Econ 201
Ch. 2
Economics:
Foundations & Models
Or Thinking Like and Economist
Building a Model
• Why?
– Explain the past and/or predict the future
– Understand factors that motivate individuals
and firms to take the actions that they do in
the marketplace
– Possibly be able to influence the decisions
they make
• Make the markets more efficient -> create bigger
benefits for all (consumers and firms)
What Comprises a Model?
• Hypotheses and/or assumptions about
how consumers and firms behave
– Hypos/assumptions may be testable or nontestable (“maintained”)
– When you construct the model you need to
specify which is which
• Not always done – author may be unaware of
“implicit” assumption
Overview
• Basic assumptions underlying economic
modeling
– Rationality and self-interest
• Tradeoffs: evaluate benefit/costs of “relevant”
alternatives
• Marginal analysis
– Totals versus marginal (incremental analysis)
• Basic questions economics addresses
• Alternative Market approaches to
production and allocation
• Modeling and the Scientific method
An Example
• Consumer Demand Model
– Assume that individuals are “rational”
– Assume that they will act in their own self
interest
• Implications
– Self-interest
• Will want more, rather than less of a good
• No altruism, i.e., sacrificing their own well-being for
others
Basic Assumptions
• People are rational
– Implications
• When price increases then quantity
demanded/purchased decreases
• Testable/maintained
– Rationality – observable from market data
• Key assumption
– Self-interest – harder to observe
• May not significantly impact major implications
1. Rationality
• Individuals will make economic decisions
in their own best interest, based on the
information that they have available
– Imperfect information (due to costs of
obtaining it, difficulty in interpreting and
evaluating it) may “appear” to lead to less
than “optimal” or “best” choices
• Gary Becker’s weaker assumption
– Individuals do not systematically make
irrational decisions
1. Rationality
• An example: the First Law of Demand
– As the price per unit of the good declines, a
consumer (all other things held constant, e.g.
their income) will choose to buy more of the
good over the same time period
1. Rationality
• Becker’s point
– As long as people don’t always buy more
when the price goes up and even if they
randomly buy more/less; they will behave as
though they are adhering to the First Law of
Demand
• A more rigorous version (for consumers)
– Individuals seek to maximize their
utility/satisfaction subject to their
income/budget constraint
1. Rationality
• More rigorously:
Max U ( x, y ) subject to I  pxQx  p yQy
2. People Respond (rationally)
to Economic Incentives
• An example (Hubbard and O’Brien)
– Average age of the populations of US, Japan and
most Europeans countries are getting older
• Declining birth rates (below replacement level)
• People living longer
• Post WWII baby boom (“mouse in the python”)
• Challenge for governments as
– Social security and medical care payments will
increase as larger % of population retires
– Fewer younger folks replacing them in the workforce
• -> tax payments are decreasing
An Interesting Solution
• Estonia
– UN estimated that population would decline by 0.7M
by 2050 (from 1.4M to 0.7M)
– Starting in 2007
• Working women paid entire salary up to 15 months for having
a child
• Non-working: $200 per month (avg income ~$650)
– Impact
• Birth rate increased from 1.6 to 2.1 children per woman
• 45 other european countries in the process of
adopting a similar set of incentives
Learning Objective 1.1
Making
the
Connection
•Will Women Have More
Babies if the Government
Pays Them To?
The Estonian government is
encouraged by the results of
providing economic
incentives and is looking for
ways to provide additional
incentives to raise the
birthrate further.
3. Optimal decisions are
made at the “margin”
• What do we mean?
– When making an economic decision, e.g. to purchase
1 more unit of a good, we compare the marginal (or
incremental) benefits against the marginal costs
• For example
– When studying for an exam
• Given you’ve already studied 8 hours, when deciding
whether or not to study 1 more hour, you compare
– the expected benefits (a “marginal” improvement in your grade
– Versus the next best (highest valued) use of your time
» E.g., sleeping, eating, time with friends
Marginal Decisions
• Back to the First Law of Demand
– How much of a good do you buy?
