MA

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ATIICAL
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CO
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BS
ScMA
ATHE
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(201
11Admiission)

UNIVE
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OF CA
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SCHO
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Ca
alicut Univ
versity P.O. Malappurram, Kerala
a, India 673 635

421

SchoolofDistanceEducation

UNIVERSITY OF CALICUT
SCHOOL OF DISTANCE EDUCATION
STUDY MATERIAL

Complementary Course for

B Sc Mathematics
III Semester
MATHEMATICAL ECONOMICS

Preparedby

Sri.Venugopalan.P.K,
AssistantProfessor,
DepartmentofStatistics,
SreeKeralaVarmaCollege,
Thrissur.

Layout:

ComputerSection,SDE

Reserved
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CONTENTS

Pages

MODULEI

MODULEII

18

MODULEIII

25

MODULEIV 31

MathematicalEconomics(IIISem.)

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MathematicalEconomics(IIISem.)

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MODULEI

FIRSTORDERDIFFERENTIALEQUIATIONS

DefinitionsandConcepts

Adifferentialequationisanequationwhichexpressesanexplicitrelationshipbetween
Functiony=f(t)andoneormoreofitsderivativesordifferentialequationsinclude.
dy/dt=5t+9y=12yandy2y+19=0

Equations involving a single independent variable, such as those above, are called
ordinary differential equations. The solution or integral of a differential equation is any
equation, without derivative or differential, that is defined over an interval and satisfies the
differential equation for all the values of the independent variable (s) in the interval. See
Example1.

Theorderofadifferentialequationistheorderofthehighestderivativeintheequation.
The degree of a differential equation is the highest power to which the derivative of highest
orderisraised.SeeExample2.

Example 1. To solve the differential equation y(t) = 7 for all the functions y(t) which
satisfytheequation,simplyintegratebothsidesoftheequationtofindtheintegrals.
Y(t)={7dt=7t+c1
Y(t)={(7t+cl)dt=3.5t2+c1t+c

Thisiscalledageneralsolutionwhichindicatesthatwhencisunspecified,adifferential
equation has an infinite number of possible solutions. If c can be specified, the deferential
equationhasaparticularordefinitesolutionwhichaloneofallpossiblesolutionsisrelevant.

Example2.Theorderanddegreeofdifferentialequationsareshownbelow.

1. dy/dt=2x+6

Firstorder,Firstdegree

2. (dy/dt)45t5=0

Firstorder,Fourthdegree

3. d2y/dt2+(dy/dt)3+x2=0secondorder,Firstdegree
4. (d2y/dt2)7+(d3y/dt3)5=75yThirdorder,Fifthdegree

GENERALFORMULAFORFIRSTORDERRLINEARDIFFERENTIALEQUATIONS

For A firstorder linear differential equation, dy/dt and must be first degree and no
producty(dy/dt)mayoccurs.Forsuchanequation
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dy/dt+vy=z

Wherevandzmaybeconstantsorfunctionsoftime.Theformulaforageneral
solutionis

y(t)=e vdt A ze
dt

Where A is an arbitrary constant. As solution is composed of two parts:

e
A is called the complementary function, and e
e
dtis called the
particular integral yp equals the intertemporal equilibrium level of y(t); the complementary
function yc represents the deviation from the equilibrium. For y(t) to be dynamically

stable, yc must approach zero as t approaches infinity (that is, k in e kt must be

negative). The solution of a differential equation can always be checked by
differentiation.

Example 3. The general solution for the differential equation

dy.dt+4y=12iscalculatedasfollows.Sincev=4andz=12,substitutinggives

y(t)=e
A 12e
dt
4dt+c,cisalwaysignoredandsubsumedunderA.Thus,
y(t)=e

A
12e dt

Indegratingtheremainingintegralgives{12e4t dt=3e4t +c.Ignoredandconstantagain

andsubstituting

y(t)=e

3e

=Ae4t+3

sincee4te4t=e0=1Astyc=Ae4t

0 and y(t) approaches yp = 3 the intermporal equilibrium level. Y(t) is dynamically

stable.

To check this answer, which is a general solution because A has not has not been
specifiedstartbytakenthederivative.

Fromtheoriginalproblem,

+4y=12

=124y

Substitutingy=Ae4t+3

=124(Ae4t+3)=4Ae4t

Example.Givendy/dt+3t2y=t2Wherev=3t2andz=t2.Tofindthegeneralsolution,
firstsubstitute
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y(t)=e

t e

dt)

Integratingtheremainingintegralcallsforthesubstitutionmethod.Lettingu=t3,

du/dt=3t2,anddt=du/3t2,
t e dt

t e

du
3

1
3

13e

13e

e du

Finallysubstituting
y(t)

t3

et

Ae

t3

Ast,yc=Aet30andy(t)approaches Theequilibriumisdynamicallystable.

Differentiatingcheckthegeneralsolution,dy/dt=3t2Ae .Fromtheoriginalproblem,
+3t2y=t2

=t23t2y

Substitutingy
=t23t2(Ae +1/3)=3t2Ae

EXACTDIFFERNETIALEQUATIONSANDPARTIALINTEGRATION

Givenafunctionofmorethanoneindependentvariable,suchasF.(y,t)where
M=aFlayandN=aFlat,thetotalDifferentialiswritten

dF(y,t)=Mdy+Ndt

Since F is a function of more than one independent variable, M and N are partial
derivativesandequationiscalledapartialdifferentialequation.Ifthedifferentialissetequal
tozero,sothatMdy+Ndt=0,itiscalledanexactdifferentialequationbecausetheleftside
exactly equals the differential of the primitive function F(y,t). For an exact differential
equation, M/ t must equal N/ y, that is, 2 F| t y
a F|( y t). For proof of this
proposition.

Solutionofanexactdifferentialequationcallsforsuccessiveintegrationwithrespectto
oneindependentvariableatatimewhileholdingconstanttheotherindependentvariable s .
Theprocedure,calledpartialintegration,reversestheprocessofpartialdifferentiation.

Example.Solvetheexactnonlineardifferentialequation

6yt 9y2 dy 3y2 8t dt 0

1. Test to see if it is an exact differential equation. Here M 6yt 9y2 and N 3y2 8t.
Thus, aM1 at 6y and aN1 ay 6y. If aM1 at aN1 ay, it is not an exact differential
equation.
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2. SinceM AFlayisapartialderivative,integrateMpartiallywithrespecttoybytreating
tasaconstant,andaddanewfunctionZ t foranyadditivetermsoftwhichwouldhave
beeneliminatedbytheoriginaldifferentiationwithrespecttoy.Notethatayreplaces
dyinpartialintegration.

F y,t 6yt 9y2 y Z t 3y2t 3y3 Z t

Thisgivestheoriginalfunctionexceptfortheunknownadditivetermsoft,Z t

3. Differentiatewithrespecttot,tofind

F
t

earliercalledN .Thus
3y

Z t

Since F/ t=NandN=3y2+8t,substitute

=3y2+8t

3y2+8t=3y2+Z(t)Z(t)=8t

4. NextintegrateZ(t)withrespecttottofindthemissingtterms.

Z(t)=Z(t)dt=8tdt=4t2

5. Substituteandaddaconstantofintegration

F(y,t)=3y2t+3y3+4t2+c

Thisiseasilycheckedbydifferentiation.

