An Economic Model is a set of assumptions about economic
variables and their relationships concerning certain aspects of
economic reality.
It is constructed to simplify the complexities of reality in
order to understand the interactions of forces operating in the
economy.
Economic models are constructed by using logic and mathematics
for deducting implications on the basis of assumptions.
3. 1. Ceteris Paribus assumption
Laws and hypotheses of economics are always stated with the
qualifying phrase:
other things being equal.
i.e. Ceteris paribus.
For example, in price theory, analysis of a price change is
carried under ceteris paribus assumption, i.e. assuming supply and
determinants of supply remaining unchanged.
4. Psychological assumptions
The behaviour of an economic man, whether he is consumer or
producer, is normal and that he is a rational person.
The rational consumer seeks to achieve total satisfaction in
his purchases. Law of equimarginal utility, seeks to achieve
utility maximisation.
A firm behaves rationally trying to maximise profits.
5. Structural assumptions
In order to study a particular phenomenon, certain implicit
assumptions about the nature of physical structure, topography of a
region, climatic conditions and biological limitations of human
resources, are to be made.
6. Institutional assumptions
Man being a socio-political animal, his behaviour is influenced
by the social, political and economic institutions of the
time.
Institutional assumptions are specifically related to the type
of economic system and its political setting whether Capitalist,
Govt. controlled or Mixed.
7. Equilibrium
A person is in equilibrium when he regards his actual behaviour
as the best possible under the circumstances and feels no urge to
change his behaviour as long as circumstances remain
unchanged.
In economic analysis, we deal with the equilibrium of a
consumer, a firm, an industry, a factor market and the economic
system as a whole.
8. Types of Equilibrium:
Partial Equilibrium
General Equilibrium
9. Partial equilibrium
Ceteris paribus is at the root of partial equilibrium.
Changes in one variable are considered, keeping all other
things fixed.
10. Advantages of Partial equilibrium
It is simple.
It is useful for prediction purposes.
It easily solves certain problems at micro-level.
It serves as a basis to appreciate and analyse General
Equilibrium.
It helps to review the working of market mechanism in a free
enterprise economy.
It helps to understand how a consumer behaves rationally to
maximise satisfaction.
It analyses the behaviuour of the firm in maximisation of
profits.
11. Limitations of Partial equilibrium
It deals with only one economic factor.
It does not deal with entire economy.
It is based on ceteris paribus.
Its assumptions are unrealistic and hence unsuitable to study
world phenomenon.
Its analysis is incomplete. Its studies only primary effects
and does not consider secondary effects.
Segregating individual behaviour from the rest of the economy
is unrealistic.
12. General Equilibrium
An economy is in general equilibrium when all consumers, all
firms, all factors of production, all industries, all markets are
in equilibrium simultaneously.
All the organisms functioning in an economic system are
accounted in general equilibrium and are presumed to be
inter-dependent.
13. General Equilibrium (contd.)
Two sets of conditions must be fulfilled:
A Subjective Condition: Each individual economic entity is
attaining its maximisation goal.
An Objective Condition: Each market commodity as well as factor
is in equilibrium with its demand equal to supply.
14. General Equilibrium
Walras has presented general equilibrium approach in
mathematical terms through a system of simultaneous equations,
considering a number of variables and their relationships. This is
a highly complicated analysis.
15. General Equilibrium Advantages
It explains the structure, mechanism, operating forces and
working of the economic system as a whole.
It is useful in analysing inter-sectoral changes.
It explains the complexities of commodity and factor markets
and the nature of their inter-relationship.
It examines the functions of prices and price structure in the
economy.
It provides conceptual basis for input-output analysis, used in
planning process.
It helps to study the determinants of functional income
distribution and factor shares in the economy.
It is useful in public policy making.
It is used in modern welfare economics and monetary
policy.
16. General Equilibrium - Drawbacks
It is static in its approach.
It assumes perfect competition, which is unrealistic.
It is a complicated form of analysis, involving a series of
simultaneous equations.
It ignores leads and lags; considers only instant happenings
which is not the case with the real world.
