Chapter Six: Dynamic Optimization

CHAPTER SEVEN
DYNAMIC OPTIMIZATION

Chapter Contents:

Dear students, this chapter covers the following major sub-topics

 Definitions and concepts on static and dynamic analysis.

 Discrete time, differential, and difference equations
 First order linear differential equations
 First order linear difference equations
 Cobweb Model and its application in economics
 Economic applications of dynamic optimization using linear difference and differential
equations

Objectives:

After going through this chapter, students are expected to

 Understand the distinction of static analysis vs dynamic analysis and

 Understand the distinction of continuous time vs discrete time case.
 Know the forms and concepts of linear differential and difference equation including
understanding their general forms and finding their general and definite solutions.
 Familiarize yourselves about the application of linear differential and difference
equations in economics.
 Familiarize yourselves with the basic knowledge of cobweb model and its application in
economics .

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 Chapter Six: Dynamic Optimization

7.1 Definitions and Concepts

In static analysis an economic variable is assumed to be a function of another variable in the

same time period.
Example: 1) consumption is the function of income for the same time period.
C=f ( y )
2) Supply is the function of price for the same time period
S=f (P)
But, dynamic analysis introduces the explicit consideration of time in to the picture.
Example 1) Current consumption may depend on past incomes.
Ct =f ( Yt −1 )∨C ( t )=f ( y ( t )−1)

2) Quantity supplied in one period may depend on the price of the previous period. A good
example is agricultural food supply. The time paths of variables can be studied in two ways:

I. Discrete –time case: - Where time can be considered as a discrete variable, in which (case) the
variable undergoes a change only once within a period of time. This utilizes the methods of
difference equations. Example Interest compounding per year, month e.t.c. The curve is not
smooth here.
II. Continuous-time case: -where time is considered as a continuous variable, in which case
something is happening to the variable at each point of time. Here, integral calculus and
differential equations are used. Example population growth.

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 Chapter Six: Dynamic Optimization

7.1.1 First –Order Linear Differential Equations

Differential equations are equations involving derivatives (differentials). They express the rates
of change of continuous functions over time. The objective in working with differential
equations is to find a function, without a derivative (differential) which satisfies the differential
equation. Such a function is called the solution or integral of the equation.
Note: The order of a differential equation is the order of the highest derivative in the equation.
The degree of a differential equation is the highest power to which the derivative of the highest
order is raised.
dy
Example: 1) =2 x +6 : First order, first degree
dx

( )
2 3
d y dy 2
2) 2
+ + x =0: Second order, first degree
dx dx

( )( )
2 7 3 5
d y d y
3) 2
+ 3
=75 y : Third order, fifth degree
dx dx
dy
General form: +VY =Z where V and Z are constants or functions of time.
dt
dy
When constants⇒ + 2Y =3
dt
dy
When functions of time ⇒ + V ( t ) Y =Z (t)
dt
dy
Note: For a first order linear differential equation and y must be not higher than the first
dt
dy
degree and no product y may occur.
dt
−vt Z
General solution: y ( t ) =A e +
V
Where, A ≡is an arbitrary constant.
−vt
Ae ≡Yc ⇒the complementary solution.
Z
=Yp⇒Particular integral
V
Proof: Given the general linear differential equation:
dy dy
+VY =Z ⇒ =Z−VY
dt dt

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 Chapter Six: Dynamic Optimization

dy
Separating the variables: =dt
Z−VY
dy
Integrating both sides:∫ =∫ dt
Z −VY
−1
ln ( Z−VY )=t +C1
V
ln ( Z−VY )=−Vt +(−V C 1)
l n ( Z−VY ) =−Vt +C 2 Where, C 2=-VC 1
− vt +c2
Z−VY =e Since if ln y =x ⇒=e x
− vt c2 −vt
Z−VY =e e =e c Where c=e c 2
−vt
−VY =c e −Z
−C −vt Z −C
Y= e + Where A=
V V V
Hence, for the above general linear differential equation, the general solution is given as
−vt Z
Y=A e + . This general solution works for both V and Z as a constants and functions of
V
time.

Finding a Definite solution for a Differential Equation

Given a general solution of a differential equation, if an initial condition (boundary value) is
given, A can be specified, in which case a definite solution is possible. Hence, the arbitrary
constant in the general solution (i.e. A) can be definitized by means of an initial condition.
−vt Z
Given Y ( t )=A e +
V
− v(0) Z Z Z
At t=0 , y ( 0 )= A e + =A + ⇒ A=Y ( 0 )−
V V V
Z
Thus, the definite solution is formed by replacing ‘A’ by Y ( 0 )− in the general solution as
V
follows.