INTEGRATINGFACTORS

Not all equations are exact. However, some can be made exact by means of an
integratingfactor.Thisisamultiplierwhichpermitstheequationtobeintegrated.

EXAMPLE.Testingthenonlineardifferentialequation5ytdy+(5y 2+8t)dt=0revealsthatitis
notexact,withM=5ytandN=5y2+8t,

=5y

=10y.Multiplyingbyanintegratingfactor

oft,however,makesitexact:5yt2dy+(5y2t+8t2)dt=0.Now

=10yt=

,andtheequation

canbesolvedbytheprocedureoutlinedabove.

Tochecktheanswertoaprobleminwhichanintegratingfactorwasused,takethetotal
differentialoftheanswerandthendividebytheintegratingfactor.

RULESFORTHEINTEGRATINGFACTOR

Tworuleswillhelptofindtheintegratingfactorforanonlinearfirstorderdifferential
equation,ifsuchafactorexists.Assuming

=f(y)alone,thene

isan

integratingfactor.
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Rule2.If1/M(aN/ayaM/at)=g(t)alone,thene
isanintegratingfactor.

EXAMPLE.Toillustratetherulesabove,findtheintegratingfactorgiveninexample7,where

5ytdy=(5y2+8t)dt=0,M=5yt,N=5y2=8t

Applyingrule1,

=5y

10

=10y

Which is not function of y alone and will not supply an integrating factor for the
equation.ApplyingRule2,
1
5
1

10
5
5
5

The integrating factor, therefore, is

Which is a function of t alone.

e

1n t

=e

=t

SEPERATIONOFVARIABES

Solutionofnonlinear firstorderfirst degreedifferentialequationsiscomplex,(Afirst

orderfirstdegreedifferentialequationsisoneinwhichthehighestderivativeisthederivative
dy/dtandthatderivativeisraisedtoapowerof1.Itisnonlinearifitcontainsaproductofy
anddy/dt,oryraisedtoapowerotherthan1)Iftheequationisexactorcanberenderedexact
by an integrating factor; the procedure outlined in Example 6 can be used. If, however, the
equationcanbewrittenintheformofseparatedvariablessuchthatR(y)dy+s(t)=0,whereR
ands,respectively,arefunctionsofyandtalone,theequationcanbesolvedsimplybyordinary
integration.
EXAMPLE.Thefollowingcalculationsillustratetheseparationofvariablesproceduretosolve
thenonlineardifferentialequation.
dy/dt=y2t

First,separatingthevariablebyrearrangingterms,
dy
y

tdt

Where R = and s = t, Then integrating both side

y-2 dy = tdt

-1/y =

y=
Letting, c = 2c2 -2c1
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Since the constant of integration is arbitrary until it is evaluated to obtain a particular solution,
it will be treated generally and not specifically in the initial steps of the solution ec and Ln c can also
be used to express the constant
This solution can be checked as follows: Taking the derivatives of y = -2(t2+c)-1 by the
generalized power function rule,
dy/dt = (-1)(-2)(t2+c)-2(2t) =
dy/dt = y2t. substituting into

dy/dt =
EXAMPLE. Given the nonlinear differential equation

t2dy + y3 dt = 0
Intergrating the separated f(t). But multiplying by 1/(t2 y3) to separate the variables gives
1

Integrating the separated variables,

and

dy

F(y,t) =

12y

= 12y

12y

dt

t
1/ t

For complicated function, the answer is frequently left in this form. It can be checked by
differentiating and comparing, which can be reduced through multiplication by y3t2.
ECONOMIC APPLICATIONS
Differential equations serve many functions in economics. They are used to determine the
conditions for dynamic stability in microeconomic models of market equilibrium and to trace the
time path of growth under various conditions in macroeconomic. Given the growth rate of a
function, differential equations enable the economist to find the function whose estimate the demand
growth is described; from point elasticity, they enable the economist to estimate the demand function.
They were use to estimate capital functions from marginal cost and marginal revenue functions.
EXAMPLE Given the demand function Qd =c+bp and the supply function Qsg +hp, the equilibrium
price is

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Assume that the rate of change of price in the market dp/dt is a positive linear function of
excess demand Qd Qs such that

= m(Qd-Qs)

m = a constant > 0

The conditions for dynamic price stability in the market (i.e under what conditions p(t) will
converge to p as t] can be calculated as shown below. Substituting the given parameters for Qd and
Qs

dp
dt=m[(c+bp)(g+hp0]=m(c+bpghp)

Rearranging to fit the general format, dp/dt +m(hb)p = m(cg). Letting

v=m(hb)andz=m(cg)

P(t)=
e

Ze
v

AeZe

Att=0,P(0)=A+z/vandA=p(0)z/v

Substituting
vv

Finally,replacingv=m(hb)andz=m(cg),

P(t)=[p(0)z]e vt+z

P(t)=

Thetimepathis
P(t)=

Sincep(0),p,m>0,thetermontherighthandsideconvergetowardszeroastand
thusp(t)willconvergetoward ponlyifhb>0.Fornormalcaseswheredemandisnegatively
sloped(b<0)andsupplyispositivelysloped(h>0),thedynamicstabilityconditionisassured.
Markets which positively slopeddemand functionsornegatively sloped supply functions will
alsobedynamicallystableaslongash>b.

PHASEDIAGRAMSFORDIFFERENTIALEQUATIONS

Many nonlinear differential equations cannot be solved explicitly as functions of time

phase diagrams, however, offerqualitative information about the stability asfunctions that is
helpfulindeterminingwhethertheequationswillconvergetoanintertemporal(steadystate)
equilibriumornot.Aphasediagramofadifferentialequationdepictsthederivativewhichwe
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nowexpressasyforsimplicityofnotationasafunctionofy.Thesteadystatesolutioniseasily
identified on a phase diagram as any point at which the graph crosses the horizontal axis,
becauseatthatpointy=0andthefunctionisnotchanging.Forsomeequationstheremaybe
morethanoneintersectionandhencemorethanonesolution.

Diagrammatically,thestabilityofthesteadystatesolution(s)isindicatedbythearrows
of motion, The arrows of motion will point to the right (indicating y is increasing) any time
graph of y is above the horizontal axis (including y>0) and to the left (indicating y is
decreasing)anytimethegraphofyisbelowthesolutionisstable;ifthearrowsofmotionpoint
awayfromasteadystatesolution;thesolutionisunstable.

Mathematically; the slope of the phase diagram as it passes throught a steadystate

equilibriumpointtellsusiftheequilibriumpointisstableornot.Whenevaluatedatasteady
stateequilibriumpoint.

Ifdy/dy<0,theequilibriumisstable
Ifdy/dy>0,thepointisunstable
EXAMPLE.Giventhenonlineardifferentialequation
Y=8y2y2

Aphasediagramcanbeconstructedandemployedinsixeasysteps.
1. The intereporal or steadystate solution (s), where there is no pressure for change, is
foundbysetting
Y=0andsolvingalgebraically.

