Chapter 1 lecture outline AAEC 3315, Benson 1 Chapter 1 of Nicholson and Snyder (pages 3-19) 1. Economic models are simplified abstractions of reality 1.1. What is a “good” model? 1.2. How are economic models verified? 1.2.1. Directly – by establishing validity of assumptions 1.2.2. Indirectly – by showing that the model correctly predicts real-world events 1.3. Verifying profit maximization model 1.3.1. Assumptions: 1.3.1.1. Profits are the only relevant goal for firms 1.3.1.2. Firm has complete and sufficient information 1.3.2. Direct verification – testing assumptions 1.3.2.1. In questionnaires, managers mention other goals and/or recognize limited information, while agreeing that profit is important 1.3.2.2. Generally inconclusive results for testing assumptions 1.3.2.3. Milton Friedman argues that models can’t be directly verified 1.3.2.3.1. Assumptions are “unrealistic” by nature 1.3.2.3.2. Perfectly “realistic” assumptions make models no different, and no less complex, than the systems they’re trying to simplify 1.3.3. Indirect verification – testing predictions 1.3.3.1. The model can be verified as “good” if economic agents behave as if they were profit maximizers 1.3.3.2. Profit maximization hypothesis generates empirically testable propositions about economic behavior 1.3.3.2.1. A firm is competitive, faces price p and cost C, function of quantity, q; profit isChapter 1 lecture outline AAEC 3315, Benson 2 1.3.3.2.2. Profit maximization requires finding q that maximizes the equation above 1.3.3.2.3. π is maximized when Or 1.3.3.2.3.1. In other words, when price equals marginal cost of production 1.3.3.2.4. The above is only a “first-order” condition for a maximum (meaning that it must hold for a value of q to maximize profits, but it doesn’t guarantee that a given q actually does maximize profits 1.3.3.2.5. The second-order condition for maximization is that at q* it must be the case that Or 1.3.3.2.6. That is, marginal cost must be increasing at q* if it is a true maximum 1.3.3.3. We can use the above to “predict” how a firm will react to a change in price 1.3.3.3.1. Differentiate the first-order condition with respect to p and get Rearrange to get 1.3.3.3.2. So, the model predicts that when price increases q* should increase as well.Chapter 1 lecture outline AAEC 3315, Benson 3 1.3.3.4. One testable implication of the profit maximization model is that output should increase with output prices; if producers fail to increase output when price increases, the model can be rejected. 2. General features of economic models – most models, despite their variety, incorporate four common elements 2.1. Ceteris paribus assumption 2.1.1. To be useful, models are meant to portray simple relationships 2.1.2. Economic models assume that many “outside” forces are held constant to keep the model simple 2.1.3. We don’t assume that other factors don’t exist, just that they aren’t necessary to understand the variables modeled explicitly. 2.1.4. The ceteris paribus assumption makes real-world validation difficult 2.1.4.1. Imagine a simply model of gasoline demand: , where dg is gasoline demand per month, in 1,000s of gallons, pg is price per gallon, and a, b > 0 2.1.4.1.1. What factors are being held constant in this model? 2.1.4.1.2. What are the testable implications of this model? 2.1.4.2. Suppose that, in one month, price is $3.00 per gallon, and total consumption is 51,250 gallons; then in the next month, price goes up to $3.50/gallon, but consumption increases to 51,500 gallons 2.1.4.2.1. Does this observation invalidate the model? 2.1.4.2.2. Why or why not? 2.1.4.3. Controlled economic experiments are difficult to design and conduct, so we end up having to rely on statistical methods to control for outside forces 2.2. Structure of economic modelsChapter 1 lecture outline AAEC 3315, Benson 4 2.2.1. Most economic models are mathematical 2.2.1.1. Math is useful for describing relationships between variables 2.2.1.2. Variables in models fall into one of two classifications: 2.2.1.2.1. Exogenous variables – variables determined outside of a model (or outside of a decision-maker’s control) 2.2.1.2.2. Endogenous variables – variables determined within models 2.2.1.2.3. Variables that are exogenous in some models (like price for a model of a perfectly competitive producer) can be endogenous in other models (like price in a model of a market equilibrium) 2.2.1.2.4. Exogenous/endogenous variable distinction is closely related to the ceteris paribus assumption 2.2.1.3. Being comfortable with the mathematics used in constructing economic models is necessary for competency in intermediate micro 2.3. Optimization assumptions 2.3.1. Most models assume that economic actors pursue some goal rationally 2.3.2. This is modeled by assuming that actors optimize some value 2.3.2.1. Utility maximization, profit maximization, cost minimization 2.3.3. The rationality assumption is popular, despite being unrealistic, because of its ability to predict real-life outcomes 2.4. Positive-normative distinction 2.4.1. Economists are careful to differentiate between “positive” and “normative” questions 2.4.1.1. Positive theories describe the world as it exists 2.4.1.1.1. Ex: what happens to producer profits and consumer welfare when gas taxes increase? 2.4.1.2. Normative theories describes something that should existChapter 1 lecture outline AAEC 3315, Benson 5 2.4.1.2.1. Ex: taxes on gasoline should be increased to decrease producer profits, because profits are currently too high 2.4.1.2.2. Normative analysis requires a value judgment that defines something as “good” or “bad” 3. The economic theory of value 3.1. Much of economics can be considered an investigation into the value of commodities 3.2. What is value of a good? 3.2.1. In early economic thought (e.g. Smith, Ricardo; in roughly 1750-1850), value was distinguished as different from price 3.2.1.1. Value was either “value in exchange” (price) or “value in use” (intrinsic value) 3.2.1.2. There must be some difference, because some “valuable” things, like water, have much lower prices than things that aren’t as “essential,” like diamonds 3.2.2. Ricardo suggested that price (or value in exchange) of a good is