discrete (however, we can look at the service attribute of a commodity
to change it into a continuous case. For example,2.l566 hours of car service, instead of
one car, two cars etc.).

In 1970s economists like Lucas (Nobe1 prize 1995: rational expectation) think if
government policy changes (announced at discrete time point, applicabie to discrete
periods, e.g. increase in income tax for the fisca.l year 2008-2009, raising of benchmark
interest rate between policy meetings), then rational economic agents will react
accordingly by changing their decision rules for each period.
econometricians cannot assume fixed behavioral equations for empirical work. More
importantly, policy implication is that people's reaction based on expectation on
govemment policy car render policymakers' effort useless.

Counter argument:
1. Such changes in behavioral equation parameters are either too smali or too slow
to seriously affect the usefulness of optimal control calculations.
2. Sims [1980]: govemment policy rule can be framed in the form ofa reaction
function (e.g. monetary policy as a function of observed state like differential
between TIPS and straight treasurys, inflation rates, credit expansion . .. .).

With the above caveat, we will proceed with discrete growth models and re-visit
Bellman's dynamic programming for applying to such models.

Let us start with some preliminaries of a deterministic (no risk) optimal growth model:
Given: Time

ID'

Capital kt J

>

inputs

Labor n, J
Product

y, J
r

ouput

linked by production function y t = F (k t , tt)

JI

h,t'

F(&,nt)
F:
r:

I
I
I

differentiable;!
uolllllluuusly ult.teterrlraurr
continuouslY
quasi-concave;
strictly
homogeneous ofdegree I

f;

F(0,n)=0
nk,.Fn,>0;
li. Fr, =o

kt,nt

*' *'

|
I

lim Ft, =-

II

k'

{/

-'"

ka

allocated by

consumption-savings decision

to

/\,
currentconsumption
C1

-.--:'--"

assume s.t. constmints:

grossinvestments
lg

- cr * irS

and kr.r =kr - -6k,

lfl

machy

)c1+kt*r

-(1

Yt

depreciatedmchY

- 6)k, S

= tllU(ct)
P.V.

Y,

P'u(t'){"(tl

n,=

cr, c2' .""

(normalized) V

0<[l<l

t=0

[!0

u(co

lL

h",rG)

constant depreciation rate

new machy

Assume labor inelastic (fixed) each period

Given society's util fcn U(co,
and U additively seParable

0<6<1[N-0]

i,

ul&,)

) + [3'U(c1 )+t!'?u(cz)

u(c.)

[3'U(ct ) +

u(

U also bbd, cont diffble, strictly t

concave,
c

lim U ' (c r;
t*-

: 5

To apply dynamic progamming:

Wenote

[IV-0] kt*r:kt - 6kt

And society's cunent utility function U(c

it -

A recursive equation!!

is given to depend only on c 1 , is separable

and is additive over discrete time period. Discount rate Bt for each period t are given so
that we can discount different future period utility to PV

dynamic programming can be used to fmd optimal consumptive-investment allocative

policy to Max society's utility over planning time horizon (finite or infinite) as follows:

r
Social planner wishes: find sequence consumption and capital{c r , k t. n, }oo to:
@

0<f3<1

Max IBtu(ct)

IIV-U

t=0

* kt*r -(l- 6)kt < F(k1,n1)

at opt, assume output not wasted ) c1+ kt*r -(1 - 6)k, : F(kt,n,)
) F(kt,nt): F(kt'1)
at opt, assume all labor employed ) nt= I
s.t. feasibility constraint

ct

f(kt )=F(kt,I )r (ltunction of k, filnrv ."rr"r. k I beginniDg-of-period capiial

can defure fcn

6) k,

f(kt) -

)c,:

kt*r

flkt) is cont. diffble, strictly 1, concave, (0)=0, f '(k,) >0,

lim f'(kt): oo
lim f'(kr):1- 6
k r--' 0
kr-'-

Lemma:

Pf:

Since

F continuously diffble, strictly 1, concave

- 6)kt cont diffble, stictly 1, linear (i.e. both concave and convex)
) f:F+(l - 6)kt also continuously diffble, strictly 1, concave
f (0) : F(0,1 ) +(1- 6)0 : 0

(1

f'(kt)= Ft,(kt'1)+
>0

(1

-6)>0
>0

er,

lim

lim Frt + lim

'(k,)

lim

kt-.

k,-- -

kt-'co
f

'(k,)

k, '0

(1

- 6) =

- 6)

(1

"o

rt + lim (1 - 6):o+
k,...'0
k,.-'0
lim F

(1

- 6 )=-

Note: similarity between above F & f and Solow Growth Model F & f.

can rewrite

[IV-l]

as

c, = f(k1) - k,*1 fiom

@ll

ulf(kt)-kr*rl

tIV-21 =MaxI[l'
t=0
s.t. feasibility constraint 0

<

k,*r

< f(k,)

o<[!<1

-{'.'

L
glven ko and

ko >

feasibility equality constaint

0 < ct

tk.r

:f(kt)-kt*r
S (k,)and

o< k.''

J(et)

0.

1*rr'
#ft
&-t

*.T

&")=o

In particular, if [IV-2] frnite time horizon, stops at time T, we get

tIV-31

Max t

0<B<1

r=0

s.t. feasibility constraint 0

Note: at T, k r+t

[3'ulf(k,)-k,*r]

< kt*r S f(kt)

given ko and ko >

0.

0 (no more capital after T, all consumed)

'\-""11\

Since cont.

diflble

l"t order condition:

--{tulf(ko) - k rFB' ulf(kr) - kzl + ... + BL'u[(k

t-r)

-kj+ Btut(k,)- k*1]+ ......1:6

ak

only these 2 terms have

k1

t [3F'u' [(k ur) -k] Gt) + B' u'[f(k,)- k,*1] f '(k t) = 0

.) [rv-4] f3u'[f(kt)-kr*r]f'(k)= u' [(kt-r)-kd t:1,2,.....,7
)

from bdary condition

[IV-5] k t*t:6

given k 6 > 0
to determine specific solution

TD

t) :

-14,

-{t-

tI-'
-')

o(

&

o(

a_ttca4 &

t
-t ) = l-

ltt =a,t=&

:- l- 4- +<
+

t -ot$ * s61 =(-.tF) c -v

+ t- fi-*A)rr*6:o
7=

-6.
kr*ttt= *-l-{

l3ou'eult*

yr

9+-

t*

/ft-t

-)T
o( p

( /t-.{

-r-

o<.lt +

. +(F

,-

/+ <A+
/+a(p

+gpf- vg(r+

- o<6(,+*

YP"+G

r)

rt <6 +("a6)'+for

+<p,t$cf)

Ig-c-r8-,rJ
+ - --- +(*
3+ - - -- t("crs)Ft +U

>A

->

(r-<F) ar

t =l4C -:l

"<s(

T-t+l

e9

<(\ /

/r,-"(F

Lg-t'

=l 2 - -- -

ff=1)

e.'+r"t*

q,*7.-*

fu {r"-c-}"EL

[o -t']
f r {"zF)r*t+rl

:k

Fr'-

:' -."F * Grp)'-'*"

u'( ft&tt - L*", ) *

oa

a4

-K.