Y=84y=0

2y(4y)=0

Y=0

y=4steadystatesolutions

Thephasediagramwillpassthroughthehorizontalaxisaty=0,y=4

2. Sincethefunctionpassesthroughthehorizontalaxistwice,ithasoneturningpoint.We
nextdeterminewhetherthatpointisamaximumorminimum.

dy/dy=84y=0
y=2isacriticalvalue

=4<0

concave,relativemaximum

3. Arough,butaccurate,sketchofthephasediagramcantheneasilybedrawnseeFig.

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4. The arrows of motion complete the graph. As explained above, where the graph lies
abovethehorizontalaxis,y>0andthearrowsmustpointtotheright;wherethegraph
liesbelowthehorizontalaxis,y>0andthearrowsmustpointtotheleft.
5. The stability of the steadystate equilibrium points can now be read from the graph.
Sincethearrowsofmotionpointawayfromthefirstintertemporalequilibriumy1=0,y1,
is an unstable equilibrium. With the arrows of motion pointing toward the second
intertemporalequilibriumy1=4,y2is2stableequilibrium.
6. The stop of the phase diagram at the steadystate solutions can also be used to test
stabilityindependentlyofthearrowsofmotion.Sincetheslopeofthephasediagramis
positiveaty1=0,

Wecanconcludey1isanunstableequilibrium.Sincetheslopeofthephasediagramis
negativeaty2=4,weknowny2mustbestable.

EXAMPLE.Withoutevenresortingtoaphasediagram,wecanusethesimplefirstderivative
evaluated at the intertemporal level (s) to determine the stability of differential equations.
Giveny=8y2y2

Evaluatedatthesteadystatelevels,y1=0andy2=4,

4 0

isunstable

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USEOFDIFERENTIALEQUATIONSINECONOMICS

1. findthedemandfunctionqf(p)ifpointelasticityis1forallp>0

gQp/dpp/Q=1 dQ/dp=Q/p

separatingthevariables, dQ/Q+dp/p=0
Integrating,inQ+Inp=Inc

Qp=c

Q=c/p

2. Findthedemandfunctionf(p)if=kaconstant.

E=dQ/Dp p/Q=k

dQ/dp=kQ/p

Separatingthevariables,

dQ/Q+k/pdp=0

inQ+klnp=c

Qpk=cQ=cpk

FIRSTORDERDIFFERENCEEQUATIONS
DEFINITIONSANDCONCEPTS

Adifferenceequationexpressarelationshipbetweenadependentvariableandalagged
independentvariable(orvariables)whichchangesatdiscreteintervalsoftime,forexample,I1
= f(yt 1), where 1 and y are measured at the end of each year. The order of a difference
equation is determined by the greatest number of periods lagged. A firstorder difference
equationexpressesatimelagofoneperiod;asecondorder,twoperiod;etc.Thechangeiny
astchangesfromtto+1iscalledthefirstdifferenceofy.Itiswritten.

Where is an operator replacing d/dt that is used to measure continuous change in

differentialequations.Thesolutionofadifferenceequationdefinesyforeveryoftanddoes
notcontainadifferenceexpression.Seeexamples1and2.

EXAMPLE1.Eachofthefollowingisadifferenceequationoftheorderindicated.
1t=a(yt1y12)

order2

Qs=a+bpt1

order1

Yt+39yt+2+2yt+1+6yt=8 order3
yt=5yt
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Substitutingfromforyt,above,

Yt+1yt

yt+1=6yt

order1

EXAMPLE2.Giventhattheinitialvalueofyisy0inthedifferenceequation
yt+1=byt
asolutionisfoundasfollowsbysuccessivesubstitutionsoft=0,1,2,3etc.

y1=by0

y2=by1=b(by0)=b2y0

Thus,foranyperiodt,

y3=by2=b(b2y0)=b3y0

y4=by3=(b3y0)=b4y0

Yt=bty0

Thismethodiscalledtheiterativemethod.Sincey0 isaconstant,noticethecrucialrole
bplaysindeterminingvaluesforyastchanges.
GENERALFOMULAFORFIRSTORDERLINEARDIFFERENCEEQUATIONS
Given a first-order difference equation which is linear (i.e, all the variable are raised to the
first power and there are no cross products),
yt=byt1+a
wherebandaareconstants,thegeneralformulaforadefinitesolutionis
yt=(y0a/1b)bt+a/1bwhenb1
yt=y0+at

whenb1

If noinitialconditionis given,anarbitraryconstantAisusedfory0a/(1b). Thisis

calledageneralsolution

EXAMPLE 3. Consider the difference equation yt = 7yt 1 +16 and y0 = 5. In the

equation,b=7anda=16sinceb1,
yt=(516/1+7)(7)t+16/1+7=3(7)t+2

Tochecktheanswer,substitutet=0andt=1
Y0=3(7)0+2=5since(7)0=1
Y1=3(7)1+2=19

SubstitutingY1=19forytandy0=5foryt1intheoriginalequation,
19=7(5)+16=35+16

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STABILITYCONDITIONS

Inthegeneralform
Yt=Abt+c

WhereA=y0a/(1b)andc=a/(1b),hereAbtiscalledthecomplementaryfunction
andcisthe particular solution.The particular solutionexpressestheintemporal equilibrium
level of y; the complementary function represents the deviation from that equilibrium.
Equationwillbedynamicallystable,therefore,onlyifthecomplementaryfunctionAbt0,ast.
AlldependsonthebasebassumingA=1andc=0forthemoment,theexponentialexpression
bt will generate seven different time paths depending on the value of b, as illustrated in
Example4.Asseenthere,ithetimea.if |b|>1thetimepathwillexplodeandmovetowards
equilibrium.Ifb>0,thetimepathwilloscillatebetweenpositiveandnegativevalues;b>0,the
timepathwillbenonoscillating.IfA 1,thevalueofthemultiplicativeconstantwillscaleupor
down the magnitude of bt, but will not change the basic pattern m of movement. If A = 1, a
mirrorimageofthetimepathofbtwithrespecttothehorizontalaxiswillbeproduced.Ifc0,
theverticalinterceptofthegraphisaffectedandthegraphshiftsupordownaccordingly.
THEHARRODMODEL

TheHarrodModelattemptstoexplainthedynamicsofgrowththeeconomy.Itassumes

St=syt

WheresisaconstantequaltobothMPSandAPS.

Italsoassumestheaccelerationprinciple.Theinvestmentisproportionaltotherateof
changeofnationalincomeovertime.
It=a(ytyt1)

Whereaisaconstantequaltoboththemarginalandaveragecapitaloutputratios.

Inequilibrium,It=st

Dividingthroughbyastoconformto(17.3),Yt=[a/(as)]Yt1,sinceal(as)1,

a(ytyt1)=syt=(as)yt=ayt1

Yt=(Y00)(a/as)t+0=(a/as)tY0

Thestabilityofthetimepaththusdependsonal(as).Sincea=thecapitaloutputratio,
whichisnormallylargerthan1,andsinces=MPSwhichislargerthan0andlessthan1,the
basea;(as)willbelargerthan0andusuallylargerthan1.Therefore,Ytisexplosivebutnon
oscillating.Incomewillexpandindefinitely,whichmeansithasnobounds.
EXAMPLE 8. The warranted rate of growth (i.e., the path the economy must follow to have
equilibrium between saving and investment each year)can be found as follows in the Harrod
Model.
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Yt increases indefinitely. Income in one period is a/(as) times of the income of the
previousperiod.
Y1=(a/as)Y0

TherateofgrowthGbetweentheperiodsisdefinedas
G=

Substituting

G=

1=

Thewarrantedrateofgrowth,therefore,is

Gw=

Ref:IntroductiontoMathematicalEconomics3rdedition.

