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Evaluation Of Economic Decisions

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Questions:

1.Economic Models are False and so Government should Ignore their Predictions. Explain, discuss and evaluate the accuracy of this statement.

2.Using the Economics or Other Literature (but not the textbook) to Identify Estimates of the Price Elasticity of Demand for at least three different Products. Provide full Citations for the Employed Literature. Comment on the magnitudes of these estimates in relation to the standard economic determinants of the Price Elasticity of Demand.
 
 

Answers:

Economic Models

1.Today, economic models have become a major component in decision making in the modern economy. Generally, these models are used by the federal and local governments for analysis and evaluation of economic decisions. Particularly, these models are useful in making forecasts about the performance of various activities in the country. They also enable agents in the economy to carry out simulations of different economic scenarios to achieve specified results.    Furthermore, they are useful in forecasting the implications of economic policies initiated by the government to the performance of the general economy. For this reason, it is imperative for one to argue that economic models are an essential component in the functioning of the general economy, and their predictions should be implemented by governments to attain economic efficiency.  

2.Primarily, economic models offer a useful foundation for governments to formulate production decisions. Particularly, models such as the production possibility frontier (PPF) provides useful information on the possible combination of two products that can be produced within the country, given the available set of factor inputs (“PPF,” n.d.). Using this model, government agents can determine the production tradeoffs of the economy. Also, using its resources it can establish the optimal point of production. In the process, they can discern the different combinations products that can be produced within the economy. This way, the nation can attain production efficiency given a particular production set amidst the scarcity of resources. In this regard, the use of the PPF in making predictions about production is useful as it allows the country to produce efficiently and use its resources in the best way possible.

The Production Possibility Curve

                                                 


Source: (Khan, n.d.).

In addition to this, economic models help the government in making decisions about international trade. To be specific, the concept of comparative advantage is applied by economic agents to determine the country’s area of specialization (Beggs, 2014). Basically, this model allows decision makers to determine which product to specialize production on, given that it has a comparative advantage over its trading partners. As such, a country has a comparative advantage over another if it can manufacture the commodity at lower cost others. Therefore, given the economy’s natural resources and factor endowments, policymakers can determine the products to specialize in for international trade (“Comparative Advantage,” n.d.). Likewise, the model enables decision makers to determine which products the country has a comparative disadvantage in, and thus decide to import. By specializing in a product, the nation can reap more benefits from trade. In turn, this highlights the usefulness of economic models in making viable predictions for government implementation.

Furthermore, these models are useful in the determination of a state’s absolute advantage. Predominantly, absolute advantage pertains to the capability of one country to produce higher quality products at a faster rate than others. For this reason, a nation’s absolute advantage or disadvantage plays a significant role in the type of products that it produces. Specifically, this concept is adopted by the government to determine commodities that it can produce better and faster than its trading partners in the international community (Khan, n.d.). Consequently, the country can devote resources and manpower in the production of goods that it has an absolute advantage and import those products that it has an absolute disadvantage. Consequently, this saves time and resources. Besides, the nation benefits more from trading in a good that it has an absolute advantage than when it trades in a commodity that it has an absolute disadvantage. 

Example

 

Country A

Country B

cars

20

25

Trucks

5

10

Source: (Beggs, 2014).

In this example, country A can produce 20 cars or 5 trucks while country B can produce 25 cars or 10 trucks. In this case, B has an absolute advantage in producing both products but a comparative advantage in producing trucks since it is relatively better in producing trucks (Beggs, 2014).

Above all, economic models are important in making predictions about the effects of economic policies implemented by the government. From the model of the circular flow of income, economic agents can understand the extensive coordination and interconnectedness between households, firms, and the economy in general. Through this model, one can establish that any changes in tax policies, interest rates, investments affect the entire economy. With this in mind, it can implement policies that have minimal effects on the households and firms. Therefore, economic models are vital and should not be ignored. Instead, the government should adopt them in decision making to achieve efficiency in the economy.

