ajaz_eco204_2009_chapter_2.1

ajaz_eco204_2009_chapter_2.1 - University of Toronto,...

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University of Toronto, Department of Economics, ECO 204 2009 2010 S. Ajaz Hussain ECO 204 2009 2010 S. Ajaz Hussain (Draft) Chapter 2.1: Consumption and Convex Sets, Preferences, Felicity Plots, Indifference Curves Please help improve the course by sending me an e mail about typos or suggestions for improvements 0. About Economic and Scientific Models We begin ECO 204 by modeling consumer preferences and behavior, in particular how consumers make optimal choices and how these choices react to changes in the economic environment. Since we will be working with models in economics and finance, it is important to understand what a scientific model is. Economics, like finance, is a social science which uses scientific models to understand and investigate economic, social and human phenomena. It is important to note that models are deliberate abstractions of reality. Models are not meant to understand and explain every detail of reality; rather, models seek to capture salient aspects of reality. That models ‐‐ being exactly that ‐‐ do not purport to predict everything, is a point lost on those who of late have criticized economic and finance models for “failing to predict” the recent economic crisis 1 . Many disciplines, including physics, have long accepted the fact that no model can explain everything 2 . Indeed, no model should explain everything: a model that explains everything (such as homeopathy or Marxism) is unscientific 3 as it can never be tested. 1 See for example Paul Krugman’s How Did Economists Get It So Wrong? and John Cochrane’s , David Levine’s responses. 2 For example, in physics, you cannot simultaneously predict the position and momentum of a particle. One way that modern science deals with prediction is by introducing probability ‐‐ rather than trying to predict with 100% accuracy, models attach a probability to an event. When probability theory was introduced as a mechanism to deal with the “unknown”, it created a great deal of controversy. If interested, read Against the Gods: the remarkable story of risk . 3 If you’ve ever taken a philosophy of science course you know that a theory that explains everything is not scientific. If you get the chance, do read Karl Popper’s Logic of Scientific Discovery and Imre Lakatos’s Criticism and the Growth of Knowledge . 1 ECO 204 (Draft) Chapter 2.1
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University of Toronto, Department of Economics, ECO 204 2009 2010 S. Ajaz Hussain Scientific models proceed by making simplifying plausible assumptions. We make assumptions because we know that we cannot incorporate every detail of reality. For example, if we’re trying to explain how much money someone spends each month on consumption (and therefore savings) we’d recognize that in reality several factors determine consumption: age, size of family, income, wealth, etc. If we try to incorporate every one of these factors, our model will very quickly become unwieldy and intractable.
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This note was uploaded on 05/02/2011 for the course ECO 204 taught by Professor Hussein during the Fall '08 term at University of Toronto- Toronto.

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ajaz_eco204_2009_chapter_2.1 - University of Toronto,...

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