Cr-LqFf-LJ

r-QrPlT*trl

t-{Epf't*t -o{A +t<

'-Qcl3i*:*'

t- sF)

(t- *

: 421 T+A

T+o
*7 L;

p,,- 4&a:.<. U.arL&

SO

,-EF
=4.

lw-1-t

Dc A,*, (^,o.q, uq- L AM.e

a*Lt- L /*r/t*.r

a***dat

Chapter [V C. ii) infinite time horizon case usins

Lagrangian method

lReminder note: constrained optirnization is called mathematica] programming (lco,nputer

progr:amming which is a branch of numericar anarysis). Lagrangiau
is used tJhansform a
constJained optimization problem into an unconstrained optimization
one.
Interpretation ofthe La,grangian multiFlier l, : at the optimal level, 2"* shows
the approximate
chaage in the objective function when there is marginal change in the
constraint.l
Given cobb'Douglas production function f with unit labo! hclurring capital good
depreciation:

f(kr)

kf

0< q < 1

=kf -

aldkr*r

k t = capital good quantitry at beginning ofperiod t

0 andis given

ko>

ct

We want to choose consumption c t (control variable) to:

T

Max

B, In

0<B<l

Ct

t=0

s.t.

kt+r =kto

- Cr
\ kt*r - kto

k t state variable (','controlled by c J

+

ct=

cJ

Lagralgian:
T

O= : Bt ln cr

ll

t*r (kt*r' kto

- Bi+l L

where

t*r is the Lagraagian multiplier

+r is margina-l contribution of A k t*r to multi-period objective
function at period t +1
) I t+t must be discounted back to period t I B t*rtrt*r
Since

.L

l"t order condition

lrv-91

ao

Bt

[lt*r).tnr =0 )

Act

I
.-"-

Blt*r=0
t=0,

llv-lol

a@

dkt

1, 2, ...,

can solve for c

* ,

[3t].t .tr

Bt+l lt+1 ( ' o k to-1; =

B t ( - tr

t+

t*

We solve recursively backwards, starting from time T.

Wenotekr"r

is assumed to be not providing utiJity

) kr+r = 0

[3

t*r

o k 1o-1; = e

I
and [rV-g]
Forperiod

cr* =kr

" tomaxutility(U'

> 0) (&om tie constraint equation when t = T)

B.tr

r*r

Irv,10]

).r +(1 / cr)( o kr'-')= -trr+(1 /kr") ( a kr'1)

=-Ir + (o/kr) =0
Ir*= (a/kr)
-

And for period T -

trv-91 I
=
c

f3Lr = f3(o

/kr)= aB[1/(kr,," -cr.rrl

T.1

) (kr-r' / cr.t) ' I = aB

t

cr-r

from

* = kr,t" / ( 1+ qB)

IIV.1ol

-|1.1 +B),r.r*ro kr'ro-1 =0

I hr = f3 ).ro k r.ro-1
=(tlcrJ cr kr-ro-1
= (r+crB)/ k r-1oo k r-r"-1

)rr.r* = q( 1 + cx[!) /kr.r

And for period T - 2

tw-el

=
c

fJ.Lr.r = f3(q(1+a13

) /kr.r)

T.2

= qf3(1+qB) /[ kr,r" - crz]

) cr.z * = kr_2" /[1 + dB(1+qfl)]= kr-r" / lr +

ct

B+

tcrB)2

[v.1ol

l\ r.z

* = [11+qf!1r+atl )) q] / krz
::
;;

= [cr (1+crB + 1aB)z) J

/ kr2

And for period

T -t

cTr* = kr,.' /tt + cxB+ 1oB;z + .... + (a&)t I

[a ( l+q B + (a [!)z a . . . + {qt!)r] / kr.t

try-ll]

Ir.'*=

tiv-i2l

ForT)co 1+o B + 1c t3)z + . . . + (cx B,)r + . . . . . = f /(1, crt3)

lrv- il1 t crt* = (t- ot!) kr_t"
tIV-lBl
[IV-12] t lr,t* = o / t (1+crB) kr.tl
tfv.l4l
) optirnal control consumption IIV.lgl = &action (1- oB) ofproduction k r,1"
And optimal

kt*r * = kt"
= k,o
=

kf

- ct
- t(t-dt3)kt. l

(1

= crBkf

_r(1-cB)l

whichis [V-g.r]

[Note in the^above approach, we erc letting T) o during the derivation

of the solution. This
is different from taking the l_imit of solutio"n as T) oI

This approach is also convenient for us to intooduce technologicar level

into the model by
adding a technology factor At in period t, assuming A, to be a glven parameter.

)
)

kf
above [fV-13] becomes c r., * = (1.q8)Ar kr_to
production function f (k t

above [V-14j becomes ].

tech A

)=

At

r.t * = a /[11+at3) krt]

[V.lA-A]
IfV.t4-Al

to allow technological progress (A or shock) we change At parameter

into a
variable.

stochastic model ) to introduce ri,"ks, we change At into a random

variabre (with a
probability distribution/density function attached) ind we
will be -r*i_d;;l;;";;;;;;
value of the above objective function

(e

To begin to answer this question, examine how the decision or control

variables including consumption c,,, leisure W, demand jrrl for input in the
7
production of good I, and labor input L, in producing good r' behave, given the
parameters 0, of the utility function, a, in the production functions, and
the derived paramelers y, from the former parameters through equation (3.1g).

Equation (3.22) srates thar c, equals (0,,{,)y,,, and equation (3.24) srates that

x,,, = (py,a/'l)Y 1,, p being the discount factor. Thus, consumption o[ sood i is
proportional ro lhe out.put Y,r of good i, and so is the demand lor gooJ i in the

production of good k. Equations (3.23) and (3.25) state that leiiute W, and
labor input l, used in producing good f are both given fractions of total hours
H. If random shock 2,, is introduced in the production of Y,, output of each
good i is subject to this shock. Consumption cu of each good i and the use of
good i as input r^ir in rhe production of good /< will be affected proportionally,
because both are given fractions of Y/r. Because

H is fixed, and leiiure W. and

labor input L,, are both given fractions of H, they will not be affected by the
random shock z,i. Thus, the Cobb-Douglas utility and production functions
impose very restrictive behavior on cn, xr*Wu and Lu if the only shock is a

multiplicative shock

in the production of output y,r.