[
Y ( t )= Y ( 0 )−
V ]
Z −vt Z
e +
V

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 Chapter Six: Dynamic Optimization

Note: the particular integral (Yp) represents the intertemporal equilibrium level of Y (t ). The
complementary solution Yc denotes the deviation of the time path from the equilibrium level.
For Y ¿) to be dynamically stable, Yc must approach zero as t approaches infinity (∞ ).

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 Chapter Six: Dynamic Optimization

Examples:
dy
1. Find the general solution for a differential equation + 4 y=12
dt
Method 1: since V=4 and Z=12, the general solution will be Y ( t )=A e 4 t +3
Method 2: using the equation in separated form, an explicit solution can be found as
dy dy
follows: + 4 y=12 ⇒ =12−4 y
dt dt
dy
Separating the variables: =dt
12−4 y
dy
Integrating both sides:∫ =∫ dt
12−4 y
−1
ln (12−4 y)=t+C 1
4
−4 t−4 c1
ln (12−4 y)=−4 t−4 C 1⇒ ¿=12−4 y=e
−4 c 1
− 4 t −4 c 1 −4 t e
−4 y=e e −12 ⇒ y=e +3
−4
−4 t −1 −4 c
The general solution is given by : y =A e +3 where A= e 1

dy 2 2
2) Find the general solution for +3 t y =t
dt
Solution:
Rearranging the function to the general form of differential equations, we get:
dy 2 2 2
=t −3 t y=t ( 1−3 y )
dt
dy 2
Separating the variables: =t dt
1−3 y
dy
Integrating both sides:∫ =∫ t dt
2
1−3 y
−1 1 3 3
ln ( 1−3 y ) =¿ t +C 1 ⇒ ln ( 1−3 y )=¿−t +C2 C2 =−3 C1 ¿ ¿
3 3
3 3

1−3 y =e−t +C ⇒ 1−3 y=e C e−t

2 2

C 2 −t 3 −1 C −t 1 3

−3 y=e e −1 ⇒ Y = e e +
2

3 3

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 Chapter Six: Dynamic Optimization

−t 1 3
−1 C
This is a general solution since it contains a definite integralY = A e + where A= e 2

3 3

7.1.2 First Order Linear Difference Equations

First order linear difference equations are used to analyze changes with respect to time when
what happens in one period depends up on what happened in the previous period. A difference
equation expresses a relationship between a dependent variable and a lagged independent
variable which changes at discrete intervals of time. Example: consumption in one period
depends on the previous income. That is, c t =f ( y t −1 ) A t=for discrete case ,

A(t) =for continous case

Note: The order of a difference equation is determined by the greatest number of periods
lagged. A first order difference equation expresses a time lag of one period; second order
difference equation a two period time lag and so on.

Example:

The change in y as t changes ¿ t ¿ t +1 iscalled the first difference of y

Δy
i .e . = Δ yt= y t +1− y t [ first order ]
Δt

Most of the time delta (Δ)is omitted, and we write like this

I t=a ( y t−1−t t −2) [ second order ]

Qt =a+ b p t−1 [ first order ]

y t +3−9 y t +2 +2 y t +1+ 6 y t=8 [ third order ]

The solution of a difference equation defines y for every value of t and does not contain a
difference expression.

The general form of a linear difference equation is given by

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 Chapter Six: Dynamic Optimization

y t +1−b y t =c∨¿ some cases y t =b y t −1 +c where b∧c are constants .

Note: The dependent variable does not appear raise to a power higher than one or as a cross
product.

Methods of Solving Difference Equations

1. Iterative method
The first order difference equation describes the pattern of change of y between two
consecutive periods only. Hence, once the difference equation is specified and an initial
value y 0is given, it is possible to find y, from the equation. Similarly, once y 1is found, y 2
will be immediately obtained, and so on, b y repeated application (iteration) of the
pattern of change specified in the difference equation. The results of iteration will
enable us to inter a time path or the variable under consideration.
Examples:
1) Find the solution of a difference equation Δ y t =2 assuming aninitial value of
y=15.
solution:
since Δ y t = y t +1− y t , Δ y t =2⇒ y t +1= y t +2
Then by successive substitutions of t=0 , 1 ,2 , 3 , e . t . c we obtain
t=0 : y 1= y 0 +2
t=1 : y 2= y 1 +2=( y 0+ 2 ) +2= y 0 + 4= y 0 +2(2)

t=2 : y 3= y 2 +2= [ y 0+ 2(2) ]+2= y 0 +6= y 0 +3(2)

t=3 : y 4 = y 3 +2=[ y 0 +3 (2) ] +2= y 0 +8= y 0+ 4 (2)
. . .
. . .
. . .
For any period t= y t = y 0 +t (2)
⇒ y t =15+2 t ( this is the time path of the variable ) .
2 Find the solution of the difference equation
y t +1=b y t given that the initial value of y is y 0.

