3 Economics is the study of how scarce resources are allocated among alternative use “Economic models” are used for this purpose
4 Economic Models Economic models are built to address particular questions. There is no a 4-W economic model. The best model to use will depend on the question, the setting, the information available… Example: How do a increase in the price of potatoes influence the consumption of potatoes? –Forces that one could consider: –price effect: possibility to substitute its consumption. It will depend on possibilities of storage, transportation costs, range of products available in the market –income effect: consumer if poorer than before because he can buy less potatoes –endowment effect: consumer is richer if he cultivates potatoes –nutrition effect: less consumption of potatoes can decrease calories intake, hence consumer will work less and his income decrease further
5 Economic Models Understanding the interactions of these 4 forces can be too complicated An economic model will tend to ignore those forces that are believed not be important in the setting or problem under consideration –Previous example in New York: ignore endowment, income, and nutrition effect –Previous example in a rural village in Bolivia: ignore substitution effect, and concentrate on endowment, income and nutrition effect Economic models are not pictures of reality They are abstractions from reality, incorporating the main forces to simplify the problem The forces to incorporate will depend on the particular question and setting
6 Features of Economic Models Ceteris Paribus assumption Optimization assumption Distinction between positive and normative analysis
7 Ceteris Paribus Assumption Ceteris Paribus means “other things the same” Economic models attempt to explain simple relationships –focus on the effects of only a few forces at a time –other variables are assumed to be unchanged during the period of study
8 Optimization Assumptions Many economic models begin with the assumption that economic actors are rationally pursuing some goal –consumers seek to maximize their utility –firms seek to maximize profits (or minimize costs) –government regulators seek to maximize public welfare
9 Positive-Normative Distinction Positive economic theories seek to explain the economic phenomena that is observed Normative economic theories focus on what “should” be done
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