ByEDWARD.T.DOWLING

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MODULEII
PRODUCTIONFUNCTION

Thetheoryofproduction playstwoimportantrolesinthetheoryofrelative prices. It

providesabasefortheanalysisofrelationsbetweencostsandvolumesofinputcostsinfluence
supplieswhichalongwithdemand determineprices.Thetheory ofproductionservesabase
for the theory of demand for factors of production. Production means a transformation of
inputs into outputs. The inputs are the things brought by the firm and the outputs are the
thingswhichthefirmsells.

Productiontakesplacebythecombinedforcesofvariousfactorsofproductionsuchas
land, labour capital and enterprise. In production there are two processes, namely theory of
production and theory of costs. The theory of production shows the physical relationship
betweeninputsandoutputs.Thetheoryofcostsrepresentthelevelofoutputandcosts.

A production function is a technique which represents the technology involved in the

processofproduction.

Productionexplains the relationship between the inputs andoutputs. The output of a

commodity depends on the employed inputs. Production function explains the physical
relationship between the units of employed inputs and the output. The money price do not
appearinaproductionfunction.

MathematicallyX=f(L,K,l,E)

WhenX=output,L=labour,K=capital,l=landandE=Enterprise

Theoutputinthedependentvariableandallothersareindependentvariables.

Ifanyfirmwantstoincreaseitsproductionitcandointwoways.Eitheritcanincrease
all the units of required inputs or can increase the units of some inputs white others remain
constant.

Production not only depends on the quantity of inputs but also depend upon the
technique of production. The improvement in technology results in increased production,
withoutanyincreaseininputs.Inthiscaseproductionfunctionitselfchanges.Theproduction
function depends upon two things i) The quantity of production and ii) The range of
production techniques. The possibility of substituting different factors of production play an
importantroleintheproductionprocess.

Production Analysis: The production of certain commodities requires use of two or more
factorsofproduction.Theamountofproductionofanycommodityuniquelydependsuponthe
amountsofdifferentfactorsusedundercertaintechnicalconditions.

SupposethequantityxofcommodityXisproducedbyusingamountsa1a2offactorsA1
andA2.Thentheproductionfunctionisx=f(a1a2).

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We assume that only factor A1 is varied and A2 is held constant. Then the ratio is

termed as average product of factor A1. The partial derivative

is termed as marginal

productionoffactorA1
Lawofvariableproportions

Relation ship between average product (AP), Marginal production (MP) and total
product(TP)curves.

Totalproduct,averageproductandmarginalproductarerelateddifferentways.Their
relationshipisdifferentindifferentstagesofproduction.
StageIMPbeginstodeclinebutAPreachesitsmaximumandMPcurvecutsAP

curveatitsmaximum.
StageIIAPandMPbothfallandMP=0,thenT.Pismaximum.
StageIIIMPisnegative:TPandAPbothfall.

EndofstageIiswhereAPismaximumandatthismaximumAP=MP.

EndofstageIIiswhereMP=0andTPismaximum.

Thethreephasesoflawofvariableproportionsare
i)

Stageofincreasingaveragereturns

ii)

Stageofdiminishingaveragereturns

iii)

Stageofabsolutediminishingreturns.

Law of variable proportions is based on technological facts. The law of variable

proportionsoperatesbyassumingthattechnologicalproductionremainunchanged.

APandMPCurve
T.P.Curve

TP

A1

TPCurve
AP
MP

MPCurve

APCurve

FactorX1

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TP,APandMPCurveinastageproportion

StageIII

StageII

AP StageITPCurve
TP
MP
MPCurve

APCurve

Factorx1

Isoquants

Isoquantsorequalproductcurvesarealsoknownasproductionindifferencecurves.It
isacurvewhichrepresentsthedifferentcombinationsoftwofactorsofproductionwhichare
capable of producing the same output. These curves may be infinite numbers. Different
isoquantssharedifferentlevelsofoutputthatcanbeobtainedfromdifferentcombinationsof
factorsofproduction.Theisoquantcurvehavethefollowingproperties.

i)

Theisoquantsslopedownfromlefttoright

ii)

Isoquantscannotcuteachother.

iii)

Isoquantsareconvextoorigin.
ISOQUANT

UnitsoffactorX2

Isoquant

UnitsoffactorX1

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ProducersEquilibrium

In the consumers theory, the consumer is in equilibrium when he gets maximum

satisfaction for his fixed income. Likewise a producer also tried to maximize his output at
minimum cost. If he attains such a point then he has no tendency to move further Thus,
producers equilibrium is that situation where he has no tendency to move further or where
producers gain is mazimum. The maximum gain can be achieved through two method i)
Maximisationofproductionandii)Minimisationofproductioncost.
MaximisationofProduction

Let the production function be q = f(x1, x2) and cost function be

TC=x1p1+x2p2,wherep1 andp2betheunitpricesoffactorsx1 andx2respectively.Themain
aimofaproduceristoattainthemaximumoutputforthegivenlevelofinputs.

Theconstrainedobjectivefunctionis

WhereistheLagrangesmultiplier

Letq=f(x1,x2)betheproductionfunction

Then dq =

Z=f(x1,x2)+[TCx1p1x2p2]

is the rate of change in total product q with respect to

changeininputs.

Sinceonbeingthesameisoquant,outputremainsunchanged.

f1dx1+f2dx2=0

iscalledtherateoftechnologicalsubstitution.

representsthemarginalrateat

whichtheproducercansubstituteinputX2forX1orX1forX2,inordertomaintainspecificout
levelq.

Themarginalrateoftechnicalsubstitution

MRTS=

. .
. .

representtheslopeofisoquanthavinganegativesign.

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MRTSofX2forx1isthatamountoffactorX2whichtheproducerisreadytosacrificeto
getanadditionalamountoffactorX1.

OndifferentiatingZPartially,weget

And =TCx1p1x2p2

Byapplyingtheconditionsformaximum

Weget

=f1p1,

=f2p2

wheref1=

. .