The above dynamic characteristics of the economic variables generated by
this multisector model are examined by Long and plosser (19g3) who emphasize the ;mplied comovements of economic variables:
2,,

If the output of commodity i is unexpectedly high at time, ldue to a stochastic

shock on the production functionl, then inputs of commodity i in all of its

productive employments will also be unexpectedly high at time ,, Assuming that

the commodity has at least several alternative employments, this not only propagates the output shock forward in time, it also spread the future effects of the
shock across sectors of the economy. At the most simplistic level of analysis, this
is the primary explanation of persistence and comovement in the consumDtion.
input, and output time series in our example. (p. 49)

Cfrot/J

ousi t,ts

Lyctas

6J

Keynesians question the ability of these two

basic mechanisms to do so satis_
factorily (see the discussions oi prose..lresljanJ
r'r."ti* iis"8;), ,".,n",
iepresenting an RBC viewpoint, and the f.ti", u
i"yriisl"an vrewpoint;.
As pointed out in section 5.1, Keynes did not, und ""r"
rh" _;l;;;'ieynesians do
not, believe that an equilibrium theory wittr full empklyment-of
,e.ou."es
prevailing can explain observed economic fluciuaiions.
3l.ways
l"-or example,
Markiw (1989, p. 85) questions whether mosr ,"";;;;-;;;';,
associated
with some exogenous deteriorarion in the economy,s
capabilities.
f;;;";;;
-simuttaneous
the model of section 3.2 may be
r.; *,;i;i. ;h;
r, ltll:uch
"bt"
)menhof macroeconomic variables ro
some exlent, it might be inad_

""

in explaining the leadJag relationships umong e.onomi"

O,

other hand, such leadJag rllations.appear to be well

"iii"U[r.
captured,
through
tral analysis, by a simple linear multiplier_accelerato. fiquiJity_pr"f"r"n".
consisting of
.an aggregate consumption r"*ti.", i*"'r'gir"gri" i._
nt functions based
on the ilves tment,accelerator, and a liquidity.
'erence relarion. See Chow and Leviran
(19691, Cf,o*
sl,

chow (1993b). The key question

is whether the

ifS;,lh;t",

dynamiJ"ir"r""t'-.lti*

through business cyctes can be adequatety

"r
agen6 in equitibrium. Research is still

T:"::::il"T"_11iables
mooers ol optlmizing
.Dy

:jl,,"g:il::

this questLn. No .onr"r,ru, or opi"ion

"":werprofession.
red by the economics
The remainde,

n".i""n

;h;;;;*_".
the resulrs of some recent studies, \4,ith th" p".p;;;iili;ni
"f
so_e
on this question.
thi,

Esllmotlng Economlc Etfecls ot polllicot Evenls

In Chlno

optimization models are useful not only for studyinq .economic

b:t arso fo' studyinsec.l,.fir" .rrriei,

:'-,:*:.!fi"-._1T:T"l
counrries, To illustrate, I provide .;;;il;;;ii,o

aagveloniye
Long and Plosser (1983) also examine the dynamic properties of pnce, wage
rates, and interest rates. Prices and wages are studied by using ihe partLl
derivatives of the value function with respect to the state variables output
and leisure W,. Using the Lagrange method to solve the dynamic optimization
problem for the centralplanner (or equivalently for the market economy), one
can obtain prices and wages by the Lagrange multipliers themselves. The
rate
of interest is found as the ratio of prices of goods in I and , + 1, as discussed in
section 4.4, 4.5, and 4.6. As the optimal decision functions for the control::

y!

"

.,rroy

to measure the economic-effeciJii poriticar

:1,":j:.:nTJ:',l
inctuding 9lT:*l
the.creat Leap Forward *d rh"a;ft,";i
ilf"i;r#:
serves as an introduction to sections 5.4
and 5.5. It araws,fJm
'and Chow (1996).
Chinese economy is modeled as if there were
central planners who
ize, at any initial year zero,

!E,p,rnc,
r-0

ln z,*, = ln z, + p+ e,.,

(s.4)

Per capita consumption or investment is determined by the social planners

solving the dynamic optimization problem. One might object that this model is
too simple, but it is useful in providing a crude answer to the question: If the
Great Leap had not occurred, what would per capita output in 1992 be as
compared with actual output? (By the way, the answer is, Twice as large.)
To arrive at this answer, estimate the optimization model by using annual
Chinese data from 1952 to 1993. The model consists of the random walk
equation for ln z and an equation for lnk,,, derived from solving the dynamic
optimization problem. Because the variables are nonstationary, first detrend
by dividing by 2,, yielding k,.1= k,r1|2,,7,= z/zt and d,= c12,. The model in
terms of the detrended variables consists of

lnz, =p+e,
ln i<,.,

=g+G,ln!

G"lnE,

l)=[o.zrs

(o.oroa),

o.wr

re55 1950 re65

+ e,

(5.6)

(o.ooor), o.ozrs (o.oozs)]

The labor exponent 0.7495 in the Cobb-Douglas production function

FIcuRE,5.1 Observed and simulated residual

'

smoothed residuals. The result is a tactor of 2.0 in per capita ootput in L992
I ,using the residuals free of the effects of the Great I-eap,
and a factor of 1.2
:,using the residuals free of the effects of the Cultural Revolution. The latter
estimate appears reasonable, because this estimate is concerned only with
measured physical output and not with emotional sufferings.
E,| Esllmollng ond lestlng o Bose-llno Reol Buslness
Cvcle Model

Returning to the study of economic fluctuations in the United States, I present

in this section a base-line real business cycle model discussed in King, ilosser,
and Rebelo (1988a,b). The model is slightly more complicated than the one
presented in section 5.3, having another control variable, the number of working hours per capita ur,, in addition to investment t,r,,. The representative
economic agent is assumed to maximize

is

reasonable. The large p = 0.9999 shows that the Chinese planners place great
weight on future consumption as compared with current consumptiqn, thus
devoting a large fraction of output to investment, which is in the neighborhood
of 0.35 for most years from 1952 to 1993. The annual labor augmented technological progress of2 percent is reasonable if I include the years 1979-1993 after
the economic reform. In Chow (1993c), a Cobb-Douglas production function
with constant total factor productivity was shown to fit China data from 1952

eie,p,[tnr,
_.

