Explain what is meant by the term ?an economic model? and outline a model of price and output determination in a free market. Examine the effect of a change in real disposable income on equilibrium price and output.
An economic model or theory is a simplified explanation and analysis of economic behaviour. It allows us to predict, and therefore intervene, if we do not like the outcome of a possible chain of events.
Theories and models are mainly derived from past responses to similar stimuli or from statistical surveys, and this information may not always be accurate as it assumes ceteris paribus, or all other things remaining equal. For example, figures may show that the number of people smoking doubled when the price of cigarettes halved in the 1960?s. This does not mean to say that following a similar price reduction today, the response would be the same, as advertising has increased the awareness of the dangers of smoking.
Such a difference in behaviour patterns can be explained when we consider that economics is a social science, concerned with people, who have a free will and cannot be made subject to laws. This also explains why many models are generalised, dealing with trends in economic behaviour rather than the choice of the individual, as this varies and is difficult to surmise and predict.
A market is a place where buyers and sellers communicate for the purpose of the exchange of a good. In free market, the price of a good can fluctuate, determined by supply and demand.
When economists discuss demand, they mean effective demand, or how much people will want, and can afford to buy at any given price of a product. This means that demand is dependent on price. The graph above is a demand curve that illustrates...