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 Chapter Six: Dynamic Optimization

Solution:
Given y t +1=b y t
At t=0 : y 1=b y 0
2
At t=1: y 2 =b y 1=b ( b y 0 )=b y 0

At t=2: y3 =b y 2=b ( b2 y 0 )=b3 y 0

. . .
. . .
t
At t=t : y t =b y 0 (The solution of the difference equation)
The solutionof the differential equation :
−vt
y ( t ) =A e (¿ is natural logarithm expreses constant rate of continuous growth)
The solutionof the difference equation:
t
y t =A b ( exponential equation expreses constant rates of discrete growth )
[Link] Method:
Given the first order difference equation: y t +1−b y t =c its general solution will consist of
the sum of a complimentary function( y ¿¿ c )¿ and a particular integral ( y p ).
Definition: y p equals the intertemporal equilibrium level of y and y c represents the
deviation of the time path from that equilibrium level. For the time path to be
dynamically stable, y c must approach zero as t approaches infinity.
y c -is the general solution of the reduced (homogeneous) equation.
y t +1−b y t =0
y p-is the general solution of the complete or non-homogeneous equation.
y t +1−b y t =c
a) First find y c for the homogeneous equation;
Given: y t +1−b y t =0 ⇒ yt +1=b y t
The general solution will be of the form y t =A bt (see example 2 above in iterative
method) where,
A b ≠ 0 , for otherwise y t becomes a horizontal straight line on t-axis. In that case the
t

complimentary solution will be y c = A b t .

b) Next, find the particular integral for the non-homogeneous equation:

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 Chapter Six: Dynamic Optimization

Given y t +1−b y t =c , we can choose any solution particular integral ( y p). Thus, we take
the simplest form of the trial solution: y t =k (a constant). Then, since y maintains the
same constant value over time, we must also have y t +1=k . Then, substitute these values
in to the complete equation:

c
y t +1−b y t =c ⇒ k −bk =c ⇒ k ( 1−b )=c ⇒ k=
1−b
c
Hence, the particular solution becomes y p=k ⇒ y p= , b ≠ 1.
1−b
c
Note that since is a constant, a stationary equilibrium is indicated in this case.
1−b
Since y pis undefined at b=1, we need to find some other solution for the non-
homogeneous equation. So, let’s try a solution of the form y t =kt which indicates a
moving equilibrium, y t =kt implies y t +1=k (t+1).
Substituting these values in the complete equation, we obtain
y t +1−b y t =c ⇒ k ( t +1 )−b ( kt ) =c
⇒ k ( t +1 )−kt=c , since b=1
⇒ k ( t +1−t )=c ⇒ k=c thus , y p =kt ⇒ y p=ct , for b=1
c) Finally, adding y p∧ y c we arrive at the general solution
t c
y t = y c + y p ⇒ y t= A b + … … . ( 1 ) General solutionwhen b ≠ 1.
1−b
t
y t =A b + ct ⇒ y t= A+ ct … … … . ( 2 ) General solution whenb=1.

Eliminating the arbitrary constant, the definite solution will be written as:

0 c c
From (1) at t=0 , y 0= A b + ⇒ A= y 0−
1−b 1−b

(
y t = y 0−
c
1−b
bt +) c
1−b
( 1' ) [ Definite solution , when b ≠1 ]

From (2) at t=0 , y 0= A+ c ( 0 )= A

y t = y 0 +ct ( 2' ) [ Definite slution , whenb=1 ]

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 Chapter Six: Dynamic Optimization

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 Chapter Six: Dynamic Optimization

Examples:

7
1) Solve the first order difference equation y t +1−5 y t =1 ,( y 0= ).
4

Solution:

Using the definite solution formula (b ≠ 1)

(
y t = y 0−
c
1−b )
bt +
c
1−b

Sinceb=5 , c=1 ⇒ y t = ( 74 − 1−5

1
)¿
y t =2 ¿
2) Given the difference equation y t =−7 y t −1 +16∧ y 0=5 ,find the time path.

