CSCI 1210

Economic Models – a brief overview

Introductory Example:

In early 2003 President Bush proposed a massive, multi-year tax cut. He described this proposal as a badly needed economic stimulus package.

His political opponents in the Democratic Party described the proposal as an unconscionable giveaway to the rich.

Conservative commentators responded that these criticisms amounted to class-warfare rhetoric.

How can we evaluate these claims? Is it possible to judge on the basis of economic theory, or is this purely a subjective question of values?

Some specific questions:

1. How much tax benefit will the average person receive?

2. Will the majority of the benefits go to rich, poor, or middle-class taxpayers?

3. How much will the tax cut stimulate the economy in the next year?

4. What will be the long-term effects on the economy and budget deficits?

5. Is it a good idea to stimulate the economy?

6. Is it OK if most of the benefits go to wealthy taxpayers, or is this unfair?

How we answer these questions:

(1-2) These are considered questions of fact; we have confidence that they can be accurately answered using Government economic statistics.

(3) This is a projection using economic models; it is fairly non-controversial

(4) This is also a projection, but the models are controversial. It should be a question of fact, but it is not!

(5) This is a value judgment, but non-controversial. Almost everyone agrees more economic growth is good at this time

(6) This is a highly controversial value judgment.

Some interesting questions involving economic models:

1. Effects of medical cost inflation

2. Average income vs. income inequality

3. Keynesian vs. supply-side economics

4. Cost of mitigating global warming

5. Future of Social Security and Medicare

Effects of medical cost inflation

In recent years medical costs have consumed an increasingly large portion of our total national income (Gross Domestic Product). Here is a worksheet for investigating this. Try these scenarios:

1. GDP grows at 4.9% year and national health care costs grow at 7.4%

2. Salary grows at 2% per year and health insurance premiums grow at 7.4%

3. Salary grows at 2% per year and health insurance premiums grow at 10%

Click to see the full text of the US government report from which these estimates are taken

Average income vs. income inequality

Economic statistics are like a keyhole through which we view the vast complexity of economic data.

The average is a simple linear model that tames the complexity of the real world. Sometimes important details may be lost – see the “Inequality” tab of the worksheet above.

Do you choose to view income through the “average” keyhole, or try to see the details? It depends on:

1. How much detail you can tolerate;

2. Whether you think inequality is important;

3. Whether you think the details help or hinder the point you are trying to prove.

Keynesian vs. Supply-side economics

The basic factors of production are labor and capital. We will leave technology out of this simple model.

Demand is people wanting to buy stuff, which encourages producers to make it.

Two theories on how to increase production:

1. Increase aggregate demand (Keynesian economics, after John Maynard Keynes, 1883-1946)

2. Increase the supply of labor and especially capital (supply-side economics)

How to increase aggregate demand:

1. Tax cuts to people who will spend it

2. Government spending

How to increase supply:

1. Tax cuts to people who will save it

2. Eliminate welfare, encouraging people to work

Which theory is more correct?

The answer should be a scientific question, but in reality tends to be an ideological one! (People favor the theory that best fits their political viewpoint)

Costs of Mitigating Global Warming

This graph from the report, Multi-Gas Contributors to Global Climate Change by the Pew Charitable Trust, deals with the marginal costs of reducing greenhouse gasses.

A ‘rational person’ would pick the cheapest opportunity to save carbon first, then the next cheapest, etc.

The marginal cost of the first batch of carbon saved: $50/ton

The marginal cost of the second batch of carbon saved: $100/ton

The marginal cost of the third batch of carbon saved: $150/ton

n As Mr. Economic Man is forced to choose more and more expensive opportunities, the marginal cost goes up. Perhaps, it is better to choose some other gas besides C0₂.

n This “bottom-up” model predicts a low cost for avoiding global warming. Other ‘top-down’ models predict a higher cost.