. .

i.e,

andf2=

MinimumisationofCost

Here,theobjectiveistominimizethecostatoptimumoutput

Heretheobjectivefunctionis

Thentheminimisingconditionare

=p1f1=0

=p2f2=0

And

Usingthereconditionweget

Z=x1p1+x2p2+[qf(x1,x2)]

=qf(x1,x2)=0

or

ExpansionPath

Intheproducersequilibriumconditionitisassumedthatproducerscostremainfixed.
Butifthechargeinthecosttakeplacewhilepricesoffactorsofproductionremainsamethen
what will be the effect in equilibrium point? When isocost line changes the producers
equilibriumwillcharge.Ifweconnectalltheproducersequilibriumpointsofdifferentisocost
lines,wegettheexpansionpathofaproducer.Thesizeofexpansionpathdependsuponthe
natureofproductionfunction.
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Problem:Findthefirmsexpansionpathiftheproductionfunctionisq=12logx1+30logx1
andtheinputpriceofunitvaluesofx1andx2respectivelyareP1andP2andP1=2,P2=5
Solution

UsingLagrangesmultiplication,theobjectivefunctionbe

Z=12logx1+30logx2+[TC2x15x2]

Thenthemaximisingconditionsare

=0

=0

=0

2=0,

5=0

Usingtheseconditions,weget

=2and

Ondivision,weget

Onsimplificationwegetx1=x2

Hence

TC=2x1+5x1

TC=2x2+5x2

Thesevalueconstitutestherequiredexpansionpath

AndTC2x15x2=0

or

=5

x1= ,

x2= andhence=

ElasticityofSubstitution

Theelasticityofsubstitution,,isdefinedas

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Ifi) =,thenbothfactorsx1andx2areperfectsubstitutesforeachother.
ii) >0ie,0< <thenbothfactorsx1andx2areclosesubstitutesforeachother.
Ifiii) =0,thenthereisnopossibilityofanysubstitutionbetweenthem.
Problem:Iftheprofitremainsunaltered,theratioofamountofcapitalemployedperunitof
labourshiftsfrom10:10to12:11,giventhatriseinwagesis25%.

Determinetheelasticityofsubstitution.

Solution:

WhereK=Capital,L=Labour

= andchangedto =

Thewagesareincreasedby25%

Theinitialratioofpricesoflabourandcapitalbe

Thewagesareincreasedby25%.Sotheratiobecomes1.25:1=

= =

= =

i.e,

MathematicalEconomics(IIISem.)

changein =

=1:1

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MODULEIII

EULERSTHEOREM

Eulers theorem states that when all factors of production are increased in a given
proportion,theresultingoutputwillalsoincreaseinagivenproportion,providedeachfactors
ofproductionispaidthevalueofitsmarginalproductandthetotaloutputisjustexhausted.

Iftheproductionfunctionq=f(x1,x2)isalinearhomogeneousfunction,them

Whereq=totaloutput,x1=unitofoneinput,x2=unitofsecondinput

Iftellsusthatfactorx1willgetitsawardequalto

+x2.

q=x1.

=MP and

=MP
andx2willget

Sinceifafirmpaysthesuppliesofaninputitsawardequaltomarginalphysicalproduct,
thetotaloutputisjustexhausted.

Eulerstheoremplaysanimportantpartintheeconomicfield especiallyinthefieldof
distribution. The theorem suggests to afirm howtheinputs should be employed. Theinput
shouldbeemployedtothatextentatwhichthepriceoffactorisequaltoitsmarginalrevenue
product.Thusitalsosuggeststhedeterminationofpriceofafactorofproductions.

Eulerstheoremisbasedonfollowingassumption.
a) Thelawofconstantreturnstoscaleisbeingapplied.Itholdsgoodonlyinthecaseof
alinearlyhomogeneousproductionfunctionofdegreeone.
b) Thereisperfectcompetitioninthemarket.
c) Itassumerperfectdivisibilityofthefactorsofproduction.

d) Thetechnologyremainconstantinthegiventimeperiod.

CobbDouglasProductionFunction

ThegeneralformofCobbDouglasProductionFunctionis

Q=AKL
whereQ=output,K=capital,L=labour

KandLarethecapitalandlabourinputs.

Q=AKL

MathematicalEconomics(IIISem.)

Aisaconstantandarepositiveparameters

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If+=1,theproductionfunctionwilloperateunderconstantreturntoscale.

If+>1,therewillbeincreasingreturnstoscale.

If+<1,therewillbedecreasingreturnstoscale.

Properties
a) Iftheinputsareincreasedbyttimes,thetotaloutputwillalsoincreasebyttimes

Proof

Q=AKL

IfKandLareincreasedbyttimes

Q1= A(tK)(tL)=t

= t. AK L (if+=1)

= tQ

. AK L

b) Theproductionfunctionishomogeneousofdegreeone.

Proof

Iftheproductionfunctionishomogenousofdegreeonethentheproductionisoperating
underconstantreturnstoscale.i.e+=1

Q=AKL

i.e,logQ=log A

log K

log L

OndifferentiationpartiallywithrespecttoKandL,respectivelyweget

Then .

=Qif+=1

= and =

=Q+Q=(+)Q

c) Iftheproductionfunctionislinearandhomogeneous,thenelasticityofsubstitution
equaltounity(if+=1).
Proof

Theelasticityofsubstitution,

%
=
%

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Q=AKL

DifferentiatingwithrespecttoKandLrespectively,

Wehave

Onsubstitutionweget

Then=

=A.K1.Land =A.K.L1

= .

=1

Hencetheelasticityofsubstitutionisunity.
d) andrepresentsthecapitalshareandlaboursharetothetotaloutputrespectively.

Proof

Q=AKL

ThenlogQ==log A

DifferentiatingpartiallywithrespecttoK,weget

log K

log L

i.e,

i.e,

Similarly,differentiatingpartiallywithrespecttoL,weget

MathematicalEconomics(IIISem.)

M. Pofcapital

MarginalProductivityoflabour

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i.e,=

e) and represent the elasticities of output with respect to capital and

labourrespectively.

Proof

Q=AKL

logQ==log A

DifferentiatingpartiallywithrespecttoK,weget

i.e,

Similarlyweget

Then

%
=
%

Similarly

log K

log L

= .

= .

f) The expansion path of Cobb Douglas production function is linear homogeneous

andpassesthroughorigin.
Proof

Proceedingasintheearlierproperties,weget

and =

i.e,MP

andMP

Usingtheconditionforoptimization,weget

MathematicalEconomics(IIISem.)

i.e.,

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i.e.,

i.e,

.L.PL=.K.PK

. L. PL . K.PK = 0, Which is the expansion path of Cobb Douglas production

functionwhichislinearhomogeneousandPassesthroughorigin.
ImportanceofCobbDouglasproductionfunction

CobbDouglasproductionfunctionismostcommonlyusedfunctioninEconomics.This
function is helpful in wage determination principles. This function is helpful in explaining
marginal productivity principles and used to explain product exhaustion theorem. The
parameterandrepresentelasticitycoefficients.Theyarehelpfulincomparinginternational
levels.Thisfunctionishelpfulinthestudyofdifferentlawsofreturnstoscale.Thisfunction
playsanimportantroleineconomicfield.Itisusedtodeterminewagepoliciesundersector
comparisons,substitutabilityandthedegreeofhomogeneity.

Limitations:CobbDouglasproductionfunctionhascertaindrawsbacks.
a) Ifcontainsonlytwoinputs,capitalandlabour.Thereareseveralotherfactorswhichare
equallyimportantinproduction.
b) The production function operates under constant returns to scale. The conditions of
increasingreturnsanddiminishingreturnsareignored.
c) Thefunctionassumesthattechnologicalconditionsremainsconstant.Butitisnottime.
Theoutputconditionsvarywiththechangeintechnologicalconditions.
d) The function assumes that all inputs are homogeneous. In practice, all factors are not
equallyefficient.
e) Itassumesperfectcompetition.Butifthereisimperfectcompetitionthisfunctiondoes
notholdgood.
f) Thisfunctionignoresthenegativemarginalproductivityofafactor.
ConstantElasticityProductionFunction(C.E.S.function)

CobbDouglasproductionfunctionisafunctionwhoseelasticityofsubstitutionisunity
everywhere.Anyproductionwhoseelasticityofsubstitutionisconstantbutotherthanunityis
calledConstantElasticitysubstitutionproductionfunctionorC.E.S.Productionfunction.

