6 Economic Models and Problems
Economic Models
In studying economics, we must build models and test theories . The purpose of economic models is to understand the complex reality and predict outcomes.
Because the world we live in is too complex to be studied as it is, we need to build models to reduce such complexity. Models are simplified versions of the complex reality built to answer only certain questions. A good model is one based on certain assumptions (which are often false statements, when compared to their applicability in the real world) that is able to predict well most of the time. Models are constantly refined, and some of their assumptions relaxed, so as to build better models (with better predictability). Theories need to be tested with real-world data. Empirical research tests such models and their hypotheses. Theoretical research builds such models in an effort to explain certain aspects of the complex economic reality.
Economic Assumptions
Ceteris Paribus — “Other Things Being Equal” — is the biggest assumption in Economics. In order to establish a relationship between two variables, you must hold all other variables constant.
Economic Relationships
Economic relationships can often be expressed as mathematical functions. Variable Y is a function of variable X; when X changes, Y responds either by increasing or decreasing. Mathematically, economic relationships can be captured by linear or non-linear functions. (4)
Y = F(X)
Linear Functions:
Y = 20 + 4X
D = 100 − 2P
S = 35 + 4P
Non-linear Functions:
Y = A × K 1/3 L 2/3
Y = a + b × e x
The Economic Way of Thinking
People make choices. Every choice involves a tradeoff, which represents an exchange — giving up one thing to get something else. In addition, people make rational choices by comparing the costs and the benefits of their alternative options, as well as using all of the available information to them up to that point in time. In other words, a rational choice is made when one uses all the available resources to most effectively satisfy the wants of the person making the choice.
The benefit of a given alternative option is the gain or pleasure it brings and is determined by personal preferences — by what a person likes and dislikes and the intensity of those feelings. Economists measure the benefit of something by what a person is willing to give up to get it.
The cost of a given alternative option is what must be given up to get it. The opportunity cost of an option in Economics refers to the monetary value of the best alternative one must give up to obtain it. In a broader sense, the opportunity cost includes both direct and indirect costs associated with a given option. Only economists account for these indirect costs, such as the monetary value of the best alternative one must give up to obtain it. Accountants, for example, only consider the direct costs of a given option, the ones that require a direct outlay of money. Economists, on the other hand, consider a broad