Models and Methodologies in Economics

What is a Model? A Model is a simplified representation of reality. Economic models are based on certain assumptions. Assumptions simplify the complex world and make it easier to understand.

Assumptions of Economic Laws

Ceteris Paribus

Psychological

Assumptions
Structural

Institutional

Ceteris Paribus
Latin word meaning Other things being constant. The dynamic nature of economy makes economic phenomena 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.

Psychological Assumption

Rationality

Consumers try to maximize utility

Producers try to maximize profits

Factor owners try to maximize factor income

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

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

Methodology in Economics

Economic Methodology

Logical Reasoning

Induction Deduction

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.

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.

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.

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.

Characteristics of Economic Laws

Economic laws are statements of economic tendency. Economic laws are based on certain assumptions. Economic laws are relative.

Economic laws are human laws. Certain economic laws are universal.

Circular Flow of Income

The flow of money and goods& & Services in an Economy The Flow of Money and Goods services in an economy in a cyclical manner. in a 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

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)

Two Sector Model Without S &I

Equilibrium
Real Flow = Money Flow

Real Flow Money Flow

Flow of factors of production, goods& services Factor payments + consumption expenditure Real Flow Money Flow

Outer loop of the circular flow diagram Inner loop of the circular flow diagram

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)

Two Sector Model With S &I

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

Circular Flow with Government Sector

Govt. Intervention in the Economy

Taxation

Govt. Expenditure

Households From the Firms - Wages &Salaries - Transfer Payments Firms - Purchase of Goods - Subsidies

From the Households

Circular Flow in a Three Sector Economy

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

Circular Flow in a Four sector Economy

Foreign Trade Sector

Households

Firms

Export Manpower

Import Goods & Services

Export Goods & Services

Import Raw materials machines

Receive Remittances

Make Payments

Receive Payments

Make Payments

Circular Flow in a Four sector Economy

Production Possibility Curve(PPC)

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 problem What to Produce?. It deals with allocation of scarce resources.

Assumptions
Given Resources Given Technology Full Employment Short Period Analysis

PPC
B,D & C are Efficient Points Unattainable Point

Inefficient Point

Slope of PPC
Slope of PPC = Marginal Rate of Production Transformation (MRPT)

MRPT =Y/X

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 other commodity. This sacrifice is inevitable because of the resource scarcity.

PPC

Upward Shift PPC

PPC Inward shift

Shift due to Technical Progress