Solution:

Given y t =−7 y t −1 +16 , to change it in to the general form of difference equation, shift the
equation by one year: y t +1=−7 y t −1+1 +16

y t +1 +7 y t−1 +1=16

c t c
Since b=-7 and c=16, y t =( y ¿ ¿ 0− )b + ¿
1−b 1−b

(
y t = 5−
16
1+ 7
¿)
To check the answer, substitute t=0 and t=1 in the solution.

at t=0 , y 0=3 ¿
at t=1, y 1=3 ¿

Then, substitute y 1=−19 , for y t∧ y 0=5 for y t −1 in the original equation y t =−7 y t −1 +16

−19=−7 ( 5 ) +16 ⇒−19=−19 (compare)

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 Chapter Six: Dynamic Optimization

7.2. The Dynamic Stability of Equilibrium

In the continuous- time case, the dynamic stability of equilibrium could be done using stability
conditions. Stability condition using the general formula for the difference equation

(
y t = y 0−
c
1−b
bt +
c
)
1−b
,it can be expressed in a more general formula as:

t c c
y t =A b + a , A= y 0− ∧a=
1−b 1−b

The time path y t will be dynamically stable only if the complimentary function A bt → 0 as t → ∞
i.e.

For difference equation (discrete function)

y
When t ≠ ∞ (for a continuous function)

y t =a
a t=∞

Assuming for the moment A=1 and a=0, the exponential expression b t generates seven
different time paths depending on the value of b (which can range from -∞ ¿ ∞ ).

1. If b> 1,b t increases at an increasing rate as t increase. Thus, the time path will explode
(diverge) and move farther and farther away from the horizontal line.

Example:

If b=3, the value of b t at different time periods will be

t 0 1 2 3 4

b
t
1 3 9 27 81

2. If b=1, b t=1 for all values of t, thus the time path is represented by a horizontal line.

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 Chapter Six: Dynamic Optimization

3. If −1<b< 1, (i.e. b is a positive fraction), b tdecreases as t increases, thus the time path
would be damped and moves towards the equilibrium line (horizontal line).
1
Example: if b=
3

t 0 1 2 3 4

b
t
1 1 1 1 1
3 9 27 81

4. If b=0,b t=0 for all value of t.

5. If −1<b< 0 i.e. (b is negative fraction), b t oscillates between positive and negative
values, and the time path will draw closer and closer to the horizontal line (equilibrium).
−1
Example: if b=
3

t 0 1 2 3 4

b
t
1 −1 −1 −1 −1
3 9 27 81

6. If b=−1 , bt oscillates between +1 and -1.

Example:

t 0 1 2 3 4 5

b
t
1 -1 1 -1 1 -1

7. If b←1 , bt will oscillate and move farther and farther away from the horizontal line
equilibrium.
Example:

t 0 1 2 3 4 5

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 Chapter Six: Dynamic Optimization

b
t
1 -2 4 -8 16 -32

t
b

0
t

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 Chapter Six: Dynamic Optimization

-1 t

t
b

Summary:

If |b|>1∧b←1, then the time path explodes (diverges).

If |b|<1∨−1< b<1, the time path converges.
If b> 0, the time path is non-oscillatory.
If b> 0, the time path is oscillatory.
The Roles of A and a
a) The magnitude of A produces a scale effect without changing the configuration of the
time path, i.e., the Value of A serves to scale up or down the value of b t (the time path).
b) The sign of A produces a mirror effect. If A=−1, a mirror image of the time path of b t
with respect to the horizontal axis will be produced.
c) The magnitude of ‘ a’ affects the vertical intercept of the graph and the graph shifts up
or down depending on the sign of ‘ a’ . This in no way affects the convergence or
divergence of the time path, but alters the level with respect to which the convergence
or divergence is gauged.

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 Chapter Six: Dynamic Optimization

Activity 1: Dear students please try on the space provided and check your
1
progress 1) Given a difference equation y t +1− 3 y t =6 (where y 0=1)

(a) Solve the difference equation.

(b) Check the answer using t=0 and t=1, and

(c) Comment on the nature of the time path.