C.E.S Production function represents the more general form of production technique
than Cobb Douglas production function. In C.E.S. Production function,
1,butaconstantC.E.S.Productionfunctionhaswiderscope,substitutabilityandefficiency.

C.E.S. Production function removes all the difficulties and unrealistic assumptions of
CobbDouglas production function. Cobb Douglas production function is a special case of
C.E.S.productionfunction.
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A.C.E.S.Productionfunctionisexpressedas

Q=r c

WhereQ=output,C=Capitalinput

N=labourinput,=Substitutionparameter

1=labourintensitycoefficientand

V=degreeoffreedom

C.E.S.Productionfunctionhasseveraladvantages

Ithassomelimitations

,(r>0

0<<1and>1)

a) ItconsideronlytwofactorNandC.
b)
C.E.S. function contains only one parameter, V, which is affected by the scale of
operationandtechnologicalchange,Theretwofactorsmayaffectthedegreeofreturnstoscale
butcannotdistinguishthemseparately.
c)
Itisassumedthatinthisfunctionthat changesinresponsetotechnologyonly
andfactorproportionsdonotaffectit.
Whiletheempiricalstudyshowsthattheelasticityofsubstitutionalsochangesdue to
changedfactorproportions.Thefunctionhasignoredthisimportantfact.
Returnstoscale

Aproductionfunctionexhibitsconstantreturnstoscaleifwhenallinputsareincreased
by a given proportion, K, output increases by the same proportion. If output increase by a
proportion greater than K, there are increasing returns to scale. If the output increase by a
proportion smaller than K,thereare diminishing returns to scale. If a productionfunction is
homogeneousofdegreegreaterthan,equalto,orlessthanonereturntoscaleareincreasing,
constantordiminishing.EconomicanalysisemploystheCobbDouglasproductionfunctionQ
=AKL,whereQisthequantityoutput,Kisthecapitalinput.Lislabourinput.,andAare
parameters.If+=1,CobbDouglasfunctionshowsconstantreturnstoscale.

If + >1, increasing returns to scale and if + < 1, diminishing returns to scale.

Optimisation of Cobb Douglas production function is performed subject to a budget
constraint.

Forfurtherreadingreferto
i) Edward.T.Dowling:

IntroductiontoMathematicalEconomics(3rdedition)

ii) S.P.Sing.A.K.Parashar,H.P.Singh
EconometricsandMathematicalEconomics
iii) C.R.Kothari.
AnintroductiontooperationResearch(3rdedition)

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MODULEIV
INVESTMENTDECISIONS&ANALYSISOFRISK/UNCERTAINTY

NATUREOFINVESTMENTDECISIONS

Investment decisions are also termed as capital investment decisions. They

represent a long term commitment. Such decisions form the framework for future
developmentofanorganization.Theyhaveaprofoundeffectonitsfutureearningsand
growth. They are a major determinant of efficiency and competitive strength of a
businessfirm.Toreachsuchdecisionsthefollowingstepsaretobefollowed.

a. Formulationofobjectives.
b. Establishingexistingdemandandfuturedemandforaservice.
c. Determinewhetherthedemandcanbemetwithexistingproductivecapacityor
whethernewinvestmentisrequiredtoincreasesupply.
d. Consideralternativeprojectsthatwouldenabletheobjectivetobeachieved.
e. Appraisetheinvestmentprojects.

AppraisalNecessary

Investment appraisal is necessary in case of investment decisions. Investment

appraisalhappenstobeanaidtodecisionmakingintheallocationofscarceresources
tocompetingusesofbothinpublicandprivatesectors.Iftheappraisalindicatesthata
projectcanbeundertakenprofitably,thentheinvestmentprojectthatshowsthebiggest
return on the investment capital should be chosen. But if it is a case of public sector
investment projectswhich are to provide socialservices then the criterion adopted in
selecting such project happens to be one of maximizing social benefit. Investment
decisionsinpublicsectorarenotonlygovernedbyananalysisofaccountingcostsand
benefitsbutalsoinfluencedbyseveralotherfactorssuchaspoliticalorsocialpressure.

For proper and appropriate investment decisions the information required are
givenbelow.
a. Estimatesofcapitaloutlayfortheproject.
b. Estimatesofthefuturecashflowsoftheproject
c. Estimateoftheavailabilityofcapitalalongwiththecostofcapital.
d. Setofstandardsfortheselectionofprojectsforexecution.(biggerbenefitsare
preferabletosmallerones;earlybenefitsarepreferabletolaterbenefits.)

There are several appraisal techniques for judging the profitability of new
investmentsinassets.
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TheymaybeclassifiedasNondiscountingandDiscountingtechniques.
Nondiscountingtechniquesare
1. Paybackmethod.
2. Averagerateofreturnmethod(ARRMethod)
Discountingtechniquesare
1. NetpresentvalueofNPVmethod
2. ProfitabilityIndex(P.I)
3. NetterminalvalueorNTVmethod.

4. InternalrateofreturnorIRRmethod.

PAYBACKMETHOD

Underthismethodprojectsareassessedonthebasisoftheperiodthatitwould
take to generate sufficient income to repay the original outlay. Payback is simply a
measureofthetimerequiredforthecashincomebeforechargingdepreciationbutafter
payment of tax from a project to return the initial investment to the firms treasury.
Payback occurs when the cumulative cash inflows from a project minus the initial
investmentisequaltozero.

Theadvantagesofpaybackmethodare
1. It is the most simplest criterion for appraising investment proposals since
shorterpaybackispreferredtolongerpayback.
2. Ittakesintoaccountpreferenceforanearlyrepaymentofcapitalinvested,the
capitalisthenavailableforotheruses.
3. Themethodispreferredbecauseofthefactthatthereturnsbeyondthreefour
yearsarequiteuncertain.

The method has some drawbacks. It fails to allow returns after the end of the
payback period. This method gives weights only to cash flows before the recovery of
investmentzeroweightstoallsubsequentreceipts.Itoveremphasizesliquidityaspect.
It ignores time value of money. Projects with longer gestation periods can never be
launched if we use this method since they begin to give return after a lapse of
considerableperiodoftime.

Paybackmethodispopularmethodforevaluatinginvestmentproposals.

AVERAGERATEOFRETURNorARRmethod

Thismethodofevaluatinginvestmentproposalsisprimarilybasedonaccounting
approach rather thancashflowapproach.Thismethodconsists ofaggregatingallthe
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earnings from the project after depreciation and dividing them by the projects life to
obtain the average annual earnings and then this average earning is divided by the
averaged investment and the resulting figure is multiplied by 100 so as to obtain the
desireARR.

ARR=(averageannualearnings)/(averageinvestment) 100.