1980, excluding certain abnormal yeari, but total factor productivity increased substantially after 1980. The current production function incorporates

total factor productivity and fits ihe data well enough for the entire
sample from 1952 to 1993 to be included in estimating the parameters.
Figure 5.1 shows the estimated residual0, in the log productivity equation.
The impacts of the Great Leap and the Cultural Revolution on this residual is
obvious. To estimate the economic effects of the Great Leap, smooth out the
residuals , and e, in the Great [-eap period and simulate the model using the

dt

eln(l - a..)l

to the constraint on the evolution of capital stock

",.,_,

= (t

(s.7)
Jr,,

-6)r,, +r,,

(s.8)

a Cobb-Douglas production function for per capita output, per capita

rDtion is

to

a random

1970

(s.5)

with lnk,*, as the control variable, and lnZr and ln&, as two state variables. The
coefficients (g, G,, Gr) are derived from optimization, given the structural
parameters o, 0, and T = sp. The residual e, is added to the optimal control
equation for ln k,.r to account for the fact that the simple model cannot explain
the actual data on lnk4r cornpletely. Given the structural parameters, and
time-series data on per capita output q, and per capita capital stock k, we can
construct z, by solving q,= zf kl-) and derive the coefficients (9, G,, G) and
hence the residuals q and e, in the above statistical model. Assuming (g, e,) to
be jointly normal, we can evaluate the likelihood function and maximize it
with respect to the parameters o, p, T and p.
The results are, with standard errors in parenlheses,

(a, 0,

rsso

c,

in.which the first state variable

= sr"(z,ur,)" -uu
s,,

117,

(s.e)

f6llows a random walk with drift y.

the,conslrainl on

..ot

::"::

cstcd in multisagc dccision

B.lltnrn died on Mcch 19, l!

in his own wods sinc. be lft
inforiouivc autobiograpbt
publisher bas generously approvcd cxtjnsive excerpting.
During tbc summer of 1949 Bellmen a Eourd associate profcssor of mathcmatics at Staniod Univcrii; wi6
a derclopilg intcrcst in analytic numbcr thcory, was consulting for the second suD-mf, at the RAND Ccooration
in Santa Monica- Hc had rcceived his ph"D. from *nccton

in

19,,16

at the agc of

5,

despite

vaiqr!

(trd tDe nane,

l95os wqc not
gmd ycars for maitematical rcsegrcb- We had a very inErcsting gentlemal i! Washitrgton named wilson. He was

of Defens, and he actually bad a pathological

fea and hatrEd of thc wm4 rcsefich. I'm not using the
term Iightly; I'm u$ng it precisely. His facc would sufttse,
he would tum rcd, ard be would get violent if pecple used
Secretary

war-related

actiyitis during World War Il-inchrding being assigaed

by tbe Arny to the Manhattan project in Irs Alamos.
He had already xhibiEd ouBtanding ability both in pul
matbematics and in solving applied problems arising ftom
the physical world" Assured of a successfirl convcntional

tbc trm, rcsearcb. in his prcsencc. You can imagine how he

fe& tbea about the term" matlenatical Tbe RAND Corpcration was cnployed by the Air Force, and the Air Force
had Mlson as ia boss, essentirlly. Henc, I felt I hsd to do
something to shield Tilson and tbe Air Force from the fact
that I was rcally doing mathematics inside the RAND Ccrrpcration Wlat title, wbat name, could I choose? In the fust
place I was intercsted in plaaning, in decision making, in
thinking. But planning, is Dot a good word for vrious reasons. I decided therEfqe to use the wo4 programmiag.'
I wanted to get adoss th idea that this was dynamic, this
was multistage, tbis was time-varying-I tbought, let's kil
two birds witb one storc. IJt's take a word that has an
absolutely precise neaaing, namely dynamic, in tbe c.lassical physical sense. It also has a very interesting property
as an adjcctive, and that is it's impossible to use the word,
dynaEic, in a pejorative sense. Try tbinking of some combination that will possibly give it a pcjorative me3dn8.
It's impossible. Thus, I thought dynadic pmgrarudng was

academic carecr, Beulca& dudng the period under consideratiorl cast his lot instead
'r'ith tbc kind of applied
mathematics later to h hown as opcf,atioDs rar."t"i. to
those days applied practitiooers wre regarded as distinctly
second-class citizcns of the matbematical Aatcmity. Always
one to enJoy conEoverst when invited to spea& at various univenity mat[ematics depdtmeft seminars, Bellman
delighted in jusdfying his choice of applied over purc matheoatics as being motivaEd by the real world's greater challenges aDd mrtbematical dcmands.

Following ar excerp6, takn cbjonologicaly ftom

Richard Bcllman's autobiogaphy. The page numbers arc
giveu after cach. Th excerpt sction titles arc mine. These
excrpts are far morc serious tban most of the book which
is full of entcrtaining anccdotes and outraeous bchsviors
by 80 exceptionally hunot bebg.

gd

a
nam. It was soEethirg not svcn a Congressman
could objcct to. So I used it as al umbrella for my activi

Stuafi Drtlrls

ties" (p. 159).

BELLI'AN'S INTRODUCTION TO MULTISTAGE

OECISION PROCESS PROBLEMS
"I was vay eagf, to go to RAND in tbe sumrer of
1949 . . .I bcsse fricndly wir! Ed Paxson and asked him

EARLY AI{ALYNCAL RESULTS

-Ihe sumner of l95l was old-hooc-weekHaI Shqiro wer at IiAND.

Sam Kadin and

Sbj.c, ctarri'rotb{: Dr!.ric For'tEEils: bindrr. prf..sbn t: coocrn o[.

Afra d!

tukw: A,vxrvlr!^jry ItsJ! (SrEr^!I

Op.rdd n....rt
\,b1. 50. No.

l.

O 2qn INFORMS

JllorFFhuq ?,rt\fr. a8-5t

m3{!364xi12l5m104 t&t.@

48

152&J{d} clcdto.ic

[;sN

f>,rs)

i.:,fl-',*
nd to'solvc
mber tbcory,

firDc-

doing tlis.

whicb

aay othrs
whcn I found

se9n Pr

was clcar

ClictrbrCl

THE MOOERN MAT}IEMAIICAL IMTELLECTUAL

Ivinq
lngeD'ous

mattrceaticirns-

'I !4d !o mrLe 1 6alor decision. Should I rctum to StaDford

or. stay at RAND? I bad thought about
this question in
ttrDcton, but it was Dot an easy decisiotr !o makc
sioce
tierc were sbong arguments on each side.
"At Stanfond, I bad I tenured positioq good for anotber
,
uury-lgbt yeas. Tbc retircment age at StaDftrd was
sevcnty. I also had I good teaching position,
with not too mucb
teachtng, aDd a fine bouse, which I have
described abovc.
nor te importa considr.tiotrs. Ar Stan-

':me toot we uscd ias tbe calculus of yadations. Wlat

we foud was that very simple problems rcquired grear
ingeDuity. A sEall change in 6e problem caused a great
change in thc solution.
'Clearly, something w8s wrong. Tber was an obvious
lack of balancc. Reluctrntly, I was forced to the conclusion
tbat the calculus of variations Eas not an efectivc tool for

trumber thetry, which I

was sixteen.
_ "Howevr, I had to face be fact that I could not do wbat
I-laDted b do. Possibly the state of matheoratics
did aot

FORMULANON OF TTIE MARKOV DECTSION

PROCESS PROBLEM

:",. T*_
,*
IoT

*T

to do analytic
I bchanc.
do since

nad wa.nted

allow this. CrtaiDly, ny state of howledge

was not up

to iL

"I.
_sfTt cnough timc in Los Angeles to know that I
would_enjoy living there. I also knew th;
Los Aagetes had
many fiae bouses. although it was not undl
196g that I had
one that was btr than lhc one up in Stanford.
"I was htrigued by dynanic progasming. It was clear
^