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 Chapter Six: Dynamic Optimization

Check Your Progress

(a) From the difference equation, since b=1/3 and c=6, using the formula for the definite
solution,

( ) ( ) ()
t t
c t c 6 1 6 1
y t = y 0− b+ = 1− + =−8 +9
1−b 1−b 1 3 1 3
1− 1−
3 3

()
t
1
Hence , y t =−8 +9
3

() ()
t 0
1 1
(b) Given y t =−8 +9 , at t=0 , y 0=−8 +9=1
3 3

()
1
1 19
at t=1, y 1=−8 +9=
3 3
19
Then, substituting y 1= for y t +1∧ y 0=1 for y t ∈the original equation :
3
19 1 18
− ( 1 )=6 ⇒ =6 (compare)
3 3 3
1
(c) Since the base, b= > 0 , y t is non−oscillatory .
3
1
|b|= <1 , y t is convergent .
3
Therefore, the time path is non−oscillatory and convergent.

Graphic Illustration

()
t
1
Given the definite solutionof the difference equation as y t =−8 +9, the possible rounded
3
values of t and y t in graph are tabulated as follows:

t 0 1 2 3 4 5

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 Chapter Six: Dynamic Optimization

yt 1 6.3 8.1 8.7 8.9 8.97

yt

y p=9

t
1 2 3 4 5

Activity 2: Dear students please try on the space provided and check your
progress (2) Given a difference equation x t +3 x t−1 +8=0∧x 0 =16 ,

(a) Solve the difference equation.

(b) Check the answer using t=0 and t=1, and

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 Chapter Six: Dynamic Optimization

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 Chapter Six: Dynamic Optimization

(c) Comment on the nature

(d) of the time path.

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 Chapter Six: Dynamic Optimization

Check Your Progress

(a) Shift the time periods forward one period to conform to the general form:
x t +1+ 3 x t −1+1+ 8=0⇒ xt +1 +3 x t=−8

Since b=−3 andc=−8, the definite solution formula gives:

(
x t = x 0−
c
1−b )
bt +
c
1−b (
= 16−
−8
1−(−3) )
(−3)t +
−8
1−(−3)
⇒ x t =18(−3)t −2

(b) At t=0 , x 0=18(−3)0−2=16∧at t=1 , x 1=18(−3)1−2=−56

Substitution in the original equation yields:
x t +1+ 3 x t =−8 ⇒−56+3 ( 16 )=−8(compare)
(c) With the base b=−3>0 ,∧|b|=3>1, the time path is oscillatory and divergent.

In the concepts of saving and interest, negative values of y p is feasible, but in other cases it
may not be possible.

Graphic Illustration

t
Given the definite solutionof the difference equation as x t=18 (−3 ) −2 , the possible values of
t and x t in graph are tabulated as follows:

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 Chapter Six: Dynamic Optimization

t 0 1 2 3 4

xt 16 -56 160 -488 1456

yt y t =1456
y t =−56

16

0 t
y t =−2

y t =−56

y t =−488

Activity 3: Dear students please try on the space provided and check your
progress (3) Given ∆ g t=14 ,

(a) Solve the difference equation.

(b) Check the answer using t=0 and t=1, and

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 Chapter Six: Dynamic Optimization

(c) Comment on the nature of the time path.

Check Your Progress

(a) Rewriting the equation: ∆ g t=gt +1−g t=14 , since b=1∧c=14, the formula for the
general solution gives:
gt = A+ct= A +14 t ⇒ g t= A+ 14 t
(b) At t=0 , g 0= A+14 ( 0 )= A∧at t=1 , g1= A+14 ( 1 )= A+14
Substituting in the original equation: gt +1−gt =14 ⇒ A +14−A=14 (compare )
(c) Since b=1>0 , gt is non-oscillatory. And if A ≠ 0 ,|b|=1 , gt is neither divergent nor
convergent because it is a moving equilibrium (it changes from time to time).

gt Time path= A+14t y p=14 t

0 1 2 3 4 5 6 7 8 9 10

For the case A > 0

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 Chapter Six: Dynamic Optimization

7.3. Economic Applications of Dynamic Optimization

7.3.1. Uses of Differential Equations in Economics

Differential equations are used to determine the conditions for dynamic stability in micro-
economic models of market equilibria and to trace the time path of growth under various
conditions in macro-models.

Given the growth rate of a function, differential equations enable the economist to find the
function whose growth is described. Furthermore, from point elasticity they enable him to
estimate the demand function.

Examples:

1. Given the demand function Q d =c +bP and the supply function Q s =g+hP determine the

condition for price stability in the market (i.e. under what conditions p (t) will converge to p
(equilibrium price) as time→ ∞).