• If the marginal/incremental value of the next unit is
less than what it costs, are you willing to buy it?
MV < price
Don’t buy!
MV < price
Do buy!
Totals versus Marginals
• When you make a “consumption” decision
– You may be comparing Total Value of consuming x
amount of the good (TV(x)) to the Total Cost (TC(x))
– But it’s really a step-wise comparison
• If TV(9) > TC(9)
– Buy at least 9
– then check at x =10
• If TV(10) < TC(10)
– Stop at 9
– MV(10th unit) less than MC(10th unit)
– Easier and faster (fewer calculations) to compare
marginals than totals
Optimal Decisions
Made at the Margin
• For consumers
– If price > additional/incremental/marginal
“use” value of the good -> don’t buy
– If price < MV -> buy
• For suppliers
– If P > marginal costs of producing that last
unit -> supply it to the marketplace (sell it!)
– If P < MC then don’t produce it
Key Questions in Economics
• What goods and services will be
produced?
• How will the goods and services be
produced?
• How will the goods and services be
allocated?
– How do we decide who gets them?
A Simplification of Market Types
•
Two Extremes
1. Centrally Planned Economies
–
Government determines what goods get produced, who
produces them and how they are allocated
–
E.g. Soviet Union’s 5-year plan (1917-1991)
2. Market Economies
–
Market determines all
–
–
–
Prices signal consumer willingness to pay for goods and
services
Firms respond to price signals by comparing consumers WTP
to the firm’s (marginal) cost of producing goods
Goods are allocated to those with highest WTP (and hence
value them most)
In Reality
• Real-world markets have mixes of both
Market and Centrally planned structures
– Market failure may require government
regulation (e.g., monopolies, pollution,
fisheries)
– Public goods may require subsidies (e.g.,
national defense, education, clean energy)
– Lobbying to protect certain groups
• Dairy farmers, energy producers
Scientific Method
Economic Models
•
The Scientific Method (Hubbard and
O’Brien)
1. Decide on assumptions to be used in
developing the model
2. Formulate a testable hypothesis
3. Use economic data to test the hypothesis
4. Revise the mode if it fails to explain well the
economic data
5. Retain the revised model to help answer
similar economic questions in the future
Role of Assumptions
• Assumptions
– Role of assumptions is to
• reduce the complexity of the problem to its key elements and,
• focus on the items that have the most significant impact
(“80/20” rule)
– 80% of the impact is due to 20% of the factors
• Robust
– If relaxing the assumptions has minimal impact on
your conclusions then the model is deemed “robust”
and is largely unaffected by these testable or nontestable assumptions
– “robustness” is a desirable property
Normative and Positive Analysis
• Positive economics
– “what is”, e.g., if prices go up, quantity
demanded will go down
• If rates increase faster than the rate of growth in
income then demand for telephone (or electricity)
services will decline
• Normative economics
– “what ought to be” or “what is fair”
• Everyone should be able to afford basic telephone
(or electric) services
– “universal service” mandate
Macro- versus Microeconomics
• Microeconomics
– Focuses on analysis of consumers and firms in
specific individual markets
• E.g., automobile, PC computers, wireless telephone service
– Several sub disciplines
• Labor, Industrial Organization, Natural Resources, Industry
Types, Theory, International Trade, Finance, Health Care
• Macroeconomics
– Focuses on aggregate economic behavior
• All markets lumped into GDP = C+I+G+NX
• Look at impact of government impact (taxes, subsidies,
regulation, monetary and fiscal policy), trade policies on
GDP, employment
Economics as a Social Science
• Is economics a science?
Key Point
• A Key or Critical Point
– If the assumption is not testable –
• how “robust” are the model’s predictions if the
assumption is false; that is how sensitive is the
model to the assumption
• If it assumption is not testable we have to be very
sensitive to this
– If the assumption is testable
• Still need to know “sensitivity”
• Model can be rejected or accepted depending on
test results