*.r a good deal of good analysis tbere.

could see many applicatioDs. It was a clcar
cDolce. I could either be a tradidoual iDte[ectual,
or a mod_
cm. inElletua.I using 6e rcsults of
foiO"
problems of
society. Thii
a"rrgo*i
parn. Elther I-conemporary
" roo litrlc
could do too much rcsarch and
appligtion, or too littlc rcsealch and too
tion. I had conEdencc that I could do &is aalcate
^u"t "ppU"uaiivity,
pic a la modc" (p. 173).
th:rc

T"
:o
F.u1tbrTorc,

.y ,"r"*l
**

THE PRINCIPLE OF OPTIIIAUTY AND

ASSOCIATED FUNCTIONAL
'I,

rrs

EOUAIOIS

dcqided to itrvestigate tbrec areas: dyoamic program_

mrng, control tbcory, aad time-lag processes.

obtaining a solution" (e,p. 174-175).

"I spent a geat deal of tine and effort on the firnctional

equations of dynanic Fogramning. I was able to solve
somc equations and to dctermitre tbe propenies of the
ftnction and &e policy for others. I devIoped sone new
tbeories, Markovian dccision processcs, and was able to
rcintrprf an old thecry like the calculus of variations, of
which I will speat morc about below,' (p. 17g).
OYNAMIC PROGRAMIIING AilD OPTIMAL
CONTROL THEORY

"A number of mathematical models of dynamic programning typ were analyzed using the calculus of variations.
The treatmeDt was not rortiae since we suffered cithcr Aom
tbc prcsenc of constraiDts or from an excess of lincrity.
Ar itrterBsting fact that cmerged ftom this detailed scrutiny
was that tie way on utilized rcsourccs deprnded critically
upon the levcl of these rcsources, and 6e tinc remaining
in tbc process. Nanrrally this was surlnising only to soEone u rscd in ecoaooics such as mvself. But this was
my condition wi6 rbe rcsult that the observation of rbis
phenomenon came as quite a sbock" Again the indgling
thoughe A solution is not mercly a sct of functions of time,

p obdm closcty rctari

'As I result of a &tailcd i

as a

over-involvd sincc all along I had

Do desir to

wod

scri_

ously io the calqllus of variations. A corsc ir tbe sub.

ject in college had grven me simultanously
a rather low
opinion of its intrinsic intrest and a healthyrcspect fd its
inticacic.s. It ryFared to be [Ued with comDlicated xisteDce and uniqueness tbeorems

with self-imposcd rcstrictions, none pointbg ia any particular dirertion. This is

Prtnent to a commeat made by Felir Klein, the great

t:erman mathcmaticia4 concerning a crtain

rypc of math_
ematician Wlen this iadividual discorms that he cal jump
aqoss a streaE, he rcnuls to the otht sidc, ties a chair
hit l"S, and sees if he can st'rll jump across the stream.
lo
lory T"y enjoy this spcq others, like myself, may feel
lnat rt is &ce firn to see if you can jump across bigger

sEams, or at last

diftrcnt

ones.

"Despite Ey personal ;selings, tbe cballenge remaiaed-,

trow
drd one obtain the nurcrical solutions of ootimization problems? Were there reliable methods? As oointcd
gut abov.e, I_ did not wish to gapple witb this thorny ques_
o:1 -d had ccrtainly rot contenplarcd tle appication
J
or.dynaEic progratnming to contsol processcs of determintsfic typcs. OriginaUy, I bad developed tbe thcory 8s a rool
for stochatic_ decision processes. However, the thought was_
llruy torccd upon me that the &sired solution in a conEol Foccss was a. po.licy: .Do thus-and-thus if you 6nd'
yourself in this portion of stare space wirh this s-mount
of
!m-_cJcft.''Cowenely, once it was realizcd tbat th coocpr
was fi.6rrqmen6t in conrol tbeary, the natbipaticization of thc basic enghering concept of fecdback
conBol,' tben the empbasis upon a state variable forDrulanatural. We s-iEE-ErEr,-irErBritrgEeracuotr bctweetr dyna.mic goga'nming and contol theory
lDls gntorces tbc point tbar whcn working in tbc field of

of potcy

e": ry"."

A SYST$'ANC METHODOLOGICAL
APPROACH TO MAIHEMAfICS
"As pointed out abovc, as of 1954 or so I had stumblcd into
some importaat types of pmblems and had ben pushe4
willy-nilly, into answcring somc significant kinds of guestions. could handle deterministic conaol ptocesses to
some extent and stochastic decision orocess in ecolomics
and operations rcscarch as well Where next? At 6is point,
.I began !o thiD& in a logical fashio4 using a systeEatic
methodological approach. The point about th suitable ph.ilosophy Plcpaing ouc for the fortunate accident sbould bc
kpt in nind.
'Thf,e are sevenl ways in which a mathmatician can
Pmced to extend his rcsearch eforts, particularly one who
is deeply intercsted in problems arising from the physicsl
world He can, on onc hand, examine thc equations he has
been vorking witb and modify thea in a vriety of ways.
Or hc can ask questions tbat have not been asked beforc
conceming the Datul! of the solution of the original cquations. This is basically a very dificult way to carry out
rcscarch- It is very casy to cbaagc tbe form of at cquation in a largc number of ways. Th glEar orajorify of the
ns, equatioDs ee not Eesningful, and, i-n conscgueoce,
lcad to both difficult and unimporant problems. Similarly,
&cre are many questions that are diffcult to answcr, but
hardly worth asking. The weU-taincd mathematician docs
not Ecasule tbe valuc of a problem solely by ia int-actability- The challenge is thec, but cnen very small boys do not

acc?t all

dares.

uisc

df

!gF,'alt
qongo!
'

of tbc co
ls tle assunptlon Uat ril

of

thc staE v{iableg caD bc

'"In thc ibsl wcl4 n;

fomly r4id Oftcn pa
and comlltltss cannot
problcns of society, as
I'
boondoggte ald high encrgr-ligl cost pt
ues rn tE tict thal wc dont Lnow hdx, to
plx systems of soci*y involving people, wc don't understa.nd cause and ctrcct, which is to say the consqucnccs
of decisions, and we don't erren klow how to make our
objcctives reasonably p{cise. Nooc of the rcquirements of
classical scienc are met. Gradlally, a ncw
-"thodology

for dealing with these 'fuzzy' problems is being developci,

but tbe path is not e.sy.
'Upon 6rst gaeing upoa thc complexities of tbe real
wortr
in temptation to rturn to nu-obf, thehowwer, does Dot seem to be rcwad-

dontinual e.ffon. The prcbleos are too

difficult and &e victoris too few. Taking up the challenge
of complexity, J felt ih'r the apprcpriate +t"g to do was
to start with deterministic control prccesses and to modiS them stage by stage to obtain tbeories which could be
usd to deal with basic uncrrtainties in a morc soohisti_
catcd fashion.
this end, we can begin by inroducing well-beiaved

