Lecture by: Jacinto Fabiosa

Fall 2005

Methodology in Economics

2

Modeling

• Modeling – simplified (abstract) representation of relationships of agents and variables that exist in reality.– Structure of model

• Identify economic agents and objective• Identify decision variables and given variables• Specify relations of variables

– Outcomes• Decision rules• Equilibrium conditions

3

Modeling

• Determined in the model – values they take are determined in the model (e.g., quantity demanded)– Endogenous variables– Decision variables– Dependent variables

• Given or assumed in the model – values they take are given or assumed (e.g., income of households)– Exogenous variables– Independent variables

4

Modeling

• Representation of relationships of variables in a model

– Table form presentation of data

– Graphical form

– Functional form• Individual equations or systems

• Specific functional forms (e.g., linear, quadratic, logarithmic, exponential)

• Specific parameters

5

Tables of Related Variables

Advertising ($1,000s per Month)

Sales ($1,000s per Month)

2 46 3 49 6 58 7 61

11 73 12 76

Table A.1 Advertising and Sales at Len & Harry’s

6

Graphs of Related Variables

7

Graphs - Curves

8

Slopes and Intercepts

9

Shifts in the Graphs

10

Shifts in Lines and Curves

11

Solving Equations

Y = 40 + 3X

• If X = 4, solve for YY = 40 + 3(4) = 40 + 12Y = 52

• If Y = 64, solve for X64 = 40 + 3X3X = 64 – 40 = 24X = 24/3X = 8

12

Solving Equations

Equation 1 Qd = 500 – 50PEquation 2 Qs = 50 + 25P

Solve for Qd, Qs, and P

• Equate the two equations, i.e., Qd=Qs 500 – 50P = 50 + 25P

• 1 equation 1 unknown, solve for P 500 - 50 = 50P + 25P 75P = 450 P = 450/75 P = 6

• Substitute P=6 in either equation 1 or 2 Qd = 500 – 50(6) = 500 - 300 = 200 Qs = 50 + 25(6) = 50 + 150 = 200

13

Applied Modeling Process

• Specification – edogenous-exogenous variables and their functional form

• Estimation of parameters• Validation

– Theoretical consistency of estimates• Signs

• Magnitudes

– Statistical properties of estimates• Fit

• Significance

– Forecasting performance of model