I pick up the gauntlet
Published by Ravikiran Rao February 9th, 2004 in EconomicsGautam claims below that the approach required to understand economics is different from the one that I would use as an engineer. I beg to differ. Rather than argue over theory, I would like to prove him wrong by explaining Macroeconomics the way I understand it, which I believe is the way a physicist would construct the whole theory. He’d be surprised how easy it is to model complex reality starting from simple models. I’ll do it using a series of posts, and here is post no 1.
Suppose that there is a small economy consisting only of two people, me and Yazad. The economy has only one activity, growing wheat. The currency base of the country consists of one hundred rupee note. The land is owned by Yazad and I work for him. At the end of every year, Yazad pays me using the 100 rupee note, and I immediately buy from him half the wheat that we grow using that hundred rupee note. The other half Yazad consumes.
Question: What is the GDP of this economy?
200?
The GDP, is equal to the total value of the commodity that is produced, ad in this case it is Rs. 200?
Well, I was thinking about what I had written in this context, and I’d like to point out, that Neoclassical Economics, which is current mainstream and provides the toolbox, that is often used by Socialist minded economists, to highlight such problems as “monopoly power, “market failure” etc. is very closely associated with the physicists perceptions of modelling and uses techniques developed in mathematical physics.
Yazad will be better able to point out the major problems of the Neo-Classicals.
That was a sweet illustration of GDP. Thanks! Makes me glad to be back!
100! the cost incurred by yazad is rs 100, its immaterial at what rate he sells the wheat to ravikiran, the produce therefore (i.e. to mr yazad & and since no other substance is produced in the country, it has to be 100)
the answer being the value of produce ie. the qty of wheat produced is the gross domestic product of the economy valued in real terms. no matter whatever be the price charged/claimed by yazad. in this case the gdp is 100 ie real gdp
its 100 in real terms, the value of the produce irrelevant of the cost charged by yazad. in this case the nominal gdp is 200 and the real is 100
so, if I were to dig oil from the ground and sell it, it wouldn’t count in the GDP, right gk?…I don’t employ anybody, by the way..and I built my own rig!
The GDP of the island is the wheat we produce. (GDP=Gross Domestic Product) Ravi tills the land that I own and he gets half the wheat produced. The 100 rupee note seems to be a worthless piece of paper. I don’t see anywhere else that either he or I could “spend” the money. The exchange needs in a two person economy can be completely fulfilled by barter.
BTW, this example looks suspiciously like the famous Robinson Crusoe model with me as Crusoe and Ravi as Man Friday ;-)
However superflous it may be, it’s still the “monetary” system of “your” island..and the produce measured in its terms is 200.
I think I know where ravikiran is headed, but I still think gautam had a point when he said: “…it is the Ideological pre-disposition of an economist, that taints his use of economics tools. Statistics, mathematics and even economic theory on their own are rather sterile, it is the value judgements that economists carry with them a priori that determine the interpretations that they proffer.”
I think that’s a difference between the more disinterested (as synonymous to unbiased) enterprises of knowledge like the physical sciences and technology and ‘humanity’ oriented enterprises like economics. I must also add, in response to gautam’s ‘different in approach’ remark, that all our knowledge is ’synthesis’ in method. synthesis defined as: the composition or combination of parts or elements so as to form a whole.
—-So, if I were to dig oil from the ground and sell it, it wouldn’t count in the GDP, right gk?..—
Yes it would if your country produces only one oil!
yazad: Yes barter is suffuucent here but i believe Ravi is trying to make a point!!
:)
GDP = The sum of all the products and services of an economy produced in the year - plus net income from abroad = Since we can discount net income from abroad - GDP = The quantity or the value of the wheat produced + the cost of Ravi’s labour
GDP therefore = Rs 200 (Wheat’s value) + Rs 100(Ravi’s wages). Rs. 300
Is that right?
Yes of course the needs of this simple island can be fulfilled by simple barter, but yes of course I am making a point. The point being that virtually the whole of macroeconomics can be built up using simple models. A whole lot of problems, controversies etc. can, if not be resolved, at least be *illustrated* by using simple models. I am then going to claim that my scientific method, is superior to the emprical method economists seem to be using.
Sorry for the superfluous comma after “scientific method” in the previous comment and sorry for this superfluous comment.
What according to you is “macroeconomics”? And in what way does your two-person, one-product economy illustrate it?
I think your model is trivial. Even Robinson Crusoe, living alone on an island (one-person economy) made many things apart from food (multiple-product economy). Economics textbooks generally look at a two-person, two-product economy model. Anything simpler is trivial. And even this two-person, two-product economy does not require money. Money enters the equation only when there is a “cost” in barter transactions — at least 3 person economies.
Not all economists are “empiricists” — the school closest to libertariansm, the Austrian school is largely a priori. Mises, for example, preferred to ignore empirical data and depended upon deductive logic instead. His work “Socialism”, published in 1922, argued that
His conclusions in 1922 had no empirial backing. That came more than 50 years later. And proved him right.
I’m no economist, and I never pretend to understand all this, but how do you create mathematical models for human behaviour which isn’t always predictable?
Just as a thought experiment, let’s take your ultra simple two person economy.
Yazad the cruel glutton decides that since he’s now started going to the gym, he needs to eat more food to put on more muscle. Instead of selling half the produce to Ravikiran, he eats 75% of it, giving Ravi only 25%. As a result, Ravi grows weaker and is not able to work as hard. The wheat production drops to 80% of what it used to be because of Ravi’s failing health. This obviously affects the GDP of the economy. Yazad fires Ravi because of his incompetence and decides to work the farm himself. Ravi now has no money and no food. Etc. etc.
Even a two person and single product economy has problems.
:)
See my follow up post. I’ve started complicating things over there.
My point is that I’ve created this simple model to understand how GDP is calculated and the problems inherent in that assumption. I know that this two-person economy cannot exist in practice. But I am assuming them and making them carry out these artificial transactions because that is a way to understand that GDP is a measure of *value*. That is actually how *I* understood GDP.
GK: I can only say you are wrong!
madman: I don’t think ravi’s staking claim for perfect mathematical models…and I guess he implicitly assumes such kind of limitations.
… typo typo i meant only one product, “oil”!! but then that’s ok if iam wrong it was a thought over guess not exacly a, “I know my stuff” variety! :)