-*fo

wrcrtainty of the type exteasively treated by the classi_

caLllEo+f@iilitJFTbi{ leads to thc modern theory
of stochastic contol processpwhere uncefiainry is rcpre_
sedltdbv-randnln v+eblefwith known probabitiry disributions, and where the objective is to maximize xDected
values. This gives rise to an clegant 6eory with a good deal
of alts'active analysis. It is a new part of pure matbematics-

it

tbe
was

ical algorith'n".

this Sorccreds

sidrd thc last rsort of an incomptent mathcmaticia!.

tue. Once working in the area,
it is vqy quickly rcalized that far Eore ability and sophistication is rcqutd to obtain a numffical solution than b
establish the usual *istcace and uniquaess theorems. It
is far more difficult to obtaitr an efective algorirhm than
one that stops with a denonstation of validity- A final goal
of any scient'ric theory must be the derivation of nunbers.
Theories stand or fall, ultimately, upon numbers. Thus I
became intrestcd in computers, not as electronic toys but
rathr because of whar tbey signified mathcmatica.lly ald
scientifically. This interest led in oany uDexpcted directions, as I will indicate subsequendy. This is a significant
pafi of the story of scietrtific methodology. It is usually, if
The opposirc, of course, is

not always, impossible to predict where a theoretical iavestigation will end onc started But wbat one can be certain
of is that the investigation of a meaningfirl scientific area
will lead to meaningfrl mathematics. Inevitably, as soon as

thcm ofobtaining numrical arswCs

to numerical questions, one will be led to all kinds of
one pursues the basic

intercstiag and signifcant problems in purc mathematics"

Crp. 182-185).

Chapter

IV

C.

ii)

b) infinite time horizon case using Bellman Functional Equation

In previous sections, we covered general principle of Bellman's Dp. we illustrated it

with simple examples. ln discrete period growh analysis, we oan again use Dp.
Now
otll coverage is on more advanced level since we already have concept maturity in Dp.
For above optimal savings (= optimal consumption q) model, social planner is looking
at
the following problem: (c s control variable, k t state variable ... controlled by c

We want to choose infinite sequence

Max
{ ct, kt*r},-6'
s.t.

{c, , k,*r },=o- to:

BtU(ct)

0<B<1

,:o

-ct

kt+r =g(ct,kt)=(k)

glven ko>0 k1e K1c R*

t2

1i'.'-'-

{o76
u(co)J

e"

pu cct)
Q

r'u-trr

&s

$-y

t3

(c")

f .r(c6;1
Max Bb(c

6)

BlU1c,;

B2U(c2)

+ ... + ntU1c,; + .. ..

s.t.kt*r=(k)-ct
If can find value fcn V(k J = max (all future utility) fmm time t = I onwards
s.t. lerr=f(kJ-ct
then [IV-15] =

Itv-f6l (T uo

u(co)"' BV(kr)

o"?"oov(t

\cr
I s.t. co+>kr :f(ko)
I\ stven ko o
That is, we convert [IV-15] Max

to

o)

Bt

U( c t )

[IV-16] MaxU + BV

without any

:(44,

But how do we solve for value function V:

First we notice above [v-16] reasoning applies to all periods (not just initial period 0).
i.e. social planner actually max the following for EVERy period t (recursive):

Max U(c)+ BV(k*r)

s.t. kt+r =f(kt) -ct

ko>

t
&(

o t 23

[v-17]
[ry-18]

t+t

t*z

tt*t

ij-l,rax alL fuWe have two equations [IV-17] and

need one more equation.

pz'"*aL+ uz-I^-z-

[V-18] but 3 variables c1,k1

and

k1a1

Social planner needs some policy function h(k

= c 1 [V- I 9]
to max in each period t by controlling the consumption c 1 , depending on k 1. We note
again the recursive nature of the policy function which is same for EACH period t (called
time-invariant policy).

[IV-I7-18-19] means

Max U(h(k) )+ BV(f(k) -h(kt))

given ka > 0

this functional equation all in terms of k

can solve for k1 and then get kpq and q from [V-18-19]

)
)

Dynamic Programming DP: frnd policy function h (state k1)

then iterate following 2 equations from initial k0 ('.'recursive)

control

h(k) =c1 [V-19]

kt*r:

g(kt,

c1) (which

the iteration will generate

oo

=f

ft)

- c l in our example) [IV-18]

sequence {

}=o
""

which solves original problem [IV-l5].

The value functional equation linking value and policy functions:

Vft) :maxU(c) + B V(f (k) -c) [V-20] is called Bellman Equation

'-1..,

The fi:nction tl'at solves Max on RHS

satisfi es functional equation:

u(h(k))

v(f (k)

h(k)

of [IV-20] is the policy function h(k)

which

[rv-21]

There are 3 methods to solve the Bellman Equation, depending on U and g, namely:

1) value function iteration

method (since value function V is recursive, we can use

iteration as we did in previous - the recursive compound interest equation).
2) Guess-and-veriff (Guess-and-verify a solution V for the Bellmaa Equation) and
3) Howard's improvement algorithm (or policy improvement algorithm). We iterate
the policy function
for each successive period until h1 converges to the optimal
policy function.

Here we will just cover method 1) value function iteration. (We have seen a crude
version ofthis method in our min effort example in previous chapter):
From Vo , construct

V;*r (k)
s.t.

k-:

+ B q G)}

max {U (c)

g (c, k), given

for

j:

0,

r,2,

Iterate V.;tr until sequence of value functions converges and we solved the Dp problem.
Retuming to our example (2 alternative approaches), we know by the Lagrangian
approach, the optimal path for capital in the oo horizon planning case is

k+r: o0kt"

[IV-09-1]

We want to check

if this

is also correct by Bellmaa functional equation approach.

rr\

|
^ 04
t-+oz at-,
ol Bk,
=

st.

Ca+

*]2.fr-eJ,

s!,0!4r,t4@-

k-,. =

--) v&) - nax L t

L
^
K+.,;
rfl

<A

(--(+@D-

t
'al
{ii

r/-,-(kt.(,-<
,z Ltt+94t +1,

(t t-*(,-<
" /.- (L"

t-("p

2 *il

+ <"/^.(Lo)

A(+) r

+[E:-*]

,=

[g:"-a] >

lsf

P2AJ.v

h+,1u+

z-aa*<';

t. .4- t -"a,
V'= k.,

i;:

r' ((ct l (/-)

L,

t"

It

sK>

ts'

k'
tt pKr
Kr

tL&')

pV

-- ot t',"L' l*(t+$p>: + Fk,+ fr. 4t)+ frr</-k - fr,t^{+*")

= (rrgr,)v t^-k, -(elr)L,Q+Akz)

(r.

v-Lt)

rv:-r:- A]
u-'

+ gk,+

tn*-= l(>, l-r-lc-, t ?)K+

a'.-

u:a-f el*&-k,

rc-,-

tlpEt-)4 =

k, = - [r+Ak,-)

IAJ(l+pt!)tAt,
--------s

tr{o 7-= \;r-<F

+ F k, +Fkz

? tt6k'= w *-J

t1

-r-*F /

= :- ./

h!-!D +pr,+l*-[u*l - r^(,-<tt+ or,

= /-(r'<p)
...,.........-:--

t<l?