Either {Qs=g+ hP , g< 0∧h> 0

Q s=−g+hP , g , h>0 } {
Qd =c+ bP , c> 0 ,b <0
Qd =c−bP , c , b> 0 }
are correct .

Solution:

c−g
First find equilibrium price ( p): Q d =Q s ⇒ c +bP=g+hP ⇒ ( h−b ) p=c−g ⇒ p=
h−b

Price (P)
Excess Supply Supply

P Demand=Supply (Equilibrium)

Excess Demand
Demand

0 Q Quantity

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 Chapter Six: Dynamic Optimization

Assume that the rate of change of p in the market ( )

dp
dt
is a positive linear function of excess

demand(Q ¿ ¿ d −Qs ):¿

dp
=m(Q ¿ ¿ d−Qs ), wherem>0 ¿
dt

m ≡adjustment coefficient substituting the values ( parameters ) of Qd ∧Qs ; we get :

dp
=m ( c +bp−g−hp )=m(c−g+(b−h) p)
dt

Rearranging to fit the general format of differential equation: ( dydt + vy= z)

dp
+m ( h−b ) p=m ( c−g )
dt

Then, since v¿ m ( h−b ) p , and z=m ( c−g ) , the general solution becomes

−vt z −m (h−b)t c−g

( y ( t )=A e + ): p ( t )= A e +
v h−b

The definite solution will be:

c−g −m(h−b)t c−g

p ( t ) =( p ( 0 ) − )e +
h−b h−b

c−g −m (h−b )t
Using the relation p= : p ( t )=( p ( 0 )− p)e +p
h−b

Let k =m(h−b)⇒ p ( t )=( p ( 0 )− p)e−kt + p

Whether
−kt
p ( t ) tends ¿ p as t → ∞ depends on whether the exponential expression e →0 as t → ∞ . since p ( 0 )∧ p are constants∧

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 Chapter Six: Dynamic Optimization

Consequently, the time path will indeed lead the price towards the equilibrium position. In this
case, the equilibrium is said to be dynamically stable.

But, depending on the relative magnitude of p ( 0 )∧ p , the above solution yields three possible
time paths.

Case 1: If p ( 0 )= p (the initial price is equal to the equilibrium price), the first term on the right
disappears and p ( t ) =p . The time path is horizontal and adjustment is immediate.

Price

The time path of price lies on the stable (long

P run) equilibrium called particular integral.

0 Quantity

Case 2: If p ( 0 ) > p , p ( 0 )− p>0. thus thetime path p ( t ) > p and

( t ) approaches p ¿ above as t → ∞ [ since ( p ( 0 )− p ) e−kt → 0 as t → ∞ ]
Price
P(0)

P(t ) when

p p ( t ) when p ( t ) =p

0 Quantity

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 Chapter Six: Dynamic Optimization

Case 3: If p ( 0 ) < p , p ( 0 )− p<0 .Thus, p ( t ) < p and approaches it from below as t → ∞ .

In general, to have dynamic stability, the derivation of the time path from equilibrium must
either be identically zero or steadily decreasing with time. Or, dynamic stability requires
asymptotic vanishing of the complimentary function as t becomes infinite.

Price

p p ( t ) when p ( t ) =p

p ( t ) when p(t)< p
P(0)

Quantity

Activity 4: Dear students please try on the space provided and check your
progress Find the demand function Q=f ( p ) if E=−k , a constant .

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 Chapter Six: Dynamic Optimization

Check Your Progress:

We know that the price elasticity of demand (E) is given by

dQ Q dy
E= . =−k (we aretrying ¿ derive + vy =z)
dP P dt

dQ Q
=−k
dP P

dQ dP
Separating the variables : =−k
Q P

dQ dP
Integrating both sides :∫ =∫ −k ln Q=−k ln p+c
Q P

⇒ ln Q+ k ln p=c ⇒ln Q+ ln pk =c ⇒ ln ( Q p k )=c ⇒Q pk =ec

We can say:Q p k =c 1 where c 1=e c ⇒ c1 p−k

7.3.2 Uses of Difference Equations in Economics

The change from continuous time to discrete time produces no effect on the fundamental
nature of dynamic analysis, although the formulation of the problem must be altered. Basically,
our dynamic problem is still to find a time path for some given pattern of change of a variable y
over time, where t now allowed to take only integer values.

The difference between differential and difference equation is the nature of time. Time is
considered continuous in differential but discrete in difference equations. Otherwise, they serve
the same purpose.

