Economic Models and Key Concepts UNIT 2

Economic Modeling

2.2 ECONOMIC MODELS: HOE TO SEE MORE BY LOOKING AT LESS

The Need for Models

  • Economy is complex, influenced by millions of decisions.

  • Impossible to understand by examining every detail.

  • Models simplify by focusing on essential features and ignoring unimportant details.

  • Unrealistic assumptions are a feature, not a bug.

Examples of Models

  • Malthus' model: income vs. population.

  • Irving Fisher's hydraulic model (1891): represents flows in the economy.

    • Used interlinked levers and floating cisterns to show price dependence on supply, consumer incomes, and valuation of goods.

    • Figure 2.2 mentioned.

    • Referenced: American Journal of Economics and Sociology 64, 1, pages 57-83.

How Models are Used

  • Capture elements of the economy that matter.

  • Show interactions between these elements to determine prices.

  • Conduct experiments by changing economic conditions.

    • Example: If supply of a good increases, what happens to its price and other prices?

Irving Fisher's Contribution

  • His doctoral dissertation was described by Paul Samuelson as the greatest in economics.

  • Formed the basis of modern theories of borrowing and lending.

  • Equilibrium: self-perpetuating situation that only changes with external forces.

  • Fisher's hydraulic apparatus represented equilibrium with equalizing water levels indicating constant prices.

Equilibrium

  • Equilibrium: a situation that is self-perpetuating unless an external force is introduced.

  • Can exist with increasing GDP or prices, but at a constant rate.

Building a Model (Steps)

  1. Construct a simplified description of conditions.

  2. Describe what determines people's actions.

  3. Determine how actions affect each other.

  4. Determine the outcome of these actions (often an equilibrium).

  5. Study what happens when conditions change.

Attributes of a Good Model

  • Clear: helps understanding.

  • Predicts accurately: consistent with evidence.

  • Improves communication: clarifies agreements and disagreements.

  • Useful: helps improve the economy.

Tools Used in Economic Models

  • Mathematical equations, graphs, words, and pictures.

  • Mathematics provides precise communication.

  • Clear descriptions and standard definitions are crucial.

  • Leibniz features provide additional equations behind graphs.

Key Ideas of Economic Modeling

  • Ceteris paribus: other things being equal; simplification to focus on variables of interest. Look at less to see more.

  • Incentives: affect benefits and costs of actions.

  • Relative prices: use to compare alternatives.

  • Economic rent: the basis of how people make choices.

2.3 BASIC CONCEPTS: PRICES, COSTS, AND INNOVATION RENTS

Ceteris Paribus and Simplification

  • Isolates the effect of a price change while holding other influences constant.

  • Umbrella sales example: color and price as variables; other variables held constant.

Incentives

  • People respond to economic incentives.

  • Prices are an important factor in decision-making (e.g., supermarket vs. corner shop).

Relative Prices

  • The price of one option relative to another.

  • Expressed as a ratio of two prices.

  • Firms' choices are influenced by relative prices.

  • Industrial Revolution example: ratio of energy prices (coal) to wage rate.

Reservation Positions and Rents

  • Innovation rent: profit exceeding competitors' due to a unique, cheaper method.

  • Economic rents: occur throughout the economy.

  • In economics, rent is defined as the benefit received from a choice, taking into account the next best alternative (reservation position).

  • Capitalism benefits from innovation because economic rents incentivize innovation and create a more favorable environment for implementing new technology.

  • Motivates firms to switch from one technology to another.