+ kf
\7{ u.

)2 s, = -+-l

- : ;

l^, Q'<F)

-F
frl

=*P-

From above,

optimal savings policy function

g(k) (:

-q=k1*1)which

f(k)

maximizes value function

(k)

Max U(

(k) - g(k)

) + 0 V (g(k))

and we solved it and got optimal policy function:

FKz
g(k) = ------- h"
1+ BK2

q
where Kz

l-crF

of Kz into g function

In fact when we substitute value

0[

cG,) =

o/ (l -

we get

cxp)]

Kt-

1+ BIo/(1-qF)]

F I cxl (1

cxp)]

(1-oF + Fcx) /(l-oF)

0B

k"

which

In particular, if we assume

g(k):s

ktnr

0<

s< I

(analogous to Solow Growth Model,

constant c s of output is saved

and invested)

fis continuously differentiable and strictly concave

s f= gft) also cont. differentiable & strictly concave, get following

Since

phase diagram:

(difference equation phase diagram)

{&tr

!(111

Aj&t)= 1Gt)
?6'

&t'

tx

ft.r,'
,

: .gi:'l

stationary solutions (= steady states, rest points, fixed point, equilibdum)

where gG,) k (wffie g crosses the 45o line)

steady states at kt = 0 and at k

only k * steady

but

k1

> 0 by model assumption

state

Stability: pick arbitrary kt point (e.g. kr , ka ) and trace out lines vertically to g, the
horizontally to 45o line, vertically to g ..... to see if convergent or divergent.
From above phase diagram, ifka > or
(note: divergent away from k1 :0)

k,*r
.\
In particular g (k)

k *, all
fraction

convergent to k * as t

) o

fraction

{{

cx B f (lq)

optimal savings policy function g

{ k r}'=o

<

0<o
ft)

converges to that steady state .

B<1

has steady state and infinite sequence

Chapter IV.

D.

Stochastic Optimal Growth Models

We extend above deterministic (=certainty) model to include risks

stochastic optimal growth models.

Brief review ofProbability Theory, Theory of statistics and dynamics of distributions.

Ref

Wu,

L,

Economics of Finance Academy Press 1990

Terminology:
Random experiment / transaction: Given experimenVtransaction under identical
conditions, if outcomes will not be the snme every time (: no certainty outcome), then
experimenVtransaction is called random.

(= experimenVtransaction whose outcomes cannot be predicted with certainty before the

experiment/transaction. )
Examples of random experiments

COINTOSSING
(by same person, same coin)
H, T, T, H, T, H, T,

ABC company STOCK PRICE RETURNS

(same management)

8......

z00r
3.6%

U 03 04 0s 06

07

-7% -2%

5%

4%

-5o/o 6%o

Since outcome are not certain, we wish to find a way to assign probability (chance) P
each outcome occurring.

e.g. P(Hoccurs) :.4999 OR49.99% P(ABCRETURN2006:

e.g. P(coin landing on edge):0%
P is called a

probability function. To define

Definition: Random ( = stochastic) variable

certainty

outcome)

12.760/0

P properly we need a random variable.

t:

value offr known probabilistically (not

outcome governed by a probability function.

Random variables can be discrete fr; or continuous

Population: complete

5%):

of

t.

set of measwements to be analyzed.

,..,f*:tu

BASIC POSTULATE:

probability function P which govems outcomes of events in a

random experiment.
P which assigrrs probability to each fl = q (a quantity or number) in population.

=l

Probability function: is a function ofrandom variable. Two types:

probability function for
discrete random variable fl

probability distribution function P

with properties :

P(t;

Q: q e PoPulation)

>

P(fi) > 0
r

1u;

dii :1

-ao

Vq
e.g. coin flipping experiment

probability density function P

with properties:

r P(fii):l

P(ii' : !I)

probability frrnction for

continuous ranilom variable

P(nz

T)

:'/z

e.s. normal (Gaussian) distribution

z- f G:]

l \-Af-l.-r' 'r eKA

|
)n
P(0)= eJ2Ir Q.
--

*
'.\

-l

can check PGI) =

P(T) >

P1fi\=>
'\-,/

Vfi

J P(u)ou

andX P(itt)=%+n
H,T

-@

by p'd' function and pick the

We just denote all probability (distribution/density) function

ttt" ipptop.iut"

one according to which type of variables we are

working with'

,i.r1

)
;

1
t

(* t4\.*

Adr,,\

J.ote,-

a6t

Y) = ELzl
t

raTl utt-.LC-a-.

t-sP

zEc

t&.,...c.. = q(i)

i - g:!:\l

)/,1

rH

+6t

T-31

el.-

*sl

$o

{-{

6-r

-o;-,

t.rlif.

l-:"J 7t>
=W

{l or7

q, *4.ao

N..#..-{

v*a,tbt

AIA-.-.&

+ b !_(ll:rl:

a E+ql
.

;- (r-r,-,.e)-=

/llv.t

7.--t
*,-1t--

l!e
i-c. a" T+@ ,
k

tl L. ,.e'Ea^1

lA4)

r-..--.- 4 I,*;

=l
{s l,Dt *

t/J4.'L..-t

(t4

'

r l-

t-te
l.r-.)

n 6t*
Ltsll4

el-',"c-

lar- L-

ar+tL A.

eLT a*lJ/il'rJ

\y

L\-

l"'L (Le4

t,c, t '^.."u-d,^. o".n T,*-,

Q^-51"

'L

1-

t{ut

= Yi t"p L)

(.=

_t

v<J

t>1

&,ta-Ll

+r,..

at'|ltt'T

r\

Above is a brief review of probability and statistics theory. Based on that we proceed to
a short inhoductory note on stochastic models:
Recall Ramsey's Model on optimal savings (continuous, infinite horizon case):

Max J PV(society's utility U (c t ))

s.t. technology in the form of feasibility constraint'

We find the caPital stock k 1 level to

U (c t) maximized.
max consumption c t

tech is viewed as
A production set

tr

represented by

Current cap stock k

given current state k I

: k,*r is optimal investment policy
B( k , )

J o=s)

optimal savings PolicY

recursive method based on curent cap stock k t

find g and get next period opt cap stock k r*r

But if the model is stochastic (uncertain outcomes after action), k t*r depends on both k
AND as-yet-to realize technology shock

we need Anow-Debreu state-contingent concept

i.e. k. is expressed as

k,*tt,

{k,itt',

..., k,*"n}

and these states depends on history

Hence to extend a deterministic model

oftech shocks'

toa stochastic model, we introduce risks through

\\

./

A.

technology affecting outPut

function

B.

some other factors affecting

other variables in the mode..

