ECN104 Lecture 2

Models and Data

Introduction to Economic Models

Economic models are essential tools used by economists to simplify and represent complex real-world phenomena. By focusing on key relationships and variables, models help economists analyze and predict economic behavior.

• Model: A simplified description of reality, often using mathematical or graphical representations.

• Data: Empirical evidence used to evaluate the accuracy of models and understand how the world works.

• Correlation vs. Causality: Correlation refers to a statistical relationship between two variables, but does not necessarily mean that one causes the other.

• Experiments: Controlled or natural experiments help economists measure cause and effect, distinguishing correlation from causality.

Evidence-Based Economics

Opportunity Cost of College

Economists use evidence and data to evaluate decisions, such as whether attending college is worth the investment. Opportunity cost is a key concept in microeconomics, representing the value of the next best alternative forgone.

• Tuition and Fees (Toronto Metropolitan University, 2023-2024):

  • Domestic: $7,236—$13,288

  • International: $35,072—$40,485

• Opportunity Cost: The minimum wage as of October 1, 2025 is $17.60 per hour. For 50 hours per week over 28 weeks, the opportunity cost is $24,640 per year (before tax).

Example: The opportunity cost of attending college includes both tuition/fees and the income forgone by not working full-time.

The Scientific Method in Economics

Steps of the Scientific Method

The scientific method, also known as empiricism, is the foundation of economic inquiry. It involves two main steps:

• Developing Models: Creating simplified representations to explain aspects of the world.

• Testing Models: Using data to assess how closely the model matches observed reality.

Role of Models: The Wright Brothers Example

Models are not exact replicas of reality but serve as useful tools for experimentation and prediction. The Wright brothers succeeded in building a functional airplane by first testing models in a wind tunnel, demonstrating the value of model-based experimentation.

• Model: A paper airplane or wind tunnel prototype is a model, not a real airplane, but it helps test design ideas.

• Application: Economists use models to test hypotheses before applying them to real-world scenarios.

Returns to Education: An Evidence-Based Example

Modeling the Returns to Education

Economists often use models to estimate the impact of education on future earnings. A common assumption is that each additional year of education increases earnings by a fixed percentage.

• Assumption: One more year of education results in a 10% increase in future earnings.

Example Calculation:

• With 13 years of education: $15 per hour

• First year of college (14 years): $15 \times 1.10 = $16.50

• Second year of college (15 years): $16.50 \times 1.10 = $18.15

• Third year of college (16 years): $18.15 \times 1.10 = $19.965

• Fourth year of college (17 years): $19.965 \times 1.10 = $21.9615

• General formula for nth year: $15.00 \times (1.1)^n$

Hypothesis: Getting a college degree (years 13-16) increases wages from $15 to $21.9615, or 46.41%.

• Percentage increase: $(21.9615 - 15)/15 = 0.4641$

• Model prediction: $(1.1)^4 = 1.4641$

Features of Economic Models

• Not Exact: Not everyone will see their wages increase by 10% with each additional year of education. Averages can mask individual variation.

• Testable Predictions: Models generate predictions that can be evaluated using data.

Empirical Data: Canadian Wages by Education Level

Data from Canada (2016, ages 30-34) shows average wages by education level:

Education Level	Average Wage ($)
No certificate, diploma or degree	31,778
Secondary (high) school diploma or equivalency certificate	39,152
Apprenticeship or trades certificate or diploma	48,785
College, CEGEP and other non-university certificate or diploma	44,535
University certificate or diploma below bachelor level	43,496
University certificate or degree at bachelor level or above	56,182

Comparison: College graduates earn, on average, $56,182 per year, while high school graduates earn $39,152. The wage for college graduates is 43.5% higher, close to the model's prediction of 46%.

Limitations and Signals in Education

• Not all college graduates earn the average wage; there is variation.

• Does finishing university increase earnings by more than 10% over the last year, or does it act as a signal of ability, work ethic, or perseverance?

Additional info: In economics, signaling refers to the idea that completing a degree may indicate certain qualities to employers, beyond the direct productivity gained from education.