Cob Web Model

To illustrate the use of difference equations in economic analysis, we use a market model of a
single commodity (cobweb model).

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 Chapter Six: Dynamic Optimization

For many products (such as agricultural commodities) which are planted a year before
marketing, current supply depends on last year’s [Link] , t +1=f ( pt ) ¿ Qs ,t =f ( pt −1 ).

When such a supply function interacts with a demand function of the form: Qd ,t =f ( p t )
interesting dynamic price patterns will result.

Using the linear version of the lagged supply and un-lagged demand function we get the market
model with the following equations:

Qdt =c +b pt ( c> 0 , b<0)

Qst =g+h pt −1 (g< 0 , h>0)

Q dt =Qst [ equilibrium conditions ]

Using the last equation, the model can reduced to a single first order difference equation:

Qdt =Qst

c +b pt =g+h pt −1 ⇒ b pt =( g−c )+ h p t−1

g−c h h g−c
pt = + pt−1 ⇒ pt − pt −1=
b b b b

h g−c
Shifting the periods forward by one period: pt +1− p t=
b b

[ (
The definite solution is given as p t= p0 −
C
1−b )
bt +
C
1−b
:
]

( )
g−c g−c
t
b h b
pt = p 0 − ( )+
1−h b 1−h
b b

( )
t
g−c h g−c g−c
pt = p 0 − ( )+ let p=
b−h b b−h b−h

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 Chapter Six: Dynamic Optimization

t
h
Hence , p t =( p 0− p ) ( ) + p
b

Two points may be observed in regard to this time path:

i. The significance of the expression ¿ ¿) : (same as A in A bt )

a) Its sign tells us whether the time path commences (starts) above or below
equilibrium (mirror effect)
b) Its magnitude helps us to determine how far above or below the time path is (scale
effect)
h
ii. Under ‘normal’ demand and supply condition ( b< 0∧h>0 ) so that <0 , indicating that
b
the time path is oscillatory.

a. if |h|>|b|,|bh|> 1,∧ p explodes ( diverges ).

t

b. if |h|=|b|,| |=−1 ,∧ p oscillates uniformly .

h
t
b

c. if |h|<|b|,| |< 1,∧ p converges∧approaches p .

h
t
b

In short, for stability the supply curve must be flatter than the demand curve. (or, h<b in
magnitude). Assuming p0 > p, the time path of price and quantity can be illustrated as follows.

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 Chapter Six: Dynamic Optimization

Graphic Illustration

Pt Pt Pt

P P P

|h|>|b| ⇒ The supply |h|=|b| ⇒ The supply |h|<|b| ⇒ The supply

curve is steeper than the curve is as steep as the curve is flatter than the
demand curve. Panel (a) demand curve. Panel (b) demand curve. Panel (c)

Q Q Q
D
S
S S
Q3 Q1 Q1
Q1 Q3
Q
Q Q
Q2 Q2
Q2

Q4 D D

P3 P 1 P P0 P2 P P1 P P0 P P1 P P2 P 0 P

Fig (a): assume that the intersection of D and S yields the intertemporal equilibrium price p.
Given an initial price¿ ¿) (where p0 > p), quantity supplied in the next period (period 1) will be Q1.
But, at this point (Q1), supply exceeds demand, so that there is a tendency for price to fall.
Consequently, the market clears at p1.

-Assuming p1 to prevail, period 2’s supply will be limited to Q2(Q2 <Q1).

-AtQ2, demand exceeds supply, so there is a tendency for p to rise. As a result the market clears
at p2.

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 Chapter Six: Dynamic Optimization

- Again, assuming p2 to prevail, the supply in period 3 will be Q3(whereQ3 >Q2). AtQ3, since
supply>demand, the market clears at p3 . Replacing this reasoning we can trace out the prices
and quantities in subsequent periods by following the arrowheads, thereby, spinning a cob web
around the demand and supply curves.

The time path of price is oscillatory and explosive when S is steeper than D or (h>b).

Fig (b): pt oscillates uniformly so that equilibrium is unstable. pt Neither diverges nor converts.

Fig (c): pt is oscillatory and convergent when S is flatter than D (h<b) so that equilibrium of time
path ( pt ) will be dynamically stable.

Examples:

1. Given the demand function

Qt =20−2 pt ∧the supply function Qt =−5+3 pt −1 ,
a. Find pt ∧Qt when p0=4
b. Find p and Q
c. Find p1 ,Q1 , p 2 , Q2 .. e . t . c .
d. Using cobwebs comment on the stability of the system.