1l-'

We look at approach A. by assuming y

1:

z1

f(k

where sequence \ z1 | arc independently & identically distributed (i'i'd) random

variables, representing technological shocks.

Note: if z1 negative

some damaging shocks' like machinery breakdown, reducing

output.
Furthermore, assume households use expected values ofutility to rank stochastic
consumption sequences (Von Neumann- Morgenstem Expected Utility Thm)

Finite time horizon case:

social planner
T

MaxE[

o<B<1

lt3'u(cs)]

[Iv-24]

t=0

s.t.feasibilitykt*r*

ct S zt(kt)

ct, kt*t}

Vt'V{ zt\AY-251

Assume
Begiruring

ofperiod

beginning of next period

t+1

shock z t realized

t(k ), cs known

r+t

(k t, z t ) state of econ at time t

deterministic model

Social
Planner

Maxbv tct , tt+t

choosing

+--0

stochastic model

continsent on realization
-T
ofzrlz2,......,z1for
lct,L**,1
- +?o each
period

(i.e. a sequence of contingent plans

for each period)

r'. lrl

P-- -

v,t, u(ed= Fou

+?:t. h [t,G,

u[C1Car)

= !(Co

+z

?n

uQ(a;) ...u(c

3,,1. (, u3r?r>\+

(, u(c,@,D --. +?-u(Ci@"\

,))+P

=2 dt

,'<-

t-.r4r*

P14*1

ft*,

A*

,:t,)

?, u(C, @i))

.T

Ri, ci ---x el

pli.*4

c
0-

c-t+-teK'i

{4 e *+ c,(tt)e

'- {+,

eL+ , k,qt

e2,

tr(ar) e &'i

kn(Zr) e

) L*t..-+a *A
,*.agr szf
c(ko,1i ={c. ( ctgts an,,Lf,)e 9(kt ,6t), t--o. t,..-,t\
Lop

+ +r

C-^tyzf U^'z.f

ScS

. *o I'o+--

td n^/.t-., Lt.4rfr;.

V+ 7E

(cl

L onh

dt^L &-- t*

'- ' q

gvta

Fl-

-)

ItU4-

D+f

|,il riJ ,.*

,"J

i { n7c,1a ;," )) +

l,a-,,ar*, trool^--il--;

d-,Vl,-..-,

G^l*e" 6

t^tLcl-, ttlt-S

&rt-V-'

L,
:

: , r)o y,+^E;

2<,

vQt*,,

-r1..,.--

.F-f.^i

6.J/* ^

k\

ct +

FEV(LI*')

a^* 3 "^-fu*&, E hL; aaav<1a"5.;-. 711- A u*;4c4. .\ bt

+4!bQ + ktLA+

# Lz/iF-,.--'l

1.,,)= tq+ lcz d^' (&ll,,cr) +E,l^?t*,

k,

K:.

t*(l"i*r-cc)+
t tt"^<,*

P.

EI[-LI.*,

t*C* - l^(+fz*) +
a L^.L+ + bTt

= "t!^-L++L-\t - b(+fb'-) r

+frL)"/. L"

il_r,*

Fr:

Er*

A( rAk')

(tf f'L- )t .

L,

('t,

- L-(

5c-1 + Se''

l^ti;

'ir

5./

L
(r

* Er=L

E->1-t-

te-raa-r1

t.1 t^t"f+

bG-;tt *O

4,,4rt!.-c[ = A* 4 -L-"DE 6e

__

L:

j-?

4{-;L
-5
-t

ltl/ al.ut

2j-.. =
LoweLt -i

u' A+ t&+> - t(L+,y\ = F ELY 1c.,t.>, 6' >f

i1 u 1-ct\=
ItL

b (t

a-.A

(4)=

d
t +., +Iy]

- Ll

Lra

uo ua-t

ts v-'4-, v (kr,kt

=P!E)]i-;t.

A*'e+'" LE-sr7

-E'-;1;{'rtti;;i)

--

(.1"i-

o"{tv
+ l"Zn
tr
?
- .i3.
L
'

y' I

co

o:l t-l

'

-t(,,v3)+t3

?l)"

1.

"1-lV*

+'L{J

n=
a ')o-:p

n=
-

t
I

'"-

).-

P-

,f4-ib

4t-t-o^

<+-r-, Ef

4,6'

.+-

n+ f e'

l- sa<-

(lB?. j

"\.17"*

dt"'tt>-'tn

o?tn>o
--.L

a+
F

3l-rl

1.r.-^-7-r-L

L'J baL frclqrc;

/.ft.--+

et'*t'g,'-'

a,,+. a,l'l.c<L tw- aLp Hft-epov 0aac'4 t

/Jc l:

ca-tL

U'a+ {- . A frLtT'-L

?L'

14

atJ

9ntt4+

u;u

iz.^f t&\

u ,^ fu-,

S a+

t/./'.t

=/

EoLt^t+7

E,[t.tg\P)+

Lfu-yl

]LL

tgr} L;-a 4gd]-+-ry'- L r "t W!

b a:-r

t&

t+a+,.}t-..+J-',
frv-+c'\
)8t.1

-@'Y'l

,--f 14

!
+J)

l-.<E/

*"1 .+e e

O<oa<,

Jtz*

v*n^[

*-L + i;.
h^-r--

1{

d.'

t+o

t-tr

r.,&.*, +1+

.ltO

Lor

cY

-+S -.rb

t+ o ,

tnt'^ dzv tlaq.

,J(
; nr.uJ,

0*

kt fut^

a2 ulaf F-.^

Lo >o

Au+U

vlr'|-a- u7t4-

tUtl-*"le-a;

r
= t.t4 ( k, 4\

c";"'t'*-t

t#fL
= f*t (uFtoa! La-

oL*,*)=a(*
pE-*-*:-

( a. E\

(,,ut

(L*",3 al Q=t')-= 6

.G

$ a,6>o

h,rrzr<-s

6 a- l'^'4

LcA: /r'-.1'* (

/u4 f A ruJ-L t^,.,a''"* d6fi)J2.<Jd C^rb^ h,-ci.*.;

tl .+ V q^--, t^.ta*inz a-sr-+f-. a 4 rt*t-.*;rtt
--=v- cl
a.-2 4t4 *; *t ' r 4
^vt+r--

d-;9: 4+<.

a-t+
.,aa.t,

Yp

4 (lr>

951/^Lz;

CIL>

Va al

/.i-ZLr a,- l;A- 4

tL-e
-

t4<.r<-dr+--}L

.^t 6'

1P z-ta-'"

"t'rL

,.:1.{j

ev&)

E*^l-E;^

)-rl

+6EIv(qr't