NETPRESENTVALUEorNPVmethod

Payback and ARR methods do not consider the time value of money which is a
factor of basic importance in evaluating investment proposals. The money received
todayisworthmorethanthesameamounttobereceivedatalatertime.Itispreferable
to have money now than the same amount in future. The future is uncertain and in
meantimecapitalmaybeearningareturn.Discountedcashflow(DCF)techniquedos
considerthetimevalueofmoneyandisconsideredmoreobjectivebasisforevaluating
investmentproposals.UnderDCFtechniquethecashflowsarediscountedatacertain
rate. i.e; the rate must be earned so that the value remains constant over a period of
time. DCF method is superior on another ground as well since it does consider all
benefits and costs of the project during the entire period of its life. DCF methods are
mainlyoftwotypes.Netpresentvaluemethodandtheinternalrateofreturnmethod.
Twovariantsofnetpresentvaluemethodhappenstobe1.Netterminalvaluemethod
and2.Theprofitabilityindex.

NPVisoneoftheDCFtechniquesofevaluatinginvestmentproposals.Inapplying
NPVmethodthefollowingstepsaretobefollowed.

a. First the annual net cash flow expected from a project is calculated by
estimating all cash receipts and deducting from them all expenditure arising
outoftheproject.
b. Thenetcashflowisthendiscountedtogiveitspresentvalue.Therateusedto
discount the cash flow is the required rate of return. The minimum rate of
returnexpectedtobeearnedfromtheinvestmentprojects.

c. Thenetpresentvalueofaninvestmentproposalisthencomputed.Itisequal
tothesumofthepresentvalueofitsannualnetcashflowsaftertaxlessthe
investmentsinitialoutlay.

NPV=

whereCFt=netcashflowintimeperiodt, r=rateofdiscount

I0=Initialcashoutlay,

n=projectsexpectedlife
AcceptprojectifNPV>0,RejectifNPV<0IfNPV=0,apromotionofindifference

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TheadvantageofNPVmethodare
a. Thismethoddealswithcashflowsratherthanaccountingprofits.Thus,itis
sensitivetotruethetimingonthebenefitsassumingfromtheinvestment.
b. Itrecognizesthetimevalueofmoneyandallowscomparisonofbenefitscosts
inalogicalmanner.
c. This method is consistent with the goal of maximizing the shareholders
wealth since projects under this method are accepted only if they have
positiveNPVwhichinfactincreasesthevalueofthefirm.

d. Thismethodisspeciallyusefulinevaluatingmutuallyexclusiveprojects.

The major limitation of this method is that it requires detailed long term
estimates of the incremental benefits and costs. There may also arise difficulty in
decidingtheappropriaterateofdiscountforfindingthepresentvaluesofthecashflows
coming in over projects life. The relative desirability of an investment proposal may
changewithachangeinthediscountrate.Anothershortcomingofthismethodisthatit
maynotgivedependableresultsincaseofprojectsinvolvingdifferentoutlaysorhaving
differenteffectivelives.

NPV method is theoretically most correct criterion and is frequently used in

practice.

THEPROFITABILITYINDEX(P.I)

Theprofitabilityindexistheratioofthepresentvalueofthefuturenetcashflows
totheinitialoutlayoftheproject.Thusindexprovidesarelativemeasureforjudging
desirabilityandevaluatingtheworthofaninvestmentproposal

P.I=

Where

CFt=netcashflowintimeperiodt

r=rateofdiscount

n=Theprojectsexpectedlife

I0=Initialcashoutlay

AccepttheprojectifitsP.I>1

RejecttheprojectifitsP.I<1

RemainindifferentbetweenacceptanceandrejectionifPI=1

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TheAdvantagesare
1. Itusescashflows.
2. Itrecognizesthetimevalueofmoney.

3. Itisconsistentwiththegoalofmaximizingtheshareholderswealth.

Themaindisadvantageofitisthatitrequiresdetailedlongtermforecastsofthe
incremental benefits and costs. It also poses difficulty in determining appropriate
discountrate.

NETTERMINALVALUE(NTV)method

NetterminalvaluemethodisanimportantvariantofNPVmethodbutseparates
the timings of the cash inflows and outflows more distinctly. The assumption
underlying this method is that each cash inflow is reinvested in another asset at a
certain rate of return from the moment it is received till the termination of project.
Under thus method we calculate the compounded reinvestment cash flows and then
take their total and of this total and present value is determined at a given rate of
discount.Fromthispresentvaluewesubtracttheoriginaloutlaysoastoobtainthenet
terminalvalue,NTV.

AccepttheprojectifNTVispositive

RejecttheprojectifNTVisnegative

RemainindifferentbetweenacceptanceandrejectionoftheprojectifNTViszero

This method has several disadvantages. It evaluates the investment worth in a

bettermanner.Thismethodiseasiertounderstand.Themaindrawbackofthismethod
liesindeterminingthefutureratesofinterestatwhichthecashinflowsreceivedareto
bereinvested.

INTERNALRATEOFRETURN(I.R.R)METHOD

Internalrateofreturnisthediscountratecorrespondingto whichtheNPVofa
projecthappenstobezero.Internalrateofreturnmaybedefinedasthediscountrate
thatequatesthepresentvalueofprojectsfuturenetcashflowwiththeprojectsinitial
cashoutlay.

AcceptinvestmentproposalifitsIRRisgreaterthantherequiredrateofreturn
byinvestors.RejecttheinvestmentproposalifitsIRRislessthantherequiredrateof
returnbyinvestors.

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IRRbeingoneofthediscountedcashflowcriteriaisconsistentandprovidesthe
same acceptreject decision for an investment proposal as is being provided by either
NPVmethodorPI.

AprojecthaveonlyoneNPVandonePI.Butundercertainsituationsitcanhave
morethanoneIRR.ThisistheproblemofmultipleIRRs.

IRRmethodhascertainadvantages.
a. Ittakesintoaccountthetotalcashinflowandoutflows.
b. Itrecognizesthetimevalueofmoney.
c. Itisconsistentwiththeobjectiveofmaximizingshareholderswealth.
d. IRRmethodiseasytounderstand.
IRRmethodhassomelimitations.
a. Itinvolvestediouscalculations.
b. Itrequiresdetailedlongtermforecastsofincrementalbenefitsandcosts.
c. Possibility of multiple IRRs remains in some situations which reduces the
utilityofthismethod.

ANALYSISOFRISK/UNCERTAINTY

Whilemakinginvestmentdecisionswemakeanestimateofbenefits,intermsof
cashflows,tobederivedfromtheprojectonthebasisofcertainassumptions.Butthe
actualflowdependsonseveralotherfactorssuchaspriceofproduct,volumeofsales,
therateofinflationetc.Theactualcashflowsmaynotcorrespondtotheestimatedcash
flow.Thevariationbetweenactualandestimatedcashflowsoftheinvestmentproject
istermedasrisk.Theriskofaprojectdependsuponthedegreeofvariabilitybetween
thetwo.Ifthevariabilityhappenstobegreater,theprojectisconsideredmorerisky.

Riskreferstothesetofuniqueoutcomesforagiveneventwhichcanbeassigned
probabilitieswhileuncertaintyreferstotheoutcomesofagiveneventwhichareunsure
tobeassignsprobabilities.Inrisksituationtheprobabilitydistributionisknowntothe
decisionmaker.Whenuncertaintyexists,thedecisionmakerhastocomputesubjective
probability on the basis of his experience. Variability is less in the situation of risk
comparedtovariabilityinuncertainsituations.

