Lecture 3: Linear Functions
ECO-10026
Quantitative Methods I
Dr Alena Audzeyeva
e-mail: [Link]@[Link]
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Lecture 3: Linear Functions
LECTURE CONTENT
• General and linear functions
• How to represent ‘linear functions’/‘straight lines’
• Sketching linear functions
• Interpreting linear functions
• Applications of linear functions in business
READING
• Bradley (M): Sections 2.1-2.5
• Swift: Part 1, Sections 4.1-4.3 (EM 4)
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Lecture 3: Linear Functions
General Functions – The demand for a good
These can be expressed:
1. Verbally – quantity demanded depends on price of good, price of other goods,
income............,
2. Algebraically – Qd = f ( P, Y , PR , T ....)
where:
Qd is quantity demanded Dependent Variable
P is price of good
Y is income
Independent Variables
PR is price of rival/complementary goods
T are other factors that affect demand
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Lecture 3: Linear Functions
❑ f(.....) indicates that Qd depends on the variables inside the brackets (or
the arguments). This is a general form for the model – just indicates what
variables determine what, existence of a relationship.
❑ A function can be defined as a rule or mapping which assigns to each
value of a variable x a unique value f(x)
❑ Dependent variables- means that it is determined by the model
❑ Independent variables – means that they are determined elsewhere in the
economy, i.e. exogenous to the model
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Lecture 3: Linear Functions
Linear Functions
Say, we would like to explore relative importance of various variables in
explaining demand for a product - umbrellas. We need to know:
A) The form for the relationship between demand and explanatory
variables. Common form is linear. A general linear form:
Qd = a + bP + cW + dT + eI ...
where a, b, c, d, e are fixed numbers or parameters.
B) Specific form, i.e. values assigned to the parameters
Qd = 100 − 3P − 6W − 0.4T + 0.05 I
We can now discover what happens to Qd if price P rises or falls, say,
by £1, providing the values of all the remaining variables stay the same.
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Lecture 3: Linear Functions
Diagrams: typically only show 2 variables, y and x – otherwise difficult
to draw/visualise
Using demand function above: let’s fix values for other variables
(assume that their values remain constant for now):
W =0.5; T = 15; I = 40 which gives
Qd = 100 − 3P − 6 0.5 − 0.4 15 + 0.05 40
= 93 − 3P
It is easier to see from this simplified expression that if P goes up by £1,
Qd will decline by 3*1 = 3 units. If Qd is measured in ‘000 (1 unit
=1,000 umbrellas), then the decline in 3units = 3,000 umbrellas.
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Lecture 3: Linear Functions
Linear Functions
A linear function is often written in this form
f(x) = c + mx
• where c and m represent real numbers
• While we show this graphically, c represents the y-axis intercept -
often called the vertical intercept
• And m represents the gradient, or slope, of the linear function
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Lecture 3: Linear Functions
What happens when we vary c in the linear function f(x)= c + mx
We are looking at linear
equations which represent
straight lines. To draw straight
lines, we only need 2 points.
Examples:
First function:
f(x) = 3+ 2x
f(0) = 3; f(1) = 5; f(2) = 7
Second function:
f(x) = 1+2x
f(0) = 1; f(1) = 3; f(2) = 5
Third function:
f(x) = -3 +2x
f(0) = -3; f(1) = -1; f(2) = 1
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Lecture 3: Linear Functions
What happens when we vary m in the linear function of type f(x) = c + mx
More examples:
f(x) = 2 + x
f(0) = 2; f(1) = 3; f(2) = 4
f(x) = 2 + 2x
f(0) = 2; f(1) = 4; f(2) = 6
f(x) = 2 – 2x
f(0) = 2; f(1) = 0; f(2) = -2
f(x) = 2 – x
f(0) = 2; f(1) = 1; f(2) = 0
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Lecture 3: Linear Functions
Ways to draw linear functions
➢ General linear function: y = c + mx
➢ c, m are parameters; y dependent variable, x independent variable
a) Find values and draw a line between them:
Consider our earlier example: Qd = 93 - 3P
Here c = 93 and m = -3.
Pick some reasonable values for P, say, set P = 0, 10, 20, 30. Then plug each
of these values into the equation to find the corresponding value of Qd:
P 0 10 20 30
Qd
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Lecture 3: Linear Functions
Quantity demanded
100 93
One could calculate
80 63 lots of values along
60 the line but only
Qd
40 33 need any 2 because
it is a straight line
20 3
0
0 10 20 30
P
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Lecture 3: Linear Functions
b) intercept method:
y = c + mx
➢ Find x and y intercepts, i.e. where the line cuts x-axis and y-axis
(i) To find y-axis intercept:
Let x = 0, then y = c + m× 0 = c
(0, c) is the (x, y) point for the y intercept
(ii) To find x-axis intercept:
Let y = 0 and find the appropriate value for x
y = 0 ⇒ c + mx = 0
Using the rules of algebra:
⇒ mx = ‒ c subtract c form both sides
⇒ x = ‒c/m divide both sides by m
The x intercept is (‒c/m, 0)
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Lecture 3: Linear Functions
(iii) We can then plot these two points and join them with a straight line
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Lecture 3: Linear Functions
Interpretation of the Slope: Slope shows how y changes as x changes
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Lecture 3: Linear Functions
Algebraically:
Let x2 – x1 = x - the change in x, or change in distance
y2 – y1 = y - the change in y, or change in height
For the two points on the line: (x1, y1) and (x2, y2) :
y1 = c + mx1
y2 = c+ mx2
So y = y2 – y1 = c + mx2 – (c + mx1)
= mx2 – mx1
= m(x2 – x1) = mx
Δy
So, slope Δx =m
=
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Lecture 3: Linear Functions
Linear function has constant slope equal to m.
