Economic Models and Market Structures

What is an Economic Model?

An economic model is a simplified representation of reality, designed to clarify relationships between economic variables and predict outcomes when variables change. Models are essential tools in economics for understanding complex systems.

• Components of a Model: Typically includes a small set of variables, explicit assumptions, an equation, and often a graph.

• Purpose: To act as a 'map'—not a perfect depiction, but a useful abstraction for analysis.

Perfectly Competitive Market Model

The perfectly competitive market is a foundational model in economics, characterized by:

• Many buyers and sellers

• Identical products sold by all firms

• No barriers to entry for new firms

Buyers aim to maximize their utility given their income, while sellers aim to maximize profit.

Demand and Supply

Demand

• Individual Demand: The demand of a single consumer.

• Market Demand: The sum of all individual demands for a good or service in a market.

• Demand Schedule: A table showing quantities demanded at various prices.

• Demand Curve: A graph showing the relationship between price and quantity demanded.

• Quantity Demanded: The amount a consumer is willing and able to purchase at a given price.

Law of Demand

• Holding all else constant, as the price of a product falls, the quantity demanded increases; as the price rises, the quantity demanded decreases.

Shifts in Demand

Factors other than price that shift the demand curve:

1. Income

2. Prices of related goods (substitutes and complements)

3. Tastes and preferences

4. Population and demographics

5. Expected future prices

6. Natural disasters and pandemics

• Normal Good: Demand increases as income increases.

• Inferior Good: Demand decreases as income increases.

Examples

• Increase in income raises demand for new clothes (normal good), but lowers demand for secondhand clothes (inferior good).

• Natural disasters may decrease demand for most goods but increase demand for essentials.

Supply

• Quantity Supplied: The amount a firm is willing and able to supply at a given price.

Law of Supply

• Holding all else constant, as the price increases, the quantity supplied increases; as the price decreases, the quantity supplied decreases.

Shifts in Supply

Factors that shift the supply curve:

1. Prices of inputs

2. Technological change

3. Prices of related goods in production

4. Number of firms in the market

5. Expected future prices

6. Natural disasters and pandemics

• Higher input prices decrease supply; lower input prices increase supply.

• Technological improvements increase supply.

• More firms in the market increase supply; fewer firms decrease supply.

Measuring Economic Activity: GDP

Gross Domestic Product (GDP)

GDP is the market value of all final goods and services produced within a country during a specific period.

• Market Value: Uses prices to value production.

• Final Output: Only counts final goods/services, not intermediates.

• Domestic Production: Only production within a country's borders counts, regardless of ownership.

• Flow Over Time: Measures new production within a year or quarter.

Value Added

• Only the value added at each stage of production is counted to avoid double-counting.

GDP Identity

• Production = Income = Expenditure

The expenditure approach formula:

• C: Consumption (household spending)

• I: Investment (business, residential, inventories)

• G: Government purchases

• NX: Net exports (exports minus imports)

Consumption is typically the largest component; net exports can be negative.

Income Components

• Labor Income: Wages and salaries

• Capital Income: Profits, interest, rents

Measuring Inflation

Price Level and Inflation

• Price Level: A measure of the average prices of goods and services, usually expressed as an index number.

• Inflation Rate: The percentage change in the price level from one period to the next.

Formula for inflation rate:

Measures of the Price Level

• GDP Deflator: Measures the price of all goods and services included in GDP.

• Consumer Price Index (CPI): Measures the average change over time in prices paid by urban consumers for a market basket of goods and services.

• Producer Price Index (PPI): Measures the average change over time in the selling prices received by domestic producers.

Consumer Price Index (CPI)

• CPI is a weighted average; goods with larger spending shares have more influence.

• Problems with CPI:

  • Substitution Bias: Consumers switch to cheaper alternatives.

  • Quality Adjustment: Some price increases reflect improved quality.

  • New Products: New goods may not be immediately included in the basket.

• CPI is useful but not a perfect cost-of-living index.

Nominal vs. Real Values

• Nominal Wage: Dollar amount earned.

• Real Wage: Purchasing power of earnings (adjusted for inflation).

• Formula for real wage (example with apples):

• Nominal interest measures dollar growth; real interest measures purchasing power growth.

• High inflation erodes the purchasing power of future repayments.

Measuring Unemployment

Employment Classification

• Employed: Currently has a job or is temporarily away from work.

• Unemployed: Not working but available and actively seeking work in the past month.

• Not in the Labor Force: Neither employed nor unemployed (e.g., not seeking work).

Key Definitions and Formulas

• Labor Force: Employed + Unemployed

• Unemployment Rate:

• Employment Rate:

Types of Unemployment

• Frictional Unemployment: Short-term, due to job search; normal in a dynamic economy.

• Structural Unemployment: Mismatch between worker skills and job requirements; may require retraining.

• Cyclical Unemployment: Caused by business cycle downturns; temporary but can be severe.

Natural Rate of Unemployment

• Sum of frictional and structural unemployment; represents "full employment".

• In the US, typically 4.0–5.0%.

Factors Affecting Unemployment

• Government Policies: Unemployment insurance, minimum wage laws, training programs.

• Labor Market Institutions: Labor unions, efficiency wages.

Long-Run vs. Short-Run Analysis

Long-Run Economic Growth

• Long-run analysis: Focuses on trends and economic growth.

• Main measure: Real GDP per capita ()

• Represents average standard of living.

• US Real GDP per capita has increased more than eightfold since 1900.

Growth Rates

• Short-term growth rate: Average of annual rates (e.g., for 2018–2020).

• Long-term growth: Use compound growth formula:

• Rule of 70:

• Example: 4% growth doubles in 17.5 years; 3% in 23.3 years.

Short-Run Fluctuations: The Business Cycle

• Business Cycle: Alternating periods of expansion (rising GDP) and recession (falling GDP).

• Peaks: Transition from expansion to recession.

• Troughs: Transition from recession to expansion.

Effects on Inflation and Unemployment

• During expansions: Higher demand, higher inflation, lower unemployment.

• During recessions: Lower demand, lower inflation or deflation, higher unemployment.

Other Key Concepts

• Disposable Personal Income: Personal income minus personal taxes; reflects income available for spending and saving.

Summary Table: Types of Unemployment

Additional info: Where formulas or definitions were referenced but not explicitly given, standard macroeconomic definitions and equations have been provided for completeness.