Theimportantriskhandlingapproachesare
a. Riskadjusteddiscountrateapproach(RADapproach)
b. Certaintyequivalentapproach
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c. Probabilitydistributionapproach(FrederickHilliermodels)
d. Decisiontreesapproach
e. Simulationapproach
f. Sensitivityanalysis.

Riskadjusteddiscountrateapproach

It is the most simple and widely used approach for incorporating risk into
investmentdecisions.Underthisapproachthediscountrateusedinthepresentvalue
calculationissoadjustedastoincorporatetheamountofriskinherentinaproject.For
moreriskyprojectsthehigherdiscountratesandforlessriskyprojectslowerdiscount
ratesareusedforpresentvaluecalculations.RADapproachcanbeusedwithNPVand
IRRtechniquesofevaluatinginvestmentproposals.IncaseofNPVmethod,theNPVwill
becalculatedusingtheriskadjustedrateandtheprojectwouldbeacceptedinNPVis
positive. In case of IRR, the internal rate of return would be compared with the risk
adjusted rate of return. If IRR exceeds the riskadjusted rate, the project would be
accepted.

RAD approach is simple and easy to understand and possesses the merit of
operationalfeasibility.Thusitisfrequentlyusedinpractice.RADapproachisacrude
methodofincorporatingriskintoinvestmentdecisions.

CertaintyEquivalentApproach

Underthisapproachofincorporatingriskinevaluatinginvestmentproposals,the
expected cash flows are soadjustedas to takecare of theinherent risk of the project.
Thefollowingstepsareinvolvedunderthisapproach.

a. Astheexpectedcashflowaretobemodified,thefirststephappenstobethe
determinationofbasisformodifyingthecashflowstoadjustforrisk.Thisis
done by computing the certaintyequivalent coefficient which shows the
relationship between certain and uncertain cash flows. This coefficient is
calculatedwhenwedividerisklesscashflowbyriskycashflow.
Certaintyequivalentcoefficient=Risklesscashflow/riskycashflow
b. Withthehelpofcertainty=equivalentcoefficientstheexpectedcashflowsare
convertedtocertaintyequivalents.
c. Thepresentvaluesofcashflowscalculatedareworkedoutusingtheriskfree
discountrateortheratewhichappropriatelyreflectsthetimevalueofmoney.
d. Foracceptingtheprojectornotacceptingit,eitherNPVorIRRmethodmaybe
used.

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ForthepurposeofcomputingNPVundercertaintyequivalentapproachweuse

NPV=

Where

at=Certaintyequivalentcoefficientfortheyeart.

I=risklessinterestrate

C=Cashoutflow(ortheinitialinvestment)

Thisapproachissimpleandeasytounderstand.Itissuperiortotimeadjusted
discountrateapproach.

ProbabilityDistributionApproach

This approach is also known as statistical distribution approach. Under this

approach, the degree of risk associated with a project is measured in terms of the
varianceofNPVdistribution.Investmentdecisionsaretakenonthebasisofmeanand
standarddeviationvaluesofthenetpresentvaluedistribution.Inthismethodnetcash
flow from an investment in each period is viewed as a random variable which can
assumeanyoneofthepossiblevalues.Itrequiresthatprobabilitydistributionofcash
flows for each of the years be obtained and made use of it. The expected value and
varianceofNPVdistributionarecalculatedas

ExpectedvalueofNPV

E(NPV)= =

Where

E(NPV)=expectedNPVoftheproject

ct=meanofthecashflowsinyeart

i=rateofdiscount

VarianceofNPV(HillierModel)

i.
Independentcashflows:Whencashflowsofoneperiodarenotrelatedto
cashflowsofanotherperiod.

VarianceofNPV;V(NPV)=

Where =Varianceofcashflowsinyeart,i=rateofdiscount

ii.

Perfectlycorrelatedcashflows:whencashflowsareperfectlycorrelated,

MathematicalEconomics(IIISem.)

V(NPV)=

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Where
iii.

=Standarddeviationofcashflowsinyeart.i=rateofdiscount

Mixedcashflows:(whereapartofcashflowsareperfectlycorrectedand
partareindependent)

V(NPV)=

C =independentcashflowsinyeart, i=rateofdiscount

C =Correlatedcashflowsinyeart,correlatedwithanyotherperiod.

V=Variancecashflowstreams

100

CoefficientofVariation=

Ahighercoefficientofvariationindicateshigherriskintheconcernedproject

DecisionTreesapproach

Decision trees approach is considered very useful and convenient approach for
incorporating risk into investment decisions. Under this approach the problems of
investmentdecisionsaredepictedintheformofdiagramsonthebasisofwhichthebest
course of action is suggested. The main feature of this approach is that it takes into
accounttheimpactofallprobabilisticestimatesofpotential outcomes.Thisapproach
particularlysuitsthosesituationswhereindecisionsatonepointoftimealsoaffected
decisions at some later date. Projects requiring sequence of decisions over time and
having several possible outcomes are most suitable to be tackled by decision tree
approach.

Simulationapproach

Simulationapproachmaybeusedininvestmentdecisionsespeciallywhendueto
uncertaintiesasatisfactorymathematicalmodelcannotbeused.Simulationtechnique
can be used to approximate NPV or IRR and its dispersion about the expected value.
Thefollowingstepsareinvolvedinsimulationapproach.

a. The various factors influencing cash and NPV of an investment proposal are
identified.
b. Theprobabilitydistributionsofeachofidentifiedfactorsare obtainedeither
usingpastdataorbyanexperienceofdecisionmaker.
c. Then the values of each of variables are simulated with the help of random
numbers.Avalueforeachofthefactorsisthenselectedatrandom.
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d. OnthebasisofthesetofvaluessoobtainedNPVorIRRiscomputedforeach
combinationofidentifiedfactors.
e. RepeattheaboveproceduretodevelopprobabilitydistributionofNPVorIRR
and calculate mean standard deviation and statistical parameters. Then a
decisionistakenontherelatedproposal.

Sensitivityanalysis

Sensitivity analysis is also a technique of incorporating risk in investment

decisions.

Followingstepsareinvolvedinusingsensitivityanalysisininvestmentdecisions.
a. Data relating to cash flows of an investment proposal are broken down into
some major variables like initial outlay required, wage rates, selling prices,
interest rates, etc. A model of the project is drawn up on the basis of some
estimatedvaluesofrelatedvariables.
b. Eachvariableisconsideredinturnanditsvalueischangedbothupwardand
downwardfromitsoriginalestimate.
c. TheNPVorIRRvaluesrecomputedbytakingeachnewestimateinturn.
d. WithrecomputedNPVorIRRvaluesaneffortismadetodetermineastowith
whichvariablefluctuationsthegivenprojectisparticularlysensitive.
Sensitivity analysis serves as a guide and indicate areas where additional
effort to produce better estimates may be made. In view of this sensitivity
analysisiswidelyusedinpractice.

Forfurtherreadingandreference:

AnintroductiontooperationsresearchbyKOTHARI.C.R.

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