Methods and Models in Eco

7/31/2019 Methods and Models in Eco

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Models and Methodologies in

Economics


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What is a Model?

A Model is a simplified representation of reality.

Economic models are based on certain

assumptions.

Assumptions simplify the complex world andmake it easier to understand.


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Assumptions of Economic Laws

Assumptions

Ceteris Paribus

Psychological

Structural

Institutional


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Ceteris Paribus

Latin word meaning Other things being constant.

The dynamic nature of economy makes economicphenomena very complex.

This assumption helps to reduce complexity by assuming

certain factors as constant.

Eg.The Law of demand

Other things being equal demand varies inversely with

price.

Other things are the determinants of demand other than

price : income,tastes and preferences,prices of related

goods,population,technology etc.


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Psychological Assumption

Rationality

Consumers try

to maximize

utility

Producers try to

maximize profits

Factor owners

try to maximize

factor income


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Structural Assumptions

Assumptions related to the utilization of factors of

production.

Eg.1: All lands are not capable of being used for all kinds

of crops in all seasons.

Eg.2: Biological factor limits the labour supply of an

individual worker


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Institutional Assumptions

Assumptions about socio-political and economic

institutions influence human behaviour and eco.

activity.

Eg 1.Absence of Govt. intervention under

capitalism.

Eg.2. Absence of free market system under

socialism


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Methodology in Economics

Economic

Methodology

Logical

Reasoning

Induction

Deduction


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Deduction

Conclusions and generalizations are based on certain

fundamental assumptions or accepted axioms.

The logic proceeds from general to particular.

E.g All scientists are intelligent,

Mr.John is a scientist.

He is intelligent.

This method is called abstract or a priori because it is

based on abstract reasoning and not on actual facts.


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Induction

This method is known as empirical method as it derives

conclusions based on observation, collection and analysis

of facts which are relevant to the enquiry.

The logic in this case proceeds from particular to general.

The generalizations are based on the observation of

individual examples.


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Steps involved in Inductive reasoning

Identify the problem

Collection, classification and analysis of data by

using appropriate statistical methods.

Identify the relationship between different

variables based on the analysis of data.

Develop a theory based on the relationship

between different variables.

Make predictions and test them. If the predictions

are in conflict with the facts discard the theory and

develop a superior alternative.


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Economic Theory

Hypothesis is a provisional statement of relationship

between variables which is not proved. It can be true

or false.

Economic theory is a proved economic fact or an

observed economic truth. It establishes relevant

patterns in data and establishes cause & effect

relationships between eco. Variables.

The term law is used to represent a widely accepted

premise or theory about a particular causal

relationship. It is more widely accepted than a theory.

A model is a simplification of various relationships

among economic variables used to explain or predict

economic phenomena.


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Characteristics of Economic Laws

Economic laws are statements ofeconomic tendency.

Economic laws are based on

certain assumptions.

Economic laws are relative.

Economic laws are human laws.

Certain economic laws are

universal.


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Circular Flow of Income

The flow of money and goods& services in an economy ina cyclical manner.

Types

Circular Flow in a Two sector Economy

- Without Savings &Investments

- With Savings &Investments

Circular Flow in a Three sector Economy

Circular Flow in a Four sector Economy

The Flow of Money and Goods & Services in an Economyin a Cyclical Manner.


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Two Sector Model Without S &I - Assumptions

Neither the households save

from their incomes nor the firms

save money from their profits.

No govt intervention(no taxes &

no govt. expenditure)

No foreign trade(Absence of

exports & imports)


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Two Sector Model Without S &I


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Equilibrium

Real Flow Flow of factors of production, goods& services

Money Flow Factor payments + consumption expenditure

Outer loop of the circular flow diagram Real Flow

Inner loop of the circular flow diagram Money Flow

Real Flow = Money Flow


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Two Sector Model With S &I - Assumptions

Households do not spend their entire income

for consumption.

A part of their income is used for

savings.(Leakage from circular flow)

This savings goes to the financial market.

Firms borrow these household savings from

the financial market for making

investments.(Injection into the circular flow)


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Two Sector Model With S &I


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Condition for Constancy of Circular Flow

Total Expenditure(E) = Total Income

Total Expenditure(E) = C + I

Total Income (Y) = C +S

C + I = C + S

I = S


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Circular Flow with Government Sector

Govt. Intervention in

the Economy

Taxation

From the Firms

From the

Households

Govt. Expenditure

Households

- Wages &Salaries

- Transfer Payments

Firms

- Purchase of Goods

- Subsidies


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Circular Flow in a Three Sector Economy


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Equilibrium Condition in Three Sector Economy

Total Expenditure(E) = Total Income(Y)

Total Expenditure(E) = C+I+G

Total Income(Y) = C+S+T

C+I+G = C+S+T

I+G = S+T

Ci l Fl i F E


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Foreign TradeSector

Households

Export

Manpower

Receive

Remittances

Import Goods &

Services

Make Payments

Firms

Export Goods &

Services

Receive

Payments

Import Raw

materialsmachines

Make Payments


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Production Possibility Curve(PPC)


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What is PPC???

PPC shows various combinations of two goods which

the economy can produce with a given amount of

resources and given technology.

A concept related to the central economic problemWhat to Produce?.

It deals with allocation of scarce resources.


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Assumptions

Given Resources

Given Technology

Full Employment

Short Period Analysis


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PPC

Unattainable

Point

Inefficient Point

B,D & C are Efficient

Points


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Slope of PPC

MRPT measures the opportunity cost of producing one

commodity.

It means the number of units of one commodity forgone

in order to produce additional units of the othercommodity.

This sacrifice is inevitable because of the resource

scarcity.

Slope of PPC = Marginal Rate of Production Transformation

(MRPT)

MRPT =Y/X


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PPC


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Upward Shift PPC


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PPC Inward shift


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Shift due to Technical Progress

Methods and Models in Eco

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