Introduction to Economic Modeling and Objective Analysis

Economic Methods and Modeling:  Economics is an important part of social and political debate.  As a field of study, economic thinking strives to be objective and accurate in its methods, predictions and prescriptions.  The following are common issues in assessing the soundness of economic reasoning and analysis:

Normative statement:  Includes judgment as to what is good or bad.

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Positive statement:  Statement of fact.

Fallacy of composition:  Assumption that fact about one element of the economy is true of the whole.

Fallacy of causation:  Assumption when there is an association between two events, that one event caused the other.

Model:  A model is a simplification of reality specifying factors and processes to be considered in analysis.  The concept behind the use of models is to strip away all unnecessary information to focus on the essential elements of an issue.  Yet, because models limit factors considered and the way in which they interact – and because we must use proxies (substitutes) for the data we would really like to consider – models and economic analytical tools have “blind spots.”  The user and consumer of economic analysis must consider these blind spots when evaluating analytic data and conclusions.

Theory:  A theory is a statement about how the world works.  Theories represent thoughts that are organized toward answering selected questions.

Ceteris ParibusLiterally, in Latin, the term ceteris paribus means “all things being equal.”  In economic analysis, ceteris paribus is a blanket assumption that all other factors that might influence the market outcome, other than those specifically stipulated (often meaning Price and Quantity, in supply and demand analysis), are assumed to be unchanging, for the sake of examining one relationship and set of conditions at a time.  The purpose for setting such a stringent restriction on the scope of analysis is to provide a tractable scope to analyses, by focusing on a very limited set of factors.  This limitation does not reflect likely real world conditions, but does allow us to more closely study the influence of the factors under investigation.  It is important in “consuming” economic analysis to evaluate whether this restriction is acceptable for the circumstances under investigation, or whether it is too restrictive to adequately represent the issues being modeled.

Comparative Static Analysis:  Comparative statics analyzes equilibrium positions of the market, but does not include the transition or the adjustment process by which the market moves from one equilibrium to another.  Most economic analysis uses comparative static techniques.

Dynamic Analysis:  Dynamic analysis attempts to include consideration of how markets adjust to changing conditions.

Partial Equilibrium Analysis:  Partial equilibrium analysis focusses on the behavior of individual decisions and individual markets, without considering the broader economy.  Most economic analysis is partial equilibrium analysis.

General Equilibrium Analysis:  General equilibrium analysis looks at the behavior of individuals and individual markets taken together simultaneously.

 

It is important to carefully consider the foundations and assumptions of economic arguments and analysis.  Every economic model, theory or argument has implicit assumptions that do not fully mesh with reality.  The most valuable lesson you can get out of this class is to be a thoughtful and cautious consumer of economic reasoning.

Factors of Production:  Resources are required for satisfying human wants.  They are necessary inputs for the production of goods and services.  Economics refers to resources as the factors of production and divides them into four groups:

Land:  Land encompasses all free gifts of nature and all resources in their natural state (mineral ores, water, and soil).  The “return” to land is called “rent.

Labor:  Labor is the human element of production or people’s capacity to work.  “Returns” to labor include wages, salaries, tips, benefits and commission.

Capital:  Capital is the human-made factor of production.  This is physical capital, and does not include financial capital such as financial instruments.  Capital includes human capital, improvements in labor’s capacity to produce.  The “return” to capital is referred to as interest.

Entrepreneurship (enterprise):   Entrepreneurship combines the other factors of production into a functioning whole.  Combining resources requires technology or techniques of production.  As technology changes, the resource mix also changes.  The return to entrepreneurship is profit.

While many theorists have contributed to our body of economic knowledge and insight, a few stand out as chief architects of how we understand and approach economic issues today.  While all of these are long since dead and most lived and wrote over 150 years ago, they continue to define the field of economic understanding and debate.

 

American economic theory, as we study it in the U.S. today, has its roots in Adam Smith’s seminal work Wealth of Nations (published in 1776).  Adam Smith (1723 – 1790) first described how the behaviors of individuals pursuing their own interests in a marketplace come together collectively to form a market, with predictable economic and social outcomes.  Adam Smith’s work still defines the approach we take to understanding how markets behave today.

 

Other important theorists that followed closely on Adam Smith’s work were David Ricardo (1772 – 1823; who wrote on the economic ramifications of international trade and competition), Thomas Malthus (who wrote about the economic limitations imposed by exhaustible resources), and Karl Marx (1818 – 1883; Capital, 1867; who wrote not only on controversial political theory, but extensive analysis on the inherent tensions in capitalist markets).

 

Later were to come Alfred Marshall (who first applied mathematical analytic tools to economics, including the supply and demand graphs commonly used in economics coursework), and John Maynard Keynes (1883 – 1946; The Economic Consequences of the Peace; The General Theory of Employment, Interest and Money; who first diagnosed and developed prescriptive measures to address issues of market failure and government intervention in a depression).

 

The work of these theorists continues to define how economic issues are presented, analyzed and understood today.  Some understanding of the historical context and intent of these theoretical contributions and analytical tools gives greater insight into the economic models we use today.

 

You will be introduced to each of these theorists in our first and second class sessions.  They will resurface throughout our nine weeks, as their insights still form the core of current economic methods and thought.

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