If m is positive, m> 0, as x increases by 1 unit, y will increase by m
units.
If m is negative, m<0, the formula is the same but the graph will look
different. As x increases by 1 unit, y will decrease by m units
Here c is positive but m is
negative
Slope:
change in hight
=
change in dis tan ce
y
= =m
x
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Lecture 3: Linear Functions
Using the demand example again:
Qd = 93 − 3P
m = -3 , c = 93
Interpretation of slope:
as price (x) increases by £1 (more generally, 1 unit) , demand Qd (y)
decreases by 3 units because the coefficient on price, x, is -3.
Interpretation of intercept:
If price is equal to 0, demand Qd will be equal to 93 units.
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Lecture 3: Linear Functions
A point to note:
1) Often, a general linear equation may be written as:
ax + by + c = 0
where a, b and c are constants.
If we are interested in exploring the relationship between x and y, this
equation can be rearranged to give the same convenient form as above:
y = −c / b − ( a / b) x
For example, we have 9x – 3y – 24 = 0.
Re-arrange the equation to give y as a function of x.
(white board)
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Lecture 3: Linear Functions
Application I: Demand function
Demand for a good if often analysed as a function of price:
Q = f(P)
Example:
Assume the demand for jackets is described by
Q = 200 – 2P
The slope is negative (-2 < 0), implying a negative relationship
between price and quantity demanded.
Now, if we know the price, say, P = 20, we can determine the exact
quantity of jackets that will be bought, Q = 160.
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Lecture 3: Linear Functions
Application II: Inverse demand function
What if instead of the price, we only knew how many jackets had been
bought? Could we determine the price that was paid for each jacket?
This time, we need to solve the equation with respect to the price.
2 P 200 Q 1
Q = 200 − 2 P 2 P = 200 − Q = − P = 100 − Q
2 2 2 2
this is known as the inverse demand function
Note that it is usually the inverse demand function that is plotted
(i.e. P on the vertical axis and Q on the horizontal axis)
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Lecture 3: Linear Functions
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Lecture 3: Linear Functions
Application III: Supply function
The supply function can be modelled by the simple linear equation
Qs = c + dP
In this case the relationship between quantity and price is positive, d > 0
Example:
Qs = 10 + 0.5P
What is the vertical (y) intercept and what is the slope of this supply
function?
Plot the graph
Again, supply and inverse supply function can be used.
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Lecture 3: Linear Functions
Applications IV: Cost function
Producing goods involves costs. A production firm faces two kinds of
costs:
• Variable costs:
that is the cost of the variable input(s) given by the multiple of the cost
and the quantity of the input used in the production of the good:
VC (Q) = w*Q
here w is the cost per unit of input and Q is the number of units;
w, Q > 0
• Fixed costs:
FC = C0, say the rent of a building housing the production, or the
cost of heavy machinery.
The fixed cost function is a horizontal line.
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Lecture 3: Linear Functions
➢ The total costs that the firm incurs are given by the following
function
TC(Q) = FC + VC(Q) = C0 + wQ
Example: A pumpkin grower has a fixed cost of £10 for the rent of a
stall at the farmers’ market, and variable production costs of £2 per
pumpkin.
What is the total cost function?
Fixed Costs: FC = £10
Variables costs: VC = £2*Q
Where Q represents the number of pumpkins
So TC = FC + VC = 10 + 2Q
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Lecture 3: Linear Functions
Applications V: Revenue function
Assume that our hypothetical firm operates in a perfectly competitive
market. This means that our firm is a price taker. In other words, the
firm cannot influence the price for the product; the price is given.
▪ Let p be the price of the product and
▪ Q be the firm’s output level,
▪ Then the total revenue function: TR = pQ
This is a line with a positive slope and a zero intercept
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Lecture 3: Linear Functions
Example from Bradley: Suppose that each chicken snack box is sold for
£3.50 irrespective of the number of units sold
What is the total revenue?
TR = 3.5*Q
Graph:
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Lecture 3: Linear Functions
Profit:
Profit is total revenue less total cost, usually represented by π:
π = TR – TC
A company will break-even if π = 0 or TR = TC
When TR > TC , π > 0 and the firm makes a profit
When TR < TC , π < 0 and the firm makes a loss
Example cont. The company that sells chicken snack box for £3.50 has
fixed costs of £800 a day and variable costs of £1.50 for each chicken
snack box.
What are the equations for total cost (TC) and profit (π)?
TC = 800 + 1.5Q
TR = 3.5*Q
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Lecture 3: Linear Functions
Substitute expression for TR into an equation for π:
π = 3.5Q – (800 + 1.5Q) = 2Q – 800
How many snack boxes must be sold to ‘break-even’?
Firm break-even when TR = TC
3.5*Q = 800+1.5Q
Q = 400
Or we could have calculated the break-even point by taking π = 0
Graph:
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Lecture 3: Linear Functions
Summary –
Linear functions:
o Interpretation
o Sketching
o Applications
➢Read the chapters in the textbook.
➢Practice solving examples from the textbook.
➢Prior to attending the tutorial: solve the Quiz questions from week 1 and
attempt all the Tutorial 1 home exercises from week 2.
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