Economic Theory and Models

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C. Economic Theory and Models
Economic models are a formal representation of economic theory. Economic models follow the principle of Ockham’s Razor which state that irrelevant detail should be cut away. Like a road map, economic models are simplified generalization of reality that helps explain economic behavior. Models can be expressed in words, graphs or mathematical equations. In this course, we’ll be using mathematical equations to illustrate relationships between two or more variables. A variable is a measure that can change over time or across observations.

Oftentimes, there can be many variables that could explain an outcome you observed. For example, if there is an increase in auto sales at the local car dealership. The upsurge in sales could be due to a host of factors such as lower prices, increase in consumer income, higher prices in a competing dealership, etc… How do we know which variable caused the higher sales at the dealership? Economists will look at only one variable at a time and try to isolate its effect. This idea is called ceteris paribus (all else equal). In the economic model, we will assume that only 1 variable is changing at a time and hold all other variables as fixed. By doing this we can clearly analyze the relationship between two variables, by holding all other variables unchanged.

When examining the relationship between two variables you should keep the following pitfalls in mind: (1) The Post Hoc Fallacy: This is a common error made in thinking about causation between two variables. If Event A happens before Event B, it is not necessarily true that A caused B. The post hoc fallacy is the incorrect belief that because event B occurs after event A then A caused B. This is closely related to correlation and causation. Correlation refers to things happening together. Just because two variables move closely together doesn’t mean one causes the other. Example: The following statement shows the...
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