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.
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.
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.
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.
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.
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.
Types of Equilibrium:
Ceteris paribus is at the root of partial equilibrium.
Changes in one variable are considered, keeping all other things fixed.
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.
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.
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.
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.
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.
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.
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.