2. Decision making
Chapter 2: Decision Making and Economic Models
A. Decision Making
Fundamental Concept:
Economic phenomena are the results of decisions made by various entities including individuals, firms, and governments.
Understanding the economy requires a thorough comprehension of decision-making processes.
Illustrative Scenario: Should you attend a concert?
Contextual Details:
Assume the ticket price is 25 EUR.
Your willingness to pay for attending the concert is 55 EUR.
Interpretation: You are only willing to pay up to 55 EUR for this experience, reflecting its perceived value to you.
Net Benefit Calculation:
The formula for net benefit is: Net Benefit = Willingness to Pay - Cost.
For the concert: Net benefit = 55 EUR (willingness to pay) - 25 EUR (ticket cost) = 30 EUR.
The decision: Should you attend? Consider evaluating alternative options before concluding.
Evaluating Alternatives:
The potential alternative for the evening is babysitting, which yields a net benefit of 22 EUR.
Calculation for Babysitting: Net Benefit = Payment Received - Evaluated Cost (i.e., payment received – your assessed effort).
Comparison:
Concert: Net Benefit = 30 EUR
Babysitting: Net Benefit = 22 EUR
Conclusion: With the concert presenting the highest net benefit, economic reasoning suggests attending the concert.
Opportunity Costs:
Definition: Opportunity cost is defined as the value of the highest alternative you forego when making a choice.
Economic Cost: Combination of direct financial costs and opportunity cost.
In the concert example:
Opportunity Cost of attending: 22 EUR (value of babysitting).
Economic Cost of attending: Total = Ticket Cost + Opportunity Cost = 25 EUR + 22 EUR = 47 EUR.
Decision Rules:
There are three equivalent ways to express the decision-making process:
Highest Net Benefit: Choose the option that gives the highest net benefit.
Concert: Net Benefit = 30 EUR
Babysitting: Net Benefit = 22 EUR
Decision: Attend the concert.
Willingness to Pay vs. Economic Cost: Choose an option if your willingness to pay exceeds its economic cost.
Willingness to pay for the concert = 55 EUR
Economic Cost of the concert = 47 EUR
Decision: Attend the concert.
Net Benefit vs. Opportunity Cost: Choose an option if its net benefit is greater than its opportunity cost.
Net Benefit of the Concert = 30 EUR
Opportunity Cost of attending = 22 EUR
Decision: Attend the concert.
B. Economic Models
What is a Model?
A model functions as a simplified representation of real-world scenarios, aiding in understanding complex systems.
Purpose of Models:
Complexity of Reality: The multifaceted nature of reality necessitates simplification for better comprehension and analysis.
Users of Models:
Different fields utilize models:
Scientists: Economists and sociologists use models to interpret historical data.
Governments and Central Banks: Employ models in guiding policy decisions.
Corporations and Consultancies: Rely on models for forecasting and strategic business decisions.
Characteristics of a Good Model:
Essential attributes of a robust model include:
Inclusion of essential features pertinent to the inquiry.
Exclusion of irrelevant details that do not contribute to understanding.
Facilitation of insight and explanation concerning specific economic aspects.
Consistency with empirical evidence and data.
Model-Building Steps:
Constructing an effective model generally follows these steps:
Define the central question.
Develop a simplified overview of the conditions influencing actions.
Articulate the factors that govern decision-making in accessible terms.
Analyze the impact of individual actions on one another.
Assess the resultant outcomes, often leading to an equilibrium state.
Investigate the effects on specific variables when underlying conditions change.
Key Concepts in Economic Models:
Equilibrium: A self-reinforcing situation where no changes occur unless disrupted by external forces.
Endogenous Variables: Variables whose values are inherently determined by the relationships modeled within.
Exogenous Variables: Variables whose values are dictated by external influences, not captured in the model.
Ceteris Paribus: A principle asserting that all other variables remain constant while analyzing a specific variable.
One Model-One Question Principle:
A model typically does not encapsulate the entirety of the economic landscape; rather, it is adept at addressing a singular question while potentially falling short for others.
Example of the Malthusian Model:
This model explores the inquiry: "Why did technological advancements fail to sustainably enhance farmers' living standards for extensive periods?"
Dynamic Relationship:
Technological improvements lead to increased average outputs per farmer, resulting in population growth.
The increase in population eventually leads to diminished land per farmer, causing average outputs to decline.
This cyclical process ultimately results in consistently low living standards despite technology advancement features.
Outcome: Although technology improves agricultural output, the population growth offsets these gains, leaving living standards stagnated at previous low levels.