Price Elasticity of Demand

Typically, price elasticity relates to the sensitivity of consumers to variations in the price of a commodity. According to the law of demand, as the price of a commodity rises, its demand declines ceteris paribus (Khan, n.d.).  

Estimating PED

PED = Percentage change in quantity demanded

                     Percentage change in price

Price Elasticity of Luxury Goods

Typically, luxury goods have a relatively elastic demand. Thus, a proportionate change in the price of the good results in a greater change in its demand (Moffatt, 2016).

Example

Suppose the price of a refrigerator changes by 20 percent and the demand changes by 40 percent.

PED = 40/20

ep= 2.0.

Interpretation.

A slight increase in its price brings about a substantial decline in its demand. The magnitude of the elasticity is 2. Hence, every time the price of the product changes by one unit, its demand changes by 2.0 units. Consequently, it can be deduced that the product is relatively elastic.

 

Price Elasticity of Essential Products

Markedly, basic goods and services have a relatively inelastic price elasticity. Explicitly, a unit change in the price of the product results in a less than proportionate variation in its demand (Mulugeta et al., 2013).

Example

Assume that the price of salt increased by 20 percent. Despite the increase in price, the demand for the commodity declined by 10 percent only.

PED = 10/20

ep= 0.5

Interpretation

The magnitude of consumers’ responsiveness to changes in the prices of salt is 0.5. Therefore, when the price of salt increases by one unit, its demand drops by only 0.5 units. For this reason, it can be concluded that the product has a relatively inelastic demand.

Unitary Price Elasticity of Demand

A product has unitary elasticity if a unit change in its price results in a unit change in its demand (Russo et al., 2013). In reality, there are no products that have a unitary elasticity. However, a close example is clothing, whose supply and demand changes proportionately to variations in price.

Example

Assume the price of a shirt changes by 20 percent. Likewise, its demand changes by 20 percent.

PED = 20/20

ep = 1

Interpretation

The magnitude of the elasticity is 1. Thus, a change in the price of a shirt by one unit will result in a variation in its demand by 1 unit. Therefore, the shirt has a unitary elasticity of demand.

 

References

Beggs, J. (2014). Absolute and Comparative Advantage. ThoughtCo.com. Retrieved from https://www.thoughtco.com/absolute-and-comparative-advantage-1146792.

Comparative Advantage. Library of Economics and Liberty.  Retrieved from https://www.econlib.org/library/Topics/Details/comparativeadvantage.html.

Khan, S. Comparative Advantage and Absolute Advantage. Khan Academy. Retrieved from https://www.khanacademy.org/economics-finance-domain/microeconomics/choices-opp-cost-tutorial/gains-from-trade-tutorial/v/comparative-advantage-and-absolute-advantage.

 Khan, S. Price elasticity of demand. Khan Academy. Retrieved from https://www.khanacademy.org/economics-finance-domain/microeconomics/elasticity-tutorial/price-elasticity-tutorial/v/price-elasticity-of-demand

Moffatt, M. (2016). Price Elasticity of Demand. ThoughtCo.com. Retrieved from https://www.thoughtco.com/price-elasticity-of-demand-overview-1146254.

Mulugeta, D., Greenfield, J., Bolen, T., & Conley, L. (2013). Price- and Cross-Price Elasticity Estimation using SAS. SAS Global Forum.  Retrieved from https://support.sas.com/resources/papers/proceedings13/425-2013.

Production Possibility Frontiers. Economics Online.  Retrieved from https://economicsonline.co.uk/Competitive_markets/Production_possibility_frontiers.html.

Russo, C., Green, R., & Howitt, R. (2013). Estimation of Supply and Demand Elasticities of California Commodities. Department of Agricultural and Resource Economics University of California, Davis.  Retrieved from https://www.cdfa.ca.gov/files/pdf/Demand&SupplyElasti
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