The Economist’s Toolbox Unit 1 1.How do economists figure out an economic situation? 2.How are models and assumptions linked together? 3.Explain how economists use graphs.

Three steps Identify the problem Develop a model Collect data & test the model

Identifying the Problem Law of unintended consequences poses an issue, as economists are not able to see every problem Do not have formal laboratory experiments; must rely on analyzing existing/historical data (“natural experiments”) Use of scientific method

Developing a Model Model—simplification of reality used to understand the relationship between two things that can change (variables) –Also known as a theory –Emphasizes two most important variables, ignores the rest---“ceteris paribus” (assumes all other relevant factors remain the same) Models must include an assumption—something accepted as being true –Explain and predict how the economy operates –Useful only if it creates accurate predictions; otherwise model is rejected

Rational-behavior model—people behave in ways that are rational (that which will fulfill needs/wants the most) –Homo economicus “economic man” model The models are represented often as diagrams, equations, or graphs, which economists use to show the relationship between the two variables –Direct relationship—positive relationship between two variables (if one increases/decreases and the other does the same) –Inverse relationship– negative relationship between variables (if one increases/decreases, the other does the opposite)

Direct relationship PointPC expenditure (thousands $/yr.) Annual income (thousands of $) A$1$30 B260 C390 D4120 PC Expenditures (thousands/yr) Annual Income (thousands $)

Inverse relationship PointPrice per game (dollars) # of Video Games purchased A$8025 B6050 C4075 D20100 Price per game (dollars) # of Video games purchased

Collect data, test the model Economist gathers data from various sources relevant to their question Analyze data and interpret it using a model If data supports the model, then the model is valid.