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1、Economic Models,Chapter 1,Slides created byLinda GhentEastern Illinois University,Theoretical Models,Economists use models to describe economic activitiesWhile most economic models are abstractions from reality,they provide aid in understanding economic behavior,Verification of Economic Models,There
2、 are two general methods used to verify economic models:direct approachestablishes the validity of the models assumptionsindirect approachshows that the model correctly predicts real-world events,Verification of Economic Models,We can use the profit-maximization model to examine these approachesis t
3、he basic assumption valid?do firms really seek to maximize profits?can the model predict the behavior of real-world firms?,Features of Economic Models,Ceteris Paribus assumptionOptimization assumptionDistinction between positive and normative analysis,Ceteris Paribus Assumption,Ceteris Paribus means
4、“other things the same”Economic models explain simple relationshipsfocus on only a few forces at a timeother variables are assumed to be unchanged,Optimization Assumptions,Many models assume that economic actors are rationally pursuing some goalconsumers seek to maximize utilityfirms seek to maximiz
5、e profits(or minimize costs)government regulators seek to maximize public welfare,Optimization Assumptions,Optimization assumptions generate precise,solvable modelsOptimization models appear to perform fairly well in explaining reality,Positive-Normative Distinction,Positive economic theories seek t
6、o explain the economic phenomena that are observedNormative economic theories focus on what“should”be done,The Economic Theory of Value,Early economic thought“value”was considered to be synonymous with“importance”the price of an item may differ from its valueprices value were judged to be“unjust”,Th
7、e Economic Theory of Value,The founding of modern economicsThe Wealth of Nations is considered the beginning of modern economicsContinuation of distinction between value and pricevalue meant“value in use”price meant“value in exchange”,The Economic Theory of Value,Labor theory of exchange valuethe ex
8、change values of goods are determined by the costs of producing themprimarily affected by labor costsdiamond-water paradoxproducing diamonds requires more labor than producing water,The Economic Theory of Value,The marginalist revolutionthe exchange value of an item is determined by the usefulness o
9、f the last unit consumedsince water is plentiful,consuming an additional unit has a relatively low value,The Economic Theory of Value,Marshallian supply-demand synthesissupply and demand simultaneously operate to determine priceprices reflect both the marginal valuation that consumers place on goods
10、 and the marginal costs of producing the goods,The Economic Theory of Value,Waterlow marginal value low marginal cost of production low priceDiamondshigh marginal valuea high marginal cost of productionhigh price,Supply-Demand Equilibrium,Quantity per period,Price,Supply-Demand Equilibrium,qD=1000-1
11、00pqS=-125+125pEquilibrium qD=qS1000-100p=-125+125p225p=1125p*=5q*=500,Supply-Demand Equilibrium,A more general model isqD=a+bpqS=c+dpEquilibrium qD=qSa+bp=c+dp,Supply-Demand Equilibrium,What happens to the equilibrium price if either demand or supply shift?,Supply-Demand Equilibrium,A shift in dema
12、nd will lead to a new equilibrium:qD=1450-100PqD=1450-100P=qS=-125+125P225P=1575p*=7q*=750,Supply-Demand Equilibrium,S,Quantity per period,D,Price,5,500,An increase in demand.,leads to a rise in theequilibrium price and quantity.,General equilibrium modelsthe Marshallian model is a partial equilibri
13、um modelfocuses only on one market at a timefor more general questions,we need a model of the entire economymust include the interrelationships between markets and economic agents,The Economic Theory of Value,Production possibilities frontier can be used as a basic building block for general equilib
14、rium modelsshows the combinations of two outputs that can be produced with an economys resources,The Economic Theory of Value,Quantity of clothing(per week),Quantity of food(per week),10,9.5,4,2,3,4,12,13,A Production Possibility Frontier,Resources are scarceScarcity we must make choiceseach choice
15、has opportunity costsopportunity costs depend on how much of each good is produced,A Production Possibility Frontier,A Production Possibility Frontier,Suppose that the production possibility frontier can be represented by,Solve for Y to find the slope,If we differentiate,we get,A Production Possibil
16、ity Frontier,When x=10,y=20,dy/dx=-4(10)/20=-2 When x=12,y 15,dy/dx=-4(12)/15=-3.2The slope rises as x rises,Welfare economicsconcerns the desirability of various economic outcomes,The Economic Theory of Value,Modern Developments,Clarification and formalization of the basic behavioral assumptions ab
17、out individual and firm behaviorCreation of new tools to study markets,Modern Developments,Incorporation of uncertainty and imperfect information into economic modelsIncreasing use of computers to analyze data and build economic models,Important Points to Note:,Economics is the study of how scarce r
18、esources are allocated among alternative useseconomists use simple models to understand this process,Important Points to Note:,The most commonly used economic model is the supply-demand modelshows how prices serve to balance production costs and the willingness of buyers to pay for these costs,Impor
19、tant Points to Note:,The supply-demand model is only a partial-equilibrium modela general equilibrium model is needed to look at many markets together,Important Points to Note:,Testing the validity of a model is a difficult taskare the models assumptions reasonable?does the model explain real-world events?,
