Economics D101: A Course in Economic Modeling

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Economics D10-1 A Course in Economic Modeling

• Lecture 1 Introduction to Economic Models

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Building and analyzing an economic model

• Assumptions
• Economic Agents
• Preferences or tastes
• Constraints they face
• Information available
• Economic Environment
• Technology
• Market and nonmarket institutions
• Selection of endogenous and exogenous variables

• Logical Analysis (Math)
• Characterization of economic outcomes
• Optimizing systems
• Equilibrium systems
• Positive, Comparative Statics Analysis (Math)
• Testable (refutable) hypotheses
• Impact on endogenous variables of changes in
  exogenous variables
• Normative Analysis (Math)
• Evaluation of econ. outcomes

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Supply and Demand an economic model of an
equilibrium system

• Assumptions
• Supply equals demand at equilibrium
• Income increase shifts demand curve out
• Supply curve upward sloping
• Demand curve downward sloping
• Testable Hypotheses
• Higher income leads to higher equilibrium price
• Higher wages lead to higher equilibrium price

• S(pe,w) D(pe,I)
• Spgt0 Swlt0 Dplt0 DIgt0
• Differentiating with respect to I and w yields

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Optimizing model monopoly choice of output

• Assumptions
• Firm maximizes profits
• ? R(x) - C(x)
• R is twice differentiable
• Technology exhibits constant returns to scale
  C(x) cx
• Characterization of outcome
• Marginal revenue equals marginal cost
• Testable hypothesis
• An increase in unit costs leads to a reduction in
  output

• Assumptions
• x ?argmax R(x)-cx
• xgt0
• R?C2
• ?
• FONC R?(x) c
• SONC R?(x) lt 0
• Testable Hypothesis
• (dx/dc) 1/ R?lt0
• Requires SOSC R?lt0

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More general model based upon an optimizing
system

• Assumptions
• Firm chooses real decision variable x to maximize
  real-valued payoff function F(x,a)
• Characterization of outcome

• x argmax F(x,a)
• F?C2
• ? Fx(x,a)0 and Fxx(x,a)lt0

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Testable Hypotheses

• Which of these are testable implications of an
  economic model?
• Higher consumer income leads to higher prices
• An increase in unit costs causes a monopolist to
  reduce output
• Higher wages lead to higher prices
• A profit maximizing firm operates where Marginal
  Revenue equals Marginal Costs
• The last statement is a tautology, it cannot be
  false!
• The first three statements are refutable they can
  be false.