Solution:

g−c −5−20
p= = =5
b−h −2−3

t
h 3
Hence , p t =( p 0− p ) ( ) + p ⇒ > 1
b 2

25 3
a. From Q dt =Qst ⇒ 20−2 pt =¿−5+3 pt −1 ⇒ pt = − p
2 2 t−1
Shifting the time periods forward one period and rearranging:
3 25
pt +1 + pt =
2 2
Definite solution:

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 Chapter Six: Dynamic Optimization

( )
25 25
t
2 −3 2 −3
t
pt = 4− ( )+ =¿(4-5)( ) +5
3 2 3 2
1+ 1+
2 2
t t
−3 −3
pt =−( ) +5∨ p t=5−( )
2 2

Substation in the demand function yields:

( ( )) ( )
t t t
−3 −3 −3
Qt =20−2 5− =10+ 2( ) ∨Qt=2 +10
2 2 2

b. If there is an equilibrium (i.e., if the price is constant at any period meaning

Pt =Pt−1=P t−2=…=Pt −n), then it follows that
Pt =Pt−1=P∧Qt =Q

Then, from Qdt =Qst

20−2 P=−5+3 P⇒ P=5

From the demand function, Q=20−2 ( 5 ) ⇒ Q=10

t t
−3 −3
c. Using Pt =5−( ) ∧Q t =2( ) +10
2 2

( )
0 0
−3 −3
P0=5− =4 Q0=2( ) + 10=12
2 2

( )
1 1
−3 −3
P1=5− =6.5 Q1=2( ) +10=7
2 2

( )
2 2
−3 −3
P2=5− =2.75 Q2=2( ) +10=14.5
2 2

( )
3 3
−3 −3
P3=5− =8.38 Q3=2( ) +10=3.25
2 2

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 Chapter Six: Dynamic Optimization

We use these points to plot the diagram.

d. Using the Cobwebs

Quantity Supply

Q0 Q2
Q
Q1
Q3
Demand

Price
P2 P0 P P1

The equilibrium is unstable because the time path is oscillatory and divergent.

SELF TEST EXERCISES:

Given Qdt =86−0.8 P t∧Q st =−10+ 0.2 Pt −1, and if P0=100 , determine
(a) The market price Pt in any time period,
(b) The equilibrium price P, and
(c) Using Cobwebs comment the stability of the time path.

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 Chapter Six: Dynamic Optimization

Model Examinations

1. Find y c , y p , the general solution and the definite solution, given:

dy
(a) + 4 y=12 ; y ( 0 )=2
dt
dy
(b) −2 y=0 ; y ( 0 )=9
dt
dy
(c) +10 y =15; y ( 0 )=0
dt
dy 1
(d) 2 + 4 y=6 ; y ( 0 ) =1
dt 2
2. Check the validity of your answers to the preceding problem.
3. Let the demand and supply be
dP
Q d =α −βP−η Q =σP(α , β , η , σ >0)
dt s
(a) Assuming that the rate of change of price over time is directly proportional to the
excess demand, find the time path P(t ) (general solution).
(b) What is the intertemporal equilibrium price? What is the market-clearing
equilibrium price?
(c) What restriction on the parameter σ would ensure dynamic stability?
4. Solve the following first-order linear differential equations; if an initial condition is given,
definitize the arbitrary constant:
dy
(a) +2 ty=0
dt
dy 3
(b) +2 ty=t ; y ( 0 ) =
dt 2
dy 2 2
(c) +t y=5 t ; y ( 0 )=6
dt
dy t 6
(d) 2 +12 y +2 e =0 ; y ( 0 )=
dt 7
5. Draw the time paths of the differential equations in the above problem where initial
condition is given.
6. Solve the following first order difference equations by iteration:

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 Chapter Six: Dynamic Optimization

(a) ∆ y t =7 ; y ( 0 ) =5
(b) y t +1= y t + 1; y 0 =10
(c) y t +1=α y t ; y 0=β
(d) y t +1=α y t−β ;( y ¿ ¿t= y 0 whent=0)¿
7. Find the equations in question (6) based on the general method and find their general
and definite solutions. Do your answers check with those obtained by the iterative
method?
8. Draw and discuss the nature of the following time paths:
(a) y t =3t +1

()
t
1
(b) y t =2
3

(c) y =5 (
10 )
t
−1
t +3

(d) y =−3 ( ) + 2
t
1
t
4

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