3 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 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 broader perspective by accounting for what we give up or sacrifice, which might not be readily observable.

The opportunity cost of attending college includes both direct costs of tuition and textbooks, and the indirect costs of a full-time or part-time job that the student could have had, but decided to give up in order to attend college full time. In summary, the opportunity cost of a given option is the best thing/alternative (usually measured as the monetary value) one gives up (sacrifices) to obtain that option.

Choices people make respond to incentives . An incentive is a reward that encourages an action, or a penalty that discourages an action. Changes in benefits and costs alter the incentives that we face when making choices. When incentives change, people’s decisions change. For example, if a research project assignment is weighed more heavily in the final grade calculation as a required assignment, as opposed to an optional assignment, the benefit of completing this required assignment increases for every student, and we would expect more students to complete this assignment, as they respond to this incentive. (1)

Economic Problems

Throughout the course, we will elaborate on most of the following topics, representing major economic themes and macroeconomic problems:

Globalization, Job Outsourcing and Multinational Corporations, and the Information Age

Recent decades have seen a trend toward globalization , which is the expanding cultural, political, and economic connections among people around the world. One measure of this is the increased buying and selling of goods, services, and assets across national borders—in other words, international trade and financial capital flows. (2)

On the other hand, globalization has caused many countries to experience job outsourcing and the brain drain phenomena.

Economics as a Policy Tool

Economics is a tool that helps us make an endless array of decisions. Personal Economic Policy involves decisions about an individual’s need for shelter, transportation, and time management. Business Economic Policy involves decisions made at the margin to accomplish a business’ goals such as increasing sales, opening a new branch, or gaining market share. Government Economic Policy is perhaps the most controversial of the three types of economic policies. How should goals such as better education, military preparedness, and safe food be balanced against limited tax revenue and the desire of individual members of government to be reelected? (1)


Icon for the Creative Commons Attribution 4.0 International License

Principles of Macroeconomics Copyright © by Lumen Learning is licensed under a Creative Commons Attribution 4.0 International License, except where otherwise noted.

Share This Book